B115 exam prep flashcards

what is economics?

• study of human action — how choices are made and how they should be made under scarcity

• study of how people make choices under conditions of scarcity and the results of those choices for society

• scarcity principle (no free lunch) = we have boundless needs and wants but limited resources with which to fulfil them

• trying to maximise utility using scarce resources

opportunity cost

• OC = the value of the next best alternative / best forgone option

• monetary costs + time and effort (economic costs)

sunk costs

• MB = MC is optimum

• sunk cost = has already happened, is irrelevant → focus on MB and MC for new options

• sunk/fixed cost fallacy = the cost doesn’t matter → price might be lower to cover costs than for when MB=MC

• when making a choice, ignore sunk costs! only think about the marginal costs and benefits which change!

decision making

• decision made IF the extra benefits are at least as great as the extra costs

  • MB=MC…

  • only make decisions which increase economic surplus

• assumption: consumers are rational (seek to maximise benefits and minimise costs)

• economic surplus = benefit of an action - its cost → want to maximise economic surplus = rational consumer

pitfalls when using a cost benefit analysis

• measuring costs and benefits as proportions rather than absolute dollar amounts — focus on the amount saved/gained on its own, not as a proportion of the price

• ignoring implicit costs — take into account forgone opportunities, consider relative values not individual values when deciding between two choices

• taking sunk costs into account — the only costs/benefits that should be considered are the ones that can be avoided if the decision is made (sunk costs are beyond recovery before a decision is made)

• failing to appreciate the distinction between marginal and average costs and benefits — should be focused on MB>MC rather than averages (trying to lower averages is like taking sunk costs into account)

normative vs positive economics

• normative economics = subjective statements about fairness and how the economy should be organised

• positive economics = uses objective and measurable terms to explain economic phenomena

• descriptive/objective = positive economics (NO value judgements)

incentive principle

an economic agent is more likely to take an action if its benefit rises, and less likely to take it if its cost rises

accounting profit vs economic profit

• accounting profit = explicit benefits - implicit benefits

• economic profit = explicit and implicit benefits - explicit and implicit costs

  • subtract the quantified opportunity cost

supply curve

• lower prices → less producers can make profit → not willing to supply

• supply shows willingness to accept different prices (per good) for different quantities

equilibrium in the market for a good/service

• Qd = Qs at Pq → only price that is stable

• surplus → incentive for suppliers to lower prices as producers compete with each other to sell

• shortage → generates incentive for buyers to pay more as they must compete with each other

• goods are allocated to the highest value buyers from the lowest cost sellers hence no waste

• at equilibrium → all possible gains are realised = efficient market

  • all profitable trades have taken place

  • “Walrasian adjustment process” = achieving this in a competitive market

determinants of demand

• income

  • normal goods → demand and income are proportional

  • inferior goods → demand and income are inversely proportional

• population/number of buyers in the market

  • due to horizontal summation in market demand

• tastes and preferences

• prices of related goods

  • price decrease for a substitute good decreases demand for the good

  • price decrease for a complementary good increases demand for the good

• price expectations

• eg. waiting for a future sale → demand will increase in the short term because the price is expected to decrease later

• consumers adjust current spending in anticipation of future prices

determinants of supply

•  impact the costs of production

  • technology

  • prices of FoPs

  • taxes and subsidies

  • price expectations (need to be able to store goods)

  • number of producers in the market

  • changes in opportunity costs → may become more efficient to produce a different good eg. farmers changing their crops (OC of using the land)

argument in favour of free market

• the price mechanism can better allocate scarce resources than government bureaucrats in a planned economy

assumption of demand/supply model

• price changes are universal for all consumers/producers (otherwise social surplus wouldn’t work)

• equilibrium assumptions: everyone can trade in the market, goods are homogeneous so consumers will buy from the cheapest seller → leads to a competitive market

consumer surplus

• consumer surplus = difference between maximin price a consumer is willing to pay and the price they actually pay

  • area beneath the demand curve and above the price

producer surplus

• difference between the market price and minimum price producers are willing to sell at

• total producer surplus = sum of all = area between price and supply curve

• producer surplus is more direct (extra revenue than the minimum they are willing to receive) but consumer surplus is less clear (allows for a smaller opportunity cost, more savings, general satisfaction)

market structures

• PC: many sellers, identical goods → eg foreign currency markets with lots of buyers/sellers

• Monopolistic: many sellers, close substitutes but slightly distinct

• Oligopoly: a few firms (eg petrol, phones)

  • incentive for collusion (price fixing) → prices become higher than with vigorous competition

• Monopoly: one firm, sometimes smaller firms on the periphery

  • monopoly firm sets the market price

monopolies

• criticism = high prices = high mark up → higher profits

• consumers cannot find substitutes

• competition is good because it leads to more productivity and innovation

• competitive fringe of other firms in the market

• Sir John Hicks (British economist): “the best of all monopoly profits is a quiet life”

  • quiet life as there is no competition, could use for report

• significant barriers to entry

how monopolies come about

• government franchise: a license from the government to a particular business to provide a good (usually with high start up costs) → natural monopolies = the nature of the good/service means that it makes more sense to only have one firm

