PowerPoint PresentationA
B
C
D
E
G
Inefficient/
Unemployment
trade-offs, opportunity costs, and efficiency?
2
4
equilibrium price and equilibrium quantity
Equilibrium Price = $3
$10
8
6
CS
PS
5
Calculate the area of: 1. Consumer Surplus 2. Producer Surplus 3. Total Surplus
1. CS= $25 2. PS= $20 3. Total= $45
Double Shifts • Suppose the demand for sports cars fell at the
same time as production technology improved.
• Use S&D Analysis to show what will happen to
PRICE and QUANTITY.
time, EITHER price or quantity
will be indeterminate.
#2-Import Quotas
D
S
Shortage (Qd>Qs)
Maximum legal price a seller can charge for a product. Goal: Make affordable by keeping price from reaching Eq.
Gasoline
below equilibrium
Q o
D
Minimum legal price a seller can sell a product.
Goal: Keep price high by keeping price from falling to Eq.
Corn
above equilibrium
10
1. CS Before Tax 2. PS Before Tax 3. CS After Tax 4. PS After Tax 5. Tax Revenue
for Government 6. Dead Weight
Loss due to tax 7. Amount of tax
revenue producers pay
Tax Practice
3. Cross-Price Elasticity of Demand • Cross-Price elasticity shows how sensitive a product is
to a change in price of another good • It shows if two goods are substitutes or compliments
% change in price of product “a”
% change in quantity of product “b”
• If coefficient is negative (shows inverse relationship) than the goods are complements
• If coefficient is positive (shows direct relationship) than the goods are substitutes
P increases 20% Q decreases 15%
• Income elasticity shows how sensitive a product is to a change in INCOME
• It shows if goods are normal or inferior % change in income
% change in quantity
• If coefficient is negative (shows inverse relationship) than the good is inferior
• If coefficient is positive (shows direct relationship) than the good is normal
Ex: If income falls 10% and quantity falls 20%…
Income increases 20%, and quantity decreases 15% then the good is a…
4. Income-Elasticity of Demand
INFERIOR GOOD
Utility Maximizing Rule The consumer’s money should be spent so that the
marginal utility per dollar of each goods equal each
other. MUx = MUy
Px Py
Assume apples cost $1 each and oranges cost $2 each. If the consumer has $7, identify the combination that maximizes utility.
Three Stages of Returns
MP rising. TP increasing at an increasing rate.
Why? Specialization.
Average Product
MP Falling. TP increasing at a decreasing rate.
Why? Fixed Resources. Each worker adds less and less.
Average Product
Workers get in each others way
Marginal Product
Average Product
o s
shaped? •When marginal product is
increasing, marginal cost falls.
•When marginal product falls,
of each other.
below the average, it pulls
the average down.
the average up.
Example:
•An additional (marginal) person enters the room: Bill Gates.
•If the marginal is greater than the average it pulls it up.
•Notice that MC can increase but still pull down the average.
The MC curve intersects the ATC curve at its lowest point.
18
The law of diminishing marginal returns doesn’t apply in
the long run because there are no FIXED RESOURCES.
Short-Run Profit Maximization
To Maximize Profit!!!!!!
output
additional revenue from each new output
equals the additional cost.
• Should you produce…
…if the additional cost of another unit is $11 20
Profit Maximizing Rule
structures (PC, Monopolies, etc.)
above AVC
perfectly competitive firms (because
more. If the price is lowered from $5 to $4
the firm should stop producing.
Shut Down Rule: •A firm should continue to produce as long as the price is above the AVC •When the price falls below AVC then the firm should minimize its losses by shutting down •Why? If the price is below AVC the firm is losing more money by producing than the they would have to pay to shut down.
22
P
Q
P
industry and firm.
Is the firm making a profit or a loss? Why?
Total Revenue
1 2 3 4 5 6 7 8 9 10
MC
AVC
ATC
Where is the profit maximization point? How do you know?
MR=P
Total Cost
What is TR? What is TC?
Where is the Shutdown Point?
What output should be produced?
24
$5
0
45
40
35
30
25
20
15
10
5
0
AVC
ATC
25
supply curve
P
Q
P
industry and firm in the LONG RUN
27
Is the firm making a profit or a loss? Why?
Price = MC = Minimum ATC
Firm in Long-Run Equilibrium
industry TC = TR
29
P
Q
P
increases in the industry
6000
P
Q
P
price takers. Price decreases and quantity decreases
S1
New Long Run Equilibrium at $10 Price Zero Economic Profit
S1
33
P
Q
P
MC
8
Currently in Long-Run Equilibrium If demand increases, what happens in the short-run
and how does it return to the long run?
ATC
Profit is made in the short-run
ATC
increases in the industry Price Returns to $15
ATC
MC
8
D1
Back to Long-Run Equilibrium The only thing that changed from long-run to
long-run is quantity in the industry
ATC
7000
S1
costly way. (Minimum amount of
resources are being used)
Graphically it is where…
39
$5 MR
20 Underallocation
of resources
marginal cost.
P D=MR
firm IS the industry.
4.Shut down rule still applies
44
competitive firms) have downward
lower its price.
• This changes MR…
THE MARGINAL REVENUE
45
Q
$15
10
5
$64
40
20
TR
D
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 Q
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18
MR
What happens to TR when MR hits zero?
Total Revenue is
MR hits zero
$15
10
5
$64
40
20
TR
D
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 Q
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18
MR
P
TR
increases then
MC ATC
48 1 2 3 4 5 6 7 8 9 10 Q
P
What output should this monopoly produce?
MR = MC How much is the TR, TC and Profit or Loss?
