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Economics Dr.

Katie Sauer

A Citizens Guide to Economics Fall 2011

Reading Guides Chapters 1 - 13 Naked Economics

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Chapter 1 Reading Guide: Power of Markets I. Introduction Berlin Wall & Coca-Cola example:

The market aligns incentives in a way that individuals working in self-interest leads to a better standard of living for society as a whole. A modern economy is complex. In a modern economy our lives are getting better. Example 1:

Example 2:

Anecdotes for a market economy vs centrally planned economy:

Economics is Technical Definition: economics is the discipline that studies how people, firms and governments use their scarce resources, and the consequences of those decisions.

According to a fundamental economic assumption, what do individuals do?

Think of 3 examples from your own life: 1)


3) 1

II. How Individuals Behave Individuals attempt to make themselves as well off as possible, given their individual preferences. Think of some examples of how your personal preferences might differ from that of someone in a developing nation.

Utility maximizing behavior isnt the same thing as being selfish. Explain.

Life is complex and uncertain. Every decision we make involves a tradeoff. Give an example of a tradeoff involving - a present activity and future activity - work vs leisure/family time - two desirable activities in the present Whenever we make a decision, we are weighting the benefits and costs of the action. Benefits can be things other than money. Explain.

Costs can be things other than money. Explain.

Technical definition: An opportunity cost is the cost of any activity as measured by the next-best forgone alternative. Give some examples of how your own behavior is influenced by cost.

Relationship between price of cocaine and cocaine users:

Relationship between price of cigarettes and smoking impact:

Relationship between cost of raising children and fertility:

III. How Firms Behave The goal of a firm is to maximize profits. (Yes, there are non-profit firms but they are relatively small in number as compared to the for-profit firms. The economics of non-profits is an advanced topic to explore) Examples of inputs:

Examples of outputs:

Firms have 5 main decisions to make. 1) 2) 3) 4) 5) A market economy will direct resources to their most productive use. Prices will signal information about the most valuable use. Tuna fishing example:

Profit opportunities attract firms to the market. Explain.

Explain the superstar phenomenon:

Even when there are profit opportunities, sometimes firms are prohibited from entering a market or face obstacles to entering the market. Technical Definition: Barriers to entry are the obstacles that a firm faces when trying to enter a market or industry. Barriers can be legal, geographic or cost-related. Examples of Barriers to Entry:

IV. Prices In a competitive market, the price will settle where the quantity offered for sale matches the quantity that people are willing and able to purchase. If the quantity offered for sale is less than the quantity that customers are looking to purchase, the price of the item will _________________________. If the quantity offered for sale is greater than the quantity that customers are looking to purchase, the price of the item will _________________________. Many firms have some degree of control over the price they charge. What is price discrimination?


Think of an example from your own life where you benefited from price discrimination. 4

V. Market Economies Make Our Lives Better Explain how markets and competition are good for consumers.

VI. Markets are Amoral Explain what we mean by amoral.

Give an example of innovations that criminals have come up with.

VII. Prices are Used to Allocate Scarce Resources in a Market System Explain how a centrally planned economy allocates resources.

VIII. Markets that Use Prices are Self-Correcting Explain.

IX. Firms Will Find a Way to Compete Even if Prices are Fixed Airline Example:

South Africa Example:

X. Market Transactions Make Involved Parties Better Off Explain.

XI. Behavioral Economics Economics assumes that people act rationally. That is, in a way that makes them better off, not worse off. Give some examples of how people act irrationally.

Bounded rationality means:

Give examples of common thinking errors that people make. Poor sense of risk and probability:

Lack of self-control:

Lack of information to make informed decision:

Thinking we see patterns:

Give an example from your life where you fell victim to one of the above errors.

___________________________________________________________________________________ In your own words, summarize the main points of this chapter.

Chapter 2 Reading Guide: Incentives Matter I. Communal Resources Technical definition: A common resource is a resource that anyone can have access to but the resource is finite. Ex: wildlife, environment Black Rhino Example: Why do people kill black rhinos?

Why will this market not correct itself?

Contrast communal property with private property. Explain what this has to do with the black rhinos endangerment.

Technical definition: A free-rider problem happens when people consume a common resource without paying for it, the resource tends to be overused. In the case of a produced good or service, if people can use it without paying, the good is likely to be under-produced. Explain the free rider problem as it applies to the black rhino.

Explain a free rider problem that you may have faced in your own life.

What are some possible solutions to the black rhino problem?

II. Incentives Matter People respond to incentives. A negative incentive can cause a person to NOT behave in a certain way. A positive incentive can entice a person to behave in a certain way. From your own life, give an example of a negative incentive that you faced: positive incentive that you faced: 1

In non-market systems, personal incentives are usually NOT related to productivity. East Germany example:

India example:

North Korea example:

III. Incentives and Policy In the United States, how can incentives be used to help design energy/environmental policy?

In the United States, how does the uniform pay scale for teachers affect incentives?

Many types of policies can result in unintended consequences. Technical definition: perverse incentives / unintended consequences are unintended and undesirable results which are contrary the intended behavior that the incentive was designed to promote. Car seats on airplanes example:

Mexico City example:

Good policies will take into account incentives and think through how individuals might respond to the policy. Bad policies either ignore incentives or fail to anticipate how individuals might respond. London example:

IV. The Principal-Agent Problem Technical definition: The principal-agent problem happens when a principal hires an agent to act on the principals behalf; problems can arise due to a difference in incentives and incomplete information. Burger King receipt example: potential problem


CEO/Shareholder example: potential problem

stock options solution

Explain how incentives and the principal-agent problem came into play in the financial crisis.

Real-estate agent / Home seller example:

V. The Prisoners Dilemma Technical definition: A prisoners dilemma is a fundamental problem in game theory that demonstrates why two parties might not cooperate even if it is in both their best interests to do so. Explain the story of the classic prisoners dilemma:

Explain how this situation applies to environmental situations.

