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Module1: Economic Concepts, Issues and Tools

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

1.2) Scarcity and Choice


-Economics: how society can satisfy wants as fully as possible given limited resources = Maximize welfare/Utility
-Resource: anything that helps to produce the g&s ppl want
-Scarcity: insufficient resources to satisfy all wants fully
-Choice: resources allocated to the satisfaction of one want, cannot be available to satisfy another

1.3) Preferences, Resources and Economic Efficiency


-Economic Decisions made involving Choice:
a) What g&s to produce;
b) How to produce selected g&s
c) What share of those g&s to be given to each indv or HH
 What, How, and For Whom
-Voluntary Exchange: It’s possible to increase utility levels w/o increasing amount of goods, thru exchanging items w/
low utility exchanged for items w/ high utility.
-Engineering Efficiency: or Technical Efficiency: when a good of stated quality is produced using fewest possible
resources.
-Economic Efficiency: when a good of stated quality is produced using fewest possible resources AND that good satisfies
wants as fully as possible

1.4) Marginal Analysis and Opportunity Cost


-Marginal Analysis: considering incremental changes in resource allocation and weighting the Marginal Benefit (gains
from change) vs. Marginal Cost (loss from change)
-Opportunity Cost: the best alternative forgone (the real cost to society)

1.5) Different Economic Systems


-3 Methods of solving Scarcity-Choice Problem (mix of each is used by societies today)
1) Traditional Economies: g&s produced and methods of production are determined by social custom
-common in underdeveloped countries or rural communities in developed countries
-eating/clothing/housing economies
-distribution of o/p = determined by birthright/social factors
-resources are owned by state, collectively and individuals
2) Command Solution: g&s produced determined by central ruling body as a Target
-choice decision implemented through Plan
-distribution of o/p = stipulating wages/salary levels and fixing prices of g&s
-black markets, queues, misplacement of gds-wants
-resources are owned by the state
3) Market (Capitalist/Free Enterprise): g&s produced determined by interaction of consumers willing to pay +
producers willing to supply
-Markets: places where consumers + producers meet & prices are determined & exchange takes place
-distribution of o/p (Income) among resource-owners is determined by competition for resources
- System rewards ppl not according to needs, But to value of contribution of resources to production
-Resources are owned by indv or private groups of indv

1.6) Production Possibilities Curve PPC (go to notes)


Module 2: An Overview of Economics

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

In perfect world, basket of g&s produced is the best basket


-contains what ppl have voted for w/ $ votes
-g&s in basket are produced using least amt of resources possible
-prices of g&s reflect value to society of scarce resources used in production

2.2.1) Criticisms of the Market Economy


a. Wrong g&s are produced (shortage of hospitals, schools, clean streets)
b. Fallacy of consumer sovereignty (ad agencies hired by companies persuade consumers’ buying behavior)
c. Pollution (free-market economies are world’s biggest polluters)
d. Poverty amongst plenty
e. Inflation and unemployment (stagflation exists= inflation + unemployment)

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

Areas of Market Failure:


1) Public Goods
-Private Good: a good that you buy and consume and for which the act of consumption affects no one else
-Public Good: when bought, others can consume without paying for it. (Ex: national defense, police and fire services,
judicial system and lighthouses)

-Two issues concerning public goods:


1) How much of a public good should be bought
2) Who should pay for it?
 Price mechanism does not solve this problem
-collective action needed by gvt addressing diff bundles of public goods and diff tax structures to pay for them

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

-Average Cost (AC) Curve = Total Cost (TC) / Amt of o/p


- having two firms produce same level of o/p as one
firm means wasted resources and extra costs incurred
while having the same o/p
-however, if only one firm supplied market (monopoly),
the price mechanism fails as it will not reflect the cost
to society of scarce resources involved in production

if we want one firm + ‘right’ price, society must


regulate monopoly.

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

- Income distribution in a nation measured by Lorenz Curve


- Curve shows cumulative % of incomes of any given cumulative% of households. HH are numbered on the
horizontal axis from lowest to highest incomes.
- If all HH received same income, curve would be straight 45 degree line.
- Income distribution is a value judgment and therefore requires collective action through political platforms.

5) Stagflation
-Macroeconomic

2.3) Macroeconomics – an Overview

Y= National Output
C= Consumption Expenditurebasic 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)

-Y = function of quality & quantity of CS and LF


-Why produce Investment goods? For higher standards of living in the
future, we must sacrifice Consumption today and allocate resources to
increase quality and quantity of CS and/or LF

- 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.

-Fiscal policies tackling Unemployment:


-gvt creates project= resources needed + unemployed labor hired  newly employed spend more = firms earn more and
produce more to meet new demand = hiring more ppl + buying capital goods
-gvt cuts taxes = HH have higher disposable income  HH spend more = more revenue for firms  more income for LF

-Monetary policies tackling Unemployment:


-gvt increases money supply= price of money (Interest Rate) falls  investment becomes more profitable = firms have
more money = hire more ppl.
= price of money (Interest Rate) falls  increase demand for goods bought using loans =
more g&s produced more jobs

HOWEVER, it’s not that simple:


1) Potential of economy changes = dynamic, not static. (technologies change, industries expand, old industries
decline, ppl emigrate/immigrate, countries impose barriers, etc)
2) Difficult to predict HH and firms’ behaviors. (tastes and preferences change) I is most volatile component of Y
3) No control over outside world on which we are dependent on for g&s (oil-importers)
4) Time lags (taking and benefiting from corrective action takes time)
5) Other economies around the world affect our own.

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.

3.2) Theory of Consumer Choice


-HH seek utility-maximization subject to budget constraint = trial and error of buying diff combos of g&s w/in budget
constraint until no change can yield higher level of satisfaction = EQUILIBRIUM = last $ spent on one g&s just equals
utility received from last $ spent on any other g&s

- 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.

 Equilibrium (max total utility)


-income (budget) + prices affect the q of g&s you buy

3.3) Individual Household (HH) Demand


-Individual Demand for a good: Relationship between Price and Quantity of gd that indv would be willing to buy in given
time period
-Demand Curve:
- hypothetical relationship (given price during given time) (doesn’t describe an event)
- change in P = change along the line of D curve (NOT shift in the curve itself)
- P & Q = Variables
- All factors other than P that affect purchases = Parameters (which are fixed)
- Q = Dependent Variable (depends on P)
- P = Independent Variable
- Position and shape of D Curve depend on Parameters (taste and preferences, income level)
- if all factors other than P are unchanged, then position and shape of D curve do not change.
- D curve = –vely inclined: @ lower prices = higher quantities purchased. \
 a) Substitution effect
b) Income/budget constraint

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

-Connection between Utility Theory and Downward-Sloping Demand Curve?


