Absolute Advantage vs. Comparative Advantage

Absolute Advantage

• Individual- exists when a person can produce more of a certain good/service than someone else in the same amount of time
• National- exists when a country can produce more a good/service than another country can in the same time period

Comparative Advantage

• Individual/National- exists when a n individual or nation can produce a good/service at a lower opportunity cost than another individual or nation

Absolute Advantage = faster, more, more efficient

Comparative Advantage = lower opportunity cost

Foreign Exchange

• Foreign Exchange- the buying and selling of currency
• Ex. In order to purchase souvenirs in France, it is first necessary for Americans to sell (supply) their dollars and buy (demand) Euros.
• The exchange rate (e) is determined in the foreign currencies markets
• Ex. The current exchange rate is approximately 77 Japanese Yen to 1 U.S. dollar
• The exchange rate is a price of a currency
• Do not try to calculate the exact exchange rate

Tips:

• Always change the D line on one currency graph, the S line on the other currency's graph
• Move the lines of the two currency's graphs in the same direction (right or left) and you will have the correct answer
• If D on one graph increases, S on the other will also increase
• If D moves to the left, S will move to the left on the other graph

Changes in Exchange Rates

• Exchange rates are a function of the supply and demand currency
• An increase in the supply of a currency will make it cheaper to buy one unit of that currency
• A decrease in supply of a currency will make it more expensive  to buy one unit of that currency
• An increase in demand for currency will make it more expensive to buy one unit of that currency
• A decrease in demand for a currency will make it cheaper to buy one unit of that currency.

Appreciation

• Appreciation of a currency occurs when the exchange rate of that currency increases
• Hypothetical: 100 Yen used to buy one dollar. Now 200 Yen buy one U.S. dollar
• The dollar is stronger because one buys more Yen than it used to.

Depreciation

• Depreciation of a currency occurs when the exchange rate of that currency decreases
• 100 Yen used to buy one dollar. Now 50 yen buys one dollar.
• The dollar is weaker because it takes fewer Yen to buy one dollar.

Dollar Appreciation

• Each dollar gets you more of the other currency
• U.S. exports gets more expensive for foreigners
• U.S. imports gets cheaper for the U.S.
• Exports decrease
• Imports increase
• Money is leaving the U.S.
• Xn decreases
• GDP decreases
• Increase in demand for the dollar
• Decrease in supply of the dollar

Dollar Depreciation

• Each dollar gets you less of the other currency
• Less of the foreign currency is needed to buy each dollar
• Exports increase
• Imports decrease
• Money is entering the U.S.
• Xn increases
• GDP increases
• Demand for the dollar decreases
• Supply of the dollar increases

Supply of the Dollar

• Sources:
1. US citizens
2. Banks
3. Industries wanting to purchase our goods, investments, and assets

Making transferred payments to foreigners --> (Supply)

Foreigners are making transfer payments to us --> (Demand)

Purchasing Power Parity- when the currency rates are set by international markets; changes will be made based on the actual purchasing power of the currencies

Why do we exchange currencies?

1. To sell exports and buy imports
2. To invest in another country's stocks and bonds
3. Build stores or factories in another country
4. To speculate on currency values
5. To hold currencies in bank accounts for future exports, imports, and business loans
6. To control excessive imbalances

Unit 7-Balance of Payments and Trade

The Balance of Payments

• Measure of money inflows and outflows between the United Sates and the rest of the world.
• A system of accounting used for international trade
• Inflows are referred to a credits
• Outflows are referred to as debits

The Balance of Payment is divided into three accounts

1. Current Account
2. Capital/Financial Account
3. Official Reserves Account

Double-entry Bookkeeping

• Every transaction in the balance of payments is recorded twice in accordance with standard accounting practice

Current Account

• Balance of Trade or Net Exports
• Exports of Goods/services - imports of Goods/services
• Exports create a credit to the balance of payments
• Imports create a debit to the balance of payments
• Net foreign income
• Income earned by U.S. owned foreign assets- Income paid to foreign-held U.S. assets
• Ex. Interest payments on U.S. owned Brazilian bonds - Interest payments on German-owned U.S. treasury bonds
• Net Transfers (tend to be unilateral)
• Foreign aid --> a debit to the current account
• Ex. Mexican migrant workers send money to family in Mexico

Capital/Financial Account

• The balance of capital ownership
• Includes the purchase of both real and financial assets
• Direct investment in the United States is a credit to the capital account
• The Toyota Factory in San Antonio
• Direct investments by U.S. firms/individuals in a foreign country are debits to the capital account
• The Intel factory in San Jose, Costa Rica
• Purchase of foreign financial assets represents a debit to the capital account
• Warren Buffet buys stock in Petrochina
• Purchase of domestic financial assets by foreigners represents a credit to the capital account
• The United Arab Emirates sovereign wealth fund purchases a large stake in the NASDAQ

Relationship between Current and Capital Account

• The current account and the Capital Account should zero each other out.
• That is...the current account has a negative balance (deficit), then the capital account should then have a positive balance (surplus).
• Ex.The constant net inflow of foreign financial capital to the united States (capital account surplus) is what enables us to import more than we export (current account deficit).

