Economics Flashcards
Stagflation describes
an economy suffering rising unemployment and rising price levels. It is caused by a leftward shift in short-run aggregate supply (SRAS). The fall in unemployment may lead to lower input prices and labor costs for producers. They will then be able to increase their short-run aggregate supply, possibly resulting in full employment. However, this process can be too slow, and therefore policymakers might try to use fiscal and monetary policy to remove stagflation, but the possibility is a permanent higher price level.
The potential growth rate in output
long-term growth rate of the labor force
+
long-term labor productivity growth rate (output per worker)
The goods included in the GDP calculation
must have been produced during the measurement period, and they must have an objective price that is determined by the market. Transfer payments, such as unemployment or welfare benefits, are excluded from the GDP calculation
Demand function
What influences the quantity of a good consumers are willing to buy, i.e. demand?
- Price
- Income
- Price of substitutes
- Price of complements
if economy is in equilibrium
G + X + I = t + M + S
Factors that influence price elasticity of demand
- Closeness of substitutes
- Products that can be more readily substituted with other products
will have a higher elasticity - Percentage of income spent on the good
- The greater the percentage of budget spent, the greater elasticity
- Time elapsed since price change
- The greater the time since the price change, the greater the elasticity
- The extent to which the good is seen as necessary
- The less the good is seen as necessary the greater the elasticity
Perfectly elastic
> Infinity
The smallest possible increase in price
causes an infinitely large decrease in the
quantity demanded
Elastic
> Less than infinity but greater than 1
The percentage decrease in the quantity
demanded exceeds the percentage
increase in price
Unit elastic
> 1
The percentage decrease in the quantity
demanded equals the percentage
increase in price
Inelastic
> Greater than zero but less than 1
The percentage decrease in the quantity
demanded is less than the percentage
increase in price
Perfectly inelastic
> Zero
The quantity demanded is the same at
all prices
Close substitutes
> Large
The smallest possible increase in price
of one good causes an infinitely large
increase in the quantity demanded of the
other goods
Substitutes
Positive
If the price of one good increases, the
quantity demanded of the other good
also increases
Unrelated goods
> Zero
If the price of one good increases, the
quantity demanded of the other good
remains the same
Complements
> Negative
If the price of one good increases, the
quantity demanded of the other good
decreases
Income elastic (normal good)
> Greater than 1
The percentage increase in the quantity
demanded is greater than the
percentage increase in income
Income elastic
(normal good) necessity
> Less than 1 but greater than zero
The percentage increase in the quantity
demanded is less than the percentage
increase in income
Negative income
elastic (inferior good)
> Less than zero
When income increases, quantity demanded decreases
Substitution and income effects
Substitution effect:
If the price of a good declines, then it becomes more of a bargain relative to other goods. Therefore, other goods are substituted for this particular good.
Income effect:
As the price declines, the consumers’ real income increases as they have to spend less on the same amount of goods. For normal goods, as income increases, more of this good is purchased.
Normal and inferior goods
Effects of a price decrease on demand
Substitution Effect: Normal
Increase
Income Effect: Normal
Increase
Substitution Effect: Inferior
Increase
Income Effect: Inferior
Decrease
Generally the income effect has less of an impact than the substitution effect.
Therefore the consumer still ends up buying more at the lower price
Exceptions to the law of demand – Giffen good
Effects of a price decrease on demand
Decrease in demand:
Subs effect: Incr
Income effect : decr
BUT
Income effect > Substitution effect
- If the income effect has a greater impact than the substitution effect for an inferior
good, then a decrease in price would result in a decrease in quantity demanded
and hence a positively sloped demand curve - All Giffen goods are inferior, but not all inferior goods are Giffen
Exceptions to the law of demand – Veblen goods
- Veblen goods are goods that increase in desirability as price increases, such as a
high status good - E.g. luxury cars
- This creates a positively sloped demand curve
Marginal product
- Increase in total product that results from a one-unit increase in the quantity of labour
employed, with all other inputs remaining the same
Law of diminishing marginal returns
- Where a firm uses more of a variable input with a given quantity of fixed inputs the
marginal product of the variable input eventually diminishes
Total revenue is maximized
when each marginal unit sold is positive
Marginal cost
- Increase in TC that results from a one-unit increase in output
- MC = Δ TC/Δ quantity produced, where TC = TFC + TVC