Profit =$6
MR=MC, buts charges the price consumer are
willing to pay identified by the demand curve.
MC ATC
49 1 2 3 4 5 6 7 8 9 10 Q
P
MR
D
MR
$10
9
8
7
6
5
4
3
P
How much is the TR, TC, and Profit or Loss?
D
MC
MR
TR=
TC=
Profit/Loss=
$14
$56
ATC
$2
51
$10
9
8
7
6
5
4
1 2 3 4 5 6 7 8 9 10 Q
P
Are Monopolies Productively Efficient?
producing at the lowest
MC ATC
1 2 3 4 5 6 7 8 9 10 Q
P
MR
The monopoly is under
MC ATC
1 2 3 4 5 6 7 8 9 10 Q
P
MR
•Use Price controls: Price Ceilings
•Why don’t taxes work? •Taxes limit supply and that’s the problem
Why Regulate? Why would the government regulate
an monopoly?
59
Where should the government
place the price ceiling?
P = ATC (Normal Profit)
Regulating Monopolies Where does the firm produce if it is
unregulated?
Pm
Qm
D
MR
MC
ATC
Pm
Qm
Pso
Qso
Pm
Qm
Pso
Qso
Pfr
Qfr
D
MR
MC
ATC
to get the socially optimal quantity?
The firm would make a
loss and would require a
subsidy
Pso
prices makers so MR is less than Demand
In the short-run, it is the same graph as a monopoly making profit
In the long-run, new firms will enter,
driving down the DEMAND for firms
already in the market.
economic profit
economic profit
D
MR
MC
D
MR
MC
ATC
up the DEMAND for firms already in the
market.
P
Q1
P1
In the short-run, the graph is the same as a monopoly making a loss
D
MR
MC
ATC
is no economic profit
is no economic profit
Are Monopolistically Competitive Firms Efficient?
74
D
MR
MC
Not Productively Efficient because not producing at Minimum ATC
QSocially Optimal
QSocially Optimal
can produce at the lowest costs
(minimum ATC) but they decide not
to.
output and the profit maximizing
output.
Excess Capacity
ATC
QLR
PLR
The firm can produce at a lower cost but it holds back production to maximize profit
QProd Efficient
Game Theory
An understanding of game theory helps firms in an oligopoly maximize profit.
The study of how people behave in strategic situations
Game Theory Matrix You and your partner are competing firms. You
have one of two choices: Price High or Price Low.
Firm 2
Firm 1
Both High =
$20 Each
Both Low=
$10 each
High Low
Game Theory Matrix
Notice that you have an incentive to collude but also an incentive to cheat on your agreement
Firm 2
Firm 1
Both High =
$20 Each
Both Low=
$10 each
High Low
Low = $30
Low = $30
High = 0
Dominant Strategy The Dominant Strategy is the best move to make
regardless of what your opponent does What is each firm’s dominate strategy?
Firm 2
Firm 1
$100, $50
High Low
1. Price Leadership (no graph)
2. Colluding Oligopoly
create an agreement to fix prices high.
1. Cartels set price and output at an
agreed upon level
similar demand and costs
cheaters
Cartel = Colluding Oligopoly
monopoly and share the profit
D
1. Match price-If one firm cuts it’s prices, then
the other firms follow suit causing inelastic
demand
others maintain same price causing elastic
demand
react to competitor’s pricing in two ways:
The kinked demand curve model shows how
noncollusive firms are interdependent
will ignore it and keep prices the same
P
Pe
Qe
As the only firm with high prices, Qd for this firm
will decrease a lot
will match it and lower their prices
P
Pe
Qe
Since all firms have lower prices, Qd for this firm
will increase only a little
P2
Q2
P1
Q1
D
Q
P
Pe
Q
MR has a vertical gap at the kink. The result is that
MC can move and Qe won’t change. Price is sticky.
MC
MR
94
SL
DL
? Wage
Q
Wage
(worker).
equals the wage set by the market and is constant.
Ex: The MRC of an unskilled worker is $8.75.
Another way to calculate MRC is:
Marginal
Resource
Cost =
additional worker (resource).
MRP equals the marginal product of the resource
times the price of the product. Ex: If the Marginal Product of the 3rd worker is 5 and
the price of the good is constant at $20 the MRP is…….
$100
Marginal
Revenue
Product =
Side-by-side graph showing Market and Firm
Who demands labor? •FIRMS demand labor. •Demand for labor shows the quantities of workers that firms will hire at different wage rates. •Market Demand for Labor is the sum of each firm’s MRP.
DL
99
are willing to work at different wage rates.
•Higher wages give workers incentives to leave
other industries or give up leisure activities.
Quantity of Workers
Labor Supply
Wage (the price of labor) is set by the market.
EX: Supply and Demand for Carpenters
Quantity of Workers
Wage Labor Supply
Wage Rate
Why is it downward sloping?
Because of the law of
diminishing marginal
106
increases?
MRP increases causing
1.) Changes in the Demand for the Product
• Price increase of the product increases MRP
and demand for the resource.
2.) Changes in Productivity
• Technological Advances increase Marginal
Product and therefore MRP/Demand.
3.) Changes in Price of Other Resources
• Substitute Resources • Ex: What happens to the demand for assembly line
workers if price of robots falls?
• Complementary Resources • Ex: What happens to the demand nails if the price of
lumber increases significantly? 108
Identify the Resource and Shifter (ceteris paribus): 1. Increase in demand for microprocessors leads to a(n)
________ in the demand for processor assemblers.
2. Increase in the price for plastic piping causes the
demand for copper piping to _________.