Explain how a different outcome can be reached.

VI. Creative Destruction Using Wal-Mart as an example, explain some of the benefits and costs of creative destruction.

What would happen if all creative destruction were prevented?

VII. Taxes & Government Benefits With regard to incentives, how can taxes alter behavior?

Bjorn Borg example:

marriage tax:

corporate taxes:

very high taxes:

government benefits:

Economists favor taxes that are broad, simple and fair. A broad tax means:

A simple tax:

A fair tax:

Different types of taxes affect taxpayers differently. A regressive tax:

A progressive tax:

How does the EITC work? How does it take into account incentives?

___________________________________________________________________________________ In your own words, summarize the main points of this chapter.

Chapter 3 Reading Guide: Government and the Economy I I. Negative Externalities SUV example:

An externality is

Technical definition: an externality is an uncompensated impact on a third party. Externalities can be positive or negative. What typically happens when an activity has a small private cost and a large social cost?

What will markets do to fix externality problems?

Examples of negative externalities: Pollution:

Dog poo:

A negative externality you faced in your life:

In a market economy, government policy is one way of fixing externality problems. Externalities are the reason for many types of policy suggestions. children on airplanes: mobile phone use: take-out food: global warming:

II. Positive Externalities Give some examples of positive externalities: 1

Think of a positive externality from your life:

Explain how cigarette smoking has both positive and negative externalities associated with it.

III. Dealing with Externalities A. Regulations Explain how regulations can correct externalities.

B. Taxes Explain how taxes can correct externalities.

Explain why taxing behaviors that generate negative externalities can create good incentives.

What are some of the problems associated with taxing externalities?

C. Private Solutions Explain the 3 insights of Nobel Prize winner Ronald Coase: The parties involved in the externality have an incentive to come to an agreement on their own.

The solution will be the same, regardless of who starts with the property right.

In order for a private solution to be reached, transaction costs have to be low.

IV. Governments are Needed to Make Markets Possible in the First Place Governments are needed to set the rules:

provide infrastructure:

develop institutions:

define/protect property rights:

Explain the patent system:

provide justice system:

provide public goods:

V. Public Goods Public goods have two characteristics: 1) 2) Explain how the free-rider problem is present in public goods.

Examples: Basic research:

Law enforcement:

Parks / Open Space:

VI. Governments Redistribute Wealth In order to make markets possible, deal with externalities, and provide public goods, governments need to raise money. What does economics tell us about how income and wealth should be distributed? Explain using Nobel Prize winner Amarty Sens story.

According to economists, should governments protect people from themselves?

___________________________________________________________________________________ In your own words, summarize the main points of this chapter.

Chapter 4 Reading Guide: Government and the Economy II I. Government Inefficiency Explain how more government isnt necessarily better.

Governments operate exactly as wed expect them to, given their incentives. DMV example:

Post Office example:

Governments should not be the sole provider of a good or service unless there is a compelling reason to believe the private sector will fail in that role. DMV example vs Post Office example

Even if the government does have a role to play, it does not mean the government must actually do the work. Medicare:


II. Markets vs Government The market directs resources to profitable uses. Margarita Space Pak:

Central Planners direct resources according to central planning priorities. (which are sometimes economic and sometimes not) rockets vs birth control: 1

The political process in democracies directs resources according to political priorities. (which are sometimes economic and sometimes not) particle accelerator:

In the private sector, _____________ direct resources where they will earn the ________________. In the government sector, _____________ direct resources where the ________________________.

What are two problems of crony capitalism?

III. Regulations Some regulations are helpful to the economy, some are harmful to the economy, and all have costs associated with them. Why did Milton Friedman argue that more lawyers should be allowed into the practice? Why did many existing lawyers disagree?

Why did the workers in Delhi, India protest the regulation that was imposed in order to clean up pollution?

How does the prohibition of DDT use affect the developing nations?

Not all regulations are created equal the structure matters. Striped bass example:

Sometimes regulations are used to keep out competition. Illinois manicurists:

good citizenship requirements:

Explain how through regulations, the government could be acting as a Helping Hand:

Grabbing Hand:

IV. Taxes Even when the government is engaging in good activities, it must finance its spending through taxes. All taxes exert a cost on the economy. A. Explain Fiscal Drag:

B. Explain how taxes cause individuals to change their behavior and in turn cause deadweight loss.

C. Explain how taxes can discourage investment.

What is the Laffer Curve?

When tax rates are low, explain how cutting taxes will NOT result in more government revenue.

Explain the tax-cuts-increase-revenues fallacy.

V. An Economic Framework for Thinking About the Government A. Government has the potential to enhance the productive capacity of the economy, which makes us better off.

B. Some government activity shrinks the size of the pie but still may be socially desirable.

C. Sometimes government involvement in the economy is purely destructive.

___________________________________________________________________________________ In your own words, summarize the main points of this chapter.

Chapter 5 Reading Guide: Economics of Information I. Introduction Explain why the Hope Scholarship problem was doomed to fail from the start.

In 2001, the Nobel Prize for economics went to Akerlof, Spense and Stiglitz for their work that explored:

Job candidate example:

Maternity leave example:

What is rational discrimination?

Information asymmetry lies at the heart of many discrimination-related problems. II. Information Asymmetry and Adverse Selection Markets can break down if the information imbalance is too large. Technical definition: Information Asymmetry is a situation where one party has more or better information than the other. Technical definition: Adverse Selection refers to an outcome due to information asymmetry that is bad from the perspective of the uninformed party. Explain Nobel Prize Winner George Akerlofs market for lemons.

Explain how information asymmetry is present in the health care market. Fee for service:

Fixed fee per patient:

Health Care is different from other markets: 1. 2. 3. 4. 5.

Explain what insurance has to do with information asymmetry.