• patents can lead to monopolies, particularly in technology and medical industries

  • guarantee the price will be higher BUT ensures incentive for R&D as firms have secrets

• control of raw materials eg OPEC, DeBeers

• first on the market → market leader, strong brand presence → loyal consumers, EoS

  • can often buy competitors eg facebook bought instagram

oligopolies

• a few large firms → no set number but typically less than 5, can differ based on country and industry

• determining an oligopoly: using market share and market concentration

  • concentrated = power held by a few firms

    • combined market share of the largest firms

• oligopolies won’t use MR=MC to set prices because they need to pay attention and respond to competitors’ actions → strategic decision making needed for prices → principles of game theory used

• monopolies have higher profits → oligopoly firms want to act as monopolies = incentive to collude → cartel formed

  • monopoly price and output used, profit split between firms

  • behind the scenes (tacit) collusion used to get around the commerce commission

oligopoly promises to match competitors

• matching competitor price promises (meet the competition clause)

  • can lead to price wars when additional discounts are offered (eg beat it by 10%)

  • promises to drop prices eventually drive customers between firms and prices become so low firms cannot make economic profit → behind the scenes collusion, price fixing → both firms maintain economic profit

  • this form of collusion can work well with 2 firms in the market but with 3/4/5 it can break down → economic profit reduces

monopolistic competition

• monopolistically competitive: no long run economic profit due to lack to barriers to entry/exit, consequent changes to market supply — end up like PC firms

• monopolistically competitive: products differentiation = most important strategic decision, NOT pricing (less market power anyway)

market power

• market power = ability of firms to determine the price they charge

• competing with others and the limits to market power

  • economic profit attracts new firms → no. competitors increases → market share decreases → competition increase → profit margins decrease

  • more firms → PED becomes more elastic → eventually firms return to normal profit

  • demand curve for a monopolist is steeper (more inelastic) than for a oligopolist

• principle of competition is that firms compete to provide us with the best goods and services

• PC firms have no market power: availability of substitutes means they must accept the market price in order to sell any goods at all

• monopolies cannot charge any price: it is determined by demand

variables to graph for perfect competition and monopolies

• explicit costs = fixed, variable

• profit (to economists): revenue is greater than explicit + implicit costs

  • sunk costs are not factored in as they cannot be recovered

• marginal product = change in quantity produced/change in workers → used to show the law of diminishing marginal returns → leads to tick shape of MC curve

  • average product uses totals instead of changes

• MC= change in TC/change in Q

how does marginal cost affect average cost?

When marginal cost falls it drags average cost down and when marginal cost is rising it pulls average cost up and has the following implication. When average cost is falling, marginal cost lies below average but when average cost starts rising, marginal cost becomes greater than average cost. Marginal cost is equal to average cost at the point where average cost is minimum.

relationship between costs and profit

• at MR=MC: average cost > price = loss

• P=AC → TR=TC → normal profit

shut down price

A firm should shut down when the market price drops so low that the price is tangent to the minimum of average variable cost such that P=MC=minimum AVC such that, at the limit, operating losses from production exactly equal losses from fixed costs. If the price is slightly higher than the minimum of AVC, the firm should stay in business; it should shut down if the price drops below the minimums of AVC

profit maximisation for a monopoly

• market power = ability to raise price above MC without fear that other firms will enter the market

• source of market power: unique good, barriers to entry

  • EoS, patents, government regulations, patents, access to a natural resource

• output = MR=MC and P=intersection with demand curve

  • D sits above MR

• showing MR, MR has exactly twice the gradient of D

  • will hit the horizontal axis at half the output of D

• ATC decreases with production → firms with greater output can charge lower prices → firms with high capacity of production are more competitive

pros and cons of monopolies

• major downside: inefficiency shown by DWL

  • shift from CS to profit is not considered as someone still gains

  • DWL units are beneficial socially but not privately for the firm

• need for monopoly: patents

  • high costs to develop the good, R&D costs are not considered in MC, if price was MC straight away, high R&D costs would never be recovered

  • remembering that MC is the jump from 1st to 2nd good, not the cost of the very 1st

• Douglas North (economic historian): “The failure to develop systematic property rights in innovation up until fairly modern times was a major source of the slow pace of technological change.”

• patent buyouts enable static efficiency

  • government buys patent for a little more than monopoly profits → removes the patent → competitors enter market, price becomes MC

• R&D = dynamic efficiency

• prizes can encourage R&D as costs can be recovered by successful firms

elasticity

• degree of responsiveness of one variable to changes in another

price elasticity of demand

• PED = the % change in quantity demanded that results from a 1% change in its price

  • PED = %change Qd/%change P → is negative due to downward slope of D

  • elastic demand: large response, Qd changes by a greater proportion than P → decrease in price leads to higher revenue

  • inelastic demand: small response, Qd changes by a smaller proportion than P → increase in price leads to higher revenue