Official Reserves

• The foreign currency holdings of the United States Federal reserve System
• When there is a balance of payment  surplus the FED accumulates foreign currency and debits the balance of payments
• When there is a balance of payment  deficit the FED accumulates foreign currency and credits the balance of payments

Active vs. Passive Official Reserves

• The U.S. is passive in its use of official reserves.  It does not seek to manipulate the dollar exchange rate.
• The peoples Republic of China is active in its use of official reserves. It actively buys and sells dollars in order to maintain a steady exchange rate with the U.S.

Balance of Trade 

• Goods and Services Exports - Goods and Services Imports
• Trade Deficit- when the balance of trade is negative (more imports then exports)
• Trade Surplus- when the balance of trade is positive (more exports then imports)

Current Account

• Balance on Trade + Net Investment + Net Transfer

Capital Account

• Foreign purchases of your country's assets + your country's purchases of assets abroad

Official Reserve

• Current Account + Capital Account

Balance on Goods and Services

• Goods Imports + service imports
• Goods exports + goods imports

Unit 6

Economic Growth

• Sustained increase in Real GDP over time
• Sustained increase in  Real GDP per Capita over time

Why Grow?

• Growth leads top greater prosperity for society
• Lessens the burden of scarcity
• Increases the general level of well-being

Conditions for growth

• Rule of Law
• Sound legal and economic institutions
• Economic Freedom
• Respect for Private Property
• Political and Economic Stability
• Low inflationary expectations
• Willingness to sacrifice current consumption
• Saving 
• Trade

Physical capital

• Tools, machinery, factories, infrastructure
• Physical capital is the product of investment
• Investment is sensitive to interest rates and expected rates of return
• It takes capital to make Capital
• Capital must be maintained

Technology and Productivity

• Research and development, innovation and invention yield increases in available technology
• More technology in the hands of workers increases productivity
• Productivity is output per worker
• More productivity = Economic Growth

Human Capital

• People are a country's most important resource.  Therefore human capital must be developed.
• Education
• Economic Freedom
• The right to acquire private property
• Incentives
• Clean water
• Stable food supply
• Access to technology

Hindrances of Growth

• Economic and Political Instability
• High inflationary expectations
• Absence of the Rule of Law
• Diminished Private Property rights
• Negative Incentives
• The welfare state
• Lack of savings
• Excess current consumption
• Failure to maintain existing capital
• Crowding out of investment
• Government deficits and debt increasing long-term interest rates
• Increased income inequality --> Populist policies
• Restrictions on Free International Trade

Laffer Curve

• It is a trade-off between tax rates and government revenue
• Used to support the supply side argument
• As tax rates increase from 0, tax revenues increase from 0 to some maximum level, then decline.

Criticisms of the Laffer Curve

• Research suggests that the impact of the tax rates on incentives to work, save and invest are small.
• Tax cuts also increase demand, which can fuel inflation, which will cause demand to exceed supply
• Where the economy is actually located on the curve is difficult to determine

Supply-Side Economics

Supply-side economists tend to believe that the AS curve will determine levels  of inflation, unemployment, and economic growth

To increase the economy you take actions to shift the AS curve to the right, always benefiting the company first.

They focus on marginal tax rates (the amount paid on the last dollar earned or on each additional dollar).

If they reduced the marginal tax rates you encourage more people to work longer in which they will forgo their leisure time for extra income.

Lower taxes are an incentive for businesses to invest in our economy.

Lower taxes are incentives for people to increase savings and therefore create lower interest rates for increases in business investment.

They believe only in AS, not AD

Reaganomics

• Lowered the marginal tax rate to get the U.S. out of a recession --> led to a deficit

Phillips Curve

Phillips Curve- it is the relationship between unemployment and inflation (only occurs in the short run)


LRPC (Long Run Phillips Curve)- it occurs at the natural rate of unemployment; it is represented by a vertical line and there is no trade-off between unemployment or inflation in the long run.

• The major LRPC assumption is that more worker benefits create higher natural rates and fewer worker benefits create lower natural rates.

SRPC- have relevance to Okun's Law

• Inverse relationship between unemployment rates and inflation rates

High Inflation=Low unemployment

Low Inflation=High unemployment

Aggregate supply shocks can cause the rate of inflation and the rate of unemployment to increase.

Supply shocks are rapid and significant increases in resource cost which causes the SRAS curve to shift.

Since wages are sticky, inflation changes (move the points on the SRPC)

If inflation persists and the expected rate of inflation rises, then the entire SRPC moves upward which creates a situation called Stagflation.