When your insurance company offers you a choice in your deductible, what information are they trying to get you to reveal?

Why is it so difficult to reform health care in a way that provides more access and more affordability?

III. Information Asymmetry and Branding In the vast majority of cases, consumers and firms create their own mechanisms for solving information problems. McDonalds example:

How does corporate branding help consumers?

How does branding help firms?

Think of a time you bought something solely because of a brand.

Explain signaling in the context of information asymmetry. Law firm:

Offices in Asia:

Harvard Graduates:

The last time you interviewed for a job, created an on-line dating profile, etc, what signals were you purposely trying to send?

___________________________________________________________________________________ In your own words, summarize the main points of this chapter.

Chapter 6 Reading Guide: Productivity and Human Capital I. Human Capital To understand poverty, economists start with the concept of human capital. Human Capital is:

If someone took away all of your assets (job, money, home, etc) and left you on a street corner, what types of skills and abilities make up your own personal human capital?

How is the labor market similar to the market for goods and services?

How does the price of a certain skill compare with the social value of the skill?

Use the Nobel Prize vs pro baseball salary example to explain how economists think about labor:

Some human capital is natural ability, much of human capital is built through investing in education and training. Go back to your list of your personal human capital attributes. Indicate which ones are natural ability and which you have acquired or developed through education and training. Human capital is an economic passport. Explain:

Why are fast food workers paid a relatively low wage?

The problem that underlies poverty is a lack of human capital. - The poverty rate for high school dropouts is ________times the rate for college graduates. - One of the reasons that India is a poor nation because ________% of the population is illiterate - Many of the homeless in the US suffer from _____________________________________ which makes acquiring human capital difficult.

Explain the relationship between the economy, human capital and the ability to find a good job.

Thought Experiment: 100,000 high school dropouts vs 100,000 top graduates

How does the NWAC plant-closing compare with typical mill/factory/mine/plant-closings?

Explain the Lump of Labor Fallacy:

Farming Community example:

Human capital is about more than earning more money. Some of the other benefits are:

Explain the relationship between total human capital and the standard of living for society.

There is a strong correlation between a countrys level of human capital and its economic wellbeing. Natural resources are not correlated with a countrys standard of living. Japan & Switzerland:


Saudi Arabia & Israel:

The reason human capital matters so much for the economy is because it is a major component of productivity and productivity is ultimately what determines the standard of living. II. Productivity Productivity is:

Productivity is determined by ___________________ and ________________________________. - Of the two determinants, _________________________________ is more important.

Why is America rich?

Examples: In 1870 it took about _________ hours to buy a households annual food supply. Today it takes about ________ hours. The average work week has fallen from _________ hours to _________ hours while GDP per capita has increased from _________ to __________. 3

Explain why Ross Perot was wrong about the giant sucking sound that would come from NAFTA.

Why has America lost industries like manufacturing textiles and shoes?

What was the overall effect of NAFTA on US jobs?

Productivity growth is what improves our standard of living. If productivity grows at 2% per year, then we will become _______% richer each year. Explain why.

An interesting economic debate is whether or not the US economy has undergone a sharp increase in productivity growth. Alan Greenspan says:

Robert Gordon says:

From 1947 to 1975, productivity grew at _______ % per year on average. From 1975 to the mid-1990s, productivity grew at _______ % per year on average. From 2000 to 2008, productivity grew at _______ % per year on average. The Rule of 72 says: 72 / a growth rate = how many years the quantity will take to double. Example: If productivity is growing at 2.7% per year, then it will take 72/2.7 = 26.7 years for the standard of living to double. Example: If a bank account pays 4% interest, then it will take 72/4 = 18 years for the principal to double. Productivity growth makes the US richer, regardless of how fast other economies are growing. (Productivity growth is not a zero-sum game.) India Example:

Productivity growth depends on investment. Investment in Human Capital Physical Capital Research and Development Effective Government Institutions Whenever investments are made, consumption in the present must be sacrificed. Examples:

Productivity growth also depends on: the legal, regulatory and tax structures example: social factors example: innovation and technological progress example:

III. Other Applications of Human Capital and Productivity Economic History: In the 18th century, Thomas Malthus predicted that as societies grew richer, they would also become more populous and the food supply would not be able to keep up. Explain how increases in productivity caused an alternative outcome.

Fertility Rates: Why do people in poor nations have more children than people in rich nations? Explain.

IV. Income Inequality: In the US, the poorest 20% of households were earning only 2% more in 2004 than they were in 1979. The richest 20% of households were earning 63% more in 2004 than they were in 1979. Explain this using what youve learned about human capital.

Explain what is happening to the gap between rich and poor in the US. Explain why.

The US economy is evolving in ways that favor skilled workers. Examples:

Explain how international trade makes US workers that are high-skilled better off and can make US workers that are low-skilled worse off.

Given the above, which do you think is a better long-term solution for helping low-skilled US workers: shelter them from international competition by restricting trade or help them to increase their human capital? Explain.

There is disagreement about the degree to which various other factors are responsible for the gap in wages. Unions: Hours worked: Performance pay:

Two arguments for why the gap in income equality isnt too worrisome: 1) powerful signals

2) standard of living is rising

Two arguments for why the gap in income might be a problem: 1) relative wealth matters to people

2) if the gap gets too large

V. Looking Forward Does the free market system make poverty inevitable? Must there be economic losers if there are economic winners? Explain.

In theory, a world in which every individual was educated, healthy and productive would be a world in which everyone lived comfortably. Explain how this could be true.

___________________________________________________________________________________ In your own words, summarize the main points of this chapter.

Chapter 7 Reading Guide: Financial Markets I. Introduction Explain what miracle diets and many peoples investing strategies have in common.

