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1 Question 1: What is GDP? Answer 1: From a macroperspective, the broadest measure of economic activity is gross domestic product (GDP). GDP represents all the goods and services that are produced within a country s borders. GDP is measured based on consumption, government spending (at all levels of government), investment, and exports minus imports. The formula for GDP is C + G + I + (X - M). In the United States, the vast majority of GDP is consumer spending, at approximately 66% of GDP. Also, the United States has run a trade deficit (importing more than it exports) since the 1970s, reducing GDP. Question 2: What are some of the key economic statistics that business executives need to monitor? Answer 2: Interest rates are significant because firms have to pay interest on the money they borrow. Lower interest rates mean less expense to businesses. The main interest rate that is monitored closely in the United States is the federal funds rate, an interest rate that is charged by a depository institution to another bank when that bank borrows money to meet reserve requirements (minimum cash deposit reserve levels required by law). Business executives also closely watch unemployment and inflation. Question 3: How do economic events affect businesses? Answer 3: Economic events either have a positive or negative impact on businesses. When an economy is expanding (indicated by rising incomes, low unemployment, and overall GDP growth), most businesses do well. However, economic activity can, and does, slow down. When this occurs, it is typically followed by firms cutting back on labor thus, unemployment increases, income declines because there are fewer people employed, consumer spending slows or declines, and overall GDP grows slowly or declines. Two consecutive quarters of negative economic growth is defined as a recession. During a recession, most businesses see a slowing or reduction in revenues and profits. Question 4: What are the similarities and differences between perfect competition and monopolistic competition? Answer 4: Several similarities between perfect competition and monopolistic 1

2 competition exist; both have many buyers and sellers and low entry barriers. The major difference between perfect competition and monopolistic competition is whether the product is homogenous or heterogeneous. This condition determines whether the companies in a market are price takers or price setters. In situations of perfect competition, there are many buyers and sellers because the industry has low entry barriers relative to other market structures. Low entry barriers may occur naturally because some industries simply do not require the financial and physical capital like other industries. Products are homogenous because buyers perceive all products sold are the same. Because of homogeneity, consumers make decisions solely based on price. All suppliers must take the price that consumers are willing to pay because there is no differentiation of product in the buyer's mind; hence, all suppliers are price takers. Wheat farming is a good example of perfect competition. Wheat farmers have to sell their wheat at the market price, entry and exit into wheat farming is relatively easy, buyers and sellers are numerous all over the world, and the product is perceived to be the same whether the wheat is from Texas or from South Dakota. Like perfect competition, monopolistic competition has many buyers and sellers because the industry has low entry barriers. Unlike perfect competition, products are slightly heterogeneous because buyers perceive slight differences in the products sold. Because of this slight heterogeneity, consumers make decisions based on price and product. This gives some pricing control to suppliers rather than relegating suppliers to price takers. Fast-food restaurants are a good example of monopolistic competition. It is relatively easy to start a fast-food restaurant by simply opening a restaurant or franchise, and there are many fast-food options and numerous fast-food consumers. They all offer fast, convenient food, but the food is slightly different (hamburgers, tacos, pizza, etc.). Prices vary from one chain to another but remain in the same range because of this slight differentiation. Question 5: What is an oligopoly, and what is a monopoly? Provide an example of each. Answer 5: In an oligopoly, there are few firms that control industry output because of the high barriers to entry. High entry barriers may exist naturally because achieving a good cost per unit may require large-scale operations or 2