- Decreases at low outputs because of increasing factor returns
- Eventually increases due to the law of diminishing returns
MC always cuts ATC and AVC at their minimum points
ATC is U-shaped
- Spreading total fixed over larger amount
- Eventually diminishing returns
Breakeven point
Price = ATC
Shutdown point
price = AVC
Profit maximization
occurs when MR = MC, this is where
the difference between total revenue
and total cost is the greatest
Characteristics of perfect competition
- Many firms sell identical products (homogeneity) to many buyers
- Few and easily surmountable barriers to entry/exit
- Established firms have no advantage over new firms
- Sellers and buyers are well informed about prices
- Non-price competition is absent
Price takers - Firms that take market price as given when selling their product
- Each is small relative to the market and cannot affect price
- Price = Marginal revenue
- Price remains constant when quantity sold changes
Profit maximization - Goal is to maximize economic profit
Marginal revenue (MR) = Marginal cost (MC)
Perfect competition of firm
P = D = MR = AR
short-run
Economic profit : P > ATC where P= MC = MR
Economic loss: P < ATC
Breakeven : P = ATC
LONG-RUN
no profitability
MC =SR
pmin = AVC
qLR = ATC
Industry supply curve
- Sum of the individual firm’s supply curves across a range of prices (where the
quantities supplied by the firms remains constant)
Key characteristics of monopoly
- Single seller
- No close substitutes
- High barriers to entry
- Strong pricing power
Barriers to entry can take the form of: - Legal barriers
- Patents, copyrights or ‘public franchises’ that is government license
- Natural barriers
- Economies of scale in, for example, electricity generation and water supply
- One firm can supply the whole market at a lower cost than two
or more firms
Monopoly price-setting strategies:
- Single-price monopolies
- All output sold at same price to all customers
- Price discriminating monopolies
- Able to charge classes of customer the highest possible price per
class and can prevent low price customers selling to high price customers
A single-price monopoly
produces the quantity Qm at which marginal revenue equals marginal cost and sells that
quantity for price Pm
=> pROFITS
Price discrimination arises where the monopoly can:
- Identify and separate buyer types
- Sell a product that cannot be resold
Supply = MC
Demand = MB
> monopolist aims to extract the entire consumer surplus
First-degree price discrimination
A monopolist is able to
charge each customer
the highest price the
customer is willing to
pay
Second-degree price
discrimination
A monopolist uses the
quantity purchased to
determine what to
charge the customer
* If the customer is
buying a large
quantity, they value
the product more, and
will therefore pay
more (and vice versa)
Third-degree price
discrimination
Customers are
segregated by
demographic or other
traits and each group
is charged a different
price
Gross Domestic
Product (GDP)
Income approach
Total amount earned by
households and companies
in the economy
=
Expenditure approach
Total amount spent on goods
and services within the
economy during a period
of time
Nominal GDP
Value of goods and services measured at current prices
Real GDP
Value of goods and services if prices were
unchanged (no inflation)
Per capita real GDP
= Real GDP / Population size
- Used as a measure of the average standard of living in a country
The GDP Deflator
- The GDP price deflator is a measure that accounts for inflation by converting
output measured at current prices into real GDP - It is also known as the GDP implicit price deflator
GDP deflator = (Value of current year output at current year prices / Value of
current year output at base year prices) x 100
GDP deflator = (Nominal GDP / Real GDP) x 100
GDP =
C + I + G + (X - M) + SD = (C + GC) + (I + GI) + (X - M) +SD
Where:
C = Consumer spending
I = Business investment in capital goods and inventory
G = Government spending (= GC + GI = Current spending and investment in capital goods)
X = Exports
M = Imports
SD = Statistical discrepancy
If the economy is in equilibrium
G + X + I = T + M + S
Changes in aggregate demand (shift in the aggregate demand curve)
- Wealth
- Increase in household wealth increases current consumption
- Expectations
- Increases in expected future income increases current consumption
- Increases in expected future inflation increases current consumption
- Increases in expected future profits increases firms current investment
- Fiscal and monetary policy
- Government expenditure is a component of aggregate demand
- Increase or decrease in interest can be used to produce a change in aggregate demand
- World economy
- Increasing foreign income increases domestic exports
- Appreciating currencies encourage imports as they become less
expensive and discourage exports, causing demand to decrease
The Macroeconomic Long-Run and Short-Run
Short-run
- Period during which some money prices are sticky
- Real GDP might be below, above, or at potential GDP
- Unemployment rate might be above, below, or at the natural unemployment rate
The Macroeconomic Long-Run and Short-Run
Long-run
