INTRODUCTION TO BUSINESS ECONOMICS
Scarcity: All resources are limited.
Incentives: A reward that encourages an action or a penalty that discourages an action.
Economics:
Economics is the social science that studies the choices that individuals, businesses,
governments, and entire societies make as they deal with scarcity, and the incentives that
influence those choices. It is divided into two main parts:
● Macroeconomics: The study of the performance of the national and global economies.
● Microeconomics: The study of choices that individuals and businesses make, the way
those choices interact in markets, and the influence of governments.
Two Big Economic Questions:
Two big questions summarise the scope of economics:
01. How do choices end up determining what, how, and for whom goods and services get
produced?
02. When do choices made in the pursuit of self-interest also promote social interest?
How do choices end up determining what, how, and for whom goods and services get produced?
What? - Goods and services are the objects that people value and produce to satisfy human
wants. Goods and services people want can change over time. As wants change, the goods and
services produced also change.
How? Goods and services are produced by using productive resources that economists call
factors of production. Factors of production are grouped into four categories:
01. Land - In economics, the gifts of nature or natural resources that are used to produce
goods and services are considered as land.
02. Labour - The work time and work effort (physical and mental) that people use to produce
goods and services is labour. The quality of labour depends on human capital –
knowledge and skill that people get from education and experience.
03. Capital - The tools, instruments, machines, buildings, and other equipment that
businesses use to produce goods and services are called capital.
04. Entrepreneurship - The human resource that organises land, labour, and capital is
entrepreneurship. This is the resource that takes the risk of success or failure.
Whom? Who gets the goods and services depends on the incomes that people earn. The people
who earn income and have the ability to buy, are for whom goods are produced.
When do choices made in the pursuit of self-interest also promote social interest?
Self Interest: It is when people make choices based on what is best for them.
Social Interest: When people make choices that are best for society. Social interest has two
dimensions – efficiency and equity. These dimensions are important because resources are
limited in every society.
Draw & Interpret Graphs in Economics
Graphing Data:
● A graph reveals a relationship.
● A two-variable graph uses two perpendicular scale lines.
● The vertical line is the y-axis.
● The horizontal line is the x-axis.
● The zero point in common to both axes is the origin.
Graphs used in Economic Models:
Graphs are used in economic models to show the relationship between variables. There are four
patterns to look for in graphs:
01. Variables move in the same
direction:
A relationship between two variables that
move in the same direction is called a
positive relationship or a direct
relationship. A line that slopes upward
shows a positive relationship. A
relationship shown by a straight line is called a linear relationship.
02. Variables move in opposite directions:
A relationship between two variables
that move in opposite directions is
called a negative relationship or an
inverse relationship. A line that slopes
downward shows a negative
relationship.
03. Variables have a maximum or a
minimum:
There are relationships that have a maximum and a
minimum. These relationships are positive over part
of their range and negative over the other part.
04. Variables are unrelated:
Sometimes, there are two variables that
are unrelated (no relationship).
While graphing relationships between more than two variables, use the Ceteris Paribus
assumption.
Ceteris Paribus assumption: Assumes that all other variables are held at a constant value while
graphing more than two variables.
KEY BUSINESS ECONOMIC CONCEPTS
Production Possibility Frontier (PPF)
● The production possibilities frontier (PPF) is the boundary between the combinations of
goods and services that can be produced and those that cannot.
● To illustrate this, two goods should be focused on and the qualities of all other goods and
services should be held constant.
● Use the ceteris paribus assumption in a model economy where everything remains
constant.
Example: This is the PPF for two goods: colas and pizzas. Any point on the frontier such as E
and any point inside the PPF such as Z
are attainable. Points outside the PPF
are unattainable.
If production efficiency is achieved,
more of one good cannot be produced
without producing less of another
good. All points on the PPF are
efficient.
Any point inside the frontier, such as Z, is inefficient. At such a point, it is possible to produce
more of one good without producing less of the other good. At Z, resources are either:
unemployed (not used fully) or misallocated (used incorrectly).
Tradeoff Along the PPF: Every choice along the PPF involves a tradeoff. One good must be
given up to obtain more of the other. Every choice made is a tradeoff.
Production Possibilities and Opportunity Cost:
Opportunity cost is the highest valued alternative given up to get something else. While moving
along the PPF, if good A is produced more than the other, the quantity of the good B decreases.
The opportunity cost of good A produced will be the good B forgone (given up). The opportunity
cost is a ratio. The opportunity cost of producing good A is the inverse of the opportunity cost of
good B.
Opportunity Cost of Producing Product A:
𝐷𝑒𝑐𝑟𝑒𝑎𝑠𝑒 𝑖𝑛 𝑃𝑟𝑜𝑑𝑢𝑐𝑡 𝐵
𝐼𝑛𝑐𝑟𝑒𝑎𝑠𝑒 𝑖𝑛 𝑃𝑟𝑜𝑑𝑢𝑐𝑡 𝐴
Increasing Opportunity Cost: Because resources are not equally productive in all activities, the
PPF bowed outward. The outward bow of the PPF means that as the quantity produced of each
good increases, so does its opportunity cost.
Using Resources Efficiently: All the points along the PPF are efficient. To determine which of
the alternative efficient quantities to produce, costs and benefits should be compared.
The PPF and Marginal Cost: The PPF determines opportunity cost. The marginal cost of a
good or service is the opportunity cost of producing one more unit of it.
Gains from Trade
Comparative Advantage and Absolute Advantage:
● Absolute advantage involves comparing productivities while comparative advantage
involves comparing opportunity costs.
● A person has a comparative advantage in an activity if that person can perform the
activity at a lower opportunity cost than anyone else.
● A person has an absolute advantage if that person is more productive than others.
PPF & Future Expansion (Economic Growth)
Economic Growth: The expansion of production possibilities—an increase in the standard of
living—is called economic growth. Two key factors influence economic growth:
● Technological change - Technological change is the development of new goods and of
better ways of producing goods and services.
● Capital accumulation - Capital accumulation is the growth of capital resources, which
includes human capital.
The Cost of Economic Growth: Increasing investment in capital and technology creates
economic growth and increases income. To use resources in research and development and
produce new capital, there should be a decrease in the production of consumption goods and
services. So economic growth is not free. The opportunity cost of economic growth is less
current consumption.
DEMAND AND SUPPLY
Demand: Wants are the unlimited desires or wishes people have for goods and services. Demand
is the decision about which wants to satisfy. One should be able to “willing” and “able” to buy it.
The Law of Demand:
Other things remain the same, the higher the price of a
good, the smaller is the quantity demanded and, the
lower the price of a good, the larger is the quantity
demanded.
A change in price affects demand for two reasons. Firstly,
01. Substitution Effect: When the relative price (opportunity cost) of a good or service
rises, people seek substitutes for it, so the quantity demanded of the good or service
decreases.