-Law of Diminishing Marginal Utility implicitly argues that indv will buy more of gd if P falls

3.4) Market Demand


-Market Demand for a good: Sum of the demands for that gd of the individuals who comprise the market
-Market Demand Curve: derived from individual demand curves
-* same info about Individual Demand Curve about variables and parameters holds for Market Demand Curve *

-Price Elasticity of Demand: Sensitivity of Quantity Demanded to Price changes


i) Price Inelasticity
ii) Price Elasticity
iii) Unitary Price Elasticity

3.4.1) Price Inelasticity


- when, as P changes, the proportional change in Quantity Demanded is less than proportional change in P
-if D for X is PI= a P increase  increase expenditure on X
a P decrease  decrease expenditure on X

*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

3.4.2) Price Elasticity


-when, as P changes, the proportional change in Quantity Demand is greater than proportional change in P
-if D for X is PE= a P increase  decrease in total expenditure on X
a P decrease  increase in total expenditure on X

-When E > 1, the gd = Price-Elastic


-Total expenditure on the good (P x Q) decreases as P increases; and increases as P decreases
-Demand Curve is Price-Elastic over the certain range of prices measured

3.4.3) Unitary Price Elasticity


-when, as P changes, the proportional change in Quantity Demanded exactly equals proportional change in P
-to resolve problem of which P and Q to use in calculating elasticity is to use Averages for the divisor

sd
sds
sds
sd

-When E = 1, the gd = Unitary Price-Elastic


-Total expenditure on the good (P x Q) remains constant for both P increases and P decreases

3.4.4) Variation in Price Elasticity of Demand


-Linear Demand Curve

-P Elasticity of D is not constant throughout length of D


Curve

-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)

-Ex: operation for person suffering from chronic heart disease


-necessities (salt) (cigs in general)
-constitute small portion of budget

-Perfectly Elastic
-P is the same at each QD
-P Elasticity of D is infinite because (change in P/P =0)

-Ex: one farmer’s wheat output


-the more numerous & similar substitutes available (certain brand of cigs)
-luxury goods (vacations) –constitute big portion of budget
-Unitary Price Elasticity
-Total expenditure on gd remains unchanged throughout
- P Elasticity of D = 1 at all points on curve

*SINCE STEEPNESS OF CURVES DEPENDS ON UNITES DENOTED ON AXES, IT IS MISLEADING TO JUDGE PRICE ELASTICITY
OF DEMAND BASED ON DEMAND CURVE ONLY*

3.4.5) Other Elasticities of Demand


-Cross Elasticity of Demand: responsiveness of a change in P of one good affecting QD of another good

- Ratio can vary from plus infinity to minus infinity


a) –ve cross elasticity = Complementary goods (increase in P of one good = reduction in QD of complement)
b) +ve cross elasticity = Substitute goods (increase in P of one good = increase in QD of complement)
c) 0 cross elasticity = D for goods is independent

-Income Elasticity: responsiveness of a change in income levels affecting the QD of a good


-5 values for Income Elasticity
a) –ve: QD decreases as income increases
b) 0: QD does not change as income increases
c) 0>, <1: QD increases by a smaller proportion than the increase in income
d) Unitary: QD increases in proportion to the increase in income
e) >1: QD increases by greater proportion than increase in income
-as income rises, expenditure on housing rises by a greater proportion = (e) Income elasticity is >1.
-goods with –ve income elasticity = inferior goods (cheap cuts of meat)

3.5)The Theory of Consumer Behavior and the Real World


-Business and firms’ use of Demand for product/service planning:
1st step: identify characteristics of major consuming groups of product (young/old, renter/owner, M/F)
2nd step: estimate elasticities (Price, Income and Cross) (how are incomes of target groups going to change? How are
prices of competing or complementary products likely to change?)
3rd step: collect and analyze that data
4th step: make realistic estimates to whether D curve for product will be shifting right, left or staying the same

-Government use of Demand:


1) Make estimations of future D to include public g&s in election manifestos
2) Taxes
-imposing income taxes affects HH disposable income
-how taxes affect work effort (in countries with high marginal tax rates ppl won’t be motivated to accept work
with high effort even if higher salary is offered) (ppl may emigrate)
-Taxes on goods have dual effect:
-reduce income
-make taxed gds relatively more expensive (less attractive as purchase)

-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

-production frontier can shift only if


assumption of certain fixed i/p is relaxed. (if
the cet par things are changed)

-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

-Relationship between AP, MP and TP Curves graphically:


1. When TP= 0, AP = 0

2. When AP is at max., AP = MP

3. When MP > AP, AP is increasing

4. When MP < AP, AP is decreasing

5. When change in TP is 0, MP = 0

-Marginal Concept is fundamental for decision-making


Profit-maximizing firms must follow this rule:
-Continue hiring factor of production until the point where the value of MP of factor = the unit cost of factor
-Even though hiring extra input may result in a positive ‘net’, this will not be the highest ‘net’ you can get
-using marginal analysis is a shortcut to realizing your break-even point without calculating Total o/p vs. total cost.
-where MP crosses Cost (when decreasing) is the point
at which input should stop being hired.

-Cost = shaded area = return to the labor input

-area under MP curve (sum of rectangles) = TP

-TP – Cost = return to all other factors of production


other than labor input

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

-total cost of production will increase as output increases

-however, since increase in variable factor input doesn’t


necessarily mean proportional increase in output, the
relationship between cost of production and output will be
positive BUT not fixed.

-we see that shape of TC and VC curves are determined by


shape of TP curve
TC of o/p is a function of the productivity of factor i/p

Derivations:
-Average Cost of Production:

-Average Variable Cost:

-Average Fixed Cost:

-ATC = AFC + AVC

-As o/p increases, since we are dividing a fixed amount by an


ever-increasing #, AFC decreases.
-the greater the o/p, the smaller the AFC

-shape of AVC curve is determined by


shape of AP curve. (Inversely Related).

-when AVC = min, AP = max.

-Marginal cost: cost of producing


additional unit of o/p

 the average variable cost of output is


determined by the average productivity
of variable factor inputs

-since W is fixed (given), AVC varies inversely with AP


*L = Labor
*W = Wage
*Q = Quantity output

-Marginal Cost and Marginal Productivity have inverse


relationship

-when MC = min, MP= max.

the cost of producing additional units of output, is


determined by the marginal productivity of variable
factor inputs

-since W is fixed (given), MC varies inversely with MP


4.4 Firm Supply in the Short Run
-Break-even is when profit = 0
-AR = P

-Profit Maximization:
-to be profitable firms must operate at level of TR > TC or where AR > ATC

-Profit/unit will be at maximum when AR – ATC is at maximum.

-increase output as long as MR > MC to guarantee


profit.

-shaded area = max profit (at the output level


where MR = MC)

-because P is constant: P = AR = MR

-Total Profit = AR – ATC

-there is still profit anywhere AR > ATC

WHAT Q FOR DIFF Ps


-keep increasing Q only If MR > MC

-try to cover at least AVC (by setting Q at point


where p/AR > AVC)

-optimal point is @ MR = MC / AR = ATC


-Break-Even pt @ AR = ATC (firm covers VC & FC)

-profit @ Q6, P6 = (AR – ATC) x Q6


Plotting Firm SR Supply Curve
= MC curve from the minimum point of AVC curve

-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

4.5 Market Supply


-Market Supply: aggregate of amounts that all firms in given market would be willing to supply @ each P
-Market Supply Curve: add together supply curves of all firms in given market
-by adding the quantity output of each firm supplied at each and every price

4.5.2 Shifting Market Supply


-a change in P of variable factor i/p will shift each SR S Curve (because it affects each firm’s MC curve)
market SR S Curve must also shift
-(wages go up, S shifts left because AVC rises and MC shifts left)

4.5.3 Equilibrium of Firm


-SR: when factor inputs and consequently costs are fixed, Equilibrium o/p of firm will be that o/p @ which MR = MC
this is EQ level of o/p. no other level of o/p will yield a higher profit
-firm has no incentive to leave this level of o/p…and is in equilibrium in SR

-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)

-firm is a price-taker so, P = AR = MR

-Profit-maximizing behavior dictates that MR must = 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.

