Econ 2
comparative advantage & absolute having more of smt means having less of
advantage something else
Shifters of PPF scarcity principle someone or something faces constraint
diagram that shows combination of two outside of ppc shows scarcity--unattainable
types of goods that can be produced in an
economy using all available inputs take an action if and only if its benefit
cost benefit principle
chapter 1: scarcity and choice outweighs cost
ex: PPC of US economy divides production
slope is (minus) OC of goods on x axis
into consumption vs investment goods the value of what must be forgone to
undertake an activity
g/s. that satisfy some current want for
consumption goods
people reflects tradeoff in production process
each choice has cost--opportunity cost
g/s that makes us more productive in the OC of good brought in market is usually its
future price
ex: machines, infrastructure education, r&d investment goods includes out of pocket costs+forgone value
adding this shifts PPC production possibility frontier/curve (PPF,
PPC) slope up marginal cost rises as production rise
when it is impossible to produce more of
supply
something w/o decreasing production of productive efficiency
chapter 2 producers are price takers
smt else
time when unemployment is above
normal and economy is not producing at
full potential
recession
bc demand is marginal utility, which falls
not producing at full capacity displayed as a point in the PPC
demand slopes down
"willingness to pay", this dec as you get
more
discrete, only two people.
buyers are price takers
For whole population, it becomes bowed
out and continuous innovation that inc productivity
chapter 3
outward price of inputs needed going down
This explains why the PPC for a country is more producer enter industry
likely to be “bowed out” or concave shifters of supply
regulation dec productivity
role of comparative advantage in trade
inward price of inputs for prod. go up
S/D reveal welfare producers exit ind
difference between what consumer willing new complementary good released
to pay for a good and actually pay(market
price) price of substitute goes up
Consumer surplus
outward
are under demand curve, above price ppl richer
area under market price, above supply product more fashionable
curve shifters of demand
producer surplus price of compl. go up
difference between what producers
recieve for a good and min. price willing to inward price of sub. go down
accept (their cost)
product go out of fashion
total benefut society gets from market
economic surplus
transaction
Markets do not produce equitable
allocations rise in household income, shifts budget
constraint line out
Conditions for allocative efficiency
- good is produced where MB=MC in perfect market -> efficient allocation, CS
+ PS is maximized (allocative efficiency)
-Good allocated to consumers w/ highest
MB, producers w/ lowest MC
households face budget constraint
total amount household spends cannot
exceed its income. assume: spending =
income
does not realize all gains from trade Area of lost surplus relative to market
if price of one good inc, household will re-
equilibrium when quantity differs from
optimize. Red. spending on that good, inc.
efficient quantity
spending on other goods
Rational Spending Rule
households is maximizing utility if: MU
Chapter 5/6 from spending one more dollar on a good
is same for all good
dividing MU by price= MU per dollar spent
Deadweight Loss on good
Chapter 5: Households
costs more to producers than it creates households optimize choices so that each
benefit to consumers diff. goods have diff. marginal utility, and
marginal utility gained from last dollar
their marginal utility have diff. slopes
spent is same across goods
too little or too much production relative
implications
to efficiency creates deadweight loss
deadweight loss triangle points towards
efficient allocation. Grows outward to
current Q
Relationship between total/marginal utility
competitive equilibrium where supply
equals demand, maximize total economc
surplus (Efficiency) The competitive equilibrium maximizes
first theorum of welfare economics
economic surplus
competitive markets are efficient
willingness to pay depends on income
measure of welfare doesn't take into
account how consumers enter market Equity Issues
w/diff income
1st welfare theorum is blind to
distributional aspects
Utility from total consumption of all goods
tradeoff between equity and efficiency
must sacrifice some economic surplus to
get more equitable outcome equity VS efficiency trade off
reminder: maximized economic surplus =
allocative efficiency
max price, belowequilibrium
lead to shortage Price ceiling
Subtopic 3 price controls
min price, above equilibrium Price floor
this is assumption.
