Economics
Course Summary
Module 1: Economic Concepts, Issues, and Tools
Economics is the study of how individuals and nations use resources under their command to
satisfy their wants as fully as possible or to maximize their welfare (or utility) given their
resource constraints.
Engineering or Technical Efficiency describes the situation in which a good of stated quality is
produced using the fewest possible resources.
Economic Efficiency the goods and services have to be produced in the most engineering
efficient manner but also these goods and services have to be allocated so that the wants are
satisfied as fully as possible.
Production Possibility Diagram
for two goods
Any point outside the production
frontier can not be produced
Good B
Production Frontier
Any point inside
the production
frontier does not
use resources at
eggineering
efficiency
Good A
Marginal Benefit is the gain from an incremental change.
Marginal Cost is a loss associated with an incremental change.
Marginal Analysis examines the relationship between the cost and the benefit (utility) when
applying incremental changes to the variable of which the effects are to be examined. It is used
in economics frequently on maximization problems.
Scarcity Problem is defined as the dual existence of insatiable wants and limited resources for all
societies that result in scarcity. Economies need to consequently make a choice what to produce
with the limited resources available as resources used to satisfy one want are no longer available
to satisfy other wants.
A resource is scarce whenever having more of it would make someone better off. In general, if
there are unsatisfied wants, resources are scarce.
All nations no matter what political philosophy have to make the following economic choices:
 What goods and services to produce
 How to produce the selected goods and services
 To whom and in what share the goods and services are given
The scarcity problem can be resolved by
 Tradition
 Command
 Markets
Free goods are goods that are not scarce. The wants for free goods can be satisfied without the
need for choice.
Opportunity cost is the “virtual” cost of the best (maximum utility) alternative that is/was not
produced/picked/implemented for a given resource/activity. Essentially this is the benefit that
one would have received if the next best alternative had been chosen.
Module 2: An Overview of Economics
Microeconomics is concerned with the behavior of particular items. Examples are the prices of
meat vs. vegetables, the role of government taxes on private savings. International
microeconomics is concerned with exports, imports, tariffs, and exchange rates. The basic theory
used is the theory of demand and supply.
Macroeconomics is concerned with aggregates in the economy. Examples are the unemployment
rate, control of money supply. International macroeconomics is concerned with balance of trade,
balance of payments and the policy making to affect the exchange rate. The basic theory used is
the theory of circular flows of national income.
Criticisms of the Market Economy
 Wrong goods and services
 The fallacy of the consumer sovereignty – consumers don’t vote with money, advertisers
persuade consumers
 The pollution problem
 Poverty amongst plenty
 Inflation and unemployment
Externalities occur when the actions of an individual or firm confer benefits or costs on
individuals or firms not directly involved in those actions.
Private Goods: A good bought and consumed for which the act of consumption affects no one
else. Public Good: A good bought or owned that others can still consume without paying for it.
Economies of Scale arise when, as a firm’s level of output raises the unit cost of producing falls.
Monopolist is a firm that is the sole supplier of a certain good to a market. The price of the good
will not reflects the cost of the goods used during production to the society, thus enabling the
monopolist to earn above-normal profit. New entrants to the market that have access to the same
resources to produce the good will be deterred since they would in the beginning not be able to
achieve the same economies of scale and thus be at a disadvantage when trying to compete with
the monopolist. To regulate a monopolist and influence the price collective action will be
required, as the market has failed in this situation.
One criticism of the market economy is unequal income distribution. The income across the
households can be depicted using the Lorenz Curve. In order to change an income distribution
determined purely by market forces collective action is required.
Lorenz curve representing
inclome distribution
100%
Income
Realistic (e.g. UK)
Income Distribution
Equal Income
Distribution
100%
Households
National Output (Y) = Consumption Expenditure (C) + Investment Expenditure (I) +
Government Expenditure (G) + Net Exports (Exports – Imports)
Consumer
65
%
Goods
Capital Stock
Together produce the
National Output
Labor Force
Investment
Goods
20 %
15 %
Government
Goods
Idle Capital Stock and Unemployed Labor means that the economy is not producing the
maximum possible national output and a portion of the “potential” national output is lost.
Investment goods are produced in order to achieve a higher standard of living in the future. That
means consumers and firms are forfeiting fulfillment of current needs (utility) in the hope of
achieving higher utility in the future.
Fiscal Policy is concerned with changing government expenditure and/or tax rates.
Monetary Policy is concerned with the changing of interest rates and/or the money supply.
Module 3: Demand
Equilibrium is reached when the last dollar spent on any good or service equals the utility
received from every dollar spent on any other good or service.
Marginal Utility is the additional utility derived from consuming an additional unit of a given
good.
The Law of Diminishing Marginal Utility states, that the marginal utility decreases as the
consumption of a good increases.
Maximum Utility is derived when across all goods for a household (individual) the Marginal
Utility (MU) in relation to the Price (P) is as follows:
MU A MU B

 ...
PA
PB
Individual Demand is represented in the relationship between the price and the quantity of a
good that an individual would be willing to buy in a given time period (hypothetical relationship)
ceteres pares (all other parameters equal). A typical demand curve is negatively inclined.
Individual demand curve for a
certain good in a certain time
period
Price
Demand
Demand
The Substitution Effect occurs when an individual substitutes a cheaper good for another good.
The substitution effect is always negative: the increase of the price of a good will always lead to
the substitution of relatively cheaper goods for that good.
The Income Effect can be described as follows: a higher price of a good X will, cet. par., lower
an individual’s total utility because it decreases the quantities of goods that that he is able to
purchase, i.e. he suffers a loss in real income.
An Inferior Good is a good for which the quantity that is sold falls when real incomes rise. A
Giffen Good is a good for which at higher prices of the good a larger quantity is purchased. For a
Giffen good the range of prices for which this relationship holds true is limited.
A shift of the demand curve can be caused by a change in any of the factors determining the
position of the curve, e.g. income, prices of other goods, preferences. A movement along the
demand curve is caused by a change in the price of the good.
A Market Demand curve is constructed by adding together the combined demand curves of all
individuals in the market (along the demand axis).
Price Elasticity of Demand (Demand Elasticity) describes the sensitivity of the quantity of a
good demanded in a market relative to price changes.
Demand Elasticity
Q
Q
E=
P
P
If E < 1 the demand for that good is called price-inelastic
If E > 1 the demand for that good is called price-elastic
E = 1 is called unitary price elasticity
Also used:
Q
 Q1  Q 2 


2 
E= 
P
 P1  P2 


 2 
By using the average of the price and quantity as the base
Total Expenditur e  PQ
Extreme Demand Curves
Price
Perfectly Inelastic
Demand Curve
E<1
Perfectly Elastic
Demand Curve
E>1
Unitary Elasticity
E=1
Quantity
Cross Elasticity of Demand defines the change in demand of good B if the price of good A
changes.
Cross Elasticity of Demand
 QA 


QA 

Ecross 
 PB 


P
 B 
Ecross < 0 for complementary goods
Ecross > 0 for substitute goods
Ecross = 0 shows that the goods are independent
Income Elasticity
 Q 


Q 

Eincome 
 I 
 
 I 
For an inferior good income elasticity is negative.
Module 4: Supply
The supply curve of a market can be constructed out of the summation of the individual supply
curves of the companies in the market. A company’s supply curve is determined by its
production curve.
Outside of the
production frontier
(not reachable with
current technology)
Output (e.g. kilos of salmon) Q (quantity)
Production Frontier
(productivity curve)
better technology, boat,
etc. changes production
frontier
production frontier
(operating at
engineering efficiency)
Inside the
production frontier
(not engineering
efficient)
marginal physical
product MPL
average physical
product APL
Variable Factor Inputs (man-days) L (labor)
Average and Marginal Product of the Variable Factor Inputs
Q
Q
APL 
MPL 
L
L
Resource Classification: Resources are classified either as capital or labor.
Total Cost (TC), Fixed Cost (FC), Variable Cost (VC), Average Total Cost (ATC)
TC  CPc  CPL
n
m
i 1
j 1
TC   C i Pci   C j PLj
TC  FC  VC
ATC 
TC
FC VC
 AVC  AFC 