If inflation expectations drop due to new technology, then the SRPC will move downward.

Stagflation-high unemployment + high inflation at the same time
The Misery Index- it is a combination of inflation and unemployment in a given year. Single digit misery index is good.

The Long-Run Phillips Curve

• Because the long-run Phillips curve exists at the natural rate of unemployment, the structural changes in the economy that affect unemployment will also cause the LRPC to shift
• Increases in Unemployment will shift LRPC -->
• Decreases in unemployment will shift LRPC <--

Relating Phillips Curve to AS/AD

• Changes in the AS/AD model can also be seen in the Phillips curves
• An easy way to understand how changes in the AS/AD model affect the Phillips curve is to think of the two sets of graphs as mirror images.
• The two models are not equivalent. The AS/AD model is static, but the Phillips curve includes changes over time.  Whereas AS/AD shows one time changes in the price level as inflation or deflation; the Phillips curve illustrates continuous change in the price level as either increased inflation or disinflation.

Disinflation- reduction in the inflation rate from year to year, which is usually displayed in the long-run Phillips curve.

• Also occurs when aggregate demand declines
• In the short-run, profits fall and the unemployment rate increases
• Decrease in inflation rates

Deflation- it is an actual drop in the price level

*Cost-push inflation causes supply shocks*

Wages

Short-Run AS- time too short for the wages to adjust to the price level.

• Workers may not be aware of changes in their real wages due to inflation and have adjusted their labor supply decisions and wage demands accordingly

Nominal wages- it is the amount of money received per day, per hour, per year
Sticky wages- the nominal wage level is set accordingly to an initial price level and it does not vary
Long-Run AS- time long enough for wages to adjust

• Flexible wage levels and price levels
• Both offset each other

Keynesian- Price Level (fixed), Wage level (fixed), Employment level (flexible), Implications (output depends on changes in employment).
Intermediate- Price Level (flexible), Wage level (fixed), Employment level (flexible), Implications (output depends on changes in price and employment level).
Classical- Price Level (flexible), Wage level (fixed), Employment level (fixed), Implications (output depends solely on the price level).

Demand-Pull Inflation Graph


Cost-Push Inflation Graph

Monetary Policy Video

Video Summaries

Video #1
The three different types of money are commodity money, representative money, and fiat money.  A negative about representative money is that when the value changes it effects the value of the national currency.  Fiat money is money that is backed by the government who says it has value.  A function of money is that it is a medium of exchange.  The second function is that money is a store of value.  The last function is money is a unit of account. 

Video #2
On a money market graph the interest rate is on the "y" axis and the quantity is on the "x" axis.  Demand for money slopes downward because when the price is high, quantity demanded is low.  Supply of money is vertical because it does not vary based on the interest rate; the supply of money is fixed by the FED.  If the government wants to bring the interest rates back down, they can increase the money supply.

Video #3
Expansionary policy is easy money and contractionary policy is tight money.  If the FED wants to increase the money supply, then they will decrease the required reserves.  If the FED wants to decrease the money supply, then they would increase the required reserves.  The discount rate is the rate at which banks can borrow money from the FED.

Video #4
On the loanable funds graph, interest rate is on the "y" axis and quantity is on the "x" axis.  Supply of loanable funds comes from the amount of money that people have in banks.  Supply of loanable funds is dependent on savings.  If people have an incentive to save more, then the supply of loanable funds increases.  If the people have a disincentive to save less, then the supply of loanable funds decreases.

Video #5
Banks create money by making loans.  The reserve requirement is the percentage of the banks total deposits that they have to keep either as vault cash or on deposit in a FED branch.  The money multiplier is 1/RR.  If the reserve ratio is 20% then the amount a banking system can loan out from a $500 loan is $2500.  Use the reserve ratio (1/.2) which is equal to 5 and multiply that by $500.

Video #6
If the government is going through a deficit, they are borrowing money.  The majority of the government's debt id from borrowing money from Americans, not foreign countries.  There will be an increase in demand for money because the government is borrowing it.  In the money market graph the Demand for Money line will shift to the right based on the above scenario.

The Loanable Funds Market

The market where savers and borrowers exchange funds at the real rate of interest

The demand for loanable funds, or borrowing comes from households, firms, government, and the foreign sector.  The demand for loanable funds is in facts the supply of bonds

The supply for loanable funds, or savings comes from households, firms, government, and the foreign sector.  The supply for loanable funds is in facts the demand of bonds

Changes in the deamnd for Loanable Funds

• Remember that demand for loanable funds = borrowing
• More borrowing = more demand for loanable funds
• Less borrowing = less demand for loanable funds

Changes in supply of Loanable Funds

• Remember that supply of loanable funds = savings
• More saving = more supply pf loanable funds
• Less saving = less supply of loanable funds

