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EC250 - Midterm #1
What Economics Is All About
Scarcity - li ited atu e of so iet ’s esou es
Economics - study of how society manages its scarce resources
- how people decide what to buy, how much to work, save, and spend
- how firms decide how much to produce, how many workers to hire
- how society decides how to divide its resources between national defence, consumer goods,
protecting the environment, and other needs
Microeconomics - study of how households and firms make decisions and how they interact in markets
Macroeconomics - study of economy-wide phenomena, including inflation, unemployment, and
economic growth.
HOW PEOPLE MAKE DECISIONS
Principle #1: People Face Tradeoffs
- Society faces an important tradeoff
Ex. Going to a party the night before your midterm leaves less time for studying.
Ex. Having more money to buy stuff requires working longer hours, which leaves less time for leisure
Ex. Protecting the environment requires resources that could otherwise be used to produce consumer
goods
Principle #2: The Cost of Something Is What You Give Up to Get It
- Making decisions requires comparing the costs and benefits of alternative choices
Opportunity cost - whatever must be given up to obtain it ; it is the relevant cost for decision making
Ex. The opportunity cost of seeing a movie is not just the price of the ticket, but the value of the time
you spend in the cinema.
Principle #3: Rational People Think at the Margin
Rational people:
- Systematically and purposefully do the best they can to achieve their objectives
- Make decisions by evaluating costs and benefits of marginal changes – incremental adjustments
to an existing plan
Ex. When a student considers whether to go to college for an additional year, he compares the
fees and foregone wages to the extra income he could earn with the extra year of education.
Principle #4: People Respond to Incentives
Incentive - something that induces a person to act, prospect of a reward or punishment
- Rational people respond to incentives.
Ex. Adding extra credit for class participation, when cigarette taxes increase, teen smoking falls
HOW PEOPLE INTERACT
Principle #5: Trade Can Make People Better Off
- Rather than being self-sufficient, people can specialize in producing one good or service and
exchange it for other goods
Countries also benefit from trade & specialization:
- Get a better price abroad for goods they produce
- Buy other goods more cheaply from abroad than could be produced at home
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Principle #6: Markets Are Usually A Good Way to Organize Economic Activity
Market - group of buyers and sellers (need not be in a single location)
O ga ize e o o i a ti it
ea s dete i i g
- what goods to produce
- how to produce them
- how much of each to produce
- who gets them
Market economy - allocates resources through the decentralized decisions of many households and
firms as they interact in markets.
Famous insight by Adam Smith in The Wealth of Nations (1776):
- Ea h of these households a d fi s a ts as if led a i isi le ha d to p o ote ge e al
economic well-being.
The invisible hand works through the price system:
- The interaction of buyers and sellers determines prices.
- Ea h p i e efle ts the good’s alue to u e s a d the ost of p odu i g the good.
- Prices guide self-interested households and firms to make decisions that, in many cases,
a i ize so iet ’s e o o i ell-being.
Principle #7: Governments Can Sometimes Improve Market Outcomes
- Important role for govt: enforce property rights (with police, courts)
HOW THE ECONOMY WORKS A WHOLE
P i iple # : A ou t ’s sta da d of li i g depe ds o its a ilit to p odu e goods & se i es
Huge variation in living standards across countries and over time:
- Average income in rich countries is more than ten times average income in poor countries
- The Canadian standard of living today is about eight times larger than 100 years ago
Productivity - most important determinant of living standards: amount of goods and services produced
f o ea h hou of a o ke ’s ti e.
- Productivity depends on the equipment, skills, and technology available to workers.
- Other factors (e.g., labour unions, competition from abroad) have far less impact on living
standards.
Principle #9: Prices rise when the government prints too much money
Inflation - In the long run, almost always caused by too much quantity of money, which causes the value
of money to fall.
- The faster the govt creates money, the greater the inflation rate.
Principle #10: Society faces a short-run tradeoff between inflation and unemployment
- In the short-run (1 – 2 years), many economic policies push inflation and unemployment in
opposite directions.
What is the Role of Assumptions & Models?
Assumptions - simplify the complex world, make it easier to understand, ex. To study international
trade, assume two countries and two goods.
- Unrealistic, but simple to learn and gives useful insights about the real world.
Economic models - simplified versions of a more complex reality; irrelevant details are stripped away
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Used to sho elatio ships et ee a ia les, e plai the e o o ’s eha io a d de ise
policies to improve economic performance
Use different assumptions to explain different aspects of macroeconomy
Economists use different models to explain different questions
Example of a Model: Supply & Demand for New Cars
- Shows how various events affect price and quantity of cars
- Assumes the market is competitive: each buyer and seller is too small to affect the market price
Variables:
Qd = quantity of cars that buyers demand
Qs = quantity that producers supply
P = price of new cars
Y = aggregate income (total of all incomes in an economy without adjustments for inflation, taxation,
etc.)
Ps = price of steel (an input)
The Demand for Cars
demand equation: Qd = D(P,Y)
- Shows that the quantity of cars consumers demand is related to the price of cars and aggregate
income
Specific functional form - shows the precise quantitative relationship
ex. D(P,Y) = 60 – 10P + 2Y
Market for Cars: Demand
Demand curve - shows the relationship between quantity demanded and price, other things equal
Market for Cars: Supply
Supply curve - shows the relationship between quantity supplied and price, other things equal
Increase in Income
- Increase in income increases the quantity of cars consumers
demand at each price which increases the equilibrium price and
quantity.