-firm can remain in LR equilibrium only if fixed costs


don’t change. If fixed costs are acquired, firm is no
longer in LR equilibrium

-only when price of gd, technology and all factor input


prices are unaltered that firm can remain in both SR and
LR equilibrium, which isn’t realistic. LR Eq is a position
firms must aim at.

-if P ever falls below min pt on LAC, firm would produce


0 o/p cuz opportunity cost wouldn’t be covered.

4.5.5 Market Supply in LR


When resource-owners observe higher than normal profit, they will direct resources into that industry:
-we could either assume that factor input prices would stay the same or would increase.

-when factor input prices stay the same, cost of


producing unit of o/p stays the same

-all firms have the same ATC

- Therefore they will produce output at the same P of


min point of ATC = horizontal line LR S Curve

For example, the supply of steel when home


construction increases (where home construction is a
negligible part of the steel market compared to
shipbuilders and skyscraper construction)

-when factor input prices rise, cost of


producing unit of o/p rises

-firms ATC curves rise

-therefore they will sell @ higher prices


to reach min ATC = positively sloping LR
S Curve
4.6 Real World Applications
1) Estimating Production Frontiers
-helps in decision-makers compare between firms for example in order to optimize conditions for production
2) Labor Productivity
-to be able to calculate average labor productivity (o/p per unit of labor for specified time period)

-
-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)

-LR elasticities are usually > SR elasticities


Module 5: The Market

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

5.2) Market Supply and Demand


-Market Demand Curve: relates Q of gd that indv would be prepared to buy @ diff P
-Market Supply Curve: relates Q of gd suppliers would be prepared to sell @ diff P
necessary condition for exchange: must be at least one common P @ which suppliers would be prepared to sell a Q of
gd and at which indv would be prepared to buy a Q of gd

-Free Good: at all +ve P in market, the Q of gd > QD, so the P =0. (fresh air)

-Excess Supply -Excess Demand

-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

5.4) Changes in Market Equilibrium

-increase in D = increase in Eq P & Eq Q


-decrease in D = decrease in Eq P & Eq Q

-upward pressure would be exerted on P until new Eq


established where new D intersects S

-change in Demand = shift in position of the whole curve caused


by change in factor other than P of gd in question

-change in QD = a movement along D Curve caused by change in


Q that would be demanded if P were different, other factors
unchanged
-increase in S = fall in Eq P & rise in Eq Q
-decrease in S = rise in Eq P & fall in Eq Q

-downward pressure on P until new Eq established where new S


intersects D

-change in S = shift in whole position of S Curve caused by


change in a factor other than P of gd in question

-change in QS = movement along S Curve caused by change in Q


which would be supplied if P were different, other factors
unchanged.

Simultaneous increase in D & S Increase in D & Decrease in S


- Eq Q will always rise -Eq Q might rise, fall or remain the same
-Eq P might rise, fall or remain the same (depending on D)
(depending on S) -Eq P will rise

Decrease in D & Increase in S Simultaneous decrease in D & S


-Eq Q will fall, rise or remain the same -Eq Q will fall,
(depending on S) -Eq P will fall, rise or remain the same
-Eq P will fall (depending on D)
5.5) Intervention in the Market
-Market Intervention or Market Regulation: when non-market forces cause P and Q of gd bought and sold in competitive
market to be diff from P/Q combo that would occur if market operated freely

5.5.1 Price Ceilings


-Price Ceiling: when the P of gd is fixed below Eq level = excess Demand
(P alone will no longer be adequate to allocate S among potential buyers; first come first serve)

-when P ceilings exist and there is excess D, black markets develop where Eq P will
be reached

5.5.2 Price Floors


-Price Floor: when the P of gd is fixed above Eq level = excess Supply
(P cannot dispose of surplus)

-how would regulating agency dispose of excess supply?


1) destroy the surplus
2) buy the surplus, stock it and release at a time when production
was very low
3) pay farmers not to produce excess supply

Example: Minimum Wage

5.5.3 Taxes and Subsidies


-Taxes: affect market S Curve through impact on MC curve of each producer
-suppliers provide same S @ higher P
shift in S curve upwards (to the left)

-effect of tax on Eq P and Eq Q depends on relative elasticities of S & D

-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

-Loss in Surplus because of Tax


Consumer: PP’EY
Producer: P”PEZ

Imposition of Tax:
-raises P paid by indv and lowers P received by suppliers
= reduces volume of transactions
= reduces gains from exchange

5.6) Dynamic Adjustments in the Market


-Comparative statistics: analyzing market changes comparing Eq points before and after D or S changes occur
-When D for a gd changes, P will reach diff levels in diff time periods depending upon differences in elasticities of S
-If LR and S was Inelastic, Eq P would change but Eq Q would not. (because suppliers cannot change variable inputs)

-the Market Period: period as transactions take place; no time for any inputs
of outputs to change (day at the supermarket)

-suppliers cannot produce more Q, greater D = greater P without changes in Q

5.6.1 Effect of Changes in SR


-S of gd is less inelastic than in market period, because suppliers would be able to
adjust the Q of variable factors of production

-if D changes, Eq P would change but not as much as in market period


-Eq Q would change.
5.6.2) Effect of Changes in LR
-S of gd would be more elastic than in SR because producers would be able
to alter Q of all factors of production AND firms would be able to enter or
leave the industry

-Eq Q changes more in LR than SR


-Eq P would be lower than SR but higher than market period

-If costs are unaffected by firms entering the market, S curve =


completely elastic = horizontal line.

-Eq P would return to original level


-Eq Q however would change by more than in SR

5.6.3 Cyclical Patterns in Markets


-markets that operate in cyclical fashion are analysed using cobweb model
-depends on assumptions that producers don’t learn from experience and assumption that there are no speculators

(S is steeper than D) (D is steeper than S)


- suppliers adjust Q less than consumers do –buyers adjust Qd less than producers adjust Qs

-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

8.2) Private Goods and Public Goods


-Private g&s: each unit is consumed by one indv or HH. Characterized by:
- Excludability: once you buy gd, it is yours and others are excluded from consuming that particular gd
-Rivalry: once you buy gd, there is less of that gd for others to enjoy

-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)

8.3) Externalities: Positive and Negative


-Private Costs: costs that indv or firm must solely bear in taking an action
-Private Benefits: benefits that accrue only indv or firm using good

-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.

8.4) Externalities, Collective Action and Economic Efficiency


-collective action is required to equate MU and MC equations for all g&s

S1) per unit tax imposed on firms that do not account for
external costs in their decisions (raises MC and P)

S2) subsidy paid to producers who generate external benefits


(lowers MC and P)

-the changed pattern of resource allocation following


introduction of tax or subsidy holds the consumers and
producers accountable for societal benefit or societal cost

-when external costs or benefits are brought within scope of a


single org, the externalities are internalized.
(Chemical company who pollutes river buys fishing rights of that
river)
OR: Establish and Enforce property rights if possible: Chem Company would be sued for polluting river owned by
fishermen

8.5 Problems of Collective Decision-Making


-Voting Paradox and failure of democratic system
Module 9: Income Distribution
-To make international comparisons, convert GNP per capita for each country into dollars by comparing costs of basket
of representative g&s in each country with same basket in USA in $.
=Purchasing Power Parity (PPP) Exchange Rate.
-this can vary from ‘official’ exchange rate

-Income earned by factors of production:


-Labor: Wages and Salaries (Largest share of national income)
-Owners of capital: Interest and Dividends
-Owners of land: Rent

9.2) Marginal Productivity


-Value of Marginal Product VMP: how much the value of o/p will increase for every additional i/p hired
-D for g&s determines the D for the factor inputs required to produce them.
-S for factors of production are determined by resource-owners

\-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.

