The answers may not be 100% complete, but they give a good starting point. You may need to add and expand if I ask one of these questions on the exam.
1. In the simplest terms, the variation in living standards across nations is a result of the variation in labor productivity across nations.
2. The standard of living is a measure of how well people live. Income per person is an important dimension of the standard of living and is positively correlated with other things such as nutrition and life expectancy that make people better off. Productivity measures how much people can produce in an hour. As productivity increases, people can produce more (and use less to produce the same amount) and so their standard of living increases.
3. A production function is a mathematical representation of the relationship between the quantity of inputs used in production and the quantity of output from production. A typical production function could be written as Y = A F(L, K, H, N), where Y denotes the quantity of output, L the quantity of labor, K the quantity of physical capital, H the quantity of human capital, N the quantity of natural resources, and A is a variable that reflects the available production technology.
4. Natural resources are one of the factors of production. However, a country need not have a lot of natural resources in order to be richÄÄconsider Japan and Switzerland. To a large extent, natural resources are what an economy and its technology make of them. Some countries have abundant natural resources and so are richÄÄconsider the major oil producing countries. However, natural resources are just one of several factors of production. Obviously countries in the past had abundant natural resources and yet lacked the physical capital, human capital, and technology to produce much with them. Further, while abundant natural resources may make a country rich, a given stock of natural resources does not create growth in income per person.
5. Productivity is the amount produced per hour of labor. If a farm family can produce much more in a year, on average they produce much more in an hour as well. Technology is likely responsible for most of the increase in productivity. A farm family today clearly has more capital, but not enough to explain such a large increase. A modern farm family's understanding of agriculture is better than their colonial counterparts, but not so much because they had more education as because society's understanding of how to produce food has increased. It is difficult to imagine a very well-educated farm family with considerable capital but restricted to using colonial technology, producing more than a small fraction of what could be produced by a farm family with modest modern education and capital taking advantage of modern technology.
6. One way for society to become more productive is to generate a larger capital stock. Because capital is a produced factor of production, society can change the amount of capital it has by producing more capital goods. If more capital goods are produced, however, fewer consumer goods can be produced. Hence, consumers must consume less and save more. Therefore, if a society wishes to increase future productivity by increasing the capital stock, the society can do so by investing more and saving more in the present.
7. The catch-up effect is based on the idea that it is easier for a country to grow fast if it starts out relatively poor. This is because poor countries have very low capital-labor ratios, hence, a given increase in capital per worker will have a large impact on productivity in those countries. On the other hand, the law of diminishing returns states that rich nations, which already have high capital-labor ratios, experience only a small increase in productivity from a given increase in capital per worker. Hence, a given rate of investment in a poor country leads to a higher rate of economic growth than does the same rate of investment in a rich country. As a country develops, growth rates slow down. In the long run, the higher saving rate leads to a higher level of productivity and income, but not to higher rates of growth in those variables.
8. A country can increase its investment in capital through borrowing from foreigners. This kind of investment can take the form of foreign direct investment, where a capital investment is owned and operated by a foreign entity, or through foreign portfolio investment, where the real capital investment is financed with foreign money but operated by domestic residents.
9. An educated person might invent new products or generate new ideas about how best to produce goods and services. An educated person might discover a cure for cancer. As these ideas and developments enter society's pool of knowledge, so everyone can use them, they are an external benefit of education.
10. In addition to investment in physical and human capital, a country might increase productivity by (a) specifying and enforcing property rights, (b) encouraging free trade, (c) controlling population growth, and (d) promoting research and development.
11. It is important to remember that income per person is closely tied to the standard of living. With greater population, the amount of other inputs per worker falls. This decrease results in lower productivity, and so lower output per worker. This is evident for example for human capital where a rapidly increasing population burdens the educational system.
12. Patent laws encourage invention and innovation through granting property rights to the patented product or process. In this way, the laws encourage technological progress and economic growth. By protecting the product or process from competition, however, the patent laws slow down the diffusion of the developed technology. Most economists believe that the advantages of patents in encouraging innovation outweigh the disadvantages of patents in slowing down the rate of technological diffusion.
13. From 1959 to 1973 productivity grew 3.2 percent per year. From 1973 to 1998 productivity grew at 1.3 percent per year. As productivity growth slowed, so did the growth of real wages and real income. Consequently, the standard of living has not increased as rapidly.
14. The decrease in the growth rate of productivity is usually attributed to slow technological progress. Other industrial countries also experienced a slowdown. Although productivity growth slowed from its 1950-1973 rate, productivity growth remained high relative to other periods in the last 125 years.
15. The financial system consists of those financial institutions that help coordinate the decisions of savers and borrowers. The two categories of financial institutions are financial markets and financial intermediaries. The purpose of the financial system is to move the economy's scarce resources from savers to borrowers.
16. Financial markets are the institutions in which a person who wants to save can directly supply funds to a person who wants to borrow. The most important financial markets in the United States are the bond market and the stock market. Financial intermediaries are financial institutions through which savers can indirectly provide funds to borrowers. Two of the most important financial intermediaries in the United States are banks and mutual funds.
17. A bond is a certificate of indebtedness that specifies the obligations of the borrower to the holder of the bond, while stock represents ownership in a firm and is, therefore, a claim to the profits that the firm makes. The sale of bonds to raise money is called debt finance, while the sale of stock is called equity finance. Whereas the owner of shares of stock in a company shares in the profits of a company, the owner of bonds receives a fixed interest rate. Compared to bonds, stocks offer the holder both higher risk and higher return.18. a. The Colombian government bond would likely pay a higher interest rate because the market perceives a higher level of risk in the Colombian bond relative to the U.S. bond.