Financial instruments, like every other good or service in a market economy, must create some value. Both the buyer and seller must perceive themselves to be better off by entering into the deal or they wouldnt choose to enter in to it. II. The Role of Financial Instruments All financial instruments are based on 4 simple needs in society: 1) The Need to Raise Capital Some examples of borrowing:

Three examples of borrowing you have in your own life: -

Individuals, firms and governments need capital to __________________________________________. Financial markets provide the capital to them, but at a price. Modern economies could not survive without credit. Explain how access to credit is helping people in developing nations.

2) The Need to Store, Protect and Make Profitable Use of Excess Capital Three reasons not to store your money under your mattress: Harvard endowment example: Explain what consumption smoothing is.

Give 3 examples of ways you have engaged in consumption smoothing in your life. 3) The Need to Insure Against Risk Some of the reasons a person might face financial ruin:

Health, life and auto insurance are three common ways people try to minimize their financial risks. Which of those three do you personally have? Why/why not?

Most people are willing to pay a predictable amount of money to protect against the unpredictable. Almost anything can be insured: Pirate attacks:


Products that function like insurance policies: -Explain how a futures contract works:

Corn trader: 2


Fast food restaurants:


-Explain what a catastrophe bond is:

- Explain how a mutual fund works:

- Explain what a credit default swap is:

4) The Need to Speculate The same financial instruments that are used to mitigate risk or to raise capital can also be used to bet in the short run. Analogy: Financial products are to speculation what sporting events are to gambling. When it comes to credit default swaps, parties other than those in the original contract can get involved. Explain. Brother-in-law:

US financial crisis:

Explain how gambling in Las Vegas is a zero-sum game but the speculating on Wall Street is not.

III. Capital Markets Give some examples of losing in the capital market.

Financial markets allocate capital to the uses that can earn the highest return. What are some ways that government can help and hinder the capital markets?

IV. Investment Strategies The reason get-rich-quick schemes fail is because they violate even the most basic economic principles. Home buying example:

Hot-stocks example:

The efficient markets theory says:

An index fund is:

How do index funds compare to actively managed ones?

Irrationality and Investing In recent years, neither the stock market nor the housing market has behaved in ways consistent with rational human behavior. Behavioral economists point out that individuals are prone to making flawed decisions: An interesting finding from neuroeconomics is:

Even though people are known to behave irrationally, the efficient markets hypothesis isnt going away anytime soon because 1)


Basic economic principles give us a set of rules for investment advice: 1. Save. Invest. Repeat.

2. Take risk, earn reward.

3. Diversify.

4. Invest for the long run.

___________________________________________________________________________________ In your own words, summarize the main points of this chapter.

Chapter 8 Reading Guide: The Power of Organized Interests I. Introduction Even when economists reach consensus on policies that would society as a whole economically better off, those policies often run into political opposition. International Trade Example: Economists think: Others think: Many policies that are passed by Congress do not promote the economic interest of society as a whole. Mohair Example: Original intent: No longer necessary when: Removed in ________________________ and reinstituted in _______. How is it possible that the average tax payer didnt notice the mohair subsidy? Why do politicians allow the mohair subsidy?

Ethanol Example: Taxed less than pure gasoline because: Scientists and environmentalists say: The GAO says: Other problems with ethanol: Politicians think:

II. A Theory of Political Behavior When it comes to interest group politics, it pays to be small. Nobel Prize winner Gary Becker theorized that small, well-organized groups are most successful in the political process. Explain why and use ethanol as an example.

Interesting Farming Example: In countries where farmers are a small part of the population, the governments provide large subsidies for ________________________________________. In countries where the farming population is large, the governments provide large subsidies for ___________________________________________________.

III. The Economic Effects A. Death by a thousand subsidies Each individual subsidy is trivial when compared with the size of the US economy, but they all add up. If the price of milk is too low that some dairy farmers cant make a living without government milk subsidies, then economics tells that the real problem is ___________________________________________________.

B. Regulation Seeking Nobel Prize winner George Stigler proposed a counterintuitive theory:

Public School teacher certification example:

Other aspects of the teacher certification requirement: Private school teachers:

Certification requirements and student achievement:

Illinois example:

C. Tyranny of the status quo Joseph Schumpeter gave us the term creative destruction. Explain how it is good for society as a whole but problematic for some individuals and some firms.

Assistance can be given to the individuals who lose out during the creative destruction process. NAFTA:

Tobacco farmers:

There is a crucial distinction between using the political process to build a safety net for those harmed by creative destruction and using the political process to stop creative destruction in the first place. Pony Express:

The economic benefits of competition are huge and spread over society as a whole; the costs are smaller but are highly concentrated. International Trade is good for American consumers:

International Trade is bad for workers in industries that would be in competition with lowskilled workers from around the globe:

The term Luddite is often used to describe someone who is slow to adopt (or begrudgingly adopts) new technologies. Explain where this term originally comes from.

China used to be the most advance nation in the world. Why wasnt it the origin of the Industrial Revolution?

One institution that has been developed to help the greater good prevail over narrow interest is the Presidents fast-track authority. Explain. 3

D. We are all special interests Authors townhouse association:

There is a saying that goes where you stand depends on where you sit. Give some examples of a group that you are in that has a narrower interest than society as a whole.

Explain what an earmark is.

Would campaign finance reform change anything?

___________________________________________________________________________________ In your own words, summarize the main points of this chapter.

Chapter 9 Reading Guide: Keeping Score I. GDP Gross Domestic Product is:

Technical Definition: Gross Domestic Product is the market value of all final goods and services produced within a nations borders in a given time period. Economic growth = growth in GDP A. GDP is a decent measure of economic well-being. Explain:

Real GDP means the number has been ________________________________________. Nominal GDP means the number has not. Which number is more meaningful? Why?

GDP per capita is:

GDP per capita tells us more about economic well-being than GDP does. GDP GDP per capita India Israel Explain how population growth affects GDP per capita.

