Economics Flashcards
Microeconomics
Factor Market
As opposed to goods market, a market for factors of production such as labour, capital or raw materials.
Demand for the factors is derived demand since it derives from the ability to produce goods for a goods market.
Microeconomics
Aggregate Demand/Supply
The total amount of demand or supply at a given price level across the whole market (i.e. all buyers or suppliers).
Microeconomics
Market Equilibrium
Unstable Equilibrium
Market equilibrium is the point at which demand and supply clears in the market. Markets generally tend towards equilibrium as sellers adjust price and quantity available to satisfy the demand in the market.
An unstable equilibrium is when an external shock to the market equilibrium does not stabilise back to equilibrium.
Microeconomics
Consumer Surplus
The area below the demand curve but above the market price of the goods (top left triangle).
The buyers in this area were willing to pay above the market price, the area represents the total amount they were willing to pay less what they actually paid (market price) collectively.
Reflects the gain to buyers of the market exchange.
Microeconomics
Producer Surplus
The area above the supply curve line and below the market price.
Represents the revenue achieved above marginal cost (the price at which 1 unit will be supplied to the market, i.e. intersection with y axis) by all suppliers due to market price being above the marginal cost of the goods.
Microeconomics
Total Surplus
What is it?
When is it maximised?
The sum of consumer and producer surplus.
Maximised at market equilibrium where market price = marginal value to consumer = marginal cost to producer.
Microeconomics
Utility Theory
Definition of Utility
Utility Theory
The total satisfaction received by a person from consuming a good or service.
Utility theory is a quantitive model of consumer preferences, represented by an ordinal function U = f(Qx1, Qx2, …, Qxn)
Ordinal means it provides a ranking not a value (as in cardinal functions). The function shows the relationship between utility and every possible bundle of goods.
Microeconomics
Axioms of Utility Theory
Completeness: A person can compare any two bundles A & B such that either A>B (ie A is preferred to B), A=B or A
Transitivity: If A>B and B>C then A>C.
Nonsatiation: If A has more than B of all positive factors then A is preferred to B.
Microeconomics
Indifference Curves
Show combinations of amounts of two goods which provide the same amount of utility.
Microeconomics
Indifference Curves
Features
Which curves are better?
Shape of each curve and reason
Number of curves in existence
More goods always preferred to less so curves to north-east of chart are better.
The value of a good reduces as more is consumed, which causes the convex shape of the curve. The slope of the curve is the marginal rate of substitution.
Indifference curves are everywhere dense (can draw one through any point) and will never cross.
Microeconomics
Opportunity Set
A consumer buys X items of good x at price Px, and Y of good y at Py. If they have income of M then X * Px + Y * Py <= M is their budget constraint. A graph of this is a downward sloping diagonal line showing the combination of x and y within budget.
So the opportunity set is the set of combinations of goods they can buy given the budget constraint.
Companies have production opportunity sets and investment opportunity sets which show possible combinations of 2 goods to produce or 2 investments to make.
Microeconomics
Maximising Consumer Utility
Using opportunity sets and indifference curves to maximise utility
Choose the point on the budget line which lies on the furthest out (ie highest utility) indifference curve.
Microeconomics
Effect of consumer equilibrium of price changes
(in the 2-product substitution model)
Name and define the two “effects” of a price change
Substitution Effect: If the price of one good decreases the slope of the budget line changes so (typically) more of this good will now be purchased relative to the alternative.
Income Effect: In addition the “real income” of the consumer has increased, therefore higher utility can be achieved (although this could lead to lower consumption of an “inferior” good.
Microeconomics
Effects of price change on consumer equilibrium
(in the 2 product substitution model)
For a normal good, what does price change (fall in price of one good) look like on chart?
Which part of increase in quantity of that product is income effect and which is substitution effect?
Price of product B has fallen.
Draw a dotted line parallel to the new budget line going through the original indifference curve. Increase in QB is substitution effect. The rest of the increase is income effect.
Microeconomics
Effects of price change on consumer equilibrium
(for 2 product substitution model)
For an inferior good, what does the change in price look like on the chart?
For inferior goods the substitution effect leads to an an increase in quantity, but the income effect is negative. The substitution effect is the larger of the two.
Microeconomics
Effects of price change on consumer equilibrium
(for 2 product substitution model)
For an Giffen good, what does the change in price look like on the chart?
For an inferior good with a price decrease, if the income effect outweighs the substitution effect it is called a Giffen good. This is rarely the case.
Microeconomics
Effects of price change on consumer equilibrium
Type of good for which price increase = quantity increase
Veblen Good
Microeconomics
Effects of price change on consumer equilibrium
Behaviour of Substitutes and Complements
If price of product B falls, quantity demanded of product B usually increases, but what about product A?
If A and B are complements then the quantity of A demanded will also increase.
However if they are substitutes, then fewer of quantity A will be purchased, the consumer will “switch” from A to B.
Microeconomics
Accounting Profit
Accounting Profit = Total Revenue - Total Accounting Costs
Microeconomics
Economic Profit
Economic Profit = Total Revenue - Total Opportunity Costs
Same as accounting profit but considers additional opportunity costs of resources used.
For an entrepreneur this could include their salary if they worked instead of running the business.
For a corporation this is the required return on equity capital.
Microeconomics
Normal Profit
This is the accounting profit earned when economic profit is zero.
AP = EP + NP
Alternatively this is the total implicit opportunity cost.
Alternatively it is the normal amount of profit expected to be achieved from the resources available (eg required return on equity for a corporation).
