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1.1) Intro
-Wants > Means = Scarcity-Choice problem
Economics: how indv & soc tackles ^
-Centrally-Planned: small group of indv
-Market-System (Free Enterprise System): S&D forces and price
-Traditional: position of indv in soc = job/rewards
2.1) Intro
-Economics= Micro + Macro
-Micro: -behavior of particular items -Macro: -concerned w/ big picture
-price of computers vs comics -aggregates in economy
-salaries of lawyers vs wage of farmers -level of nation’s o/p, unemployment rate, inflation rate
-behavior of HH in spending income -gvt policy-making, taxes, transfers, gvt expenditure
-behavior of firms in hiring resources -control of money supply
-Demand and Supply: -Circular Flow of National Income:
-interaction of D&S determines the price and -how well off a nation is depends on how well it utilizes
quantity of commodities its resources (quality &quantity of its stock of natural &
-resource allocation occurs in response to P signals manmade resources + quality & quantity of LF) in order
to produce g&s
-Internationally:
-exports and imports of goods and services, -balance of trade (exports and imports summed),
tariffs, quotas, and exchange rates. balance of payments (balance of trade + capital
flows), and policy-making to affect exchange rates
2.2) Strengths and Weaknesses of Capitalist System
-Nation’s Capital Stock= nature’s endowment (land, rivers, mineral deposits) + manmade resources (roads, buildings)
-Nation’s Labor Force= proportion of population able and willing to work @ going wage rates and working conditions
Figure 2.1 Resources and output
-When you have successful product and your profit (difference between cost of production and selling price) increases
-Other resource-owners will join your industry.
-Consumers don’t have to bid as high a price as before.
-Prices go down, until resources stop moving into the industry.
-This happens only when returns that could be earned in other industries are higher.
Resource-owners are motivated to seek highest returns from their resources
Entrepreneurs and business firms are motivated to hire at lowest prices and sell at highest prices
-Prices: -tell consumers how far their budgets can stretch= how well off they are
-tell business firms Revenue
-prices of resources = business costs
All determined by forces of competition
Political ‘Left’ think the gvt should solve these problems by:
a. ban ‘bad’ g&s and providing ‘good’ g&s
b. establish advertising standards
c. set and enforce pollution standards
d. provide g&s to the poor
e. control wages and prices in times of inflation and become employer when unemployment threatens
Political ‘Right’ think the gvt should be less involved: greater reliance should be placed on market forces
2) Externalities
-Externality: extra benefit/cost society bears from actions that it is not directly involved in
-when actions of indv or firm confer benefits/costs on indv or firm not directly involved in those actions (ex: smoking,
polluting)
-society must decide on optimal levels of air, water and noise pollution + who should pay for achieving these levels
3) Economies of Scale
-Economies of Scale: when as firm’s level of o/p expands, unit cost of producing o/p falls.
Figure 2.6
4) Income Distribution
-the Demand for resources is a derived demand = derived from g&s produced from these resources.
-Firms give Resource Owners (HH) provide:
-Wages & Salaries Labor
-Rent Land
-Interest & Dividends Capital
5) Stagflation
-Macroeconomic
Y= National Output
C= Consumption Expenditurebasic rationale 4 economic activity (large)
I= Investment Expenditure guarantees higher future standard of living
G= Government Expenditure goods consumed by all (public goods)
N= Net Exports (Exports- Imports)
- How can gvt get economy to full employment + avoid wasting resources?
Fiscal policy: changing government expenditure and/or tax rates.
Monetary policy: changing the money supply or interest rates.
Module 3: Demand
3.1) Intro
-Income= scarce resource for HH
-HH supplement income: savings + borrowing against future income
-HH try to allocate this limited income on g&s that create greatest HH satisfaction = maximize utility subject to budget
constraint
-Driving forces of market/free-enterprise economy: Consumers trying to maximize utility from the way they spend their
incomes + Firms trying to maximize profit from hiring resources to produce the g&s consumers want most.
- as indv consumes more of a certain gd in given time period, total utility increases, but at a decreasing rate.
- Marginal Utility: extra utility derived from consuming additional unit of gd
- Law of Diminishing Marginal Utility: marginal utility decreases as consumption of gd increases.
Indv can increase total utility by purchasing combo of g&s rather than by allocating budget to 1 gd only.
a) Substitution Effect:
- the decrease in Q of gd X purchased that results from a change in P of X relative to other gds
- always –ve relationship
- price increase X = loss in real income less quantity of X purchased
more quantity of Y (cheaper good) purchased
b) Income Effect:
- could be -ve or +ve relationship
- price increase X = loss in real income (lower total utility)
less quantity of X purchased
- income (budget) reduced (lower total utility)
less quantity of X purchased
i) Normal Goods: +ve relationship
- price increase X = loss in real income
less quantity of X purchased
- price decrease X = rise in real income
more quantity of X purchased
- P and Q always go in same direction.
- the +ve income effect reinforces the –ve substation effect
ii) Inferior Goods:
- a gd where Q of X purchased falls when real income rises.
- Ex: X= cheap meat, low-cost housing, and bus tickets
- money income increases = rise in real income (while all P remain the same)
less quantity of X purchased
- –ve substitution effect > income effect.