02. Income Effect: When the price of a good or service rises relative to income, people
cannot afford all the things they previously bought, so the quantity demanded of the good
or service decreases
Graphing Demand Law
● Demand: Demand refers to the entire relationship between the price of the good and the
quantity demanded
● Demand Schedule: A demand
schedule is a chart (table) with data
about the quantities demanded at
each price.
● Demand Curve: A demand curve
is a graph of the data in a demand
schedule. It shows the relationship
between the quantity demanded of a good and its price, all other influences remaining the
same. (Other things being equal).
Difference between Quantity Demanded & Change in Demand
Quantity Demanded:
● Quantity demanded is a certain point on a demand curve
showing the quantity demanded at a particular price.
● The demand curve also shows willingness and ability to
pay. The willingness to pay measures the marginal benefit
of the good or service.
● Quantity demanded shows movement on the same curve.
● Only price changes
● If the price rises, other things remaining the same, the
quantity demanded decreases - a movement up along the
demand curve.
● If the price falls, other things remain the same, the quantity
demanded increases - a movement down along the demand
curve.
Change in Quantity Demanded vs Change in Demand:
● If only price changes, there is a change in the quantity demanded and there is a
movement along the demand curve.
● When something other than price changes, demand
changes and the entire demand curve shifts.
● Price does not change.
● When anything other than the price influences
buying plans there is a change in demand for that good.
● The quantity of the goods that people plan to buy
changes at each and every price, so there is a new demand
curve.
Six main factors that change demand are:
01. Prices of Related Goods: A substitute is a good that can be used in place of another
good. A complement is a good that is used together with another good.
02. Expected Future Prices: If the price of a good is expected to rise in the future, and the
good can be stored, current demand for the good increases and the demand curve shifts
rightward.
03. Income: When income increases, consumers buy more of most goods, and the demand
curve shifts rightward:
● A normal good is one for which demand increases as income increases
● An inferior good is a good for which demand decreases as income increases.
04. Expected Future Income and Credit: When income is expected to increase in the future
or when credit is easy to obtain, the demand might increase now.
05. Population: The larger the population, the greater is the demand for all goods.
06. Preferences: People with the same income have different demands if they have different
preferences.
Supply: If a firm supplies a good or service, then the firm:
● Has the resources and the technology to produce it
● Can profit from producing it, and
● Has made a definite plan to produce and sell it
The Law of Supply: Other things remain the same, the higher the price of a good, the greater is
the quantity supplied; and the lower the price of a good, the smaller is the quantity supplied. The
reasons why the law applies are:
● The general tendency that the marginal (additional) cost of producing a good or service
increases as the quantity produced increases
● So, producers are willing to supply a good only if the price covers at least the marginal
cost of production.
Graphing the Law of Supply
Minimum Supply Price: A supply curve is also a
minimum-supply-price curve. As the quantity produced increases,
marginal cost increases. The lowest price at which someone is willing to
sell an additional unit rises. This lowest price is marginal cost.
Supply: The term supply refers to the entire relationship between the quantity supplied and the
price of a good. It is illustrated by the
supply schedule & supply curve.
Supply Curve: The supply curve shows
the relationship between the quantity
supplied of a good and its price when all
other influences on producers’ planned
sales remain the same. An increase in
price brings an increase in the quantity supplied.
Difference between Quantity Supplied & Change in Supply
● When only price changes, there is a change in the
quantity supplied and a movement along the supply
curve. The quantity increases or decreases.
● When something other than price changes, supply
changes and the entire supply curve shifts to the right or
left.
Change in Supply: A change in supply is when the price does not change. When anything other
than the price influences selling plans there is a change in supply for that good. The quantity of
the goods that producers plan to sell changes at each and every price, so there is a new supply
curve. When supply increases, the supply curve shifts rightward. When supply decreases, the
supply curve shifts leftward.
The six main factors that change supply of a good are:
01. Prices of Factors of Production: If the price of a factor of production used to produce a
good rise, the producer’s profitability decreases therefore supply decreases. A rise in the
price of a factor of production decreases supply and shifts the supply curve leftward.
02. Prices of Related Goods Produced:
● A substitute in production for a good is another good that can be produced using
the same resources
● The supply of a good increases if the price of a substitute in production falls.
● Goods are complements in production if they must be produced together
● The supply of a good increases if the price of a complement in production rises.
03. Expected Future Prices: If the price of a good is expected to rise in the future, supply of
the good today decreases and the supply curve shifts leftward.
04. The Number of Suppliers: The larger the number of suppliers of a good, the greater is
the supply of the good. An increase in the number of suppliers shifts the supply curve
rightward
05. Technology: Advances in technology create new products and lower the cost of
producing existing products. So advances in technology increase supply and shift the
supply curve rightward
06. The State of Nature: The state of nature includes all the natural forces that influence
production (for example, the weather). A natural disaster decreases supply and shifts the
supply curve leftward.
Equilibrium & Surplus and Shortage
Market Equilibrium:
● Equilibrium is a situation in which opposing forces balance each other.
● Equilibrium in a market happens when the price balances the plans of buyers and sellers.
● The equilibrium price is the price at which the quantity demanded equals the quantity
supplied
● The equilibrium quantity is the quantity bought and sold at the equilibrium price
● If the price increases, the quantity supplied exceeds the quantity demanded. There is a
surplus and prices will fall.
● If the price decreases, the quantity demanded exceeds the quantity supplied. There will be
a shortage and prices will rise.
● If price is kept normal, the quantity supplied equals the quantity demanded. There will be
no shortage or surplus or change in supply.
Price Adjustments: At prices above the equilibrium price, a surplus forces the price down. At
prices below the equilibrium price, a shortage forces the price up. At the equilibrium price,
buyers’ plans and sellers’ plans agree and the price doesn’t change until an event changes
demand or supply.
How markets correct a shortage: When demand increases the demand curve shifts rightward.
At the original price, there is now a shortage. The price rises, and the quantity supplied increases
along the supply curve.
How markets correct a surplus: When supply increases the supply curve shifts rightward. At
the original price, there is now a surplus. The price falls, and the quantity supplied decreases
along the supply curve.
PRODUCTION OUTPUT
Decisions:
All major companies have annual budgets and must plan in advance. Every firm (business), has
to decide:
● How much to produce?
● How many people to employ?
● How much and what type of capital equipment to use?
Decision Time Frames:
The firm makes many decisions to achieve its main objective: profit maximisation. (Total
Revenue –Total Cost). Some decisions are critical to the survival of the firm. Some decisions are
irreversible (or very costly to reverse). Other decisions are easily reversed and are less critical to
the survival of the firm, but still influence profit.
All decisions can be placed in two time frames:
01. The Short Run:
● The short run is a time frame in which the quantity of one or more resources used in
production is fixed.
● For most firms, the capital (factory building and machines), called the firm’s plant, is
fixed in the short run.
