Industrial Economics
Introduction
Structure conduct performance
1.
Structure: (a) No. and size disturb of sellers
Perfect comp- only many small no of sellers. Not able to influence the
price. Supply product at a price equal to the opportunity cost (Value of
resources needed to produce it)
Monopoly – only one single seller. Can restrict the output and set the price
above the opportunity cost of Production. Monopoly – an inefficient way to
organize production, buyers who can. Pay only the cost of produce cannot
obtain monopoly Product. Dints- Market with one large firm and several
small firms act as a monopoly rats than a market with many firms of roughly
equal size.
(b)
No. and size dist of buyers Consent rations in one part of a market
will evolve balancing concentrations in other parts. It when a few large
buyers buy from few large sellers then it’s diff. to hold price above the cost
or even equal. This is the theory of countersealing passers
(c)
Product diff. – in P.C the products are not differentiated. In
monopoly differentiation of products is these. As differentiation incuses
products of diff. produces become pours substitutes for one another and as a
result each firm is able to inference the price of its product.
(d)
Entry conditions – Focuses on factors that influence the decision of
the firms to enter a market. For egg, amount of invest to be mode sales
effects in case of failure – info. About how much invest can be recouped by
selling off assets etc.
Conduct
Conduct is significant ruler the competition is imperfect
1. Collision – If independent firms code (join this operations) they can
restrict the output and raise the price above the many cost of prod. But
this produces every member an in certain to its own output and new films
to enter the market. If firms cheat and Thais own output the price will fall
and if new firms would enter then old firms well have to cut back its
own output and attempt to control price will fall.
2. Strategic Behaviors - in imperfect comp. established firms can restrict
the entry of theirs firms by holding down the price. This behaviors the
society due benefit of lower prices However entry can also be restricted
by raining the costs of rivals (for egg. By doing costly in vest) Tues
behaviors is not socially beneficial
3. Advertising / R&D – Adv. Convergys info to potential consumers. It
leads to better performance of product. Rand D can create product
differentiating product innovation technological advancement. This
enable produce to get his prices for this products.
Performance
In P.C- O demanded= Q supplied at P= MC All firms have same
technology:
1. Profitability
In P.C, firms can earn only a normal rate of return on their invest –
Economic profit – profit above the normal rate of return in imperfect
camp- firms will inevitably earn same economic profit.
2. Efficiency (Static efficiency) in umpessfect
camp, since there is no
camp, the firms are slows to reorganize prod. Efficient by can’t be an
element of IC because of the suspicion that market Puma will shoo
was a waste of resources.
3. Progressiveness
Also called dynamic efficiency – refers to the rate of technological
progress in imperfect comp, no tech unnouatation is these
Interactions
Structure determines conduct, conduct determines performance.
Structure and conduct are determined by demand conditions and
technology. Strict effects conduct but conduct- strategic behaviors
affects structure. They both in turn determine the performance. Sales
effects (conduct) affects demand. Performance in turn affects
technology and structure.
Progress
ever
molds
the
available
technology.
Profitability
(performance) which determines how adsorptive it is to enter the
market effect affects market structure
Rest- refers to registers
Chicago school etc.-
Market Concentration
Market canc. Refers to the degree to unhitch production in/ for a particular market
is concentrated in the hand of few large firms.
1. Absolute concentration – relates to both dimensions of market conc. Firm
nose and relative market shares.
2. Inequality measures – measures the dispersion of market shares
3. Aggregate conc. – extent to which mresocconony is demanded by largest
firms.
An index should fulfill the following criteria’s:
Criteria can be divided into elementary and more general criteria.
Under elementary criteria.
1. Index should be easy to calculate and understand.
2. should be independent of market size (it should depend on market share
rather than size)
3. it should range from o (in case of PC) to 1 (monopoly)
General criteria
Concentration curve – it plots the cumulative % of output against the cumulative
no. of firms lanced from largest to the smallest.
100
A
Cu% of output
B
C
situation of ambiguity
Cu no of firm 10
A, B and C are came curves (CC) curve concave from below - : firms are
cumulated from the largest.
Concavity – firms size inequality no. of firms – intersection of C.C with 100%
output level.
Conc. Is higher in that industry whose conc. Curve lies higher (above) everywhere
over that of others.
In case if CCs intersect (in B and C) we connote determine which industry has
highest conc. In such a case, following indices Aare used
They provide diff. Cogs to diff. parts of CC and hence can rank them (given by
Hannah and Kay)
1. Conc. Curve ranking criterion: An Industry will have highest conc. If CC
would lice above everywhere over other’s CCs.
2. Sales transfer principle: It means transfer of sales from a small firms to a
large firm it canc. In can curve it will cause the CC to bulge up words over
part of its length (as gain in dashed sec. in diag.)
3. Entry condition: the entry of a new firm into the market and congested the
relative for exit would decrease the market conc. But this condition would
not hold if the firm (entrant) is very large because in such a case con. Would.
4. Merger condition: the meager of 2 as more firms would the conc. A merger
can be regarded as a sales transfer causing the smallest firm to exit the
market. It means causing the dashed bulge’ to extend up to 100% line.
Concentration Indices
A conc. index is a summary representation of a CC.
No. of firms in industry = n
Outputs = xi (I = 1, n)
Industry output x=
Market share of it firm Si =
1. Reciprocal of firm’s nose- - simplest conc. index is the reciprocal of firm
nose i.e. 1. It ranks industries in the order of A, B and C firm high to low
conc. And attaches O weight to relative sizes of firms where firms an of
equal size it is beams the appreciates measure
2. Conc. Ratio – It’s the proportion of industry output accounted for by the
largest firms
Cr =
Disavow
(a) Arbitrary selection of r (no of targeting )
(b) Only a single part and the CC are taken. Which can suppress an info which
might be of some relevance to the problem?
(c) When conc. curves intersect the measure will give difference value for can
for diff values of r suppose at B and C all equality conc. with r = 10 but for r
< 10 C is more concentrated and for r> 10 B is more conc.
Hirschman – Her finely index – Takes into account all the pts and CC.
3.
𝑛𝑖
H = ∑𝑛𝑙=1( )2 = ∑𝑛𝑙=1 𝑆𝑖 2
𝑥
This method (squashing) gives more weight to the larges fines in the industry every
firm size x = 1
Vary of firm’s size
Coif of vary C2 =
H=
Properties –
(a) It lies between O (for P.C or small equally sized firms)
C2 = O, n – O 1 = o and
1 (for monopoly) C2 = O
n= 1
(b) The reciprocal of H is a nose equivalent being the unique no. of equally
sized firms which would give the cossesponding H value
Note: This measure satisfies every uitesion of Hannah and key i.e. conc. curve
clattering sales transfer entry condition and merges condition
4.
Hannah and Kay’s Index – The H index implies a specific weighting of
market share inequality and firms nose which is reliant in cases curve CC cross.
Hannah and key interdicted a simpler conc. Index but it Maries in the weight gain
to large firms.
R=
L=2 in case of H index
The nos. equivalent of R is HK =
Main pt – flexibility it allows by giving greatest wet. To large firms by the value of
5.
Entropy Index – It’s an inverse measure of conc. It weights market shares by
in
E= is in
E = O in monopoly case
E = lie (n in case of n firms of equal
E gives less weight to large fines than the H index.
Inequality Measures - These are the summary repress dentations of losers were
Lange were plots the contusive % market output against the cumulative % of firms
(cumulated from smallest to largest).
cu
O
S
% of firms
The cure for industry A is diagonal from below. (lefloctroy) conflation from the
smallest firm The diagonal OT recusants the situation in which firms are of equal
size greatest the dist b/w line of equality and cuvee greatest inequality in firm size.
Following are the measures of inequality.
1
Gina coefficient – It’s the ratio of should Ares to the area of OST the
greater the inequality in firms size the greatest is shaded area & greatest
gin coif. G b/w o and 1
2
Coif. Of variation – It’s the ratio of S.D of firm size to mean firm size
Unit free measure of dispassion – C = 6
3
Vary of log of firm size –
Useful – dist of firms by size is lognormal i.e. logs of firm size are moral
distributed
Fruquency
Firm size
Her, most firms are small or moderately sized while few large firms dominate the
market
Limitations: don’t take into a/c firm nose I don’t satisfy sales transfer will cause v2
to fall rather than rise
The series of conc. -
Unite – 3
Braziers to Entry
Den.
By Density
All govt. restrictions that raise cost of prod. Causes an entry basses Entry basses
can aisle only because of govt. intervention because only the govt. have the legal
power to prevent entry streets an legal condition as busies
By stingless
That cost of producing which must be borne by firm which seeks to enter an
industry but is not bone by firms already is the industry. Any advantages of
established firms over potential new entrants is a basis to entry
No basis – when cost 2 demand stones on asymmetrical market condition as
bossier
By Bain
Basis to entry is the extent to which new entrants may be disadvantaged relative to
established firms It relates to the extent to which in the long run established firms
can elevate this selling prices above the minimal avg. – cost of prod 2 dist. Without
inducing potential entrants to enter an industry It means Bain considers scale
economies as a braises to entry He introduces market conduct as well as market
conditions into his def.
Sowed of braises to Entry by Bain
3
Basic condition
1
Absolute cost advantages
2
Product differentiation
3
Economies of scale
Max Entry for stalled price – It is the highest price which established firms can set
without inducing entry.
Conditions of entry – it’s the % markup of the max entry outselling price over the
min attainable avg. costs of established firms. Measures the heist of entry basses.
Max entry fore – stalling price is determined by objective market condition and
entry expectations. If entrants expect established firms to indulge in intense price
compaction following entry then they will tend to be less really to enter.
1.
Absolute cost advantages
Absolute cost basis refer to the ability of established firms to produce any given
level of output at lower unit costs than optical entrants in/ the
P2
a
LAC2
P1
b
LAC1
O
n1
output
In the above fig potential entrants have a cost curve LAC and established firm
LAC it established firms agree to maintain the pre-entry price after entry then the
max forestalling price will be P2 and long even Supernormal profits will be P1 P2
abs
Condition entry is given by proportionate abs cost adv. Of established firms i.e.
Abs cost adv is abs recognized as entry braises by stages. They can arise 1
established firms may have control of superior prod techniques relative to entrant
firms.
2 they may have access to superior resources including management relative to
new entrants
4
New truants may have to pay highest prices for inputs compared with
established firms. (discounts not available) Entrants may face difficulty
in raising finds
2.