Microeconomics
Economic Rent
Definition
Effect of elastic/inelastic supply
This is the income received by an owner of a factor of production ABOVE the opportunity cost.
Inelastic supply ⇒ Income mostly economic rent
Elastic supply ⇒ Income mostly opportunity cost
Microeconomics
Marginal Revenue
Definition
Perfect/Imperfect competition
The change in TOTAL revenue from selling 1 extra unit.
In perfect competition firms are price takers, every unit sold at market price (P) so MR = P.
In imperfect competition (ie monopoly) an extra unit sold requires a price decrease, so extra revenue from the unit is offset by lost revenue on all other units sold. As such TR is maximised at the quantity where MR = 0.
Microeconomics
Chart of costs vs quantity produced
Marginal Cost, Average Variable Cost,
Average Fixed Cost, Average Total Cost
Note: MC always crosses AVC at its lowest point
MC falls at first due to economies of scale but eventually increases due to diminishing returns.
Microeconomics
Maximal Profit in perfect competition
In perfect competition the market price (P) is fixed.
Therefore maximal profit (may be negative) is achieved when marginal cost (MC) = P.
Keep on producing and selling more until the marginal cost per unit exceeds the market price.
Microeconomics
Shutdown point
Production should be temporarily suspended when revenue just covers variable costs, equivalent to P = AVC.
Note P < AVC slightly in this chart.
Microeconomics
Long run average total cost curve
Red line is small factory, green is medium factory etc.
In the very long term curve smooths out connecting the troughs of each individual curve.
Microeconomics
Minimum Efficient Scale
At low production levels there are economies of scale, whilst at very high levels there are diseconomies of scale.
In the middle there is a range of output with the lowest average total cost, where there are constant returns to scale.
The lowest output quantity in that range is the minimum efficient scale, ie minimum output amount to reach lowest possible ATC per unit.
Microeconomics
Profit Maximisation
Goal of each firm is what?
To maximise economic profit. That is total revenue less total costs including normal profit.
Microeconomics
Economic Profit in Perfect Competition
How much economic profit is made if a firm maximises its profits in perfect competition?
For some of the microeconomic analysis perfect competition is assumed (ie the price is always equal to market price at all output levels).
In the case of perfect competition, if a firm maximises its profits it will be earning the normal profit. IE in perfect competition no economic profit can be earned.
Microeconomics
Long-run industry supply curve
Where production cost per unit is constant regardless of industry output (“constant costs of production”)
The normal supply and demand lines are for the short term. If demand shifts from D1 to D2 the price shifts to P2 and firms make +VE economic profit in the short term.
This economic profit attracts new competitors however, and over time a new short term supply curve S2 develops.
If costs of production (across the industry) are constant against output the long term supply curve will be too.
Microeconomics
Long-run industry supply curve
In the case where costs per unit across the industry increase with industry output (“increasing costs of production”)
In the short term as demand increases from D1 to D2 the price increases to P2 and economic profit is achieved.
As new firms enter the new short term supply curve S2 will be at a higher price per unit due to the increasing costs of production, and P3 will be above P1.
As such the long run supply curve will be upward sloping.
Microeconomics
Productivity
What are total product, marginal product, average product?
Production levels in # units as a function of the amount of a certain input used.
For example marginal product of labour is the number of extra goods produced if one extra person is hired, and average product of labour is the average number of units produced per employee.
Microeconomics
Productivity
What is Marginal Revenue Product (MRP)?
How is profit maximised (in terms of level of production input)?
Marginal Revenue Product (MRP) is the amount of revenue produced by one extra unit of input, equal to marginal product * marginal revenue (MP * MR).
To maximise profits choose the level of input such that MRP = Cost per unit of input.
Since MC = cost per unit of input / MP, this is equivalent to the usual condition MR = MC.
Microeconomics
Perfect Competition
4 features
- Firms are price takers
- Demand curve is horizontal, so infinite demand at the market price, no extra sales from reducing price, zero sales above the market price
- All firms products are homogenous
- Low barriers to entry
Microeconomics
Monopolistic Competition
Description
AKA
Long term profits
- NOT the same as a monopoly
- AKA competitive price-searcher market
- Lots of firms, low barriers to entry, competing on quality, price and marketing
Max profit at MR=MC. Economic profits attract new entrants pushing demand curve to the left, reducing economic profits. Therefore zero economic profits in the long run.
Microeconomics
Oligopy
What are the three pricing strategies?
- Pricing Interdependence (competition will match price reductions but ignore price increases)
- Cournot Model (each firm determines ouput level assuming competitors will not respond, market heads to an equilibrium)
- Nash Equilibrium (game theory)
Microeconomics
Oligopy
Pricing Interdependence
Demand and MR chart
Assumes that competitors match price reductions but ignore price increases.
Results in a kinked demand curve. Note that marginal cost changes in a range as shown have no effect on output since marginal revenue is discontinuous at that level.
Microeconomics
Oligopy
Cournot Model
Resulting price (compared to monopoly & perfect competition)
The assumption is that competing firms will not respond to your output decisions.
Instead the industry reaches equilibrium over time. Equilibrium can be calculated in a simple 2 company market using formulae.
The result is a price somewhere between a monopoly and perfect competition, heading towards the perfect competition level as the number of competitors increases.
Microeconomics
Oligopy: Collusion
What are profit prospects with zero collusion
Without any collusion an oligopy ends up like perfect competition, with price driven down to marginal cost and zero economic profit being made.