● Other resources used by the firm (such as labour, raw materials, and energy) can be
changed in the short run.
● Short-run decisions are easily reversed.
02. The Long Run:
● The long run is a time frame in which the quantities of all resources including the plant
size can be varied.
● Long-run decisions are not easily reversed.
● A sunk cost is a cost incurred by the firm and cannot be changed.
● If a firm’s plant has no resale value, the amount paid for it is a sunk cost.
● Sunk costs are irrelevant to a firm’s current decisions.
Short Run Products & Curves
Short Run Product - Constraints: To increase output (called ‘product’) in the short run, a firm
must increase the amount of labour employed. Three concepts describe the relationship between
output and the quantity of labour employed: total product, marginal product and average product
Short Run Product Schedules:
Total Product: Total product is the total output produced in a given period.
Marginal Product: The marginal product of labour is the change in total product that results
from a one-unit increase in the quantity of labour employed, with all other inputs remaining the
same.
Average Product: The average product of labour is equal to the total product divided by the
quantity of labour employed.
As the quantity of labour employed (used) increases:
● Total product increases.
● Marginal product increases initially, but eventually decreases.
● Average product increases initially, but eventually decreases.
Short Run Product Curves:
Product Curves: Product curves show how the firm’s total product, marginal product, and
average product change as the firm varies the quantity of labour employed.
Total Product Curve: The total product curve shows how total
product changes with the quantity of labour employed. The total
product curve is similar to the PPF. It separates attainable output levels
from unattainable output levels in the short run.
Marginal Product Curve: The
marginal product curve relates to the
total product curve. The curve is the total product curve. The
height of each bar measures the marginal product of labour. Example: The first worker hired
produces 4 units of output. The second worker hired produces 6 units of output and the total
product becomes 10 units. The third worker hired produces 3 units of output and the total
product becomes 13 units and so on. When labour increases from 2 to 3, total product increases
from 10 to 13, so the marginal product of the third worker is 3 units of output.
Short-Run Marginal Product Curve:
To make a graph of the marginal product of labour, the bars in the
previous graph are stacked side by side. The marginal product of
the labour curve passes through the midpoints of these bars. Most
production processes are like the one shown here and have:
Increasing marginal returns initially Diminishing marginal returns
eventually.
Increasing Marginal Returns: Initially, the marginal product of a
worker exceeds the marginal product of the previous worker. The
firm experiences increasing marginal returns.
Diminishing Marginal Returns:
Eventually, the marginal product of a worker is less than the marginal
product of the previous worker. The firm experiences diminishing marginal
returns.
Short Run Technology Constraint:
Increasing marginal returns arise from increased specialisation and division of labour.
Diminishing marginal returns arises because each additional worker has less access to capital and
less space in which to work. Diminishing marginal returns are so pervasive (common) that they
are elevated to the status of a “law.” The law of diminishing returns states that: "As a firm uses
more of a variable input with a given quantity of fixed inputs, the marginal product of the
variable input eventually diminishes."
Short Run Average and Marginal Product Curve
Average Curve:
This shows the average product curve and its relationship with the
marginal product curve. When marginal product exceeds the average
product, the average product increases.
● When a marginal
product exceeds the average
product, the average product increases.
● When a marginal product is below average
product, the average product decreases.
● When marginal product equals average product,
average product is at its maximum.
● The most efficient number of workers is the
number that produces the highest average product.
Short-Run Costs
To produce more output in the short run, the firm must employ more labour, which means that it
must increase its costs. Three cost concepts and three types of cost curves are: total cost,
marginal cost and average cost.
01. Total Cost:
● A firm’s total cost (TC) is the cost of all resources used.
● Total fixed cost (TFC) is the cost of the firm’s fixed inputs.
Fixed costs do not change with output.
● Total fixed cost is the same at each output level. Total variable cost increases as output
increases. Total cost, which is the sum of TFC and TVC, also increases as output
increases.
● Total variable cost (TVC) is the cost of the firm’s variable inputs. Variable costs do
change with output. Total cost equals total fixed cost plus total variable cost.
TC = TFC + TVC
02. Marginal Cost:
● Marginal cost (MC) is the increase in total cost that results from a one-unit increase in
total product. When MP is ↑ MC is ↓ and when MP is ↓ MC is ↑
● Over the output range with increasing marginal returns, marginal cost falls as output
increases.
● Over the output range with diminishing marginal returns, marginal cost rises as output
increases.
03. Average Cost:
Average cost measures can be derived from each of the total cost measures:
● Average fixed cost (AFC) is total fixed cost per unit of output. (TFC / TP)
● Average variable cost (AVC) is total variable cost per unit of output. (TVC / TP)
● Average total cost (ATC) is total cost per unit of output. (TC / TP)
ATC = AFC + AVC
Short-Run Average Costs
The Figure shows the AFC, AVC, and curves.
The AFC curve shows that average fixed cost falls as output
increases. The AVC curve is U-shaped. As output increases,
average variable cost falls to a minimum and then increases.
The Figure shows the MC,
AFC, AVC, and ATC curves. The ATC curve is also U-shaped.
The MC curve is very special. For outputs over which AVC is
falling, MC is below AVC. For outputs over which AVC is rising, MC is above AVC. For the
output at minimum AVC, MC equals AVC.
When MC is below ATC, the ATC is decreasing. When MC
moves above the ATC, the ATC is increasing At the
minimum ATC, MC equals ATC. The most efficient quantity
to produce is the quantity where the ATC is lowest
(minimum).
Why the Average Total Cost Curve is U-Shaped?
The AVC curve is U-shaped because:
● Initially, MP exceeds AP, which brings rising AP and falling AVC.
● Eventually, MP falls below AP, which brings falling AP and rising AVC.
● The ATC curve is U-shaped for the same reasons.
● In addition, ATC falls at low output levels because AFC is falling quickly.
The ATC curve is the vertical sum of the AFC curve and the AVC curve. The U-shape of the
ATC curve arises from the influence of two opposing forces:
01. Spreading total fixed cost over a larger output - AFC curve slopes downward as output
increases.
02. Eventually diminishing returns - the AVC curve slopes upward and AVC increases more
quickly than AFC is decreasing.
Short-Run Cost Curves
Cost Curves and Product Curves: The shapes of a firm’s cost
curves are determined by the technology it uses.
Average and Marginal Product and Cost: The firm’s cost curves
are linked to its product curves. MC is at its minimum at the same
output level at which MP is at its maximum. When MP is rising, MC
is falling. AVC is at its minimum at the same output level at which AP is at its maximum. When
AP is rising, AVC is falling.
Shifts in the Cost Curves
The position of a firm’s cost curves depends on two factors:
01. Technology :
● Technological change influences the product curves and the cost curves.
● An increase in productivity shifts the product curves upward and the cost curves
downward.
● If a technological advance results in the firm using more capital and less labour, fixed
costs increase and variable costs decrease.