3. Increase in demand for small homes (compared to big
homes) leads to a(n) _________ the demand for lumber.
4. For shipping companies, __________ in price of trains
leads to decrease in demand for trucks.
5. Decrease in price of sugar leads to a(n) __________ in
the demand for aluminum for soda producers.
6. Substantial increase in education and training leads to
an ___________ in demand for skilled labor.
109
3 Shifters of Resource Demand
Identify the Resource and Shifter (ceteris paribus): 1. Increase in demand for microprocessors leads to a(n)
________ in the demand for processor assemblers.
2. Increase in the price for plastic piping causes the
demand for copper piping to _________.
3. Increase in demand for small homes (compared to big
homes) leads to a(n) _________ the demand for lumber.
4. For shipping companies, __________ in price of trains
leads to decrease in demand for trucks.
5. Decrease in price of sugar leads to a(n) __________ in
the demand for aluminum for soda producers.
6. Substantial increase in education and training leads to
an ___________ in demand for skilled labor.
increase
increase
decrease
decrease
increase
increase
110
Resource Supply Shifters
Supply Shifters for Labor 1. Number of qualified workers • Education, training, & abilities required
2. Government regulation/licensing Ex: What if waiters had to obtain a license to serve
food?
3. Personal values regarding leisure time and societal roles. Ex: Why did the US Labor supply increase during
WWII? Why do some occupations get paid more
than others?
SL
DL
Wage
Q
Wage
Q
market and firm if new workers enter the
industry?
SL
DL
Wage
Q
Wage
Q
market and firm if new workers enter the
industry?
SL1
W1
Q1
increasing the federal minimum wage to
$12 an hour
Why or why not
116 5 6 7 8 9 10 11 12
S
Wage
S
Wage
S
Wage
Surplus of workers (Unemployment)
Minimum Wage
Assume that this firm CAN’T wage discriminate and must pay each worker the same wage.
Acme Coal Mining Co.
Wage rate (per hour)
SL
Wage
QE
WE
If the firm can’t wage discriminate, where is MRC?
Market Failures and the Role of the Government
122
failures: 1. Public Goods
3. Monopolies
In each of the above situations,
the government step in to
allocate resources efficiently.
Why must the government provide public
goods and services?
opportunity to earn profit.
Free Riders are individuals that
benefit without paying.
essential services would
be under produced.
government can:
punish free-riders.
provide the service to
126
Price
D=MSB
The Demand is the equal to the marginal benefit
to society
The supply is the public good’s
marginal cost to society
Price
made 1 park?
made 4 parks?
Market Failure #2:
•There are EXTERNAL benefits or external costs to
someone other than the original decision maker.
Why are Externalities Market Failures? •The free market fails to include external costs or
external benefits.
•With no government involvement there would be
too much of some goods and too little of others. Example: Smoking Cigarettes.
•The free market assumes that the cost of smoking is
fully paid by people who smoke.
•The government recognizes external costs and makes
policies to limit smoking.
person other than the original decision maker.
The costs “spillover” to other people or society. Example: Zoram is a chemical company that pollutes the air when it produces its good.
•Zoram only looks at its INTERNAL costs.
•The firms ignores the social cost of pollution
•So, the firm’s marginal cost curve is its supply curve
•When you factor in EXTERNAL costs, Zoram is
producing too much of its product.
•The government recognizes this and limits
production.
131
P
Q
QFree Market 132
Market for Cigarettes The marginal private cost doesn’t include the
costs to society.
cost are factor in?
greater than the MSB.
Too much is being
If the market produces QFM why is it a market
failure?
Overallocation
P
Q
QFree Market 135
Market for Cigarettes What should the government do to fix a negative
externality?
QOptimal
QFree Market 136
Market for Cigarettes What should the government do to fix a negative
externality?
QOptimal
Positive Externalities (aka: Spillover Benefits)
Situations that result in a BENEFIT for someone other than the original decision maker.
The benefits “spillover” to other people or society. (EX: Flu Vaccines, Education, Home Renovation)
Example: A mom decides to get a flu vaccine for her child •Mom only looks at the INTERNAL benefits. •She ignores the social benefits of a healthier society. •So, her private marginal benefit is her demand •When you factor in EXTERNAL benefits the marginal benefit and demand would be greater. •The government recognizes this and subsidizes flu shots. 137
P
Q
QFree Market 138
Market for Flu Shots The marginal private benefit doesn’t include
the additional benefits to society.
P
Q QFM 139
Market for Flu Shots What will the MB/D look like when EXTERNAL
benefits are factor in?
140
Market for Flu Shots If the market produces QFM why is it a market
failure?
Too little is being produced
P
externality?
externality (Per Unit Subsidy)
Monopolies
143
Monopoly Monopoly Review 1. Draw a monopoly making a profit. Label
price, output, and profit.
monopolies are bad.
4. Label the Socially Optimal price and
output.
idea.
144
D
MR
$9
8
7
6
5
4
3
2
MC ATC
145 1 2 3 4 5 6 7 8 9 10 Q
P
100
80
60
55
40
30
20
15
5
0
100
80
60
55
40
30
20
15
5
0
In this unit we will analyze how each
of these are measured.
economic goals:
economic growth?
year to year?
= Year 2 - Year 1
Year 1 X 100
Mordor’s GDP in 2007 was $4000 Mordor’s GDP in 2008 was $5000 What is the % Change in GDP?
Transylvania’s GDP in 2007 was $2,000 Transylvania’s GDP in 2008 was $2,100
What is the % Change in GDP? 152
Calculating GDP
1. Expenditures Approach-Add up all the
spending on final goods and services
produced in a given year.
