Economics Flashcards
Own Price Elasticity
Measure of the responsiveness of the quantity demanded to change in a price. Negative if an increase in price decreases quantity demanded
Elastic
When quantity demanded is very responsive to a change in price (absolute value of elasticity > 1)
Inelastic
When quantity demanded is not very responsive to change in price (absolute value of elasticity < 1)
Perfectly Elastic
At any higher price, quantity demanded decreases to zero. Elasticity = infinity (horizontal line). When one or more goods are very good substitutes
Perfectly Inelastic
A change in price has no effect on quantity demanded. Elasticity = 0 (vertical line). Few or no good substitutes for a good
Portion of Income
The larger the proportion of income spent on a good, the more elastic an individual’s demand for that good
Time
Elasticity of demand tends to be greater the longer the time period since the price change
Inelastic Range
Lower part of the demand curve, where percentage change in quantity demanded is smaller than the percentage change in price. Total revenue will increase when price increases (percentage decrease in quantity demanded will be less than the percentage increase in price)
Elastic Range
Upper part of the demand curve, where percentage change in quantity demanded is greater than the percentage change in price. Total revenue will decrease when price increases (percentage decrease in quantity demanded will be greater than the percentage increase in price)
Unitary Elasticity
A 1% increase in price leads to a 1% decrease in quantity demanded (-1 elasticity). Point of greatest total revenue. Price increase moves into elastic region, price decrease moves into inelastic region
Income Elasticity
The sensitivity of quantity demanded to a change in income. Ratio of the percentage change in quantity demanded to the percentage change in income
Normal Goods
The sign of income elasticity is positive (an increase in income leads to an increase in quantity of goods demanded) –> positive income effect
Inferior Goods
Sign of income elasticity is negative (an increase in income leads to a decrease in quantity demanded) –> negative income effect
Cross Price Elasticity
The ratio of the percentage change in the quantity demanded of a good to the percentage change in the price of a related good
Substitutes
When an increase in the price of a related good increases the demand for a good (an increase in the price of one will lead consumers to purchase more of the other) –> cross price elasticity is positive (price of one is up, quantity of the other is up)
Complements
When an increase in price of a related good decreases demand for a good (an increase in the price of one leads consumers to purchase less of the other as well) –> cross price elasticity is negative
Substitution Effect
Always acts to increase the consumption of a good that has fallen in price
Income Effect
Can either increase or decrease consumption of a good that has fallen in price (total expenditure on the original bundle of goods falls as result of substitution effect)
Giffen Good
Inferior good for which the negative income effect outweighs the positive substitution effect when price falls (demand rises when price rises, and demand falls when price falls) –> bread, rice, wheat (few substitutes, substantial portion of buyer’s income)
Veblen Good
A higher price makes the good more desirable. Consumer gets utility from being seen to consume a good that has high status (luxury goods). This is not an inferior good. Both substitution and income effects of price increase decrease consumption
Factors of Production
Resources a firm uses to generate output
Land: where facilities are located
Labor: all workers (unskilled to management)
Capital: manufacturing facilities, equipment, machinery
Materials: raw materials and manufactured inputs
Production Function
Quantity of output that a firm can produce as a function of the amounts of capital and labor employed
Diminishing Marginal Productivity
The quantity of labor for which the additional output for each additional worker begins to decline (diminishing marginal returns)
Short Run
The time period over which some factors of production are fixed (capital) –> If total revenue is greater than total variable cost, and price is greater than average variable costs, firm can stay open in the short run. If average revenue is less than average variable costs, shut down
Long Run
All factors of production are variable (leases can expire, sell equipment) –> firm can avoid short run fixed costs by shutting down. If price is below average minimum total cost, shut down
Perfect Competition
Many firms produce identical products, and competition forces them all to sell at the market price. price = marginal revenue = average revenue (price taker). Perfectly elastic demand curves
Barriers to Entry: very low
Substitutes: very good
Nature of Competition: price only
Pricing Power: none (supply and demand determine)
Short Run Shutdown Point
If average revenue is less than average variable cost in the short run, shut down. If average revenue is greater than average variable cost, can still operate even with losses
Long Run Shutdown Point
Firm should shut down if average revenue is less than average total cost
Breakeven Point
Average revenue is equal to average total cost (total revenue = total cost)
Price Searcher Firms
Downward sloping demand curve, marginal revenue does not equal price (imperfect competition)
Long Run Average Total Cost Curve
Drawn for many different plant sizes or scales of operation. Each point along the curve represents minimum ATC for a given plant size or scale of operations
Minimum Efficient Scale
Average total costs first decrease (economies of scale) with larger scale and eventually increase (diseconomies of scale). Lowest point is scale or plant size where average total cost of production is at a minimum
Monopoly
Only one firm is producing a product with no close substitutes. Chooses the price at which it sells. Patents, copyrights, control resources (supported by the government) Barriers to Entry: very high Substitutes: none Nature of Competition: advertising Pricing Power: significant
Monopolistic Competition
Many independent sellers and differentiated products (products not identical). Downward sloping demand curve.