9.3) Economic Rent


-Economic Rent: the diff btw the Value of Marginal Product VMP of a factor of production in its most productive use and
in its next best alternative

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

-exploitation of labor: paying wage rate less than VMP of labor


-Labor should organize itself into trade unions in order to protect against exploitation

9.5) Trade Unions


-Trade Union: represents a group of, or all, resource owners in a market

-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.

9.6) Income Distribution, Collective Action and Economic Equity


-how efficiently an economy’s resources are allocated and how evenly an economy’s income is distributed are not
related.
-market economies alter distribution of income caused through market forces for equity reasons
-gvts provide income for the aged, sick and unemployed
-taxes
-programs that redistribute income w/in society cause the indv who are taxed to receive less than their contribution to
total o/p (< their VMP) while causing indv who receive transfers of cash to receive incomes in excess of their
contribution to total o/p ( > their VMP)

-income distribution is a value judgment

-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.

10.2) Theory of Absolute Advantage


-by Adam Smith in 1776 Wealth of Nations
-Theory of Absolute Advantage: the same commodity can often be produced in one country using less labor and capital
than in a second country trying to produce the same good.
-the taste and income differences among indv w/in each country interact w/ specific absolute cost advantages
across countries and provide a mutually advantageous basis for int’l trade.
-explains the direction of trade
-explains resource movement
-Adam Smith viewed int’l trade as an important extension of domestic commerce, providing greater scope for division of
labor and economies of scale

10.3) Theory of Comparative Advantage


-Theory of Comparative Advantage: resources are fully mobile w/in country so that returns to equivalent labor and
capital are equalized on a national basis
-David Ricardo’s theorem on trade: a poor country without absolute advantage can still trade to mutual benefit with a
wealthy one
-The potential availability of both gds increases when each country produces according to its comparative advantage

-point R, the Ricardo point, is where each country is completely


specialized in its comparative advantage.

10.4) Terms of Trade and Voluntary Exchange


-the independent profit-seeking actions of private traders, responding to the different relative prices ine ach national
market, ensure that each country begins to specialize according to its comparative advantage.

10.5) Tariffs and Quotas


-argument for restricting int’l trade: protection of domestic industries
-Tariff: tax imposed by an importing country when a g&s enters that country
-Quota: restriction specifying max. amt of a gd that may enter a country during specific time period
10.5.1 Tariffs

-Pre-tariff: exporter country receives 180 (30*6) which is spent


on tariff-imposing country
-tariff= 80 (20*4) which goes to gvt
-Post-tariff: exporter country receives 160 (40*4) and suffers a
loss of the amount of tariffs that would have been spent on
tariff-imposing country

-imposition of tariff has no effect on balance of trade but on


the volume of trade

-everyone suffers by paying more for both imported and


domestically produced g&s

-total world production is reduced;


-resources are not employed in the most efficient way globally
-the only ppl benefiting are the workers who remained employed in the ‘protected’ industry (society is subsidizing those
workers)

10.5.2 Quotas
-deff from tariff is that there is no tax advantage for government

-Pre-quota: exporter country receives 180


-quota: 4 units; $80 (4*20) which accrues to the importer
-Post-quota: supplier receives 20/car; importer receives 40/car

10.6 Arguments for Trade Restrictions


1) Infant industry argument: developing countries argue that as industries start to develop, there must be period of
protection to allow them to reach size & scale that is economically viable in int’l competitive world
2) Dumping: the practice of selling a good in a foreign market @ P lower than prevails in the market of exporting nation.
This is illegal because it may cause domestic companies to shut down, in which case the exporter will raise its P w/out
competition
3) Countervailing Duties: tariffs that are imposed on imported gds produced by firms that receive production subsidies.
They cancel the effect of the gvt subsidy on the P of imported gd.
4)*While, on average, everyone benefits from free trade, some people lose. The total benefits from free trade exceed
the total costs incurred when trade restrictions are abolished, but, at the margin, some ppl become worse off.

10.7 Exchange Rates


-Foreign Exchange Market: the market in which ppl buy and sell different national currencies
-currency appreciates: price of that currency rises
-as the value of the $ in terms of pound increases, the Q of $ Supplied
increases and the Q of $ Demanded decreases

-Flexible Exchange Rate: the level in a free market where QD and QS of a


currency are equal

-Fixed Exchange Rate:


-to keep ER at level ER1, the US would have to sell ‘cd’ $ in exchange for
pounds.

-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 $

10.8) Balance of Payments


-Balance of Payments account: records country’s int’l trade, its int’l borrowing and its int’l lending
-the flows of foreign currencies required to carry out transactions (such as vacationing in other countries, buying foreign
film, real estate abroad, foreign company building plant in my country) must be recorded in each country’s balance of
payments
-Three major accounts:
1) Current Account or Trade Account (balance of trade)
2) Capital Account
3) Official Settlements Account

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

3) Official Settlements Account:


-the change in a country’s holdings of foreign currency
-Balance of Payments must always be in
balance.

-deficit in current account = imports>exports


-deficit has to be offset by foreign borrowing
(which occurs in capital account as part of
foreign investment in X)

-diff btw deficit in Current and surplus in


Capital is accounted for by a change in holdings
of foreign currency

-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.

10.9) Operation of the International Sector


-Current Account Factors: Factors that affect D for country’s exports:
1) foreign demand Yf (foreign national income)
2) domestic versus foreign prices Pd vs Pf (the lower domestic prices, the higher the exports)
3) exchange rate ER (if our currency depreciates, foreigners will receive more of it for one unit of their own
currency and can buy more imports for their own currency)

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.

-Capital Account Factors:


-Rd vs Rf: domestic vs foreign interest rate
-expectations about whether our currency will appreciate or depreciate
expectations about potential appreciation or depreciation of our currency will play critical role in D for our currency. S
of our currency may affect these expectations, SO, D for and S of our currency will not be independent of each other.
Module 11: Macroeconomics Overview
11.1) Intro
-Macroeconomics: describes and explains the working of the whole economics
-tries to explain the behavior of the level of prices of all g&s taken together, and;
-Inflation Rate: the change in this price level from one period to another
-Deflation: when the price level falls
-concerned with the behavior of total income and total o/p for the whole economy
-studies the employment and unemployment rates for the economy as a whole

11.2) Potential and Actual Output

-Capital Stock = man-made + natural resources


-Labor Force = proportion of the population able and willing to
work at going wage rates and working conditions

-how large national o/p can be depends on quality and quantity


of Capital Stock, quality and quantity of Labor Force and existing
technology

-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

-if part of CS (factories, machine tools) is idle, and part of the


LF is unemployed = national output < potential

11.2.2 Potential Output


-Potential Output: o/p that the economy would produce if both LF and CS were fully employed
-Full Employment: % of ppl in the LF being employed for an expected # of hrs/week for an accepted # of weeks/year
-Natural Rate of Unemployment = Full-Employment Rate of Unemployment.

