Lecture: Midterm Review & Exam
Lecture script · about 15–20 minutes spoken · Week 8
Opening
Picture a small-business owner at a kitchen table with two pieces of paper. One shows this year's sales. The other shows what's still owed on a loan. Both are dollar amounts, and both matter. But one is an amount per year, and the other is an amount at one moment. Mix them up and the owner draws the wrong conclusion.
That same mix-up shows up when a nursing student reads a headline about the national debt, or when a renter wonders whether prices are still rising. So in this lecture we'll do two things. First, we'll walk back through Weeks 1 to 7, one calculation and one curve for each topic, using numbers you've already met. Every one of them comes from an illustrative dataset built for this course, not real data. Second, I'll give you one new habit, the flow-versus-stock habit, which sorts amounts per year from amounts at a moment.
Here's where we are. Week 1 gave you models and the frontier. Weeks 2, 3, and 4 gave you the big measures: output, prices and jobs, and growth. Weeks 5 and 6 gave you the one diagram the rest of the course runs on. Week 7 put government spending and taxes onto that diagram. After this week, Week 9, Money & the Banking System, opens the second half of the course, and the new habit will keep you steady there.
1. The frontier, and the line between is and ought
Think about a town where half the workers are home with no shifts, even though the shops and garages are ready to run. The town isn't short of people. It's wasting them. That was the first picture you drew.
A production possibilities frontier is a diagram showing the largest combinations of two goods an economy can produce with all of its resources and its current technology. In our illustrative economy, there are 24 labor-hours to spend, counted in millions. A unit of consumer goods takes 3 hours, and a unit of capital goods takes 6.
Your one calculation is to test a point. Take 4 consumer goods and 2 capital goods. Three times 4 is 12, and 6 times 2 is 12, so the point uses 24 hours. That's every hour available, so the point sits on the frontier. Now take 2 and 2. Three times 2 is 6, plus 12, makes 18 hours. That leaves 6 hours idle, counted in millions. The frontier's picture of unemployment is a point inside the line.
The slope of the frontier is opportunity cost. Giving up 8 consumer goods buys 4 capital goods, so one capital good costs 2 consumer goods.
Week 1 also gave you one distinction you'll use on every policy question. A positive statement is a claim about how the economy is, was, or will be, which evidence can confirm or refute. A normative statement is a claim about how the economy ought to be, which rests on values and cannot be settled by evidence alone.
Pause and try this. Someone says, "The economy ought to put its idle hours to work." Is that positive or normative?
Find the word that carries a value.
Here's the answer. It's normative, because "ought" makes it a value judgment, even one most people share.
2. Output, and real versus nominal
Every time a family buys groceries, a shop buys a new oven, or a city pays a bus driver, output shows up as spending. Week 2 added that spending into one number.
Gross domestic product is the market value of all final goods and services produced within a country during a given period, such as a year. In our illustrative account, everything is in billions of dollars. Consumption is 700. Investment is 200. Government purchases are 250. Exports are 100, and imports are 150.
Do net exports first, with the sign. Exports of 100 minus imports of 150 gives negative 50, a trade deficit. Then add all four parts with the sign: 700 plus 200 plus 250 minus 50 is 1,100. In words, this economy produced 1,100, in billions of dollars, of final goods and services in the year.
Now the distinction. Nominal GDP values output at the prices of the year it was made. Real GDP values the same output at fixed base-year prices. In our account, real GDP is 1,000. Divide 1,100 by 1,000 and multiply by 100, and the GDP deflator is 110. So prices sit 10 percent above the base year. And here's what matters most: 100 of that 1,100 is higher prices, not more stuff.
Pause and try this. If nominal GDP rises, can you say the economy made more goods and services?
Think about what else can make a dollar total grow.
Here's the answer. Not yet, because nominal GDP can climb when prices alone rise, so you convert to real terms before comparing years.