The US economy is about $_______ trillion. It is the largest economy in the world. The second largest economy is ____________ and its GDP is the equivalent of $_______ trillion. US real GDP per capita is about $_______________. How does this compare with other nations? The average American is ____ times as rich as in 1970 and _____ times as rich as in 1940. (and these numbers have been adjusted for inflation) How is it possible we are so much richer than 60 years ago?

Time spent working to afford basic items: Time Spent Working to Afford Time Spent Working to Afford

Item stockings chicken cell phone



Year 2000 2009 today

Price $4 $3.86 .

1900 $0.25 1919 $1.23 Mid1980s .

A rapidly rising standard of living has not been the norm throughout history. Over the period between 500AD and 1500AD the GDP per capita in Europe grew by about _______%.

What it means to for a country to be poor by global standards: India example:

Using GDP as a measure of social progress has its problems. B. Drawbacks to using GDP as the measure of social progress: 1. It does not count economic activity that is not paid for.

2. It does not account for environmental degradation

Green GDP is:

3. There are no value judgments attached to GDP calculations.

4. Leisure is not counted.

5. GDP does not take into account the distribution of income.

An alternative to using GDP to measure social progress is the UNs Human Development Index. This index includes:

Explain how richness may not be correlated with happiness:

C. Other measures of economic progress ? List some factors that have been suggested.

II. Recessions In general, recessions stem from some shock to the economy. The USs 1929 and 2007 recession were caused by ________________________________. The USs 1973 recession was caused by _________________________________________. The USs 2001 slowdown was caused by _______________________________________. In developing nations, economic shocks often take the form of _________________________. 3

In our global economy, recessions spread from nation to nation. 2001 sudden coffee bean low price:

When consumers sustain a shock to income, they spend less. This has the effect of _____________ ________________________________________. The Paradox of Thrift - In troubling economic times, our natural reaction is to _____________________________. However, this makes our collective situation worse. Explain.

Did you or anyone you know adjust their spending in the recent recession? Explain.

The Great Recession of 2007 Part 1: Housing Bubble Burst During the housing boom, houses were getting bigger and mortgages were getting _______________. Down payments were getting __________________. Also, many households were excessively leveraged which means ______________________________________________________________. Additionally, subprime mortgages made it easier for people who werent otherwise creditworthy to get mortgages. When housing prices are rising and someone finds they cant afford their mortgage, they can ______________________________ to repay the loan. When housing prices are falling and someone finds they cant afford their mortgage, they cannot sell their home to repay the loan. As people defaulted on mortgages and banks foreclosed the properties and put them up for sale, the price of houses _____________________________. Part 2: Financial Sector The mortgage problem spread to the financial sector through 2 channels. 1. Banks who had made loans that went bad:

2. Wall Street investment banks and hedge funds: 4

Part 3: Financial System Seizes Up The Lehman Brothers investment bank realized ________________________________________. This meant it would have to declare bankruptcy. This caused panic in global financial markets. What happens when the financial system seizes up?

Girl Scout Example:

Adult Film Industry Example:

Part 4: Recession Spreads Internationally Whenever any large economy falls into recession, it hurts the US economy and vice versa. Explain.

Recovering from Recessions There are often underlying issues that need to work themselves out before an economy can recover. Examples Tech Wreck recession:

recessions from high oil prices:

financial crisis:

In terms of long-run economic growth, recessions might be a positive thing. Explain.

In the short run, however, recessions have real costs. 5

III. Government Economic Policy In a recession the objective of both fiscal policy and monetary policy is to encourage consumers and firms to begin spending and investing again. A. Fiscal Policy Fiscal Policy is when the government: Explain the recent stimulus bill. Spending:


The insight from economist John Maynard Keynes was that the government could use spending and taxing to fine tune the economy. Many economists agree with this in theory. In reality, fiscal policy might not be a good answer to a recession. Three requirements for successful fiscal policy: 1. 2. 3. In many cases, Congress was unable to pass stimulus legislation until after the recessions had ended. May 1977 legislation was for a recession that ended in __________. How did the recent stimulus legislation fare? Explain some of the support and opposition.

B. Monetary Policy Monetary policy refers to the actions undertaken by the Federal Reserve, specifically the raising and lowering of interest rates. In terms of speed, monetary policy works ____________________. In order to stimulate the economy during the Great Recession of 2007, the Fed ________ interest rates. The intended effect of this was: 6

IV. Other Key Economic Indicators A. Unemployment The unemployment rate is calculated as:

A discouraged worker is:

Okuns Law says that an economic growth rate of 3% will _________________________ the unemployment rate. If the economy grows at 4%, unemployment will fall by ________________________. If the economy grows at 2%, unemployment will rise by ________________________.

B. Poverty In the 1960s, the US government created the poverty line. It is defined to be:

Poverty Line for single adult = Poverty Line for family of 4 = The poverty rate is defined to be:

The current US poverty rate is ______%. C. Income Inequality The Gini Index measures income inequality. A score of 0 means A score of 100 means How does the US compare to other nations?

How does the US compare to itself over time?

D. Size of Government How do we measure the size of a government?

Historically, for the US this number has been about _______% of GDP. How does this compare to other nations? 7

E. Budget deficit / surplus Explain why economists dont mind if there is a short run deficit but in the long run the budget should balance.

F. Current Account deficit / surplus The Current Account reflects: The biggest component of the Current Account is the _____________________________. Sometimes it is good to have a Current Account deficit, sometimes not. Explain.

G. National Savings Savings are necessary to finance investment. If collectively Americans do not save, then:

In the 1960s, the personal savings rate was ______%. In the 1980s, the personal savings rate was ______%. In the mid 1990s, the personal savings rate was ______%. By the end of the 1990s, the personal savings rate was ______%. When the recession of 2007 hit, the personal savings rate: H. Demographics Explain how demographics factor in to the sustainability of Social Security.