Collusion allows firms to increase profit by holding prices at a higher level.
Microeconomics
Oligopy
Dominant firm pricing
This is the case where there is one monopoly like firm and several competing firms. The left chart shows supply curve for the 10 small firms. The dominant firm effectively sets the market price.
At $1.50 the small firms can satisfy all demand, but at $1 there is residual demand which creates the demand curve for the dominant firm. Thus the dominant firm sets price and output based on it’s MC and the resultant MR curve.
Microeconomics
Regulating Monopolies
Average Cost Pricing
Government forces the monopoly to sell at its long-run average cost.
From the usual situation of setting MR=MC (P0) the price is reduced to P1 where the firm will only make normal profits.
Microeconomics
Price discrimination
Describe the three degrees of price discrimination
First degree: Each customer is charged the price they are willing to pay. Consumer surplus is nil, producer surplus is maximised. Output levels are the same as in perfect competition.
Second degree: Price varies on quantity purchased. Consumers put themselves into consumption groups to maximise their consumer surplus.
Third degree: Consumers segregated by demographic or other traits. Prices determined by the demands of each group.
Microeconomics
Price Discrimination
How profits are affected and maximised
Compared to normal monopolistic situation output can be increased since profitable demand of price-sensitive consumers can be satisfied.
Each set of consumers has a different demand curve, thus a different MR curve. The firm solves MC = MR for each set of consumers and achieves higher profits than without discrimination.
Key is different elasticity of demand of different consumers, increase prices for consumers with low elasticity and drop it for those with high elasticity.
Microeconomics
Identifying the market structure
N-firm concentration measure
Simply the percentage of the market output generated by the N largest firms in an industry.
Microeconomics
Identifying the market structure
Herfindahl-Hirschman Index (HHI)
The “moderate” range for the index
For the n biggest producers in an industry,
H = M12 + M22 + M32 + … + Mn2
Where Mi2 is the market share of th ith biggest producer. 0.1 to 0.18 is the moderately competitive range (below is competitive, above is uncompetitive).
If all firms have an equal share H = 1/n. So if H=0.28, the structure is equivalent to 1/0.28 = 3.57 equal size firms.
Macroeconomics
GDP
5 properties:
- Market Value of
- Domestically produced (inc. by foreigners)
- Final goods and services
- During a specific time period
Macroeconomics
GDP Inclusions
Government production?
Household production?
Underground economy?
Government and household production is estimated and included in GDP.
The underground economy can be substantial but is excluded.
Macroeconomics
GDP Deflator
A price index (like CPI) for goods and services which are included in GDP. Base of 100 (currently in 1992).
Broader than CPI, also includes capital goods, and goods purchased by government and businesses.
Macroeconomics
GDP measurement
Expenditure Approach
Sum of the following items, C+I+G+(X-M)
- C: Consumption (personal) expenditure
- I: Investments expenditure (private) - expenditure on inventories and capital goods by private sector which will result in future productive capacity
- G: Government (public) consumption and gross investment
- X-M: Net exports (exports less imports)
Macroeconomics
GDP Calculation
Income approach
Sum of income payments to resource suppliers and other costs of producing goods.
Largest component is employment costs, others are rent, self-employment income, profits and interest.
Macroeconomics
GDP Components
Consumption (function of what?)
Marginal Propensity to Consume (MPC)
Consumption (C) refers to personal consumption, and is a function of disposable income. Therefore increases as income (Y) increases and/or taxes decrease.
MPC = 1 - MPS (marginal propensity to save) is the % of additional disosable income that goes into consumption (as opposed to savings).
Macroeconomics
GDP Expenditure
Personal consmption function of?
Investments spending function of?
Government spending function of?
Net exports function of?
C: Function of income (Y) and MPC
I: Function of interest rates (i) and income/output level
G: Government deficit (G-T) depends on income (Y)
X-M: Depends on relative income and prices between countries
Macroeconomics
IS Curve
Formula
S = I + (G - T) + (X - M)
S is personal savings
I is total investment
(G-T) is the government deficit
(X-M) is net exports
Put another way, 3 uses of savings are private investment, funding the government deficit and improving the trade deficit.
Macroeconomics
IS Curve
What is the relationship between interest rates and income?
Effect on IS curve of change in government purchases
The IS curve describes points at which the market for goods and services clears.
High interest rates discourage investment (stick money in gilts instead) therefore reduce income.
A non-IR shift such as change in government expenditure shifts the IS curve, a change in interest rates results in a movement up or down the IS curve.
Macroeconomics
LM Curve
What is it, explain the relationship
Describes combinations of interest rates and income at which money demand and money supply clear.
As income (Y) increases demand for money increases (since people are richer) however money supply is constant. In order to clear supply and demand rates must rise to reduce demand for money (since money pays no interest).
Macroecnomics
Quantity Theory of Money
Formula
MV = PY
Where M is amount of money in the economy and V is the velocity of money.
P is price level and Y is income (volume of transactions).
Transaction produces the LM curve, balance of money supply and money demand.
Macroeconomics
Aggregate Demand Curve
How is it produced?
Aggregate demand curve is produced by the combination of the IS curve and the LM curve.
Macroeconomic
Aggregate Demand Curve
Explain the relationship
A fall in price levels has the following effects:
- Increase in wealth of people holding money
- Reduction in the real interest rate
- Domestic goods cheaper than foreign goods
Which all have the effect of increasing the demand for domestic goods and services.