- (the change in relative price of X = change in quantity of x purchased) > (change in quantity of X
purchased because of change in real income caused by price of X changing)
iii) Giffen Goods:
- A gd where @ higher prices, a larger Q of X purchased (for limited range of P)
- Income effect > -ve substitution effect
*the “change in” sign is the difference between new and original
*the bottom P and Q are the original
-When E < 1, the gd = Price-Inelastic
-Total expenditure on the good (P x Q) increases as P increases; and decreases as P decreases
-Demand Curve is Price-Inelastic over the certain range of prices measured
sd
sds
sds
sd
-3 special types of D Curves where P elasticity of D does not vary along length of curve, but remains constant
-Perfectly Inelastic
-QD is the same at each P level
-P Elasticity of D is 0 at every point on curve because (change in Q/Q =0)
-Perfectly Elastic
-P is the same at each QD
-P Elasticity of D is infinite because (change in P/P =0)
*SINCE STEEPNESS OF CURVES DEPENDS ON UNITES DENOTED ON AXES, IT IS MISLEADING TO JUDGE PRICE ELASTICITY
OF DEMAND BASED ON DEMAND CURVE ONLY*
-Governments can also change individuals’ behavior by using incentives (transfers and grants) that either expand budget
constraints or reduce prices of specific g&S
Module 4: Supply
4.1) Intro
-Suppliers of g&s face 3 basic problems:
1) How much output should be produced for each time period?
2) What price should be charged for each unit of output?
3) What is the most efficient way to produce that output?
4.2) Productivity
-Total Product Curve: traces out the Production Frontier of a firm (shows max possible o/p for diff amts of factor i/p)
-reason for shape of Production Frontier: Specialization (having more workers means each person has specific
task and therefore more will be done in less time compared to if one worker had to do everything on his own)
=Division of Labor
-increases in variable factor i/p yield
proportionately greater increases in o/p up to a
certain level of o/p... then, less than
proportional increases in o/p
-Average Product = total output (Q) divided by 3 of units of variable factor input (L)
- Increases at beginning as input increases, reaching a maximum, then declines as input increases
-Marginal Product = change in the output (Q) because of change in input (L) at a given level of employment of that factor
-the importance of Marginal Analysis in problems involving maximization
when hiring the optimal amt of any variable factor i/p, firm requires info on MP of each factor i/p @
each level of employment
-MP is measured by calculating how much the next factor input will add to your output.
-when MP = 0, no more inputs should be hired
2. When AP is at max., AP = MP
5. When change in TP is 0, MP = 0
4.3 Costs
-total cost of producing gd = # of factors of production employed x P or cost of that unit.
-wage rate = # of units of type of labor (workers) employed x P of that unit
-Total Cost of Production = total cost of producing gd+ wage rate
-Fixed factors of production: factors which cannot be altered practically in quantity (factories, machine tools)
-Variable factors of production: factors whose numbers can be altered immediately (labor)
-‘short-run’: time period during which certain factors cannot be altered in quantity
-‘long run’: time period during which all factor inputs can be varied
Derivations:
-Average Cost of Production:
-Profit Maximization:
-to be profitable firms must operate at level of TR > TC or where AR > ATC
-because P is constant: P = AR = MR
-then becomes vertical line because no further input will cause increase in
output, it would only increase cost.
Shifts in S Curve:
-increase cost of variable input = shift upwards = min AVC will increase
-decrease cost of variable input = shift downwards = min AVC will decrease
-Firms may never reach LR Equilibrium (even if they are in SR Eq) because change occurs constantly
(new g&s, consumer taste changes, technology, changing R&D)
-opportunity cost: best alternative given up when a good is produced (the alternative foregone)
-in the LR if a resource owner can earn higher Profit in production of diff g&s, he will move resources there
4.5.4 Firm in LR
-in LR, no factors of production are fixed
-the rule for profit maximization in LR is same for SR (mostly): MR =MC (but the LRMC)
-for o/p levels < Q, producing additional o/p adds more revenue than
TC because MR > LMC
(Vice versa)
-Total Profit is +ve for all o/p @ which AR > ATC but only max at one
o/p level where MR = LMC
-in SR and LR Equilibrium because MR = MC and MR =
LMC @ o/p Q.
-
-realizing labor output has implication on the working class for society, whereby increasing their output can lead
to a better well-being
3) Factor Returns and Scale Returns
-Returns to Factor Inputs:
-varying one factor while keeping all other inputs constant
-SR phenomenon
-the relationship between changes in factor inputs and resultant changes in outputs is not constant. It can take
three forms:
a) Increasing
b) Constant
c) Diminishing
(We learn this from the shapes of production frontiers and concomitant SR AC curves)
-Returns to Scale:
-a change in output resulting from a change in all inputs
-LR phenomenon
a) Increasing
b) Constant
c) Diminishing
4.6.4 Price Elasticity of Supply/ Supply Elasticity
-Supply Elasticity: a measure of the responsiveness of Q of o/p supplied to a change in P
-measured along diff pts on the supply curve (SR or LR)
-the supply of some goods is completely Inelastic (Mona Lisa)
5.1) Intro
-Market: exists when indv, HH and firms who want to buy g&s are in contact with firms willing to supply that g&s
-competition among buyers to buy and sellers to sell, determines P and Q that are bought and sold
-Market prices provide info to buyers attempting to maximize utility and to suppliers attempting to maximize profits
-Suppliers must decide which resources are employed = which g&s produced, and how much of each g&s produced.
- prices indicate society’s preferences for diff g&S which suppliers must respond to to remain competitive
Prices determine how resources are allocated
-in market economies: resource-allocation is outcome of millions of HH expressing their preferences for diff kinds of
food and drink in markets and the decisions of independent suppliers to hire resources to produce the food and drink to
satisfy these HH
-Free Good: at all +ve P in market, the Q of gd > QD, so the P =0. (fresh air)
-Q of gd that consumers are willing to buy = Q of the gd firms are willing to sell
5.3) The Operation of Markets
-if a P causes excess D or excess S in market, forces in market will change P of good and Q bought and sold.