Economies of scale – In this case established firm have no cost adv. rather
the entry braises arises from entrants being unable to secure the five advantage of
scale.
If the entrant enters at min efficient scale x or above it makes a significant
contribution to industry output and is likely to cause a substantial drop in market
price below its unit cost. But if it enters at less than min efficient scale x, it will
suffer cost disadvantage assuming that established firms are producing x and again
will make a loss.
Established firms can raise price above P in long run price
P1
LAC
D
O
n1
output
3
product differentiation adv. – In a matched characterized by product
differentiation established firms may have advantages over new firms arising from
consumes preferences for this products such preference arise when:1 Established firms have control of superior product design through patent
protection.
2 Established firms may have an adv. Of customer goodwill (supplying good
quality products)
3 cumulative effects of past advertising expenditures may have built up consumer
allegiance to established products.
Established firms may be able to charge above the cost without attracting entry.
New entrant – will have to offer discounts or incur greater selling expenditures but
suffer ab. Cost disadvantage
P3
P2
P1
LAC
D3
D1
D2
O
n3
output
Suppose established firm is a monopoly with demand curve d1 both new 2 old
firms have same LAC if established firm have product difference adv. Then it can
set price above avgas cost. If est. firm sets price P3 then new firms demand curve
is D3 and if price set is P2 then firms demand curve is D2 Max entry forestalling
price is P2 because entrant connote produce output profitably
Now suppose there are economies of scale show by lace then established firms a
raise price to P3 and entrant with D3 demand will barely cover prod costs at output
x3
Gag. Barriers to entry – more than one type of entry bevies usually exists in any
industry Bain consider this as gag. Enter barriers. He basified industries into 3
categories: (a) High – established firms can raise price by 10% or more without industry
Entry
(b) Substantial – 5-9%
(c) Moderate or low – 1-4%
Limit price throwing
When established firms form an oligopoly and set If the rice is above price the max
forestalling price it will give lies to new entry and reduce this market share and
profits and if its equal to or less than the entry forestalling price/limit price the
entry will be restricted 2 this market share & fro fit will If established firms want
to max this language II they will choose the policy that will best suit them. Bain
classified these as four:(a) Entry conditions may be easy in which case price in the long run could not
exceed competitive levels
(b) Entry conditions may be ineffectively impeded that established firms have
the option to limit price but will not to do
(c) Entry conditions may be effectively impeded when established firms choose
the option of limiting price
(d) Entry may be blockaded i.e. prices at the monopoly level fail to attract
entrants
Limit pricing under silos postulate
Under silos postulate – an ascend is made that entrants expect established firms to
maintain their current output levels entry. Given this entrants can estimate how
much the established firms will reduce price and hence whether entry is
worthwhile. Or established firms can work out what current price to set which
would dates entry firm faking pulse.
Limit pricing further considered
Limit prizing under silos postulate make some an assumptions
1
it assumes that established firms in the industry coordinate their actions
to set the limit price
2
It’s assumed that established firms dates enter absolutely but this may not
be the case. In general entry is allowed but the rate at which this takes
place is regulated. Bain’s classification impeded entry is just a static
approximation.
Gaskins have given it that it’s assumed that new entrants view the event
price is a reasonable proxy for future price. The rate at which entry takes
place is the diff. b/w limit price and current price.
Gaskins shows that where level outputs are low the dominate firm will
set a highs price initially to permit entry but will gradually reface it
towards the limit price. The stab used firms chooses neither to max-short
run profits nose to prevent entry but rather to regulate the rate at which it
takes place.
3
Basic silos postulate is or literary there is no reason why new entrants
should expect established firms to maintain pre-entry output level after
entry.
4
It’s assumed that the prospect of negative profits is sufficient to dates
new entry. But the presumption that new entrants may be at a warranted
because they may be operated at small scale so suffer servility in a period
of loss- making or they make new products which are liked and being
profit
Entry deterrence
For egg: firms 1 are an active firm in the industry and Firm 2 is the possible
entrant. Firm 2 observes firm is output level before deciding whether to enter and
how much to produce
II1m(q1m)
II1m(q1D)
II1S(q1S)
II2m(q1m)
q1
q1S
q1M q1D q1
II is the profit curve of firm 1 when it’s a monopoly and II is the II curve where
firm 2 enters the market Ii is firm 2 profit curve.
If firms1 is source that is would be a monopolist it will set output at q, M 2 earn II
m q m profit. But if firm 2 will enter then it will set output q, s and each II, s (q, s)
Suppose firm 1 sets monopoly output. The prob. Is that with this output firm? R’s
profits from entry level be positive II2 (q, m)
> O firm 1 should expect that
salting quid = q, m entry would take place. But, if entry will be there firm its profit
will be II, s (q, m) (much lows than monopoly profit). Now suppose if firms set q,>
q, D says q firms 2’s profit would be negative output level q>ad achieves thee goal
of
Entry Deterrence this is optional entry when II m (q, D)> II (q, s)
By setting q,D > q D firms 1 sacrifices II m (Qing) – II (q,D) but it’s lower than
what firm 1 would lose if it would let firm 2 to entry and make profits.
Entry Accommodation and blockaded Entry
If entry costs are low then it would be optimal for firm 1 to allow entry. Suppose,
firms 1 now sets a qty q to deter entry much larger than
II1m(q1m)
II1m(q1D)
II1S(q1S)
II2m(q1m)
q1
q1S
q1M q1D q1
Then the profit that firm 1 will earn will be much lower II m (q, D). This profit is
even lesser that what is would have earned if it would have allowed entry Idiom q,
D < II‘s as
Firms is optimal strategy is one of entry accommodation.
Now suppose if entry costs are high then firm 1 should ignore the threat. Even if
firm 1 chooses monopoly output then firms 2 wouldn’t entry because it will earn
negatives profits. This satiation is known as blockaded entry.
II1M(qM)
IIM
II2
qM
Commitments ex –Ante and Ex – Post optimality
Firms’ intention of producing an output
= q, D in case firm 2 enters is credible
or not.
Now suppose that firms 2 decide to enter the industry and produces output at the
cornet equaled. q N Now firms 1 strategy is also to produce at Qing which is less
than monopoly output q,m and much lesser than q,D therefore firms2 will make
positive profits therefore it should enter firms isannouncent to set output at q,D is
not credible
Now before firm 2 divots whether to enter or not firm 1 must choose prod.
Capacity. Capacity costs are high 2 invest is sunk so even if firm 1 later chooser an
output lower than installed capacity it still connote avoid the capacity cost.
Suppose output costs are O. in such case firm 1 has greater incentive to output. It’s
equally costless for firm 1 to set an output level up to capacity it’s needed that
capacity costs should be high and also sunk.
There are 2 imp quality captions of model of deterrence by capacity expansion:
1
It’s not only a matter of deterring versus accommodating firms 1 should
use doff. Strategic invest that would influcince the tune at which entry
will occur.
Suppose firms 2’s max profits are given by II2 (q, t) where t is tune profit
will with t. due to exogenous factors (tech progress, deregulation etc)
firm & (q, t) = cost of entering further when t > t firm 2 prefers staying in
the market. Now firm 1 has to choose q coz diff. values of q1 would
input diff. optimum entry tunes t 2 for firms 2 and diff. profits for firms 1
2
In addition to capacity there is a need to invest in other quality them for
egg in case of a telecommunication company investing in service quality
cost reduction etc.
Product prifaeration
Contracts (entry deterrence)
By signing a contract incumbent and buyer act as a monopolist wart potential
entrant. It’s optimal for a potential entrant to enter if its cost is lower than the
incumbent’. But monopolist knows that entrant will make positive profits from
entering on entry price will be set i.e. a fee must be paid to the buyer for breach of
long turn contract signed with the supplies If entrant is very efficient entry take
place but if it’s more effect than the incumbent but not much more efficient the
contract will dates entry egg Monsanto acquired as partake (scent) entered contract
will Pepsi and color.
Predation
Practices that induce exit of rival from the industry are known as predation i.e.
pricing below the marginal cost is known as predatory pricing
Egg KLM and easy jet from notes
Chicago school – long purse throwing of predatory pricy
1
rational players should Neuse exit when preyed upon
2
Rational predators should Neuse engage in predation.
Suppose there are 2 periods. In 1st period incumbent must decide whether or not to
set low price if it does bother incumbent 2 entomb will make loser L If incumbent
does not act aggrustely turn both will make duopoly profits Aid then at the end
entrant must decide whether to leave or not In the sand period if it leaves then
incumbent will earn monopoly profit II but if it sties then in cement must not act
aggressively because Aid > L. suppose in 1st period the entrant behaves
aggressively then it’srational for entrant not to exit even of its making loser If it
does not have money to bear loser than it can barrow form bank. Bank will also
give because IID > L in later period acc. To Chicago theory.
Butt depends on rationality It bank refuses to provides lone Let the profit of refusal
be p (shoo) from entrants pt overview stayed in the market and leaving L is less
than what it expects to gain in future II d Tunis the probe that bank will give loan
((1-p) Aid > L
From in cement’s pet for view aggressive behaviors in first period may be an
optimal strategy By accommodate enter of will receive Aid +Aid duopoly fro fits
in each period By against If wall suffer L sassier in first period but Aim profit in
and period for the entrant have exited and with prob. (1-p) the entrant will remain
active and obtain Aid profits
Aim > L+ (l-p) Aid
In above case predations persistent it’s rational for incumbent to be a predator and
p% of times predation helps in drug out comp.
It not imps. For one firm to be incumbent 2 other to be entrant but one firm being
financially constrained to apply for loan and other which is not this is known as
long purse or dup pocket theory.
Why est. firms use predatory pricing?
1
low cost signaling
The predatory actions by a large and established firm helps in convincing small
and new firms that the farmer’s costs are very low and thus the prospect of
competing against is not very promising. More over this helps in creating a repute
action which innocence the outcome of future clashes b/w large firms and small
firms. Egg: American tobacco acquired 43 completions; it engaged in predatory
pricing it lowered the cost of being rivals by up to 60%
2
reputations for toughness
By pricing aggressiuly in cement may acquire an image of being tough so that in
future no more entry takes place. For egg: British Aircuays (BA) in 1970
successfully fought lakes arduous entry then 1980 fool sector steps against virgin
Atlantic and in 1990s fought against easiest etc and showed the image of being a
tough competitors.
3
Growing Markets
In growing market long term success requires significant market share from early
on.