Macroeconomics
Aggregate Supply
Function of which factors
Aggregate quantity of goods and services supplied given by:
Y = F(L, K, T)
Where L = labour, K = capital and T = technological level.
Macroeconomics
Short-term aggregate supply
Chart and explanation
In the short-term some prices are fixed due to longer term agreements (eg rent, wages) therefore an increase in prices leads increases profit margin so producers increase output.
Macroeconomics
Long-run aggregate supply
Chart and explanation
In the long term aggregate supply is vertical, ie amount supplied by the market is unaffected by price level.
Y = F(L, K, T), people adjust behaviour based on price levels, output depends on availability of resources (L,K,T) in the economy.
Macroeconomics
Long-term aggregate supply/demand Equilibrium
Chart
The real level of GDP and price level in an economy are determined by the balancing of aggregate demand and supply charts.
Macroeconomics
Factors which shift aggregate demand
How do changes in these factors increase AD?
(impact on C, I, G or X)
Real wealth, optimism about the future, high capacity utilisation, expanding fiscal policy, money supply, interest rates, FX rate, global economy.
Function of C, I, G and X.
- Increase in real wealth increases C
- Higher optimism increases C and I
- High capacity utilisation increases I
- Higher gov borrowing increases G and increases C due to lower taxes
- Increased money supply increases C
- Lower rates increase C and I
- Falling FX rate increases X
- Global economy growth increases X
Macroeconomics
Factors which shift aggregate supply
Specific short-term AS factors
Short term resource price shift, expectations of future inflation rates, business taxes, FX rates with importers
Short term aggregate supply increased by:
- Reduction in resource prices
- Reduction in expected inflation (high inflation motivates firms to hold on to goods now for sale in the future)
- Lower taxes (or higher subsidies)
- Favourable FX rates against importers
Macroeconomics
Factors which shift aggregate supply
Long term aggregate supply factors
In the long term output is a function of L, K and T.
Therefore an increase in LRAS is caused by increases in availability of resources or an increase in the technological level.
Macroeconomics
GDP Equilibrium
Short-run and long-run equilibrium
How is the level of output at full employment of resources denominated?
In the short term this occurs when short-run aggregate supply (SAS) and aggregate demand coincide. If GDP is below equilibrium firms increase prices and production (and the opposite).
Long-run equilibrium occurs when GDP is equal to the potential GDP, denominated by Yf.
Macroeconomics
Economic Growth and Inflation
Causes of each
Illustration on LAS and AD equilibrium
Economic growth involves LAS shifting to the right, caused by increased availability of resources or technological advancements.
Inflation occurs due to growth in the quantity of money and shows up as a shift right in the AD curve. This is faster than economic growth therefore prices increase.
Macroeconomics
Business Cycle
Below full employment equilibrium
Recessionary Gap
Below full employment equilibrium occurs when real GDP falls below potential GDP due to resources not being fully utilised. The difference between real GDP and potential GDP is the recessionary gap.
SAS and AD are in equilibrium but LAS is not.
Macroeconomics
Business Cycle
Above full employment equilibrim
Inflationary Gap
Above full employment equilibrium occurs where real GDP rises above potential GDP. The GDP difference is the inflationary gap.
SAS and AD are in equilibrium but LAS is not.
Macroeonomics
Inflationary Gap
How this occurs in case of an AD shift
Short term AD increase shifts the AD curve to the right, causing price increases and consequently an increase in short term supply (which is unsustainable in long run) and therefore an increase in output and thus GDP.
Macroeconomics
Stagflation
What is it?
What is the cause?
What do SAS, LAS and AD look like?
A short term supply shock (eg drought) is a cause.
Shifts SAS to the left which increases prices and reduces GDP, this is stagflation.
Macroeconomics
Production Function
Basically same as the function for aggregate supply, Y = F(L, K, T).
However technology can be expressed as a multiple A, so Y = A*F(L, K).
L and K have positive marginal products with diminishing returns, Y scales with A for a given level of inputs L and K.
Macroeconomics
Convergence
This is the process of one economy catching up with another one. Countries with lower levels of capital have a higher marginal product of capital therefore attract investment and therefore grow faster.
Macroeconomics
5 Sources of economic strength/growth
L, HC, K, T, NR
- Labour supply is the quantity of the work force
- Human capital measures quality of the work force
- Physical capital results from savings and investment
- Technology
- Natural resources
Macroeconomics
Measures of sustainable growth
Labour productivity
Calc for potential GDP (based on labour prod)
Calc for potential growth (based on labour prod)
Labor productivity is the amount of real GDP produced by one hour of labour. Growth of this depends on physical capital, human capital and technology.
Potential GDP = Hours worked * labour productivity
Potential growth = LR labour force growth * LR labour productivity growth
Macroeconomics
Business Cycle
Neoclassical & Austrian Schools
Neoclassical & Austrian Schools
- Self-correcting economy
Business cycles are caused by governments trying to increase GDP and employment.
If Y is below YN (natural real GDP) firms cut wages and prices, increase them if Y>YN, and Y heads to YN. Thus no business cycle.
Macroeconomics
Business Cycle
Keynesian School
Keynesian School
- No self correction - changes in output and employment restore equilibrium, not prices
Expectations drive aggregate demand, which is the driving force of the economy.
Wages and prices are sticky (esp. on downside) so SAS is horizontal
Thus a fiscal policy response is required to restore equilibrium.