-if excess S: competition among suppliers would force down P of gd, larger Q of gd will be demanded, and S will
be reduced.
-if excess D: competition btw consumers would force up P of gd, suppliers would be willing to sell greater Q of
gd, and D will be reduced.
-Equilibrium: when forces that act to eliminate excess D or excess S exactly offset each other
-Eq P, intentions of all potential buyers and sellers are exactly matched
-Eq Q, identical Q of gd which two sides wish to buy and sell at that price
-Consumer Surplus: additional gain from obtaining units of gd at P that is less than what consumers r prepared to pay
-measured by the diff btw P indv actually pays for gd and the higher P they would be prepared to pay
-Producer Surplus: additional gain from selling units of gd at a P that is higher than they would be prepared to accept
-measured by diff btw P suppliers actually receive for selling gd and lower P they would be prepared to accept
-when P ceilings exist and there is excess D, black markets develop where Eq P will
be reached
-the amount of tax = the diff btw the two S Curves (on y-axis)
-what consumers will pay = diff btw Eq P before and after tax
-what producers will lose = diff btw Eq P before tax and (‘Eq P after tax’
– tax)
-Pre Tax:
Consumer Surplus: DPE
Producer Surplus: 0PE
-Post Tax:
Consumer Surplus: DP’E
Producer Surplus: 0P’Z
Imposition of Tax:
-raises P paid by indv and lowers P received by suppliers
= reduces volume of transactions
= reduces gains from exchange
-the Market Period: period as transactions take place; no time for any inputs
of outputs to change (day at the supermarket)
-whether market will converge or diverge depends on slopes of D and & S curves
-when S is steeper than D, P will converge towards Eq
-when D is steeper than S, P will diverge from Eq
Module 8: Public Goods and Externalities
8.1) Intro
-Why society does not rely on market forces completely in determining allocation of scarce resources
1) to help achieve economic efficiency
2) to alter the distribution of g&s to HH
-The 2 underlying assumptions that must hold for a competitive market economy that is economically efficient:
1) when firm produces g or s it will have to pay all costs of production
2) if HH wants g or s it will have to pay for it
-However, there are g&s produed in economy wehre firms don’t bear all costs and are enjoyed by HH who don’t pay for
them
-Public g&s: each unit is consumed by everyone and from which no individual can be excluded. (Ex: National defence)
-Non-excludability: you can consume security without preventing others from benefiting
-Non-rivalry: the amount you consume does not reduce the amount consumed by others
The efficient allocation of resources cannot be achieved because of the “Free Rider” Problem: someone who consumes a
gd without having to pay for it.
-Governments like individuals and firms, can apply same efficiency criteria to spending on g&s: Equating costs and
benefits at the margin. Optimum provision of any g&s: @ Marginal social cost of production = Marginal social benefit
-only at this level will the optimum level of provision be obtained
-how ppl are taxed is an issue of income distribution: Proportion of income vs. Equal sum.
-Flat-rate or Equal sum: poor families are worse off
-Proportion of Income: ppl with higher incomes are worse off
=Economic criteria can determine the most efficient amts of public goods, but they cannot determine the optimal
income distribution: Equity, not Efficiency. (judgment call)
-External Benefits or Positive Externalities: benefits that accrue to indv external to activity (neighbor landscaping)
-External Costs or Negative Externalities: costs borne by indv external to activity (pollution from nearby factory)
-economic efficiency will not prevail in society if Private marginal costs/marginal benefits < societal marginal
costs/marginal benefits. Private MU or MC will be understated in the equation
-if external benefits exist in consumption of gd A, then allocation of resources to A would make the value of MU
understated. So, marginal equivalency would not hold.
S1) per unit tax imposed on firms that do not account for
external costs in their decisions (raises MC and P)
\-the greater the amt of resources owned by an indv and the higher the MP of each resource, the higher will be the
income of a resource-owner
-resources can be given to indv by nature, from another indv, or by employing resources.
9.4) Monopsony
-Monopsony: opposite of monopoly= only one buyer in a market and occurs when only one employer of factor inputs
exists in a market.
Lack of competition on the D side for factors of production
-since monopsonist is sole employer of factors, it creates the market D schedule for each factor
-if a monopsonist wants to hire more factor inputs (like labor) , the marginal cost of the increase would be the higher
rate necessary to attract more of a factor + the increase in rate to existing employed units of that factor.
MC of a factor to a monopsonist > going rate
-a profit-maximizing monopsonist won’t hire a factor until the VMP = the going rate for that factor (which is less than
MC) AND will hire a factor of production up to the pt at which the benefit of hiring one additional unit of the factor =
cost to the firm of hiring that factor: VMP = MC
-if monopsony in factor markets exists, by negotiating forced rate for a factor that is higher than the going rate, unions
can reduce MC of hiring additional units of a factor and cause increase in employment of that factor!
-ppl argue that trade unions by forcing up wage rates have caused Unemployment in many sectors of the economy
because such gains are at the expense of the unemployed = total o/p in economy reduced
-others argue that trade unions by forcing up wage rates have not caused unemployment but a redistribution of income
from exploiting monopsonists to workers.
Trade unions create monopoly power for workers VS. Trade unions offset monopsony power of employers.
-Most programs employed in market economies around the world do not work and poverty still exists
-one solution: Negative Income Tax
-instead of having a marginal tax rate of 100%, where if a person finds a job paying 2000 and the transfers cease
so the indv has no incentive to look for work.