Reality: also care about workers,
community, customers
economic profit: total revenue-total cost
total cost= Opp. cost of All inputs Firms (objective) maximize profits
profits sign depends on whether p-atc is
profits= p x q - (atc x q) = P=(P-atc)xq
pos, neg, or zero
%change in qD / %change in price
Set MR=MC Condition
Firms do not have market power + free
entry/exist. -> Profits are competed down
to zero
each firm knows that it has no impact on
market price
occur in industry w/ many firm, each is
relatively small
and slope of demand curve: change in
When demand is flat, MR is also flat price over change in quantity
-MR is same at every quantity (equal to P) price elasticity of demand
relationship between slope of demand
and elasticity
0 is perfectly inelastic, inifinity is perfectly
elastic
Demand curves in a perfectly competition price might change
graph for a perfectly competitive firm market
aka revenue total expenditure depends on how
maximize profit conditions: quantity responds: elasticity
MC=MR
P=MC inelastic when there is resource constraint -
- usually short run
Price elasticity of supply
Supply is elastic when there are no hard
resource constriats -- usually long run
elasticity is inverseley prop to slope. E=
Revenue, cost, profits on graph 1/slope x p/q
Perfect competiton
-0 profits for all firms (p=atc)
-p=mc=atc
-supply curve perfectly elastic
chapter 6: Firms and Profit Effects of tax
when all firms are identitcal
Maximimization
both supplier and demanders feel effects
Chapter 4: Elasticity
Long Run Industry SUPPLY CURVE
-firms produce p=mc
-least productive firm makes 0 profits
when firms differ in productivity
-other firms make pos. profits
-supply curve upward sloping
market supply curve= mc curve for whole
industry & also = horizontal sum of ind.
firm's supply curve/MC curve ⬇️
If firms are making positive profits, entry of welfare analysis of tax
new firmsd rives price down and so drives
profits down
• If firms are making negative profit, exit of summary
firms drives price up and so drives profit up
• In the long-run, profit is zero for the
marginal firm: p = atc = mc
Short run choice of output: How much to
produce w/ existing set up
- tax extracts Consumer/producer surplus
Long run choice of output: Expand, -no misallocation, still allocated acc. to
contract? Exit/Enter industry? Decisions of firm willingness to pay
-Dwl is larger when demand/supply is
Both short/Long run--choice of input mix: elastic
What combo of inputs (labor, capital, raw
materials etc...) to use to produce output
cost that don't vary w. quantity produced Fixed
cost that vary w. quantity produced Variable
sum of fixed & variable Welfare analysis of Subsidy
Total cost
ATC x quantity
Change in total cost from producing add. subsidy distorts production above
unit competitive equilibrium-> resulting level of
Marginal cost production and consumption is MB<MC
FC don't change w/ add. unit. MC = change
in VC from producing add. unit
total cost/ quantity
Types of cost
Average total cost
As a firm scales all inputs up, average cost
economies of scale
per unit falls.
Beyond some size, average cost per unit
diseconomies of scale
rise
but we assume upward mc for perfectly
competitive model
only one producer of a differentiated good
Monopoly
choose quantity to maximize profits, takes
into acc. how demand slopes down
when one producer can supply whole
market at lower avg cost
Natural monopoly
MC very low, efficient for firm, allow it to
price low
high fC
patents & legal protections Barriers to entry
licensing/forms of gatekeeping
Profit max, set quantity supplied where
MR=MC
set price off demand curve, and quantity add. cost/benefits triggered by market
supplied where mc=mr activities that aren't paid or enjoyed by
market participants that effect third parties
Raise SMC above PMC
negative externalities
ppl in market choose to produce where
MR curve of monpolist PMC=PMB but society is better off if
market produce/consume less at SMC=SMB
raise social marginal benefit above PMB
Mr is twice as steep as demand positive externalities
ppl in market choose to produce where
monopolist doesn't take price as given, PMC=PMB, but society would be better off
constrainted by demand curve but can if produce/consume more at SMC=SMB
choose any point along it
add. cost to third parties when one more
external marginal cost
for demand curve, only one quantity unit is produced/consumed
monpolist willing to supply
special aspects of monpoly add. benefit to third parties when one
doesnt really have a supply curve terms external marginal benefit
A monopolist sets quantity, not price, by more unit is produced/consumed
the rule MR=MC. Then it reads price off the
demand curve at that quantity. PMC + EMC
social marginal cost/benefit
PMB+EMB
Does not produce where MC=P aka MC=MB
private markets overproduce neg.