Barriers to Entry: low
Substitutes: good but differentiated
Nature of Competition: price, marketing, quality
Pricing Power: some (each firm has relatively small market share, no one can control the price). Too many firms for collusion –> price searchers
Maximize Profit: MR = MC (that’s where you find Q and also P on demand curve)
Oligopoly
Few firms that compete in a variety of ways (interdependent). Very large firms respond to actions of the others
Barriers to Entry: high
Substitutes: very good or differentiated
Nature of Competition: price, marketing features, quality
Pricing Power: some to significant
Natural Monopoly
Single firm supplies entire market demand for product. The average cost of production is falling over the relevant range of consumer demand. Having two or more producers would result in significantly higher cost of production and be detrimental to consumers
Network Effects
Synergies. Make it very difficult to compete with a company once it has reached a critical level of market penetration (has a moat). Changes in technology and consumer taste threaten
Marginal Revenue
Increase in total revenue from selling one more unit of a good or service. Maximize profit by selling quantity for which MR = marginal cost
Shutdown Point
If the firm is only just covering its variable costs (P = AVC)
Long Run Equilibrium Output
MR = MC = ATC for perfectly competitive firms (where ATC is minimized)
Short Run Supply Curve
MC line above the AVC curve
Short Run Market Supply Curve
Horizontal sum (add up quantities of all firms at each price) of the MC curves for all firms in a given industry (upward sloping to the right)
Markup
In monopolistic competition, P > MC (price slightly higher than perfect competition)
Excess Capacity
ATC is not at a minimum for quantity produced, suggesting inefficient scale of production
Product Innovation
Firms that bring new and innovative products to the market are confronted with less-elastic demand curves, enabling them to increase price. Optimal amount of innovation is when MC addtl. innov = MR addtl. innov
Kinked Demand Curve
An increase in a firm’s product price will not be followed by its competitors, but a decrease in price will (more elastic, flatter, above a given price than below). Gap in MR curve (MC passes through)
Cournot Model
Model considers a duopoly, where both firms have identical and constant marginal costs of production. Each firm knows the quantity supplied by the other firm in the previous period and assumes that this is what it will supply in the next period. Subtract Q from linear market demand curve to construct own demand and MR curve to determine profit maximizing Q. Quantities will change each period until they are equal
Nash Equilibrium
Reached when the choices of all firms are such that there is no other choice that makes any firm better off (increases profits or decreases losses)
Prisoner’s Dilemma
Prisoner A confesses, B remains silent: A freed, B 10 yrs
Prisoner B confesses, A remains silent: B freed, A 10 yrs
Both silent: 6 months each
Both confess: 2 years each
Equilibrium is that both confess
Collusion
Nash equilibrium is to undercut the agreement to have two firms raise prices (going lower). Collusive agreements more successful when there are fewer firms, products more similar, cost structures more similar, purchases small and frequent, retaliation for cheating certain and severe, less competition from outside firms to the cartel
Dominant Firm Model
Single firm that has a significantly large market share because of its greater scale and lower cost structure. Market price determined by this firm, other firms take this price as a given
Price Discrimination
If a monopoly’s customers cannot resell the product to each other for a lower price, maximize profits by charging different prices to different customers for same product or service
Deadweight Loss
Quantity produced by a monopolist reduces the sum of consumer and producer surplus by an amount represented by empty triangles under demand curve. Monopoly is inefficient compared to perfect competition because of this reduction, but price discrimination reduces this inefficiency
Rent Seeking
When producers spend time and resources to try to establish a monopoly
Average Cost Pricing
Forces monopolist to reduce price to where ATC intersects the market demand curve. Increases output and decreases price, increases social welfare, normal profit (price = ATC)
Marginal Cost Pricing
Forces monopolist to reduce price to the point where firm’s MC curve intersects the market demand curve. Increases output and reduces price, but causes monopolist to incur a loss because price is below ATC (requires a government subsidy)
N-firm Concentration Ratio
The sum or the percentage market shares of the largest N firms in a market (relatively insensitive to mergers of two firms with large market shares)
Herfindahl-Hirschman Index (HHI)
Sum of the squares of of the market shares of the largest firms in the market
GDP
Total market value of the goods and services produced in a country within a certain time period (size of the nation’s economy). Includes only purchases of newly produced goods and services
Final Goods
Goods and services that will not be resold or used in the production of other goods and services (input goods’ value included in final prices)
Expenditure Approach
GDP calculated by summing the amounts spent on goods and services produced during the period --> value of final output method -Consumption -Investment -Government Spending -Exports/Imports (Net Exports) C + I + G + (X - M)
Income Approach
GDP calculated by summing the amounts earned by households and companies during the period (wage income, interest income, business profits) –> sum of value added method