2. Income Approach-Add up all the income
that resulted from selling all final goods and
services produced in a given year.
Both ways generate the same amount since
every dollar spent is a dollar of income.
153
2. Investments -When businesses put money
back into their own business.
Ex: Machinery or tools
3. Government Spending Ex: Bombs or tanks, NOT social security
4. Net Exports -Exports (X) – Imports (M)
Ex: Value of 3 Ford Focuses minus 2 Hondas
GDP = C + I + G + Xn
Expenditures Approach
154
Real vs. Nominal GDP Nominal GDP is GDP measured in current prices. It
does not account for inflation from year to year.
Real GDP is GDP expressed in constant, or unchanging, dollars.
Real GDP adjusts for inflation.
REAL GDP IS THE BEST MEASURE OF ECONOMIC GROWTH!
155
Does GDP accurately measure standard of living?
Standard of living (or quality of life) can be measured, in part, by how well the economy is doing…
But it needs to be adjusted to reflect the size of the nation’s population.
Real GDP per capita (per person) • Real GDP per capita is real GDP divided by the total
population. It identifies on average how many products each person makes.
Real GDP per capita is the best measure of a nation’s standard of living.
156
CYCLE
157
THE BUSINESS CYCLE The national economy fluctuates resulting in periods of
boom and bust.
A Recession is 6 month period of decline in output, income,
employment, and trade. (If really bad…then depression)
Inflation Unemployment
The Unemployment rate
The percent of people in the labor force who want a job
but are not working.
• Above 16 years old
• Not institutionalized (jails, hospitals)
What is Unemployment?
160
jobs.
transferable skills but they aren’t working.
Examples:
jobs.
a better job.
Seasonal Unemployment
•This is a specific type of frictional unemployment which is due to time of year and the nature of the job.
•These jobs will come back
Examples:
3 Types of Unemployment
#2. Structural Unemployment •Changes in the structure of the labor force
make some skills obsolete.
these jobs will never come back.
•Workers must learn new skills to get a job.
•The permanent loss of these jobs is called
“creative destruction.” (Why?)
automation and machinery replace
production
fire assemblers
#3 Cyclical Unemployment •Unemployment that results from economic downturns (recessions).
•As demand for goods and services falls, demand for labor falls and workers are fired.
Examples:
•Steel workers laid off during recessions.
•Restaurant owners fire waiters after months of poor sales due to recession.
This sucks!
3 Types of Unemployment
Two of the of the three types of unemployment are unavoidable: •Frictional unemployment •Structural unemployment
•Together they make up the natural rate of unemployment (NRU).
We are at full employment if we have only the natural rate of unemployment.
•This is the normal amount of unemployment that we SHOULD have. •The number of jobs seekers equals the number of jobs vacancies.
The Natural Rate an Full Employment
166
unemployment! Economists generally agree that an
unemployment rate of around 4 to 6
percent is normal.
California is at ______% 167
What is wrong with the unemployment rate?
It can misdiagnose the actual unemployment rate because of the following:
Disgruntled job seekers- • Some people are no longer looking for a job
because they have given up.
Part-Time Workers- • Someone who wants more shifts but can’t get
them is still considered employed.
Race/Age Inequalities- • Hispanics – 5.8% for January • African American- 8.9% for January • Teenagers- 15.3% for January
Illegal Labor- • Many people work under the table.
Criticisms of the Unemployment Rate
168
Annual Inflation Rate- 79,600,000,000%
What is Inflation? Inflation is rising general level
of prices
bought in 1982
bought in 1961
•When inflation occurs, each dollar of income will buy fewer goods than before.
Make a T-Chart
Cost-of-Living-Adjustment (COLA) Some works have salaries that mirror inflation.
They negotiated wages that rise with inflation
Consumer Price Index (CPI)
Price of market basket
Consumer Price Index (CPI) The most commonly used measurement inflation for
consumers is the Consumer Price Index Here is how it works: • The base year is given an index of 100 • To compare, each year is given an index # as well
1997 Market Basket: Movie is $6 & Pizza is $14 Total = $20 (Index of Base Year = 100)
2009 Market Basket: Movie is $8 & Pizza is $17 Total = $25 (Index of ) 125
•This means inflation increased 25% b/w ’97 & ‘09 •Items that cost $100 in ’97 cost $125 in ‘09
= Real GDP
Nominal GDP
CPI vs. GDP Deflator The GDP deflator measures the prices of all goods
produced, whereas the CPI measures prices of only
the goods and services bought by consumers. An increase in the price of goods bought by firms or the
government will show up in the GDP deflator but not in the
CPI.
The GDP deflator includes only those goods and services produced
domestically. Imported goods are not a part of GDP and
therefore don’t show up in the GDP deflator.
If the nominal GDP in ’09 was 25 and the real GDP
(compared to a base year) was 20 how much is the
GDP Deflator?
Problems with the CPI 1. Substitution Bias- As prices increase for the fixed
market basket, consumers buy less of these products
and more substitutes that may not be part of the
market basket. (Result: CPI may be higher than
what consumers are really paying)
2. New Products- The CPI market basket may not
include the newest consumer products. (Result: CPI
measures prices but not the increase in choices)
3. Product Quality- The CPI ignores both
improvements and decline in product quality.
(Result: CPI may suggest that prices stay the same
though the economic well being has improved
significantly)
Units of Output
= Price of the same market basket in base year
x 100 CPI Price of market basket in
the particular year
Price Per Unit
CPI/ GDP Deflator
Inflation Rate
$40 40 60 80
Nominal,
GDP
Calculating CPI
Nominal GDP
Calculations 1. In an economy, Real GDP (base year = 1996) is $100
billion and the Nominal GDP is $150 billion.