___________________________________________________________________________________ In your own words, summarize the main points of this chapter.

Chapter 10 Reading Guide: The Federal Reserve I. Introduction The USs Federal Reserve (aka the Fed) has tools with more direct impact on the global economy than any other institution in the world. The Chairman of the Fed is named _______________________________. The Federal Reserve controls the USs money supply. By controlling the money supply, the Fed is controlling the economys credit tap. When the tap is open wide, interest rates ___________ and consumers and firms spend more freely. This would be done to:

When the Fed tightens the tap, it __________ interest rates so consumers and firms spend more slowly.

There are ________ Fed banks spread out across the country. The Board of Governors has 7 members and is located in _______________________________. - Ben Bernanke is the chairman Some of the duties of the Federal Reserve System are The other main responsibility of the Fed is to make __________________________________.

II. Monetary Policy A. Introduction Explain how economists view the Fed:

What did Nobel Prize winner Robert Mundell have to say about the importance of monetary policy?

There are limits to how fast an economy can grow. PT Cruiser example:

The pace at which the economy can grow without causing _________________________ might reasonably be considered the economys speed limit. There are only so many ways to increase production: Each of the above is scarce and or unpredictable. The speed limit for the US economy is probably somewhere near ______% growth per year. Its the Feds job to stimulate the economy if it is sluggish. However the Feds job is also to take away the punch bowl just as the party gets going. Explain what this analogy means.

When inflation gets out of control, the Fed might need to engineer a recession to get it under control. Inflation in 1972 was ______%. Inflation in 1980 was ______%. To slow the party down, the Fed raised interest rates to _____%. During the 1981-1982 recession, GDP __________________________________ and unemployment _________________________________________. By 1983, inflation was _______%. B. Interest Rates The Fed cant tell commercial banks what interest rate to charge nor can it tell people to borrow money to buy things. The Feds control over interest rates is indirect. When banks have a lot of money, interest rates will be __________to attract borrowers. When capital is scarce, interest rates will be _____________ to reflect the scarcity. It is simple supply and demand and the Fed controls the supply of money. 2

The decision to raise or lower the money supply (and therefore interest rates) is made by the ___________________________________________________________________. Its membership is comprised of: The chair is _____________________________. The FOMC has 2 primary tools. 1. The discount rate is the rate the Fed charges to _________ for loans. When the Fed lowers the discount rate:

2. The federal funds rate is the rate ____________ charge to banks for loans. The Fed targets this rate by: When the Fed lowers the federal funds rate target:

C. Where does the Feds money come from? In the US, the power to create new money rests with the Fed. The Fed, however, doesnt give money to the banking system, instead it trades the new money for _______________________________________________. The reason that banks hold government bonds is:

When banks are holding bonds instead of cash, funds are not being __________________________. When banks are holding cash instead of bonds, funds are available to lend out. Explain the cascading effect of a monetary injection:

D. The difficulty of the Feds job The Feds mandate is to facilitate a sustainable pace of economic growth. This is difficult because 1. 2. 3. Speed limit analogy recap: The Fed must facilitate an economic growth rate that is neither too fast nor too slow. This is difficult because: Some people give credit to former Fed chairman Alan Greenspan, some criticize him. Explain.

III. The Nature of Money Money is not the same as wealth. Explain.

A. What is Money? In most societies, some kind of money has evolved to make it easier to trade with one another. In order to be money, the item must fulfill 3 functions. Means of Exchange:

Unit of Account:

Relatively Scarce:

Examples of money used in prisons: 4

B. History Prior to the 20th century, banks: In 1913, the US government: In 1917, the US: Even though modern currency is not backed by gold, it has value because it has purchasing power. In order for money to have purchasing power, individuals must be willing to accept and use it. India example:

C. Inflation Inflation means that:

The inflation rate is measured as:

The way to think about inflation is NOT that prices are going up, but that the purchasing power of the dollar is going down. A paper currency has value only because _________________________________. The ____________________________ controls that scarcity. An incompetent or corrupt central bank can destroy the value of its money. Germany example:

Latin America example:

Belarus example:

The Costs of Inflation: 1. Ways that high inflation distorts the economy: 2. Low to moderate inflation leads to ___________________________________ comparisons. Example:

3. Moderate inflation eats away at wealth.

4. Inflation arbitrarily redistributes wealth.

Side note on Real & Nominal Interest rates:

5. Inflation distorts taxes

6. Inflation creates uncertainty When moderate inflation is constant or predictable, it has very little effect. In reality, inflation is not constant or predictable. Salary negotiations: Lenders: D. Governments and Inflation While it seems obvious that governments and central banks would want to fight inflation, in reality, we often see the opposite. Why? 1. +2. +3. =

Explain the inflation tax:

Explain how inflation can factor in to re-election strategy.

In order to do their jobs properly, central banks need to be independent of politics. Countries that have independent central banks end up with _____________ inflation rates. Explain some of the ways that the Fed is structured to be more independent and how it is not perfectly isolated from politics.

E. Deflation Deflation is: Explain how deflation can kick off a dangerous economic cycle.

Monetary policy may be unable to break a deflationary spiral. Japan example:

US example:

F. The Financial Crisis Explain the actions that the Fed took during the recent financial crisis.

___________________________________________________________________________________ In your own words, summarize the main points of this chapter.

Chapter 11 Reading Guide: International Economics I. Introduction Explain what the European Exchange Rate Mechanism (ERM) is:

In 1992, the value of 1 British pound was pegged to be ________ German marks. At the time, the British economy was _____________________________. An exchange rate is:

- the value of the exchange rate is determined by ___________________________________ Because the British economy was in recession, investors were looking to invest elsewhere. - the demand for the pound was ____________________________ - the value of the pound was _______________________________ The British government said it was committed to maintaining its ERM target. Tools: 1. 2. Problem:

What did George Soros do?