-Potential Output expands by:


a) growth in quality and quantity of labor
b) growth in quality and quantity of capital stock
c) technological advances
-allocating large part of current
o/p to production of capital
goods = possess more capital
goods + will have more
technologically advanced capital
goods
-human capital is part of CG
-therefore, devoting current
resources to educating and
training labor, will increase
quality and potential of the LF =
higher national future potential
o/p

-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

11.2.2) Actual Output


-Actual Output = Gross National Product GNP: the value of all final g&s produced in the economy in a year
-calculated by multiplying each good and service produced by its price and adding them all

-all resources owned by HH, some of which form firms

-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

-HH pay firms for the g&s produced and bought

-Gross National Expenditure GNE: value of total spending by the HH


-Gross National Income GNI: value of the services of the factors of
production hired by the firms

Three Ways to Measure Economic Activity in a nation each year:


1) GNP: total output of g&s produced
2) GNE: total expenditure made by HH for these g&s
3) GNI: total income flowing to resource owners

-Firms can either produce C (consumer gds) or I (capital goods/inv)


-GNP = C + I
-HH can only use income for C (consumer gds) or S (savings)
-GNI = C + S
-GNP must = GNI
-however, the decision on production on C or I is made by firms
-whereas, the decision on how much to spend on C or how much to S is made by HH

11.2.3) GNP vs GDP


-diff btw them
-GDP: defines economy as existing w/in the country’s borders (location)
-GNP: defines economy according to ownership of factors of production (ownership)

-GNP = GDP + Net Income from Abroad

11.3) Demand for Gross National Product


-GNP is purchased by 4 separate groups
-Aggregate Demand = the sum of their expenditure
1) Consumers (HH)
2) Firms
3) Government
4) International (HH, firms & gvts)
-gvt policies affect each group’s spending, + Unemployment Rate and Inflation Rate
-it’s difficult to keep aggregate D constantly at the desired level
- policy tools act with a lag
-potential o/p increases continuously causing the gvt to always pursue a moving target
-HH and firms have minds of their own and are unpredictable
-exogenous shocks: outside-world events over which policy makers have no control but impact economy

-Domestic: -International (National Income Identity)

11.4) Policy Tools


-Policy tools that gvt controls
-Fiscal Policy: control of gvt expenditure and tax rates (income taxes, sales taxes, excise taxes, corp. taxes)
-Monetary Policy: control over the supply of money, which directly affects interest rates
-Aggregate Demand keeps growing but is limited by Potential Output (Q) which is determined b quality and quantity of
the Capital Stock and quality and quantity of the Labor Force
-Economy is at full employment @ Y = Q (the natural rate of unemployment)

-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

-since Q is always expanding because of supply-side


factors which are outside control of gvt (growth in
quality and quantity of CS, growth in quality and quantity
of LF, & technological change)

-to expand aggregate from D3 to D4


a) increase gvt expenditure (FISCAL)
b) reduce tax rates (FISCAL)
c) increase money supply (MONETARY)

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

2) Gvt cuts taxes: (T decreases)


-Gvt reduces marginal tax rate OR raises exemption threshold;
-individuals’ disposable income will rise, which they spend portion on additional g&s
-…. As scenario above.

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

-political Left wing favor higher G


-conflict about ideal levels of C and I
-in reality, full employment comes with inflation
(Inflationary bias of market economics)
Module 12: Potential Output
12.1) Intro
-Resources are more than just Capital Goods and Labor, as mentioned before
a) Capital Goods:
-Land: all natural resources (agricultural land, rivers, forests, climate and mineral deposits
-Capital: all factories, offices, warehouses, shops, houses, machinery and equipment, stocks of materials, roads,
railways, harbors, airports, vehicles, ships, school, universities and similar assets produced in previous times
b) Labor Force:
-Labor: proportion of population able and willing to work (quality depends on age, effort, hours of work,
education, skills, aptitudes and attitudes)
-Enterprise: individuals in the LF with organisational and managerial ability or financial skills

-in the SR, these things are considered fixed


 Productive Potential: fixed upper limit to the total output that can be produced
-Production possibilities frontier describes that to produce more
of one good, you must sacrifice less of another, which is the
opportunity cost of producing that one good

-when all resources are fully employed, additional output of one


commodity requires sacrifice of some other output

-Opportunity Cost = Slope of PPF

-Microeconomics is concerned with how society determines


allocation of resources btw competing uses, given fact of scarcity

-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.

12.2 Potential Output in the Long Run


-the Supply of factors of production changes only slowly, and the PPF may be taken as fixed for short periods
determined by the existing supply of factors of production and the stock of technical knowledge; in the SR, most
important macro question is whether society attains its given PPF.
-over long periods of time, PPF is not fixed, as witnessed in recent half-century

-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

-shaded area in CS and LF: depreciation of physical


and human capital
-shaded area in investment: replacement investment
necessary to maintain the CS and LF
-If society wants to increase, not just maintain, stock of human and physical capital = investment must exceed that
necessary to replace human and physical capital stock = +ve net investment
-Net Investment = Gross Investment – Replacement Investment

P: devotes all resources to current consumption


S: provides sufficient resources to offset capital
depreciation alone
T: undertakes sufficient capital investment to offset
depreciation and make net addition to existing capital
stock

12.3 Measuring Potential Output


-potential national output is a Supply concept: a measure of productive capacity that is represented diagrammatically by
the PPF. It’s achieved only when economy reaches full employment of all factors of production
-potential national output and potential national income cannot be directly observed by may be inferred indirectly.

-To estimate potential output:


-Unemployment Rate: # unemployed as a % of the LF in work or seeking work
-Capacity Utilization
relationship btw those 2: as degree of capacity utilization increases, the rate of unemployment falls.
-unemployment never falls to 0; capacity utilization never reaches 100
-potential output and full employment are defined in terms of labor utilization

12.3.1) Types of Unemployment


1) Frictional Unemployment:
-people changing jobs; movement in labor
-arises when unemployment Is matched by unfilled job vacancies in the same occupations and same locations
-arises from imperfect information
-short-term unemployment, generally resolved by a search for work in same occupation or same location
-amount of frictional unemployment depends on # of persons changing jobs, and avg length of job search

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.

-Factors Determining Unemployment


a) level of economic activity: when actual o/p is close to potential o/p, employment is high and employers
compete to hire labor. Therefore, employers will be active in advertising job opps & improved flow of info = less
frictional. Employers will offer better retraining allowances and financial assistance to attract ppl from other occupations
and areas = less structural
b) transmission of info: the better the methods of communicating info, the lower the unemployment
c) rate of structural change: there is always some structural change in economy (tastes change, new products,
technical change). These changes require redistribution in skills & location of workforce. The higher the structural
change, the higher the structural unemployment
d) ease of changing occupation and home: the easier & cheaper these are, the less structural
e) institutional restrictions and barriers: these are any action by gvt or org. by employers/employees that restrict
efficiency of labor market.
f) dependence on seasonal industries: seasonal fluctuations in 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)

-Output Gap: expressed as % diff btw potential and actual output

-Okun fond relationship btw U and Output Gap

-where Uf= full-employment rate of unemployment

-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

-AggD of D2, national output = Y2, employment = E2


-AggD of D3, economy will be at full employment because Y3 = Q
-AggD of D4, inflationary gap, prices will rise, economy will remain at
full employment at a higher price level.