For egg: Sacra man to cable T.V (SCT) was given the first fructose of cable TV in
California later the second franchise was given to cable America It stated its
operations across 700 homes office36 channels for monthly free $ 13 Maud
favorably to SCT 13 Realizing this SCT soon cut its eats giving 3 months free
service in same area 2 then cent cued service at $ 5 After same turn cable amerces
exited.
Conclude
Predatory pricing may be scornful when
(a) the prey is financially contrived
(b) low prices signal low costs or predator’s toughness
(c) capturing significant market share for long turn survival
Non pricing predatory strategies
1. Predatory pricing is not the only form of predation for ego Microsoft MSDOS dominance in the market for operating systems. Microsoft’s strategy
did not consist of lowering the price of MS – DOS rather it imposed
contractual terms where computes malefactions would have to pay Microsoft
per computer sold The opportunity cost of selling a computer with MS-Dos
was very small
2. Bundling or tying – egg Kodak opted a strategy of designing a film and
camera in a format that was incompatible with other existing film formats.
Public policy towards predation
1.
it’s not sure that whether predatory pricing exists in practice or not Price
reduction by an incumbent in response to entry can be interpreted as a competitive
response to entry can be interpreted as a competitive response to new comp
rather than as an attempt to drive that comp. of the market
2.
even if predatory pricing exists it should be dusting vesting from straight
comp. more comp means low prices and exit even if no firm is attempting to drive
rivals out of the market In US reeds turns test helps in distinguishing comp from
predation prices can be regarded as predatory if they are set below Mc but a firm
can price below MC for the purpose of money down its learning curve At
amatively one can look for post exit price
3.
Welfare effects – In predatory pricing consenters are benefited.
Entry costs and market structures
Q.
How no. of firms change in relation to in market size and technology (i.e.
mess)
Ans. We consider a simple model in which all firms are of equal size – suppose
each firms has cost feign. C=Fact and demand curve Q= (a-p) S. in equaled, profit
is given by II (n = S () 2 – F
A free entry equaled is characterized
1. No active firms exit the market
2. No inactive firms enters the market now equating =0
(a)
market size and concentration
n = [(a-c)]
A
no of firms is an firm of market size and (s and a)
B
no of firms is an in use of both fined costs and variable cost (F and C)
C
Relation b/w S and n is non proportional. It’s approx. quadratic to double the
n 7 should fourfold.
This explains that if market price S and n were proportional. But as the no – of
firms market becomes competitive II. As a result this limits the no of firms market
can sustain
Due to price comp., the equaled no firms varies less than proportionally west
market size.
(b)
Min Efficient scale and conc.
All firms have a U shaped ague. cost curve. On the felt of U shaped curves there is
recurs to scale and on sight return to scale.
To measure the relation b/w returns to scale and market structure it’s necessary to
mescals the degree of returns to scale. By using min efficient scale (MES) this is
the min scale at which firm’s avg. cost is close to min
C=Fact
AC=
Min ague. cost is C let the MES be the sculls at which AC=
AC=C
An in F by implies an in MES by same factor now since
N = [(a-c]
So MES and F can be compassed. If MES (F) by a factor of then no of firms by
factor of
If both S and F by same proposition then equaled no. of firms remain constant. For
this reason when comparing the strict of diff industries we consider an explanatory
vas. Market size divided by MES or MES divided by market size
(c)
Scale economics and concentration
Another way of meaning deg. Of entry to scales is the coif. Of scale economies i.e.
ratio of AC to MC i.e. P=
If p>1 i.e. AC> MC turn economies of scale delivery AC>MC when AC is
economies of scale = returns to now p=
Rages Clarke
Ch-4
Technical progress
Process development
Product development
1 it involves the introduction of new
1 it involves making changes in the
processes or techniques in the
nature of products o flared for sale
production of products
2 it’s difficult to measure the
2 it’s easier to measure the contribution
contribution of this in economic growth
of process developments to economic
because they are difference to value.
growth
Invention: The inertial stage in product or process development is invention
whirring a new ides is developed and possibly a prototype is produced. It involutes
come basic research into new scientific principles.
Innovation: It’s a phase evlcisin a company future refines and develops a product
for commercial launch technical development is combined with evntreprevral
expertise and marketing that the new product can be successful.
Diffusion: In this phase as other firms came to see that the innovation is worth
while they also adopt or imitate the product or process. This is called diffusion.
Economics of research
Research is a special economic process because of 2 reasons;
A High level of uncertainly is attached
B Output acquires characteristics of public good
(a)
Uncertainty- It arises because the output obtained from employing resources
in a new research process in not known before. Therefore there is a risk associated
with it an optimal sole is to spread the risk over all members of the community so
the risk bore by a single member is reduced. One way to do so is for firms to raise
money on capital market. But only with money is raised from capital market. One
reason behind this is the moral hazard where by the incentives to undertake
successful research is not independent of the risks bone. If there are no risks then
incentives would be reduced. Insufficient funds are deviled to research due to lack
of much funds.
However large firms can niceties there selves against frailness by pooling risks
such that successes 2 frailness in research are mortally offsetting
More owe independent firms may combine their reassures to undertake research in
an area of common interest thereby reducing risks.
(1)
Because they involve a partial means of pooling risks
(2)
Large firms have monopolistic
(b)
Public good: The product once produced acquires the features of a public
good. Which are non excludability (irappropriabilety) and non-realness
(indivisibility?)
Non –excludability – once the product info is available it can be reproduced at
little or no cost. A firms may attempt to keep them in see set but in doing so it may
be unable to exploit them to fell more owe its diffident because incentives will
exist for industrial espionage and in same circumstances same info is likely to be
embodied in the product itself. Chemical product)
One sole to this problem is to patent the idea or inversion ie to establish legal pro.
Rights. To that that product can be produced by them any but patenting also leads
to infringement of prop rights.
Non – realness - It means making info available to one person does not reduce the
amt. available for others Social opperatering cost of presiding info is zero An
inventor is given an incentive to invent precisely because of his ability to restrict
the use of his invention in order to earn a monopoly profit.
Technical Progress and comp.
Arrow
W
x
P
C
y
P
t
u
P1
C1
y
MR
s
D
(1)
Arrow considered a simple case of process innovation in which costs fall
drastically. The inventor will change reflect per unit of output for his invention. It’s
asserted that the monopolist is the inventor. In pica price equal to avgas- cost and
in monopoly M.R = M.C both pre – 2 post
In the above dig. D is the demand curves and C is pre – invention unit cost curve.
Then in P.C price = C and in monopoly MR=C giving price = W and II = P= wing.
Now in mention troves place and cost curve shifts down drastically to c:
(1)
In P.C inventor charges royalty therefore the output is restricted to where
MR= C giving profits = p = pave the inventor would be leveling to invest if cost of
invention is less than p
(2)
In monopoly monopolist sets MR=C his profits are P but the incentive to
invent is P-P being the extra profits arising from invention. Since P-P is less than P
Arrow’s argument is that the inventor in the competitive situation can extract a
total royally equal to what the monopolist could gain post – invention. The letter
has lessee’s incentive since he was previously earning same monopoly profits P
Imp. Results:
(1)
The inventive to invent under P. C and monopoly will be less than the
realized social benefit in case of drastic cost saving for inventor extracts all
monopoly profits = p Since price consume gain supposes = ct up Such drastic cost
savings inventions will not be undertaken because of inventor’s inability to extract
whole consumes surplices
(2)
The potential social benefits firms reducing costs equal to ct sc this would
arise only if invention curve made freely available to P.C
System of per unit royalty payments is inefficient in 2 ways:
(a)
It leads to under utilization of the invention awing to monopoly incentive
for invention provided this is associated with the dead weight loss us.
(b)
Since any invention whose research cost is less than cuts is socially worth
wile same high cost but disenable in mention will be undertaken of P =
pave is the max royalty available.
(2)
Now arrow has considered another case where cost falls moderately:Now cost falls to C
W
x
P
C
C1
u
y
t
a
v
MR
b
D
output
(a)
In P.C the inventor can set royalty = CC The total royalty is cab
(b)
The monopolist sets MR= C and earns profit puce the incentive to invent
is puce – waxy. the incentives is less because
Waxy > puts since firms area I max under D given C
Area cab > cave by inspection
The extra incentive to invent under comp is thus area tuba+ (why- patch)
Dempsey
Mersey Postulated a case in which inventor supplied an invention to both
competitive 2 monopolized industry the inventor is contrived to change same
royalty to both P.C and monopoly.
Price
C
P
a
u
P1
C1
b
v
MR
D output
If royalty is Pc then total royalty paid by competitive industry
is p = puce
while in monopoly it would be only half this since motorist expands output only
to intersection of up and MR this will lead to greater incentive to invent in P.C
However is order to see area only special disincentive to invention to monopoly
deguts aroused that industries of equal size should be compared this can be
done by defang D as demand curve for monopoly and M.R as demand curve for
P.C so that each industry produces same output. Doing this with per unit loyalty
Pc both industries operate where up intersects M.R and total royalty is same pay
be the same incentives to invent for 2 under this even equal size
Density argued that an inventor supplying a monopole industry will have a
greats incentive to invent than if he supplied an equally size competitive
industry if he’s not cant raved to change the same per unit royalty to each here
M.R curve is demand curve for competitive industry.
(a) Given M.R is demand curve the inventor change a per unit royally PC such
that total royally is P=P we
(b) Given monopoly demand D the monopolist will each II = p = p y x c post –
invention if her not changed royalty giving an inventive to invent P-P where
P = pre- invention profits this is the monopolists inventive if he’s the
inventor attentively a lump Sun sayalty
would be changed by a separate
inventor the monopoly incentive > competitive one if area avow > put thus
density concluded
Q
Why more concentrated market structures may be conductive to more
innovation?
1.
Monopoly profits are associated with market conc. The firms in concentrated
industries are better able to finance R 2 D than firms in competitive industries R
and D is risky and is typically trained with central finds rather than funds raised is
capital market.
2.
There may be economies of scale in research actives which favor relatively
large firms when min efficient scale exists it may not be feasible for independent
firms in comp. market to consulate R and D only large firms are able to undertake
it.
Several advantages of oligopolistic markets (why undertake)
1. Firms earning monopoly profits are able to protect their patents better than
comp. industries Undertake R and D
2. Rapid product and process innovation is an imp competitive strategy not
only w rat existing competitors but also wart to forestalling possible new
entry
3. Firms in concentrated industries may undertake research to couture booths
actual and potential comp.
4. Firm’s earring monopoly profits may be able to alert qualified personnel and
so and improve their research output.
Arguments against monopoly being conductive to innovation:
1.