Calculate the GDP deflator.
2. In an economy, Real GDP (base year = 1996) is $125
billion and the Nominal GDP is $150 billion.
Calculate the GDP deflator.
3. In an economy, Real GDP for year 2002 (base year =
1996) is $200 billion and the GDP deflator 2002 (base
year = 1996) is 120. Calculate the Nominal GDP for
2002.
4. In an economy, Nominal GDP for year 2005 (base
year = 1996) is $60 billion and the GDP deflator 2005
(base year = 1996) is 120. Calculate the Real GDP for
2005.
1. The Government Prints TOO MUCH Money (The Quantity Theory)
3 Causes of Inflation
• There are more “rich” people but the same
amount of products.
Examples:
2. DEMAND-PULL INFLATION “Too many dollars chasing too few goods”
DEMAND PULLS UP PRICES!!!
same. What is the result?
• A Shortage driving prices up
• An overheated economy with excessive
spending but same amount of goods.
3 Causes of Inflation
3. COST-PUSH INFLATION
Higher production costs increase prices A negative supply shock increases the costs of
production and forces producers to increase
prices. Examples:
causes gas prices to go up. Companies that use
gas increase their prices.
3 Causes of Inflation
A Perpetual Process: 1.Workers demand raises 2.Owners increase prices to pay for raises 3. High prices cause workers to demand higher raises 4. Owners increase prices to pay for higher raises 5. High prices cause workers to demand higher raises 6. Owners increase prices to pay for higher raises
The Wage-Price Spiral
foreign countries
Changes in price level cause a move along the curve
= C + I + G + Xn
Shifters of Aggregate Demand
186
the economy
In Long Run, price level increases but GDP doesn’t
LRAS
Long-run
Aggregate
Supply
QY
Full-Employment
We also assume that in the long run the economy
will be producing at full employment. 188
Shifters Aggregate Supply
I. R. A. P.
Shifters of Aggregate Supply
1. Change in Inflationary Expectations If an increase in AD leads people to expect higher
prices in the future. This increases labor and
resource costs and decreases AS.
(If people expect lower prices…)
2. Change in Resource Prices
Prices of Domestic and Imported Resources
(Increase in price of Canadian lumber…)
(Decrease in price of Chinese steel…)
Supply Shocks
(Positive Supply shock…) 190
Shifters of Aggregate Supply 3. Change in Actions of the Government
(NOT Government Spending)
Taxes on Producers
(Lower corporate taxes…)
Government Regulations
4. Change in Productivity
(The advent of a teleportation machine…)
191
Actual GDP above potential
Price
Level
195
AD
Actual GDP below potential
Debates Over Aggregate Supply
Classical Theory 1. A change in AD will not change output even in the short run
because prices of resources (wages) are very flexible.
2. AS is vertical so AD can’t increase without causing inflation.
Price
level
in AD are temporary.
economy will fix itself.
Debates Over Aggregate Supply
Keynesian Theory 1. A decrease in AD will lead to a persistent recession because
prices of resources (wages) are NOT flexible.
2. Increase in AD during a recession puts no pressure on prices
Price
level
Debates Over Aggregate Supply
Keynesian Theory 1. A decrease in AD will lead to a persistent recession because
prices of resources (wages) are NOT flexible.
2. Increase in AD during a recession puts no pressure on prices
Price
level
Debates Over Aggregate Supply
Keynesian Theory 1. A decrease in AD will lead to a persistent recession because
prices of resources (wages) are NOT flexible.
2. Increase in AD during a recession puts no pressure on prices
Price
level
lead to higher prices
employment
AD3
1. Keynesian Range- Horizontal at low output
2. Intermediate Range- Upward sloping
3. Classical Range- Vertical at Physical Capacity
Price
level
unemployment. What happens to inflation and unemployment when AD
increase?
Inflation
203
SRPC
1%
5%
When the economy is overheating, there is low unemployment but high inflation
When there is a recession, unemployment is high but
inflation is low
1%
5%
What happens when AS falls causing stagflation? Increase in unemployment and inflation
SRPC1
Inflation
205
SRPC
Unemployment 2% 9%
SRPC1
3%
5%
increase. AS falls. SRPC shifts right.
What happens in the long run?
Inflation
206
Unemployment 2% 9%
Long Run Phillips Curve
In the long run there is no tradeoff between inflation and unemployment
The LRPC is vertical at the Natural Rate of Unemployment
Inflation
207
SRPC
Unemployment 2% 9%
SRPC1
3%
5%
Long Run
Phillips Curve
In the long run wages fall and there is no tradeoff between
inflation and unemployment
AD/AS and the Phillips Curve
Price
Level
209
AD
AS
GDPR QY
AD1
Price
Level
210
AD
AS
GDPR QY
SRPC
Unemployment
UY
LRPC
Correctly draw the LRPC and SRPC with the recessionary gap. What happens when AD falls?
AD1
Price
Level
211
AD
AS
GDPR QY
SRPC
Unemployment
UY
LRPC
Correctly draw the LRPC and SRPC at full employment. What happens when AS falls?
AS1
SRPC1
Price
Level
212
AD
AS
GDPR QY
SRPC
Unemployment
UY
LRPC
Correctly draw the LRPC and SRPC with an recessionary gap. What happens when AS goes up?