Q
Q
Q
Fixed factors of production are certain factors of production that can not be practically altered
in quantity in the short run. They can only be altered in the long run.
Variable factors of production can be altered in the short run (almost immediately).
Profit
  Totalrevnue  Total cos t  TR  TC
Profit maximizing behavior of a company: A company with Marginal Revenue (MR) bigger
than Marginal Cost (MC) will expand, as revenue will increase faster than cost. Similarly if
MR<MC a company will reduce output as the cost are changing more than the revenue. Profit
will be at a maximum where MR=MC.
If a perfectly competitive company were to maximize revenue, it would produce an infinite
quantity of goods as revenue maximization does not take profit into account (an imperfectly
competitive firm would produce until the marginal revenue was zero).
A perfectly competitive firm would produce at a level where ATC was at a minimum, however
for a monopoly that might not be the case.
Assumptions for the following figure: Price is exogenous, cost of factor inputs is exogenous, one
good only, and goal is profit maximization.
The average variable cost curve is constructed out of the average productivity per factor of labor
input curve. (APL)
Cost and Supply in the "Short
Run"
Average Revenue =
Marginal Revenue
AR = MR = P
Short Run Supply
Curve
Price (P)
Average Total Cost
(ATC)
Average Variable
Cost (AVC)
Marginal Cost (MC)
Output (Q)
How does the behavior of a company change if the price changes in the short run?
 If the price were below the minimum of the Average Variable Cost, the company would
produce nothing as the Average revenue (AR) equals price is below the average variable
cost and thus it would just be cheaper to have no variable cost at all.
 As soon as the price is higher than the AVC, the company would output Q at which
Marginal Cost MC equals the Marginal Revenue MR equals Price P.
Returns to factor inputs refer to varying one factor and holding all other factors constant and so
is a short run phenomenon. Returns to scale refer to a change in output resulting from a change
in all factor inputs and thus is a long run phenomenon.
Returns to factor inputs, Returns to scale
Q L

Q
L
Q L
Diminishing factor returns

Q
L
Increasing factor returns
Q ( L, C )

Q
( L, C )
Q ( L, C )
Increasing returns to scale

Q
( L, C )
Increasing returns to scale
Price Elasticity of Supply (Supply Elasticity) describes the sensitivity of the quantity of a good
supplied in a market relative to price changes.
Supply Elasticity
Q
Q
E=
P
P
If E < 1 the supply for that good is called price-inelastic
If E > 1 the supply for that good is called price-elastic
E = 1 is called unitary supply elasticity
Also used:
Q
Q
 1  Q2 


2 
E= 
P
 P1  P2 


 2 
By using the average of the price and quantity as the base
The long run supply curve of an industry with companies moving in and out of it is a horizontal
line as long as the factor inputs are not affected. The long run supply curve is not affected by the
supply curve of any current company in the industry. If the cost of factor inputs increases as
more firms move into the industry, the long run supply curve will go up as the quantity produced
grows.
The average labor productivity (APL) is calculated by dividing the output by the total number of
workers.
Module 5: The Market
A market exists if potential buyers and sellers are in communication with each other. The
characteristics of a perfect market are:
1. Many buyers are sellers to ensure sufficient liquidity
2. Perfect information on the market (e.g. asking price) and the goods and services to be
traded
3. Freedom of entry and exit to the market
4. Homogenous product
If a price causes excess demand or excess supply to exist in a market, forces in the market will
change the price and the quantity bought and sold until excess supply or excess demand is
eliminated. A market is in equilibrium if the forces that act to eliminate excess demand or excess
supply exactly offset each other; there is no excess demand and no excess supply.
Supply and demand in
a market
Supply S
Consumer
Surplus
Price
Equilibrium
Price
Producer
Surplus
Demand
Quantity
The consumer surplus is difference between the actual price paid and the (higher) price some
consumers would be willing to pay. The producer surplus is the difference between the actual
price received for a unit sold and the (lower) price producers would have been willing to sell for.
If a price ceiling exists the price of a certain good is not allowed to rise above a certain level. If
the price has reached the price ceiling, price itself will not be sufficient to allocate the supply.
Additional allocation mechanisms will have to be used. Usually if a price ceiling has been
reached, a black market will tend to develop.
If a price floor exists the price of a certain good is not allowed to fall below a certain level. If the
price has reached the price floor, price itself will not be sufficient to dispose off the additional
supply. Additional disposal mechanisms for the excess supply will have to be found. Those could
be: destruction of surplus, government purchase of surplus, selling of surplus in another market,
pay the producer not to produce.
Effects of a tax on the
market
Tax per
item added
to MC of
supplier
Supply S
P2
Price
P1
Demand
Quantity
If a tax is imposed on every quantity of a good bought and sold, the consumer and the producer
surplus will decrease. The imposition of a transaction tax affects the market supply curve
through its input on the marginal cost of the producer, who will have to pay the cost to the
government and thus will only be willing to supply each quantity for a price that is increased by
the tax imposed. The final change in price and quantity sold depends on the elasticity of the
supply and demand in the market. In general, the overall volumes of transactions will go down
and thereby the overall gain from the exchange will decline. Subsidies work exactly the opposite
way.
Dynamic adjustments
in the Market
Supply S in the market
period (fixed supply)
Supply S in the
short run
Supply S in the long run
(assuming that costs of factor
inputs rise as more and more firms
enter the market)
Price
Supply S in the long run
(assuming that costs of factor
inputs remain the same as more
and more firms enter the market)
Demand D'
Demand D
Quantity
If there is a time lag in the change of the supply of a market in relation to the current price, a
cyclical pattern can occur. Dependent on the relative slopes of the supply and demand curves the
fluctuations in the market will converge or diverge from the equilibrium price. This dynamic
behavior can be analyzed using a cobweb model. The model will converge if the supply curve is
(in absolute terms) steeper than the demand curve. Only if the following assumptions hold true,
is the cobweb model valid: Producers never learn from consumers, production is always
adjusted, there are no speculators in the market.
Cyclical patterns in the
market
Price
Supply S
Demand
Quantity
Module 6 Economic Efficiency
If producers specialize in what they can produce, the best way so that total output of an economy
increases this is called division of labor. The total utility will be greater with trade or exchange
occurring.
Marginal Equivalency
A utility maximizing consumer will allocate it’s income in a way that the Marginal Utility that a
consumer gains from a good A relative to the price of that good is the same as the Marginal
Utility for good B relative to the price of good B.
Since the Marginal Cost of a company to produce a good equals the price for that good if the
company is competitive and profit maximizing it follows that if:
MUA MU B MUC


 ...
MCA MCB MCC
economic efficiency will prevail in the economy.
An industry is in equilibrium if no forces exist to cause change. That is the case if firms are