sum of CS & PS where total surplus is large externalities and underproduce positive
externalities.
negotiation & compensation
Allocative Efficiency
private solutions social sanction
educaton
gov regulation fines
chapter 8: monopoly and
emitters can trade their emission
reminder, CS/PS part above/below price
market power emission permits and trading~cap & trade
allowance
Remedies for externalities
Chapter 11: Externalities and
climate change
tax for neg externality, vice versa for subsidy
corrective tax, subsidy
idea to internalize externality by
incorporating it in the price
MC = Atc at minimum
recall profit = (p-atc)xq
set tax equal to EMC
Long Run Profit Maximization
neg. econ. profits
dwl points towards socially opt
DWL, points towards socially optimum
Profits 0
monpolist want to leave industry Neg. profits
less livable--droughts, heatwaves
Opp cost will be covered Zero profits
How Monpoly respond to Profits
agricultural production disruptions, risk for
Monpolist can make pos. econ. profits in Costs of global warming
food security--famines
long run by definition-- must have barriers
to entry if monpoly exist impact on biodiversity--mass extinction
patent protection--pharmaceutical dev Patents
choice of qs affect price
profit max results in: When firm have market power
-quantity too low
-price extracted too high
-dwl
arise due to either large fixed costs,
barriers to entry, or patent protection
market power
solutions: usually involve gov actions
market outcomes don't mazimize total
surplus
market fazilure
gov intervention make things better
rising demand for firms product raise labor
demand, falling demand reduces it
firms are demanders of labor: choose how
technology/capital makes some workers
much to employ based on profit
more productive, shifts labor demand out
maximization
technology and machines could replace
workers
Opportunity inequality
Wealth inequality
shift MRP for high skilled workers bc MP
price of labor=wage inc
profits maximized where MR=MC
extra revenue generated by one more
worker
mrp= mp x mr skill biased tech. doesn't affect wage of
low skill worker-> inc inequality
mp: extra output produced by one more
worker Marginal revenue product (MRP) When MP increase faster than price of When workers MP cannot compensate for
services fallen, lifting MRP. (Graph: falling prices. MRP and labor demand falls
mr: extra revenue from selling one more computer & service)
skill biased technological change
unit
mr=p, so mrp= mp x p
special case: perfect comp
mp x p is the value of the marginal
product of labour
bc mrp= mr x mp
tech. change tend to benefit high skilled
mp declines bc of diminishing returns workers
mr is either constant (comp. firm) or skill based tech. change increase inequality
declining mrp declines as L (employement inc) -> inc in education decrease inequality
US has comparative advantage in goods
that use high skilled labor, vice versa
Labor and wages rising labor income inequality
Tend to specialize/export in high skilled
labor goods, and import low skilled labor
goods
globalization Increased Trade
Inequality
firms hire labor to where mrp=W (wage)
Profit maximization
changes in relative wages of low/high skill
workers parallel trends in rising income
ineq.
in labor market, Demand is MRP
Income inequality
households like leisure, mu of leisure demand =mrp (mp x mr)
P(leisure) is wage
declines as q inc Household are supplier of labour: choose
how much to supply based on utility
maximization
condition for utility maximization
poverty & income ineq. correlated
labor income inequality start rising in early
1970s
substitution effect: when wage inc,
consumer sub. away from leisure
share of income going to very top of
effect of inc in wage
income dis. risen quickly
income effect: when wage rise, consumer
is richer and wants more leisure (work less)
current trend of rising ineq. due to inc
inequality of labor income
ambiguity between which dominates;
assume substituion effect dom. so labor Education won't change inequality quickly, long term
supply slope up
-program help workers who lose jobs bc
of trade
Trade adjustment assistance:
-Job training, help, unemployment
benefits, wage subsidy
Targeted policies to groups hurt by skill
biased tech change and globalization tax benefit, subsidies, incentives for
inc unemployement; firm cut employers for employing troubled locality
effect of negotiated wage Remedies Place based policies
employement to L d1 ; supply> demand
Funds, training program
Minimum wage
acts like price floor
Policies that raise incomes at bottom of earned income tax credit, wage subsidy
income distribtuion
capital: physical stuff that helps produce Labor & capital are two main physical
other things; durable factor inputs to production
market interest rate as 'price' of capital
direct cash payments--universal basic
income
quantity of capital firm wants to rent
depends on profit max.