Monopolized firms may become tax and inefficient and fail to group
research oppcuturisties
and to sun efficient research programmers
compared with firms in more competitive environments
2.
Firms in conceal tiled market may have an incentive to innovate because
acc. To arrow an innovation produce only limited enter profits for a
monopolist
3.
Monopolized firms may also consider the costs of re-equipping this
industry to take advantage of protective innovation and may visit such
innovation.
We can say that a monopolized industry may have less incentive to innovate than a
competitive industry but it may be in a better position in terms of research
resources and finance to undertake research activities. This means that same
mixture of monopoly and comp. is most conductors to innovation.
Moderate degrees of concentration favor R and D while too much comp or too
much monopoly leads to less research activity
Louis Cabral
Replacement Effect
The firms with more market pulse have a lower incentive to innovate because they
have more to lose than firms with little market pulse who have little or nothing to
lose from innovation
Joseph Schumpeter hypotheses
Perfect comp is not only impossible but inferiors and has no title to being set up as
a model of ideal efficining
Replacement effect and Schumpeter hypothesis are to necessary to be inconsistent
with each other large firms are main sours of R and D because they have more
resources to invest than small firms But since small firms have more to gain it can
borrow money to invest in R and D but the problem is that capital market are not
perfect specially for R and D suppose a small firm has idea but no money to
finance it and a VC has money but no idea. Both can solve each other Prob. But the
prob. Is that to converse the VC that the idea is good the firms needs to reveal it,
risking to lose the idea without getting the funding Non disclosure Agreements
(NDA) are a such but VCS seldom sign. It by claiming that they see too money
similar ideas to have their tongues tied by one.
That is why most of R and investments is self – financed original in large firms
having scale economies and economies of scope can also speed the risks.
In contrast one could expecting more R and D not the capacity to do so A firms
with no monopoly power changes from a situation with no profits to one with
positive profits Even if the profits are lower the is likely to be larges i.e. the
incentive.
From schumpecesion Pt. of view the optimal capital structure is not likely to be a
perfect comp. but rather a form of dynamic comp that involves same monopoly
power (assumed that innovation lower cost allowing the innovator to undercut its
lunar and capture enter market) monopoly or for monopoly that involves some deg
of comp. from potential comp. From new products or prod processes that may
displace or prod. Process this is the process of creative destruction.
It implies that the optimal system is one of dynamic comp culler in short run there
will be some market Power i.e. temporary market power
Effacing effect and pressure of monopoly
Suppose there are and firms
Patents
Public policy toward them
The primary propose of patents is to regard innovators. It greats the holder the
monopoly signets imply and efficient cost allow active inefficient from monopoly
pricing.
Her patent application to be accepts. Qualities like novelty and non obviousness
should be there fancy process of combing tea with ice cubes (iced tea) is deficient
to be patented because it’s not a novel product just tea combined with ice cubes
and an obvious product (obvious idea).
Another related issue is patent breath for egg earliest tennis rackets were produced
of standard size but now diff sizes available.
The concepts of novelty requirement and breadth also apply to copyrights (that
apply to armistice walks find in tangible medium) where as patents apply to
products presses etc.Despite this same principle apply to both of them.
Now as for as patent’s optimal duration and strength are concerned a larger and
stranger patent is optimal one linger patent provider greater inventor for innovation
long lasting monopoly power. Stronger patent also proudest great’s incentive for
innovation and less comp.
Pm
LM
A
B
C
C
Gm q
Q
A stranger patent quads to monopoly profits given by gm (pm-c) where am and pm
are monopoly output and prices and C is the M.C but if we maker patents slightly
weaker such that patent holder connote charge above p the profits would be q (q –
c) now wart string patent case patent holder loses profits corresponding to areas a
and gain over C Patent holder suffers slightly from working of patents. But this
also leads to in welfare by an ant equal to B t C
Society has much more to gain from working of patents than the monopolist has to
lose optimal patent system should make patents very long but very work. Proper of
patents One other is to publicize the relevant info regarding the product process in
ques.
If patent is weak manta has little in native to patent He may keep it in secret to gain
more. but from social pt of view it will be costly Balance benefits from greater in
under for R and against cost of market power implied by patent rights R and D
agreements Inter firm R.D agreements are neccerary
No firm performs R and is isolation R and D results get spreader frequently It’s
generally agreed the J of R and D expenditure by firm I benefits firm j to the same
extent as if firm j would have spend Rs 4 down on R and D with O< Y < 1.
1. If j is close to than there are very high spillers R and exp. Are like a public
good and then the problem of free ridership arises.
2. Additionally a reason why there should be cooperation is because of the
share size and risk of same R and projects such a developing a new aircraft
microchip etc
3. Now for egg if y is close to o s pullovers are very low social cost of
innovation > private cost when john exp. The probe that firm I will innovate
and sanitary vice versa when I’s exp i.e. gain for one will be loss for other.
But of both firms cooperate then they could and of choosing lower levels.
But this would be bad for social view pt.
Good market CH-3
GDP – the value of final goods and services produced in an economy during a
fixed period of time
Decomposition of GDP
Consumption (C) Good and services which are purchased by consumers eg food
tickets etc highest component- 70.5% (2003)
Investment (I) – Sum of non – residential invest and residential invest. Residential
– the purchase by people of new houses / apartments Non- residential – purchase
by firm of new plants / machines
Govt. spending (G) – Purchases of goods and services by federal state and local
govts. (airplanes etc.). does not include govt. thausfors like medical social security
debt interest etc.
Exports Imports (M) Goods and services purchased by home country form foreign
county
are imports Good /service purchased by foreign country from home
country are exports. Diff. b/w x and M is called notexports/ trade balance.
X>M – trade surplus
M>X – trade default
Inventory invest – diff b/w goods produced and sold in a given year tve inventory –
when prod > sales
Ve inventory – when prod < sales
Let demand for goods be Z
Z = C+I+G+X-M
Identity eqn.
Demand for goods
Assumption
All firms produce the same good can be used for consumption in vest a govt.
The firms are willing to supply any amt. of the good at a gin price P
Economy is closed ie X=M=O
Z = C+I+G
Consumption (C)
Consumption (C) depends an money factors – disposable in come the income that
is felt after paying taxes and receiving transfers
C=
yd = disposable income
Yd consumption also
C (yd) is cons f this is a behavioral eq
C = C+cyd (linear f)
C is the propensity to consume. Effect of an additional rupee of yd has an
consumption. Always tve and o c because people are likely to consume only a past
of yd and save the rest
C is what people will always consume even if their yd= o because even if current
income is o people would still need to eat.
C
cons fn C= C +cyd
Slope = C
C1
yd
Also yd=Y-T
T is the taxes paid minus govt transfer
Investment (I)
Endogeveous variables – explained within the model
Exogeneous – not explained
We take invest as given
Ie I = I
Govt. spending (G)
G. T are exogenous because :(a)
Govt. do not behave with regularity
(b)
Equilibruim output
By decomposition of GDP
Z = C+I+G
Z = C+Cyd + I + G
Z = C+c(Y-T)+I + G
If firms hold inventories then prod = demand. Therefore we assume that inventory
invest = O equilib in goods market requires that prod y = demand Z
Ie Y = Z
This is the equilib condition
Now Y = C+c(Y-T)+i+G
In equilib prod y is equal to demand Z demand in turn depends on income Y which
is itself equal to prod.
Y = C+ c(Y-T)+I+G
Y = C+ cY –CT + I+G
Y-CY = C=CT+I+G
Y(L-C) = C+I+G-CT
Y = [C+I+G-CT]
(C+I+G-CT) is that part of demand for goods that does not depend on output –
autonomous spending C+I are tve. Govt. is running balanced budget and T= G 2 C
is less than 1 turn (G-CT) is tve
The no. which multiplies autonomous spending is multiplies. The closer c is to one
the greater is the multiplies.
demand
Productive
prod.
ZZ
Slope = C
A
Autonomic
Spinally
Y
Income
First we plot prod. As a f of income then we plot demand as a f of income (y)
Now Z = (C+I+G-cy)+cy
Demand depends an autonomous spending and an income. When come by demand
by C(1)
In equilib Prod = demand
Equilib output y occurs at the intersection of prod 2 demand f ie at A to the left
demand > prod and to the right demand<prod.
Now suppose consumption increases as a result demand issueses demand cure
shifts from ZZ to ZZ (Perfect upward shift)
As a result equilib shifts from A to A and equilib qty. shift to Y the increase in
output (Y-Y) is larges than the initial in consume this is the multiplies effect
(a) In first sand cons by Rs 1 billion as a result demand by Rs 1 million this in
demand lead to in prod (shown by dis AB)
(b) The 1st round in prod. Leads to in income show by dist BC leads to incomes
(c) The 2nd round in demand cures prod to shown by dist CD equals Rs 1 billion
(in saw) times C.
(d) This in prod leads to in income (shown by dist DE)
(e) The 3rd round in demand equals to Rs C billion (in y in 2 nd sow) times C and
so on
The total in prod.
= 1+c+C+…………...+C
This is the G.S
Explanation
Prod depends on demand which depends on income which is itself equal to prod.
An is demand due to in G etc lead to in prod and corresponding in income. This in
income leads to future in demand which leads to future in prod. And so on the end
result is an in output that is large than the initial in demand by a factor equal to the
multiplies
Has + 2 to pics – readings
Ch -4
Financial markets
Finds
Money
1.
bonds
Money : can be used for transaction bbut it pays no interest Money is of 2
types – currency – coins 2 biles and chekable deposits – banks deposets on which
cheques on be written
2.
Bonds: Refer to those financial assets which cannot be used for transaction
but pay a positive interest rate (i)
Determinants of Md and Bd
1.
Level of transaction – If the level of transactions is high then the demand
for money will be low high ie Higher the level of transaction higher the demand for
money
2.
Interest rate on bond – If the interest rate is high on bonds then people will
be more willing to invest in bonds ie higher I leads to higher B.
Money market funds (money market mutual funds) pool together the funds of
money people. These funds are then used to buy bonds – govt band these funds
pay I close to but slightly below the I they get on the bonds they hold.