-marginal tax rate of 50% means indv can keep whatever they earn up to threshold of 4000 and always pays 50%
tax. Incentive is there to keep looking for better work because you keep half of what you pay.
--ve income tax costs almost nothing to implement.
Module 10: International Sector
10.1) Intro
-even if two individuals have goods that they both like, benefits can come out of exchange if MUs are different.
10.5.2 Quotas
-deff from tariff is that there is no tax advantage for government
-to keep ER at level ER2, the US would have to buy ‘ab’ $ in exchange for
pounds.
-IF, there is excess D for $, US can obtain enough $ to sell on forex market
by borrowing internally and/or raising taxes.
-IF, there is excess S for $, the US gvt has to buy the dollars, and will only
be able to do that if it has enough reserves of pounds, OR it can persuade
UK to purchase $
1) Current Account:
-imports of g&s, and exports of g&s
-any items that do not result in addition to, or subtraction from, a country’s claims on foreign resources
2) Capital Account:
-all transactions that affect the amt of claims that your country has abroad and that foreign countries have in
your country
-all int’l borrowing and lending transactions
-Balance of Payments Deficit: excess supply of a country’s currency that results from int’l transactions and that the gvt
must purchase if the exchange rate is to be preserved.
-Balance of Payments Surplus: excess demand for a nation’s currency that the gvt must sell if the currency is to remain at
its existing exchange rate if gvt does not intervene, the currency will depreciate
-the fluctuation of exchange rates cannot be blamed on fluctuations in imports or export of g&s; value of world trade is
very small % of value of world financial transactions.
X: a measure of exports
INF: relevant inflation rate (both domestic and foreign)
App: currency appreciation factor
Dep: currency depreciation factor
The growth rate of exports will depend on the growth rate of foreign income, relative inflation rates and the degree of
appreciation/depreciation of the currency against a basket of foreign currencies
Z: measure of imports
Same factors that affect X but work in opposite direction and depend on domestic national income Yd instead of Yf.
-Purchasing Power Parity PPP: method of comparing across countries by taking cost of similar basket of goods in diff
countries and comparing them in a common currency
-Dilemma: resources allocated to capital goods, education and training today = greater deprivation for the current
generation
-SR: there is little gvt can do to influence nation’s potential o/p; ti is dominated by existing quality and quantity of the CS
and LF
-the effects of investing in capital goods is only seen on potential output after the policy is pursued over a number of
years
-firms hire resources owned by HH and produce g&s that flow back to HH
-firms pay resource-owners in the form of wages and salaries for labor, rent
for use of land, and interest and dividends for the use of capital
-If Aggregate Demand = D2, then level of GNP = Y2 and employment rate = E2 = Unemployment exists above natural rate
of unemployment = Employment Gap or Output Gap = less o/p than can be produced, idle labor and unused capacity in
capital stock. (waste of resources).
-If Aggregate Demand were D4, then Prices will rise = inflationary gap. Extent of gap depends on by how much Aggregate
Demands exceeds Full-employment output. (how much it exceeds Q). Prices will rise, marginal buyers will drop out of
markets and economy will return to full-employment equilibrium but @ higher P level.
-if Gvt wants to avoid Inflationary Gap and Output Gap, Aggregate Demand must be at the level where Y = Q
Scenarios for Gvt to expand Aggregate Demand in order to meet growing Potential Output Q:
1) Gvt increases expenditure on project: (G increases)
-Y rises as first part of project is built;
-workers receive additional income which they spend portion on additional g&s
-firms that produce those g&s receive higher income from increased sales, which they spend on more g&s
-Process continues as long as additional expenditure and additional income are generated
Multiple increase in Y resulting from given increase in G = Government Expenditure Multiplier
-to expand economy from Y3 to Y4, Gvt must create additional aggregate demand of (D4-D3).
-If Gvt Expenditure multiplier = 2, then an increase in G of (D4-D3)/2 =
-increase in total aggregate demand of (D4-D3)
-increase in GNP of (Y4-Y3)
-increase in Employment of (E4-E3)
=full employment
3) Gvt increases money supply faster than growth in demand for money (R decreases)
-Price of money falls (which is the rate of interest R)
-borrowers (HH, firms or gvt) will increase borrowing, which they spend portion on additional g&s
-…. As scenarios above
policy maker must calculate size of multiplier and figure out how sensitive consumer and business firm
expenditures are to interest rate changes; then calculate how fast the D for money is growing and increase the
money supply by the amt required to obtain that value of R that will yield the required initial increase in
consumer spending and business investment.
-The macroeconomic policy used to increase aggregate demand and close the output or employment gap depend on
which specific macroeconomic goals the country is trying to achieve at the same time
-in an economically rational perspective, any point on the PPF itself is preferred to any point within the frontier.
-society knows whether it is within or on the frontier by whether or not it needs to sacrifice one good in order to
produce more of the other.
-Economic growth is depicted graphically as a rightward shift of the PPF; society makes choices in the current period
between current consumption and capital investment.
-unless resources are set aside for depreciation, the productive capacity of an economy will diminish
to maintain productive capacity of capital stock, resources must be devoted to replacement investment
to maintain labor force at same quantity and quality, new entrants must be trained
therefore, to maintain potential output at a constant level requires part of o/p be diverted from consumption gds
towards investment to replace physical and human capital
2) Structural Unemployment:
-a more stubborn frictional unemployment
-mismatch btw characteristics of the unemployed and characteristics of job vacancies (occupation or location)
-the unemployed can only match the jobs if they undergo training or change location of work, or both.