What did Britain do?

International economics isnt different from economics within countries. - National borders are _________________________ drawn, not economically. - Transactions across borders must still make both parties better off or else _______________ __________________________________________________. There is a layer of complexity though:

II. Exchange Rates An exchange rate is: 1

Explain the theory of Purchasing Power Parity:

If a currency is losing purchasing power within a nation, wed also expect it to lose value relative to _________________________________. Explain the difference between real exchange rates and nominal exchange rates:

The concept of Purchasing Power Parity is useful for:

In the long run, economic logic tells us exchange rates should be:

How do current official exchange rates differ from PPP?

Explain why this is the case.

An overvalued currency means:

An undervalued currency means:

Explain what the Big Mac Index is.

In July 2009, a Big Mac in the US cost on average $3.57 and cost 12.5 renminbi in China. This suggests that $3.57 should equal 12.5renminbi or $1 should equal ________. The actual exchange rate in July 2009 was ___________________________. This means the renminbi was _________________________ versus the dollar.

Exchange Rate Fluctuations Explain what it means to say a currency has depreciated versus another currency:

Explain what it means to say a currency has appreciated versus another currency:

Explain some implications of a weak US dollar:

There is nothing inherently good or bad about a strong or weak currency. The most important factors affecting the relative demand for currencies are ______________ _______________________________________.

When the demand for a currency increases, the currency ____________________________. Saudi Arabia example:

High interest rates example:

Fluctuations in exchange rates are hard to predict. 2007 financial crisis example:

Individual governments can try to influence their nations exchange rates by _______________ ____________________________________.

III. Types of Exchange Rate Systems A. Gold Standard Explain how the gold standard worked: 3

An advantage of the gold standard is:

A disadvantage of the gold standard is:

In the US, in 1933, ____________________________ could no longer exchange paper currency for gold, but ________________________________ still were able to. In _________, the US went off the gold standard entirely. - Why?

B. Floating Exchange Rates Most __________________________ economies have floating exchange rates. - currencies are traded on foreign exchange markets - at any given time, the exchange rate reflects:

An advantage is that governments:

A disadvantage is:

C. Fixed Exchange Rates Explain how fixed exchange rates work:

An advantage is a stable exchange rate. Investors, importers and exporters can conduct transactions without worrying that the exchange rate will change. A disadvantage is:

D. Currency Boards Explain Argentinas currency problem.

Explain how they tried to solve it.

Explain some of the consequences.

E. Soft Currencies Explain what a soft currency is and give some examples.

How did the Pepsi company deal with the problem of soft currencies?

IV. Currency Crises List 7 countries that have had major currency crises:

While each currency crisis is unique, they tend to follow a pattern: 1. 2. 3.

A. Icelands currency crisis Act I: The value of the krona was ____________ and interest rates were ____________. Icelands banking sector was relatively unregulated and was attracting ________________. - banks used the funds for: Because of the high interest rates, the people of Iceland:

Act II: The US financial crisis hits in 2008 and goes global. In Iceland, the banks were: The value of the krona _______________________________. - This impacted the consumer loans: 5

Act III: The krona lost _________________________. The Icelandic stock market ______________________________. GDP fell by ____________________________. Unemployment ________________________________.

B. Preventing Currency Crises 1. Capital Controls What is a capital control?

Problems to requiring capital controls:

2. Common Currency Benefits:


What we really care about is the flow of goods and services. Currencies are simply a tool for making it easier to exchange goods and services.

V. The Current Account The Current Account measures:

There is nothing inherently good or bad about a current account surplus or deficit. When the US buys more goods and services from the rest of the world than the rest of the world buys from the US, then to make up the difference, the US could - sell ___________________________. - buy ___________________________. Why does the US run a current account deficit?

The Current Account and National Savings Any country that consumes more than it produces must be running a current account deficit because: 1. 2.

Farming analogy:

Normally, a country with a large current account will see its currency _________________________. New Zealand example:

The US-China situation is different. Explain.

In the long run, this has consequences for both the US and China. Explain.

VI. Global Financial Stability After World War II, world leaders gathered together with the mission of ______________________ _________________________________. The World Bank was created to:

The International Monetary Fund was created to:

___________________________________________________________________________________ In your own words, summarize the main points of this chapter.

Chapter 12 Reading Guide: Trade and Globalization I. Introduction A modern economy is built on ___________________________. We pay people to do or make things that we cant do ourselves. Examples of things you personally pay for that you cant do yourself: We pay people to do or make things that we choose not to do for ourselves. Examples of things you personally choose not to do and pay for instead. What would life be like if you had to be entirely self-sufficient?

When a good or service originates in a foreign country, it crosses a political boundary not an economic one. What does Paul Krugman have to say about the effect of globalization?

The world is growing more economically interdependent. World exports as a share of GDP have grown from _______% in 1950 to ______% today. US exports as a share of US GDP have grown from ______% in 1950 to ______% today. The bulk of the American economy consists of:

Even so, the economy is so huge that the US is one of the worlds largest exporters.

Nearly all economic theory and evidence suggests that the benefits of international trade far exceed the costs.

II. Trade Makes Us Richer Trade is one of the ____________________________ ideas in economics but also one of the _______________________________________. 1

Abraham Lincoln once said It seems to me that if we buy the rails from England, then weve got the rails and theyve got the money. But if we build the rails here, weve got our rails and weve got our money. Explain the fallacy in his logic.

The reason we trade with other is because it:

Explain what Absolute Advantage is.

Explain what Comparative Advantage is.

Productivity is what makes us rich. Specialization is what makes us productive. Trade allows us to specialize. This is true at the individual level and national level.