When government does fiscal policy it will affect the loanable funds market

 Changes in the real interest rate will affect gross private investment

Key Principles & Tools of Monetary Policy

A single bank can create money (through loans) by the amount of excess reserves

The banking system as a whole can create money by a multiple of the initial excess reserves

Cash is existing money that increase bank reserves, but it does not create an immediate change in MS

FED purchase of a bond from the public is new money that increases bank reserves and causes an immediate change in MS

Bank purchase of a bond from the public is new money that increases bank reserves and causes and immediate change in MS

Factors that weaken the effectiveness of the deposit multiplier

• If banks fail to loan out all of their ER the FED has to change the multiplier
• If bank customers take their loans in cash rather than in new checking account deposits
• Demand for money has an inverse relationship between the nominal interest rates and the quantity of money demanded

What happens to the quantity demanded of money when interest rates increase? Decreases

What happens to the quantity demanded when interest rates decrease? Increase

Money demand Shifters

• Change in price level
• Change in income
• Change in taxation that affects investment

Functions of the FED

1. It issues paper currency
2. Sets reserve requirements and holds reserves of banks
3. It lends money to banks and charges them interest
4. They are in check clearing service for the banks
5. It acts as a personal bank for the government
6. Supervises member banks
7. Controls the money supply in the economy

In an open market operation you can either buy bonds (increase money supply) or sell bonds (decrease money supply)

The discount rate and the reserve requirement both decrease in an expansionary policy

The discount rate and the reserve requirement both increase in an contractionary policy

Federal Fund rate- it is the investment rate that commercial banks can charge other commercial banks for overnight loans

Prime rate- the interest rate that is given to a bank's most credit-worthy customer

Unit 4- Money

Money is any asset that can be easily used to purchase goods and services.

3 uses

• Medium of exchange
• Unit of account
• Store of value

3 types

• Commodity money-value within itself
• Representative money- represents something of value
• Fiat money- money because the government says so

 6 characteristics of money

• Durability
• Portability
• Divisibility
• Uniformity
• Limited supply
• Acceptability

Money supply- all of the available money in an economy

M1 money- liquid money

• Currency
• coins
• checkable deposits
• travelers checks

M2 money

• Consists of M1 money, savings accounts, and money market accounts

3 purposes of financial institutions

• Store money
• Save money
• Loan money

4 ways to save money

• Savings account
• Checking account
• Money market account
• CD (certificate of deposit)

Loans-banks operate on a fractional reserve banking system, which means they keep a fraction of the funds and loan out the rest

Interest Rates

• Principal- it is the amount of money borrowed
• Interest-price paid for the use of borrowed money
• Simple interest- paid on the principal
• Compound- paid out the principal plus the accumulated interest

Simple interest formula
I=P*R*T / 100

Types of financial institutions

• Commercial banks
• Savings and loan institutions
• Credit Unions
• Mutual savings banks
• Finance companies

Investment- redirecting resources that you would consume now for the future

Financial assets- claims on property and income of the borrower

Financial intermediaries- Institution that channels funds from sources to borrowers

3 purposes for financial intermediaries

• Share risk
• providing information
• liquidity

Bonds- loans or IOU's that represent debt the government or a corporation must repay to an investor

3 components

• coupon rate- it is the interest rate that a bond issuer will pay to a bond holder
• maturity- time at which payment to a bond holder is due
• Par value- the amount that an investor pays to purchase a bond and that will be re-payed to the investor at maturity

Yield- the annual rate of return on a bond if the bond were held to maturity

Is a dollar today worth more than a dollar tomorrow?

• Yes

Why?

• Opportunity cost and inflation
• This is the reason for charging and paying interest

Let v=future value of money
p=present value of money
r=real interest rate (nominal rate-inflation rate) expressed as a decimal
n=years
k=number of times interest is credited per year

The simple interest formula

• v=(1+r)^n *p

The compound interest formula

• v=(1+r/k)^nk * p

Monetary Equation of Exchange

• MV=PQ
• M=money supply
• V=money's velocity
• P=price level
• Q=real GDP

Unit 3

Long Run: Period of time where input prices are flexible and adjustable to changes in price level.

• Level of RGDP supplied is independent of price level 

Short Run: Period of time where input prices are sticky and do not adjust to change in price level

• Level of RGDP supplied directly related to price level 

RGDP = output 

Long- Run AS (LRAS):
-LRAS makes level of full employment in economy (analogues to PPC)
-Because input prices completely flexible in long-run, changes in price level do not change firms real profits and do not change firms level of output. This means LRAS is vertical at economy's level of full employment.