-But, economies already suffer from inflation before D4

12.5.1) Inflation Rate


=Inflation Rate: % increase/year in the avg P level from one time period to another.
; the price level in period t+1

-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.

=Annual Inflation Rate as measured by index = 10%

-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

-each point on Phillips Curve corresponds to level of AD


-SR relationship
-shows combos of U & INF that result from diff levels of Y

-A = combo of U and Inf @ D2


-F= full-employment output (natural rate of
unemployment)
-B=
-in the face of AD >Q, some factories and part of LF now
work overtime and avg frictional and structural rates of U
fall because there are so many unfilled vacancies.
 in the SR, economy squeezes out extra o/p from
economy represented by (Y4-Y3)
-the cost of this is higher P of g&s and the
higher costs that firms must pay for factor i/p

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.

-THIS DOES NNOT HAPPEN IN REAL WORLD, because:


1) market for labor is not just one market
2) wages are sticky in the face of high unemployment, don’t’ equate to S&D
-many labor markets wage rates are determined by collective bargaining btw labor unions and mgmt reps +
union members have seniority that they wouldn’t be laid off even when there is high unemployment so they wont vote
for wage cuts to save unemployment

-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

13.2) Structure of the Economy: A Two-Sector Model


-HH and Firms
-HH = consumers = buy g&s from firms to satisfy their wants
= resource-owners = own all land, labor, capital good and enterprises
-Firms = hire resources from HH to produce g&S
= buy g&s from other firms
Markets have 2 groups:
-market for g&s producers buy from HH
-market for g&s that producers sell to HH

13.2.1) National Income Accounting


-National Output: flow of all final g&s in an economy w/in given period (year).
- GNP vs NNP: Gross National Product vs Net National Product
-GNP – Depcreciation = NNP
-should only include Final g&s, not intermediate g&s that are used up in the production process

-GNP can be calculated in 3 ways:


a) by finding the expenditure on final g&s (GNE)
b) by finding the value added by each producer (Value-Added)
c) by finding the total income earned by each factor of production (Accrued Income)

a)-GNE: Gross National Expenditure: the


total amount spent by HH (and by
gvt/firms acting on their behalf) on final
g&S
-Final g&s: all g&s not used up in the
production of other g&s
-Intermediate g&s: any g&s used up in
production of other g&s

b)-value added by producer = value of


the o/p of firm – value of i/p used in
production
-Sum of Values Added by all producers
in Economy =GNP
c) Accrued Income to those who provide factor services that producers use in production of g&s is derived from value-
added at each stage of production. All that value must accrue as a factor income to some HH.
 sum of all factor incomes = GNI
-value added at each stage of production will be distributed to HH (wages, salaries, rent, interest, profits/dividends)

-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

The Circular Flow Model idea:


-Income created by the process of production = value of that production
-So, income received by HH must be sufficient to purchase all o/p produced by firms
-demand (income) of HH must be translated into ‘effective demand’= actual expenditure
level of o/p depends on level of Expenditure or Effective D.
-since actual output or diverges from “potential” or “capacity output”, then income and actual output depend on AD

-Consumption C: expenditure on g&s to satisfy current needs


-Savings S: income not spent on consumption (residual obtained by subtracting consumption from HH income)
-Income Y = C +S
-Investment I: production of g&s not used for consumption purposes (investment goods)
a) Inventories: stocks of inputs required in the production process and stocks of their output
-increase in inventories= additional investment
-decrease in inventories = disinvestment
-changes in inventories can be planned/intended or unplanned/unintended
b) Capital Goods: capital stock, factories, offices, machine tools, airports, railways
-investment can make good on depreciation of these goods or add new gds to capital stock
-Total Gross Investment (I) = replacement investment + net investment

13.4) Savings-Investment Schedule


GNP (Y): flow of g&s available for satisfying wants
-Consumption: when g&s satisfy immediate wants
-Investment: remainder of o/p that are not consumed immediately and are added to capital stock or inventories
-
-Savings: what is not consumed

-
C=S

13.5) Concept of Equilibrium


-While Actual S and Actual I, as defined for national income accounting purposes must be equal, Planned S and Planned I
are not always equal. ONLY equal @ equilibrium national income

-IF all income is consumed


-all value-added (output) would accrue to HH and factor incomes
-all factor incomes would be used by HH to purchase consumption g&s provided by firms

-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

-system remains @ eq bcuz withdrawal = injection


-Aggregate Demand = C + I = Aggregate Supply

-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)

-If HH save 1/5th of income


-planned saving > planned investment = national
income will fall.
-Aggregate Demand = C + I < Aggregate Supply
=unplanned increase in inventories

-businesses will react by reducing output


--the fall in national income will be some multiple of
the initial increase in planned saving of 10$bill
Module14: Simple Model of Income Determination
14.2) Development of Macroeconomic Models
-Exogenous variables: variables that are determined externally (position of D curve for ice cream)
-Endogenous variables: variables that the model explains (P & Q of ice cream)

14.3) Consumption Function


-Consumption expenditure influenced by income more than other factors
-JM Keynes in 1936: Consumption Function – relationship btw consumption and income
-fundamental psychological law that people increase consumption as income increases, but not by as much as
the increase in income.
-Marginal Propensity to Consume: the change in consumption accompanying a change in income
-if ^ were unity or >, then the economic system is highly unstable

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)

.. so, at disposable income level 0Z

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

14.4) Solution to the Simple Model

-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 amount of the shift is D1D2


-the point of intersection with 45^ line moves from A to B
-Aggregate Demand changes from D1 to D3
autonomous increase of demand of D1D2 = total increase of
aggregate demand of D1D3
-the autonomous increase in Aggregate Demand leads to equal
increase in Y which induces further increase in Aggregate Demand
which leads to increase in national income, which leads to further
increase in Aggregate Demand.
-why doesn’t multiplier effect go on forever?
-increase in national output will not lead to an equal increase in consumption expenditure.
 it will induce an increase in aggregate demand that is less than the increase in output
-not all of the increase in national income will be spent, some will be saved = withdrawal
-when some of disposable income is saved, MPC will be <1

-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

-if MPC = 0, multiplier would = 1 (doesn’t happen in real world)


-if MPC = 1, multiplier would = infinity and economy would be unstable
Module 15: Expanded Model of Income Determination
15.2) Investment Function
-investment behavior is instable over time
Subjective facts: I decisions depend on expectations about future = uncertainty
Objective facts: technology of modern industry = more instability for I than in C

-to assess if investment will be profitable:


a) cost of investment
b) expected returns from investment (increased income)
c) cost of financing the investment = (rate of interest R)
-A) and b) = rate of retun over cost (marginal efficiency of investment MEI)
-a firm considering investment decision will, consider cost (or value) of that investment and the expected future stream
of income  future dollars are less valuable than present dollars.

