ECO 9740 Fundamentals of Macroeconomics

Midterm Study Guide

The Midterm Exam will be based on the topics covered from chapters 2, and 5 through to 10 from the course textbook.
The video lectures and accompanying handouts, An Overview of the Macroeconomy, Economic Growth, and The AD – AS
Model (parts 1, 2 & 3) provide very good concept summaries, and outline the topics you should know for the exam. The
lecture activities, Lecture Activity 1 through to Lecture Activity 4, including the additional week 2 activity, and the problem
sets, Problem Set 1, Problem Set 2, and Problem Set 3, provide very good practice questions. As you prepare, you should
try to understand the methodology in addressing these questions and what information the answers provide. Remember
that this is a study guide and although it is very indicative of the test material, it is not exhaustive. There will be 3 short
answer questions, each with parts that may involve some calculations and/or explanations. This 120-minute, individual-
effort, no-collaboration-allowed exam will take place in our course on Brightspace so ensure that you are in a distraction-
free environment with adequate internet access.

Chapters 2 & 5 | An Overview of the Macroeconomy

Our macroeconomics discussion begins with these two chapters and discusses the macro-economy using U.S. historical
data as examples for key concepts and definitions. Also discussed are the three macroeconomic concerns: inflation,
recession, and economic growth.
Specific Points
o Output: GDP, real GDP, and GDP per capita defined
o Aggregate Demand – the relationship between the quantity of domestic product demanded and the price level
o Aggregate Supply – the relationship between the quantity of domestic product supplied and the price level
o be comfortable with sketching (for yourself) the graph of a macro-economy with domestic output (GDP) on the x-axis
and the price level (typically the GDP deflator) on the y-axis, AD sloping downward and AS sloping upward, and using
this graph to determine the presence of inflation, recession, or economic growth
o inflation – a sustained increase in the general price level
o recession – a period during which the total output of the economy declines
o Gross Domestic Product (GDP) – sum of the money value of all final goods and services produced in the domestic
economy during a specified period (usually a year). Remember the difference between real GDP and nominal GDP.
o remember only final goods and services (not intermediaries) produced domestically in the given period are counted in
GDP | remember the limitations of the GDP and what it is not

Chapters 6 & 7 | Economic Growth

These two chapters begin our look at macroeconomic policy. Essentially, there are two goals of macroeconomic policy –
economic growth in the long run (growth policy) and managing the economy through to AD, aiming for low unemployment
and low inflation (stabilization policy). While Chapter 6 gives a general analysis, Chapter 7 presents a more detailed look at
growth policy.
Specific Points
o economic growth - potential GDP and the economy’s production function (shift the function upward by adding more
capital or better technology
o growth rate of potential GDP depends on labor productivity (amount of output a worker produces in one hour)
o remember how to categorize the adult civilian population – in the labor force (employed, unemployed) and not in the
labor force
o types of unemployment – frictional, structural, and cyclical. Also, remember that with full employment, unemployment
> 0 still occurs
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 ECO 9740 Fundamentals of Macroeconomics

o remember discouraged workers and part-time workers

o be comfortable with calculating and interpreting the unemployment rates, U-3 and U-6
o unemployment rate – number of unemployed as a percentage of the labor force
o U-3 = (unemployed ÷ labor force) × 100
o U-6 = ((unemployed + underemployed + discouraged) ÷ (labor force + discouraged)) × 100
o inflation and real wages | real wage = (nominal wage ÷ price level) × 100
o inflation and real interest rates | real interest rate = nominal interest rate – expected inflation rate
o wealth redistribution | if actual inflation > expected inflation, lenders lose and borrowers gain | if actual inflation <
expected inflation, lenders gain, and borrowers lose
o Consumer Price Index. Calculating CPI and using CPI to calculate the inflation rate.
o CPI = (cost of basket in current year ÷ cost of basket in base year) × 100
o Inflation rate = percentage change in CPI from the previous year | can use GDP deflator
o be comfortable with the factors determining long run growth: capital (physical and human), technology and labor