Derivation of M (Money people want to hold)
M = YL (i)
Where y = momural income
L (i) = fn of integrate rate
Demand for money depends an level of transactions (= nominal income) and I is
inversely rotated because which I M
Where Y transaction so Md
i
ii
A
B
Md
Md
M1
M2
M
We can say that for a given interest rate in an in nominal income (y) would shift
the Md cure towards rightwards to Md and money demand will
Change in I would create a movement along the M curve
Change in y would shift the M curve
Md, Ms and Equilib rum
Suppose supply of money by central bank (currency) is M
So Ms = M
Equilib in financial market would
Aply – Md = Ms
Or Md = M
Or yl (i) = M
It means that I must be such that given the income y people are willing to hold an
ant of money = existing Ms . this relation is called LM relation
i
MS
i*
A
Md
M*
M
The Ms curve is a vertical line Ms = M is independent of I equilib occuss at A and
equils int rate I
Changes in Y or Ms
i
i2
B
Md
i1
A
Md1
M
M
Initial equilib is at A An in mammal income from y to Y in causes the level of
transaction result which increases Md. As a md will shift rightuaids to Md Equilib
will move up from A to B and equilib I from li to I in y leads to in I reason At is
Md2 > ms so in order to the Md I has to be so that people invest more in molds and
hold less money
2.
Change in Ms
MS MS2
i1
A
i2
B
M1 M2
M
If the money supply MS to MS Initial equilib is at A with if (interest) 2 M as
Money If money supply from MS = M to MS = M it leads to a shift of the money
supply curve from MS to MS Equelib pt shifts from A to B and I Falls down from I
to I in Ms leads to a in I holding less Money. So by I people will keep less of bends
2 establish equilib.
Open market operations (How does central bank change Ms)
The way central bank change the Ms is by buying or Selling in the bonds market if
it wants to increase the Ms it buys bonds and pays for them by creating money. If it
wants to ms it will sell bonds 2 ramous money from the market These actions are
called OMS take place in the open market for bonds buys bonds – expansionary
OMO
Sees bonds – constractionary OMO.
Bond prices
Suppose a bond promises to pay Rs 10 after 1 year and price of band today is P and
rate of interst is i.
A=P
100 = P
PB is inversely related to I ie PB so is or vice – versa
Expansionary OMO ESM EDB P I
Contractionary OMO – EDM,ESB, PB I
Determination of int rate (i)
Supply and demand of central bank moeney
1. Supply of central bank money = demand of central bank money
2. Equilib interest – D = S.
Demand or Money
People hold both currency and checkable deposits (demand for money) involves –
how much to hold and decision abt how much of this money to hold in currency
and how much to hold in checkable deposits.
Overall demand = currency + checkable deposits
For money
M = YL (i)
Lets assume that people hold a fined proposition of this money in currency say c so
(1-C) for checkable deposits
Demand for CVd = currency
Dd = demand for checkable deposite
CV d = c Md
2
Dd = (1-c) Md
3
We knows that banks have to keep a fined proposition of checkable deposits as
resaves say Q
Rd = QD (D=amt. of checkable deposits)
Rd=demand for reserves
Rd = Q (1-c) Md
4 [from 3]
Let hd = demand for central bank money
We know hd = CVd + Rd
Hd = cMd + Q (1-c) Md [firm 2 4]
Hd = [c+Q (1-c)]YL (i) [from 1]
Demand for what bank money
Now let H be the supply of central bank money H is controlled by central bank
through open market operations
Equilib will be attained when demand for central bank money = supply of central
bank money
Ie H = Hd
H=[c+Q (1-C)] YL (i)
Supply of C.B money
Demand for central bank money
i
A
H
Hd = CUd +Rd
i is determined from A
If is then M [Bd]
Because so Cud and Dd
H
Equilib can be attained also when supply of reserves = supply of central bank
money H – CVd. The demand for reserves is Rd. so the equilib is attuned when Rd
= Rs
Rs = H – CVd = RD
This is called federal funds market where I changes to balance Rs and Rd.
I - federal funds rate Banks that have excess reserves at the end of the day lend
than to banks that have insufficient reserves
Money multiplies
Eqvilib
H = [C+Q (1-c) YL (i)]
H=
Supply of money = demand for maoney.
Overall demand for maoney (currency + check deposite)
Overall supply of money is not equal just to central bank money but to central bank
money times a constant term
This constant is called the money multiplies
Central Bank money (other names)
(H) high – pound money – in central bank (CB) money (H) lead to more
(a)
in overall money supply than initial in C.B money
Monetary base – overall money supply demands ultimately an a base ie
(b)
the amt. of central bank money.
Concept of money multiplies – Refer register
Ch – 5
Goods and Financial Market
Equilib in the goods market is Z = C (Y-T) + I +G
This is the IS relation
Equilib in the financial market is
Md = M
This is the LM relation
Here invest is not considered to be constant. For eg if a firm wants to product it
will need more machines So it will take an rent more machines if the interest rate is
low so we can say that If the prod will then invest will But if I will invest will
I = I (Y, T)
+ Y = c (Y-T) + I (y, i) +C
Derivation of IS curve
Prod.
Z
ZZ
A
ZZ1
X
B
O
Y1
Y
Y
The demand curve is given by ZZ ox is the amt. of autonomous spending. The
equilib is attained at A (Prod = demand) Now suppose interest rate from I to I
higher interest rate leads to a lower invest. Since invest is a part of demand in
invest would lead to in demand. The demand curve will shift down to zz. The neew
equilib is now at B The equilib level of output has fallen from Y to Y
So we can say – in I leads to in I in I leads to in Y which leads to further in C and
demand and Prod. Through multiplies effect.
Demand
ZZ
A
ZZ1
B
Y1
Y
i
i1
B
i
A
Is curve
Y1
Y
(a)
Now A and B are the 2 equilib pts. In (2) figcere interest is measured an the
vertical axis and output an horizontal axis. When int rate is I A is the equilib Pt and
when it falls to I b is the equilib pt. So this relation b/w interest rate and output is
represented by the downward sloping IS curve.
IS curve – curve depicting the lower of equilib pts in goods market.
Shifts in IS curve
Change in either Tor G will Shift the IS curve
Is curve depicts the relationship b/w output and into rates. Now supposes taxes
from T to T so at a given I desposible income (y) leading to in C leading to in
demand for goods and in equilib Y Equilib output from Y to Y As a result Is curve
Shifts to its left.
i
IS1
IS2
Y
Y
Some would hold if G is but if T are or G then IS curve will shift rightwards and
equilib Y will
Financial Market and LM relation
Equilib in = M = YL (i) financial Market
It given relation b/w money hominal income and interest rate. But here we wil take
real income =
∴
𝑀
𝑃
𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝑖𝑛𝑐𝑜𝑚
𝑌𝐿 (𝑖)
𝑃𝑟𝑖𝑐𝑒
(𝑒𝑞𝑢𝑖𝑙𝑖𝑏)
Deprecation of LM curve
i
i’1
B
Md
i
A
Md
M/P mom (M/P)
LM curve
i
i1
B
A
Y
Y1
Y
Real money supply (M) is given by ms Money demand is given by Md Initial
equilib is taking place at A and equilib interest rate is i
Now suppose income from Y to Y .which leads to in at given I Md curve shifts
rightwards to md and equilib shifts from A to B and I to
So we can say that when income was y then equilib was at A and interest was and
when Y rate to to Y equilib shifted to B so this relationship b/w I and y is depicted
by upward sloping curve called lig curve. It is the lower of equilib pts in financial
market
Shifts in LM curve
Real money stock =
Changes in either M or p will shift the LM curve
Now suppose if money supply from M to M given a fined P will to Turn at given y
i will fall down from i to i
LM
LM2
I
ii
Y
LM curve will shift down from LM to LM similarly if p then also same will
happen but Lm curve will shift up and I will if M or P
Is – LM curves (Equilib)
IS Y = C(Y-T) + I (y,i) + G
LM = YL(i)
Is rule than follows that D of goods = s of goods and LM relation for ows that D
of money = So fof money Any gt. On The IS curve is the equilib pt in good
market. Any pt on the LM curve is the equilib pt in financial market.
interest
LM
i
A
IS
Y
output
Only at pt. A both equilibrium condition in goods as well as financial market are
equal. Equilib level of output is y and equilib interest rate is i
Fiscal policy and i
A change in fiscal policy which leads to incase in taxes by govt, keeping the
spending costant to reduce the bedget deficit is called fiscal contraction or fiscal
consolidation (or in G keeping canstant)
An in deficit either due to in G or in T is called fiscal expansion
(a)
in
I
A
IS
IS1
Y1
Yo
Y
Is curve shows the initial equilib in the goods market. By constriction of arbitrary
pt. A output yo and interest rate I are such that the supply of goods = demand for
goods At interest rate I now if taxes are from T to T yd will so C will and demand
for goods will. Consequently IS curve will shift to its left to
IS
LM
i
B
Yo
Y
Now LM curve show the equilib in financial market At pt B demand for money =
supply of money at interest rate I and output yowith in taxes nothing will happen to
the LM curve Taxes do not appear in the LM relation they do’t affect the equilib
condition (LM curve will not shift)
i
LM
Io
A
IS
i1
B
IS1
Y1
Yo
Y
Now equilib in both goods and financial market will take place at A at io interest
rate and yo output (before in taxes) with in taxes IS curve shifted leftwards to IS
and equilib shifted to B the interest rate feel down from io to ia and output has
from yo to Y
The reason behind this is that in taxes leads to in yd leading to in C and ferther in
demand caring the prod to and in income at the some time in Y reduces the
demand for money leading to in the decline in I reduces but does not completely
offset the effect of higher taxes on demand for goods G remains unchanged C and
lower output means lower sales and lower invest On the other hand lower in leads
to higher invest We cannot tell which effect dome rates.
Monetary Policy
1. In MS – monetary expansion
2. In MS – monetary contraction /tightening
𝑀
𝑀
𝑃
𝑃
Suppose central bank nominal money M Given P in Ms leads to in from to
i
io
IS
Yo
Y
The money supply doesn’t directly affect the IS curve Ie it neither affects the
supply nor demand for goods M does not appear in IS relation Is curve will not
shift.
LM
LM1
i
A
B
𝑀
𝑀1
𝑃
𝑃
M
When money supply changes from M to M LM curve Shifted from LM to LM and
money supply from to
i
LM
LM1
io
A
i1
B
IS
Yo
Y1
Y
These shift affect the equilibrium earlier the equilib in goods and financial market
was attained at pt – A at io interest rate and Yo output But with in money supply
from M to M equilib shifted to pt b Interest rate fell down from io to is and output
from yo to Y,
Reason in money supply ie ESM leads to EDB (excess demand for bands) So pB
and I with lower I invest which in turn demand and y
Policy mix
Combination of monetary and fiscal policies is know as monetary fiscal policy mix
or simply policy Mix
Section 5-5 refer notes (?)