-can persist for long periods
3) Seasonal Unemployment
-the level of production is dictated by weather or by calendar
-periods of high employment combined with overtime, alternating in regular seasonal pattern with periods of
lower employment, short-time working and unemployment.
12.4) Relation Btw Unemployment Rate (U), Potential Output (Q) and Actual Output (Y)
-Demand-Deficient Unemployment: arises because of insufficient demand for labor
-full employment is realized when # of unfilled job vacancies (V) = or > # Unemployed (U).
-When economy is operating at Full-employment rate of Unemployment (Natural Rate of Unemployment) (only
unemployment is frictional, structural and seasonal) then Y (actual o/p) = Q (potential o/p)
-the larger the gap, the higher the unemployment
-the smaller the gap, the closer unemployment rate will be to full-employment unemployment rate (Natural)
-Okun’s Law: for each 1% by which Actual Output Y falls short of Potential Output Q, the Unemployment Rate U will
exceed its Full-Employment Rate of Unemployment (normal) by 1/3%
-each % increase in U above Uf = 3% reduction in Y
-reasonable measurement of the loss in real output attributable to demand-deficient unemployment
12.5) Output and Inflation
-Aggregate Demand (the D for o/p by consumers, firms and gvt) will determine the Actual Output Y of g&s.
-given Potential Output Q for any short time period, the level of Aggregate Demand will determine Unemployment Rate
-Price Level = Consumer Price Index: measures the avg level of prices of the g&s consumed by the typical HH
-calculated monthly by prices of several 100 g&s purchased by avg HH
-the Price Index for Base Period is always 100, because it’s the same # divided by itself, x 100.
-GNP deflator: the index that includes all g&s produced in the economy
-how do firms set prices?
-expected costs of production
-expected demand for g&s to be produced
-how do firms predict expected cost and demand for g&S?
-previous Aggregate Demand: the higher it was, the higher will have been demand for firm’s g&s and demand
for factors of production and the higher will be firms’ expectations about what to pay for L, RM and other factor i/p in
coming period.
-AD will influence both Unemployment and Inflation in the SR, (illustrated by Phillips Curve)
-when AD is high; U is low, Inf is high
-when AD is low; U is high, Inf is low
Important Features:
1) Steep Slope (downwards from left to right) indicates an increase in rate of inflation
=lower U associated with higher INF (inverse relationship) (trade-off btw U and INF)
2) Inflationary Bias of economy: +ve inflation rate occurs at Full Employment. (@ F)
3) Curvature: curved line bowed toward the origin. Trade-off btw U and INF depends on where economy is on the
curve.
-@ high U, curve is flatter: change in U = smaller change in INF.
-@ low U, change in U = large change in wages, and consequently INF
IDEALLY:
-at overfull employment, firms employ more resources than normally supplied, S&D put upward pressure on wages,
rents & factor costs = firms expect production costs to rise and raise prices in anticipation.
-at excess unemployment, firms employ fewer resources than are normally supplied= firms expect excess S of labor and
resources to drive wages/ costs down, so firms set P at lower level in anticipation
-at full employment, neither excess D nor S in the market for resources, there would be neither inflationary nor
deflationary pressure, and a stable avg P level.
-how gvt decides where along INF-U trade-off economy should be depends on position of Phillips Curve
-if low and to the left: choose targets close to full employments
-if high and to the right: choose targets to emphasize low inflation
Module 13: The Circular Flow of Income
13.1) Intro
-SR assumption that technical knowledge is unchanging and therefore PPF is fixed
-SR assumption that there will be fixed relationship btw Output (income) and Employment (because the productivity of
labor cannot be altered, so that output and employment must move in the same direction)
-Actual income is determined by AD: relationship btw AD and AS determines whether society experiences
Unemployment of factors of production and failure to realize productive potential, full employment at capacity o/p, or
overfull employment and rising P
-Primary Factors of Production: all inputs used to produce output in the current period but not themselves produced in
current period (labor means skilled gained from previous years, capital means buildings produced long time ago)
-land, labor, capital, enterprise
-Income paid to owners of Primary Factors employed by a producer must be financed form firm’s sales
a) Wages and Salaries: paid in return for use of labor services
b) Rent: paid in return for use of land and capital gds not owned by producer
c) Interest: paid to the HH who have loaned money to purchase land and capital
d) Gross Profits: residual accruing to the firm after all payments of wages, salaries, rents and interest been made
-Sum of payments by a producer for intermediate gds and for primary factors of production = total receipts from sales of
output.
producer’s Value-Added = sum of payments to primary factors (Gross Profit is considered a factor income ?)
-Since GNP = sum of producer’s value added, then GNP also = sum of producers’ payments to primary factors of
production (GNI)
GNP = GNI, & GNP= GNE
GNE = GNI
-These 3 methods are summarized in the national income accounts which provide a method of assessing past economic
activity, allow measurement of living standards over time, and give assessment of diff living standards among diff
economies
13.3 Equilibrium Level of National Income
-National Income can be measured in 3 ways:
1) sum of expenditures GNE
2) sum of outputs (Value-Added) GNP
3) sum of factor incomes GNI
-
C=S
-in such an economy, Supply would create its own Demand, as all Y is
consumed
-whatever HH receives in form of factor incomes, they return as
consumption expenditure to firms
-system would be in equilibrium with no tendency for level of national
income to change.