AS1
SRPC1
Two Types of Fiscal Policy
Discretionary Fiscal Policy- • Congress creates a new bill that is designed to change AD through government spending or taxation. •Problem is time lags due to bureaucracy. •Takes time for Congress to act. •Ex: In a recession, Congress increase spending.
Non-Discretionary Fiscal Policy •AKA: Automatic Stabilizers •Permanent spending or taxation laws enacted to work counter cyclically to stabilize the economy •Ex: Welfare, Unemployment, Min. Wage, etc. •When there is high unemployment, unemployment benefits to citizens increase consumer spending.
214
(Close a Inflationary Gap)
Contractionary Fiscal Policy (The BRAKE)
Laws that reduce unemployment and increase GDP (Close a Recessionary Gap)
• Increase Government Spending • Decrease Taxes on consumers • Combinations of the Two
Expansionary Fiscal Policy (The GAS)
How much should the Government Spend? 215
Marginal Propensity to Consume Marginal Propensity to Consume (MPC)
•How much people consume rather than save
when there is an change in income.
•It is always expressed as a fraction (decimal).
MPC= Change in Consumption
Change in Income Examples:
3. If you received $100 and spent $100. 216
Marginal Propensity to Save
MPS= Change in Saving
Change in Income
Marginal Propensity to Save (MPS) •How much people save rather than consume
when there is an change in income.
•It is also always expressed as a fraction (decimal)
Examples:
1. If you received $100 and save $50.
2. If you received $100 your MPC is .7 what is
your MPS? 217
Why is this true? Because people can either save or consume
218
in Spending
Assume the MPC is .5 for everyone •Assume the Super Bowl comes to town and there is an
increase of $100 in Ashley’s restaurant.
•Ashley now has $100 more income.
•She saves $50 and spends $50 at Carl’s Salon
•Car now has $50 more income
•He saves $25 and spends $25 at Dan’s fruit stand
•Dan now has $25 more income.
This continues until every penny is spent or saved
219
If the MPC is .5 how much is the multiplier?
Change in
in spending
•If the multiplier is 4, how much will an initial
increase of $5 in Government spending increase
the GDP?
decrease GDP?
The Multiplier Effect Let’s practice calculating the spending multiplier
Simple
$2M. How much will GDP increase?
4. If MPC is 0 and investment increases $2M.
How much will GDP increase?
Conclusion: As the Marginal Propensity to
Consumer falls, the Multiplier Effect is less 221
P ri
ce l
2. Contractionary or
to fix the gap?
4. How much initial
AD2 AD1 $100 Billion
manipulate the following economy (MPC = .8)
P1
2. Contractionary or
to fix the gap?
close gap?
manipulate the following economy (MPC = .5)
-$10 Billion
223
What about taxing? •The multiplier effect also applies when the government
cuts or increases taxes.
•But, changing taxes has less of an impact of changing
GDP. Why?
Expansionary Policy (Cutting Taxes) •Assume the MPC is .75 so the multiplier is 4
•If the government cuts taxes by $4 million how much
will consumer spending increase?
•When they get the tax cut, consumers will save $1
million and spend $3 million.
•The $3 million is the amount magnified in the
economy.
•$3 x 4 = $12 Million increase in consumer spending .224
Unit 4: Money and Monetary Policy
225
226
10
7.5
5
2.5
0
Dmoney
money falls
hold it due to higher opportunity cost.
227
directly related? •When Price Level increases, people need more money.
•The demand for money increases. So…
•i increases
R a
te o
f in
te re
s t,
10
7.5
5
2.5
0
Dmoney
D1
228
10
7.5
5
2.5
government office that sets
and adjusting the money
This is called Monetary
Policy.
In the U.S. the Money Supply is set by the Board of
Governors of the Federal Reserve System (FED)
229
10
7.5
5
2.5
0
Dm
ie
supply, a temporary
at 5% interest.
interest rate).
10
7.5
5
2.5
0
Dm
supply, a temporary surplus of
money will occur at 5%
interest.
interest rate).
Showing the Effects of Monetary Policy Graphically
232
233
Investment Demand S&D of Money
The FED increases the money supply to stimulate the economy…
234
200
DM
SM
10%
5%
2%
QuantityM
Interest
THE FED Monetary Policy
money supply by …
2. Lending Money to Banks & Thrifts
•Discount Rate
236
237
The Reserve Requirement The Reserve Requirement or “reserve ratio” is the percent
of deposits that banks must hold in reserve
(The percent they can NOT loan out).
Example: Reserve ratio = .10 or 10%
• You deposit $1000 in the bank
• The bank must hold $100. It lends $900 out to Bob.
• Bob deposits the $900 in his bank.
• Bob’s bank must hold $90. It loans out $810 to Jill.
• Jill deposits $810 in her bank.
SO FAR, an increase of $1000 has cause the CREATION of
another $1710 (Bob’s $900 + Jill’s $810)
This demonstrates the MONEY
FED charges commercial banks.
•If Banks of America needs $10 million, they borrow it
from the U.S. Treasury (which the FED controls) but
they must pay it bank with 3% interest.
To increase the Money supply, the FED should
_________ the Discount Rate (Easy Money Policy).
To decrease the Money supply, the FED should
_________ the Discount Rate (Tight Money Policy).
DECRAESE
INCREASE
239
Open market Operations • Open Market Operations is when the FED buys
or sells government bonds (securities).
• This is the most widely used monetary policy and
the most often tested.
_________ government securities.
_________ government securities.
FED You
When the government sells bonds, you give
them money. This decreases the money supply.
BUY
SELL
240
• You lend out $100 with 20% interest.
• Prices are expected to increased 15%
• In a year you get paid back $120.
• What is the nominal and what is the real interest rate?