making normal profits, average
revenue (price) equals long run average cost (that includes
normal profit) and no incentives for firms exist to either leave or enter the industry.
An economy is in general equilibrium if no forces exist that cause change. That implies, that no
consumer wishes to change the spending pattern (they are already achieving maximal utility),
and no firm is moving into or out of an industry.
Government intervention in a market economy is needed to move the economy to economic
efficiency in the following areas:
 regulation and providing of public goods
 dealing with externalities
 dealing with the problem of economies of scale and the resulting monopolies
 adjustment of the income distribution if desired
Module 7 Organization of Industries
Industry
Characteristic
Perfect
Competition
Monopolistic/
imperfect
competition
Oligopoly
Number
of firms
Very
Large
Large
Type of
product
Homogeneous
Barriers
to entry
None
Control
over price
None
Degree of
Concentration
Zero
Example
Differentiated
None/
few
Some
Low
Restaurants,
Clothes
Small
Homogeneous
Scale
Substantial
High
Monopoly
One
Unique
Scale or
Legal
Complete
100%
Cars,
Chemicals,
Public utilities
Agricultural
products, steel
A perfectly competitive company is making above normal profits if the average revenue (price)
exceeds the average cost. If above normal profits exist in an industry, resources will flow into
that industry.
When no resources are moving from one industry to another each firm will be in the long run
equilibrium, and price will be the long run marginal cost.
A monopolist is a producer that supplies the complete market for a good or service. The market
supply curve is the short run marginal cost curve of the monopolist and the markets demand
curve is the demand curve faced by the monopolist. Since the average revenue curve is the same
as the demand curve and the demand curve is downward sloping, the marginal revenue curve
will fall steeper than the average revenue curve. In comparison, the AR=MR and is a vertical line
in a perfectly competitive industry.
Short Run Profit Maximization
for a Monopolist
Price (P)
Short Run Supply
Curve
Average Total Cost
(ATC)
Market Demand =
Average Revenue
Marginal Cost (MC)
Output (Q)
In the short run the monopolist will produce Q where MR=MC (short run equilibrium) but will
be able to sell at a price P=AR, giving it a higher than normal profit since the price is above the
marginal cost. The “fair” price (P=AR=MC) would have been lower and the monopolist would
have produced more. However the monopolist would not have maximized profit at that point.
If the long run marginal cost (LRMC) is lower that the current marginal revenue a monopolist
will expand. If the LMRC > MR the monopolist will decrease output. In both cases the (above
normal) profits will increase in the long run. If a monopolist exists in an economy economic
efficiency will not prevail as the marginal equivalency condition for all goods and services will
not be reached (P is not equal MC thus the ratios of MU/MC are not all equal).
The main problem with a monopolist (from an economist’s point of view) is that the price of the
good exceeds the marginal cost (including reasonable profit), thus the price that the consumer
pays does not reflect accurately the marginal cost for society of producing that good.
It might be in a society’s interest to have a monopolist if economies of scale exist. In economies
of scale the average cost of a good declines as output expands.
A monopolist can be regulated to achieve economic efficiency by
 setting the output and pricing strategy (e.g. through the government) to realize P=MC or
by
 taxing a monopolists profit and subsidizing losses, thereby again aiming to achieve
P=MC.
The problem with these suggestions is that they will not produce any incentives in the
monopolist to operate efficiently.
Under imperfect competition fewer firms exist in a market, each faces a downward sloping
demand curve (same as figure above for monopoly). Companies will move into the industry as
long as above normal profits are earned and therefore the market supply curve will shift to the
left. In the long run, equilibrium the average total cost will equal average revenue again, but
companies have spare capacity, as they are not producing output at the minimum average total
cost curve.
Long Run equilibrium for
imperfect comtetition
Short Run Supply
Curve
Price (P)
Average Total Cost
(ATC)
Market Demand =
Average Revenue
Marginal Cost (MC)
Output (Q)
The principal agent problem describes a situation with a conflict of interest. An agent is an
individual or a group of individuals to whom a principal has designated decision-making
authority. However, the agent might not act in the best interest of the principal as he might have
other (conflicting) interests. An example is the CEO is the agent of the board (principal) but
might have his own and not the boards interest.
Module 8: Public Goods and Externalities
Reasons to not purely rely on market forces to determine the allocation of resources:
1. Help to achieve economic efficiency when the market fails.
2. Alter the distribution of goods and services to households
Economic equity distribution is the distribution of ownership of human and non-human capital.
Economic efficiency and economic equity are separate concepts.
The market will not allocate resources in the most economic efficient way if
1. The costs that firms pay for production of a good differ from the total production costs
2. Some households can consume goods and services without having to pay for them
Private Good is a good or service for which each unit is consumed by only one individual or
household. Characteristics:
 Excludability: Only one household owns the right (for consumption) of that good.
 Rivalry: If one household consumes a good there is less for other households left
Public Good is a good or service for which each unit is consumed by everyone and from which
no individual can be excluded.
Many goods are not purely private or public goods.
The allocation for public goods cannot be achieved through market forces alone, due to the free
rider problem.
A free rider is someone who consumes a good without having to pay for it.
Public goods require collective action by societies in order to produce them.
For a society to operate in an economic efficient way it needs to aim at allocating the resources at
it’s disposal so that the marginal equivalency condition holds true.
Marginal Equivalency for a Society
MSB A MSBB MSBC