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Increase in Steel Price
Increase in Ps reduces the quantity of cars producers supply at each
price which increases the market price and reduces the quantity.
Endogenous vs. Exogenous Variables
Endogenous variables - determined in the model
Exogenous variables - determined outside the model: takes their values and behavior as given
- Fixed at the moment they enter the model
In the model of supply & demand for cars:
Endogenous: P, Qd, Qs ; Exogenous: Y, P(steel)
**Exogenous variables affect endogenous variables, ex. Price of steel affects overall price of the car
The Use of Multiple Models
- Our supply-demand model of the car market can tell us how a fall in aggregate income affects
price & quantity of cars but it cannot tell us why aggregate income falls.
- So we will learn different models for studying different issues (e.g., unemployment, inflation,
long-run growth).
For each new model, you should keep track of
- its assumptions
- which variables are endogenous, which are exogenous
- questions it can help us understand, those it cannot
- Implicit or explicit consistency with microeconomic foundations
**DOES NOT INCLUDE functional relationships based on controlled experiments.
Prices: Flexible vs. Sticky
Market clearing - assumption that prices are flexible, adjust to equate supply and demand.
- In the short run, many prices are sticky - adjust sluggishly in response to changes in supply or
demand. Ex. Price of a soda in a vending machine, many magazine publishers change prices only
once every 3-4 years
The e o o ’s eha io depe ds pa tl o hethe p i es a e sti k o fle i le:
- If prices sticky (short run), demand may not equal supply, which explains: unemployment
(excess supply of labor) and why firms cannot always sell all the goods they produce
- If prices flexible (long run), markets clear and economy behaves very differently
Continuous market clearing - at any given instant, buyers can buy all that they want and sellers can sell
all that they want at the going price
Chapter 2: The Data of Macroeconomics
GDP - market value of all final goods & services produced within a country in a given period of time
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GDP includes tangible goods (physical items like DVDs, mountain bikes, beer) and intangible
services (dry cleaning, concerts, cell phone service)
- GDP includes currently produced goods, not goods produced in the past
- Usually a year or a quarter (3 months)
- Measu es the alue of p odu tio that o u s ithi a ou t ’s o de s, hethe do e its
own citizens or by foreigners located there
Goods are valued at their market prices, so:
- All goods measured in the same units (e.g., dollars in Canada)
- Thi gs that do ’t ha e a a ket alue a e e luded, e.g., house o k ou do fo ou self.
Final goods - intended for the end user
Intermediate goods - used as components or ingredients in the production of other goods
**GDP only includes final goods – they already embody the value of the intermediate goods used in
their production
Gross Domestic Product: Expenditure and Income
Two definitions:
1. Total expenditure on domestically-produced final goods and services.
2. Total income earned by domestically-located factors of production.
**Expenditure equals income because every dollar spent by a buyer becomes income to the seller
Factors of production - resources the economy uses to produce goods & services, including labour, land,
and capital (buildings & machines used in production)
The Circular Flow
Households - Own the factors of production, sell/rent them to firms for income
- Buy and consume goods & services
Firms - Buy/hire factors of production, use them to produce goods and services
- Sell goods & services
The Components of GDP
- Consumption (C)
- Investment (I)
- Government Purchases (G)
- Net Exports (NX)
These components add up to GDP (denoted Y): Y = C + I + G + NX
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Consumption (C)
- value of all goods and services bought by households. Includes:
Durable goods - last a long time, ex. cars, home appliances
Nondurable goods - last a short time, ex. food, clothing
Services - intangible items purchased by consumers, ex. dry cleaning, air travel
Investment (I)
- total spending on goods that will be used in the future to produce more goods.
Includes spending on:
- capital equipment (e.g., machines, tools)
- structures (factories, office buildings, houses)
- inventories (goods produced but not yet sold)
- More generally Investment is spending on goods bought for future use (i.e., capital goods)
including:
Business fixed investment - spending on plant and equipment
Residential fixed investment - spending by consumers and landlords on housing units
Inventory investment - ha ge i the alue of all fi s’ i e to ies
Investment vs. capital
- Note: Investment is spending on new capital.
Example (assumes no depreciation):
- 1/1/2016: Economy has $10 trillion worth of capital
- During 2016: Investment = $2 trillion
- 1/1/2017: Economy will have $12 trillion worth of capital
Government spending (G)
- Spending on goods and services by local, territorial, provincial, and federal governments
- Includes salaries of government workers and spending on public works.
- Excludes transfer payments (e.g., unemployment insurance payments), because they do not
represent spending on goods and services
Net Exports (NX)
- NX = exports – imports
- E po ts ep ese t fo eig spe di g o the e o o ’s g&s.
- Imports are the portions of C, I, and G that are spent on g&s produced abroad.
Value added - value of output - value of the intermediate goods used to produce that output
- The value of the final goods (GDP) already includes the value of the intermediate goods, so
including intermediate and final goods in GDP would be double-counting.