- Time frame which is long enough for the real wage rate to have adjusted to
achieve full employment - Real GDP equals potential GDP
- Unemployment is at the natural rate
- Price level is proportional to the quantity of money
Inflation rate
= Money growth rate - Real GDP growth rate
Aggregate Supply
Short-run aggregate supply
- Relationship between quantity of real GDP supplied and the price level when the
money wage rate, prices of other resources, and potential GDP remain constant - Changing price levels might alter short-run aggregate supply if product prices rise
and input costs (particularly wages) do not
Aggregate Supply
Long-run aggregate supply
- Relationship between quantity of real GDP supplied and the price level in the long-run when real GDP equals potential GDP
- The quantity of real GDP supplied (Y) is a function of:
- Quantity of labor (L)
- Quantity of capital (K)
- State of technology (T)
Aggregate Supply
Movements along the LAS and SAS curves
LAS : Price level rises and money wage
rate rises by the same percentage
SAS: Price level rises and money wage rate is unchanged
Changing price levels might alter short-run aggregate supply if product prices rise
and input costs (particularly wages) do not
* Changing price levels ALONE does not induce a change in long-run aggregate
supply
Shifts in Short-Run Aggregate Supply
The following factors would cause a shift in the SRAS
- Changes in nominal wages
- Higher wages cause a decrease in aggregate
supply, a leftward shift - Changes in input prices, i.e. prices for
raw materials - Higher prices for raw materials cause a
decrease in aggregate supply, a leftward shift - Expectations about future output prices
and price levels - If companies expect prices to rise, they may
increase production in anticipation of increased profit margins - Business taxes and subsidies
− Higher taxes cause a leftward shift, where as subsidies cause a rightward shift - Exchange rate
− A stronger currency will lower the cost of imports, which may make up some of the raw
materials
Aggregate Supply
Changes in long-run aggregate supply
- Full-employment quantity of labour increases
- Population growth increases long-run supply
- Quantity of capital increases
- Increasing physical and human capital increases long-run supply
- Labour productivity and technology advances
Long-run and short-run macroeconomic equilibrium
- Short-run definition
- Aggregate demand = Aggregate supply
- Long-run definition
- Real GDP = Potential GDP
If aggregate demand grows at the same rate as aggregate supply
- GDP growth and no inflation
If aggregate demand grows by more than aggregate supply
- Inflation occurs
Aggregate demand and short-run aggregate supply fluctuate
> Below full-employment equilibrium
Recessionary gap
Long-run equilibrium
Full employment
Above full-employment equilibrium
Inflationary gap
Stagflation
- Stagflation occurs when there is both high inflation and high unemployment
- Decreases in aggregate supply (leftward shifts) may create stagflation
> Higher input costs will cause SRAS to shift leftward
Economic Growth and Sustainability
- Economic growth is the annual percentage change in real GDP or the annual
change in real per capita GDP - Growth in real GDP measures the pace at which a given economy is expanding, whereas per capita GDP determines the standard of living in each country and
average individual purchasing power - Rapid growth is not always a good thing for an economy, as it may lead to higher
inflation - Sources of economic growth: all shift the LRAS curve outwards
- Raw materials
- Supply of labor
- Supply of physical capital
- Supply of human capital
- Technological knowledge
- The sustainable growth rate is the rate of increase in the economy’s potential
GDP
The Production Function
- The production function expresses the relationship between the quantity of
productive factors (labor and capital) and level of output for the economy - Output (Y) can be described in terms of a production function as follows:
Y = Aƒ(L,K)
L: Quantity of labor
K: Capital
A: Technological knowledge/total factor productivity - Labor and capital have diminishing marginal productivity. For a given level of labor, each additional unit of capital contributes less to output
- Due to diminishing returns to capital and labor, the way to sustain growth in
potential GDP is through technological change
Measures of Sustainable Growth
Growth in potential GDP =
Labour productivity =
Potential GDP =
Potential growth rate =
> Growth in potential GDP = Growth in technology + (Labour share of
national income) x Growth in labour + (Capital share of national income) x
Growth in capital
Labour productivity = Real GDP/Aggregate hours
Potential GDP = Aggregate hours x Labour productivity
Potential growth rate = Long-term growth rate of labour force + Long-term labour productivity growth rate
Phases of the Business Cycle
A business cycle consists of four stages:
- Trough – Economy hits its lowest point
- Expansion – Aggregate economic activity is increasing
- Peak – Economy hits its highest point.
- Contraction – Economy starts slowing down (often called a recession but may
be called a depression when the contraction is severe).