Refer ragsts for IS – LM
Ch-6
The labour Market (Refer regster)
Participation rate It’s the ration of labour force to the non institutional civilian
population
Unemployment rate It’s the ratio of unemployed people to the labour force
Discouraged workers They are the ones who are not actively looking for a job but
they will take one if they find one
Non employment rate The ratio of pop mineus employment to population
Wage determination
Permeation wage – The wage rate that makes workers in afferent b/w working or
being unemployed Imp Pts
Workers are typically paid wage exceeding the reservation wage so that hey
choose to be employed rather than unemployed wages depend on labour market
conditions ie lowe the unemployment rate higher are the wages
Why workers are paid abous reservation wage ?
1. Bargaining power : The bargaining power of a worker depends on 2 factors
(a) Nature of a job – The greater the skills require to perform a job the more is
the bargaining power for eg job of a delivering boy in Mc Donaelds Is an
unskilled job The firm can lay win off and find a replacement at min cost he
will have less bargaining power in conteast to a highly skilled worker who
know in detail how the firm operates (he can ask for higher wages)
(b) Labour market condition – When the unemployment rate is low it’s casier
for the worker to find another job they have more bargaining power and are
able to obtain higher wages But when unemployment rate is high its difficult
for workers to find another job they have less bargaining power and
therefore are ready to accept lower wages
(ii) Efficiency wages – Firms want this worker to be productive and a higher
wage can help them achieve the goal. But of worker are paid only their
reservation wage they le be indifferent to staying or leaving. It depends on 2
factors.
(a) Nature of job – High tech firm are ready to pay a high wage to skilled
worker who se employs morale and commitment as essential to the quality
of their work
(b) Labour market conditions – when unemployment rate is law it’s easy to
find another job so a frrm who wants to avoid an in quits will have to wages
to certain the best of lot and conversely of unemployment rate is high wages
paid welled be lower.
Model of Wage Determination
W = PF (u,z)
+ The agg. Nominal wage depends an expected price level (pe) unemployment rate
(4) and z other variables
(a)
Expected price level – Wages are set in nominal terms and when they
are set the relevant price level is not known Nominal wages are set for a
specific time period so they are decided acc. To prices which are
expected in future and not an current prices because workers do not case
about the money they receive but how money goods they can buy from
that money. They are about nominal wages relative to the price of goods
ie similarly the firms
(b)
Unemployment rate – These is an inverse relationship b/w
unemployment rate is high wages paid are lower It depends an bargaining
power and efficiency wages
(c)
Other factors (z) – It’s assented that z induces are to the factors that
affect wages gun the unemployment level and expected price. A direct
relationship is assumed b/w z and wages For eg z can be unemployment
insurance – the payment of unemployment benefits to workers who lose
their job If unemployment ivs. Is there then unemployed workers can
hold out for higher wages but if these isno unemployment ins. They will
hae nothing to live on and they will be radyto accept even lower wage
similarly min wage – It so wages above min. wage (w) and employment
protection makes it more expensive for firms to lay off worker in wages
Price Determination
The price set by frims depend on the costs they face Depends on prod f relation
b/w inputs and qty of output prod duced and on prices of inputs
Y= AN
Y = output
A = labow productivity constant (outper / worker)
N= employment
We assume that worker produces only / unit output so
Y=N
Meaning that cost of producing an additional unit is the cost of employing a one
more worker at wage W In P.C – P = MC P= W
But in other market P>MC (assuming cab is of the price employed)
Where U = markup ower cost in P.C – u = o Here P will exceed w by a factor =
(1+u)
Natural Rate of unemployment
Assumption – let W depend on P rather than P (ie P = P)
Wage setting Relation
W = PF (U,z) both sides by P
𝑊
𝑃
= 𝐹 (𝑢, 𝑧)
(Real wage)
W = nominal wage
W/P = real wage
Wage determination implies a negative relation b/w real wage (w/P) and
unemployment rate (we know why)
This relation b/w real wage and unemployment is the wage setting relation.
Real wage W/P
1
1+𝑢
A
SP
W.S relation
unemployment rate (u)
W.S relation is a elowenewond
(U) sloping curve As u
Price setting relation
P = (1+u) W
÷ Both sides by W (Nominal wage)
𝑃
𝑊
=1+𝑢
Now taking inverse
𝑊
𝑃
=
1
1+𝑢
Price setting decisions determine the real wage paid by firms An in markup leads
to is prices given the wage they have to pay (leading to in wage)
Eg: If the employs firm its markup its price will but employes will be paid the
same nominal wage Now of all the firms their markup all prices will so even if
nominal wage is not changed the real wage will go down P.S relation is a st.
horizontal line The real wage is and does not depend on unemployment rate
Equilib Real wages and unemployment
Equilib Real wage in W.S = real wage in P.S
Equilib is attuned at pt. A and the equilib Unemployment rate is given by un (given
as follower) F (u,z) =
The leal wage chosen in wage retting = ral wage chosen in Price setting
The equilib unemployment rate un is called the natural rate of unemployment
Natural because its appear naturally though Q.S and P.S curves depends on z and u
In z (unemployment benefits)
w/p
A
B
R.S
1
1+𝑢
WS1
WS
un
un1
u
An in z makers the prospect of unemployment less painful . this leads to in eal
wages demanded by worker at a given unemployment rate. So it shifts WS curve
rightwards to WS economy mous along the P.S line from A to B 2 un to un
Reason : Higher a causes real wages to.So a higher (unemployment rate) is regd.
To being the real wages back to what frims are willing to pay.
2.
change in u
If firms coulee and this market power it leads to an in u to u leads to in real wage
paid by turn result P.S curve shifts downwards to PS the economy mous along I.S
curve from A to B and un to un
PS
1
1+𝑢
PS1
1
WS
1+𝑢′
Un
un1
u
Reason By in markup the real wages go down (due to less stringent enforncemt of
antitrust legislation unemployment rate) A higher un is regd. To maker worker
accept this lower real wage.
Equilib rate of unemployment since reffects uarious characteristics of structure of
economy also called structural rate of unemployment
Natural level of employment
The level of employment that prevails at equilibrant unemployment (when
unemployment is equal to its natural rate)
U = unemployment N = employment
L = labour force u = unemployment rate
U = unemployment rate [ratio of unemployed to above force]
Level of unemployment = labour force – employment
N = L (1-u)
So , Nn = L (1-un)
Natural rate of unemployment= un
Nn = Natural level of employment
Natural level of output
The level of prod when employment is equal to natural level of employment.
Equilebuir in the labour market determines the natural rate of unemployment
which determines the natural level of employemt which in fun determines the
natural level of output.
Ch-7
AD – AS Model
A.S Model
W.S relation
W= pe f (4,z)
(1)
P.S relation
P = (1+u) w
(2)
Putting 1 in 2
P = p (1+u) f (u,z)
u=
𝑈
𝐿
=
𝐿−𝑁
𝐿
(3)
=1−
=1−
𝑁
𝐿
𝑌
𝐿
(4)
Putting (4) in (3)
P = Pe (1+u) F
1−𝑈
𝐿
,3
A.S relation
It has got 2 properties:1
in y leads to in P – N in N leads to in U and u. this in leads to in WE. This
in leads to in P set by firms 2 in price level.
2.
An in Pe leads to in actual p If wage return expect the price level to be
higher they set a high nominal wage and in w leads to in cost of prod which leads
to in P by the firms .
Price level
P =P2
AS
A
Y=Yn
output
Prop. Of AS curve
(a)
(b)
(c)
It’s up word stopping ie in y leads to in P
A.S curve passer through A where Y = Y and P = pe When y>Yn then P>
pe and if Y < Yn then P<Pe
An in pe will shift the A.S curve up wards at a given level of output in pe
leads to an in w which P so the price level will be higher Now the A.S
curve will pass through A instead of A
AS1
Price level
AS
P=P’e
P=Pe
Y=Yn
output
A.D Model
A.D relation in derived from equaled conditions in goods 2 financial markets
Good market equilib
Y= c (Y-T) + I (y,i) + G
Financial market equilibrant
𝑀
𝑃
= 𝑌𝐿 (𝑖)
Is curve is drown for given values of G and T Its downward sloping An in I leads
to in y LM curve is upward sloping. An in y the Md and I At Pt both the market are
in equilib.
LM(P1>P)
LM (P)
i1
A1
i
A
IS
Y1
Y
output
Price level
P1
P
A1
A
AD
Y1
y
output
Now if price level to from P to P then given M M This implies that The LM
company mouse along shifts up to LM. As a result Is equilib shifts from A to A
the int rate from I to I and output from Y to y in p leads to M/p EDM and ESB Pb I
IY
The negative relation b/w price level and output level is drown as the downward
sloping AD curve Pts A and A on the AD curve corresponds to pts A and A in Is –
LM model An in the price level from P to P leads to a in output from Y to Y
Any variable other than the price level that shift either the Is curve or the LM curve
also shifts the AD relation.
In G at a given price level would shift the equilib in the good and financial market
to a higher pt AD curve will shift rightwards to AD
In M [contractionary monetary policy at a given price level would shift the equilib
in goods 2 financial market to lower Pt AD curve will shift leftwards to AD”]
Price level
P
AD1 (in G)
AD
(in M) AD
output
𝑀
Y= Y ( , 𝐺, 𝑇
𝑃
(+)
(+)
(-)
Ie output Y is an fn of real money stock (M/P) an fn of govt. spending (G) and fn of
taxes (T)
Equilibrium [In short run and medium run]
1−𝑌
AS
P = Pe (1+u) F (
AD
Y= Y ( , 𝐺, 𝑇)
𝐿
, 𝑧)
𝑀
𝑃
In short – run
We take Pe as given
Price level
AS
P
Pe
A
B
AD
Yn
Y
output
As curve is drown for a given value of Pe. it’s upward sloping ie th higher the level
of output the higher the price level. when output = natural level of output, P = Pe
as curve passes through pt B
AD curve is downward sloping the higher the P the lower the level of Y.
Equilib is attained at the intersection of AS and AD curve ie at pt A At this pt goods
market financial market and labour market all are in equilib. the equilib leel of
output and price level is Y and P resp.