• perfectly elastic: PED = infinity, horizontal curve

• perfectly inelastic: PED = 0, vertical curve

price elasticity of supply

• = %change Qs/%change P

• determinants

  • flexibility of inputs (flexible, mobile, easily substitutable, labour)

  • time — build new factories, hire new workers etc

    • PES is greater (more elastic) in the long run than in the short run

• supply = elastic when PES>1

cross elasticity of demand

• cross price elasticity of demand (Exy) = the responsiveness of quantity demanded to a given change in the price of another good

  • = %change in Qd good x/%change in P good y

  • positive sign when the goods are substitutes

  • negative sign when the goods are complements

income elasticity of demand

• the responsiveness of consumers of a particular good to a change in their own incomes

• how much the quantity demanded by a consumer changes when their income changes

• percentage change in the quantity demanded of a good / percentage change in income

• %ΔQd/%ΔY

determinants of PED

• closeness and availability of substitutes

• budget share (proportion of income)

• time — to adapt to the change in price, petrol is a necessity in the short run but in the long run people can switch to electric cars

relationship between PED and TR

• elastic demand: large response, Qd changes by a greater proportion than P → decrease in price leads to higher revenue

• inelastic demand: small response, Qd changes by a smaller proportion than P → increase in price leads to higher revenue

interpreting YED

• the percentage change in income

• Necessities — normal goods with a positive YED of <1

• Luxuries — normal goods with a positive YED of>1

• Inferior goods — any good with a negative income elasticity of demand

incidence of indirect taxes, linked to elasticity

• indirect tax introduced → cost of production effectively increases → supply curve shifts upwards by tax amount → new eq, lower quantity and higher price

• when PED>PES, producers pay most of the tax

• when PES>PED, consumers pay most of the tax

• Peq increases → some buyers/sellers leave the market → DWL occurs → community surplus decreases

  • total value of mutually beneficial trades that would have occurred before the tax was imposed but no longer occur

• change in total surplus = DWL

• highly inelastic D/S → few buyers/sellers exit the market → small DWL

• tax incidence depends on elasticity not who actually pays the tax

price controls

• price ceiling = maximum price below Peq

  • generally to help consumers

  • shortages → not everyone can buy → queues, rationing, black markets (higher prices than legal)

• price floor = minimum price above Peq

  • generally to help producers

  • surpluses → dumping (literally), dumping on other countries (harms domestic producers in those countries), black markets (lower prices than legal)

• quantity traded is the smaller amount when there is a shortage/surplus (the short side of the market)

• minimum wage = lowest price an employer can legally pay an employee → price floor above Peq on the labour market → surplus of labour = unemployment (want to work but can’t find work) ← amount depends on PES/PED of labour

  • France: government sets new Wmin each year and must increase it by at least as much as inflation

  • US: new legislation must be passed to change Wmin → rare for it to change

• emission trading scheme (ETS) has a price ceiling and a price floor

excludability and rivalry

• excludable = it is relatively easy to prevent someone from consuming the good

• rival = once provided there are additional resource costs for another person to consume the good

• roads?

  • toll roads are excludable

  • congested roads are rival

  • therefore roads can be any of the four goods

public goods

• examples of public goods: honesty, basic research, programs to fight poverty (everyone enjoys a poverty free environment at once), fair income distribution, fireworks displays, national defence

  • non-rival, non-excludable

• even though everyone consumes the same amount of a public good, not everyone needs to value the good the same

  • eg some people don’t care about fireworks displays

• MB = sum of all new benefits AND MC=0

• free rider problem = receives benefits but does not pay → private markets are unlikely to provide public goods → the good is under produced → role of government?

  • should be provided if the total benefit > total cost

common pool resources

• free rider problem also applies → little incentive for firms → role of government is to ensure they are provided

• additional problem = rivalry → role of government to ensure the resources are not overused

• tragedy of the commons = depletion of the common resource → is a negative externality of consumption

• preventing tragedy of the commons

  • impose a corrective tax to internalise

  • command and control approach

  • auction permits to allow use of land

  • divide land and sell

  • bottom two both allow for property rights → now costs and benefits are faced individually → will choose where MB=MC → efficiency achieved

• examples: clear air and water, congested roads, fish, whales, other wildlife

externalities

• externalities = impact on a third party’s wellbeing who receives no compensation

  • adverse impact → negative externality → Qeq too high

  • beneficial impact → positive externality → Qeq too low

• quantifying an external cost: identify cause of harm → identify the associated activity → identity the value of the damage done

  • why assign a monetary value? need to have incentives to realise externalities → must be monetary

• DWL = social surplus at social equilibrium MINUS social surplus at market equilibrium and area of benefit at market equilibrium

command and control policies

• command: sets a standard for the maximum level of permissible pollution

• control: monitors and enforces the standard

• ambient standards = minimum desired level eg air quality

• emissions standards = maximum allowed level

CAC vs incentives

• CAC easy to understand, pragmatic when there is limited knowledge of the exact value of the externality BUT CAC give firms no incentive to exceed the standard, standards tend to be less cost effective than market-based instruments

• main drawback of CAC = no producer incentive beyond meeting minimum requirements → does not maximise the amount of positive change