National Income + Capital Consumption Allowance + Statistical Discrepancy
Nominal GDP
GDP as described under the expenditures approach (inflation will increase nominal GDP)
Real GDP
Measures the output of the economy using the prices from a base year, removing the effect of changes in prices so that inflation is not counted as economic growth
GDP Deflator
Price index that can be used to convert nominal GDP into real GDP, taking out the effects of changes in the overall price level. Based on the current mix of goods and services, using prices at the beginning and end of the period
Per Capita Real GDP
Real GDP divided by population (measure of economic well-being of a country’s residents)
Capital Consumption Allowance
Measures the depreciation of physical capital from the production of goods and services over a period. The amount that would have to be reinvested to maintain the productivity of physical capital from one period to the next
Statistical Discrepancy
Adjustment for the difference between GDP measured under the income approach and the expenditure approach
National Income
Sum of the income received by all factors of production that go into the creation of final output
+Compensation of employees (wages and benefits)
+Corp and govt. profits before taxes
+Interest Income
+Unincorporated business net income
+Rent
+Indirect business taxes - subsidies
Personal Income
Measure of the pretax income received by households and is one determinant of consumer purchasing power and consumption (includes all income that households receive) \+National Income \+Transfer Payments to households -Indirect Business Taxes -Corporate Income Taxes -Undistributed Corporate Profits
Personal Disposable Income
Personal income after taxes. Measures the amount that households have available to either save or spend on goods and services
Total Income
+Consumption Spending
+Household and Business Savings
+Net Taxes (Taxes - Transfer payments received)
Fiscal Balance
Difference between government spending and tax receipts (G - T)
- Negative value is budget surplus, positive value is budget deficit
- Government deficit is financed by trade deficit or excess of private saving over private investments
Trade Balance
Net exports (X -M) -Positive value is trade surplus, negative value is trade deficit
Consumption
Function of disposable income. Increase in personal income or decrease in taxes increase consumption and saving
- Marginal Propensity to Consume: portion of additional income spent on consumption
- Marginal Propensity to Save: proportion saved (MPC + MPS = 100%)
Investment
Function of expected profitability and the cost of financing (depends on the overall level of economic output)
Government Purchases
Tax revenue to the government, therefore fiscal balance
Net Exports
Function of domestic disposable incomes (imports), foreign disposable incomes (exports), relative prices of goods in foreign and domestic markets
IS Curve
Income-savings. Negative relationship between real interest rates and real income for equilibrium in the goods market. Points on the curve are combinations of real interest rates and income consistent with equilibrium in goods market
LM Curve
Liquidity-money. Positive relationship between real interest rates and income consistent with equilibrium in the money market (increase in money supply shifts curve downward)
Real Money Supply
M/P constant. Increase in real interest rates must be accompanied by an increase in income for equilibrium.
- M is nominal money supply
- P is price level
Aggregate Demand Curve
Relationship between the quantity of real output demanded (real income) and price level. Slopes down because higher price levels reduce wealth, increase real rates, and make domestic goods more expensive
Aggregate Supply Curve
Relationship between price level and the quantity of real GDP supplied when all other factors are kept constant (amount of output firms will produce at different price levels)
Very Short Run Aggregate Supply Curve (VSRAS)
Firms will adjust output without changing price by adjusting labor hours and intensity of use of plant and equipment (perfectly elastic curve)
Short Run Aggregate Supply Curve (SRAS)
Slopes upward because some input prices will change as production is increased or decreased. Output prices will change proportionally to price level, some input prices are sticky. Total level of output willing to supply at different price levels
Long Run Aggregate Supply Curve (LRAS)
All input costs can vary. Wages and other inputs change proportionally to the price level, so price level has no long run effect on aggregate supply (Potential GDP or Full Employment GDP) –> perfectly inelastic
Increase in Agg Demand
Increase in aggregate demand (quantity of goods and services demanded is greater at any given price level)
- Increase in Consumer Wealth (C increases)
- Business Expectations (I increases)
- Consumer expectations of future income (C increases)
- High capacity utilization (I increases)
- Expansionary monetary policy (C and I increase)
- Expansionary fiscal policy (C and G could increase with tax cut or spending increase)
- Exchange Rates (net X increases)
Shifts in Short Run Agg Supply Curve
Quantity supplied at each price level increases.
- Labor Productivity: output per hour worked (decreases unit costs to producers, increases output)
- Input Prices: decrease in wages or prices of other inputs increases production
- Expectations of future output prices
- Taxes and govt. subsidies: decrease in taxes, increase subsidies decrease cost of production and increase output
- Exchange Rates: appreciation in currency decreases cost of imports (reduces production costs for inputs)
Shifts in Long Run Agg Supply Curve
Affect the real output that an economy can produce at full employment.