-most economies Save and Invest
-Savings are a Withdrawal from circular flow
Savings do not constitute component of Aggregate Demand (expenditure)
-saving does not create demand for output thereby generating income and employment
-rise in Savings reduces national income
-Investment is an Injection into circular flow of income
Investment is part of Aggregate Demand (expenditure)
-investment creates a demand for output thereby generating income and employment
-rise in investment increases national income
-Withdrawal: any part of income of private HH that is not passed on in circular flow of income
-Contractionary effect on national income
-Injection: any addition to income of firms that does not accrue from expenditure of HH
-Expansionary effect on national income
Equilibrium National Income can only be achieved if there is consistency btw plans of savers & plans of investors
-Changes that can occur: National Income moves with Planned Investment
a) increase in planned Saving = reduction in national income (unless offset by increase in planned Investment)
b) reduction in planned Saving = increase in national income (unless its with reduction in planned Investment)
c) increase in planned Investment = increase in national income (unless offset by increase in planned Saving)
d) reduction in planned Investment = reduction in national income (unless with reduction in planned Saving)
a) HH with low incomes consume high proportion of HH income or dissave; HH with high incomes save higher proportion
b) over long periods of time where living standards increased, relationship btw consumption and income is proportional
c) relationship btw changes in income and changes in consumption is much less reliable. Time lag before consumption
responds to changes in incomes resulting from habit, custom and existing institutional arrangements (SR relationship
different from LR relationship.
-Consumption is plotted against Disposable Income = consumption is influenced by income after taxes & transfers
-45^ line reflects points where Consumption = Income (all income is consumed, none for saving or dissaving)
-if consumption function lies above 45^ line, Consumption > Income = dissaving
-if consumption function lies below 45^ line, Consumption <Income = saving
-amount of dissaving/saving = vertical distance between consumption function and 45^ line (KL)
-amount of consumption = vertical distance between consumption function and x-axis (KZ)
-LR consumption function is series of points of SR consumption functions
-SR unstable flat shape
-LR stable and predictable
Short Run formula:
-C = consumption
-a = amt of consumption that is independent of income (when Yd =0)
-b = how consumption changes as income changes (Marginal propensity to consume) = slope of cons function
-Yd = disposable real income (income –taxes + transfers)
Long run formula:
-there is no intercept
-at all levels of income, the same prop of income is consumed: linear relationship
-difference between Marginal Propensity to Consume (MPC) and proportion of income consumed at any level of income
(Average Propensity to Consume APC)
where
-MPC important in determining how economy reacts to initial change in component of Aggregate Demand
-If MPC high, large part of initial increase in D is passed on in circular flow = higher consumption (multiplier)
-movement along Consumption Function: changes in consumption that are associated w/ changes in disposable income
-indicates changes in consumption that are consequence of changes in come
-shift in Consumption Function: distribution of income and wealth, tastes, habits, social conditions, advertising, liquidity
-indicates that amount consumed is diff at each level of income
-C = consumption function
- C +I = Aggregate Demand (expenditure) runs parallel to consumption function
-when lies above 45^, aggregate demand > national income
-when lies below 45^, aggregate demand < national income
-@ point of intersection, aggregate demand = national income = equilibrium level of national income, Ye
-planned saving= vertical distance btw consumption function and 45^ line = planned investment
14.5) Multiplier
-if shift in I happens, C + I will shift. Shift in I creates a bigger shift in Aggregate Demand by a multiple of the change in I.
-the sum of all autonomous + induced changes in aggregate demand = total increase in national output
-the larger the MPC, the larger the multiplier
....
-for the multiplier process to work, there must be sufficient unemployed resources
-If economy were at full employment, any autonomous increase in Aggregate Demand would = inflation
-if economy near full employment, autonomous increase in Aggregate Demand would = increase in national
output + inflation
-
-marginal efficiency of investment MEI “r” will decline as volume of interest
increases
-as volume of interest increases, rate of return over cost declines
-opportunity cost of investment is the rate of interest ® what those funds
could earn if loaned out.
if MEI “r” > R =proceed with investment
-Eq when: S + T = I + G
-government borrows from HH and firms to expense the public services it offers to the country
-sometimes taxes are ‘poll tax’ or head tax which is the same for everyone: T = T
-sometimes taxes are proportional to income: T = t(Y)
15.4) In-Built Stabilisers
-in-built stabilizer: any aspect of gvt Taxation and expenditure policies that automatically reduces gvt expenditure
and/or increases government tax revenue when income and output are increasing, or automatically increases gvt
expenditure and/or reduces government tax revenue when income and output are falling.
-taxes, transfers and price supports
-tax revenues rise more quickly than HH incomes as income rises, and fall more quickly than HH incomes as income falls
-when unemployment rises, and employment incomes fall, unemployment benefits increase and income obtained from
contributions fall = unemployed maintain higher consumption than otherwise
-Unindexed tax system: one in which tax thresholds are set in money terms and are not adjusted for changes in P levels.
-Real disposable income: income net of tax and transfer and adjusted for price changes.
-Ye <Yf
-Eq at level where there is unemployment factors of production
-@ Yf, level of AD would not maintain full-employment income
- withdrawals > injections
-Deflationary Gap: insufficiency of AD compared with level of AD
necessary to obtain and sustain Yf, measured by “ab”
-Ye >Yf
-no unemployment due to deficient AD
-since Ye sets limit to physical output (real national income), the points to
the right of Ye represent a rise in price weights of output = inflation
-@ Yf, level of AD > level necessary to maintain full employment
-injections > withdrawals
-Inflationary gap: excess AD above AD necessary to obtain and sustain Yf
measured by“xy”
-Needs budget surplus (T>G) to deflate economy
-Yf = Ye
-neither inflationary nor deflationary
-level of AD just sufficient to obtain and sustain equilibrium income equivalent to
full-employment income
-Money Income: Income measured by current price weights (reflect changes in price and quantity weights)
-Real Income: income measured by adjusting money income to allow for changes over time in value of money (reflect
only changes in quantity weights)
-to calculate Real National Income: fix set of price weights, so that changes reflect only changes in quantity weights.