• cape and trade schemes combine both

  • cap on overall emissions

  • free trade below the cap

  • minimises the cost of producing emissions overall

  • incentive to find methods which involve less emissions as firms can then make money by selling their permits

coase theorem

• If, at no cost, people can negotiate the purchase and sale of the right to perform activities that cause externalities, they can always arrive at efficient solutions to the problems caused by externalities

• need well-defined and enforced property rights, transaction costs between decision-makers and bystanders are negligible

  • ie it costs no money to negotiate

• assign property rights and let people trade with each other

• coase theorem = decentralized option → mutually acceptable outcomes without government intervention

• to understand can make a table showing the net benefits to both parties with and without trade → best option has the greatest total benefit ← theory is that trade will lead to this

• where coase theorem is less effective

  • parties with different resources

  • parties of different scales

  • eg need to employ a lawyer → negotiations come at a cost → theorem not met

  • eg smaller parties must band together → inefficiencies within

  • THEREFORE the parties must have the same/similar bargaining power

defining the unemployment rate

• increases during recessions

• is never 0, not even in a boom

• employed = has a job

• unemployed = a non-institutionalised, adult, civilian who does not have a job but is actively looking for work

  • some action to find a job taken within the last 4 weeks

• unemployment rate = unemployed/labour force * 100

is unemployment undercounted?

• if an unemployed person gives up on looking for work they are exiting the labour force → no longer meet the formal definition of being unemployed

• not useful to include these people because most people who do not work would if they were paid significantly

• discouraged workers = people who want a job, have not looked for work in the last 4 weeks but have in the last year

• most alternative measures of unemployment follow the trends of the official rate

frictional unemployment

• frictional unemployment = short term unemployment caused by the ordinary difficulties of matching an employee to an employer

• for example being between education and work or between jobs

• frictional unemployment reflects that the economy is dynamic

  • often is seen when the number of net new jobs is reported, need to look at the amount gained and lost

• competition between firms can cause frictional unemployment when some firms are not competitive enough

structural unemployment

• structural unemployment = persistent, long term unemployment

  • a large proportion of the unemployed have been unemployed for over a year and this has been the case for numerous years

• cause of structural unemployment = shocks which change the amount, location and nature of jobs

  • takes time to adjust

• labour regulations can increase structural unemployment by making it more challenging to adjust to shocks

  • US has the at-will doctrine → can leave a job and dismiss an employee at any time

  • some other countries: need just cause to dismiss an employee

• more labour market rigidity → more structural unemployment

• higher unemployment benefits → less incentive to work again → more structural unemployment

• 2006 riots in France over proposed at-will employment for those 25 and under

  • restrictive labour law can create insiders and outsiders

  • employed against at-will, unemployed for at-will

cyclical unemployment

• cyclical unemployment = unemployment correlated with the ups and downs of the business cycle

• falling GDP or lower growth than expected → firms lay off workers → unemployment increases

• higher unemployment → fewer workers are producing goods and services → workers are sitting idle → capital likely also sitting idle → slower growth

• unemployment quickly spikes during a recession but takes longer to decrease when growth is stable

  • wages are sticky downwards ie nobody wants to accept a pay cut → reduces incentives/ability to hire new workers

  • labour market works differently to other wages

  • workers don’t want their new job to be worse than previous → willing to spend longer unemployed — whether they are able to remain unemployed is separate

seasonal unemployment

based on the actual seasons eg a ski instructor not working during summer

natural rate of unemployment

• frictional + structural

  • based on belief that monetary and fiscal policy can be used to target cyclical unemployment but not frictional or structural

  • NRU can only be estimated not actually measured

labour force participation

• labour force participation rate = labour force / adult population

  • excludes those in prison and the military

• reasons for variation

  • changing demographics eg. increase in women’s labour force participation rate

  • decline in manufacturing and increase in services

    • decline in manufacturing/workers needed for manufacturing → less low-skilled, male labour force participation

  • changing access to education

  • people entering retirement ← how easy it is to retire

• depends on the proportion of the adult population who are most likely to work given their stage in life (age)

  • ie adults in their prime opt out of jobs ← might be favouring further education

macroeconomics

• study of economy as a whole, economic changes which impact households, firms and markets

  • modern macro: very much founded on microeconomics

gross domestic product

• every transaction has a buyer and a seller → one agent’s spending = the other’s income → income = expenditure THEREFORE it does not matter whether we consider income or expenditure to measure GDP

  • can be shown by a closed and simple circular flow diagram

• GDP = “market value of all final goods and services produced within a country in a given time period”

  • market value = sum of the prices

  • final goods and services = all items produced and sold legally in markets, would be double counting if intermediate goods counted SO transactions only count if they occur in a legal market

    • eg steel is an intermediate good and a fridge would be the final good

    • selling a second hand good does not contribute to GDP

  • within a country = produced in the country regardless of the producer

  • specific time period = usually a quarter of year

• GDP = Y = C + I + G + NX

  • due to durability, new housing is usually considered investment not consumption