Macroeconomics
Business Cycle
Monetarist School
Monetarist School
Economy is self-regulating and will operate at full employment if monetary policy keeps pace of money growth steady. Quantity of money is the most significant influence on AD.
Macroeconomics
Business Cycle
New Classical Theory
Government policy is ineffective.
Macroeconomics
Business Cycle
Real business cycle theory
Real business cycle theory
Real shocks to the economy are the cause of business cycles.
- Adverse cost shocks lead to recession as workers spend less time working as it is less profitable
- Favourable cost shocks lead to a boom as it becomes advantageous to increase production
Government policy intervention is not required as it will exacerbate the cyle and delay convergence.
Macroeconomic
Neo-Keynesian School
Neo-Keynesian School
Assumes that prices of goods don’t change on a daily basis as the cost of changing prices outweighs the benefits of changing. Thus markets do not reach equilibrium quickly.
Macroeconomics
Unemployment
Definition of unemployment rate
Split in two types of unemployed
Percentage of the labour force who are unemployed, where labour force excludes children (<16 yrs), students, household workers, retirees and disabled.
Split into long-term unemployed (do not have required skills or live too far from jobs) and frictionally unemployed who are between jobs.
Macroeconomics
Unemployment
Lagging or leading, and why?
Unemployment is a lagging indicator because:
- Data is compiled after the event
- Firms are slow to respond by firing or hiring workers due to the costs involved and time taken
Macroeconomics
Unemployment
What is underemployment?
Underemployment is a measure of labour utilisation in the economy. It considers how well labour is being utilised in terms of skills, experience and availability to work.
Macroeconomics
Price Indices
Lasperyres index
Lasperyres index
Uses the same basket of commodities over time, which gives a meaningful comparison over time but doesn’t reflect changes in buying patterns over time.
Macroeconomics
Price Indices
Paasche index
Paasche index
A price index which uses the current composition of the basket, so changes the composition over time. Makes it more up to date but less comparable.
Tends to understate inflation.
Macroeconomics
Price Indices
Fisher index
Fisher index
Geometric mean of the Lasperyres and Paasche index types.
Macroeconomics
Inflation forces
General cause
Two different types
Inflation is caused not only by raising prices, in the long-run if quantity of money grows faster than GDP inflation will result.
Otherwise main causes are:
- Aggregate demand increase (cost-push inflation)
- Aggregate supply decrease (demand-pull inflation)
Macroeconomics
Inflation
Cost-push inflation
Non-accelerating inflation rate of employment (NAIRU), natural rate of employment (NARU)
Unit labour cost (ULC)
The result of decreased aggregate supply and increased costs of production, costs are passed on when firms are running at full production capacity.
NAIRU/NARU: Rate of employment where wage inflation is stable
ULC: Total compensation per worker divided by output per worker
Macroeconomics
Inflation
Demand-pull inflation and causes
The result of aggregate demand overtaking aggregate supply. This could be the result of acceleration in monetary supply in the long term, or increases in government purchases or weaking FX rates in the short term.
Macroeconomics
Indicators
Types of indicator (advance info or behind)
Diffusion Index and two problems with it
Types of indicator: Leading (eg stock market), lagging or coincident.
The diffusion index measures the breadth of movement in an index by indicating how many components are rising/falling. Tends to be a leading indicator.
However the lead time has been highly variable and several false alarms have occured.
Macroeconomics
Economic Policy
What is monetary policy?
Central bank activities controlling the supply of money in the economy.
Macroeconomics
Economic Policy
What is Fiscal Policy?
The use of government spending, tax and borrowing to achieve economic goals.
Macroeconomics
Economic Policy
Three aims of economic policy
- Maximum employment
- Stable prices
- Moderate long term interest rates
Macroeconomics
Economic Policy
What is a fractional reserve banking system?
Name of the related type of bank reserves
When a bank is forced to hold a certain percentage of reserves to back up its total deposits.
The reserves held to meet this requirement are “required reserves”.
Macroeconomics
Economic Policy
What is the money multiplier?
How does it work?
Inverse of the required reserve rate, this is the multiplier applied to a change in the monetary base to find out the final impact on money supply.
If you put $1k on deposit with Bank 1, they hold 20% (reserve rate example) on reserve and lend out the rest to person B (effectively creating $800 of money and increasing the monetary supply).
Person B puts their $800 on deposit with Bank 2 who hold $160 on deposit and lend out $640. Process goes on until 5*$1000 has been created by the initial $1000.
Macroeconomics
Economic Policy
M1 money supply
M2 money supply
Idea behind each
M1: Cash, checking accounts, travellers cheques
M2: M1 + savings, short term deposits and retail money funds
M1 is based on the idea of money as a medium of exchange, M2 on the idea of money as a medium of exchange and store of value.
Macroeconomics
Economic Policy
Quantity Theory of Money
Formula
Theory
Money Supply (M) * Velocity of Money (V)
=
Price (P) * Real Output (Y)
Quantity Theory of Money therefore states that a change in money supply will cause a proportional change in price level, since V and Y are unaffected by monetary supply.
Velocity of money is the average number of times a dollar is used to purchase final goods or services in a year.
Macroeconomics
Economic Policy
Equilibrium of money supply and demand
What does chart look like?
How is equilibrium reached?
Money supply is unaffected by interest rates as it is set by the central bank. Money demand is inverse to interest rates.
If rates rise, demand for money falls as people seek to invest in bonds instead, pushing up bond prices and pushing interest rates back to equilibrium (and other way around).