- Increase in supply and quality of labor
- Increase in supply of natural resources
- Increase in stock of physical capital
- Technology
Recessionary Gap
Decrease in aggregate demand results in lower real output and lower price level. Real GDP is less than full employment potential (period of declining GDP and risking unemployment)
Fiscal Policy
Increasing (expansionary) government spending or decreasing taxes –> stabilize aggregate demand
Monetary Policy
Central bank’s actions that affect the quantity of money and credit in an economy in order to influence economic activity
Inflationary Gap
Increase in aggregate demand from its previous level causes upward pressure on the price level. Competition among producers for workers, raw materials and energy shifts curve back to full-employment GDP (higher price)
Stagflation
Declining economic output and higher prices (stagnant economy with inflation) –> decrease in SRAS (shift left) caused by increase in prices of input (lower GDP, higher price). Subsequent decrease in input prices will increase demand returns to full employment at higher price
AD and AS Increase Same Time
Real GDP increases, but price level depends on magnitude of changes (price effects in opposite directions)
AD and AS Decrease Same Time
Real GDP decreases, effect on price level depends on magnitude of changes (price moves in opposite directions)
AD Increases, AS Decreases Same Time
Price level increases, effect on real GDP depends on relative magnitudes
AD Decreases, AS Increases Same Time
Price level decreases, effect on real GDP depends on relative magnitudes
Economic Growth
Labor supply, human capital, physical capital stock, technology, natural resources
Labor Supply
Number of people over the age of 16 who are either working or available for work but currently unemployed. Affected by population growth, net immigration
Human Capital
Education and skill level of a country’s labor force
Physical Capital Stock
High rate of investment (increases labor productivity and potential GDP)
Technology
Improvements in technology increase productivity and potential GDP
Natural Resources
Raw materials. May be renewable (forests) or non-renewable (coal). Countries with large amounts can achieve greater rates of economic growth
Sustainable Rate of Economic Growth
Growth in potential GDP (growth in labor force and growth in labor productivity). Rate of increase in economy’s productive capacity
Production Function
Describes the relationship of output to the size of the labor force, capital stock and productivity. Function of the amounts of labor and capital that are available and their productivity, which depends on level of technology
Total Factor Productivity
Quantifies the amount of output growth that is not explained by increases in the size of labor force and capital (inferred)
Capital Deepening Investment
Increasing physical capital per worker over time (will not sustain long term growth)
Solow (Neoclassical) Model
Contributions of capital, labor and technology to economic growth
Business Cycle
Fluctuations in economic activity. Real GDP and rate of unemployment are variables (do not occur at regular intervals)
Expansion
Real GDP increases. Growth in most sectors, increasing employment, consumer spending and business spending. Two consecutive quarters of real GDP growth
Peak
Real GDP stops increasing, starts decreasing. Rates of increase in spending, investment and employment slow but remain positive, while inflation accelerates (before decrease)
Contraction/Recession
Real GDP decreases. Declines in most sectors, inflation decreasing. Two consecutive quarters of declining real GDP
Trough
Real GDP stops decreasing, starts increasing. The economy then begins a new expansion (recovery), and economic growth becomes positive again, inflation is moderate, employment growth doesn’t increase until later
Inventory-Sales Ratio
When an expansion is reaching its peak, sales growth begins to slow and unsold inventories accumulate. This ratio will increase. When reaching its trough, inventories will become depleted more quickly and sales growth accelerates (ratio decreases)
Mortgage Rates
Low interest rates increase home buying and construction, high rates reduce
Housing Costs Relative to Income
When incomes are cyclically high relative to home costs (mortgage financing costs), home buying and construction tend to increase. When home prices are rising faster than incomes, housing activity can decrease (late cycle)
Speculative Activity
Rising home prices can lead purchases based on expectations of further gains. Higher prices lead to more construction and excess building, resulting in falling prices and decreased housing activity
Demographic Factors
Proportion of population in 25 - 40 segment is positively related to activity in the housing sector
Neoclassical School
Shifts in both aggregate demand and aggregate supply are primarily driven by changes in technology over time. Economy has a strong tendency toward full employment equilibrium. Business cycles result from temporary deviations from long run equilibrium
Keynesian School
Shifts in aggregate demand due to changes in expectations primary cause of business cycles. Fluctuations due to swings in the level of optimism of those who run businesses (overinvest and overproduce when too optimistic). Wages are downward sticky (decrease in wages unable to increase short-run aggregate supply and move from recession back to full employment). Increase aggregate demand through monetary policy or fiscal policy
New Keynesian School
Prices of productive inputs rather than labor are also downward sticky
Monetarist School
Variations in aggregate demand that cause business cycles are due to variations in the rate of growth of the money supply, likely from inappropriate decisions by monetary authorities. Recessions caused by external shocks or inappropriate decreases in money supply. Central bank follow policy of steady and predictable increases in money supply
Austrian School
Business cycles caused by government intervention in the economy. Policymakers forcing interest rates down to artificially low levels, firms invest too much capital in the long term compared to actual consumer demand
New Classical School
Real Business Cycle theory. Emphasizes effect of real economic variables such as changes in technology and external shocks, as opposed to monetary variables, as the cause of business cycles. Policymakers should not try to counteract business cycles because expansions and contractions are efficient market responses to real external shocks (individuals and firms maximize expected utility)
Frictional Unemployment
Time lag necessary to match employees who seek work with employers needing their skills
Structural Unemployment