 ...
MSC A MSC B MSCC
MSB is the marginal societal benefit
MSC is the marginal societal cost
Who pays for public goods? Two (extreme) methods could be used to determine that:
1. If each household pays an equal amount for getting the same public good, the poor pay
proportionally more of their income than the rich.
2. If each household pays a fixed proportion on income, richer households would pay
considerably more (in money terms) than poorer households.
Economic criteria cannot determine who should pay for a public good. That is a question of
income distribution and thus consideration of equity.
Costs of production that are purely borne by the producing firm are private costs. Similarly, the
benefit that a company considers if nobody else benefits from the good or service is a private
benefit.
For economic activity where some costs are borne by a party not involved directly in the activity
negative externalities or external costs are occurring. If benefits are received by a party not
directly involved with the economic activity, positive externalities or external benefits occur.
When externalities exist, market prices will not lead to an efficient allocation of resources due to
the divergence between private and societal costs/benefits. It requires collective action to achieve
economic efficiency.
How can the problems that externalities produce be solved:
1. Direct Government Legislation: If negative externalities exist in a market, a tax can be
used to bring the market to the point of economic efficiency by ensuring that the buyer
and seller take the tax on the transaction into account when making their decision. If a
positive externality exists in a market that are not accounted for, a subsidy can be used to
change the firms cost curve and thus the supply curve. This would decrease the price and
increase the quantity, resulting in an accurate representation of the real benefit of the
good/service. The government can also establish laws to regulate the externalities (e.g.
pollution limits)
2. The government can establish through indirect legislation clear property rights for the
externalities. The producer or the affected are assigned the property right of the
externality. They then can trade to the point where both are better off. The problem in this
approach is often the prohibitive transaction and negotiation cost required.
3. When external cost or benefits are brought within the scope of a single organization, the
externalities are internalized.
Coase’s Theorem: in a situation with clearly defined property rights and external costs both
parties can be better of if they account for negative externalities through negotiation and thus
achieve economic efficiency (Example with the farmer and the rancher where the farmer pays
the rancher for having less cattle graze and thus reducing the damage to the crop).
If collective decision-making to enable a “public choice” is performed using a voting process the
voting paradox might lead to undesirable outcomes.
Module 9: Income Distribution
Gross National Product (GNP) is the value of the total output of goods and services produced
by an economy in a year.
A way to compare the average materialistic well-being of a people in a country one can compare
the GNP per capita at purchasing power parity (PPP). The PPP exchange rate compares the
purchasing power of a currency for a representative basket of goods and services.
The value of the marginal product (VMP) shows the increase in value of the output for each
additional factor input. The market demand curve for a factor input is the summation of all the
VMP curves of the firms in that market. Profit maximizing firm will pay the equivalent of the
value of the marginal product as the wage rate.
Value of Marginal Product per
additional man hour
VMP ($)
VMP
man hour
Economic Rent is the difference between the marginal product of a factor of production and the
opportunity cost (the next best alternative use) for that factor. Example: In the market I might be
able to get $100K for my services. My current contract pays me $80K. My next best alternative
job would pay me $40K. The economic rent is $100K-$40K=$60K. The economic rent is
divided 66% to me and 33% to my company due to my current contractual obligations. In a
situation where the wage rate is less that the value of the marginal product of labor, labor is
exploited.
Monopsony, the opposite of monopoly, means only one buyer in a market. It occurs when there
is only one employer of factor inputs in a market.
The economic feature of a trade union is that it represents a group of, or all, resource owners in
a market for factors of production.
A household below the poverty line earns insufficient income to support life adequately.
Income distribution in an economy and the economic efficiency of that economy are not related.
The income distribution is a result of the distribution of economic equity. All market economies
elect to alter the income distribution through transfer payments (e.g. taxes, payments in kind
(welfare goods and services), etc.). One way to alter the income distribution is negative income
tax. Using negative income tax the marginal tax rate for a household stays the same (or changes
only very gradually) as the household moves from having no income, where he gets a maximum
negative income tax from the government, to the point where he starts to pay income tax to the
government.
How is economic equity distributed in different economic systems?
 Traditional economies: custom determines the allocation process with the most powerful
member of society usually served first
 Command economies: wages and salaries are fixed by a central body as well as prices
and quantities produced. The problem here is that supply might not match demand
 Market economies: competition for resources to produce goods and services determines
price, consequently the income for the resource owners. People with little or no resources
rely on charity by people with income, usually through government transfers.
Module 10: International Sector
The theory of absolute advantage (Adam Smith) states that if countries have an absolute
advantage over the other country in the production of a good by using less labor and capital, both
countries can benefit from trade with each other.
A country is said to have a comparative advantage in the production of a good if it can produce
cloth at a lower opportunity cost than another country.
To prove the theory of comparative advantage (David Ricardo) assume a system in which:
 Only two goods are produced in each country initially
 Labor is the only variable factor but labor productivity differs
 Constant returns to scale (that is no productivity gains as the scale increases)
 Fully employed labor
 The productivity difference in one good between the two countries is not proportional to
the productivity gap for the other good
 Resources are fully mobile within a country so that returns to equivalent labor and capital
are equalized within a country
 The same resources are not internationally mobile
 No transportation cost
Under those assumptions two countries can still trade at an advantage to both of them. For details
see http://internationalecon.com/v1.0/ch40/ch40.html.
Terms of Trade: The relative price of a country's exports compared to its imports.
Tariff: a tax imposed by an importing country when a good or service enters that country.
Benefits the government and the protected industry.
Quota: a restriction specifying the maximum amount of a good that may enter a country during a
specific time period. Protects a domestic industry without benefiting the government. A way to
distribute the quota rights will have to be found. If the quota right were to be sold off, it would be
worth the above normal profit.
Impact of a quotas and
tariffs
Supply with
tariff imposed
Above Normal
Profit (Economic
Rent)
Imposing Tariffs
P (with quota)
Im
p
Qu osin
ota g
P (with tariff)
Supply
Tariff
Price
P
Equilibrium
Price/
Quantity
Excess
Demand
Demand
Q (with tariff)
Q (with quota)
Quantity
Voluntary export restraints: an agreement signed with the exporting nation to restrict the
amount of imports.
Arguments for trade restrictions:
 Infant industry: As industries start to develop there has to be a period of protection to
allow them to reach size and scale that is economically viable in the international
competitive world.
 Dumping: Practice of selling a good in a foreign market at a lower price than prevails in
the market of the exporting nation with the intent to drive the foreign company out of the
market and then raise the prices. Dumping is considered illegal under international law.
 Countervailing duties: Tariffs imposed on imported goods produced by companies that
receive production subsidies from their governments.
A county’s balance of payments account records its international trade, international borrowing,
and its international lending.
The current account records all exports, imports of goods an services, and all other items that do
not result in addition or subtraction on the countries claim on foreign resources
The capital account records all transactions that affect the amount of claims that a country has
abroad and that other countries have in this county.
Current Account for Country X
Import of goods and services
Exports of goods and services
Current account balance
Capital Account
Foreign investments in X
X investments abroad
Capital account balance
Official settlements account
Change in official X reserves
Net effect
$bn
500
400
-100
300
190
110
10
0
The balance of trade deficit or surplus is deficit of surplus in the current account for that
country.
A balance of payment deficit (surplus) can be thought of as the excess supply (demand) of a
countries currency that result from international transactions and that a country has to purchase
(sell) in order to preserve the exchange rate. If the government does not buy the excess currency,
the currency will depreciate and vice versa.
Factors affecting a Countries Exports (X):
1. Foreign Demand or Foreign Income (YF)
2. Domestic Prices (PD) versus Foreign Prices (PF)
Exchange Rate
Factors affecting a Countries Imports (Z):
1. Domestic Demand or Domestic Income (YD)
2. Domestic Prices (PD) versus Foreign Prices (PF)
3. Exchange Rate
Version 1.0 on June 25, 2002
Economics
Course Summary
Module 11: Macroeconomics Overview
Full employment is defined as a percentage of people in the labor force being employed for an
expected number of hours peer week for an expected number of days in a year, taking into
account recognized holidays. The full employment rate of unemployment (also called the
natural rate of unemployment) is dependent on socio-economic factors and differs for each
nation. Each nation also has a related full employment rate of downtime (or unused capacity) for
factories and machine tools.
Expenditure on goods and Services
Gross National Expenditure (GNE)
Goods and Services
Gross National Product (GNP)
Households
Firms
Resources
Wages, Salaries, Rent, Interest, Dividends
Gross National Income (GNI)
In this simple model GNP=C+I and GNI =C+S. Therefore investment (I) has to be equal to
household savings (S).
Gross National Product (GNP) for all groups (the aggregate demand)
GNP  GNE  GNI  Y  C  I  G  ( X  Z )
C is Consumer Expenditure
I is Investment Expenditure
G is Government Expenditure
X is Exports
Z is Imports
This equation is also called the national income identity
Governments try to alleviate the effects of the cyclical tendencies of a nation’s economy. They
aim at keeping aggregate demand stable. The following factors make this difficult:
 Policy tools at the governments disposal act with a time lag
 Potential output (Q) normally increases constantly due to
o Growth in the quality and quantity of labor
o Growth in the quality and quantity of capital stock
o Technological advances
 Household and companies expenditure patterns are hard to predict
 Exogenous shocks (outside events) influence the economy
The government has tools in the following two areas at it’s disposal:
Monetary policy involves control over the supply of money, which directly affect the interest
rates.
Fiscal policy involves control of government expenditure and tax rates.
Simple Model of an Economy
including inflationary and
output/employment gaps
D1
D0
D2
Output/Employment Gap
Aggregate Demand
Inflationary Gap
45
Y2
E2
Y0=Q
E0
GNP and Employment
At D0 the economy is operating at full employment and the actual output Y equals the potential
output. If the demand increases to D1, the economy comes under inflationary pressure due to the
inflationary gap when prices for goods and services are able to rise but the output can not
increase to meet demand at current price levels. If the demand decreases to D2, the economy
operates at less than the full potential output Q and unemployment and an output gap is the
result. Due to the fact that wages are usually not adjusted downwards (due e.g. to union
contracts) if the demand for labor decreases, but wages increase if the demand exceeds supply,
the economy as a whole has an inflationary bias.
As noted above the potential output (Q) will grow over time because of the mentioned supply
side factors generally outside of the control of the government. Thus the government has the
following tools to expand/reduce demand over time:
Fiscal Policies:
 Increase government expenditure (G): an increase in G will lead to an increase in Y that
is proportionally larger than the increase in government expenditure due to the ripple