Chapters 8, 9, and 10 | The AD – AS Model

These three chapters (8, 9 and 10) focus on the AD-AS model. Chapters 8 and 9 focus on aggregate demand, AD, and use
this half or the AD – AS model to look at the equilibrium level of output (real GDP) and the corresponding equilibrium price
level. Chapter 10 introduces the short-run aggregate supply, SRAS, and relaxes the idea of a fixed overall price. Chapter 8
focuses on measuring (determining) GDP. It discusses the relationship between AD, GDP and national income (Y). There
are some equations and relationships to be aware of as well as the different ways to determine (measure) GDP. Chapter 9
focuses on this equilibrium level by establishing that total spending = output in equilibrium. Total spending is done by our
four economic agents (consumers, firms, government, and the rest of the world), and total income (Y) is always equal to
total output (real GDP). So, in equilibrium, real GDP = Y = total spending by consumers, firms, government, and the rest of
the world. The demand side analysis goes further to point out that since consumption is, in part, determined by the level of
income, Y, any changes in spending by one (or more) of these four economic agents, will have a multiplier effect. That is,
any changes in spending will change income, and this change in income will change consumption spending, which will
change income, and so on. So, an increase (or a decrease) in spending will shift the AD to the right (or to the left) by more
than the magnitude of the initial change in spending. The simple (oversimplified) multiplier and the tax multiplier are
introduced. In Chapter 10, the difference between the long run aggregate supply (LRAS) curve and the short run aggregate
supply (SRAS) curve is discussed. Specifically, the LRAS is not affected by changes in the overall price level (vertical at the
potential level of output) while the SRAS is positively related to the overall price level. The sticky-wage theory is used to
explain the upward slope of the SRAS curve. The idea is that nominal wages are fixed for some time (contracts) and so when
the selling price for output (the price level) increases (or decreases), firms can produce and sell a higher (or lower) quantity.
Overtime, wage contracts are re-negotiated in response to the change in the overall price level, and this will shift the short
run aggregate supply curve.
Specific Points
o Y = GDP (national income = domestic product, same as total income = total output) always.
o consumers’ spending is really their disposable income (“take-home-money”): DI = Y – T where T = net taxes (taxes –
transfer payments) | consumers’ propensity to spend out of their disposable income: mpc = (Δ in C) ÷ (Δ in DI)
o factors that determine consumption spending: wealth, price level, expected future income, investment, and net exports
o three ways to calculate GDP. We looked at the expenditure approach and the income approach
o Income approach: national income = wages + interest + rent income + profits + indirect business taxes
If there are no statistical discrepancies: GNP = national income + depreciation.
GDP = GNP + income paid to other countries – income received from other countries 2
 ECO 9740 Fundamentals of Macroeconomics

o Expenditure approach: GDP = C + I + G + (X – IM)

o Aggregate Expenditure, AE = C + I + G + (X – IM) | C = C0 + (mpc × (DI)) and DI = Y – T | mpc is the marginal
propensity to consume, and DI is disposable income.
o at equilibrium: Y = AE. That is: Y = C0 + ( mpc × (Y – T)) + I + G + (X – IM). Solve to find Y.
o if equilibrium level of GDP < potential GDP – recessionary gap | main concern: unemployment
o if equilibrium level of GDP > potential GDP – inflationary gap | main concern: inflation
o multiplier analysis: looks at the change in income (Y) when there is a change in I, G, (X-IM), autonomous C (a none
income change) or T
o simple multiplier = 1 ÷ (1 – mpc) | ∆Y = multiplier × ∆ G | same for ∆ I, or ∆ (X-IM)
o tax multiplier = ( – mpc) ÷ (1 – mpc) | ∆Y = tax multiplier × ∆ T
o be able to discuss changes in the economy as it relates to unemployment, inflation, and output (real GDP)
o remember factors that shift the SRAS curve: input prices (e.g. nominal wage rate), technology and productivity,
changes in resources | supply shock
o remember factors that shift the LRAS curve: changes in the factors of production, that is, technology and
productivity, and changes in resources
o remember the difference between the long run equilibrium (AD = SRAS = LRAS) and the short-run equilibrium
(AD = SRAS and these are not equal to LRAS)
o be able to recognize demand side fluctuations (factors that would lead to the AD curve shifting) versus supply
side fluctuations (factors that would lead to the SRAS curve shifting)
o be able to discuss how the economy adjusts automatically (without stabilization policies) after a short-run
macroeconomic fluctuation
o be able to discuss changes in the economy as it relates to unemployment, inflation, and output (real GDP)