It is observed that equilib level of output (y) is greater than natural level of output
(Yn) . equilib output depends clearly on the position of the A.S and A.D curses In
the short run there is no reason why Y=Yn. it all depends on the specific values of
Pe and M, G and T
In S.R Pe = P
In Medium Run
Price level
AS1 (for Pe = P)
AS (for pespe)
AS
P = Pe
A”
P1>Pe
A1
P
Pe
A
B
AD
Yn
Y1y
output
AD is agg. demand curve. as is agg. supply curve Equilib is attainedat Pt. A 2
equilib output is Y and price level is P. Y is above Yn (natural level of output) The
price level (P) is greater than expected Price level (Pe) (expected by wage setters
while setting nominal wages).
since P> Pe next time the wage setters while setting nominal wages will make
decision based higher expected price level (Pe) i.e P e > Pe
Thid in expected price will shift the A.S curve upwards to AS At a given level of
output wage setters will expect a higher price level. they set a higher nominal
wage which in-turn the price level.
AS curve shifts to AS economy mouses along AD curve and equals shifts to A
Equilib output to Y
But shift Y exceed Yn so the price level is still higher than Pe
Again wage setters will revise their price expectations upwards.
This means as long as equilib output is greater than Yn Pe continues to causing AS
curve upwards and equilib output continues to when AS curve will shift to AS
equilib will be at pt A and equilb level of output will be Yn and price level =
expected price level.
At this pt wage setters have no reason to receive their expectation and economy
stays at A
As log as Y > Yn , P> Pe this causes the wage setters to revise their expectations
upwards leading to in P. This in P causes in real money stock (M/P) leading to in i
(LM curve shift) causing in I and in Y this adjustment stops when Y = Yn . At this pt
wage setters have no reason to revise Pe in medium run output returns to the
natural level of output.
Monetary Expansion
AS1
Price level
AS
P1
P’
P
A
A
AD1
AD
Yn
Y1
output
As and AD curve intersect at Pt. A (equilib pt) and equilib output = natural level of
output = Yn and price = P
AD Y = Y
Now suppose govt nominal money M real money stock (MP) also leading to in
output. this causes AD curve to shift rightwards to AD In the short run equilib
goes to pt A and Yn to Y 2 P to P1
But ouer time price expectation being to rise Y > Yn P > Pe wage setters revise
their price expectations upwards causing AS curve to shift upwards to AS The
economy moues along AD curve 2 equilib shifts to A and equilib output Y is agian
equal to Yn 2 price level P” = Pe
Actual thing
Before the change in nominal mony the equilib is given by the intersection of IS-2
LM curves which corresponds to Pt A in (a) Y = Yn in M causing in M/ P shift the
LM curves right wards to LM causing equilib to more to A which corresponds to A
in (a). there is an in output to Y and in int rate to i
There are 2 effect behind the shift from LM to LM (in short - run )
1.
If the price level did not change in nominal money will shift the curve to LM
causing equilib to shift to B
2.
But even in the short run P (here P to P) This causes LM” curve to shift
upwards to LM causing equilib to shift to A’
We can say
in M
LM shift to LM”
in P (in response)
LM” curve shift
againg in P = P LM to LM to LM but our time since Y> Yn and P>Pe PE and So P
causing M to and LM curve to shift backward to original LM and Y = Yn 2 equilib at
A in nominal money is exactly offset by a promotional in the price level
Next rarity of money
In short – run – monetary expansion leads to in output in int rate and in price
level.
In medium run – in nominal money (monetary expansion) is reflected extirely in a
proportional in P ie No effect on Y or i.
The absence of medium – run effect of money on output and on theint rate is
known as the next rality of money
Neutrality of money in M.R does not mean that monetary expansion shoveled not
be used to affect output. but this helps the economy more out of recession and
return faster to Yn.
Decrease in Budget Defect (contractions in T or in G final policy)
Suppose govt. wants to budget deficit by G and keeping taxes unchanged .
AS and AD are original curves Equilib is at A and output Yn (nat level) and price = P
in G will shift the AD curves leftwards to AD in short – run equilib mores from A to
A’ output to Y’ and Price level to P’
In the medium run overtime Since Y’ < Yn P< Pe wage setters revise their
expectations downwards till it’s equal to P lead value AS curve keep shifting
downwards. the economy moves along AD’ curve 2 AS moves to AS’ causing the
equilib to shift at pt A” and output to get back at Yn. but unlike in M in this in
Budget deficit at pt A” not every thing is same Howeven output is same but P and
i are lower than before.
this can be studied from folu
IS- LM model.
Before the change equilib is at pt A at the intersection of IS and LM curves
corresponding to A in (a) Outout is Yn and int rate is i AS the govt. G Is curve shifts
leftwards to IS and equilib shifts to pt. B (assuming that the price did not change)
But Since Y<Yn so P< Pe ie price level declines real money stock causing Lm curve
to shift rightwards to LM’ causing equlib to shift to A’ corresponding to pt A’ in (a)
Int. rate to i 2 output to y both output 2 int rate are lower than before P also
continues to The LM curve LM “ continues to shift down to the economy moves
along the IS curve to pt A” At this pt output is back to Yn But the int rate is lower
than before ie i”
In M. R – in budget deficit i and I (because i is lower)
retor to register
Ch – 8
Natural rate of unemployment and philips curve
A.S relation P= Pe (1+u) F(u,z)
1
Let us suppose that
F(u,z) = 1 Lu + z
this means that higher the unemployment rate , lower is the wage higher z, higher
is the wage Parameter L captures the strength of the effect of unemployment on
wage so replying f (u,z) in (i)
P = Pe (1+u) (1-Lu + z)
Now, writing above fn in time t
Pt= Pet (t+u) (1-Lu+z)
(2)
now, writing (2) and dividing it both sides by Pt – 1
Now taking left side of (3) and writing it as follows:
where IIt = [depuration of inflation rate]
Similarly taking RHS of (3) 2 writing it as:
now puling
and
in (3)
in IIe leads to in II reason: An in Pe leads to in P (actual price level) Because if
wage setters expect a higher price level they will set a higher nominal
wage,
which leads to in actual price level Now given last period’s price level a high price
level this period unplies a higher rate of in price level from last period to this
period ie higher infection Given last period’s price level a higher expected price
level leads to a higher expected rate of in the price level ie higher expected
infection .
Given IIe in u or z lead to an in inflation II.
Given IIe an in u leads to decrease in II like given Pe an in u leads to a lower
nominal wage which lead to a lower P. similarly inflation.
The philips curve
Suppose inflation is the for some years so on avg. it is O
So with avg. inflation = O its reasonable for wage setters to expect O over next
years ie IIet = o
IIt = (u+z) – Lut
Wage – price spiral
given expected price level lower unemployment leads to higher nominal wage
This leads to in Price level In response to high price level workers ask for a higher
nominal wage the next time wage is set This leads to further in price As a result P
so again worker ask for figher wages next time This leads to in price infection
US Economy
From 1961 to 1969 in U.S the unemployment rate declined steadily from 6.8% to
3.4% and inflation rate Id from 1.0% to 5.5% putting formally from 1961 to 1969
U.S economy moved up along the philips curve
But in 1970, this relation b/w u and II broke down.
The philip curve vaieshed because of 2 reason:1
U.S was hit pwice in 1970s by a large in the price of oil the effoct of this was
to force firms to their price relative to wages they wave paying ie to the u and if u
Id even at a given rate of unemployment inflation.
2.
wage setters changed the way – they formed their expecttion Because in
1960s there was a change in the behaviour of inflatin sametime the and
sometimes negative before 1960s but after 1960s it was consistchtry the IT
because more persistent High II in 1 year was folowed by high II in next year.
this ud to workers to change the way they formed expectoration when II is the
year after year then expecting a O II would by systematically tve 2 more persistent
year after year people started taking into account the presence and persistence of
inflatin This led to a change in the nature of relation b/w u and II
Now suppose fist expectation of inflation are famed as :
IIet = O IIt-1
Q is the effect of last year’s inflation (IIt-1) on the current year’s inflation rate IIe
The higher the Q the more last year’s II leads worker 2 firms to revise their
expectations.
As long as inflation was low 2 not very persistent the worker and firms negleted
the last year’s II Q was close to O and II = 0
But as II because more persistent 2 the worker and firms started taking into a/c
last year’s Ii and O d But by mid 1970 People started expecting current year’s II to
be equal last year’s II and Q = 1
We know IIt = II +(u+z) – lut
IIt = QIIt-1 + (u+z) – Lut
when Q=O
than IIt = (u+z)-Lut
when Q>o
IIt = II t- 1 + (u+z) – L ut
or IIt-IIt-1 = (u+z)-Lut
So when Q=1 the unemployment rate does not only affect the inflation rate but
the change in inflation rate High u lead to II and vice – versa This is the form the
philips curve relatin b/w u and Ii takes today.
Q is called the modifed Philpis curve or the expectations augmented philips curve
or accelerations phipils curve (low u leads to in and thus an acceleration braise)
Natural rate of unemployment
In register
Deflation
Deflation happens when inflation is low and possible negative
during great depression II is high when there is high u because
1
Great depression is associated with an not only in ut but Un also there was
an in II
2.
when economy starts experiencing deflation the philips curve relation
breaks down because the worker are reluctant to accept decreeing in their
nominal wages.
When IIt becomes high worker and firms become reluctant to enter into labour
contracts that set nominal wages for a longer period of time Because if IIt>II then
real wages willfall and worker will suffer large cuts in their living standards But if
IIt<IIt then real wages would Firms may not be able to pay their worker.
wage Indexation is a provision that automatically increases wages in live with
inflation.
This changes leads to a stronger response of inflrtion to unemployment of types
for eg there are 2 labour ontherts A propostion of labour artifacts is indexed ie
wages more in live with actual price level and last (1-z) are not indexed wages are
set on the basis of IIet Now
IIt = [IIt+ (1-z)IIte]- L (ut-un)
L of contract are indexed
responds to Iit (actual) 2 (1-L) responds to IIt (expected) If IIte = IIt-1 then
IIt= [LIIt + (1-L)II+1]-L(ut-un) and if L = o all wayes set on IIet then
IIt – IIt-1 = L (ut - un)
Ch-9
O keen’s Low
Okun’s law given the formal relation b/w unemployment rate and output growth
This was given by Arthur Okun
ut-ut-1 = gyt
1
gyt = output growth
ut – ut-1 = change in unemployment rate.
the change in u should be equal to the negative of the growth rate of output. ie
when there is the output growth, the u should decline.
ut-ut-1 = -0.4 (gyt-3%)
2
In the above eg: output growth (gyt) should be greater than 3% otherwise u will
rise this is because of 2 factors labour force growth 2 labour productivity growth.