  • net exports = exports - imports = X - M

    • imports are included in C, I, and G so must be subtracted whereas exports are not so must be added

gross national income

• GNI (gross national income) = “total income earned by a nation’s permanent residents (called nationals)” = GDP + net factor income from abroad (NFIA)

  • NFIA = difference between the income earned by nationals in foreign countries and that paid to foreigners for their contribution to the GDP of the domestic country

  • difference between GDP and GNI is usually larger for smaller countries

  • GNI adds overseas profits which are repatriated back by nationals abroad and subtracts the profits of foreign nationals which are sent abroad

gross national disposable income

• Gross national disposable income (GNDI) = GNI + net current transfers from abroad

  • current transfers = payments not made in exchange for any currently produced goods or services

  • eg development aid, receiving a pension from another country

interpreting net factor income from abroad

• negative NFIA → GDP > GNI

impact of price changes on nominal vs real GDP

• GDP: total output measured at market prices → prices change → GDP changes despite no additional production → real figures more useful than nominal

• real GDP only accounts for changes in output not changes in price

GDP deflator and real GDP

• GDP deflator = nominal GDP / real GDP * 1,000 (in some countries 100 is used instead of 1,000)

• real GDP = nominal GDP / GDP deflator * 1,000 (rearranged version of the equation above)

downsides of GDP

• imputed value of labour for tasks done by oneself does not count toward GDP ← eg. means that looking after a child does not contribute but paying someone else to does

• per capita comparisons more useful or understanding standards of living

• countries where considerable remittance are sent to → GNI likely to exceed GDP

• drawback of GDP: does not reflect unequal income distribution

  • measure of income inequality: Gini coefficient = areas A / (area A + B)

  • equal income distribution: Gini coefficient = 0

  • highly unequal: Gini coefficient closer to 1

 limitations of GDP in measuring economic welfare

• GDP and GNI measure ability to obtain inputs for a worthwhile life BUT do not measure quality of life directly THEREFORE they are not ideal measures of economic wellbeing

  • need to consider environmental quality, income distribution, transaction which do not increase GDP (gifts, inheritance, shares etc), leisure time, access to healthcare, life expectancy, literacy rates, access to the internet etc

• Treasury living standard framework: 12 domains of current wellbeing

  • looks at how we are dealing with out resources and can improve wellbeing in the future

  • various measures of distribution: people, places, generations

consumer price index

• consumer price index (CPI) = “measure of the overall cost of the goods and services purchased by a typical households” → indicates how much incomes must rise by to maintain a particular standard of living

  • general price level = price of a bundle of goods and services as an index relative to a base period → index usually CPI

  • inflation = “percentage increase in the general price level over a given period of time”

  • NZ: CPI has over 700 goods and services

    • fix the goods and services, weigh them by how much consumers are using them eg food being ~20% of the basket

    • find the prices

    • compare costs of the baskets

    • choose a base period and compute the index

    • calculate the CPI inflation rate

  • CPI = cost of basket at current prices / cost of basket at base period prices * 100

  • inflation rate = (CPI2 - CPI1) / CPI1 * 100

CPI alternatives

• other price/cost indices

  • food price index = “price of food and food services purchased by households”

  • producers price index (PPI) = “prices in the production sector of the economy”

    • indication of input prices

    • used to predict changes to the CPI

income growth rate

• Rate at which individual or national incomes increase over a period of time

• Real income growth = Nominal income growth - Inflation rate 

  • Positive real income growth → purchasing power increases

  • Negative real income growth → purchasing power decreases

drivers of income growth

• Labor Productivity: Higher efficiency in production boosts wages and profits.

• Technological Advancements: Innovations create new industries and income opportunities.

• Education & Skill Development: A more skilled workforce earns higher wages.

• Government Policies: Tax cuts, subsidies, and infrastructure investments can accelerate income growth.

• Global Trade: Access to international markets enhances business revenue and wages.

• Inflationary Adjustments: Nominal income may rise simply due to inflation, without real purchasing power gains.

inflation rate

• importance of inflation: changes purchasing power → necessitates change in income

• high inflation → savings are worth less → little incentive to save → less household investment in businesses

• inflation rate > interest rate → purchasing power is decreasing

• inflation rate < interest rate → purchasing power is increasing

• inflation rate = % change in CPI = (CPI2 - CPI1) / CPI1 * 100

real interest rate

• Real interest rate = nominal interest rate - inflation rate

• Negative real interest rate → value of savings is decreasing → want to spend now

• Positive real interest rate → value of savings is increasing

limitations of CPI to measure cost of living

• difficulties in measuring the cost of living

  • substitution bias

    • basket does not change to show consumer substitution

    • if a good becomes more expensive, people are likely to substitute it → CPI overstates cost of living by choosing the more expensive good not the lower cost alternative

  • introduction of new goods

    • new products → more variety → each dollar more valuable

    • fewer dollars required to maintain standard of living

    • basket does not reflect change in purchasing power

    • index overstates the cost of living

  • unmeasured quality changes

    • when quality improves the value of the dollar rises (purchasing power) but price does not, vice versa if the quality falls