• The Nominal interest rate is 20%
• The Real interest rate was only 5%
• In reality, you get paid back an amount with less
purchasing power.
that the borrower pays including inflation.
Nominal = real interest rate + expected inflation
Real Interest Rates-The percentage increase in purchasing
power that a borrower pays. (adjusted for inflation)
Real = nominal interest rate - expected inflation 242
Loanable Funds
Loanable Funds Market • The private sector supply and demand of
loanable money.
RATE
interest rate and quantity loans demanded
• Supply- Direct relationship between real
interest rate and quantity loans supplied
• What is the result of deficit spending? • Government borrows from private sector
• Increasing demand for loanable funds
• Increases the REAL interest rate. SO…
This IS the Crowding Out Effect!! 244
The Phillips Curve Shows relationship between inflation and
unemployment. What happens to inflation and unemployment
when AD increase?
THE SHORT RUN PHILLIPS CURVE Inverse relationship between inflation and
unemployment.
PC
246
THE SHORT RUN PHILLIPS CURVE
Showing Stagflation
0 1 2 3 4 5 6 7
THE LONG RUN PHILLIPS CURVE NO tradeoff between inflation and unemployment
PC
248
THE LONG RUN PHILLIPS CURVE
An increase in prices
increase and
250
you have to go without?
Everything you don’t produce yourself!
(Clothes, car, cell phone, bananas, heath care, etc)
The Point: Everyone specializes in the production
of goods and services and trades it to others
2. What would life be like if cities couldn’t trade
with cities or states couldn’t trade with states?
Limiting trade would reduce people’s choices and
makes the worse off.
Absolute and Comparative
Per Unit Opportunity Cost Review
Assume it costs you $50 to produce 5 t-shirts. What is
your PER UNIT cost for each shirt?
$10 per shirt
each shirt in terms of hats given up?
1 shirt costs 2 hats
2. What is your PER UNIT OPPORTUNITY COST for
each hat in terms of shirts given up?
1 hat costs a half of a shirt 253
= Opportunity Cost
Units Gained
Per Unit Opportunity Cost
Per Unit Opportunity Cost Review Ronald McDonald can produce 20 pizzas or 200 burgers
Papa John can produce 100 pizzas or 200 burgers
1. What is Ronald’s opportunity cost for one pizza in
terms of burgers given up?
2. What is Ronald’s opportunity cost for one burger in
terms of pizza given up?
3. What is Papa John’s opportunity cost for one pizza in
terms of burgers given up?
4. What is Papa John’s opportunity cost for one burger
in terms of pizza given up?
254
Ronald has a COMPARATIVE ADVANTGE in the production of burgers
Papa John has a COMPARATIVE ADVANTAGE in the production of pizza
1 pizza cost 10 burgers
1 burger costs 1/10 pizza
1 pizza costs 2 burgers
1 burger costs 1/2 pizza
Absolute and Comparative Advantage Absolute Advantage
•The producer that can produce the most output OR
requires the least amount of inputs (resources)
•Ex: Papa John has an absolute advantage in pizzas
because he can produce 100 and Ronald can only
make 20.
Comparative Advantage
•Ex: Ronald has a comparative advantage in burgers
because he has a lowest PER UNIT opportunity cost.
255
Countries should trade if they have a relatively lower opportunity cost.
They should specialize in the good that is “cheaper” for them to produce.
Benefits of Specialize
45
40
35
30
25
20
15
10
5
0
30
25
20
15
10
5
0 5 10 15 20 25 30 5 10 15 20
Wheat (tons) Wheat (tons)
TRADE SHIFTS THE PPC! S
u g
a r
(t o
n s )
S u
45
40
35
30
25
20
15
10
5
0
30
25
20
15
10
5
0 5 10 15 20 25 30 5 10 15 20
AFTER TRADE
AFTER TRADE
45
40
35
30
25
20
15
30
25
20
15
10
5 10 15 20 25 30 5 10 15 20 Wheat (tons) Wheat (tons)
USA
Brazil
Which country has a comparative advantage in wheat?
1. Which country should EXPORT Sugar?
2. Which country should EXPORT Wheat?
3. Which country should IMPORT Wheat?
259
(1P costs 1R) (1R costs 1P)
Kenya wants Radios If the terms of trade for 1 radio is greater than 3 pineapples then Kenya is worse off and should make radios on their own. India wants Pineapples If the terms of trade for 1 radio is less than 1 pineapple then India is worse off and should make pineapples on their own.
What terms of trade benefit both countries?
Trading 1 radio for 2 pineapples will benefit both If Kenya produces radios by themselves, they give up 3 Pineapples for each radio. If they can trade 2 pineapples for each radio they are better off. If India produces pineapples by themselves, they give up 1 pineapple for one radio. If they can get 2 pineapples for one radio they are better off. The countries trade at a lower opportunity cost than
if they made the products themselves!
Kenya
India
(1P costs 1R) (1R costs 1P)
International Trade and
GDP.
since 1975.
Closed vs. Open Economies A closed economy focuses only on the
domestic price and the open economy
trades for the lower world price.
266
Balance of Trade vs. Balance of Payments
Balance of Trade Net Exports (XN) = Exports – Imports Trade Surplus = Exporting more than is imported Trade Deficit (aka. trade gap) = Exporting less than is imported
Balance of Payments (BOP) Balance of trade includes only goods and service but balance of payments considers ALL international transactions. •The balance of payments is a broader measure of international trade.
Details: The BOP summary is within a given year Prepared in the domestic country’s currency
Ex. If accounting the BOP of the U.S. it would be in the Dollar.