Long run changes in the economy that eliminate some jobs while generating others for which unemployed workers are not qualified
Cyclical Unemployment
Changes in the general level of economic activity. Positive when economy is operating at less than full capacity, negative when expansion leads to employment temporarily over full employment
Underemployed
Employed part time but would prefer to work full time or is employed at a low paying job despite being qualified for a significantly higher paying one
Participation Ratio
Percentage of working age population who are wither employed or actively seeing employment. Increases when economy expands
Discouraged Workers
Those who are available for work but are neither employed nor actively seeking employment
Unemployed
A person who is not working but is actively seeking work. Discouraged workers become unemployed once they start looking for jobs, which can temporarily increase unemployment rates
Productivity
Output per hour worked. Declines early in contractions as firms try to keep employees on despite producing less. Increases early in expansions as firms try to produce more output but are not yet ready to hire new workers
Inflation
Persistent increase in the price level over time (prices of almost all goods and services are increasing). Erodes purchasing power of a currency. Favors borrowers at the expense of lenders (principal is returned is worth less than when borrowed)
Hyperinflation
Inflation that accelerates out of control. Can destroy a country’s monetary system and bring about social and political upheavals
Inflation Rate
Percentage increase in the price level, typically compared to the prior year
Disinflation
An inflation rate that is decreasing over time but remains greater than zero
Deflation
Persistently decreasing price level (negative inflation). Deep recessions (consumers delay purchases, decreasing revenues)
Price Index
Measures the average price for a defined basket of goods and services (Consumer Price Index)
CPI
Represents the purchasing patterns of a typical urban household. Compares cost of CPI basket today with cost of basket in earlier base period
Price Index for Personal Consumption Expenditures
Index is created by surveying businesses rather than consumers
Producer Price Index (PPI)/Wholesale Price Index (WPI)
Observe for different stages of processing to watch for emerging price pressure. Widespread increases for producers’ goods may be passed along to consumers
Headline Inflation
Price indexes for all goods
Core Inflation
Price indexes that exclude food and energy (food and energy prices more volatile than most other goods)
Laspeyres Index
Price index calculated using a constant basket of goods and services. Biased upward as a measure of the cost of living (New Goods, Quality Changes, Substitution)
New Goods
Older products are often replaced by newer, but initially more expensive, products. New goods periodically added, older goods they replace are reduced in weight
Quality Changes
Price of a product increases because product has improved, price increase not due to inflation, but still captured by index
Substitution
Even in inflation free economy prices of goods relative to each other change all the time. When two goods are substitutes, consumers increase purchases of relatively cheaper one
Hedonic Pricing
Used to adjust a price index for product quality. Address bias from substitution using a chained index
Fisher Index
Geometric mean of a Laspeyres index
Paasche Index
Uses current consumption weights, prices from the base period, and prices in the current period
Cost Push Inflation
Results from a decrease in aggregate supply, caused by an increase in the real price of an important factor of production (wage pressure)
Demand Pull Inflation
Results from an increase in aggregate demand (increase in the money supply, increased government spending). Increase in GDP not sustainable, unemployment falls, upward pressure on real wages, price keeps increasing
Natural Rate of Unemployment (NARU)
Some segments of the economy may have trouble finding enough qualified workers even during contraction, so rate can be higher than rate associated with absence of cyclical unemployment
Unit Labor Costs
Ratio of total labor compensation per hour to output units per hour
Expected Inflation
If workers expect inflation to increase, they will increase their wage demands accordingly (difference in yield between inflation indexed bonds and treasuries)
Leading Indicator
Change direction before peaks or troughs in the business cycle (consumer expectations, weekly hours in manufacturing, manufacturers’ new orders for consumer goods, building permits for new houses)
Coincident Indicators
Change direction at roughly the same time as peaks or troughs (employees on nonfarm payrolls, real personal income, manufacturing and trade sales)
Lagging Indicators
Don’t tend to change direction until after the expansions or contractions are already underway (average duration of unemployment, inventory sales ratio, change in unit labor costs, change in CPI, prime lending rate, commercial and industrial loans)
Budget Surplus
Government tax revenues exceed expenditures
Budget Deficit
Government expenditures exceed tax revenues
Expansionary Monetary Ploicy
Easy, accommodative. Central bank increases the quantity of money and credit in an economy
Contractionary Monetary Policy
Restrictive, tight. Central bank is reducing quantity of money and credit in an economy
Money
Generally accepted medium of exchange (accepted as payment for goods and services)
Unit of Account
Prices of all goods and services are expressed in units of money
Store of Value
Money received for work or goods can now be saved to purchase goods later
Narrow Money
The amount of notes (currency) and coins in circulation in an economy plus balances in checkable bank deposits
Broad Money
Narrow money plus any amount available in liquid assets
M1
Narrowest measure of money supply, most liquid (currency in circulation, overnight deposits, travelers checks)
M2
M1 plus savings accounts, time deposits under $100k, balances in retail money market mutual funds (deposits agreed maturity up to 2 years, redeemable at notice up to 3 months)
M3
M1 and M2 plus repurchase agreements, money market fund shares, debt securities with maturity up to 2 years
Promissory Notes
Promise by the bank to return money on demand by the depositor (also a medium of exchange)
Fractional Reserve Banking
A bank holds a proportion of deposits in reserve. The portion that is not required (excess reserves) to be held can be loaned out (process of lending, spending and depositing)
Quantity Theory of Money
Quantity of money is some proportion of total spending in an economy
Velocity
Average number of times per year each unit of money is used to buy goods or services
Money Neutrality