mrp declines as more machines are rented world relative price & terms of trade is the
relative price of a country's export
Demand for capital goods slope down;
demand: mrp= mr x mp
factor= inputs to production
country tend to have comparative
advantage in goods that use inputs that
Factor Abundance are in abundance
ex: -minerals & early US industrialization
-climate/soil w/ coffee production
rental equipment demand--MRP -capital & skilled labor to determine what
US has comp. advantage today
Investment is the flow of new capital into New capital--investment spending-- is part -Many developing country have
the capital stock of national income--> national spending abundance of less skilled labor & CA in low
tech manufac. good
ppl prefer things today to things tmr
time preference some ca isn't inherent but acquired
this is why banks pay interest
Dynamic comparative advantage
by doing smt or getting early start, country
what a payment to be recieved in the may become the low opp. cost producer of
future is worth to you today a good
aka present discounted value terms at which the goods trade in the
world market
ex: US export soybeans, so its TOT are
washing machines per ton of soybeans
it is the relative price of its exports
Terms of trade & World relative price
bc TOT depends on world prices, we also
call it world relative price
PV single payment
Capital and Interest
Present value
using soybean ex: TOT must be between 1
and 2 washing machines per ton of
soybean
Terms of trade must be between the
opportunity cost of producing the good in
the two countries
PV stream of payment
Trade
suppose price of soybean= 200, Price of
profit maximizing where PV(stream of
WM=300
mrp)=price of machine
International trade then, 1 ton Soybean trade for 2/3 WM
market force move world prices
capital worth
China OC: 1 s = 2 WM
US OC: 1s = 1 WM
Investment
shows combination of the two goods that
a country can have w/ trade
The line w/ slope being (-)TOT, tangent to
relationship between interest rate and
PPC
present value and quantity bought
physical: man made aids to production Subtopic 7
process: machines, buildings, trucks,
computers
To raise financial capital
Physical & Financial capital
with a linear PPC, the line with slope equal
Issue bonds: borrow funds in return for a
to (-) TOT touches the PPC at one of the
promise to repay later with interest
Financial: Funds used to purchase, rent, or extreme-> complete specialization
build physical capital
stock price= PV(stream of expected future
dividens) you expect to gain from it the gains from trade are captured by the
Issue stocks: sell people a share of the
Consumption Possibilities Curve fact that the CPC lies outside the PPC
change in interest rate company. In return, they are entitled to a
-dec. in IR inc. stock price, all else equal share of future profits (dividends)
limitations: in real life, countries rarley
Movers of stock price specialize completely
Change in expected future dividends
-if expect lower future dividends-> lower
stock price
bowed ppc with linear trading constraint,
a CPC, shows exports & imports
Openness to trade changes prices and
consumption, shifting MRP of labor
-has to be feasible point on or inside PPC
if green line don't touch: total value is too
Optimal Specialization w curved PPC
high for this country to afford with its
gains from trade current resources/technology. PPC need to
shift out to consume @ that level
country can trade diff. combo of goods at
point of tangency along CPC
line w/ slope (-) TOT of trade, tangent to Total value doesn't change
PPC
CPC w/ trade Trade allows country to CONSUME more,
Shows combo of two goods that country not more total value. --It means you get a
can consume if it produce at point of better combo/mix using the same total
tangency and trade at world prices value
S/D for exports
Supply is upward sloping, reflect rising OC GDP measures total income in a country in
gdp per person is average income
-world price is world relative price a year
assume world demand/world supply at
world relative price are perfectly elastic. Total income= total spending = total
total spending, gdp is Y= C + I +G + EX - IM
-here, US is price taker production of new g/s
Price level (P) is different for diff.