effects on increased spending. The government expenditure multiplier is the ratio of
total change in Y to the initial change in G.
Reduce taxes: Y is not directly increased. Rather the disposable income is increased as
the government collects less tax. The additional disposable income is then spent resulting
again in the multiplier effect described above.
Monetary Policies:
 Increase the money supply: Increasing the money supply faster than the demand for
money will result in a fall in the price of money; the price of money is the interest rate
(R). Firms and households consider the interest for a loan as part of the price of making a
purchase (cost of capital). Thus if the interest rate goes down the cost for a purchase goes
down with it, which will lead to increased demand and more goods being produced and
sold.
Which tool the government should use depends on the other macroeconomic goals a nation has.
To purely close the output gap or reduce the inflationary gap all above tools would work.
Generally desirable macroeconomic goals are:
 Low inflation rate
 Low unemployment rate
 Balanced government budget
 A positive balance of trade
 A stable currency in international exchange markets
Module 12: Potential Output
Classification of Resources:
1. Capital Goods
a. Land: all natural resources including agricultural land, rivers, forests, climate and
mineral deposits
b. Capital: all factories, warehouses, offices, equipment, materials, houses,
universities, etc. that have been produced in previous time periods
2. Labor Force
a. Labor: the proportion of the population that is willing and able to work. The
quality depends on education, age, hours of work, skills, etc.
b. Enterprise: those individuals in the labor force with organizational and
managerial ability or financial skills, such as individuals taking risks in starting
new companies and launching new products with own or borrowed resources.
Capital Stock
Labor Force
Capital Stock
Consumption
GNP(t)
Replacement
Investment (RI)
Net
Investment
(NI)
Economic growth over time
Consumption
GNP(t+1)>GNP(t)
Labor Force
If a society would consume all resources produced they would not be able to consume as many
resources in the future as no resources would be available for replacement investment that is
necessary to compensate for the reduction in productivity in the capital stock and labor force due
to e.g. wear on machines, retirement, etc. If the net investment (gross investment minus
replacement investment) is positive the stock of input increases and so does the productive
potential of the economy.
The production possibility frontier shows the possible combinations of production of capital and
consumption goods at a given time (with a given capital stock, labor force, technology, etc.).
Doubling the output (rule of thumb): 72 divided by the (GNP) growth rate gives the number of
years it takes to double the output (GNP).
Estimating potential output: most widely used measures of utilization of factors of production
are unemployment rate and capacity utilization (through industry surveys).
Types of unemployment:
1. Frictional Unemployment: People currently switching jobs. Caused by imperfect
information in the labor market. Frictional unemployment exists even in an economy
where actual output equals potential output.
2. Structural Unemployment: “Long-term” frictional unemployment. Caused by a
mismatch in the characteristics of the unemployed and the job vacancies (skills, location).
3. Seasonal Unemployment: Occurs in areas where production levels are dependent on
weather or calendar events.
4. Demand-Deficient Unemployment: Caused due to insufficient demand for labor.
Okun’s Law
 1 (Q  Y ) 
U  
UF
Q 
3
U: Unemployment
UF: Full employment rate of unemployment (natural rate of unemployment)
Y: Actual output
Q: Potential Output
The inflation rate is the percentage increase per year in the average price level from one time
period to another.
The consumer price index (CPI) measures the average price level of goods and services for a
typical household.
The index that includes all goods and services produced in an economy is called the GNP
deflator. It is calculated similar to the CPI.
How do firms set prices? They use the expected demand and expected costs to decide the price.
In order to determine those firms use their own recent experience and what happens to the
economy as a whole. Of importance for both is the recent level of aggregate demand.
Philips Curve describing short
term relationship between
inflation and unemplyment
Rate of Inflation
Natural rate of
unemployment to the
left of inflation =0
due to inflationary
bias of economy
Rate of Unemployment
The Philips curve describes a short-term relationship. The Philips curve can shift over time.
Economic analysis cannot determine which point on the curve a society deems acceptable, it can
only analyze the trade-offs between inflation and unemployment and can indicate how an
economy can be moved along the curve.
Module 13: The Circular Flow of Income
Net National Product (NNP) sets the limit to consumption that does not entail the penalty lower
level of output and consumption in the future.
Net National Product
NNP  GNP  Depreciation
Only final goods and services are included, intermediate goods and services are excluded from
the calculation. Intermediate goods and services are used up in the production of the final goods

and services.
GNP can be calculated by finding:
1. The expenditure on final goods and services (GNE)
2. The value added by each producer
3. The total income earned by each factor of production (GNI)
The value added by a producer is the value of the output of the firm (sales) in a given period less
the value of the inputs (total purchased intermediate goods) used in production.
The sum of payments by a producer for intermediate goods and for primary factors of production
equals total receipts from sales of output. Therefore a producer’s value added is equal to the sum
of payments to primary factors.
For a receipt to be included in the national income it must be used in return for the use of a factor
of production.
Income can be classified as:
1. Wages and salaries – paid in return for the use of labor
2. Rent – paid in return for the use of land and capital goods not owned by the producer
3. Interest – paid to the households who have loaned money to purchase land and capital
4. Gross profits – residual accruing to the firm after all payments of wages, salaries, rent,
and interest have been made
Consumption (C): expenditure on goods and services to satisfy current needs
Savings (S): income not spent on consumption
Income (Y): comprised on Consumption and Savings (Y=C+S)
Investment (I): is the production of goods that are not used for consumption purposes; these
goods are known as investment goods. Main categories of investment goods are:
 Inventories: stocks of inputs and outputs of production. An increase in inventories
represents additional investment, a reduction disinvestment. Changes in inventories can
be planned (e.g. to ramp up production) or unplanned (e.g. unexpectedly low sales).
 Capital goods
Investment
Gross Investment (I) = Replacement Investment (RI) + Net Investment (NI)
Two Sector Model with Capital
Market
Expenditure on goods and Services
Gross National Expenditure (GNE)
Households
Savings (S)
Capital market
Goods and Services
Gross National Product (GNP)
Investment (I)
Firms
Resources
Wages, Salaries, Rent, Interest, Dividends
Gross National Income (GNI)
A withdrawal is any part of the income of private households that is not passed on to the circular
flow of income. It has a contradictory effect on the level of national income.
An injection is any addition to the income of domestic firms that does not accrue from the
expenditure of private domestic households. It has an expansionary effect on the level of
national income.
If savings (S) and investment (I) are unequal, a change in the level of national income will occur.
The economy is only in equilibrium if S=I. The motives of savers and investors being different,
there is no guarantee that the plans of savers and investors will be consistent in the short run at
all levels of income. For this reason the national income realized can and does depart from the
full employment income.
Module 14: A Simple Model of Income Determination
In an economic model, the exogenous variables are determined externally. The model itself
describes the behavior of the endogenous variables.
Keynes’s assumption for the simple model of income determination and GNP: Price is an
exogenous variable; this is a reasonable assumption in the short term as prices are already
determined by past events.
Disposable Income
Disposable Income (YD) = Income (I) – Taxes + Transfers
The relationship between the consumption and income is called the consumption function.
Empirical evidence suggests that households increase their consumption as their income
increases but not as much as their income.
Only if the MPC<1 is the economical model stable, that is if people on a change in input do not
increase their consumption by more than the increase in disposable income.
Marginal Propensity to Consume (MPC)
C
MPC 
YD
Average Propensity to Consume (APC)
C
APC 
YD
In the short run APC>MPC due to the lag time it takes for a consumer to adjust the consumption
to a change in disposable income.
Marginal Propensity to Save (MPS)
S
MPS 
 1  MPC
YD
Empirical studies have found that:
1. Households with relatively low income will save proportionally less (or even dis-save)
than households with a proportionally higher income
2. Over long periods as the living standards in a society increase the relationship between
consumption and disposable income appears roughly proportional. Consequently, the
proportion of disposable income saved has remained fairly stable over long periods of
time.
3. While the long-run relationship has been historically stable, the relationship between
short-term changes in income and changes in consumption is less predictable. In the
short-run the change in consumption tends to lag the change in income.
Short Run Consumption Function
C  a  bYD
b  MPC  APC
Long Run Consumption Function
C  bYD
b  MPC  APC
Simple Model of income
Determination
Consumption Expenditure
C=YD
Short-Run
Consumption
Function
C  a  bshortrunYd
t=3
Long-Run
Consumption
Function
a
t=2
C
S
t=1
C  blong runYD

YD
C
YD
YD
 MPC  YD
C
45
Disposable Income
A shift in the consumption function curve indicates that the amount consumed is different at
each level of income, the direction of change dependent on whether the consumption function
shifts upward or downward. A shift can be caused by a change in factors other than the
income, which leads to a change in the whole function.
A movement along the consumption function curve indicates the changes in consumption that
are a consequence of the changes in income. A movement along the consumption function is
caused by only changes in income (cet. par.).
Simple Model
Y CI  E
National Income is determined by the sum of consumption and investment expenditures resulting
in aggregate demand (or aggregate expenditure)
C  bYd
Consumption is a function of income, APC=MPC=b. Y=Yd as there is no government sector
I  I0
The level of investment is fixed exogenously (outside the model)
Equilibrium in SImple Model
Aggregate Demand (D)
D=Y
S=I
C=bYd
Y=I+C
C
45
Yequilibrium
Disposable Income
Where the aggregate demand (expenditure) function lies above the 45 line aggregate demand is
more than the national income, below it is less. At aggregate demand = national income, I=S and
the model is in equilibrium.
Multiplier Effect of an
Autonomous Increase in
Investment
Aggregate Demand (D)
B
C+I
I
A
45
National Income
An autonomous increase in aggregate demand (e.g. through increase of investment) has a
multiplier effect in the national output and income.
Multiplier for Autonomous increase in investment (or demand)
1
Multiplier 
1  MPC
1
Y  I
in this case the investment multiplier
1  MPC
For the multiplier process to work it’s way to completion, there has to be
1. sufficient unemployment. If the economy were to operate at full employment any
autonomous increase in demand would result in inflation as the output Y has reached the
potential output. The remaining demand creates and inflationary gap.
2. an MPC between 0 and 1. In the real world calculating the multiplier is very difficult. It
therefore is not easy to guide the economy to full employment.
Module 15: Expanded Model of Income Distribution
Investment expenditure is proportionally less than consumer expenditure but it is generally more
volatile, thus has a big influence on short-term behavior of income and output.
Investment decisions are grounded in expectations about the future (e.g. expected rate of return)
and thus prone to uncertainty.
Factor to consider when making an investment:
 The cost of the investment
 The expected return from investment in the form of increased income
 The cost of financing the investment (real or opportunity cost)
The first two factors give the rate of return over cost or marginal efficiency of investment
(MEI). The third factor is the rate of interest (R).
Compound Interest
Pn  P0 (1  R) n
P: Principal
R: Rate if interest (interest rate) per time period
n: number of time periods
Present Value
FIi
FI1
FI 2
PV  