Real variables (real GDP, velocity) are not affected by monetary variables (money supply and prices)
Demand for Money
Amount of wealth that households and firms in an economy choose to hold in the form of money
Transaction Demand
Money held to meet the need for undertaking transactions
Precautionary Demand
Money held for unforeseen future needs (higher for large firms, increases with the size of the economy)
Speculative Demand
Money that is available to take advantage of investment opportunities that arise in the future (inversely related to returns available in the market)
Supply of Money
Determined by the central bank, independent of the interest rate (perfectly inelastic)
Short Term Interest Rates
Determined by the equilibrium between money supply and money demand. If interest rate is above equilibrium rate, there is an excess supply of money, and securities will be purchased to reduce these balances. If interest rate is below equilibrium, excess demand for money, securities will be sold to increase money holdings
Fisher Effect
The nominal interest rate is simply the sum of the real interest rate and the expected inflation. Real rates are relatively stable, changes in rates driven by changes in inflation
Central Bank
- Central banks have sole authority to supply money. Money is legal tender. Fiat money is not backed by any tangible asset
- Banker to the government and other banks
- Regulator and supervisor of payments system (impose risk taking standards, reserve requirements, clearing system)
- Lender of last resort. Print money to supply banks in shortages
- Holder of gold and foreign exchange reserves
- Conductor of monetary policy (control inflation to promote price stability)
- Full employment, stable exchange rates, moderate long term interest rates
Menu Costs
Cost to businesses of constantly having to change their prices (result of high inflation)
Shoe Leather Costs
Costs to individuals of making frequent trips to the bank so as to minimize their holdings of cash that are depreciating in value due to inflation
Pegging
Countries choose a target level for the exchange rate of their currency with that of another country (USD)
Perfectly Anticipated Inflation
Expected inflation and actual inflation match. Price of all goods and wages could be indexed to this rate to increase incrementally each month
Unanticipated Inflation
Inflation that is higher or lower than expected inflation. Higher, borrowers gain at the expense of lenders. Lower, benefit lenders at the expense of borrowers. Volatile inflation means lenders require higher interest rates to compensate for uncertainty (reduces business investment). Supple and demand info becomes less reliable
Policy Rate
Banks can borrow funds from the Fed if they have temporary shortfalls in reserves
Discount Rate
Rate at which banks can borrow reserves from the Fed
Repurchase Agreement
Central bank purchases securities from banks that, in turn, agree to repurchase the securities at a higher price in the future
Federal Funds Rate
Rate that banks charge each other on overnight loans of reserves
Reserve Requirements
Fed increases reserve requirement, decreases funds available for lending and the money supply, which increases interest rates (and vice versa)
Open Market Conditions
Buying and selling securities by the central bank. When the central bank buys, cash replaces securities in investor accounts, banks have excess reserves, more funds available for lending, money supply increases, interest rates decrease
Monetary Transmission Mechanism
Ways in which a change in monetary policy, specifically policy rate, affects the price level and inflation
- short term lending rates increase in line with increase in policy rate (decrease agg demand)
- asset prices in general decrease as discount rates applied to future expected cash flows increase (decrease in value of household’s assets decreases consumption)
- consumers and businesses decrease consumption from expectations of future economic growth decrease
- increase in interest rates attract foreign investment in debt, appreciation of domestic currency increases foreign currency prices and reduces exports
Independence
Central bank must be free from political interference
Operational Independence
Central bank is allowed to independently determine the policy rate
Target Independence
Central bank also defines how inflation is computed, sets target inflation level and determines horizon over which target is to be achieved
Inflation Reports
Central banks periodically disclose the state of the economic environment to increase transparency. Periodically report their views on economic indicators and other factors in setting rate policy
Interest Rate Targeting
Increasing the money supply when specific interest rates rose above the target band and decreasing the money supply when rates fell below the target band
Exchange Rate Targeting
Developing countries target a foreign exchange rate between their currency and another (USD) rather than targeting inflation. Value of domestic currency falls, use reserves to purchase their domestic currency (reduce money supply, increase interest rates)
Real Trend Rate
Long term sustainable real growth rate (must be estimated). Changes over time as structural conditions of the economy change
Neutral Interest Rate
Growth rate of the money supply that neither increases nor decreases the economic growth rate
Bond Market Vigilantes
Money supply growth seen as inflationary, higher expected future asset prices will make long term bonds less attractive and increase long term interest rates
Liquidity Trap
Demand for money becomes very elastic and individuals willingly hold more money even without a decrease in short term rates (economy experiencing deflation even though monetary policy has been expansionary)
Quantitative Easing
Central bank buys assets (Treasuries, mortgages) to encourage bank lending and reduce longer term interest rates to generate excess reserves. Purchased securities with credit risk to improve bank balance sheets
Discretionary Fiscal Policy
Spending and taxing decisions of a national government that are intended to stabilize the economy
Automatic Stabilizers
Built in fiscal devices triggered by the state of the economy (tax receipts, unemployment insurance payments)
Transfer Payments
Entitlement programs. Redistribute wealth by taxing some and making payments to others (Social Security, unemployment) –> Spending Tool
Current Spending
Government purchases of goods and services on an ongoing and routine basis
Capital Spending
Government spending on infrastructure (boost future productivity of the economy)
Direct Taxes
Levied on income or wealth (income taxes, wealth taxes, estate taxes, etc.). Progressive taxes (income and wealth) generate revenue for income redistribution –> Revenue Tool