consumers, so it means the expenditure
S/D w/ trade weighted avg. price for the avg. consumer
Consumers purchase a basket of g/s in a prices of g/s change, consumers also
S/D for imports
period. change basket
Inflation
W/ rising OC, get incomplete specialization
measured in terms of dollars
intersection between world price line and Nominal GDP
supply correspond to point of tangency in market value of final g/s newly produced,
PPC/CPC diagram within the country, in some period of
time not adjusted for price changes
measured in terms of g/s rather than
market value of final g/s newly produced dollars
within the country, in some period of
time, adjusted for price changes. remove effects of changing price
the domestic price gets pulled
up toward the world price when 1. choose base year
trade open Trade policy 2. Use prices from base year to multiply
Real GDP
quantities
calculation
Macroeconomic measurement
Price & Employment effects of trade
percentage change in real gdp from one
year to the next
Growth rate
trade rearranges jobs, rather than raise or
lower employment overall
employment expands in export industries
and contracts in import industries employment effects use market price & quantities of final goods
expenditure
Rearrangement is painful for those who divided into consumption (C), investment
lose jobs, or those that don't have skills to (I), gov. purchases (G), net exports (ex-im)
move to industries where jobs are available
3 approaches to measuring GDP production(value added) follow goods thru each stage of production
no barriers to international trade Free trade
income from producing new g/s within the
country put limits on trade country
Income
divided into labor income & capital
income
growth in avg/overall level of prices
calculation: 1. choose base year
2. Use quantities for each good at base years to
multiply prices (quantity are weights)
Consumer price index (CPI)
raise employment in protected industry, tarrif: tax on import
not total employment Protection now ( using old quantity) over old
Inflation
trade retaliation may reduce foreign
demand for g/s
Inflation is the percent change in price
Currency might appreciate, tarrifed index
countries may depreciate.
Quota: limit on quantity of imports
Subsidies for domestic production
Adjusting variables for price changes
example:
countries policies towards trade Trade policy
trade policy
Shippng cost
improved logistics make trade easier Determinants of trade
better communication makes trade in
services possivle
real activity responds to the real interest
rate r -> also equals nominal interest rate
minus rate of inflation ( i - pi )
stated IR, measured in terms of dollars w.
no adjustment to prices
Nominal interest rate
nominal IR is i = r + pi denoted by i
and thus, r = i - pi
- i is expected rate of inflation, not actual IR measured in terms of purchasing
power, adjusted to price
Real interest rate
denoted by r
real interest rate is price of spending
today, the opp cost of what you forgo tmr
by spending today
real IR can be negative-> price spending
low to get ppl to inc spending
Keynesian Cross shows how
macroeconomic spending shocks
reverberate thru econom
Investment price = r
Savings are supply of funds for investment
PO determine by normal capital, labor,
technology in long run, output (gdp) = potential (LR)
output Y
can be thought of as 'supply'
determined primarily by demand: what
consumer, firms, gov are purchasing
prices don't change quickly enough to
keep output at potential in short run, output can be below, above,
or equal to potential output
limited info, long term contracts, etc Determinant of output in short run
Causes of growth
MRP= P(MR) x MP
increase when
1. trade inc global demand, raising TOT
(export price).
2. Capital or tech. makes labor more
analogy productive
aka normal output
Potential output (Y*): amount of outputs
the economy produces when using key determinants of potential output:
resources at normal rates -Labor
refer to total amount that ppl/business/gov
-Capital
plan to buy
planned agg. expenditure = planned -Technology
spending = planned agg. demand
Short Run-> if PAE changes, output physical capital & human capital
changes capital
aids to production process
Y= actual production
PAE= Planned spending
Labor
Key determinants of potential output
everything that affects how much output
per worker we produce using given
amount of capital per worker
technology
components: production/management
techniques, econ. institutions, local culture
I=Ip+unplanned inventory investment.