● In this case, average total cost increases at low output levels and decreases at high output
levels
02. Prices of Factors of Production:
● An increase in the price of a factor of production increases costs and shifts the cost
curves.
● An increase in a fixed cost shifts the total cost (TC ) and average total cost (ATC ) curves
upward but does not shift the marginal cost (MC ) curve.
● An increase in a variable cost shifts the total cost (TC ), average total cost (ATC ), and
marginal cost (MC ) curves upward.
Long Run Cost:
In the long run, all inputs are variable and all costs are variable.
The Production Function: The behaviour of long-run cost depends upon the firm’s production
function. The firm’s production function is the relationship between the maximum output
attainable and the quantities of both capital and labour. As the size of the firm increases, the
output that a given quantity of labour can produce increases. But for each plant, as the quantity
of labour increases, diminishing marginal returns occur.
Diminishing Marginal Product of Capital: The marginal product of capital is the increase in
output resulting from a one-unit increase in the amount of capital employed, holding constant the
amount of labour employed. A firm’s production function exhibits:
● Diminishing marginal returns to labour (for a given plant)
● Diminishing marginal returns to capital (for a quantity of labour).
For each plant, diminishing marginal product of labour creates a set of short run, U-shaped cost
curves for MC, AVC, and ATC.
Short-Run Cost and Long-Run Cost: The average cost of producing a given output varies and
depends on the firm’s plant. The larger the plant, the greater is the output at which ATC is at a
minimum. The long-run average cost curve is made up from the lowest ATC for each output
level.
The Long-Run Average Cost Curve (LRAC):
The long-run average cost curve (LRAC) is the
relationship between the lowest attainable average total
cost and output when both the plant and labour are
varied. The LRAC curve is a planning curve that tells
the firm the plant that minimises the cost of producing
a given output. Once the firm has chosen its plant, the
firm incurs the costs that correspond to the ATC curve
for that plant.
Economies and Diseconomies of Scale
● Economies of scale are features of a firm’s
technology that lead to falling long-run average cost
as output increases.
● Diseconomies of scale are features of a firm’s
technology that lead to rising long-run average cost as
output increases.
● Constant returns to scale are features of a firm’s technology that lead to constant long-run
average cost as output increases.
Minimum Efficient Scale:
A firm experiences economies of scale up to some
output level. Beyond that output level, it moves into
constant returns to scale or diseconomies of scale.
Minimum efficient scale is the smallest quantity of
output at which the long-run average cost reaches its
lowest level. If the LRAC curve is U-shaped, the
minimum point identifies the minimum efficient
scale output level.
PERFECT COMPETITION
Perfect competition takes place when a market has:
● Many firms sell identical products to many buyers.
● There are no restrictions to enter or exit the market.
● Existing firms have no advantages over firms that are newly opened up.
● Buyers and sellers are well informed as the market information on prices and quantities
available is transparent and accessible.
Perfect competition happens when:
● The firm’s minimum efficient scale is small relative to market demand, so there is room
for many firms in the market.
● All firms appear to produce a product or service with no unique characteristics. So,
consumers don’t mind buying from any firm.
In perfect competition firms are price takers. A price taker is a firm that has no influence over the
price of a good or service. No single firm can influence the price and must “take” the market
equilibrium price. Each firm’s output is a perfect substitute for the output of the other firms, so
the demand for each firm’s output is perfectly elastic.
Perfect Competition
Economic Profit and Revenue: The goal of each firm is to maximise economic profit, which
equals total revenue minus total cost. Total cost is the opportunity cost of production, and
includes normal profit. A firm’s total revenue equals price, P, multiplied by quantity sold, Q, or
Total revenue = P × Q
A firm’s marginal revenue is the change in total revenue that results from a one-unit increase in
the quantity sold.
Market Price, Total & Marginal
Revenue: Figure (a) shows that market
demand and market supply determine
the market price, figure (b) shows the
firm’s total revenue curve and figure (c)
shows the marginal revenue curve
(MR), which is the demand curve for
the firm’s product.
The Firm’s Decisions
A perfectly competitive firm’s goal is to make maximum economic profit, given the constraints it
faces. Firm’s need to answer and decide about these questions:
01. How to produce at a minimum cost?
02. What quantity to produce?
03. Should it enter or exit a market?
The Firm’s Output Decision
Using Total Revenue & Total Cost: One way to find the profit
maximising output in perfect competition is by looking at Total Cost &
Total Revenue curves.
Figure (a) shows the total revenue, TR, curve and the total cost curve,
TC.Total revenue minus total cost is
economic profit (or loss), shown by the
curve EP in Figure (b).
At low output levels, the firm incurs an
economic loss - it can’t cover its fixed
costs. At intermediate output levels, the firm makes an economic
profit. At high output levels, the firm again incurs an economic
loss - now the firm faces steeply rising costs because of
diminishing returns. The firm maximises its economic profit
when it produces 9 sweaters a day.
Using Marginal Revenue & Marginal Cost: The firm can
use marginal analysis to determine the profit-maximising
output. Because marginal revenue is constant and marginal
cost eventually increases as output increases, profit is
maximised by producing the output at which marginal
revenue, MR, equals marginal cost, MC. Profit is maximised
when MR=MC.
● If MR > MC, economic profit increases if output
increases.
● If MR < MC, economic profit decreases if output increases.
● If MR = MC, economic profit decreases if output changes in either direction, so
economic profit is maximised.
Temporary Shutdown Decision: If the firm makes an economic loss, it must decide whether to
exit the market or to stay in the market. If the firm decides to stay in the market, it must decide
whether to produce something or to shut down temporarily. The decision will be the one that
minimises the firm’s loss.
Loss Comparisons
The firm’s loss equals total fixed cost (TFC) plus total variable cost (TVC) minus total revenue
(TR).
Economic loss = TFC + TVC - TR
= TFC + (AVC x Q) – P x Q
= TFC + (AVC - P) x Q
If the firm shuts down, Q is 0 & the firm still has to pay TFC. So the firm incurs an economic
loss equal to TFC. This economic loss is the largest that the firm must bear.
Shutdown Point: A firm’s shutdown point is the price and quantity at which it is indifferent
between producing the profit-maximising quantity and shutting down. The shutdown point is at
minimum AVC (only variable costs are being covered). This is also the point where the MC
curve crosses the AVC curve.
At the shutdown point, the firm is indifferent between
producing and shutting down temporarily (it is minimising
its loss). At the shutdown point, the firm incurs a loss equal
to total fixed cost (TFC) point.
Minimum AVC is $17 a sweater. At $17 a sweater, the
profit-maximising output is 7 sweaters a day. The firm incurs
a loss equal to the red rectangle.
The shutdown point is where MC curve equals AVC curve.
At the shutdown point the only loss is the Fixed Cost.