Indirect Taxes
Levied on goods and services (sales, VAT, excise). Can be used to reduce consumption of goods and services (alcohol, tobacco, gambling)
Horizontal Equality
People in similar situations should pay similar taxes
Vertical Equality
Richer people should pay more in taxes
Multiplier Effect
Those whose incomes increase from govt spending will increase their spending, which increases incomes and spending of others
Fiscal Multiplier
Determines the potential increase in aggregate demand resulting from an increase in government spending
Ricardian Equivalence
If taxpayers reduce current consumption and increase current savings by just enough to repay the principal and interest on the debt the govt issued to fund the increased deficit, no effect on aggregate demand
Debt Ratio
Ratio of aggregate debt to GDP. Will increase over time if the real interest rate on govt’s debt is higher than the real growth rate of the economy (keeping tax rates constant)
Crowding Out Effect
Government borrowing causes interest rates to increase and is taking place instead of private sector borrowing
Recognition Lag
Discretionary fiscal policy decisions made by political process, and it may take policymakers time to recognize the nature and extent of economic problems
Action Lag
Time govt takes to discuss, vote on and enact fiscal policy changes
Impact Lag
Time between enactment of fiscal policy changes and when impact of the changes on the economy actually takes place
Structural Budget Deficit
Cyclically adjusted. Deficit that would occur based on current policies if the economy were at full employment
Imports
Goods and services that firms, individuals and governments purchase from producers in other countries
Exports
Goods and services that firms, individuals and governments from other countries purchase from domestic producers
Autarky
Closed economy. Country that does not trade with other countries
Free Trade
Government places no restrictions or charges on import and export activity
Trade Protection
Government places restrictions, limits or charges on exports or imports
World Price
Price of a good or service in world markets for those to whom trade is not restricted
Domestic Price
Price of good or service in the domestic country, may be equal to the world price if free trade is permitted
Net Exports
Value of a country’s exports minus the value of its imports over the same period
Trade Surplus
Net exports are positive. Value of goods and services a country exports greater than the value of goods and services it imports
Trade Deficit
Net exports are negative. Value of goods and services a country exports less than the value of goods and services it imports
Terms of Trade
Ratio of an index of the prices of a country’s exports to an index of the prices of its imports expressed relative to base value of 100
Foreign Direct Investment
Ownership of productive resources (land, factories, natural resources) in a foreign country
Multinational Corporation
Firm that has made foreign direct investment in one or more foreign countries, operating production facilities and subsidiaries in foreign countries
Gross National Product
Total value of goods and services produced by the labor and capital of a country’s citizens
Absolute Advantage
Can produce a good at a lower resource cost than another country
Comparative Advantage
Has a lower opportunity cost in the production of that good, expressed as the amount of another good that could have been produced instead
Production Possibility Frontier
Country specializes and increases production of an export good, increasing costs will increase opportunity cost of the good. Shows all combinations of two goods an economy can produce
Ricardian Model of Trade
Only one factor of production (labor). Source of differences in production costs is difference in labor productivity dure to differences in thecnology
Hecksher-Olin Model
Two factors of production (capital and labor). Source of comparative advantage is differences in relative amounts of each factor. The country with more capital will specialize in the capital intensive good and trade for the less capital intensive good. Good that the country imports will fall in price and good that a country exports will rise in price
Infant Industry
Protection from foreign competition is given to new industries to give them an opportunity to grow to an internationally competitive scale
National Security
Even if imports are cheaper, might be in country’s best interest to protect producers of goods crucial to country’s national defense
Dumping
Preventing foreign imports at less than their cost of production
Tariffs
Taxes on imported good collected by the government. Increases the domestic price, decreases quantity imported, increases quantity supplied domestically
Quotas
Limits on the amount of imports allowed over some period. Domestic producers gain, domestic consumers lose
Export Subsidies
Government payments to firms that export goods
Minimum Domestic Content
Requirement that some percentage of product content must be from the domestic country
Voluntary Export Restraint
Country voluntarily restricts amount of a good that can be exported (avoid tariffs or quotas)
Quota Rents
Domestic govt doesn’t charge for import licenses, amount gained by foreign exporters who receive import licenses
Deadweight Loss
Amount of lost welfare from the imposition of the quota or tariff
Voluntary Export Restraint
Voluntary agreement by a government to limit the quantity of a good that can be exported (protect domestic producers)
Export Subsidies
Payments by a government to its country’s exporters. Benefit exporters of the good, but increase prices and reduce consumer surplus in exporting country
Capital Restrictions
Flow of financial capital across borders. Outright prohibition of investment in domestic country by foreigners, prohibition of or taxes on income earned on foreign investments by domestic citizens, etc. Decrease economic welfare
- Reduce volatility of domestic asset prices
- Maintain fixed exchange rates
- Keep domestic interest rates low
- Protect strategic industries
Free Trade Areas
All barriers to import and export of goods and services among member countries are removed (NAFTA)
Customs Union
- Barriers to import and export of goods and services among member countries removed
- countries adopt a common set of trade restrictions with non-members
Common Market
- Barriers to import and export of goods and services among member countries removed
- countries adopt a common set of trade restrictions with non-members
- barriers to movement of labor and capital goods among member countries removed
Economic Union
- Barriers to import and export of goods and services among member countries removed
- countries adopt a common set of trade restrictions with non-members