3 because the product or service being offered requires tremendous resources. Products are heterogeneous because buyers perceive differences regardless of whether differences exist in reality. Cold breakfast cereal is an example of an oligopoly market. A few firms control the industry output, and the cereals are perceived to be different. Prices are different for different types of cereal because of this differentiation. It is not easy to start a cereal manufacturing company because a great deal of resources are required as well as a global distribution network and expertise in the consumer breakfast market. This creates barriers to entry and creates pricing power for producers. In a monopoly, only one company controls the output and the price. High barriers may prevent other companies from entering the market and competing. In some cases, the barrier to entry is imposed by the government, as with utilities. Local governments may purchase utilities from a single company because it takes 100% of the market to achieve the lowest unit cost. Consumers of the product have only limited substitutes or options and must purchase the product at the price offered by producers. Question 6: What are the effects of a government being in debt? Answer 6: Governments generate debt when they sell bonds to finance spending. Bonds require interest payments, so the government is not only obligated to pay the principal that was borrowed but also the interest. As debt increases, an increasingly greater portion of government revenue goes to pay interest payments, resulting in fewer available funds for government programs. Significant economic debt means more risk to investors, and consequently, national currency value suffers. Question 7: How can a government stimulate an economy? Answer 7: The government can use fiscal policy to stimulate the economy. When the economy is soft or in a recession, the federal government can increase spending to stimulate the economy. Increased spending leads to more jobs, more income, and thus more economic output. Alternatively, the federal government can lower taxes, allowing tax payers to retain more income and spend more, thus boosting economic output. Question 8: What are the primary tools available to the Federal Reserve (the Fed)? 3

4 Answer 8: The three primary tools are reserve requirements, open market operations, and the federal funds rate. Reserve requirements are the minimum cash reserves that banks are required to hold in their vaults to cover depositor transactions. As it sets the minimum reserve requirements, the Fed wields considerable power over how much money can be lent out in the economy. If the Fed wishes to enhance economic activity, it can lower reserve requirements. This allows banks to lend more money, which creates more economic activity, jobs, and output. Conversely, if the Fed wishes to slow growth to fight inflation, it raises reserve requirements. Open market operations are the buying and selling of government bonds in the financial markets. The Fed buys and sells government bonds to influence the money supply. Because cash held with the Fed from bond sales is not circulated in the economy, when the Fed sells bonds, it actually takes money out of the economy with the goal of tapering money demand and slowing inflation. On the other hand, if the economy is in need of a boost, the Fed can buy government bonds, thus increasing the money supply and enhancing economic output. The federal funds rate is perhaps the most visible policy tool the Fed uses. News reports stating that the Fed raised (or lowered) interest rates refer to the federal funds rate. The federal funds rate is the interest rate banks charge each other for short-term loans as the banks borrow from each other to meet reserve requirements. Because other interest rates are linked to the fed funds rate, as it changes, other interest rates change as well. When the economy is overheating and inflation is a problem, the Fed will raise interest rates in an effort to combat inflation. When the economy is in need of economic stimulus, the Fed will lower the fed funds rate in an effort to jumpstart the economy. Question 9: How does inflation with unemployment change the approach taken by policy makers? Answer 9: Inflation with unemployment, or stagflation, is an unusual circumstance that occasionally occurs. For example, the United States experienced stagflation in the early 1970s. The problem is that changes in aggregate demand are not sufficient to resolve the issue. This is because increases in aggregate demand reduce unemployment but cause inflation, and decreases in aggregate demand reduce inflation but cause unemployment. Therefore, policy makers often must use multiple approaches. These include the typical monetary and fiscal policies plus extreme measures, such as price 4

5 and wage controls or changes in exchange rate policies. For example, during the early 1970s, the United States imposed wage and price controls and allowed the dollar to freely float (i.e., it was moved off the gold standard) in an effort to eliminate stagflation. Question 10: Which policy instruments are used by policy makers to achieve the objectives of external and internal balance? Answer 10: Policy instruments include expenditure-changing policies, expenditure-switching policies, and direct controls. Expenditure-changing policies involve fiscal and monetary policies that affect the level of aggregate demand. Fiscal policies include changes in government spending and taxation. Monetary policies include the effect of changes in open market operations, reserve requirements, and the discount rate on the money supply. Expenditureswitching policies attempt to change the direction of demand by shifting it between domestic and foreign. For example, nations that have a freely floating exchange rate purchase other currencies or sell its own currency to affect demand. Finally, direct controls include government restrictions, such as wage and price controls, tariffs, quotas, and subsidies. The evidence suggests that changes in monetary policy are the most effective in affecting aggregate demand. 5

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