Profits and Losses in the Short Run: Maximum profit is not always a positive economic profit.
To see if a firm is making a profit or incurring a loss we compare the firm’s ATC at the
profit-maximising output with the market price.
In Figure (a) price equals average total cost and the firm makes zero
economic profit (breaks even).
In Figure (b), price exceeds average
total cost and the firm makes a positive economic profit.
In Figure (c), price is less than average total cost and the firm
incurs an economic loss - economic profit is negative.
Output, Price, and Profit in the Long Run
In short-run equilibrium, a firm can make an economic profit, break even, or incur an economic
loss. In long-run equilibrium, firms break even because firms can enter or exit the market. Firms
can also change their plant size, and change their costs in the long run.
Entry and Exit: New firms enter an industry in which existing firms make an economic profit
so supply increases and prices fall and every firm makes normal profit. Firms exit an industry
when they incur an economic loss, so supply decreases and price rises and every firm makes
normal profit.
MONOPOLIES
A monopoly is a market in which there is only one supplier that is protected from competition by
a barrier preventing entry of new firms into the market. A monopoly produces a good or service
that has no close substitute. Two features that help create monopolies are:
01. A product or service with no close substitute
02. Existence of barriers to enter the market that prevent competition.
Features of a monopoly
01. No close substitutes: If a good has a close substitute, even if it is produced by only one
firm, that firm effectively faces competition from the producers of substitutes. But, a
monopoly sells a good that has no close substitutes.
02. Barriers to entry: Monopoly firms are protected from potential competitors through one
of the following types of barriers to entry into the market.
●
Natural Barriers to Entry: Natural barriers to entry create a natural monopoly. A
natural monopoly is a market in which economies of scale enable one firm to
supply the entire market at the lowest possible cost. The more monopoly
produces, the lower their ATC.
● Ownership Barriers to Entry: An ownership barrier to entry occurs if one firm
owns a significant portion of a key resource.
● Legal Barriers to Entry: Legal barriers to entry create a legal monopoly. A legal
monopoly is a market in which competition and entry are restricted by the
granting of a public franchise, government licence or patent or copyright.
Setting Prices in a Monopoly
A monopoly’s price strategies are that it is a price setter, not a price taker like a firm in perfect
competition. A monopoly can have two types of pricing strategies:
01. Single Price: Sell each unit at the same price to every customer.
02. Price Discrimination: Sell at different prices to different customers.
Single Price Strategy and Marginal Revenue
Due to the fact that the monopoly is the only supplier, the demand for the monopoly output =
market demand. However, to sell a larger output, a monopoly must reduce its price.
Example: Suppose the monopoly sets a price of $16 and sells 2 units.
Suppose the firm cuts the price to $14 to increase sales to 3 units. It loses
$4 of total revenue on the 2 units it was selling at $16 each. It gains $14
of total revenue on the 3rd unit. Total revenue increases by $10, which is
marginal revenue. The marginal revenue, curve, MR, passes through the
red dot midway between 2 and 3 units and at $10.
MR<P at every quantity
A Single-Price Monopoly’s Price and Output Decision
The monopoly faces the same types of technology constraints as the competitive firm, but the
monopoly faces a different market constraint. The monopoly still selects the profit-maximising
quantity in the same way as a competitive firm: MR = MC. The monopoly sets its price at the
highest level at which it can sell the profit-maximising
quantity.
The firm produces the quantity at which MR = MC and sets
the price at which it can sell that quantity. The ATC curve
tells the average cost. Economic profit is the profit per unit
multiplied by the quantity produced.
The monopoly might make an economic profit, even in the long run, due to the barriers to protect
the form from market entry by competitor firms. But a monopoly that incurs an economic loss
might shut down temporarily in the short run or exit the market in the long run.
Price Discrimination vs Single Price: Price discrimination is when a monopoly charges
different prices for different units or different customers. Price discrimination increases the
monopoly’s economic profit.
Two conditions are required for price discrimination:
01. The firm’s product cannot be resold
02. It is possible to identify and separate different types of buyers
Two ways of price discrimination - among groups of buyers and among units of a good.
Increasing Profit and Producer Surplus: By price discriminating, a monopoly captures
consumer surplus and converts it into producer surplus. The monopoly gets consumers to pay as
close to their maximum willingness to pay as possible.
Example: A price discriminating airline. The graph shows the market
demand and the airline’s marginal cost of $40 a trip. The airline sells 8000
trips a week at $120 a trip. Travellers enjoy a consumer surplus.
The airline has a producer surplus of
$640,000.
Discriminating between types of travellers:
The leisure travellers will not pay $120 a trip,
so the demand for leisure travel will be the
curve DL. The airline sells 4,000 leisure trips at
$80 a trip.
The airline increases its output to 12,00 trips
a week. Consumer surplus increases and the
airline’s producer surplus increases.
Perfect Price Discrimination
Perfect price discrimination occurs if a firm is able to sell each
unit of its output for the highest price someone is willing to
pay. Marginal revenue now equals the price (selling additional
units to different buyers at lower prices). The demand curve is
also the marginal revenue curve. The perfect price
discriminatory monopoly increases its output until the price of
the last trip equals marginal cost. The monopoly makes the
maximum possible profit.
ECONOMIC INDICATORS
Gross Domestic Product (GDP)
It is the market value of all final goods and services produced in a country in a given time period.
This definition has 4 parts - market value, final goods and services, produced in a country, within
a time period.
Final Goods and Services: GDP is the value of the final goods and services produced. A final
good or service is an item bought by its final user during a specific time period. A final good
contrasts with an intermediate good, which is an item that is produced by one term, bought by
another firm and used as a component of a final good or service. Excluding the value of
intermediate goods and services avoids counting the same value more than once.
Within a Country: GDP measures production within a country. Domestic production.
In a Given Time Period: GDP measures production during a specific time period, normally a
year or a quarter of a year.
GDP and the Circular Flow of Expenditure & Income
GDP measures the value of production, which also equals
total expenditure on final goods and total income. The
equality of income and value of production shows the link
between productivity and living standards. The circular
flow diagram illustrates the equality of income and
expenditure. The circular flow diagram shows the
transactions among households, firms, governments, and
the rest of the world.
Households and Firms: Households sell and firms buy the services of labour, capital, and land
in factor markets. Firms pay wages for labour services, interest for the use of capital, and rent for
the use of land. A fourth factor of production, entrepreneurship, receives profit. In the figure, the
blue flow, Y, shows total income paid by firms to households. Firms sell and households buy
consumer goods and services in the goods market. Consumption expenditure is the total payment
for consumer goods and services, shown by the red flow labelled C. Firms buy and sell new
capital equipment in the goods market and put unsold output into inventory. These purchases of
new capital equipment and the additions to inventories are investment, shown by the red flow
labelled I.