- barriers to movement of labor and capital goods among member countries removed
- member countries establish common institutions and economic policy for the union (EU)
Monetary Union
-Barriers to import and export of goods and services among member countries removed
-countries adopt a common set of trade restrictions with non-members
-barriers to movement of labor and capital goods among member countries removed
-member countries establish common institutions and economic policy for the union
-member countries adopt a single currency (eurozone)
Individual countries give up ability to set monetary policy, they all participate in determining monetary policy
Balance of Payments
Adjustment for changes in foreign debt to the domestic country and domestic debt to foreign countries must balance each other
Current Account
Measures the flows of goods and services (merchandise and services, income receipts, unilateral transfers)
Capital Account
Capital transfers and the acquisition and disposal of non-produced, non-financial assets
Financial Account
Records investment flows (govt owned assets abroad, foreign owned assets in the country)
Merchandise and Services
Raw materials and manufactured goods bought, sold or given away. Tourism, transportation, business and engineering services, fees from patents and copyrights
Income Receipts
Foreign income from dividends on stock holdings and interest on debt securities
Unilateral Transfers
One way transfers of assets (money received from those working abroad), direct foreign aid (donor nation account debited)
Capital Transfers
Debt forgiveness and goods and financial assets migrants bring when they come or take with them when they leave. Gift and inheritance taxes, death duties
Non-financial Assets
Rights to natural resources, patents, copyrights, trademarks, franchises, leases
Govt. Owned Assets Abroad
Gold, foreign currencies, foreign securities, reserve position in IMF, credits and long term assets, direct foreign investment, claims against foreign banks
Foreign Owned Assets in the Country
Domestic government and corporate securities, direct investment in domestic country, domestic currency, domestic liabilities to foreigners reported by domestic banks
Current Account Deficit
Imports more than exports. Net surplus in capital and financial accounts
World Bank
Source of financial and technical assistance to developing countries around the world. Low interest loans, interest free credits, grants
- International Bank for Reconstruction and Development (IBRD)
- International Development Association (IDA)
World Trade Organization
Ensure that trade flows as smoothly, predictably and freely as possible. Interprets agreements and commitments
Exchange Rate
Price or cost of units of one currency in terms of another (Price Currency in terms of Base Currency)
Direct Quote
From point of view of an investor in the price currency country
Indirect Quote
Point of view of the investor in the base currency country
Nominal Exchange Rate
Exchange rate at a point in time
Real Exchange Rate
Cost of purchasing same unit of goods based on new (current) exchange rate and relative changes in the price levels of both countries
Spot Exchange Rate
Currency exchange rate for immediate delivery (exchange of currencies takes place 2 days after the trade)
Forward Exchange Rate
Currency exchange rate for an exchange to be done in the future (30 days, 60 days, 90 days, 1 year). Agreement to exchange specific amount of one currency for specific amount of another
Forward Currency Contract
Reduces or eliminates foreign exchange risk associated with currency transactions
Hedging
Firm takes a position in the foreign exchange market to reduce an existing risk
Speculative
Transaction in the foreign exchange market increases currency risk
Sell Side
Primary dealers in currencies and originators of forward foreign exchange contracts
Buy Side
Many buyers of foreign currencies and forward contracts
Real Money Accounts
Mutual funds, pension funds, insurance companies and other institutional accounts not using derivatives
Leveraged Accounts
Firms using derivatives (hedge funds), firms that trade for their own accounts
Cross Rate
Exchange rate between two currencies implied by their exchange rates with a common third currency (when there is no active FX market in the currency pair)
Interest Rate Parity
Percentage difference between forward and spot exchange rates is approximately equal to difference between two countries’ interest rates (no arbitrage relation)
Forward Discount/Forward Premium
Calculated relative to the spot exchange rate. Percentage difference between the forward price and the spot price (for the base currency)
Formal Dollarization
Country can use the currency of another country. cannot have its own monetary policy or create currency
Currency Board Arrangement
Explicit commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate
Conventional Fixed Peg Arrangement
Country pegs its currency within margins of +-1% versus another currency or basket that includes currencies of major trading or financial partners
- Direct Intervention: maintain exchange rates within band by buying or selling foreign currencies in forex market
- Indirect Intervention: change interest rate policy, regulation of forex transactions
Target Zone
Pegged exchange rates within horizontal band permit fluctuations in currency valuation relative to another currency (wider band than conventional)
Passive Crawling Peg
Exchange rate is adjusted periodically to adjust for higher inflation versus the currency used in the peg
Active Crawling Peg
Series of exchange rate adjustments over time is announced and implemented. Can influence inflation expectations
Crawling Bands
Width of the bands that identify permissible exchange rates is increased over time. Transition from a fixed peg to a floating peg
Managed Floating Exchange Rates
Monetary authority attempts to influence the exchange rate in response to specific indicators such as BOP, inflation rates, employment, No target exchange rate or predetermined exchange rate path
Independently Floating
Exchange rate is market determined, foreign exchange market intervention is used only to slow the rate of change and reduce short-term fluctuations
Elasticities Approach
Impact of exchange rate changes on the total value of imports and on the total value of exports (import or export demand is elastic)
Absorption Approach
View the effects of a change in exchange rates on capital flows rather than on goods flows
Marshall-Lerner Condition
The condition in which a depreciation of the domestic currency will decrease a trade deficit
J-Curve
The short-term increase in the deficit resulting from initial currency depreciation, followed by a decrease when the Marshall-Lerner condition is met