Short-Run AS (SRAS)
-Because input prices are sticky in short run, the SRAS is upward sloping
Changes in SRAS

• increase in SRAS = shifts right 
• decrease in SRAS = shifts left 
• key to understanding shifts in SRAS is per unit cost of production 

Per-Unit Production Cost: Total input cost / total output

Determinants of SRAS (all affect unit production cost)

Input Prices:

• Domestic Resource Prices 
• Wages (75% all business costs)
• Cost of capital 
• Raw material (commodity prices)

Foreign Resource Prices:
Strong $ = lower foreign resource prices 
Weak $ = higher foreign resource prices 

Market Power:

• Monopolies and cartels (Ex. OPEC dollars for oil) control resources, control prices of resources 

Increase in resource prices = SRAS shifts left
Decrease in resource prices = SRAS shifts right

Productivity:

• P = total output / total inputs 
• More production = lower unit production costs (SRAS shifts right) 
• Lower production - high unit production cost (SRAS shifts left) 

Legal Institution Environment
Taxes & Subsidies 

• Taxes ($ to gov.) to business increase per unit production cost = SRAS shifts left 
• Subsidies ($ from gov.) to business reduce per unit production cost = SRAS shifts right 

Government Regulation:

• Governemnt regulation creates cost of compliance = SRAS shifts left 
• Deregulation reduces cost of compliance = SRAS shifts right 

Aggregate Demand

• Shows the amount of Real GDP that the private, public and foreign sector collectively desire to purchase at each possible price level.  
• The relationship between the price level and the level of Real GDP is inverse. 
• Three reasons AD is downward sloping 

• Real-Balances Effect 

• When the price-level is high households and businesses cannot afford to purchase as much output. 
• When the price-level is low households and businesses can afford to purchase more output 

• Interest-Rate Effect 

• A higher price-level increases the interest rate which tends to discourage investment 
• A lower price-level decreases the interest rate which tends to encourage investment 

• Foreign Purchases Effect

• A higher price-level increases the demand for relatively cheaper imports. 
• A lower price-level increases the foreign demand for relatively cheaper U.S. exports

•  Shifts in Aggregate Demand

• There are two parts to a shift in AD: 

• A change in C, Ig, G, and/or X 

• A multiplier effect that produces a greater change than the original change in the four components 

• Increases in AD equals AD -->
• Decreases in AD equals AD <--

•  Increase in Aggregate Demand 

• Decrease in Aggregate Demand 

• Consumption
• Consumer Wealth 
• More wealth equals more spending (AD shifts -->) 
• Less wealth equals less spending (AD shifts <--)

•  Consumer expectations 
• Positive expectations equals more spending (AD shifts -->) 
• Negative expectation equals less spending (AD shifts <--) 

• Household indebtedness
• Less debt equals more spending (AD shifts -->) 
• More debt equals less spending (AD shifts <--)
• Taxes
• Less taxes equals more spending (AD shifts -->) 
• More taxes equals less spending (AD shifts <--) 
• Gross Private Investment 
• Investment spending is sensitive to: 
• The real interest rate 
• Lower real interest rate equals more investment (AD -->) 
• Higher real interest rate equals less investment (AD <--)  
• Expected returns 
• Higher expected returns equals more investment (AD -->) 
• Lower expected returns equals less investment (AD <--) 
• Expected returns are influenced by 
• Expectations for future profitability 
• Technology 
• Degree of excess capacity (existing stock of capital)

• Government Spending  
• More government spending (AD -->) 
• Less government spending (AD <--) 

• Net Exports
• Net exports are sensitive to: 
• Exchange rates (international value of $) 
• Strong $ equals more imports and fewer exports equals (AD <--) 
• Weak $ equals fewer impots and more exports equals (AD -->) 

•  Relative income 
• Strong foreign economies equals more exports equals (AD -->) 
• Weak foreign economies equals less exports equals (AD <--)

The AS/AD Model 
AS & AD determines current output and price level

• Full employment 
• Full employment equilibrium exists where AD intersects SRAS and LRAS at the same point 
• Recessionary gap 
• A recessionary gap exists when equilibrium occurs below full employment output.  

• Inflationary gap 
• An inflationary gap exists when equilibrium occurs beyond full employment output 

Interest Rates & Investment Demand 
What is investment?

•  Money spent or expenditures on 
• New plants (factories) 
• Capital equipment (machinery) 
• Technology (hardware and software) 
• New homes 
• Inventories (goods sold by producers) 

Expected Rates of Return

• How does business make investment decisions? 
• Cost/Benefit analysis 

• How does business determine benefits? Expected rate of run
• How does business count the cost? Interest costs
• How does business determine the amount of investment they undertake?compare expected rate of return to interest costs
• If expected return is greater than interest cost, then invest
• If expected return is less than interest cost, then do not invest

Real v. Normal

• Whats the difference? Nominal is the observable rate of interest. Real subtracts out inflation and is only known ex post facto.
• How do you compute the real interest rate? r% equals i% - pi%
• What then, determines the cost of an investment decision? The real interest rate
• What is the slope of the investment demand curve? Downward sloping
• Why? When interest rates are high, fewer investments are profitable, when interest rates are low, more investments are profitable

Shifts in Investment Demand (ID)