Governments: Governments buy goods and services from firms and their expenditure on goods
and services is called government expenditure. Government expenditure is shown as the red flow
G. Governments finance their expenditure with taxes and pay financial transfers to households,
such as unemployment benefits, and pay subsidies to firms. These financial transfers are not part
of the circular flow of expenditure and income.
Rest of the world: Firms in the United States sell goods and services to the rest of the world's
exports and buy goods and services from the rest of the world's imports. The value of exports (X)
minus the value of imports (M) is called net exports, the red flow (X-M). If net exports are
positive, the net flow of goods and services is from U.S. firms to the rest of the world. If net
exports are negative, the net flow of goods and services is from the rest of the world to U.S.
firms.
Domestic Vs Gross Product
Domestic: Domestic product is production within a country. It contrasts with national product,
which is the value of goods and services produced anywhere in the world by the residents of a
nation.
Gross: Gross means before deducting the depreciation of capital. The opposite of gross is net,
which means after deducting the depreciation of capital.
Measuring GDP using the Expenditure Method
The expenditure approach measures GDP as the sum of consumption expenditure, investment,
government expenditure on goods and services and net exports.
GDP = C + I + G+ (X-M)
Real and Nominal GDP
Real GDP: It is the value of final goods and services produced in the given year when valued at
the process of a reference base year. It allows to compare the value of production in two years at
the same prices.
Nominal GDP: It is the value of final goods and services produced in the given year when
valued the prices of that specific year. Nominal GDP is a more precise and accurate type
compared to the real GDP.
The Real Uses of GDP: Economists use estimates of real GDP for two main purposes:
01. The standard living over time:
Real GDP per person is real GDP divided by the population. Real GDP per person tells
the value of goods and services that the average person can enjoy. By using the real GDP,
any influence of rising prices and the cost of living on comparison can be removed.
02. The standard of living across the country:
Two problems arise in using real GDP to compare living standards across countries. The
first one is that the real GDP of one country must be converted into the same currency
units as the real GDP of the other country. The second problem is that the goods and
services in both countries must be valued at the same price.
Limitations of Real GDP
Real GDP measures the value of goods and services that are brought in markets. Some of the
factors that influence the standard of living and aren't considered as a part of the GDP are:
● Household production
● Underground economic activity
● Leisure time
● Environmental quality
ECONOMIC GROWTH
Basics of Economic Growth:
● Economic growth is the sustained expansion of production possibilities measured as the
increase in real GDP over a given period.
● The economic growth rate is the annual percentage change of real GDP.
● The economic growth rate tells how rapidly the total economy is expanding.
Real GDP Growth Rate:
𝑅𝑒𝑎𝑙 𝐺𝐷𝑃 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑌𝑒𝑎𝑟 − 𝑅𝑒𝑎𝑙 𝐺𝐷𝑃 𝑖𝑛 𝑃𝑟𝑒𝑣𝑖𝑜𝑢𝑠 𝑌𝑒𝑎𝑟
𝑅𝑒𝑎𝑙 𝐺𝐷𝑃 𝑖𝑛 𝑃𝑟𝑒𝑣𝑖𝑜𝑢𝑠 𝑌𝑒𝑎𝑟
× 100
● The standard of living depends on real GDP per person.
● Real GDP per person is real GDP divided by the population.
● Real GDP per person grows only if real GDP grows faster than the population grows
Real GDP per person =
𝑅𝑒𝑎𝑙 𝐺𝐷𝑃
𝑃𝑜𝑝𝑢𝑙𝑎𝑡𝑖𝑜𝑛
Economic Growth Versus Business Cycle Expansion
Real GDP can increase for two distinct reasons:
01. The economy might be returning to full employment in an
expansion phase of the business cycle. The return to full
employment in an expansion phase of the business cycle is
NOT economic growth.
02. Potential GDP might be increasing. The expansion of potential GDP is economic growth.
A return to full employment in an expansion is a
movement from inside the PPF to a point on the PPF: from
point A to point B. Economic growth is the outward shift
of the PPF from PPF0 to PPF1 : from point B to point C.
The Magic of Sustained Growth
The Rule of 70 states that the number of years it takes for the level
of a variable to double is approximately 70 divided by the annual
percentage growth rate of the variable.
A variable that grows:
@ 7 % a year doubles in 10 years.
@ 2 % a year doubles in 35 years.
@ 1 % a year doubles in 70 years.
How Potential GDP grows
Economic growth occurs when real GDP increases. But a one-shot increase in real GDP or a
recovery from recession is not economic growth. Economic growth is the sustained, year-on-year
increase in potential GDP.
Aggregate Production Function:
The aggregate production function tells us how real GDP
changes as the quantity of labour changes when all other
influences on production remain the same. An increase in
labour increases real GDP.
Potential GDP:
The quantity of real GDP produced when the economy is at
full employment is potential GDP. The economy is at
full-employment when 200 billion hours of labour are
employed. Potential GDP is $18 trillion.
Real GDP growth can be divided into the forces that increase:
01. Growth in the supply of labour
02. Growth in labour productivity
Growth in the supply of labour:
An increase in population increases the supply of labour. With
no change in the demand for labour, the equilibrium real wage
rate falls and the aggregate hours increase. As aggregate hours
increase, potential GDP increases. As aggregate hours
increase, potential GDP increases. Because of the diminishing
returns, the increased population increases real GDP, but
decreases real GDP per hour of labour.
Growth of Labor Productivity:
Labour productivity is the quantity of real GDP produced by an hour of labour. Labour
productivity equals real GDP divided by aggregate labour hours. If labour becomes more
productive, firms are willing to pay more for a given number of hours so the demand for labour
increases.
Technological Advances:
Technological change—the discovery and the application of new technologies and new
goods—has contributed immensely to increasing labour productivity. The growth of real GDP
per person depends on real GDP growth and the population growth rate.
Growth Theories, Evidence and Policies
Policies for Achieving Faster Growth: Growth accounting tells us that to achieve faster
economic growth we must either increase the growth rate of capital per hour of labour or
increase the pace of technological change.
The main suggestions for achieving the objectives of the growth rate of capital per hour of labour
or increase the pace of technological change are:
a. Stimulate Saving: Saving finances investment. So higher saving rates might increase
physical capital growth. Tax incentives might be provided to boost saving.
b. Stimulate Research and Development: Because the fruits of basic research and
development efforts can be used by everyone, not all the benefit of a discovery goes to
the initial discoverer. So the market might allocate too few resources to research and
development. Government subsidies and direct funding might stimulate basic research
and development.
c. Improve the Quality of Education: The benefits from education spread beyond the
person being educated, so there is a tendency to under invest in education.
d. Provide International Aid to Developing Nations: If rich countries give financial aid to
developing countries, investment and growth will increase. Data on the effect of aid
shows that it has had zero or a negative effect - due to consumption and corruption
e. Encourage International Trade: Free international trade stimulates growth by
extracting all the available gains from specialisation and trade. The fastest growing
nations are the ones with the fastest growing exports and imports.