-price index: representation of price changes (an average P change) by selecting typical basket of g&s prices over time
-GNP deflator: price index used to obtain Real GNP
-Naïve Keynesian:
-Components of AD are independent of each other
-increase in gvt expenditure (G) does not have effect on other components of AD
-it will increase AD by the amount of deficit created
-if this were so, changes in budget deficit/surplus net injection/withdrawal from circular flow of income and
would have substantial impact on level of AD and national income and employment.
-Naïve Monetarist:
-components of AD are interdependent
-changes in budget deficit/surplus are offset by equivalent changes, of opposite sign, in other components of AD
-if this were so, creation of budget deficit by raising G would not raise AD ; higher G would be at expense of
lower private expenditure
= Crowding Out Effect
-method of budget deficit differs the effect of the deficit on aggregate demand and therefore, national income and
employment.
-order of Fiscal policies from strongest
-If inflationary gap exists, AD has excess AD over level necessary to maintain full-employment income
-AD must be lowered
-gvt must create budget surplus (T>G)
size of surplus depends on multiplier and manner in which surplus is created
-KEYNES: gvt interfere with circular flow of income to reach full-employment level of national income/output Y
-through T (withdrawals) or G (injections) into circular flow
-Budget Deficit (T<G) = expansionary
-Budget Surplus (T>G) = deflationary
Functional Finance: there is no single automatic rule that should be followed regarding relationship btw G and T
-relationship btw G and T should reflect underlying conditions in economy: goal to reach full-employment rather
than inflation or deflation
17.4) Fractional Reserve System, Credit Creation and the Credit Multiplier
-under fractional reserve system, commercial banks are subject to 2 competing pulls:
-pull of profitability: cash earns no interest, so lower prop of banks’ assets are held in cash and higher prop held
in interest-bearing assets (greater profitability)
-leads to desire to minimize cash holdings
-pull of liquidity: banks have to keep sufficient assets in liquid form to meet demands of customers for cash
-necessitates that banks are ready to meet customers’ demands for cash
-the smaller “r” cash ratio, the greater the size of the multiplier and the greater the volume of bank deposits created
-Open market operations: buying and selling bonds in the open market
-if central bank buys bonds = increase supply of money and reduce cost of borrowing (expansionary)
Raises AD movement along MEI curve so I rises increase components of AD increase Y, o/p, Employm
-sells bonds = reduce supply of money and increase cost of borrowing
Reduces AD by lowering private & public I, C & X lowering Y, o/p & employment
-Five Stages of Monetary Policy Influencing AD and therefore level of economic activity
1. Central bank acts on cash reserves of comm banks
2. Comm banks act to change bank deposits and therefore money supply
3. Change in money supply influences cost of borrowing
4. Change in AD leads (through multiplier) to multiple change in income, output & employment.
1) Expansionary: central bank will buy bonds, which increases cash reserves of commercial banks
Restrictive: central bank will sell bonds, which reduces cash reserves of commercial banks
2) Change in commercial banks will have multiple impact on volume of bank deposits (through the Multiplier) and
therefore the money supply (expansionary or restrictive will increase or decrease money supply)
3) Changes in money supply will influence ease and cost of borrowing
Increase easier to obtain credit and less expensive = interest rates fall
Reduction more difficult to borrow and more expensive = interest rates rise
4) Changes in credit influence level of Aggregate Demand
Increase favorable effect on volume of private and public I, C and X
Decrease lowering effect on private and public I, C and X
5) Change in volume of AD causes national income, output and employment to change in same direction (with
multiplier effect)
-Quantity: If D for money is for day-to-day transaction purposes only, then link btw changes in Money Supply & changes
in Aggregate Demand will be direct and immediate
-Keynesian: changes in D for and S of money are reflected immediately only in the market for securities (gvt bonds)
-if HH & business have excess money balances, they will use excess to purchase bonds
Changes in D and S for money will not be reflected directly in level of AD (only indirectly)
-Monetary Side MV: supply of money x the average # of times each unit of money is spent
=sum of expenditures in a given period
-Commodity Side PT: number of transactions x price of g&s
=total receipts in given period
In any period, sum of expenditures must equal sum of receipts
-position of unemployment with unused factors of production (Y is below level of real income that would be produced at
full employment)
-IF M is increased, HH have more money balances than they need for transaction purposes = spend excess
-this additional D leads to rise in Income, output & employment = rise in real income Y.
-as economy reaches full employment, increases in M will affect P more than level of real income
-levels after full employment, further increase in M will affect only P
Module 19: Integration of the Real and Monetary Sectors of the Economy
19.1) Intro
-Keynes: monetary factors have influence on ‘real’ variables (level of income and employment).
-existence of liquidity trap may prevent rate of interest falling below certain floor impossible to use monetary
policy to counteract recession: further increase in MS would not reduce rate of interest and no effect on AD
-Quantity: in liquidity tap region, any increases in MS would calls V circulation of money to fall and offset increases in MS
-Real Sector (shape of Consumption function and Marginal efficiency of investment curve) influence Rate of Interest
-Consumption function: shows relationship btw planned savings & income
-MEI curve: volume of investment is a diminishing function of rate of interest (inverse relationship)
fluctuations in incomes and interest rates = fluctuations in planned savings and planned investment
-Equilibrium achieved when level of income & interest rate are in relationship that produces Eq btw planned
Savers and planned investors
-Monetary Sector (Demand for and Supply of Money) influence Rate of Interest (and hence level of income)
-Demand for Money: function of the level of money income and rate of interest (transactions demand for
money will be high when income is high) (speculation demand for money will be high when rate of interest is
low)
-Supply of Money: determined by monetary authorities (if MS reduced, cost of holding money R rises)
The Real Sector & the Monetary Sector interact together to influence level of income and rate of interest.