Stocks vs. Flows
Stock - ua tit easu ed at a poi t i ti e, e . U.“. apital sto k as t illio .
Ex. person's wealth, # of people with college degrees, govt debt
Flow - quantity measured pe u it of ti e, e . U.“. i est e t as $ . t illio du i g
E . i o e, pe so ’s a ual sa i g, # of ollege g aduates, go t udget defi it
.
Why does output = expenditure?
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U sold output goes i to i e to , a d is ou ted as i e to i est e t
inventory buildup was intentional.
In effect, we are assuming that firms purchase their unsold output.
hethe o
ot the
GNP vs. GDP
Gross National Product (GNP) - total income ea ed the atio ’s fa to s of p odu tio , ega dless of
where located
Gross Domestic Product (GDP) - total income earned by domestically-located factors of production,
regardless of nationality
- Does not include expenditures of ALL businesses in the economy
GNP – GDP = factor payments from abroad minus factor payments to abroad
Ex. factor payments = wages, profits, rent, interest and dividends on assets
Nominal GDP - measures these values using current prices
Real GDP - measure these values using base year prices, grows over time and growth rate of real GDP
fluctuates
Per capita - ai i di ato of the a e age pe so ’s sta da d of li i g
Changes in nominal GDP can be due to:
- changes in prices
- changes in quantities of output produced
Changes in real GDP can only be due to changes in quantities because real GDP is constructed using
constant base-year prices
Example:
1. Compute nominal GDP in each year.
nominal GDP: multiply Ps & Qs from same year
2006: $46,200 = $30 × 900 + $100 × 192
2007: $51,400
2008: $58,300
2. Compute real GDP in each year using 2006 as the base year.
eal GDP: ultipl ea h ea ’s Qs
Ps
2006: $46,200
2007: $50,000
2008: $52,000 = $30 × 1050 + $100 × 205
GDP deflator - one measure of the price level
eighted a e age of p i es that efle ts that good’s elati e i po ta e i GDP
Example with 3 goods
For good i = 1, 2, 3
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Pit = the market price of good i in month t
Qit = the quantity of good i produced in month t
NGDPt = Nominal GDP in month t
RGDPt = Real GDP in month t
Chain-weighted real GDP - updates the base year every year, so it is more accurate than constant-price
GDP; over time, relative prices change, so the base year should be updated periodically.
Consumer Price Index (CPI) - measure of the overall level of prices
- T a ks ha ges i the t pi al household’s ost of li i g
- Adjusts a
o t a ts fo i flatio COLAs
- Allows comparisons of dollar amounts over time
How to Constructs the CPI
. “u e o su e s to dete i e o positio of the t pi al o su e ’s asket of goods
2. Every month, collect data on prices of all items in the basket; compute cost of basket
3. CPI in any month equals
Then StatsCan does:
4. Movements in the price of the goods and services included in the CPI are weighted according to their
relative importance in the total expenditures of consumers.
5. To estimate the price change experienced by Canadians, Statistics Canada obtains CPI price sample
from different regions, goods and services, and from various types and locations of retail outlets. Every
month, collect data on prices of all items in the basket; compute cost of basket
Example with 3 goods
For good i = 1, 2, 3
Ci = the amount of good i i the CPI’s asket
Pit = the price of good i in month t
Et = the cost of the CPI basket in month t
Eb = the cost of the basket in the base period
Why may the CPI overstate inflation?
Substitution bias - CPI uses fi ed eights, so it a
goods whose relative prices have fallen
ot efle t o su e s’ a ilit to su stitute to a d
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Introduction of new goods - makes consumers better off and increases the real value of the dollar
(lowering inflation). But it does not reduce the CPI, because the CPI uses fixed weights.
Unmeasured changes in quality - quality improvements increase the value of the dollar (lowering
inflation), but are often not fully measured.
The “ize of the CPI’s ias
- Research from the Bank of Canada suggests that the overall estimated bias in the Canadian CPI
is about 0.5% per year.
- Lower in Canada than the United States where bias is estimated to be around 1%
CPI vs. GDP Deflator
Prices of imported consumer goods:
- included in CPI
- excluded from GDP deflator
The basket of goods:
- CPI: fixed
- GDP deflator: changes every year
Categories of the Population
Employed - working at a paid job
Unemployed - not employed but looking for a job
Labor force - amount of labor available for producing goods and services; all employed plus unemployed
persons
Not in the labor force - not employed, not looking for work
Unemployment rate - % of the labor force that is unemployed
- (U/L) x 100%
Labor force participation rate - f a tio of the adult populatio that pa ti ipates i the la o fo e
- (L/POP) x 100%
Cyclical unemployment - deviation of unemployment from its natural rate
- When business cycles are at their peak, cyclical unemployment will be low
- Due to deviations of GDP from Y*
Frictional unemployment - occurs when workers leave jobs and spend time searching for ones that best
suit their skills and tastes; short-term for most workers
Structural unemployment - occurs when there are fewer jobs than workers; usually longer-term
- Mismatch in skills, occupations, locations or geography
Okun’s law - negative relationship between unemployment and GDP
- I Ca ada, Oku ’s la i di ates that a o e pe e t i ease i eal GDP leads to a halfpercentage decrease in unemployment.