-
-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

-If managers who make investment decisions in firms become


pessimistic about future because they fear international
recession or rise in RM prices = reduction in volume of
investment (VICE VERSA)

-Marginal Efficiency curve:


-elastic
-A to B: pessimistic – lower investment
-A to C: optimistic – higher investment
-at given R, volume of investment varies between I0 and I2
depending on position of MEI curve, the position depending on
expectations about future

-if MEI curve is investment-inelastic, changes in R will have


minimal changes on volume of investment
-BUT, if the curve shifts, then change in R will be diff at any
given point

-Accelerator principle: change in net investment is a function of


the rate of change of income
-with the multiplier, it explains fluctuations of
economic activity
-a = capital-output ratio
Multiplier:
-the higher the multiplier (given by
MPC) and higher the accelerator
(given by capital-output ratio)
the more explosive reaction of
economy to any initial change in
AD and the greater the duration
and strength of movements in
income, output and employment

15.3) Government Sector


-withdrawals: HH savings + gvt taxation
-injections: business investment + gvt
expenditure

-Eq when: S + T = I + G

-S > I, and T < G = Budget Deficit


= gvt expenditure > revenue from taxes
-Expansionary – rise in national income &
employment

-S < I, and T > G = Budget Surplus


=gvt expenditure < revenue from taxes
-Deflationary – fall in national income &
employment

-Budget Deficit: G >T, and consequently, I < S


 S = I + (G – T)
-Cp: consumer goods produced + Investment goods + Government goods
-Cb: consumer goods bought + Saved income + Taxes paid

-since national output must = national income


 Cp + I + G = Cb + S + T
-if budget is balanced, (G = T), and consequently (I + S), then where Cp = Cb, Economy will be in Equilibrium!!

-Government Expenditure: 2 measures


-Gvt expenditure on current g&s (G in national income accounts)
-Gvt outlays (G + transfers)

-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

-@ Yb= budget is balanced: gvt expenditure = taxation

-below Yb = budget deficit: transfer payments increase because of


increased unemployment benefits, welfare payments and price
supports; taxation falls with falling income

-above Yb =budget surplus: taxes rise and transfer payments fall.

-In-built stabilisers may be undesirable if economy departed from


full employment and P stability is either high unemployment or high
inflation.

-high inflation + unindexed taxes, produce rapid unplanned shift of


income from HH to gvt. = real disposable income falls.

-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.

15.5) International Sector


Module 16: Fiscal Policy
16.1) Intro
-limit to national income in SR is determined by PPF, which is determined by available supply of factors of production
and technical knowledge.
-changes in supply of factor inputs and technology take place slowly.
-Y and Q do not always move in same direction (Q steady increases, Y fluctuations)
-Y<Q = unemployment of factors of production
-Y =Q = full employment of ^
-Y >Q = overfull employment of ^

16.2) Deflationary and Inflationary Gaps


-capacity output is fixed in SR by supply of factors of production and technical knowledge
-physical factors set limit to output
 Aggregate Supply cannot be increased beyond full employment or capacity national income Yf

-level of National Income depends on level of Aggregate Demand


-Aggregate Demand = C + I + G + (X-Z)
-HH C, business I, Govt Expenditure, (exports – imports)
-AD = those expenditures that make a claim on the output of the domestic economy and therefore create employment
and income for domestic factors of production.
 the higher the AD, the higher the income and employment
-increases in AD lead to increase in output of g&s only if there are unemployed resources/ factors of production

-IF AD = capacity output; full-employment & capacity income realized


-45^ line = locus of points where E = Y

-Yf: full employment income


-shaded area: levels of income achieved after full-employment realised

-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”

-needs budget deficit (T<g) to expand economy

-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

16.3) Real and Money GNP: Index Numbers


-money is common measuring rod to measure national income
-problem: value changes over time (purchasing power)
-over time, national income as measured in current prices may change because
-quantity weights change and/ OR
-price weights change
 if national income doubles because of quantity weights change, then there is increased flow of g&S (Real &
money income doubled)
-If price weights change, that is inflation (money income doubled only)

-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

16.4) Fiscal Policy


-theory of income determination shows that Eq national income can diverge from full-employment income in SR
-Keynesian analysis: gvt should intervene to ensure point of full employment: no inflationary gap and no deflationary
gap..  gvt to influence circular flow of income through taxes (withdrawal T) or gvt expenditure (injection G)
-budget deficit (T<G) = expansionary
-budget surplus (T>G) = deflationary

-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

-The closer the economy is to full-employment the stronger is the Crowding-effect


-Keynesian only holds where there is unemployment
Keynesian:
-If deflationary gap exists, AD is not covering level necessary to achieve obtain and sustain full-employment income
-AD must be raised
-gvt wants to create budget deficit (T<G) (raising government expenditure or decreasing taxes)
size of deficit necessary to create full employment depends on size of multiplier and balance between expenditure
and tax cuts

-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

-method of budget surplus, opposite of above.

-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

-Keynesian: changing G or T will change AD in that amount


-Monetarist: changing G or T will be offset by changes in private expenditure “crowding-out”
@ full-employment (Yf) crowding-out effect = unity: output cannot be increased any further; a rise in G must be at
expense of fall in private expenditure
the closer the the economy is to full employment, the greater the crowding-out effect
Module 17: Money, the Central Bank and Monetary Policy
17.2) Function of Money
-Money: anything generally acceptable for settlement of debts
-Three Types of Money:
-coins (and notes) = legal tender
-banknotes
-bank deposits = not legal tender
-Three Functions of Money:
a) Medium of exchange
b) Unit of account
c) Store of wealth

17.2.1) Medium of Exchange


-because of its convenience compared with alternative of exchanging goods through barter
-barter only possible when exchange is uncommon, self-sufficient family unit, no specialization of labor
-must be widely acceptable
-must have high value: weight ratio
-must be divisible to settle debts of differing denominations
-must not be easily produced, counterfeited or debased in value

17.2.2) Unit of Account


-money provides standard measure of value
-a measuring rod providing measure of value of one g&s relative to another

17.2.3) Store of Wealth


-can be stored for future use
-must be stable over time

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

-Cash ratio should be at 10% always to maintain equilibrium

-the smaller “r” cash ratio, the greater the size of the multiplier and the greater the volume of bank deposits created

-creation of bank deposits limited by 2 factors:


-banks’ propensity to keep cash for liquidity purposes (Cash ratio)
-public’s propensity to hold additional cash

17.5) Central Bank and Monetary Policy


-Central Bank: controls commercial banks around it in a way to support monetary policy of the economy
-the bankers’ bank & lender of last resort & gvt’s bank & manager of public debt
-Central bank’s powers:
-monopoly of the note issue -credit controls
-ability to dictate cash ratio and reserve requirements -power to issue direct instructions to banks & financial
-open market operations* institutions

-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)

Module 18: Quantity Theory and the Keynesian Theory of Money


18.1) Intro
-Equilibrium in money market: Supply of money = Amt of money HH & businesses wish to hold in money balances
-if D for money balances > Supply of money available, then HH and businesses will attempt to obtain more
money to add to their money balances (vice versa)

-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)

18.2) Quantity Theory of Money


-stresses role of money as medium of exchange
-there is a direct relationship between changes in Money Supply (M) and level of prices (P)
M: determined exogenously by monetary authority, V: Velocity of circulation (# of times each unit of
money is spent in given period), P: general level of prices, T: # of transactions in given period

-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

18.3) Keynesian Theory


-stresses money as a store of wealth
-Three types of D for money

1) Transactions Demand for Money


-emphasizes money as medium of exchange
-people need money to finance current transactions (to bridge gap btw receipt and expenditure of income)
-amount of money held for transaction purposes closely relates to level of national income
- influenced by rate of interest (If high, less transactions)
2) Precautionary Demand for Money
-emphasizes money as medium of exchange
-money held to meet sudden arrival of unforeseen circumstances
- influenced by level of income and varies inversely with interest rate
3) Speculative Demand for Money
-emphasizes money as store of wealth
-keeping all your wealth in money has high opportunity cost
-desire to hold money in order to take advantage of developments in capital market (when there is uncertainty)
-ex: buying a bond now because P is expected to rise (vice versa)
-P of bonds and interest rate are inversely related
*liquidity trap