-inc in r reduces planned investment Real IR (r)
Expectations about future demand
determinants of planned investment (Ip)
planned investments--we leave out unplanned investment in average labor productivity
inventories when PAE different from actual output. Y /= PAE (inventory
goods still counted as investment) product of normal employment to pop.
ratio and normal output per worker
politics
normal output per worker depends on
wars, natural disasters, crisis determinants of government purchase normal capital per worker and technology
Short run macro fluctuations
We take G as given inc can raise Y*/POP, but N*/POP doesn't
Planned aggregate expenditure
change much & contribution limited by
r: inc in r reduces current consumption diminishing returns
Long run economic growth
(inc cost of borrowing, better to save)
N*/POP
expectation of future income
determinants of Consumption
Wealth (inc wealth inc c) changes in normal employment to pop
ratio are not very important
disposable income: rise also inc c
inc will raise Y*/POP, important to growth
PAE can be more, less, or equal to Y*
potential output per person
(long-run / potential output) increase in normal capital per worker are
K*/N* somewhat important
do not change price or capital, mainly Short run
adjust quantity and employment Diminishing returns-> doubling K*/N* less
output respond to match PAE than doubles Y*/POP
change Y when see inventory moving
wrong way SR vs. LR argument by elimination: if its not N*/POP
Output = Y* (determined by normal or K*/N*, then it must be T
capital, labor, tech)
inc edu
PAE adjust to equal Y* Long run
T Technological change is a key Policies to encourage technological
subsidize r&d
movement in r* (long run IR) brings this determinant of economic growth process
about
make property rights more secure
Aggregate income: aggregate output (Y)
Improvement in technology is responsible
agg net tax payment = gov net tax revenue for 2/3 of overall growth
(tax-transfer back)
Level of po/person is indicator of standards of living
agg disposable income= Y - T
small difference in normal growth can
the growth rate of po/person over time have large impacts on standards of living
part of consumption that does not vary
Autonomous consumption (C cap) over time
with income (C cap) Consumption & Disposable Income
market based system for allocating
Change in consumption due to change in
resources
disposable income.
Features of inst. for high normal output
Gov protection of property from others
Poor have higher MPC Between 0 and 1 per person
MPC (marginal propensity to consume)-- c Protection of propoerty from gov.
it is the slope in formula for PAE
corruption, theft, arbitary taxation
ex: mpc=0.6 -> for each extra $1 of income,
households spend $0.60 on consumption
Consumption function
(and save $0.40).
Long run consequences of small compounds over time, significant change
differences in growth rates in long run
Capture equilibrium condition that Y=PAE
Fed charged w/ maintaining low and
stable inflation & full employment
reflects the empirical reality that output
responds to planned spending in the short Feds key policy is real interest rate
run. FED (federal reserve)--central bank of US-
45 degree Line When fed raise real IR, it reduces
- conducts monetary policy
output entireley demand driven in SR autonomous investment (I) and
Consumption (C)
cutting real IR can temporarily raise
spendin
Out put in SR determined by the Monetary policy: actions by fed to affect
shows how planned spending varies w/ nominal and real IR
keynesian cross
output more shifters of PAE
-show that in SR, output (Y) purley
determined by demand Disruptions in fancial markets: like
any other than output/income, will shift financial crisi
-Equilibrium where Y=PAE
the curve
ex: fall in autonomous consumption! depends on: riskiness of the bond or loan
& maturity (time horizon(
The Multiplier effect: A change in PAE Interest rates
changes output by more than the different nominal interest rates generally
initial change in PAE. move together.
response from change in inventory
fed only inst. allowed to put money into
expenditure line circulation
print money
FED & monetary policy
trade money for financial assets (short open market operations
term US gov debt) -isnt adding to gov spending or transfer
payments to ind/banks. (not fiscal)
these open market op change supply of
reserves
1/1-c (c is marginal propensity to
consume/slope) changes in IR that Fed put on banks
reserves
Multiplier FED & affect nominal IR
changes in supply of reserves (through
open market op.)