- % unemployment rate increases when GDP falls by 1 percentage point
Two arithmetic tricks for working with percentage changes
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Ex. If your hourly wage rises 5% and you work 7% more hours, then your wage income rises
approximately 12%.
Ex. GDP deflator = 100 × NGDP/RGDP.
- If NGDP rises 9% and RGDP rises 4%, then the inflation rate is approximately 5%.
Chapter 3: National Income: Where It Comes From and Where It Goes
The Circular-Flow Diagram
Firms - produce and sell goods and services; hire and use factors of production
Households - buy and consume goods and services; own and sell factors of production
- Use income for consumption, taxes, and saving
Markets for Goods and Services - firms sell, households buy
Markets for Factors of Production - households sell, firms buy
Factors of Production - inputs used to produce goods and services such as land, labour, and capital
Productivity - average quantity of g&s produced each hour by each worker
- Cou t ’s sta da d of li i g depe ds o its a ilit to p odu e goods a d se i es.
Y = real GDP = quantity of output produced
L = quantity of labour
Y/L= productivity (output per worker)
Why Productivity Is So Important
- Whe a atio ’s o ke s a e e p odu ti e, eal GDP is la ge a d i o es a e high.
- When productivity grows rapidly, so do living standards.
Physical Capital Per Worker
- Stock of equipment and structures used to produce g&s is called [physical] capital, K.
K/L = capital per worker.
- Increase in K/L causes an increase in Y/L.
Human Capital Per Worker
- Knowledge and skills workers acquire through education, training, and experience, H.
H/L = a e age o ke ’s hu a apital
- Increase in H/L causes an increase in Y/L.
Natural Resources Per Worker
- Inputs into production that nature provides, N, ex. land, mineral deposits
- Other things equal, more N allows a country to produce more Y (real GDP).
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In per-worker terms, increase in N/L = an increase in Y/L.
Some countries are rich because they have abundant natural resources (e.g., Saudi Arabia has
lots of oil) but countries do ’t eed u h of N to e i h e.g., Japa i po ts the N it eeds
Technological knowledge - so iet ’s u de sta di g of the est a s to p odu e g&s
Technological progress does not only mean a faster computer, a higher-definition TV, or a
smaller cell phone, it is any advance in knowledge that boosts productivity (allows society to get
more output from its resources)
Ex. Henry Ford and the assembly line.
The Production Function
- Graph or equation showing the relation between output and inputs:
Y = A*F(L, K, H, N)
F( ) - function that shows how inputs are combined to produce output
A - le el of te h olog , so i p o e e ts i te h olog i eases i A allo
o e output Y
- Function has the property constant returns to scale - changing all inputs by the same
percentage causes output to change by that percentage, ex. If we multiply each input by 1/L,
then output is multiplied by 1/L: Y/L = A F(1, K/L, H/L, N/L)
- Productivity (output per worker) depends on A, K, H, and N
Closed economy - no trade; Y = C + I + G
Open economy Closed Economy, Market-Clearing Model
Supply side - factor markets (supply, demand, price), determination of output/income
Demand side - determinants of C, I, and G
Equilibrium - goods market, loanable funds market
Factors of Production
K = capital: tools, machines, and structures used in production
L = labor: physical and mental efforts of workers
*Creates simple function: Y = F(K,L)
- Shows how much output (Y) the economy can produce from K units and L units; exhibits
constant returns to scale
Assumptions: 1. Technology is fixed.
. The e o o ’s supplies of apital a d la o a e fi ed at
Determining GDP
Output - determined by the fixed factor supplies and the fixed state of technology:
The distribution of national income is determined by factor prices - prices per unit firms pay for the
factors of production and are determined by supply (fixed) and demand in factor markets.
- When factor supply is fixed, the factor supply curve is vertical
- wage = price of L (labour)
- rental rate = price of K (physical capital)
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Notation
W = nominal wage
R = nominal rental rate
W/P = real wage
R/P - real rental rate
Demand for Labor
- Assume markets are competitive: each firm takes W, R, and P as given.
Basic idea: A firm hires each unit of labor if the cost does not exceed the benefit.
Cost = real wage (price of labour - W/P) ; benefit = marginal product of labor
Marginal product of labor (MPL) - extra output the firm can produce using an additional unit of labor
(holding other inputs fixed): MPL = F(K,L+1) – F(K,L)
Compute & Graph MPL
a. Determine MPL at each value of L = (Y2-Y1)
b. Graph the production function. (upward sloping curve)
c. Graph the MPL curve with MPL on the vertical axis and L on the
horizontal axis. (downward sloping curve)
MPL and The Production Function
- Slope of production function = MPL
- As more labour is added, MPL decreases
Diminishing Marginal Returns
- As a factor input is increased (ex. labour^), its marginal product falls (other things equal).
E . “uppose ↑L hile holdi g K fi ed; fe e a hi es pe o ke a d lo e o ke p odu ti it
MPL and Demand For Labor
Equilibrium Real Wage
The
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Determining the Rental Rate
- We have just seen that MPL = W/P (real wage).