To maintain a constant u employment must grow at the same rate as labour force
If labour forces growths at 1.7% per year then employment should also by 1.7%
per year and also if labour producing is 1.3% per year then total output growth
should be 1.7 + 1.3 = 3% ie to maintain a constant u output growth = labour
force+ labour productions growth.
Now in 2 the coeff on RHS is -0.4 and in (1) its -1.0 so we can say that output
growth 1% above normal leads only to 0.4% reduction in u in (2) adn 1% reduction
in (1) because of following 2 reasons :1.
Firms adjust employment less than enc for one in responses to deviations
of output growth from normal One reason is that some worker are always needed
no maths what the level of output is Another is that traing of new employees is
costly so firms avoid to lay off and often aske them to work overtime rather hiring
new ones In bad time firms in effect hoard labour the labour they will need when
times are better.
2.
An in employment rate does not lead to a one for-one decrease in
unemployment rate the reason is that labour force participation Is when
employment not all new jobs are filled by unemployed some are taken by
discouraged workers (who curve previously classified as out of labour force)
ut-ut-1 = (gyt-gy)
when measures the effect of output growth over normal on the triangle in u
gyt = output growth rate
gy = Normal growth rate
A.D relation
Yt = Y
To forces on relation b/w real money stock 2 output well more others factors
Yt = Y
This means that demand for goods/ output is simplify propositional to real money
stock.
Now gyt= gmt –IIt
where gyt = output growth rate
gmt = growth rate of nominal money IIt = growth rate of price inflection rate
If gmt>IIt then real money grth is tve 2 so gyt
If gmt < Iit then real money growth is ve and so gyt
In othe words given Iit expansion monetary policy (high gmt) leads to high gyt and
contractionary monetary policy (low gmt) leads to lwo gyt
Effects of Money growth
Okuso’s law
Ut – ut - = - (gyt - gy)
Philip’s curve
IIt – IIt-1 = L (ut-un)
A.D
gyt = gmt – IIt
medium Run
Assume that central bank maintains a constant growth rate of nominal money say
gm
In medium run the u must be constant nether nor puting ut = ut – 1 in okun’s law
relation gyt=gy ie the output will grow at its normal rate of growth ie gy
So with nominal money growth = gm and output growth = gy A.D relation:gy = gm – II
or Ii = gm – gy
In M.b inflation must be equal to nominal money growth minces normal output
growth If gm – gy is adjusted nominal money growth then in M.R inflation equals
adjusted nominal money growth this is because a growing level of output means
higher income higher level of evection and higher demand for real money so if
output growth rate is not equal to nominal money growth rate this would lead to
either inflation or deflation
If inflation is constant than current year II would be equal to last year’s one
putting IIt = Iit-1 in philip’s curve relation ut = un ie in M.R unemployment rate =
natural rate of unemployment.
So in m.R output growth is equal to normal growth rate unemployment is equal to
natural rate Nominal money growth affects only inflation.
Inflation is always and everywhere a monetary phenomenon.
Short – run
Suppose the central bank divides to decrease nominal money growth In M.R
fower money growth will lead to lower inflation and unchanged gyt and u
higher monetary policy will lead to lower output growth 2 unemployment This in
u leads to a in inflation and in M.R output growth relative to normal and u returns
to un Money growth and inflation are both permanently lower at this pt. The
temporary in u buys a permanent in inflation.
Disinflation
Disinflation means decrease in inflation It can be obtained only at the cost of
higher unemployment IIt-IIt-1 = - L (ut-Un)
ut must exceed un
It can be arrived at the cost of higher unemployment for few years or with a
smaller in u spread overs many years.
Pt years of excess u – It’s the left b/w actual and natural unemployment rate of
one % pt. for 1 year.
IIt-IIt-1 = L (Ut-un) (1)
Now suppose central bank wants to Ii by x percentage pts. or simply form 14% to
4% so that n = 10 lets L= 1
Suppose central banks wants to achieve reduction in 1 years So acc. to (1) what is
regd is 1 year of u at 10% above natural rate. So RHS would be – 10% so II by 10%
Suppose, CB events to being reduction in 2 years so what u reduction is 2 years
unemployment at 5% above un so RHS is -5% so that Ti > by 5% each years By
came reasoning, of CB evants it in 10 years , then RHS would by –10% and ll
would ^ by 1% for 10 years on each year, the no.of pt. years of excess.
Unemployment reqd to ^ inflation is the same ie 10 The central bank can only
choose the dist” of excess u over time Savifice ratio is the no. of Pt. years of
excess unemployment needed to achieve a ^ inflation of 1%
S.R =Pt years of excess unemployment
In inflation
(1) Unplies that S.R is independent of policy and simply equal to 1 and if l
=1,then S.R =1
Now suppose govt. tried to ^ inflation by 10% in 1 years then, this would
requires an u of 10% above natural rats for 1 years If un= 6% , then ot have
to be 16%.
ie. The output geth have to be -22% for a years then in traditional approach.
Robes lucas and Thomas Saegent gave their nicees that in O kees always (expected
inflation to be same as last years ie.
The way wage settern fames their expectations would not changes in response to
the change in policy. This was an unwanted assumption
So, they aegued that if evage settles believed that thane would be lower inflation
next years, than they will expect inflation to be down in the futues than in the
past. This will lead to actual 6^ in inflation.
So
If image settles expected current year ll to be same as past year than, the any way
to ^ ll is by ^ U But m if they are continued that ll would in next years , the
inflation would decline itself.
However , hucas 2 sugent believed that same ^ in U is reqd. but way S.R can be
much lower but than suggested by traditional approach the essential part, which
they adjust was the ttedibiesty of niouetary policy the belief but was that settles
C.B was truly commlttled to reduction inflation
Ch- 18
The Great Depression
Essantial facts:
Stock mkt crash (by 85%)
GNP fell down , unemployment rose Inuestment collapsed cpi also fell down rates
on , thane was recasician between Depression . 2 unemployment rost to 20% .
shorturm into rates , such as commercial paper was near o.
*Economic Policy
There was face in stock mkt. this was because of large-scale bank failures Banks
failed because they did not have the events with which to meal customies cash
withdrawal and, hence reduced the money stock .Also they lost confidence on the
part of depositoes and led to and ^ in desired curencey deposit ratio. Moreover , the
often souks that had not yet failed started ^ three serious .so the ^ in cuneney
deposit ratio 2 reserve deposit ratio reduced the money multiplies and shapely
contacted the money stock.
In order to ^ the Ms, the central bank started open-mkt perchases
The govt. stocked rouising texes to reduces the budget deficit Economic activity
recovered in period from 1933 to1937, with fistal policy becoming expansionary 2
money stock growurg rapidly ( through flow of glad from exnope)
International Aspects:
Great Depression was worldwide to save extext it was the result of couapse of
international financial system Also, it resulted because of the adoption of hightarigh policies which intended to keeg out foreign goods in order to protect
domestic goods. Sweden came out of recession by staitay an 12 pensioned policy
in early 1930s 2 reduced u Britain suffered heigh u in both 1920s and 1930s.
Germany give rapidly often hitler came to power ans expanded G china escaped
it.1931 because it had a floating exchange eats.
*they did depression happened? What would have been done to present it?
Keynesian Explanation
Growth in 1920s was based on the mass period of automobile , 2 radio along with
housing boom. The collapse of growth in 1930s resulted from the dyeing up of the
invest opportunities and a downward shift in invest demand Also same believed
that there was a down reward shift in contempt “ f” and poor fiscal policy in it.
i
I1
II1
I
I
I
An active stabilization policy was needed to maintance good ocanamic
performance Keynesian model gave pollcey measures that could have been taken
to percant depression 2 futeves dep.
1.
Vigorous use of coutes cyclical fiscal policy was the preferred method to
reduce cyclical fluctuations ie to^ the agg. Demand
Monotony factors:
Since interest rates were already low, so because than was no demand for I. this led
to a very slicep It were At the same time LM give was quite flat (liquidity trap). So
mortay policy in such a situation would fainess.
In order to present future depress as all the following things canbe kept in mind:
1.
Taxes would no be raised again in the meddle of depression nor would
attempts to made to balance the budget.
2
Central bank would seek actively seek to keep money supply from falling
and not allow bank fallness .
Hyper Iinfection:
A country is in a state of hyper-infection when in annual inflation rate reactes
1000% p.o. the a hyperinflationary economy inflation is so pervasive that it
completely dominates daily economic life (1) People have to shop often so as to
get to the stores before prices go up (2) They reduce holding of real balances to
avoid inflation tax but have to compensate by going to the bank more often to get
currency (3) wages are paid very often such high inflations are associated with
high deficits.
Deficits and hyperinflation
The luxuriate cause of hyperinflation is always mashies growth is the money
supply But all economics suffcienct from large budget dificits which generated
nation debt. Large budget deficits leads to rapid inflation by causing govts. To
print money to finance deficits there by increasing the M S 2 ons chanesms thus
which inflation the budget deficits tax collection effects and in nominal payments
on the national debt.
As II real resurvey obtained from taxation falls there are lays hoth in calculation
and payment of taxes secondly inferests have to be paid one national debt so when
II int rates also which leads to higher payment the deficit Inflation adjusted deficict
is caleculated which = total defit – (II national debt)
Stopping hyper inflation
Monelory fiscal and exchange rate policies are combined with income policies to
stabilize inflation wages and prices are controceed Budget process have to be
reformed tax system is reformed.
Then audibility 2 S.K Same Deficits
The govt can reduce the difficulty either by selling bends or printing money It
prints money when it the stock of high – power money typically through open
market purchases
Budget deficit = sales of bands + in money base
There are two types of links b/w budget deficits 2 money growth
1
In S.R in deficit caused by expansionary fiscal policy will nominal and real
int. rates
2
govt. may deliberately stock of money as a means of financing itself over
long run
Inflation tax
when the govt. finances deficit by creating money it keeps on buy goods and
services this money is absorbed by public.
public choose to holding of nominal money to offset the effects of inflation For eg
if a person has to add RS 1000 to a bank A/C just to maintains real value of his/her
money holder This RS 1000 is not available for spending He/she is saving because
he/she is preventing his/her wealth from as a result of inflation.
Inflation just acts like a tax because people are forced to spend ies than their in
come 2 pay the diff. to the govt. in exchange for extra money.
When the govt. finances deficit by issuing money which the people add to its
holding of nominal balances constant we say that the govt. is finacing itself
through the inflation tax.
Inflation tax reveries = inflation rat * real money base.
1R
C
1R1
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IIt
II*
Inflation rate