 ...
i
(1  r ) (1  r ) 2
i 1 (1  r )
PV: Present Value of a future investment
FI: Future Investment in time period I
r: rate of discount (discount rate) per time period
n: number of time periods
n
At a given level of technical knowledge the marginal efficiency of investment will decline as the
volume of investment increases. However, there is no convincing evidence that the rate of return
over cost has declined throughout time primarily because technical knowledge improves through
time.
When to pursue an investment project? It is only rational to undertake an investment project if
the marginal efficiency of an investment (r) is higher than the interest rate (R), as only in this
case the return on investment is higher than the opportunity cost.
As the marginal efficiency of investment decreases with the increase of investment, the volume
of investment will be lower as now the opportunity cost outweighs the investment return.
Interest rate (R)
Marginall efficiency of Investment (r)
Marginal Efficiency of
Investment
R0
R1
I0
I1
I2
Investment expenditure (I)
If the rate of interest (R0) is lowered (to R1) the opportunity cost decreases and thus the level at
which the marginal efficiency of investment is reasonable is lower, resulting in an increase in
investment (I1). If e.g. the managers of the company become more optimistic, e.g. through
reduced uncertainty in predicting the investment return, the whole marginal investment
efficiency curve shifts to the right resulting also in an increase in investment.
Another factor that contributes to the fluctuation in investment is that some of the investments
are determined by the rate of change of national income/output; this is known as the accelerator
principle. The accelerator in principle states that if the capital-output ratio is greater than unity,
the increase in net investment to reach an increase in sales will always be bigger than the
increase in sales. In other words, it takes an investment of $4 to increase sales by $2 (the capitaloutput ratio is 2).
Accelerator Coefficient or Capital-Output Ratio
I  Y
: Accelerator Coefficient of Capital Output Ratio
Accelerator principle vs. multiplier effect for investment expenditures: Changes in
investment through the multiplier process have secondary effects on the income. Changes in
income (and thereby demand) due to the accelerator effect have effects on changes in
investment. The two effects reinforce each other (during increases as well as decreases of
investment and income).
Foreign
Trade
Gross National Expenditure
G
Govern
ment
T
X
Z
C
House
holds
I
S
Capital
Markets
I
Firms
Firms
BRE
Yd
Gross National Income
BRE
I
Yd
C
S
Z
X
T
G
Business Retained Earnings
Investment
Disposable Income
Consumption
Savings
Imports
Exports
Net Taxes (= Taxes – Government Transfers)
Government Expenditure excluding transfer payments
Gross National Expenditure, Income, and Product
GNE  C  I  G  ( X  Z )
GNI  Yd  T
GNE  GNI  GDP
Expanded Model of Income Determination (without BRE)
C  bYd
Consumption is proportional to the disposable income of the households
b: (long range) marginal (equal to average) propensity to consume
Yd  Y  T
The disposable income is the national income (=GNI) minus taxes and retained earnings
I  I 0  kY
The investment is a function of a exogenous investment I0 and a component that is related to the
level of income
k: marginal propensity to invest
G  G0
Government expenditure is exogenous to the model
Z  Y
The imports are dependent on the national level of income
: the marginal propensity to import
X  X0
Exports are exogenous and are determined outside of the model
T  tY
This equation describes the tax rate for a constant tax (not progressive)
t: tax rate
Y C  I G X Z
Y  b(Y  tY )  I 0  kY  G0  X  Y
Y (1  b(1  t )  k   )   I 0  G0  X
Y
1
( I 0  G0  X )
(1  b(1  t )  k   )
The nature of the governments system of taxes and expenditure creates a system with certain
automatic stabilizers. The most important of them are:
 Taxes (e.g. income tax, sates tax, taxes on corporate profits)
 Transfers (e.g. unemployment benefits)
 Price supports (e.g. minimum prices guaranteed for agricultural products)
Monetarists believe that the system should rely on build in stabilizers that discretionary fiscal
policy aggravates rather than reduce the fluctuations in economic activity. The aim of fiscal
policy in their eyes should be a balanced budget at the highest level of unemployment that is
consistent with price stability.
Keynesians believe that discretionary fiscal policy is needed for a stabilizing influence.
There are situation (e.g. high unemployment or high inflation) in which both sides would agree
that the built in stabilizers are undesirable as they might prevent the economy from returning to
full employment.
Gross profit of a business consists of the following components:
1. Capital consumption allowances (depreciation): income necessary to cover the cost of
depreciation of capital goods used in production
2. Undistributed Profits (business retained earnings), a part of net profits
3. Dividends, paid to owners and shareholders
Complete Model of the circular flow of income:
Disposable personal income = wages, salaries, rents, interest + dividends – taxes
+ transfer payments
Business Retained Earnings = net profit + capital consumption allowances – direct
business taxes – dividends
Net taxes = indirect business taxes + direct business taxes + personal taxes – transfer
payments
Module 16: Fiscal Policy
The insufficiency of aggregate demand compared with the level of aggregate demand necessary
to obtain and sustain Yfull is known as deflationary gap. The excess aggregate demand over and
above the level of aggregate demand necessary to obtain and sustain Yfull is called inflationary
gap.
If aggregate demand is just sufficient to maintain (full) capacity output, then full employment
and capacity income would result (Yfull).
Deflationary and Inflationary
Gaps
E=Y
Total Expenditure (E)
inflationary gap
deflationary gap
45
Yequlib 2
Yfull
Yequlib 1
National Income
At Yequlib 2 (Expenditure = Income thus the economy is in equilibrium) the equilibrium income is
less than Yfull and not all factors of production are employed.
At Yequilib 1 the economy would be in equilibrium to the right of Yfull. How is that possible, as
Yfull signifies the economy at full capacity? Since Y   ( p1q1  p2 q2  ... that is the quantity is
weighted by the price, any growth of national income Y past Yfull has not changed the actual
quantities of the goods, but only the price(s), thus the trend towards inflation this scenario (the
real national income stays at Yfull).
Money income is measured by the price weights currently ruling. Real income measured by
adjusting for changes over time in the value of the measuring unit (money). A price index is
calculated by selecting a ‘typical basket of goods and services’, observing the price changes of
these goods and services and weighting the price changes to allow for the different economic
importance of the goods and services. The price index used to obtain the real GNP from the GNP
in money terms is called the GNP Deflator.
A fiscal policy of functional finance means that there is no single automatic rule that should be
followed regarding the relationship between government expenditure (G) and government
taxation (T). Discretionary fiscal policy should adjust the relationship between G and T to drive
the economy to full capacity and full employment.
The crowding out effect takes place if raising of G relative to T would not result in a higher
aggregate demand, in that higher government expenditure would be at the expense of lower
private expenditure (at full capacity of the factor of production the crowding out effect will be 1
(fully effective))
Simplistic Keynesian View
The components of aggregate demand (C, I,
G, X) are independent of each other, meaning
that a change to one does not directly impact
any of the others.
Simplistic Monetarist View
The components of aggregate demand are
interdependent, so that changes in the budget
deficit (surplus) are offset by equivalent changes
(in the opposite direction in the other
Specifically that an increase in G does not
have an adverse effect on any of the others.
Thus a budget deficit created by raising G
relative to T will increase aggregate demand
to the full extend of the increase.
components of aggregate demand.
Crowding out effect is 0
Crowding out effect is 1
Budget deficits (G>T) will have an expansionary effect on the economy as the government adds
more to the circular flow of income than it adds. Budget surpluses (G<T) will have a
deflationary effect on the economy.
Effect of fiscal policies on the aggregate demand in the order of effectiveness:
1. An increase in government expenditure G of $1 will result in an increase in aggregate
demand less the government’s propensity to import.
2. The result of a tax reduction in $1 will depend on the public’s marginal propensity to
save plus it’s marginal propensity to import. It is likely that the sum of these two
marginal propensities is higher than the government’s propensity to import. In that case a
raise in government expenditure by $1 will raise aggregate demand more than a reduction
in taxes of $1.
3. It follows that a balanced budget does not have a neutral effect on the circular flow of