3. Prices and jobs: a level versus a rate
Picture your grocery receipt for the same weekly run, kept for two years. The total went up. Week 3 turned that into two different numbers, and mixing them up is a classic slip the midterm checks for.
The Consumer Price Index compares the cost of a fixed basket with its cost in the base year, times 100. In our illustrative basket, the cost goes from 200 dollars to 216. Divide 216 by 200 and multiply by 100, and the CPI is 108. That's a level. It carries no percent sign.
The inflation rate is the percentage change in a price index from one period to the next. From 100 to 108, the change is 8, divided by 100, times 100, which is 8%. That's a rate, and it carries a percent sign. In year 3 the CPI reaches 113.4. The change from 108 is 5.4, and 5.4 divided by 108, times 100, is 5%. So the level kept climbing even as the yearly rate fell.
Jobs work the same way: one rate, one denominator. In our illustrative labor market, 114 are employed and 6 are unemployed, counted in millions, so the labor force is 120. The unemployment rate is 6 divided by 120, times 100, which is 5%. The participation rate is 120 divided by 200 adults, times 100, which is 60%. A discouraged worker has stopped looking, so the survey puts that person outside the labor force, not among the unemployed.
Pause and try this. A news reader says, "The CPI is 113.4, so prices rose 13.4% this year." What went wrong?
Ask yourself which number is a level.
Here's the answer. The 113.4 is a level measured against the base year, and this year's rate is 5%, the change from 108.
4. Growth, and the starting value
Say a neighborhood bakery sold 800 loaves last month and 840 this month. It grew, but by how much? Week 4 answered with one rule about which number goes on the bottom.
A growth rate is the percentage change in a quantity from one period to the next, found as the new value minus the old value, divided by the old, starting value, times 100. In our illustrative growth economy, real GDP rises from 800 to 840, in billions of dollars. The change is 40. Divide 40 by 800, the starting value, and multiply by 100, and you get 5%. Divide by 840 instead, and you get about 4.76%. That's the wrong-base error, and it understates growth.
Then there's the shortcut. The rule of 70 estimates doubling time as about 70 divided by the growth rate in percent. At 7% growth, 70 divided by 7 is 10 years. It's an approximation, so you always say "about."
Pause and try this. Someone writes that an economy growing at 7% doubles in 490 years. What did they do?
Think about which way faster growth should push the answer.
Here's the answer. They multiplied 70 by 7 instead of dividing, and faster growth must mean a shorter doubling time, not a longer one.
5. The AD–AS habit, and the gap
Picture your city announcing a big road project. Crews get hired, suppliers get orders, and the crews spend their pay at shops and cafés. Prices and output both start to climb. Weeks 5 and 6 gave you the picture for that.
Picture the AD–AS diagram in words. Real output runs across, in billions of dollars. The price level runs up, as an index. Aggregate demand slopes down, and short-run aggregate supply slopes up. The habit is called comparative statics: compare two equilibriums before and after one change. Name the curve that moves, name the direction, then read the new price level and real output.
In our illustrative linear pair, the curves first cross at output of 800 and a price level of 12. Government spending rises, so the curve that moves is aggregate demand, and it shifts right. The new crossing is output of 900 and a price level of 13. Output rose by 100, and the price level rose from 12 to 13. Both went up, together, walking up the short-run supply line. A short-run supply shift is different. An oil-price shock moves prices up and output down. It pulls them apart.
Week 6 added where the crossing sits. Potential output is the long-run line. In the illustrative gap economy, potential is 1,000 and actual output is 950, in billions of dollars. The recessionary gap is 1,000 minus 950, which is 50. As a share of potential, 50 divided by 1,000, times 100, is 5%. You always report both.
Pause and try this. Prices and output both rose after a shift. Which curve most likely moved, and which way?
Remember which shift moves them together.
Here's the answer. Aggregate demand shifted right, because only a demand shift moves the price level and real output in the same direction.