Macroeconomics
Economic Policy
Fisher Effect
Rnom = Rreal + Rinflation + risk premium
A nominal interest rate made up of:
- A required rate of return
- Compensation for inflation
- A premium to compensate for uncertainty
Macroeconomics
Economic Policy
Six roles of central banks
- Issue currency
- Set monetary policy
- Governments bank and bank of banks
- Lender of last resort to banking sector
- Regulate payments system
- Regulate banking system
Macroeconomics
Economic Policy
Two types of monetary policy
Expansionary: Acting to increase the supply of money in the economy
Restrictive: Acting to reduce the supply of money in the economy
Macroeconomics
Economic Policy
Three means of achieving monetary policy
- Open Market operations
- Central bank policy interest rate
- Reserve requirements
Macroeconomics
Economic Policy
Monetary policy: Open market operations
How does it work?
This involves trading in open market securities by the central bank. For example buying government securities from commercial banks will increase the money supply.
Macroeconomics
Economic Policy
Monetary policy: Central bank policy rate
How does it work?
Names of relevant rates (inc. US names)
Commercial banks may need to borrow funds from the central bank overnight in order to meet reserve requirements, this is done at the repo rate (discount rate in US).
Increasing this rate discourages banks from cutting reserves tight and decreases monetary supply (restrictive).
In the US most such borrowing is done in the federal funds market (at the fed funds rate) between banks, but rate is obviously closely linked to the discount rate.
Macroeconomics
Economic Policy
Monetary Policy: Setting reserve requirements
How does it work?
Increasing the reserve rate will decrease the amount banks can invest in interest earning assets and thus decrease money supply. This option is rarely used however since it is disruptive and can have a big impact on money supply.
Macroeconomics
Economic Policy
Effect of official interest rate decrease on:
Other short term rates, long term rates. FX rate. Money supply, money demand. Consumer expenditure, investment and net exports. Real GDP & inflation.
If interest rates are decreased:
- Short term IRs fall as they are closely linked, as do long term rates
- FX rate falls due to IR differential
- Money demand increases as bond returns fall and money supply increases as bonds become less attractive relative to deposits
- Expenditure and investment increase due to low cost of money, net exports increase due to FX
- Real GDP and inflation therefore rise.
Macroeconomics
Economic Policy
Key qualities of central banks
ICrT
- Independence: Two types, goal independence and instrument independence. Mostly they get given goals by government, but have independence to achieve it their own way.
- Credibility
- Transparency
Macroeconomics
Economic Policy
Expansionary and contractionary policy
Neutral rate of interest
- Expansionary: Decrease interest rates in order to increase the money supply.
- Contractionary: Increase interest rates in order to decrease the money supply.
The neutral rate of interest is the rate that encourages growth at its long term trend rate, the theoretical target of the central bank.
Neutral rate = Trend Growth + Inflation Target
Macroeconomics
Economic Policy
Define demand and supply shocks
Monetary policy responses
These are shocks that cause inflation to spike upwards.
Demand shocks caused by an unexpected increase in demand is responded to with contractionary monetary policy.
Supply shocks however (such as oil prices rising due to supply shortages) may be made worse by contractionary monetary policy.
Macroeconomics
Economic Policy
2 limitations of central banks in controlling money supply
- They can’t control the amount of money that households and corporations put on deposit with banks
- They can’t control the amount of credit extended by banks
Macroeconomics
Economic Policy
Quantitative Easing
Risks
This is the purchase by the central bank of financial assets in order to inject money into the economy.
Seperate to the more general use of buying and selling government bonds to meet target interest rate.
Can be over effective and cause hyper-inflation or under effective if banks hold the money instead of lending it.
Macroeconomics
Economic Policy
Crowding-out effect
This is when budget deficits funded via borrowing in capital markets, lead to higher interest rates, which results in a reduction in private investment.
This could outweight the positive impact on aggregate demand of increased government spending.
Macroeconomics
Economic Policy
Expenditure Multiplier
Expenditure multiplier is the ratio of the change in equilbrium output brought about by an independent change in one of investment, consumption, government spending or net exports.
Macroeconomics
Economic Policy
Government Purchases Multiplier
The magnification effect of a change in the expenditure llevel of the government on aggregate demand. This comes about because government expenditure is a component of aggregate demand and also has the effect of increasing consumption.
Macroeconomics
Economic Policy
Tax multiplier
The tax multiplier is the magnification effect of a change in taxes on aggregate demand. Higher taxes reduce personal income and therefore personal consumption. Thus aggregate demand and GDP fall.
Macroeconomics
Economic Policy
Fiscal Multiplier
The government purchases and tax multiplier together create the fiscal multiplier:
1 / (1 - c (1 - t))
Where c is the MPC (marginal propencity to consume) and t is the tax rate.
This is the ratio by which output increases as a result of an increase in government spending. Note that if tax is 100% or MPC is zero then this is 1. Higher MPC and lower tax magnifies the effect.
Macroeconomics
Economic Policy
Balanced Budget Multiplier
The effect of a simultaneous increase in taxes and increase in goverment expenditure on output.
A $1 increase in government expenditure increases aggregate demand by at least $1, whilst a $1 increase in taxes reduces consumption by less than $1. Therefore the net effect is increased output.
Macroeconomics
Economic Policy
Structural Surplus/Deficit
This is the theoretical surplus or deficit which would occur if the economy were at full employment and GDP were equal to potential GDP.
Macroeconomics
Economic Policy
Term for non-automatic economic policies?