The same logic shows that MPK (marginal propensity of capital) = R/P (real rental rate of capital):
- Di i ishi g etu s to apital: K ↑ the MPK ↓
MPK curve - fi ’s de a d u e fo e ti g apital; a i ize p ofits
hoosi g K su h that MPK =
R/P
The Equilibrium Real Rental Rate
Neoclassical theory of distribution - states that each factor input is paid its marginal product
- Starting point for thinking about income distribution
How Income Is Distributed To L and K
Total labour income = real wage rate * labour (fixed)
Total capital income = real rental rate * capital (fixed)
National income (fixed) = labour income + capital income
- A competitive, profit-maximizing firm hires labor until the price of output multiplied by the
marginal product of labor equals the wage.
The Cobb-Douglas Production Function
- Has constant factor shares
A = level of technology
α = apital’s sha e of total i o e sha e of output goi g to la o : i depe de t of the a ou t of la o
labor income = MPL x L = (1 – α Y
apital i o e = MPK K = α Y
- Ea h fa to ’s a gi al p odu t is p opo tio al to its average product:
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Explanations for Rising Inequality
. Rise i apital’s sha e of i o e,
apital i o e is o e i te se o e t ated tha la ou i o e
2. Technological progress has increased the demand for skilled vs. unskilled workers
- Due to a slowdown in expansion of education, the supply of skilled workers has not kept up
Result: Rising gap between wages of skilled and unskilled workers.
Demand for G&S
Components of aggregate demand:
C = consumer demand for g & s; I = demand for investment goods
G = government demand for g & s (closed economy - no NX)
Consumption, C
Disposable income - total income minus total taxes: Y – T
- I ludes se di g pa he ues e ause it is a pa t of T; does ’t i lude go ’t spe di g
Consumption function (C) = C(Y – T) ; sho s that ↑ Y – T) ⇒↑C disposa le i o e i ease, so does
consumption)
Marginal propensity to consume (MPC) - change in consumption when disposable income increases by
one dollar; expected to be between 0 and 1
The Consumption Function
* slope = MPC
Investment, I
Investment function: I = I(r)
r = real interest rate, nominal interest rate corrected for inflation.
Real interest rate - ost of o o i g; oppo tu it ost of usi g o e’s o
spending, so, ↑ ⇒↓I
fu ds to fi a e i est ent
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Government spending, G
G = go ’t spe di g o goods a d se i es, e ludes t a sfe pa e ts e . so ial se u it
unemployment insurance benefits)
- Assume government spending and total taxes are exogenous (fixed):
e efits,
The Market for G&S
-
The real interest rate adjusts to equate demand with supply.
The Loanable Funds Market
- Includes loans, bonds, saving deposits
Supply of funds: saving
P i e of fu ds: eal i te est ate
The de a d fo loa a le fu ds…
- Comes from investment - Firms borrow to finance spending on plant & equipment, new office
buildings, etc. Consumers borrow to buy new houses.
- Depends negatively on r - p i e of loa a le fu ds ost of o o i g
Loanable Funds Demand Curve
Supply of Funds: Saving
The supply of loanable funds comes from saving:
- Households use their saving to make bank deposits, purchase bonds and other assets. These
funds become available to firms to borrow to finance investment spending.
- The government may also contribute to saving if it does not spend all the tax revenue it receives
Private saving = (Y – T) – C
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Public saving = T – G
National saving, S = private saving + public saving = ((Y –T) – C) + (T – G) = Y – C – G
If T > G, budget surplus = (T – G) = public saving
If T < G, budget deficit = (G – T) and public saving is negative
If T = G, ala ed udget, pu li sa i g = .
- The U.S. government finances its deficit by issuing Treasury bonds – i.e., borrowing
Loanable Funds Supply Curve
National saving does not depend on r, so the supply curve is vertical.
Loanable Funds Market Equilibrium
- r adjusts to equilibrate the goods market and the loanable funds market simultaneously
- When L.F. market is in equilibrium, then Y – C – G = I
- Add (C +G) to both sides to get Y = C + I + G goods a ket e ’
The efo e, loa a le fu ds a ket e ’ a d goods a ket e ’ .
Things That Shift The Saving Curve
Public saving - fiscal policy: changes in G or T
Private saving - preferences, tax laws that affect saving such as 401(k), IRA, and replace income tax with
consumption tax
Things that Shift the Investment Curve
Some technological innovations - firms buy new investment goods to take advantage
Tax laws that affect investment - ex. investment tax credit
Increase in Investment Demand
An increase in investment demand raises r, which induces an
increase in the quantity of saving, which allows I to increase.
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Markets, Intermediaries, the 2008 Crisis
In the real world, firms have several options for raising funds they need for investment, including:
- borrow from banks
- sell bonds to savers
- sell shares of stock (ownership) to savers
The financial system includes:
- Bond and stock markets, where savers directly provide funds to firms for investment
- Financial intermediaries, ex. banks, insurance companies, mutual funds, where savers indirectly
provide funds to firms for investment; help move funds to their most productive uses.
- But when intermediaries are involved, savers usually do not know what investments their funds
are financing.