BUSINESS CYCLES & INFLATION
The Business Cycle
Business cycles are phases of expansion and
contraction in aggregate economic activity like
production, employment, income, and sales. In each
phase of the cycle these key economic indicators
move together in the same direction.
Stages of the Business Cycle
01. Expansion: The first stage is expansion. Here there is growth in employment, income,
output, profits, demand, and supply of goods and services. This continues as long as
economic conditions help growth.
02. Peak: Here the economy reaches its highest point, or peak, of growth. From here the fall
begins in numbers related to employment.
03. Recession: The recession stage is when the demand for goods and services fall very
quickly. As a result, all economic indicators such as income, output, wages, etc., start to
fall. But, producers take time to notice the fall in demand. So, they continue producing.
This creates a surplus in the market and prices begin to fall and the expectation is it will
fall further leading to demand falling further.
04. Depression: A recession that lasts for three or more years or an extreme recession that
leads to a 10% decline in GDP is called a depression. It results in high unemployment.
05. Trough: In the depression stage, the economy’s growth rate becomes negative. The
Trough stage is when the economy reaches its rock bottom There is wide reduction of
national income and expenditure. Here prices & unemployment reach their rock bottom
and can only rise
06. Recovery: This is where the economy begins to turn around. Demand starts to pick up
due to low prices. Expectations are more positive and production & employment start to
grow.
The Real Business Cycle Theory (RBC):
● Real business cycle theory considers random fluctuations in productivity as the main
source of economic fluctuations.
● These economic fluctuations cause business cycles.
● RBC assumes the main factor leading to a business cycle is the fluctuations in the pace of
change in technology.
● But other sources might be the reason like international disturbances, climate
fluctuations, or natural disasters.
The RBC Impulse:
● The impulse is the productivity growth rate that
results from technological change.
● Most of the time, technological change is steady
and productivity grows at a moderate pace.
● But sometimes productivity growth speeds up,
and occasionally it decreases—labour becomes
less productive, on average.
● A period of rapid productivity growth brings an
expansion, and a decrease in productivity triggers a recession.
The RBC Mechanism:
Two effects follow from a change in productivity that gets an expansion or a contraction going:
01. Investment demand changes.
02. The demand for labour changes.
Criticisms of RBC Theory:
The three main criticisms of the RBC theory are:
01. The money wage rate is sticky as employees resist wage cuts. To assume otherwise is
going against clear facts.
02. Intertemporal substitution is too weak to account for large fluctuations in labor supply
and employment with small changes in real wage rates. According to intertemporal
substitution theory, as the wage rate increases workers are willing to work more hours
and substitute their leisure time. This is due to the opportunity cost of leisure time rising
with higher wages.
03. Productivity shocks can be caused by changes in aggregate demand and not only by
technological changes. An aggregate demand shock is a sharp, sudden change in the
demand for product or service. It is usually temporary.
Defence of RBC Theory:
Defenders of RBC theory claim that
01. RBC theory explains the macroeconomic facts about business cycles and is consistent
with the facts about economic growth. RBC theory is a single theory that explains both
growth and cycles.
02. RBC theory is consistent with a wide range of microeconomic evidence about labour
supply decisions, labour demand and investment demand decisions, and information on
the distribution of income between labour and capital.
Inflation Cycles:
Inflation is a persistently rising price level. In the long run, inflation occurs if the quantity of
money grows faster than potential GDP. In the short run, many factors can start an inflation, and
real GDP and the price level interact. There are two sources of inflation: demand-pull inflation
and cost-push inflation.
Demand-Pull Inflation
An inflation that starts because aggregate demand increases
is called demand-pull inflation. Demand-pull inflation can
begin with any factor that increases aggregate demand.
Starting from full employment, an increase in aggregate
demand shifts the aggregate demand curve rightward. The
price level rises, real GDP increases, and an inflationary gap
arises. The rising price level is the first step in the
demand-pull inflation. Aggregate demand keeps increasing and the process just described repeats
indefinitely.
Cost-Push Inflation
An inflation that starts with an increase in costs is called cost-push inflation. There are two main
sources of increased costs:
● An increase in the money wage rate
● An increase in the money price of raw materials
Example: A Cost-Push Inflation Process - If the oil
producers raise the price of oil to try to keep its relative price
higher, and the Central Bank responds by increasing the
quantity of money, a process of cost-push inflation
continues.
Deflation
What Causes Deflation?
The price level falls persistently if aggregate demand increases at a persistently slower rate than
aggregate supply.
What are the Consequences of Deflation?
Unanticipated deflation redistributes income and wealth, lowers real GDP and employment, and
diverts resources from production.
How can deflation be ended?
● By increasing the growth rate of money.
● Make the money growth rate exceed the growth rate of real GDP minus the rate of
velocity change.
ECONOMIC INEQUALITY - SOURCES & REDISTRIBUTION
Global Inequality and Its Trends
● The global distribution of income is much more unequal than the distribution within any
one country.
● Inequality arises from unequal labour market outcomes and from unequal ownership of
capital.
● Causes of inequality:
1. Human capital
2. Discrimination
3. Contests among superstars
4. Unequal wealth ownership
Human Capital
The more human capital a person possesses in terms of education, experience and skills the more
income that person likely earns, other things remaining the same. The increase in globalisation
has:
● Decreased demand for low skilled labour and their wage rate has fallen.
● Increased demand for high-skilled workers and their wage rates has risen.
Discrimination
Human capital differences can explain some of the economic inequality. Discrimination is
another possible source of income inequality. If the value of marginal product of one sex (or
race) is perceived to be higher than that of another sex (or race), the equilibrium wage rates will
vary across the gender (or racial) groups, despite holding human capital constant.
Contests Among Superstars
Human capital differences can’t account for some of the really large income differences. The
huge difference in what the super rich earn cannot be explained by human capital differences.
Contests among superstars can explain large differences in incomes. Scarce resources are offered
by contests when it is hard to monitor and reward performance directly. There is only one winner
who takes it all. Prizes are hugely different to induce participation in the contest and generate
high quality performance.
Unequal Wealth
The inequality of wealth (excluding human capital) is much greater than the inequality of
income. This greater wealth inequality arises from two sources:
01. Life-cycle saving patterns
02. Transfers of wealth between generations
The significant aspect of intergenerational wealth transfers that increase economic inequality is
that marriage concentrates wealth.
Income Redistribution
The three main ways most governments in the world redistribute income are:
01. Income taxes:
By taxing incomes of different levels at different tax rates, economic inequality can be
decreased. A progressive income tax is one that taxes income at an average rate that increases
with income. Most income tax systems in the world are progressive income tax systems.
02. Income maintenance programs:
Three major types of programs provide direct payments to individuals: Social Security
programs, unemployment compensation and welfare programs
03. Subsidised services:
A great deal of redistribution takes the form of subsidised services—services provided by the
government at prices below the cost of production.