III. Trade Creates Losers Trade, like technology, can destroy jobs. Explain.

In the long run, trade facilitates growth and a growing economy can absorb displaced workers. Between 1990 and 1997, ________________________ jobs were lost per year because of free trade with Mexico. Over the same time period, ______________________jobs were created per month. In the short run, some workers are displaced. They are often worse off in the short run and long run. Explain. 2

Given that trade is good for the economy as a whole but harmful to those who lose jobs, what can be done to soften the blow?

Explain how US trade policy is becoming more protectionist.

IV. Protectionism saves jobs in the short run and slows economic growth in the long run What are the benefits of protectionism (i.e. trade barriers)?

What are the costs of protectionism (i.e. trade barriers)?

Short of using physical force, when American wants to punish a nation, what does it do?

Protectionism is essentially imposing trade sanctions on our own economy. V. Trade lowers the cost of goods for consumers, which is the same as raising their incomes Trade barriers act like a ________. Explain.

Lowering trade barriers has the same impact on consumers as ___________________________. Between 1948 and 1995 trade barriers fell from ______% to ______%.

VI. Trade is good for poor countries, too Explain how zero-sum thinking is incorrect when it comes to gains from trade.

Anti-globalization protestors disrupted the WTO meetings in Seattle. What did the developing nations think of the trade talks being disrupted?

The current round of global trade negotiations, the Doha Round, has stalled because:

Benefits of Trade for poor countries 1. Access to: African Growth and Opportunity Act example:

2. Trade paves the way for: Explain.

Bangladeshi garment industry example:

Asian tigers example:

China example:

The effects of globalization A study of 34 countries found that the nations that were fastest globalizing had economic growth rates that were _____% to ______% higher than less globalized nations. Globalized nations also enjoyed greater ______________________________ and had higher scores on the _________________________________. About ___________billion people escaped poverty. However, higher globalization was also associated with some problems: 4

VII. Trade is Based on Voluntary Exchange Individuals do things that:

The threat of cultural homogenization is a common knock against globalization. Give some examples of cultural homogenization from globalization.

Explain how the building or continued existence of an American fast-food restaurant in a foreign nation is a local issue in that nation, not a global issue.

Explain how the cultural homogenization argument might be incorrect.

Explain how the same principles of voluntary exchange and local preferences apply when it comes to sweatshops.

VIII. The Comparative Advantage of workers in poor countries is cheap labor Why are workers in poor countries paid so little?

Sweatshops do not cause low wages in poor countries, rather:

Explain how the view of sweatshop differs for people across Asia and people from the West.

Explain how boycotting sweatshops might make things worse.

IX. Preferences change with income By global standards, what does it mean to be poor?

What is one of the worlds most pressing environmental problems?

According to economists, should poor countries be held to the same environmental standards as rich nations? Explain.

Explain how economic development is not inherently bad for the environment.

Explain how a race to the bottom hasnt materialized.

What are some ways to combat climate change?

___________________________________________________________________________________ In your own words, summarize the main points of this chapter.

Chapter 13 Reading Guide: Development Economics I. Introduction Give some examples of what it means to be poor in Malawi.

According to the UNs Food and Agriculture Organization, about ___ billion people dont get enough food to eat. There are ___ billion people that live on the equivalent of $2 or less per day. Economists do not have a recipe for making poor countries rich but they do have an understanding of what makes rich countries rich.

Factors that make a difference in the wealth and poverty of nations: II. Effective Government Institutions To grow and prosper, a country needs The above need to be reasonably honest and not corrupt. Some economists have hypothesized that developing nations that had formerly been colonized were affected by the quality of the institutions that were left behind. In places where Europeans could settle without much hardship:

In places where Europeans could not easily settle:

In the study of 64 ex-colonies, the findings are:

Good governance matters for economic growth. 1

III. Property Rights People in developing nations often have informal property rights. What is the consequence of this?

Explain what dead capital is using the Malawi couples example.

Explain the less obvious benefit of property rights.

IV. No excessive regulation Russia example:

Excessive regulation goes hand in glove with corruption. Explain.

Peru example:

Economist Robert Barro studied the like between government spending and GDP per capita growth in 100 countries. He found:

V. Human Capital Human capital is what makes individuals productive and productivity is what determines the standard of living. 2

How can education benefit poor countries?

Explain the human capital trap and the brain drain problem.

VI. Geography Only ___ of the 30 rich nations in the world lie in the tropics. Economist Jeffrey Sachs theorized that ___________________ can explain much of the worlds income distribution. Why are the tropics so bad for economic growth?

Jeffrey Sachs proposes 2 solutions. - encourage more technological innovation aimed at the unique situation in the tropics Explain why this is hard.

- open the economy to ________________________

VII. Openness to Trade Explain how many developing nations have closed themselves off from trade.

Among poor countries, the closed economies grew at ___% per capita per year during the 1970s and 1980s while the open economies grew at ___% per capita per year. When a previously closed economy opened up: 3

VIII. Responsible Fiscal and Monetary Policy Explain how it is troublesome for a government to consistently overspend.

Explain how Argentina is the poster child for irresponsible monetary policy.

IX. Natural Resources Explain using examples, how natural resources matter less than one would think.

Economic Growth has actually been found to be higher in nations with lesser endowments of natural resources. Explain how mineral riches can change an economy.

Explain the origin of the term Dutch disease.

X. Democracy Explain how democracy makes a difference in nations.

XI. War Almost ___% of the worlds billion poorest people are caught in a civil war or have recently been through one. Security is a prerequisite for most of the other things that have to happen for an economy to flourish. XII. Woman Power Explain the analogy between the farmer who only plants half of his field with an economy that doesnt allow women to participate.

When women in the developing world get wealthier, what do they spend their money on?

What do men in the developing world spend additional income on?

XIII. Other Some other factors that matter: If we know what good policies look like, why is it so hard to help developing nations become richer?

What are some of the things that the rich countries can do to help the poor countries?

Explain how just giving foreign aid might not have an effect.

___________________________________________________________________________________ In your own words, summarize the main points of this chapter.