income as $1 of government expenditure creates more aggregate demand than raising
taxes by $1 reduces.
Module 17: Money, the Central Bank and Monetary Policy
Money exists in three different types:
1. Coins
2. Notes
3. Bank deposits
Money has the following functions:
1. A medium of exchange
2. A unit of account
3. A store of wealth
For money to function as the medium for exchange it has to have the following characteristics:
 Widely acceptable
 High value/weight ratio
 Divisible in order to settle debts of different denominations
 Not easily produced, counterfeited, or debased in value
Cloakroom Banking is the banking system in which the bank purely acts as a store for the
safekeeping of wealth, but does not contribute itself to the money supply.
Fractional Reserve Banking is a system where the deposit liabilities exceed the bank holdings
of cash (formerly gold). Fractional reserve banking depends on the banks ability to maintain
confidence and convertibility.
Under fractional reserve banking banks are under influence of two competing pulls:
 The pull of profitability: cash earns no interest, so the bank is interested in lending out the
cash and convert it to interest bearing accounts.
 The pull of liquidity: the banks have to keep sufficient cash on hand in order to satisfy the
demand of their customers for cash.
A bond is a legally enforceable obligation to pay cash to the bearer, normally issues by a
government or company. A bond has a redemption date and a redemption value specifying the
cash amount and the date on which the issuer pays the bearer. Usually the bond also has a
coupon payment, which is a specific sum of money that has to be paid by the bond issuer yearly.
The purchase price of a bond is determined by demand and supply in the market.
The investment multiplier (k) gives the change in Income (Y) as a result of a change in
Investment (I)
Y
k
I
The credit multiplier (d) gives the change in deposits (D) as a result of a change in cash reserves
(C).
D
d
C
The cash ratio (r) is the percentage of cash (compared to interest bearing assets) that a bank
holds as part of the overall assets. The credit creation multiplier is 1/cash ratio (r). The (potential)
increase to the money supply M by an initial deposit of X is X times 1/r (the credit creation
multiplier).
The creation of bank deposits is limited by:
 The banks propensity to keep cash for liquidity purposes (as represented by the cash
ratio)
 The public’s propensity to hold cash (when the propensity to hold cash is high, more cash
is not returned to a bank)
The function of a central bank is to control the commercial banks around it in a way as to support
the monetary policies of the economy. It acts as
 the banks’ banker,
 lender of last resort,
 the government’s bank, and
 the manager of public debt.
The central bank controls monetary policy by regulating the supply of money and the cost and
availability of credit. One way to control the supply of money is by buying and selling bonds in
the open market: by buying bonds the central bank increases the money supply and lowers the
cost of borrowing, by selling bonds it decreases the money supply and increases the cost of
borrowing.
Through changes in the money supply and the cost of money the central bank can influence
aggregate demand and consumption (mostly in consumer durable goods) thus income, etc. For
example if the interest rates are lowered, investment projects that were previously unprofitable
are now viable and will be undertaken. The steps are summarized as follows:
Open Market Operations of the Central Bank
Expansionary
Contractionary
Buy bonds
Sell bonds
Cash reserves of commercial banks increase Cash reserves of commercial banks decrease
Bank deposits increase
Banks deposits fall
Credit easier and cheaper
Credit difficult and expensive
Aggregate demand rises
Aggregate demand falls
Income increases
Income falls
Instruments of a Central Bank:
1.
2.
3.
4.
Monopoly of Note Issue
Ability to dictate cash ratio for commercial banks
Ability to set reserve requirements for commercial banks
Ability to set credit controls (e.g. the level of initial payments and repayment periods on
hire purchase contracts)
5. Ability t issue direct instructions to commercial banks and other financial institutions
6. Ability to control open market operation (e.g. buying and selling of government bonds in
the open market)
Hire purchase is a form of credit. The customer agrees to buy goods from a supplier/retailer and
to pay for those goods in installments. The customer has the right to possess and use the goods
from the time the contract is made. The supplier or the finance company keeps ownership of the
goods until all payments are completed. Until the contract is completed the customer cannot sell
the goods without the knowledge and agreement of the finance company.
The banks are in the business of lending money (extending credit) and are thus actively involved
in transacting in hire purchase contracts. The central bank can manage monetary policy by
putting controls on the banks lending activities, which obviously includes hire purchase
contracts.
Module 18: The Quantity Theory and the Keynesian Theory of Money
The Quantity Theory suggests an immediate and close link between the money supply and the
aggregate demand. Keynesian theory suggests that the change in the money supply only
influences the securities (e.g. bond) market directly and that only the resulting changes in the
interest rate will then influence the aggregate demand.
The Quantity Theory of Money
MV  PT
Monetary side  Commodity side
M: money supply
P: level of prices
V: velocity of circulation (number of times a given unit is spent in a certain time period)
T; number of transactions in a certain time period
‘Naïve’ Quantity Theory: If the number of transactions (T) is regarded as proportional to the
level of national income (Y), they can be substituted. If one then assumes that V is constant and
Y (at full employment) at the equilibrium point is also constant, it follows that: MV  PY and
thus that the relationship between money supply and prices is linear (higher money supply,
higher prices).
Modern Quantity Theory: Changes in the money supply can influence prices as well as the level
of income, the effect on those two variables being dependent on how far the economy is from
full employment.
Substantial unemployment: Increase M, household and firms have more money than they need
for transactional purposes and will spend excess, leading to more demand, more income, more
output, more employment.
No unemployment: Increase in M, household and firms have more money than they need for
transactional purposes and will spend excess, since there is no spare capacity only the prices will
go up.
The Quantity Theory does not predict short-run changes in the economy because all four
variables of the equation can change.
There are three types of demand for money:
1. Transactions Demand for Money: money held to finance current transactions. Needed to
bridge the time gap between receipt and expenditure of income. Demand is closely
related to:
a. Level of national income (Y) (high income, high demand for transactional money)
b. Price levels (higher prices demand more money in order to finance transactions,
thus there is a positive relationship to the inflation rate)
c. Interest Rate (if the interest rate is high firms and households will try to minimize
the amount of transactional money in favor of interest bearing)
2. Precautionary Demand for Money: money held to meet demand in the sudden arrival of
unforeseen circumstances. Demand is related to:
a. Level of national income (Y) (high income, high demand for precautionary
money)
b. Interest Rate (if the interest rate is high firms and households will try to minimize
the amount of precautionary money in favor of interest bearing)
3. Speculative Demand for Money: money kept in cash in order to take advantage of
developments in the capital market. Households and firms will hold some percentage of
the wealth in cash in order to finance investment transactions. The ‘liquidity preference is
not absolute’ as cash does not yield any interest. Demand is related to:
a. Level of national income (Y) (high income, high demand for speculative money)
b. Interest Rate (if the interest rate is high firms and households will try to minimize
the amount of speculative money in favor of interest bearing)
The price of existing bonds and the market interest rate are inversely related. If the price of a
bond is expected to fall (central bank or others are expected to sell bonds), it is the same as
saying that the expected interest will rise. This is due to the fixed coupon payment and
redemption value attached to a bond, and thus only the price of a bond can be changed due to
demand and supply in the open market.
Module 19: Integration of the Real and Monetary Sectors of the
Economy
The ‘real sector’ comprising of the consumption function and the marginal efficiency of
investment and the ‘monetary sector’ comprising the supply and demand for money, interact
together to influence the level of national income and the rate of interest. The equilibrium
national income (Y) and the equilibrium interest rate depend on simultaneous equilibrium in both