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

-@ Y1, amt of money required for t + p = Mt+p1


-so, the amount left for speculative – Ms1
-the only R that equates the Ms with available
supply M = R1
 A represents R1 that produces equilibrium in
monetary sector when level of income is Y1

B represents equilibrium for Y2 and R2

-Upper right hand (b) = Liquidity-Money Curve


(LM Curve)
-for interest rates > R3, LM curve = vertical line
all money used for transactions, none for specul
-for interest rates <R1, LM curve = horizontal line
 all money not used for t+p held as idle balance

-When monetary authority increases MS


-new LM curve traced corresponding to diff M
-new Eq level of Y2 and R4 (which is less than R2)

 Increase in M supply did not lower interest rate


for low levels of income = Liquidity Trap! (Limit
below which monetary authority cannot lower R)

-when M shifts to the right, new LM curve shifts to the right


-IF, Y is fixed, then R must fall to R2 to maintain equilibrium
-If, R is fixed, then Y must rise to Y2 to maintain equilibrium

level of Y determined once R is known, OR R is determined once


level of Y is known

-to determine simultaneously, Investment Saving IS curve is


needed
the intersection of both determines Eq rate of Interest and Eq
level of national income that are consistent with Eq of money
market and Eq circular flow of national income
19.3) Eq Interest Rates and National Income Levels – Real Goods Sector
IS Curve idea:
-low interest rates associated with high AD (through encouraging private I and through the multiplier process) expand Y.
-vice versa

-Eq level of national income: planned investment I = planned Saving S


-level of investment I is inversely related to MEI
-level of savings S is increasing function of level of income Y (shown in consumption function)
-Y = C +S
-C = bY (b is marginal propensity to consume MPC, proportion spent on income)
-MPC +MPS = 1 (MPS marginal propensity to save)
-S = Y-C; C = bY
 S = (1-b)Y

-Various eq points btw national income and R in real


sector

a.Y and S: Consumption function, shows for each level


of income, the amount not spent: S = (1-b)Y

b.S = I

c.MEI Curve: rate of R consistent with each I level

d. IS Curve: various combos of R and Y that will make


planned Investment of business consistent with
planned Saving of HH
-@ low Y, S is low, R is high to ensure equality
btw planned I & planned S
-@ high Y, volume of planned Savings is high,
low R to ensure high volume of planned Investment to
maintain Eq.
the lower the R, the higher the Eq Y
the lower the Y, the higher the R

-IF MEI was interest-inelastic (changes in R barely


change I) & if MPC were low = Steep IS Curve
-IF MEI was interest-elastic (changes in R greatly
change I) & if MPC were high = Flat IS Curve

- 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

-LM: shows @ high levels of Y, higher R necessary to


ensure that D for and S of M are in equilibrium
-IS: shows @ high levels of Y, low R necessary to ensure
that planned S and planned I are in equilibrium.
@intersection , Y and R where D for M (liquidity) and S
of M are in Eq (money sector Eq) & planned S and planned
I are in Eq (real sector Eq).

19.4 Expanded Model: Shifting Curves

-Government expenditure included, so


b. S = G +I
-Y2 generates S2, generates I1, associated with R3.
(Y2, R3) is one point on new IS curve IS2

when G increases, IS shifts.


-If T increased, S = I again
-If Trade Surplus, where X >Z, G would increase (vice versa)
-IS/LM approach integrates Monetary factors (D for and S of Money) and Real factors (Consumption, Investment, G and
Net Exports) within one analysis.
Together they determine Eq R and Eq Y

-Deflationary Gap: Yeq < Yf (full-employment income) =


unemployment and level of income less than what could be
achieved at capacity output

-Monetary policy will not help to reach full-employment income


because; R associated with full-employment income is R1 which is
below min. rate of interest Rm (set by horizontal part of LM)
 Liquidity Trap: prevents monetary policy from pushing R low
enough to encourage sufficient Investment to obtain full-
employment income

-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)

-Inflationary Gap: Ye > Yf


-level of AD greater than necessary to sustain full employment, leading to
rising Prices

-Reduce AD by leftward shift in LM curve and/or downward IS


-Monetary Policy: reduce Money Supply = LM left shift
-@ LM2 given IS1, Yf is reached @ higher R3
-as R increases, volume of I reduces, lowers AD = left shift along IS
-Fiscal Policy: decrease G and/or increase T (Budget surplus) = IS shift left
-@ IS2, Yf is reached @ lower R3

-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

-IS1 shifts to IS2 because of increase in G

-effects of national income/output Y and rate


of interest R depend on slope of LM Curve.

b) Liquidity Trap: national output expands but


R remains constant at R1

c) R increases to R3, but Y remains at Y1


-because increase in G offset by equal
and opposite decrease in I, where there has
been crowding out due to increase in R.

-shift IS1 to IS2 = raise R and Y


-Y shift can be in two parts: from Y1-Y3, then Y3-Y2

-decreases from Y3 to Y2 because of increase in R (partial crowding out)

-LM1 Curve shifts to right to LM2 because


of increase in Money Supply
-effects on Y and R depend on slope of IS

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

a- Decrease in R stimulates investment expenditure and through multiplier causes increase in Y to Y2


Module 20: Inflation and Unemployment
20.1) Intro
-IS/LM approach: tool for integrating monetary and real goods sectors
-LM: money demand and supply
-IS: consumption function and marginal efficiency of investment curve, net gvt expenditure and net exports
to determine equilibrium rates of interest and equilibrium levels of income

-to find out Unemployment


-If Y = Q: full-employment subject to frictional, structural and seasonal unemployment
-If Y <Q: demand-deficient unemployment caused by fiscal and/or monetary policy
-If Y >Q: deflationary policies of reduced G, increased T, and/or reduction in money supply M takes back to Yf

-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)

-given Eq level of national income, unemployment rate is determined


-given unemployment rate, inflation rate is determined
trade-off btw inflation and unemployment

-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)

20.2) Causes and Effects of Inflation


-Price inflation: impairs the efficiency of markets and redistributes income and resources in an unexpected way
-the more successfully inflation is anticipated, the more rapid the rate of inflation is likely to become
1) Impairs efficiency of price mechanism and raises costs of buying/selling because money is less reliable as
standard of value & search costs of buying/selling increase especially for consumer durables
2) Inflation penalizes people on ‘fixed’ incomes (pensioners, uni students) and favors whose money incomes
adjust quick to P changes (most wage and profit earners)
3) unanticipated inflation favors borrowers and penalizes lenders because increase in prices will reduce real cost
of borrowing.
4) with unindexed taxes (specified in money terms not real terms) inflation will redistribute resources from
private to public sector.
5) continuing higher inflation than other countries leads to increased imports and reduced exports which can
create problems for exchange rates

-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

-Ye cannot be reached by increased real output beyond Yf


consequence is that excess of desired real expenditure over real
capacity output (income) = price inflation

-Keynesian approach does not include monetary factors that may be


responsible for causing inflation (increased gold supplies or failure to
control supply of paper currency) or the monetary policy’s role in
curbing inflation + that it regards wages and salaries as responsive to P
changes only

-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

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