6. The fiscal tools, and the two cases
When a road crew gets paid, the crew spends part of its pay at a café. The café owner spends part of that at a hardware store. One dollar of new spending turns into several dollars of income. Week 7 put a number on that chain.
The spending multiplier is the number one divided by one minus the MPC. It tells how many dollars of output one extra dollar of spending creates once every round of re-spending is added up. In our illustrative economy, the marginal propensity to consume is 0.8. One minus 0.8 is 0.2, and 1 divided by 0.2 is 5. So a 20 increase in government purchases, in billions of dollars, raises output by 5 times 20, which is 100. The classic slip is dividing 1 by the MPC itself, which gives 1.25. That's off by a factor of 4.
Expansionary fiscal policy, more spending or lower taxes, shifts aggregate demand right. Contractionary policy shifts it left. And here's a caveat. The simple multiplier is a model. Taxes and imports leak out of each round, so the real-world multiplier is smaller.
Week 7 also left you a debate, and I want you to keep both sides at full strength. The Keynesian case says that in a recessionary gap, idle workers and machines can go back to work, crowding out is small, and waiting leaves the gap open longer. The classical and monetarist case for caution says government borrowing can push up interest rates and crowd out private investment, lags can make the help land late, and every deficit adds to the debt. Which risk weighs more is a judgment you'll argue, not one this course settles.
Pause and try this. A question asks how much a spending increase raises output. Should you use one over the required reserve ratio?
Think about which multiplier belongs to banking.
Here's the answer. No, that one belongs to banking, which starts next week, so you use one divided by one minus the MPC.
7. The new habit: flows and stocks
Picture a bathtub with the faucet running. You can describe the water two ways. One is how fast it pours in, an amount per minute. The other is how high it stands right now, an amount at one moment. Both are true, and they answer different questions.
That's the new tool this week. A flow is an amount measured per period of time, such as a year's GDP, a year's investment, a year's budget deficit, or a year's inflation rate. A stock is an amount measured at a point in time, such as the national debt at the end of a year, the capital stock, or the price level. The flow-vs-stock habit is one question you ask of any number. Does it need "per year" to make sense, or "as of" a moment?
Let's run three pairs you already know. First, the budget. Spending of 450 minus revenue of 400 is a deficit of 50 for the year, in billions of dollars. That's a flow. It raises the debt from 1,000 to 1,050 at the end of the year. That's a stock. Second, investment. In the expenditure account, investment is 200 in one year, a flow of new machines and buildings. It adds to the capital stock, the total amount of machines, equipment, and buildings an economy has at a point in time. Third, prices. Inflation of 8% over a year is a flow, a rate of change. The CPI of 108 is the price level, a stock-like level.
So when a coworker says, "The deficit fell, so the debt is shrinking," you can catch it. A smaller deficit is still above zero, so the debt still grows, only more slowly. Turning the faucet down isn't the same as draining the tub. One limitation, though: the habit doesn't tell you whether a debt is too big. That part of the argument is partly normative. The habit only tells you which kind of number you're arguing over.
Pause and try this. Is the debt of 1,050 at the end of the year a flow or a stock?
Ask whether it needs "per year" or "as of."
Here's the answer. It's a stock, because it's the amount owed as of one moment, the end of the year.
Closing
Let's pull it together. Inside the frontier is wasteful, and "ought" marks a normative claim. GDP adds consumption, investment, government purchases, and net exports, and you compare years in real terms. The CPI is a level, and inflation is a rate. Growth divides by the starting value, and the rule of 70 is about, not exact. On the AD–AS diagram, you name the curve, the direction, and the new price level and output, and you report a gap in units and as a share of potential. The spending multiplier is one over one minus the MPC. And the new habit sorts every number into a flow per year or a stock as of a moment.
The midterm checks Weeks 1 to 7, as they were taught, and no AI help is allowed on it. Next in this module come the slide deck, the Readings & Resources page, the practice set, and the discussion. Then Week 9, Money & the Banking System, opens the second half of the course.
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