Cost of Production

• Lower costs shift ID to the right
• Higher costs shift ID to the left

Business Taxes

• Lower Business taxes shift ID to the right
• Higher Business taxes shift ID to the left

Technological Change

• New Technology shifts ID to the right
• Lack of technological change shifts ID to the left

Stock of Capital

• If an economy is low on capital then ID shifts to the right
• If an economy has much capital then ID shifts to the left

Expectations

• Positive expectations shift ID to the right
• Negative expectations shift ID to the left

Long Run AS- it represents a point on an economy's productiojn possibilities curve

• Always vertical
• Always stable at full empoyment
• LRAS doesn't change as the price level changes
• The only things that can shift LRAS's are change in resources, change in technology or economic growth

Three Schools of Economy

Classical

• John B. Say
• Adam Smith 
• David Ricardo
• Alfred marshall
• Competition is good
• Invisible hand (market wikll take care of itself)
• Say's Law (supply creates it own demand)
• AS determines output
• Economy is always close to or at full employment
• In the long run the economy will balance at full employment
• The trickle down effect will help the rich first and the rest later
• Savings (leakage) equals Investment (injection)
• Because of the cost of borrowing our savings leak out
• Prices in wages are flexible downward
• Whatever output is produces will be demanded
• Instituted the concept of lazzie-faire

Keynesian

• John Maynard Keynes
• Competition is flawed
• AD is the key and not AS
• Leaks cause constant recession
• Savings cause recessions
• He also believed in the ratchet effect and sticky wages block Say's Law
• In the long run we are all dead
• Demand creates its own supply, therefore the AD curve is unstable
• Savers does not equal Investors
• They save and invest for different reasons
• The economy is not always close to or at full employment
• Prices in wages are inflexible downward
• Monopolistic competition
• There is government intervention (through Fiscal ot Monetary Policy)

Monetary

• Allen Greenspan
• Ben Bernanka
• Congress can't time policy options
• Government can best control the health of the economy by regulating banks and interest rates
• Easy money (recession)
• Tight money (inflation)
• Change to required reserves if needed
• Use bonds through open market operation
• use the interest rate to change the discount rate and the federal fund rate

Consumption and Saving

Disposable Income- Income after taxes or net income

• DI equals Gross income minus taxes

2 choices

• With disposable income households can either:

1. Consume (spend money on goods and services)
2. Save (not spend money on goods and services)

Consumption

• Household spending
• The ability to consume is constrained by: the amount of disposable income and the propensity to save

Do households consume if DI equals 0?

• Autonomous Consumption
• Dissaving

APC equals C/DI equals DI that is spent

Saving

• Household not spending
• The ability to save is constrained by: the amount of disposable income and the propensity to consume

Do households save if DI equals 0? No

APS equals S/DI equals DI that is not spent

APC & APS

• APC + APS equals 1
• 1- APC equals APS
• 1- APS equals APC
• APC> 1 : Dissaving
• - APS: Dissaving

MPC & MPS
 Marginal Propensity to Consume

• Change in C / DI
• % of every extra dollar earned that is spent

Marginal Propensity to Save

• Change in S / DI
• % of every extra dollar that is saved
• MPC + MPS equals 1
• 1-MPC equals MPS

The Spending Multiplier Effect

• An initial change in spending cause a larger change in aggregate sopending or aggregate demand.
• Multiplier equals Change in AD/ Change in spending
• Multiplier equals Cahnge in AD/ Change in C, G, I, or X

Why does this happen?

• Expenditures and income flow continuously which sets off a spending increase in the economy

Calculating the Spending Multiplier

• 1/1-MPC  or   1/MPS
• Multipliers are positive when there is an increase in spending and negative when there is a decrease

Calculating the Tax Multipliers

• -MPC/1-MPC   or    -MPC/MPS
• If there is a tax cut, then the multiplier is positive because there's now more money in the circular flow

Fiscal Policy
Changes in the expenditures or tax revenues of the federal government

2 tools of fiscal policy

• Taxes: government can increase or decrease taxes
• Spending: government can increase or decrease spending

Fiscal policy is enacted to promote our nations economic goals: full employment, price stability, and economic growth

Deficits, Surpluses, and Debt

Balanced Budget

• Revenues equal expenditures

Budget Deficit

• Revenues< Expenditures

Budget Surplus

• Revenues> Expenditures

Government Debt

• Sum of all deficits - sum of all surpluses

Government must borrow money when it runs a budget deficit

Government borrows from:

• Individuals
• Corporations
• Financila Institutions
• Foreign entities or foreign governments

Fiscal Policy: Two Options

Discretionary Fiscal Policy (action)

• Expansionary fiscal policy - think deficit
• Contractionary fiscal policy - think surplus

Non- Discretionary Fiscal Policy (no action)

Discretionary v. Automatic Fiscal Policies
Discretionary
 Increasing or decreasing government spending and/or taxes in order to return the economy to full employment. Discretionary policy involves policymakers doing fiscal policy in response to an economic problem.
Automatic
Unemployment compensation and marginal tax rates are examples of automatic policies that help mitigate the effects of recession and inflation. Automatic fiscal policy takes place without policy makers having to respend to current economic problems.