sectors. The equilibrium thus occurs if planned savings and planned investment are the same and
the demand and supply for money are the same.
The liquidity trap is the floor below that the interest rate does not fall. The liquidity trap exists,
because for any interest rate below the liquidity trap rate all the speculative money is held in
cash, nothing in bonds, as everybody expects the interest rate to go up.
The liquidity-money (LM) curve developed below shows the relationship between the interest
rate and the national income for which the monetary sector of the economy is in equilibrium,
given a certain fixed money supply. If the money supply is increased the part of the LM above
the liquidity trap is moved to the right. The LM curve is constructed out of the demand for M
(transactional and precautionary) related to the national income Y and the demand for M
(speculative) related to the interest rate R.
The Liquidity-Money (LM)
curve
Rate of Interest (R)
Rate of Interest (R)
Yequilibrium
National Income
Total Money
Supply
Demand for Money (speculative)
Demand for Money
(transactional & precautionary)
on
In ey S
cr
ea upp
se l y
M
Demand for Money
(transactional & precautionary)
Demand for Money
(speculative)
Money Supply
Increase
National Income
The investment-savings (IS) curve constructed below shows the combination of interest rate R
and national income (Y) for which the real goods sector is in equilibrium, that is for which the
planned investment of business consistent with the planned savings of households. The IS curve
is constructed out of the combination of the consumption function (and this the savings function)
(S in relationship to Y) and the marginal efficiency of investment function (I in relationship to
R).
The Investment Saving (IS)
curve
Savings (S)
S=I
Savings (S)
S=(1-b)Y
45
National Income (Y)
Investment (I)
IS
Rate of Interest (R)
Rate of Interest (R)
Marginal Efficiency
of Investment (MEI)
Investment (I)
National Income (Y)
In order to determine the interest rate R and national output Y for which the monetary and the
real sectors of the economy are in equilibrium, the LM and IS curves are overlaid. The
intersection of the LM and IS curve determines the overall equilibrium.
IS/LM: Equilibrium in the real
and monetary sector
LM
LM’
Rate of Interest (R)
IS
Increase in the
money supply
Re
Ye
National Income (Y)
What prevents a market economy from reaching the marginal equivalency condition and thereby
economic efficiency?
1. New goods and services are constantly introduced to the market
2.
3.
4.
5.
Factor supplies and prices constantly change
Technological change
Exogenous shocks
Imperfections in the market system:
 public goods
 externalities
 economies of scale
 market imperfections
Module 20: Inflation and Unemployment
Why is price inflation undesirable?
1. Inflation impairs the efficiency of the price mechanism and raises the cost of buying and
selling because money becomes less reliable as a standard of value.
2. Inflation penalizes people on ‘fixed’ incomes and favors those whose money incomes
adjust quickly to price changes. The former group includes pensioners, University
students, and many salary earners, while most wage and profit earners fall into the latter
category.
3. Inflation favors borrowers and penalizes lenders as long as it is unanticipated. Thus, if
interest rates are fixed, in money terms in the anticipation that the level of prices will
remain constant (or the rate of inflation will remain constant), an increase in the prices
will reduce the real cost of borrowing.
4. Given a system of un-indexed taxes, namely one where taxes are fixed in money terms
rather than real terms, inflation will redistribute income from the private to the public
sector.
5. A continuing higher rate of domestic inflation than experienced in other economies can
lead to increased imports and reduced exports and can lead to create potential problems
for stable exchange rates.
Demand-pull inflation sees prices rise as a result of excess demand for goods and services,
namely that exceeds the capacity output at current price levels. This then also causes the price in
the factors of production to rise as firms aim at fulfilling the excess demand.
Cost-push inflation is caused as a result for bargains struck in the factor market, which raise the
production costs of employers who pass on the higher costs in the form of higher prices.
In a cost-push inflation model the prices on the market are ‘administered’ by the firms that set
them at cost plus profit level. Wages and salaries are ‘administered’ by negotiated agreements.
Those administered prices then cause inflation because:
 Trade unions objective to bargain for better pay and money conditions for it’s members
 Highly centralized nature of most trade unions and collective bargaining
 High percentage of wage and salary costs in the total costs of production
Cost-push inflation can only be sustained in the longer term if it is accompanied by a permissive
monetary policy. The only way to counter cost-push inflation is to change the framework in
which wages and prices are determined. If expectations are the cause of inflation, those have to
be changed
Most economies tend to have an inflationary bias because labor costs are adjusted
asymmetrically (they increase when demand exceeds supply, but do not decrease significantly if
the supply exceeds demand, e.g. due to union contracts). This can be reinforced if coercive
comparison is a factor, that is, if employees judge their success by their ability to obtain wage
increases matching those in other sectors of the economy (which might have excess supply).
Monetary policy is set to be “permissive” if instead of controlling the money supply to prevent
inflation, the monetary authorities condone cost-push inflation by allowing an increase in the
money supply and thus allow for higher price levels without imposing costs on employers and
employees through lost output and unemployment.
Imported inflation: if the demand for a certain imported good is relative price inelastic (doesn’t
change when price changes), a rise in the price of the imported good will be reflected in higher
inflation rates.
Expectations inflation: There are three ways to figure expectations into economic models:
1. Expectations are static; they do not change over time
2. Expectations are adaptive; the expectation change gradually when current expectations
have proven wrong
3. Expectations are rational; everyone in the economy has and uses the same economic
information as the policy makers and bases their expectations on that information
Modern Quantity Theory vs. Keynes
Monetarists
Keynesians
Effect of changes in the money supply on aggregate demand
Demand for money is a stable function of variables Changes in velocity my offset changes in
i.e. level of income, expected rate of return, rate of
the money supply. For example in a
changes in prices, etc. while velocity of circulation
depression an increase in M might find
is near constant. The aggregate demand is therefore it’s way into speculative balances thus
directly influenced by the money supply as excess
reducing V, so that there is no effect on
money will be spent thus generating more Y
the aggregate demand by M.
Causes of changes in inflation rate
The money supply is independent of the demand.
The neo-Keynesian view is that the money
The monetary authority sets the supply
responds to economic variables and is thus
exogenously. As aggregate demand increases due to endogenous to the model. The monetary
an increase in M, price inflation might result. The
authority, e.g. “underwrites” the inflation
price inflation is only a result of a change in the
caused by rising wages.
supply for money, while the demand has stayed the It has also been suggested that the
same.
monetary authority might not have
efficient control of the money supply.
Companies might be able to economize on
the existing money supply.
Both agree that a high rate of inflation can only be sustained if the money supply is expanded
significantly.
How to Modify the Document to Suit your Needs
The drawings in this document were produced using Microsoft Visio 2002. The file with the
original drawings is called “Economics Course Summary Visio Diagrams” and is located at the
same place where you fond this document. In order to change any drawings you can either
double click on the drawing itself in the word document (opens Visio inside of Word, usually
slow and not recommended) or you can find the drawing in the Visio file, edit it there and then
copy and paste it back into the word document.
Thanks and Revision History
The material in this document is obviously reproduced from the Economics course text of the
Edinburgh Business School. It was intended to aid me in understanding the course content,
prepare for the exam, and serve as future reference. I have included in various places material
from past exam questions as well as comments from fellow students that answered my questions
on the “Watercooler” (http://forums.delphiforums.com/hwmba/start). Many thanks to those who
make the watercooler an invaluable study help. If you find any errors, omissions or have any
other suggestions for improvement, please don’t hesitate to contact me at [email protected].
Revision History
Version 1.0 on June 25, 2002