Automatic stabiliser example and method
Economic policy is either automatic (responds automatically to economic conditions) or discretionary.
Income taxes and transfer payments (welfare) are examples of automatic stabilisers. In a downturn people earn less income, therefore pay less tax and claim higher benefits. This leads to a budget deficit which is expansionary.
Macroeconomics
Economic Policy
3 time lags in discretionary policy
- Recognition Lag - Time between when policy action is required and when policy makers realise it is required.
- Action Lag - Time taken for policy makers to come up with a response and put it into action.
- Impact Lag - The time taken for the action taken to have an impact on economic output.
International Economics
GNP
Difference between GDP and GNP
GDP is the total market value of all domestically produced final goods and services.
GNP however is the MV of final goods and services produced by a countries citizens, whether at home or abroad.
International Economics
International Trade
5 Benefits, 2 Costs
Benefits
- Results in lower prices and higher domestic consumption of foreign goods, higher prices and lower domestic consumption of domestic goods
- Residents of each nation to concentrate on their specialisms
- Greater product variety
- Economies of scale
- Efficient allocation of resources
Costs
- May lead to loss of jobs in developed countries
- Greater income inequality
International Economics
International Trade
Definition: Comparative Advantage
(relative to absolute advantage)
This is the ability of one country to produce a certain good at a lower opportunity cost than other countries can produce it. It leads to an expansion of total output if countries specialise based on their comparative advantage.
Note that even if there is no absolute advantage (country A can make either 1 fish or 1/2 a loaf compared to 2 fish or 3 loaves in country B), there can still be comparative advantage.
In this situation they can specialise in producing fish to enable country B to specialise in loaves. They can exchange fish for loaves at 1:1 ratio and both countries will have more production.
Interntional Economics
International Trade
Models of comparative advantage (3)
- Adam Smith - law of absolute advantage, each country produces goods it can produce most of for same level of resources/time
- Ricardian Model - Labour is the only production factor, advantages based on technological abilities
- Heckscher-Olin Model - Resource availability is the only production factor, advantages based on factors of production available
International Economics
Trade Restrictions
Effect of trade restrictions by small countries and large countries
Small countries can’t affect the price of internationally traded goods, therefore always lead to net welfare losses due to distortion of production and consumption, and inefficient allocation of resources.
Large countries decisions do affect prices of goods, therefore trade barriers can generate a welfare gain within a country, although the net global welfare impact will be negative.
International Trade
Trade Restrictions
Tariffs - Chart and effect
Normal international price is Pw, with domestic supply at Qd1 and imports of Q1 - Qd1.
Tariff of amount t increases price to Pw+t, with T the additional tax revenue of the government, S the additional revenue of domestic producers and U and V being a deadweight loss of economic efficiency.
International Trade
Trade Restrictions
Quotas: Chart, effect
Import quota set at Q2-Qd2 below the natural level of Q1-Qd1.
S is the additional revenue received by domestic producers. T is additional revenue achieved by the selected importers within the quota. This encourages rent-seeking behaviour by foreign producers (ie lobbying to get permission to supply).
International Trade
Trade Restrictions
Voluntary Export Restraint (VER)
A VER is when a country agrees with another to restrict its exports of a certain product. The effect is very similar to a quota, however it is imposed by the exporting country rather than the importing country.
International Trade
Trade Restrictions
Export Subsidies - definition and effect
An export subsidy encourages exports of goods and discourages domestic sales. It costs the government instead of generating revenue and increases the amount traded (unlike other trade barriers).
The distortion creates a welfare loss for the country, more so for larger countries because increased exports push down international prices of its specialist good and damage the countries terms of trade.
International Trade
Regional Trading Blocs
Free Trade Area
Customs Union
Common Market
Economic Union
Monetary Union
Free Trade Area - No internal trade restrictions, each country sets its own external terms.
Customs Union - External trade terms set together.
Common Market - Also free movement of factors of production within the area.
Economic Union - Also common economic policies
Monetary Union - Common currency
International Trade
Capital Restrictions
Benefits and Costs of cross-border capital flows
Advantages of controls
Types of capital controls
Benefits include greater domestic competition and allowing residents of different countries to capitalise on differences by borrowing and lending internationally.
Costs are complicating economic policy or being a source of economic instability.
Restrictions can maintain the balance of payments, control FX rates, preserve savings for domestic use and protect local industry.
Include prevention of foreign investment, tax on income earned by foreigners and caps on capital flow sizes.
International Trade
Balance of Payments
Description and 3 accounts
Accounting entries for foreign transactions in a countries currency, debits (outflow of your currency) and credits (inflow).
Current Account - From trade in goods and services
Capital Account - International capital (non-financial) such as investment
Financial Account - Financial asset movements (bonds, stocks, foreign reserves. Often included within capital account.
International Trade
Balance of Payments
Consequence
The consequence is that all foreign transactions in a countries currency must balance. So if a US citizen buys foreign goods for $100 (debit current account), the $100 may be deposited in a US bank accounts (credit capital account).
Or it could be exchanged for Rupees with an Indian bank who can then lend it to a customer to buy US goods (credit current account) or purchase US government bonds (credit financial account).
A current account deficit in a country means it is a net importer, spending more than it is producing, thus investing more than it is saving.
International Trade
Trade Organisations
IMF
World Bank
WTO
IMF - Mission is to ensure stability of the international monetary system, they keep country specific market risk and global systematic risk under control.
World Bank - Helps developing countries fight poverty and enhance environmentally sound economic growth.