Eqnational Y & Eq R depend on simultaneous Eq in Real & Monetary sectors
o Simultaneous equilibrium: planned savings = planned investment & D for money = S of money
19.2) Equilibrium Interest Rates and National Income Levels –Monetary Sector
-intersection of D curve for Money and S curve of money determines Eq rate of interest. BUT what determines level of Y:
-Demand for money (transactions & precautionary): direct relationship with income
-Demand for money( speculative): inverse relationship with interest rate (higher R, smaller amount held)because money
for speculative reasons yields no immediate return, ppl hold it
waiting for R to rise… the opportunity cost of holding it is the
R foregone
-If we know Y, we know the Mt+p.
-If we know M (money supply determined by monetary authority), we know Ms (M – Mt+p)
for any Y, there is one and only one R for which total demand for money (Mt+p + Ms) = Money Supply M
b.S = I
- IS1 Steep: any change in R shows much smaller change in Y than IS2
-if MEI is interest-inelastic and MP is low (small multiplier), change in R
will produce small change in volume of I and (with small multiplier)
small change in Y
the more elastic MEI, and the higher the multiplier, the flatter the IS
curve, the greater the change in I and subsequent change in Y
-LM curve shows Eq level of R given Y
-IS curve shows Eq level of Y given R
Eq R & Eq Y determined @ intersection of LM & IS
-given LM1, could reach Yf with shift in IS to IS2 with higher eqR2
-shift could be achieved:
-MEI shifts right (rise in volume of I at every R)
-Consumption function shifts up (rise in consmp @ every Y)
-Create Budget Deficit by increasing G or cutting T (T<G)
-IF LM also shifted right because of increase in money supply, Yf could be achieved with a smaller shift in IS because
increase in M lowers the R associated with any level of Y (encourages Investment and rightward movement along IS)
-MEI shifts up: higher volume of investment at each rate of interest = IS curve shift right & higher Yeq & Req
-Consumption Function shifts up = IS curve shift right & higher Yeq & Req
-Consumption Fucntion shifts down = IS curve shifts left and lower Yeq & Req
-Functional Finance: Budget Deficit = IS curve shift right
Budget Surplus = IS curve shift left
-How effective Fiscal and Monetary Policy will be depends on shapes of IS & LM curves & starting position of Y & R
b-Extreme Monetarists
Investment expenditure completely
elastic (firms invest only at R1)
increase in LM doesn’t affect R but
increases Y to Y2
c- Extreme Keynesian
Investment expenditure completely
inelastic with respect to R
decrease in LM decreases R to R2 but
doesn’t affect Y
-Keynesian: monetary factors are critical in determining equilibrium income/output and equilibrium interest rates, but
there’s no central role to monetary factors in determining price level. Phillips Curve is missing link to that.
-shows fixed relationship btw unemployment rate and inflation rate (with a lag)
-Monetarists: who argue that there are strong equilibrating forces in market economies, which are unhampered by gvt
would lead to full-employment national income Yf, think that Money is of prime importance in determining Price level
(not in determining real variables such as employment and national income)
-Demand-pull Inflation: price rises as consequence of excess demand for g&s. Demand > capacity output.
-as real output cannot increase significantly beyond potential output, excess Demand ‘pulls up’ P of final g&s.
-as employers compete to obtain scarce factors of production, P for factor services rise, so money incomes rise.
=rise in wages, salaries and other factor incomes
Keynesian approach
-Income-expenditure Model
-aggregate expenditure function, E = C + I + G + (X-Z)
-Ye > Yf
-Cost-push Inflation: sees labor market as primary source of inflationary process, not a defensive role with a lag behind P
changes- sees price rises as consequence of bargains struck in the factor market which raise production costs of
employers, who then pass on higher costs in the form of higher prices
-prices and costs are administered rather than responsive to market forces of S and D
-wages and salaries are administered on basis that firms set prices on cost-plus basis
if costs rise, firms pass on higher costs in form of higher prices = economy placed on cost-plus basis
originates with higher wage costs, which then push up prices; price inflation generated in factor market (labor) and is
transmitted to product market
-sometimes price inflation occurs as consequence not of excess AD but of excess D I particular markets, and failure of
prices and wages to adjust downwards where D was deficient.
excess D in some markets and deficient D in others gives rise to upward drift in general price level as P are bid up in
markets of excess D and remain stable in markets of deficient D
-wage rises in sector with excess D might spill to employees in other sectors who want to match that rise
-Costpush factors can only create continuing stimulus to inflation if accompanied by permissive monetary policy that
allows expansion of money supply (higher wages that result in higher prices must raise money value of output unless
offset by reduced level of output and resultant unemployment)
-to sustain continuing inflation with successively higher price levels, Velocity of circulation would have to rise
continuously. (but its unlikely it could change that much over time due to habits)
-when faced with increase in money wages, monetary authorities can either: hold money supply constant/prevent it
rising at same rate as wages (with falls in output and more unemployment) OR they can increase money supply to allow
sufficient level of monetary demand to sustain output at higher prices.
-cost push think latter policy chosen because monetary authorities prefer higher prices to higher unemployment