    • index overstates cost of living when quality improves

    • index understates cost of living when quality reduces

• some changes to the CPI basket:

  • 1999: included internet and cellphone costs, avocados, capsicums, taro → 1999 became new base year

  • 2002: water charges and refuse charges

functions of money

• medium of exchange

  • asset that buyers give to sellers when they want to purchase goods and services

  • most important because it reduces transaction costs

    • by making it much easier to match buyers and sellers (rather than trying to trade a sheep for a cow etc)

  •  medium of exchange: want it to be practical, easy to have lots of or make lots of

• store of value

  • transfer current buying power into the future

  • doesn’t lose a significant part of its value over time compared to g+s eg apples rot so completely lose value

    • BUT inflation, ERs can change value of money

• unit of account

  • measure of economic value ie as a price

  • allows comparison of completely different products

  • convenient because it allows for the values of everything to be easily compared

  • a good unit of account needs to be the same for each version ie gold is standardised but seashells come in different shapes and sizes

what is money and how money supply is measured

• money = a widely accepted means of payment

  • anything that can easily be used to buy goods and services

  • any asset that is a widely used means of payment or can easily be converted into a widely used means of payment with minimal costs

  • currency definitely included

  • cheques and debit cards included

  • savings accounts: cannot directly be used by in practice is easy to move accounts so are included

  • funds in a money market mutual fund a included

• measure of supply of money

  • monetary base = currency + reserve deposits

    • reserve deposits = held by other banks at the central banks ie the chequing accounts that banks use to pay each other

  • M1 = currency + cheque-able deposits

  • M2 = M1 + savings deposits + money market mutual funds + small time deposits

quantity theory of money

• MV = PY — is an identity

• M*V = nominal GDP

  • velocity of money = how many times money is used a year to purchase final g+s

    • how many times the average dollar is spend

    • ie when people spend their income it becomes another person’s income who spend it etc

  • M = money

  • M*V covers the actions of buyers

• P*Y = nominal GDP

  • Y = value of finished goods and services sold = real GDP

  • P = price level of all finished goods and services

  • P*Y covers the actions of sellers

causes of inflation

• MV = PY → P = MV/Y → three situations for a change in prices

  • change in V

    • determined by payment period, time to clear a cheque etc

    • can change in short run but usually not by much → not likely to change prices significantly

  • change in Y

    • real GDP doesn’t vary much within a year → not a plausible reason for significant changes in prices

  • change in M

    • must be cause of change in P as V and Y are not significant

    • changes to the money supply → changes to prices

• growth form of quantity (showing arrows on top of variables)

  • if V and Y aren’t growing much: growth rate of M = growth rate of P

• long run: money is neutral (as change to P is proportionate)

  • if money doubles prices will too after enough time

• inflation is always a monetary phenomenon

• central banks have significant control over a nation’s inflation rate (via money supply)

the fisher effect

• relationship between inflation rate and nominal interest rate

• lender has lower real return

• real interest rate = nominal interest rate - inflation rate

• fisher effect: nominal interest rates will raise with expected inflation rates

  • lenders adjust interest rates to account for inflation so they actually gain the return they want in real terms

• eg if you want a 5% real interest rate and the expected inflation rate is 4%, you should set the nominal interest at 9%

• positive real interest rate: money increases in value ie PV<FV (principle vs final)

• negative real interest rate: money decreases in value ie PV>FV

the money multiplier

• only some of one’s money is kept in reserves by banks, rest is loaned = fractional reserve banking

  • minimum reserve requirements apply eg a reserve ratio → depends on how liquid a bank wants to be eg fearing that a lot of customers will want to withdraw money

• a loan increases the money supply (as both people have the same money in their account) → increases number of deposits which increases the number of loans → continues

  • money multiplier = how many dollars worth of deposits are created with each additional dollar of reserves = 1/reserve ratio (as a decimal)

  • banks may hold more than the reserve ratio → more banks hold, lower the money multiplier

• during a recession

  • banks reluctant to lend, less people deposit cash into banks

  • central bank may have to push harder to increase money supply

• when banks can make fewer loans, the money supply decreases

open market operations - before the great recession

• changes to money supply and interest rates

• targeting federal funds rate with open market operations

  • federal funds rate: overnight lending rate from one major bank to another

  • banks can borrow to meet minimum reserve requirements

  • OMO = central bank using its reserves to buy government securities from banks

    • increases supply of bank reserves → banks can make more loans → expansionary policy → increase AD

    • expansionary OMO increases the federal funds rate

    • contractionary OMO: central bank sells treasury bills to banks

      • raise federal funds rate → decrease in AD

• lots of interest rates in an economy ← affected by central bank’s interest rate

• sometimes announcement of change to target OCR has effect before OMO occur

fractional reserve banking - after the great recession

• great recession: interest rates were too close to zero, reserves very low → became ineffective to use OMO

• quantitative easing = central bank swaps money for assets (not treasury bills) → can affect different interest rates eg long term or more targeted eg mortgages

  • increases bank’s supply of reserves

• interest on reserves

  • raises IR → bank demand for reserves increases → upward pressure on other short term interest rates

