Economics Key Concepts: Income, Consumption, Exchange Rates, and Money Supply

Disposable Income (DI)

Income available for spending or saving (DI=C+S). It's the most important determinant of consumption (C) and saving (S).

Consumption Function

The relationship between disposable income (DI) and consumption (C).

Break-even Point

The point on the Consumption Function where Consumption (C) equals Disposable Income (DI). Saving (S) is zero.

Average Propensity to Consume (APC)

The fraction of total income (DI) that is consumed.

Average Propensity to Save (APS)

The fraction of total income (DI) that is saved.

Relationship between APC & APS

APC + APS = 1 (or 100%).

Marginal Propensity to Consume (MPC)

The fraction of a change in DI that is consumed.

Marginal Propensity to Save (MPS)

The fraction of a change in DI that is saved.

Relationship between MPC & MPS

MPC + MPS = 1 (or 100%).

Multiplier (M)

A change in a component of total spending (GDP) leads to a larger change in GDP.

Multiplier Relationship

MPC and M are positively related. MPS and M are negatively related.

Exchange Rate Systems

Fixed/Standard, Managed Floating, Flexible/Floating.

Depreciation (Weakening)

The value of one currency falls relative to another.

Appreciation (Strengthening)

The value of one currency rises relative to another.

Effect of Appreciation

U.S. goods become more expensive to EU consumers. EU imports from U.S. fall.

Effect of Depreciation

EU goods become cheaper to U.S. consumers. U.S. imports from EU rise.

Demand for U.S. Dollars (USD)

An increase in U.S. imports of EU goods requires U.S. consumers to sell USD and buy EUR.

Fixed Exchange Rates

Government determines and maintains the rate by manipulating the supply and demand of the currency to a fixed rate.

Example: Fixing Rate (China)

If the USD depreciates against the CNY, the Chinese government can buy USD or sell CNY to bring down the value of CNY.

Production Possibilities (PP) Model

Assumes full employment, fixed resources, fixed technology, and two types of goods.

Opportunity Cost

The amount of other products that must be foregone to obtain 1 unit of a specific good.

Law of Increasing Opportunity Cost

The opportunity cost of each additional unit of pizza is greater than the opportunity cost of proceeding one.

Autarky

A closed economy with no trade.

Comparative Advantage (CA)

When a country's resources are relatively more productive to produce one product.

Absolute Advantage (AA)

A country can produce a given output using the given input of resources.

Specialization & Trade

Countries specialize in the product where they have a CA to gain from trade.

Terms of Trade (TOT)

The amount of one good that must be given up to obtain one unit of another good.

Functions of Money

1. Medium of Exchange. 2. Unit of Account. 3. Store of Value.

Money Supply

The total amount of money available in an economy.

M1 (Most Liquid)

Currency held by the public + Checkable Deposits.

M2

M1 + Less liquid assets like Savings Deposits and Money Market Mutual Funds.

M3

M2 + Large time deposits.

M1, M2, and M3 Relationship

M1⊂M2⊂M3.