Contractionary vs. Expansionary Fiscal Policy

• Contractionary fiscal policy - policy designed to decrease aggregate demand
• Strategy for controlling inflation

•  Expansionary fiscal policy - policy designed to increase aggregate demand 
• Strategy for increasing GOP, combating a recession and reducing unemployment 

• Expansionary Fiscal Policy
• Increase government spending (G increases) 
• Decrease taxes

• Contractionary Fiscal Policy
• Decrease government spending (G decreases) 
• Increase taxes (T increases) 

 

• Automatic or Built in Stabilizers
• Anything that increases the government's budget deficit during a recession and increases its budget surplus during inflation without requiring explicit action by policymakers

• Economic importance: 
• Taxes reduce spending and aggregate demand 
• Reductions in spending are desirable when the economy is moving toward inflation 
• Increases in spending are desirable when the economy i s heading toward recession 

• Automatic Stabilizers 
• Welfare checks, food stamps. unemployment checks, corporate dividends, social security, veteran benefits.

• Progressive Tax System
• Average tax rate (tax revenue/GDP) rises with GDP

• Proportional Tax System 
• Average tax rate remains constant as GDP changes 

• Regressive Tax System 
• Average tax rate falls with GDP 

Unit 2

• Economist collect statistics on production, income, investment and savings; this is called National Income Accounting. 

Gross Domestic Product (GDP) 

• Most important measure of growth 
• It is the total dollar value of all final goods and services produced within a country's borders within a given year 

- What is not included in GDP 

• Intermediate Goods
• No multiple counting 
• Only count final goods 

• Second-hand or used goods 

• Non-market activity 
• Illegal drugs 
• Babysitting 
• Volunteering 

• Financial Transaction 
• Stocks, bonds, real estate 

• Gifts and Transfer Payments 
• Social security, scholarships, transfer payments 

- What is included in GDP C+Ig+G+Xn

C - Consumption - 67% of the economy

• All finished goods and services 

Ig  - Gross Private Domestic Investment

• New factory equipment, construction of housing, factory equipment maintenance, unsold inventory 

G - Government spending

• Government purchases goods and services

Xn - Net Exports

• Exports - Imports 

Gross National Product (GNP)

• It is the total value of all final goods and services by citizens of that country on its lands or on foreign land 

- Expenditure Approach
  Add up the market value of all domestic expenditures made on final goods and services in a single year
C+Ig+G+Xn = GDP

- Income Approach
   Add up all of the income earned by households and firms in a single year

W+R+I+P+ Statistical Adjustments = GDP
W=Wages
R=Rents
I=Interest
P=Profit

Wages - Compensation of employees, salary supplements (pension, health, insurance, welfare)
Rents - Tenants to landlords, lease payment by a corporation for the use of their space
Interest - Money paid by private businesses to the suppliers of loans used to purchase capital
Profit - Corporate income taxes, corporate profits, dividends

- Budget:  How to Calculate
   Government purchases of goods and services + government transfer payments - government tax and fee collection

• If you have a positive number, it is a budget deficit 
• If you have a negative number, it is a budget surplus 

- Trade:   How to Calculate
   Exports - Imports
- GNP:  How to Calculate
  GDP + Net Foreign Factor Income
- NNP - Net Nation Product:  How to Calculate
   GNP - Depreciation
- NDP - Net Domestic Product
   GDP - Depreciation

•  National Income

GDP - Indirect Business Taxes - Depreciation - Net foreign factor payment
Compensation of employees + proprietors income + corporate profits + rental income + interest income

Disposable Personal Income
National income - Personal Household Taxes + Government transfer payments

Nominal GDP vs. Real GDP
Nominal GDP:  It is the value of output produced in current prices. It can increase from year to year if output or price increases. P * Q
Real GDP:  It is the value of output produced in constant or base year prices. It is adjusted for inflation. It can only increase from year to year if output increases. 
In Real GDP, you would use the earliest year (base year). Q x BP

Price index = Measures inflation by tracking changes in the market basket of goods compared with that in a base year.