- Intermediaries were at the heart of the financial crisis of 2008
A few details on the financial crisis:
- Jul ’ to De ’ : house p i es fell %
- Ja ’ to De ’ : .
illio fo e losu es
- Many banks, financial institutions holding mortgages or mortgage-backed securities driven to
near bankruptcy
- Congress authorized $700 billion to help shore up financial institutions
Returns to Scale
Initially Y1 = F(K1 ,L1)
Scale all inputs by the same factor z: K2 = zK1 and L2 = zL1
What happens to output, Y2 = F (K2 ,L2)?
- If constant returns to scale, Y2 = zY1
- If increasing returns to scale, Y2 > zY1
- If decreasing returns to scale, Y2 < zY1
Government Budget Deficits
Crowding out - decrease in investment and consumption by households bc of increases in government
spending and deficit financing sucking up available financial resources and raising interest rates
- Because investment is important for long-run economic growth, government budget deficits
edu e the e o o ’s g o th ate
Chapter 4: Money and Inflation
Money - stock of assets that can be readily used to make transactions
- Without it, trade would require barter - exchange of one good or service for another.
- Every transaction would require a double coincidence of wants - unlikely occurrence that two
people each have a good the other wants.
- Most people would have to spend time searching for others to trade with - huge waste of
resources but unnecessary with money.
Functions of Money
Medium of exchange - we use it to buy stuff
Store of value - transfers purchasing power from the present to the future
Unit of account - common unit by which everyone measures prices and values
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Commodity money - takes the form of a commodity with intrinsic value, ex. gold coins, cigarettes
Fiat money - money without intrinsic value, used as money because of govt decree, ex. CAN $
Money supply (or money stock) - quantity of money available in the economy
- Decisions by policymakers concerning the money supply constitute monetary policy
Assets included in money supply:
Currency - paper bills and coins in the hands of the (non-bank) public
Demand deposits - balances in bank accounts that depositors can access on demand by writing a
cheque or using a debit card; deposit of money that can be withdrawn without prior notice.
Quantity theory of money - prices rise when the govt prints too much money
- Explains long-run determinants of the price level and the inflation rate
- When the overall price level rises, the value of money falls bc it is more available
The Classical Theory of Inflation
- Over the past 60 years, prices have risen on average about 4 percent per year
Hyperinflation - high rates of inflation such as Germany experienced in the 1920s
- In the 1970s prices rose by 7 percent per year.
- During the 1990s, prices rose at an average rate of 2 percent per year.
The Value of Money
P - price of a basket of goods, measured in money; 1/P is the value of $1, measured in goods.
Ex. Basket contains one candy bar, so if P = $2, value of $1 is 1/2 candy bar.
Velocity - rate at which money circulates; # of times the average dollar bill changes hands in a given
time period, ex. In 2009, $500 billion in transactions and money supply = $100 billion. The average dollar
is used in five transactions in 2009, so, velocity = 5.
T = value of all transactions; M = money supply
Quantity equation - M × V = P × Y
Use nominal GDP as a proxy for total transactions:
P = price of output (GDP deflator); Y = quantity of output (real GDP)
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P × Y = value of output (nominal GDP)
Real money balances - amount of money in terms of quantity of goods and services it can purchase
M/P = real money balances, purchasing power of the money supply
k = how much money people wish to hold for each dollar of income. (k is exogenous - determined
outside the model and fixed at the moment they enter the model)
-
When people hold lots of money relative to their incomes (k is large), money changes hands
infrequently (V is small).
Quantity Theory of Money
Quantity equation:
How the price level is determined:
- With V constant, the money supply determines nominal GDP (P×Y)
- Real GDP is dete i ed the e o o ’s supplies of K a d L a d the p odu tio fu tio
- The price level is P = (nominal GDP)/(real GDP).
Growth rate of a product = sum of the growth rates. The quantity equation in growth rates:
π - inflation rate:
-
ΔY/Y depe ds o g o th i the fa to s of p odu tio a d o te h ologi al p og ess
Normal economic growth requires a certain amount of money supply growth to facilitate the
growth in transactions.
Money growth in excess of this amount leads to inflation
The quantity theory of money implies:
1. Countries with higher money growth rates should have higher inflation rates.
2. The long- u t e d eha io of a ou t ’s i flatio should e si ila to the lo g-run trend in
the ou t ’s o e g o th ate.
Seigniorage - e e ue aised f o p i ti g o e , e . diffe e e / the fa e alue of oins and their
production costs.
- To spend more without raising taxes or selling bonds, the govt can print money
Inflation tax - printing money to raise revenue causes inflation
- Inflation is a tax on people who hold money
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-
When tax revenue is inadequate and ability to borrow is limited, govt may print money to pay
for its spending; almost all hyperinflations start this way
Applies to people’s holdi gs of o e , ot thei holdi gs of ealth
The Fisher Effect
Nominal interest rate = inflation rate + real interest rate
In the long run, money is neutral, so a change in the money growth rate affects the inflation rate
but not the real interest rate.
- Nominal interest rate adjusts one-for-one with changes in the inflation rate but r is constant
Nominal interest rate (i) - not adjusted for inflation
Real interest rate (r) - adjusted for inflation: = i − π
-
The Fishe e uation: i = + π
Recall: S = I determines r
- I ease i π auses a e ual i ease i i.