The balance of payments is made up of two accounts. The current account and the capital account.
Current Account The Current Account is made up of three parts: 1. Trades in Goods and Services (Net Exports)-
Difference between a nation’s exports of goods and services and its imports of goods and services
Ex: Toys imported from China, US cars exported to Mexico
2. Investment Income- income from the factors of productions including payments made to foreign investors.
Ex: Money earned by Japanese car producers in the US 3. Net Transfers- Money flows from the private or
public sectors Ex: donations, aids and grants, official assistance
Capital (Financial) Account The Capital Account measures the purchase and sale
of financial assets abroad. Purchases of things that stay in the foreign country. Examples:
– US company buys a hotel in Russia – A Korean company sells a factory in Ohio – Dividends earned by Chinese citizens in the New York
Stock Exchange (NYSE) – Australian company owns local Mall
Current or Capital Account? Identify if the examples are counted in the current or capital
account and determine if it is a credit or debit for the US.
1. Bill, an American, invests $20 million in a ski resort in Canada
2. A Korean company sells vests to the US Military 3. A US company, Boeing, sells twenty 747s to France 4. A Chinese company buys a shopping mall in San Diego 5. An illegal immigrant sends a portion of his earning to his
family 6. An German investor buys $50,000 US Treasury Bonds 7. Italian tourists spend 5 million in the US while American
tourists spend 8 million in Italy.
Current or Capital Account? Identify if the examples are counted in the current or capital
account and determine if it is a credit or debit for the US.
1. Capital Account (financial asset), Debit 2. Current Account (trade of goods/services), Debit 3. Current Account (trade of goods/services), Credit 4. Capital Account (financial asset), Credit 5. Current Account (net transfer), Debit 6. Capital Account (financial asset), Credit 7. Current Account (net transfer), Debit
Practice 1. U.S. income increases relative to other countries. Does
the balance of payments move toward a deficit or a surplus? - Imports are cheaper - Americans import more - Net exports (Xn) decrease - The current account balance decreases and moves
toward a deficit. 2. If the U.S. dollar depreciates relative to other countries
does the balance of payments move toward a deficit or a surplus? - US exports are desirable - America exports more - Net exports (Xn) increase - The current account balance decreases and moves
toward a surplus.
Exchange Rate = Relative Price of Currencies
Exchange Rates In the FOREX market we only look at two
countries/currencies at a time Ex: US Dollars and British Pounds
We examine the price of one currency in terms of the other currency. Ex:$2 = £1 The Exchange Rate depends on which currency you are converting.
The price of one US Dollar in terms of Pounds is
1 Dollar = £1/$2 = £.5 The price of one Pound in terms of Dollars is
1 Pound = $2/£1 = $2
What happens if you need more dollar to buy one pound (the price for a pound
increases)? Ex: From $2=£1 to $5=£1
•The U.S. Dollar DEPRECIATES relative to the Pound.
Depreciation •The loss of value of a country's currency with respect to a foreign currency •More units of dollars are needed to buy a single unit of the other currency. •The dollar is said to be “Weaker”
What happens if you need less dollar to buy one pound (the price for a pound
decreases)? Ex: From $2=£1 to $1=£4
•The U.S. Dollar APPRECIATES relative to the Pound.
Appreciation •The increase of value of a country's currency with respect to a foreign currency •Less units of dollars are needed to buy a single unit of the other currency. •The dollar is said to be “Stronger”
S&D for the US Dollars Price of US
Dollars
Q
Pound£ Dollar$
Imagine a huge table with all the different
currencies from every country
Just like at a product market, you can’t take
things without paying.
If you demand one currency, you must supply
your currency. Ex: If Canadians what Russian Rubles. The demand for Rubles in the FOREX market will increase and the supply of Canadian Dollars will increase.
FOREX Shifters Let’s use the example of the US Dollar
and the British Pound
1. Changes in Tastes- Ex: British tourists flock to the U.S…
Demand for U.S. dollars increases (shifts right)
Supply of British pounds increases (shifts right)
Pound-depreciates
Dollar-appreciates
in more imports)- Ex: US growth increase US incomes….
U.S. buys more imports…
Pound- appreciates
Dollar- depreciates
3. Changes in Relative Price Level (Resulting in more imports)-
Ex: US prices increase relative to Britain…. U.S. demand for cheaper imports increases… U.S. demand for pounds increases Supply of U.S. dollars increases
Pound- appreciates Dollar- depreciates
4. Changes in relative Interest Rates-
Ex: US has a higher interest rate than Britain. British people want to invest in US Capital Flow increase towards the US British demand for U.S. dollars increases… British supply more pounds Pound-depreciates
Dollar- appreciates
Practice For each of the following examples, identify what will
happen to the value of US Dollars and Japanese Yen.
1. American tourists increase visits to Japan. 2. The US government significantly decreases
personal income tax. 3. Inflation in the Japan rises significantly faster
than in the US. 4. Japan has a large budget deficit that increases
Japanese interest rates. 5. Japan places high tariffs on all US imports. 6. The US suffers a larger recession. 7. The US Federal Reserve sells bonds at high
interest rates.
Practice For each of the following examples, identify what will
happen to the value of US Dollars and Japanese Yen.
1. USD depreciates and Yen appreciates 2. USD depreciates and Yen appreciates 3. USD appreciates and Yen depreciates 4. USD depreciates and Yen appreciates 5. USD depreciates (Demand Falls) and Yen
appreciates (Supply Falls) 6. USD appreciates (Supply Falls) and Yen
depreciates (Demand Falls) 7. USD appreciates and Yen depreciates