Price of market basket of goods in current year x 100
Price of market basket of goods in base year

GDP Deflator - Price index used to adjust from nominal to real GDP

Nominal GDP  x 100
   Real GDP

In base year GDP deflator is always equal to 100

For years after the base years, the GDP deflator will be greater than 100

For years before the base year, the GDP deflator is less than 100

Inflation Rate

New deflator - old deflator x 100
            Old deflator

Inflation - is a rise in the general price level.
Inflation rate - measures the percentage increase in the price level over time. Key indicator of the economy's health.
Deflation - it is a decline in the general price level. 
Disinflation - occurs when the inflation rate itself declines.
CPI - it measures inflation by tracking the yearly price of a fixed basket of goods and services. Indicates changes in the cost of living and the price level.
Finding inflation rate using market basket data:

Current year market basket value - base year
=         Market basket value_           x 100
    Base year market basket value

Find inflation rate using price indexes:
=  Current year price index - base year price index  x 100
                     Base year price index

Estimating inflation using the rule of 70. 
Rule of 70 is sued to calculate the number of years it would take for the price level to double at any given rate.
Years needed to double inflation = 70
                                        annual inflation rate

Determining real wages:
Real wages = nominal wages x 100
                         price level

Find real interest rate
Nominal interest rate - inflation premium

It is the cost of borrowing or lending money adjusted for expected inflation.

Nominal interest rate - it is the unadjusted cost of borrowing or lending money.

Demand-pull inflation - It is caused by an excess of demand over output that pulls prices upward.

Cost-push inflation - it is caused by a rise in per unit production cost due to increasing resource costs.

Anticipated inflation - Expect it to happen

Unanticipated inflation -

Hurt by Inflation                       Helped by Inflation
- Fixed income                          - Borrowers
- Lenders
- Creditors
- Savers

Unemployment- it is the percentage of people who do not have jobs, but are in the labor force.
Labor force- it is the number of people in a country that are classified as either employed or unemployed

Not in the labor force:

1. Kids
2. Military personel
3. Mentally Insane
4. Prison
5. Retired people
6. Stay at Home parents
7. The discouraged

Unemployment Rate:

# of unemployed                            x 100
# of unemployed + # of employed

What is Full employment?  Full employment occurs when there is no cyclical unemployment present in the economy.

• Natural Rate of Unemployment (NRU) - 4-5% 

Why is unemployment bad?  There is not enough consumption (GDP).  It creates too much poverty.  It creates too much government assistance. 

Why is unemployment good?  There is less pressure to raise wages.  There is more workers a viabable for future expansion.

Okun's Law - for every 1% of unemployment above the NRU causes a 2% decline in real GDP.

Frictional Unemployment:  People that are between jobs.  Quitting a job for a better job.  Graduating and interviewing.  Actively looking for another job. 

Seasonal Unemployment:  School bus drivers, life guards, construction workers. 

Cyclical Unemployment:  Associated with downturns in the business cycle.  Bad for society and individuals. 

Structural Unemployment:  Associated with a lack of skills or a declining industry.

Market Economy Diagram
 

Unit 1

 

1. Macroeconomics - It is the study of the major components of economy.  Ex: Inflation, supply & demand, wages and GDP. 

Microeconomics - It is the study of how households and firms make decisions and how they interact with the market.  

2.      Positive economics - Claims the attempt to describe the world as is, very descriptive.  Ex: Minimum wage laws cause unemployment. 

Normative Economics – Claims that attempt to predict how the world should be, opinion-based.  Ex: The government should raise minimum wage. 

3.      Needs – Basic requirements for survival

Wants – Desires of citizens

4.      Scarcity – Limited; not enough; fundamental economic problem that all societies face we’ve satisfied unlimited wants with limited resources.  Ex:  Oil and water.

Shortage – It is a situation where quantity demanded is greater than quantity supplied.  QD > QS. 

5.      Goods – A tangible commodity.  Goods are bought, sold and traded; also produced. 

·         Consumer goods – Goods that are intended for final use by the consumer.

·         Capital goods – Items used in the creation of other goods such as factory machinery and trucks.

Services – Work that is performed for someone else.

6.      Factors of Production

1.      Land – natural resources

2.      Labor – work force

3.      Capital –

·         Human – The knowledge and skills a worker gains through education and experience

·         Physical – Human made objects used to create other goods and services.  Ex: Buildings and tools.

4.      Entrepreneurship – Being inventive, risk-taker and having a product. 

Trade-offs - Alternatives that we give up when we choose one course of action over another. 
Opportunity cost - We're choosing our next best alternative.  Ex: wanted Sprite, but didn't have it, so you ask for Dr. Pepper; didn't have it, asked for Coke.
Production Possibility Curve - Shows the most that society can produce if it uses every available resources to the best of its ability.

Key Assumptions of PPG:

1. Two goods are produced 
2. Full employment 
3. Fixed resources (land, labor and capital) 
4. Fixed state of Technology 
5. No international trade 

Price Ceiling - A government imposed limit on how high a price is charged.  Ex: Rent control (move into an apartment in 1982 for $400/month; the price will never go up)

Expansionary - Real output in the economy is increasing and the unemployment rate is declining.
Peak - Where real GDP is at its highest point.
Contractionary - Real output in the economy is decreasing and the unemployment rate is rising.  (recession)
Trough - The lowest point of real GDP. 

• One business cycle is from trough to trough.