    • banks less willing to lend at market interest rates

    • encourages banks to hold more reserves as it can be hard to find comparable returns at low risk

• repurchase agreement = central bank gets treasury bills back, commercial bank gets reserves → expansionary

  • reverse repurchase agreement = central bank gets reserves, commercial bank gets treasury bills → contractionary

    • drains banks of liquid cash, higher return here discourages investment elsewhere

  • can be done with other financial institutions to ensure significant enough impact → makes them different from OMOs

money demand

• reasons we hold money

  • transaction demand = carry out daily transactions eg buying groceries

  • asset demand = saving for the future eg wanting to buy a house

• interest = opportunity cost of holding money

  • ie not holding could mean buying a bond and getting interest on that

  • interest = price of holding money too → IR is vertical axis

money supply

• S is vertical ← controlled by central bank

• increase in D → increase in IR

• decrease in D → decrease in IR

market for loanable funds

• price = interest rate → vertical axis

• supply and demand are both sloping

• supply = people lending their savings to borrowers

• demand = people seeking money to pay back later

• in reality: there are multiple markets for different types of borrowers and lenders

• usually: entrepreneurs demand loanable funds and savers supply loanable funds

financial intermediaries

• financial intermediary = institution to bridge gap between borrowers and savers

  • great recession → decreased efficacy of financial intermediation

• financial intermediaries:

  • commercial banks

  • stock markets

  • the bond market

lifecycle theory of savings

• lifecycle theory of savings = using borrowing to average out how life income is spent

  • borrowing when young, saving in working prime, using savings in old age (dissaving)

  • behavioural: saving is not only costs and benefits, nudges matter eg opt-out retirement plan, different levels of patience

• borrowing for investment: entrepreneurs getting businesses started, students going to university

what banks do

• banks attract savings by paying interest on deposits → make loans and save interest → make money by charging more interest on loans than paying on deposits

• banks coordinate the lending of everyone’s deposits

  • quality of borrowers is evaluated so that risk can be managed → otherwise banks can’t pay savers back = very bad!

  • can make larger loans and spread the risk across a large portfolio of loans

stock markets

• stocks = shares of ownership in organisations

• stocks are transferred → no change to funds available to firm

• new stocks created → more funds available for firm to invest

• riskier than investing through banks

bond market and crowding out

• bond = I owe you → documents that the recipient will back the lender a specific amount at a specific time

• bypasses banks as an intermediary, allowing people to lend directly to firms

• simple lending to a firm → NO ownership of that firm

• government can demand bonds ie increase demand in the market for loanable funds → equilibrium IR increases → people save more and spend less, private investment decreases = crowding out

  • the government crowds out private consumption and investment

  • shown by the increase in savings

• less risky than stocks as people must be paid before profits can be used for anything else BUT default risk remains

  • default risk = chance that bond can never be paid back

interest rates for borrowers and savers

• multiple interest rates but combined into one average for diagram/analysis

• assume banks do not use different interest rates for savers and lenders as their profit margins

  • payment for savers

  • cost for borrowers

• savings = decision to supply funds to borrowers

• borrowing = funds needed for investment

types of saving, shifts in market for loanable funds given changes in savings

• assuming no trade

  • S = Y - C - G

  • I = Y - C - G

  • therefore S = I (savings = investment)

• public saving = taxes - government spending = T - G

  • T>G → budget surplus

  • T<G → budget deficit

• private saving = Y - C - T

• national saving = private + public saving

• people buy assets → make capital gains → government taxes capital gains: government reduces taxes on earnings from savings → saving is more attractive → S shifts right → lower IR, greater eq saving/borrowing

• investment tax credits → more firms can borrow (more likely that they can pay back) → D shifts right → IR increases, Q increases

• government debt = “accumulation of past budget deficits”

• budget deficits → government is dissaving → S decreases → IR up, Q down → business investment decreases = crowding out effect

role of budget deficit/surplus in loanable funds market

When a government runs a deficit, it effectively changes its role from a supplier of savings to a borrower, that is, it moves from the supply side to the demand side of the market for loanable funds…If the government runs surpluses, then it adds to the amount of loanable funds available in the economy (shifts supply of funds to the right). A deficit reduces the amount of loanable funds available since the government is no longer providing any saving to the economy but rather drawing down the existing pool of saving (shifts supply of funds to the left). 

OR 

If and when the government runs a budget surplus, it is generating public savings and adding to the total amount of savings available in the economy.

comparative advantage and production possibilities frontier

• answer fundamental question: who should produce what?

  • Adam Smith: those with lowest costs

  • David Ricardo: not only lowest cost but opportunity costs

    • what does society give up when a firm produces a particular good/service?