The long-term solution to their plight is education and job training—the human capital acquiring
skills and equal opportunities.
OVERVIEW OF FISCAL POLICY
Macroeconomic Policies
Governments have two main macroeconomic policies available:
01. Fiscal Policy – Government budget, and
02. Monetary Policy – Set by central banks or reserve banks
The National Budget
The national budget is the annual statement of the government’s expenditures (outlays) and
revenues (receipts). The national budget has two purposes:
● To finance government programs and activities
● To achieve the national macroeconomic objectives
Fiscal policy is the use of the national budget to achieve macroeconomic objectives, such as full
employment, sustained economic growth, and price level stability. The government’s revenues
(receipts) minus its expenditures (outlays) gives the budget balance.
●
If revenues are more than expenditures, the government has a budget surplus.
● If expenditures are more than revenues, the government has a budget deficit.
● If revenues equal expenditures, the government has a balanced budget
Supply-Side Effects of Fiscal Policy
Fiscal policy has important effects on employment, potential GDP, and aggregate supply—called
supply side effects. An income tax changes full employment and potential GDP.
Full Employment and Potential GDP
Equilibrium employment is: full employment and real GDP
produced by the full employment quantity of labour is potential
GDP.
The Effects of the Income Tax
The supply of labour decreases because the tax decreases the
after-tax wage rate.The before-tax real wage rate rises, but the
after-tax real wage rate falls. The quantity of labour employed
decreases. The gap created between the before-tax and after-tax
wage rates is called the tax wedge.
When the quantity of labour employed decreases, potential
GDP decreases. The supply-side effect of a rise in the income
tax decreases potential GDP and decreases aggregate supply.
Taxes on Expenditure and the Tax Wedge
Taxes on consumption expenditure add to the tax wedge. The reason is that a tax on consumption
raises the prices paid for consumption goods and services and is equivalent to a cut in the real
wage rate. If the income tax rate is 25 percent and the tax rate on consumption expenditure is 10
percent, a dollar earned buys only 65 cents worth of goods and services. The tax wedge is 35
percent.
Taxes and the Incentive to Save and Invest:
A tax on capital gains income lowers the quantity of saving & investment & slows the growth
rate of real GDP. The interest rate that influences saving and investment is the real after-tax
interest rate. The real after-tax interest rate = income tax paid on interest income minus the real
interest. Taxes depend on the nominal interest rate. So the true tax on interest income depends on
the inflation rate
Tax Revenues and the Laffer Curve:
The relationship between the tax rate and the amount of tax
revenue collected is called the Laffer curve. At the tax rate T*, tax
revenue is maximised. For a tax rate below T*, a rise in the tax
rate increases tax revenue. For a tax rate above T*, a rise in the tax
rate decreases tax revenue.
MONETARY POLICY
Governments have two main macroeconomic policies available:
01. Fiscal Policy – Government budget, and
02. Monetary Policy – Set by central banks or reserve banks.
Monetary Policies
● Monetary policy is the regulation of the money supply and interest rates by a central bank
in order to control inflation and stabilise currency.
● With monetary policy central banks increase or decrease the amount of currency and
credit in circulation to control the money supply and credit supply which can affect:
inflation (prices), and economic growth.
● These in turn affect things like employment.
Central Bank
● A central bank is a financial institution given control over the production and distribution
of money and credit for a nation or a group of nations.
● Central banks are responsible for monetary policy and the regulation of member banks.
The role of a central bank is established by law.
● Many central banks are owned by the government of their nations (e.g., Qatar Central
Bank), but some are not (e.g, the U.S. Central Reserve).
● Central banks are the lender of last resort to commercial banks.
● Central banks are often given a mandate by the government to achieve specific goals.
● Goals like - low or target inflation, low unemployment, price stability, economic growth,
to keep the output gap low (actual output MINUS potential output), stability in foreign
exchange markets at appropriate rates. safeguard foreign reserves These goals are
achieved through monetary policy.
● Central banks cannot control these things directly. Instead, central banks influence those
factors indirectly through the things they can control. Central banks can control interest
rates and the money supply.
Central Bank - Interest Rates
Central banks can control interest rates through the:
01. Cash rate – the very short-term rates that banks pay to borrow from each other over night.
02. Discount rate – the interest rate charged by the central bank on short-term loans to
financial institutions to meet reserve requirements. Lower rates encourage commercial
banks to lend and to provide credit to businesses and individuals
03. Exchange Rates – the price paid to purchase foreign currencies – the money of other
nations.
Central Banks - Money Supply
Central banks can control money supply through:
01. Open market operations – buy and sell government securities on the open market.
● Typically buy short-term government securities like treasury bills.
● Buying increases the money supply, selling decreases the money supply
● This is the most common tool to conduct monetary policy.
02. Reserve Requirements – the amount of currency that banks are required to have on hand
to comply with regulations.
● Lowering reserve requirements encourages banks to lend; increasing requirements
encourages banks to hold
03. Quantitative Easing – Central banks purchase large scale financial assets like
government bonds, corporate bonds, and stocks from commercial banks. Introduced in
2009 and used when interest rates are near 0%.
Monetary Policy Objectives
Objective 1: Economic Growth
● Set targets like 3-4 percent real growth per annum
● Real and nominal GDP and GDP per capita Monetary Policy Objectives
Objective 2: Price Stability
● Ensure general trust in the value and stability of the nation’s currency.
● Price stability is the source of maximum employment and moderate long-term interest
rates.
● Target an inflation rate of around 3 percent monthly - Consumer Price Index (CPI) and
Personal Consumption expenditure (PCE) deflator.
● The rate of increase in the core PCE deflator is the core inflation rate.
● Central banks usually try to keep the rate of inflation between 1% & 2%
Objective: 3. Monetary Stability
● Ensure a sound financial system
● Keep the banking system solvent – make sure banks have cash on hand
● Well functioning credit and payment system.
Objective: 4. Safeguard Foreign Reserves
● Maintain reserves of around 4 months
Objective: 5. Appropriate Exchange Rate Level
● Maintain competitive and predictable exchange rates with other currencies.
● Avoid shortage of foreign exchange.
● Avoid large, sudden foreign exchange outflows.
Expansionary vs contractionary
There are two generic monetary policies that central banks can take: expansionary or
contractionary monetary policy.
Expansionary:
● Increase the supply of money and credit.
● Lower discount rate – overnight bank lending rates.
● To stimulate growth
Contractionary:
● Decrease the supply of money and credit.
● Raise interest rates.
● To curb inflation
Transmission of Monetary Policy
The transmission of monetary policy describes how changes made to the cash rate influence
economic activity and inflation. The cash rate influences other interest rates in the economy on
things like house mortgages, business loans etc. Low interest rates stimulate spending and
economic activity – influences aggregate demand.