Early expansion :
Activity
Employment
Spending
Inflation
GDP increase
Layoffs slow, unemployment remains high
Increase spending in housing, durable consumer items
Moderate, may even fall
Late expansion :
Activity
Employment
Spending
Inflation
Accelerating rate of growth
Unemployment rate falls
Broader increase including heavy equipment,
construction
modest increase
Peak :
Activity
Employment
Spending
Inflation
Decelerating rate of growth
Unemployment rate continues to falls, slower hiring
Capital spending expands rapidly
Acceleration
Contraction :
Activity
Employment
Spending
Inflation
GDP decline
Unemployment rate rises
Cutbacks increase
Deceleration (with a lag)
Resource Use Through the Business Cycle
The following may result from the start of a contraction:
* Slow down production
* Physical capacity used less than full capacity
* No new investment in physical capital
* Stop ordering new inventory
* Unemployment
Top of cycle/ beginning of downturn
Changes in capital spending
Changes in inventory levels
> Cuts in light equipment and technology immediate.
Sudden rise in inventory-sales ratio. Cut in production to sell off inventory.
Initial recovery
Changes in capital spending
Changes in inventory levels
> Capital orders begin to pick up.
Particularly technology.
Inventory sales ratio begins fall to
normal levels. Production
increases.
Later in expansion
phase
Changes in capital spending
Changes in inventory levels
> Focus on capacity expansion and heavy and complex
equipment
Inventory sales ratio falls. Requires
a surge in production.
Unemployment
rate
Extent to which people who want jobs
cannot find them
Number of people unemployed / Lafor force *100
> * Increases in recessions
> * Decreases in expansions
Activity or participation ratio
- Indicator of willingness of people of
working age to take jobs
Labor force / Working - Age population - Discouraged workers leave
labour force during a recession and reenter during an expansion
Types of unemployment
- Frictionally unemployed
- In between jobs, but unemployed at the time of the statistical survey
- Long-term unemployed
- People who have been out of work for a long time but are still looking
- Discouraged worker
- Person who has stopped looking for a job, and therefore is not part of the labor force
- Voluntarily unemployed
- Person voluntarily outside the labour force
Unemployment is considered a lagging economic indicator of the business cycle
due to:
> The number of people employed expands and declines in response to the
economic environment
* In a recession, discouraged workers stop looking for work
Price Indices Biases
The following biases all result in an upward bias in the index:
- New products bias
- A 2012 computer is more expensive than a 1990 typewriter
- A fixed basket of goods and services will not include new products
- Quality bias
- A 2012 car is better than a 2000 car
- Part of the increase in the cost is a payment for improved quality, which is not accounted
for in the measured rate - Substitution bias
- Changes in relative prices lead consumers to change items they buy
- Ignores the substitution of expensive to cheaper items
CPI, PPI, PCE Index
Consumer price index (CPI) is a measure of average of prices paid by urban
consumer for a fixed basket of consumer goods and services.
- The CPI is a Laspeyres index
* The personal consumption expenditures (PCE) index covers all personal
consumption in the U.S. using business surveys.
* The producer price index (PPI) reflects the price changes experienced by
domestic producers in a country.
* In some countries the PPI is called the wholesale price index (WPI).
Inflation
- Inflation is an ongoing process whereby price levels are rising and money is
losing value (as opposed to changes in price levels which are one-time
adjustments in price) - Demand-pull inflation
- Inflation arising from an initial increase in aggregate demand
- Caused by anything that increases aggregate demand
- Cost-push inflation
- Inflation arising from an initial increase in costs
- Two main sources of cost-push inflation
- Increase in money wage rates
- Increases in the prices of raw materials
- Monetarists argue a surplus of money causes inflation
Monetary policy
Central bank activities influencing the quantity
of money and credit in an economy
Fiscal Policy
Decisions about taxation and government
spending
Functions of money
- Medium of exchange
- Any object that is generally accepted in exchange for goods and services
- Facilitates transactions (liquidity) and overcomes the need for double coincidence of
wants required in barter transactions - Measure of value
- Used to quote prices and compare value
- Store of wealth
- Transfer purchasing power to the future
Fractional reserve banking
The practice of lending customers’ money on the assumption that depositors will not withdraw all of
their money at once.
Reserve
requirement
The amount of depositor money that is retained by
the bank. The remainder can be lent out.
Money multiplier
The amount of money created through fractional
reserve banking
1/ Reserve requirement
Money measures in the US
- M1 is the sum of:
- Notes and coins and traveler’s checks
- Deposits at commercial banks
- M2 is the sum of:
- M1
- Savings deposits
- Time deposits accounts of less than $100,000
- Money market mutual funds and other deposits
Money measures in the Eurozone
- M1 is the sum of:
- Notes and coins in circulation
- All overnight deposits
- M2 is the sum of:
- M1
- Deposits with a maturity of up to two years
- M3 is the sum of:
- M2
- Repurchase agreements
- Money market funds and debt securities up to two years in maturity