Notation:
π = a tual i flatio ate ot k o u til afte it has o u ed
Eπ = e pe ted i flatio ate
Two real interest rates:
i – Eπ = ex ante real interest rate - real interest rate people expect at the time they buy a bond or take
out a loan
i – π = ex post real interest rate - real interest rate actually realized
Money Demand and the Nominal Interest Rate
- In the quantity theory of money, demand for real money balances depends only on real income
Y.
Nominal interest rate (i) - determines money demand; opportunity cost of holding money (instead of
bonds or other interest-earning assets).
- ↑i ⇒↓ i
o e de a d.
people a e less likel to u o ds a d assets
The Money Demand Function
(M/P)^d - real money demand, depends negatively on i (opp. cost of holding money)
- positively on Y; higher Y = more spending + demand for more money
L - used for the money demand function because money is the most liquid asset
-
When people are deciding whether to hold money or bonds, they do ’t k o
turn out to be.
“o, the o i al i te est ate ele a t fo o e de a d is + Eπ.
hat i flatio
ill
Equilibrium
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Ho P espo ds to ΔM
- (Equilibrium equation) - Fo gi e alues of , Eπ,
and Y, a change in M causes P to change by the same
percentage – just like in the quantity theory of money
Expected Inflation
- O e the lo g u , people do ’t o siste tl fo e ast i flatio , so Eπ = π o average.
- I the sho t u , Eπ a ha ge he people get e i fo atio , e . Go ’t a ou es it ill
i ease M e t ea . People ill e pe t e t ea ’s P to e highe , so Eπ ises, affe ti g P o ,
e e though M has ’t ha ged et
Ho P espo ds to ΔEπ e pe ted i flatio
▪ For given values of r, Y, and M =
Common misperception - inflation reduces real wages (cost of labour)
- This is true only in the short run, when nominal wages are fixed by contracts.
- In the long run, the real wage is determined by labor supply and the marginal product of labor,
not the price level or inflation rate
Classical view of inflation - change in the price level is merely a change in the units of measurement
Social Costs of Inflation
1. Costs when inflation is expected
2. Costs when inflation is different than people had expected
Costs of Expected Inflation
1. Shoe leather cost - resources (time and effort) wasted when inflation encourages people to
reduce their money holdings
- Includes the time and transactions costs of more frequent bank withdrawals
- Costs and inconveniences of reducing money balances to avoid the inflation tax
- ↑a tual i flatio ⇒↑ o i al i te est ate ⇒↓ eal o e ala es
- In long run, inflation does not affect real income or real spending.
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-
So, same monthly spending but lower average money holdings means more frequent trips to
the bank to withdraw smaller amounts of cash
2. Menu costs - costs of changing prices, ex. cost of printing new menus
- The higher inflation is, the more frequently firms must change their prices and incur these costs.
3. Relative price distortions - firms facing menu costs change prices infrequently, ex. A firm issues new
catalog each January; as the ge e al p i e le el ises th oughout the ea , the fi ’s elati e p i e ill
fall.
- Different firms change their prices at different times, leading to relative price distortion causing
microeconomic inefficiencies in the allocation of resources
4. Unfair tax treatment - some taxes are not adjusted to account for inflation, like capital gains tax, ex.
Jan 1: you buy $10,000 worth of IBM stock; Dec 31: you sell the stock for $11,000, so your nominal
apital gai is $
% ut the go ’t e ui es ou to pa ta es o ou $
o i al gai !!
5. General inconvenience - inflation makes it harder to compare nominal values from different time
periods complicating long-range financial planning
Additional Cost of Unexpected Inflation
Arbitrary redistribution of purchasing power - many long-te
o t a ts ot i de ed, ut ased o Eπ.
- If π tu s out diffe e t f o Eπ, the so e gai at othe s’ e pe se, e . o o e s & le de s
If π > Eπ, then i − π < i − Eπ and purchasing power is transferred from lenders to borrowers.
If π < Eπ, then purchasing power is transferred from borrowers to lenders.
Additional Cost of High Inflation
Increased uncertainty - he i flatio is high, it’s o e a ia le a d u p edi ta le - π tu s out
diffe e t f o Eπ o e ofte , a d the diffe e es te d to e la ge
- Arbitrary redistributions of wealth become more likely, creating higher uncertainty, making risk
averse people worse off.
One Benefit of Inflation
- Nominal wages are rarely reduced, even when the equilibrium real wage falls; creates difficulty
for labor market clearing to occur .
- Inflation allows the real wages to reach equilibrium levels without nominal wage cuts.
- Therefore, moderate inflation improves the functioning of labor markets.
Hyperinflation (crazy fast inflation) - actual inflation is equal or more than 50% per month
- All the costs of moderate inflation described above become HUGE under hyperinflation
- Money stops functioning as a store of value, and may not serve its other functions (unit of
account, medium of exchange).
- People may conduct transactions with barter or a stable foreign currency.
- Caused by excessive money supply growth, when the central bank prints money, price level
rises; money printed too rapidly, causes hyperinflation
- When a government cannot raise taxes or sell bonds, it must finance spending increases by
printing money
In theory, solution: Stop printing money but in reality, this requires drastic and painful fiscal restraint.