• PPF = set of all point that represent the maximum bundle of goods when using all resources

  • two good world → one on each axis

  • more resources shift curve right and upwards

  • assumption: resources cannot be saved up across time periods

    • because time is a resource and cannot be stored

  • on the curve = efficient | within the curve = inefficient| outside the curve = not possible given resource constraints

  • on the curve: only way to get more of one good is to give up some of the other → shows trade off/OC when moving along the PPF

    • amount of other good given up = OC of production

  • linear PPF = constant OC

• comparative advantage

  • absolute advantage = can produce most goods

  • comparative advantage = lower OC of production

    • when country with comparative advantage produces good, society gives up less of other goods/services

    • as long as two people have different costs of production, they will each have a comparative advantage for one good

  • price set by one country lower than cost of production for other country → should trade by specialising where they have comparative advantage

    • both can consume more than they could without trade → outside of their individual PPF with the same resources

sources of comparative advantage

• climate and geography — natural resources

  • this is how Ricardo first explained the comparative advantage mode

  • particularly for more primary goods

• factor proportions — Hecksher-Ohlin model

  • because labour is not internationally mobile

  • more low skilled labour → comparative advantage in producing low-skill goods

• increasing returns to scale and division of labour

  • created by trade rather than existing before trade

  • similar countries trade together (ie developed w developed) ← seems to go against comparative advantage BUT specialisation → higher productivity → then differences increase → comparative advantage more distinct → more trade occurs

  • ie comparative advantage can be created after trade because trade enabled increasing returns to scale through specialisation

• increasing returns to scale and division of knowledge

  • as people specialise they become more knowledgeable about an area → this increases their productivity

    • eg having surgeons for different conditions eg heart vs brain

• institutions

  • more flexibility in the labour market

  • finance eg quality of banking structures — how easy is it to raise capital?

  • contract enforcement — contracts needed for larger firms and more specialisation/division of labour eg across parts of a country

why countries trade

• why do countries trade?

  • different natural resources — largely agricultural

• 15th to 18th century: mercantilism = maximise exports and minimise imports ie aim for most resources in country

• completely specialising based on absolute advantage allows for greater consumption than with no trade

• completely specialising based on comparative advantage generates more gains from trade than partial specialisation BUT is likely to have other drawbacks — national defence/national interest

  • OC can be considered price or cost of production → we want country with lower price/cost to produce the good

how countries gain from trade (exporters and importers)

• in an exporting country: word demand = perfectly elastic (horizontal)

  • demand for apple as seen from one country

  • output of domestic producers who export does not change world price

    • domestic producers are price takers

  • Dw = Pw — above domestic price for exporting country and below domestic price for importing country

    • Px < Pw < Pm

  • domestic producers make more revenue

• in an importing country: world supply = perfectly elastic (horizontal)

  • one country’s domestic demand won’t change world price

  • disequilibrium quantity is exported/imported

  • lower consumer prices

reasons for protectionism

• protect domestic industries from foreign prodcers

  • only domestic producers who want this are those with comparative disadvantage (otherwise it is not needed)

• domestic employment

  • force consumers to purchase domestic goods → demand for domestic goods increases → greater Qe → need to produce more Q → employ more workers

  • BUT this costs jobs in other industries: price of good up → higher cost of production in downstream industries → less jobs → net loss

• level playing field

  • foreign producers have an unfair advantage eg export subsidies from foreign government

  • is all advantage unfair??

• government revenue

  • from selling quota licences and tariffs

  • BUT (in high income countries) this is a small proportion of total government revenue SO does it make sense to disadvantage domestic consumers

• national defence

  • should make sure critical industries are still around in times of war

  • can go very broad eg making buttons for soldiers’ uniforms

  • sometimes article broadened to ‘national interest’ eg protecting culture from US popular culture

• infant industries

  • protect until they are mature enough to compete on their own

  • how to know when industry should be independent?

    • govt asks industry and industry says it is never ready

    • can have time limits on protection

    • can continually decrease protection

export subsidies

• can use export subsidies to create unfair advantage for domestic producers in a foreign market → BUT protectionist retaliation

why trade is controversial

• asymmetric impacts of trade within countries → make trade controversial

• comparative advantage harder to assess when economy is widened to more than two goods

• inequality based on specialising in goods which need skilled or unskilled workers → bigger education gap, domestic and international inequality

tariffs

• tariff = tax on internationally traded goods

  • imported goods become more expensive

  • government gains revenue

  • higher prices for domestic consumers

  • less imports → worse for foreign producers

  • better for domestic producers

quotas

• quotas = limits on quantity or value of foreign goods which can enter domestic market

  • price higher → worse for consumers

  • greater Q by domestic producers, less Q by foreign producers

  • government IF quota licences sold

  • using same graph as tariff BUT government revenue becomes ‘quote rent’ which is the gain to overseas producers (additional revenue because quota makes for a higher price) → therefore some argue that quota licences should be auctioned to generate government revenue, mitigate this gain → area C no longer loss to domestic economy

• voluntary export restraint = reverse of a quota (established by the other government)

  • done when other countries request this

administrative barriers

• administrative barriers (health and safety regulations)

  • make it too hard to make a foreign product sellable in a foreign market

reasons for currency market

• need to buy currency before you can buy a good from a foreign market

  • can achieve this through using export receipts to buy imports BUT this won’t balance out → need to be able to trade currency

• currency markets: “allow market participants to buy and sell the right to transact in a given country”

  • forex facilitates transactions