WTO - Regulates global cross border trade. Creates international trading rules and fosters free trade.
FX
Quoting conventions
Direct Quotation
Indirect Quotation
FX rates quotes as: Price Currency / Base Currency
In direct quotation the local currency is the price currency. So in the US they say €:$ = 1.25 meaning €1 costs $1.25. Notation €:$ = $ per € (FC:DC = DC/FC)
Indirect quotation is used in some markets like UK, £:$ = 1.65. Notation £:$ = $ per £ (DC:FC = FC/DC)
To summarise, direct quotation tells you how much the foreign currency costs, indirect tells you what the domestic currency is worth.
FX
Bid-Ask Spread
In percentage terms quoted as percentage of bid or ask?
Quoted as a percentage of the ask
BO Spread % = (Ask - Bid) / Ask
FX
Forward Quoting Convention
If forward rate > spot rate then
Base currency is at a premium/discount
Price currency is at a premium/discount
If forward rate > spot rate then
Base currency is at a premium
Price currency is at a discount
FX
FX Regimes
3 properties of an ideal FX regime
Problem
- Credibly fixed FX rate against all currencies
- All currencies fully convertible
- All countries have fully independent monetary policy
However these 3 aims are not consistent and FX rates can only be fixed by restricting ability to convert or sacrificing monetary policy independence.
FX
FX Regimes
Flexible FX rate regime - downside
Fixed FX rate regime (how is it achieved)
In a flexible FX regime the market is allowed to set FX rates based on supply and demand. The FX rate reflects economic conditions at the time, but it can be very volatile.
Fixed FX rates are achieved by fixing your rate to somebody else and accepting their monetary policy as your own.
FX
FX Regimes
2 No Seperate Legal Tender systems
- Dollarisation: Use the dollar as your currency
- Monetary Union: eg Euro
FX
FX Regimes
Currency Board System
The monetary authority is required to maintain a fixed FX rate with a foreign currency.
It must maintain sufficient foreign reserves for all holders of its domestic currency to convert to the foreign currency (so only issues new currency when it gains extra reserves).
Gain currency stability but lose monetary policy control.
FX
FX Regimes
Fixed Parity (aka)
Fixed Parity is also known as Pegged Rates.
The country tries to keep its FX rate at a certain level but has no legal obligation to do so (unlike currency board system).
FX
Balance of Payments
What is the effect of FX depreciation on balance of payments?
How does it behave in reality over time?
In the long run depreciating currency makes imports more expensive and exports more attractive so your countries current account deficit improves.
In the short term imports and exports are unaffected though, and the price effect leads to a deterioration in the balance of payments initially - leading to the J curve.
FX
Balance of Payments
Marshall-Lerner condition
What does it relate to and what is the condition?
Regarding the effect of depreciation of your currency on the balance of payments.
This states that for depreciation to improve the balance of payments, the sum of demand elasticity of imports and demand elasticity of exports needs to be greater than unity.
FX
Balance of Payments
Absorption Approach
- Main assumption
- Definition of absorption
- Supply side requirement for effective depreciation
- Demand side requirement
The main assumption is that prices remain constant and changes in real domestic income are emphasized, making this a real-income theory of the balance of payments.
Absorption is the total goods and services taken off the market, equal to consumption plus investment.
Supply side requires idle resources for effective depreciation.
Demand side requires the Marshall-Lerner condition.
If a country has high inflation, does it currency trade at a premium or discount in forward market?
High inflation means your currency trades at a discount in forward market
Total Factor Productivity
This is A in the equation:
Y= A * F(L,K)
for GDP output
Are business cycles considered in the short run or the long run?
Only the short run since it evens out in the long run, but in the short run where you are in the cycle is important.
Budget Deficit and Trade Deficit link
Positively correlated.
Budget deficit leads to high interest rates (crowding out effect) thus foreign capital inflows.
Then your currency appreciates and exports become less competitive.
Hence trade deficit worsens also.
Disinflation
A fall in the rate of inflation (inflation may still be positive)
Micro
What is the difference between “demand” and “quantity demanded”?
Quantity demanded refers to the point on the demand curve. So a change in quantity demanded is the result of a price change and a movement along the demand curve.
Demand refers to the quantity demanded at a range of price points however, i.e. a change in some feature other than price (such as popularity of the product) resulting in a shift in the demand curve itself.
+ve or -ve?
Elasticity of demand for normal product
Cross elasticity of demand for substitute
Cross elasticity of demand for complement
normal product: -ve
cross for substitute: +ve
cross for complement: -ve
If a consumer or the market spends the same dollar amount on a product regardless of the price, what is the elasticity of demand?
1
Because although the dollar value doesn’t change, the quantity purchased changes by the inverse of the price change.
Price Discrimination
If one customer has a demand curve slope of 2.0 and another has a demand curve slope of 0.1, whose price do you increase and whose do you decrease?
Decrease the price of customers with a low slope (0.1) which equates to a high elasticity of demand. A small price fall for them increases demand a lot.
Increase the price of cusotmers with a steep slope (2.0) which equates to a lower elasticity of demand. The price change for them has a smaller effect on demand.
Remember that a horiztonal demand curve means an incredibly small reduction in prices can lead to an infinite increase in demand.
2 causes of recession
- Supply shock
- Unanticipated reduction in aggregate demand
Expansionary/Restrictionary Policy
Is it based on absolute level of deficit or deficit as a percentage of gdp?
Based on the annual deficit/surplus as a percentage of gdp.