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The Classical Dichotomy
Classical dichotomy - theoretical separation of real and nominal variables in the classical model; implies
nominal variables do not affect real variables
Real variables - measured in physical units such as quantities and relative prices, ex. quantity of output
produced, real wage, real interest rate
Nominal variables - measured in money units, ex. nominal wage (dollars per hour of work), nominal
interest rate (dollars earned in future by lending one dollar today), price level
Neutrality of money - changes in the money supply do not affect real variables, money is approximately
neutral in the long run.
Chapter 5: The Open Economy
In an open economy,
- spending need not equal output
- saving need not equal investment
Preliminaries
*d = spending on domestic goods; f = spending on foreign goods
EX = exports = foreign spending on domestic goods
IM = imports - spending on foreign goods = C f + I f + G f
NX = et e po ts t ade ala e = EX – IM
- Value of NX is also the value of the excess national savings over investment
GDP = expenditure on domestically produced g & s; Y = C + I + G + NX
NX = Y – (C + I + G)
Trade surplus - output > spending and exports > imports
Trade deficit - spending > output and imports > exports (-)
Net capital outflow (S – I) - net outflo of loa a le fu ds
- Net purchases of foreign assets - ou t ’s pu hases of fo eig assets
of domestic assets
Net lender - when S > I
Net borrower - when S < I
Trade balance = net capital outflow
Y – (C + I + G) = S - I
**Thus, a country with a trade deficit (NX < 0) is a net borrower (S < I).
i us fo eig pu hases
National Saving: Supply of Loanable Funds
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-
National saving does not depend on the interest rate
Assumptions about Capital Flows
a. domestic and foreign bonds are perfect substitutes (same risk, maturity, etc.)
b. perfect capital mobility - no restrictions on international trade in assets
c. economy is small: cannot affect the world interest rate, denoted r*
A and b imply r = r*; c implies r* is exogenous
Investment: Demand for Loanable Funds
-
If the economy were closed then the interest rate would adjust to equate investment and
saving.
But in a small open economy, exogenous world interest rate determines investment and the difference
between saving and investment determines net capital outflow and net exports.
Three Experiments
1. Fiscal policy at home - increase in G or decrease in T reduces saving
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2. Fiscal policy abroad - expansionary fiscal policy abroad raises the
world interest rate.
e = nominal exchange rate, relative price of domestic currency in terms of foreign currency (ex. Yen per
Dollar)
ε = real exchange rate, relative price of domestic goods in terms of foreign goods (e.g. Japanese Big
Macs per U.S. Big Mac)
P = price of domestic good
P* = price of good in foreign country
↑ε ⇒U.“. goods e o e o e e pe si e elati e to fo eig goods, so ↓NX
its o e e pe si e to
make domestic goods)
The NX Curve for the U.S
NX = NX ε
Whe ε is elati el lo , U.“. goods a e elati el i e pe si e so U.“. et e po ts ill e high.
At high e ough alues of ε, U.“. goods e o e so e pe si e that e e po t less tha e i po t
Ho ε is Dete i ed
- The accounting identity says NX = S – I
We saw earlier how S – I is determined:
- S depends on domestic factors (output, fiscal policy variables, etc)
- I is determined by the world interest rate r *
“o, ε ust adjust to e su e,
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- Neither S nor I depend o ε, so the et apital outflo u e is e ti al.
- ε adjusts to e uate NX ith et apital outflo , “ − I.
Demand - foreigners need dollars to buy U.S. net exports
Supply - et apital outflo “ − I - supply of dollars to be invested abroad
Four Experiments
1. Fiscal policy at home - fiscal expansion reduces national saving, net capital outflow, the supply
of dollars in the foreign exchange market causing the real exchange
rate to rise and NX to fall.
2. Fiscal policy abroad - increase in r* reduces investment, increasing net capital outflow and the supply
of dollars in the foreign exchange market causing the real exchange rate to fall and NX to rise
3. Increase in investment demand - reduces net capital outflow and the supply of dollars in the foreign
exchange market causing the real NX exchange rate to rise and NX to fall
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4. Trade policy to restrict imports - at a gi e alue of ε, a i po t uota ⇒↓IM ⇒↑NX ⇒demand for
dollars shifts right
- T ade poli does ’t affect S or I, so capital flows and the supply of dollars remain fixed.
Δε >
de a d i
ease ; ΔNX =
suppl fi ed ; ΔIM <
poli
; ΔEX <
ise i ε
Determinants of the Nominal Exchange Rate
*e depends on the real exchange rate and the price levels at home and abroad
Purchasing Power Parity (PPP) - states that goods must sell at the same (currency-adjusted) price in all
countries.
- The nominal exchange rate adjusts to equalize the cost of a basket of goods across countries.
- Reasoning: arbitrage and law of one price
Solve for e : e = P*/ P
- PPP implies that the nominal exchange rate between two countries equals the ratio of the
ou t ies’ p i e le els.
- ε = a d the NX de a d u e is ho izo tal
- Under PPP, changes in (S – I ha e o i pa t o ε o e.
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Does PPP hold in the real world? No,
International arbitrage not possible - nontraded goods, transportation costs
Diffe e t ou t ies’ goods ot pe fe t su stitutes.
A Fiscal Expansion in Three Models
A fiscal expansion (at home, not abroad)causes national saving to fall. The effects of this depend on
openness & size:
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