y= actual gdp/output
nominal IR= i
Fiscal policies are tax rates, cash and Fed & real IR (short run)
other transfers, and direct government
pi= inflation
purchases of goods and services
When fed changes i, it changes r
- Stimulating an economy in recession; Fed can affect real IR in short run, but in
-cooling off an overheating economy long run, r must equal R* at level where S*
equates I*
• Fiscal policy can be an effective tool for
- Creating investments themselves or
creating the circumstances for
investments in types of capital that
produce long-run benefits potential Investment lower when r is
higher
governments face legal or market
constraintson on borrowing; they can’t saving higher when r higher & C lower
spend more than they tax forever when r higher
inc in gov debt raise IR Real IR & PAE higher r -- lower NX
gov debt that rise too high as share of gdp
can trigger debt crisis-- investors loose
confidence debt (Reflect of this measure)
gov debt can be serviced, rather than paid
off Increase in r reduces PAE at a given Y
-our children/grand children will need to
pay more
Fiscal Policy
actions taken by central bank to affect
Monetary Policy nominal and real interest rates
Determination of short run output
contractionary monentary policy fed actions to increase i and r IR
in this model the price level is assumed
fixed in the short run. Monetary policy expansionary monetary policy fed actions to dec i and r IR
Y is real GDP (real income)
offset other force shifting PAE
change in c > change in autonomous
spending > tax cuts why use expan & cont. monetary policy persue other objective like inflation
a mistake (ex: monetary policy in great
depression)
when i is already ~0, the Fed can’t use its
main motivation: ( i )can't go much below
normal tool (cutting i more), so it switches
zero
to “unconventional” tools.
100 billion inc in G increase PAE by 100
billion; forward guidance: statement or actions
100 billion tax cuts inc PAE by MPC x 100b composition "unconventional monetary policy" that influence expectations about future
nominal IR
Different types of stimulus effect
economy w/ different speeds quantitative easing: buying bonds other
than short term gov debt with reserves
need forcast of how long PAE depressed
How long it last process of getting savings into productive
if more than a year, fiscal stimulas also Fiscal Stimulus investment
need to last more than a year financial intermediation
banks, money markets mutual funds,
pension funds etc
number of financial institutions in danger
of failing
2009 financial crisis recovery act
due to limited info, menu costs, long term
inflation (pi) is fixed
contracts, etc financial crisis
short run
fed can choose real interest rate by setting
nominal interest rate
ppl lose confidence in many financial ins.
result: widespread disruption of financial
intermediation
inflation changes with the output gap
raise credit spreads (amount IR on risky
So Iᵖ falls, C falls → PAE down.
eventually, over time bonds exceed IR on safe assets)
firms operate above capacity, so they raise raise lending standards or reduce
price relative to other firms to compensate availability of loans
Y> Y*
with many firms doing this, inflation rises harm consumer/firm confidence
effect of financial crisis on PAE
firms produce below capacity; weak
Y<Y*
demand reduces price-- deflation
inflation remain same
Y=Y* Reduce PAE at given Y
raise prices to keep up with expected
inflation
A sudden jump (usually upward) in a
small set of prices (often the price of oil) for
reasons unrelated to how Y compares with
Y*. Inflation Shocks
cause immediate change in inflation
when inflation rise: The nominal exchange rates is the price
-fed raise IR of a currency
-reduce planned spending, lowers output
(Y) Demand for currencies determine
exchange rates in the SR
inflation responds to output over time, so
inflation decrease Demand for a countrys currency increase
Central bank & inflation
when
In the short run its domestic real IR increase
global uncertainty. prompts investors to
demand safe haven currencies
demand for the countries exports increase
increased demand -> inc exchange rate =
in ex: y<y*, inflation falls over time, inflation respond to output gap appreciation or stronger
in ex: as inflation fall, lower r Currency appreciation raises export
so inc IR reduces NX
fed respond to changes in inflation by Inflation & return to potential prices and reduce exports
changing r
reduction in r increases C and Ip at given Y output
shifting PAE up, raise Y ⬇️
Ought to see law of one price prevail in LR
for traded goods
Idealic, w/no tax or transportation cost
Net exports represent net capital flows
internationally
Long run equilibrium In the long run
if countries investment exceeds savings, it
must import capital and run trade deficit
chinas trade surplus reflects high domestic
⬅️ saving
foreighners who want to buy american
as long as y =! y*, inflation continues to
goods, services, assets
change until Y=Y*
Demanders of dollars
They need to convert their currency into
dollars to buy
reaching long time equilibrium
americans who want to buy foreign goods,
service, assets.
Suppliers of dollars
Convert dollars into foreign currency
price of dollars in terms of foreign currency
Exchange rate
Long run equilibrium
= s/d for dollars used in int. transaction
require shifting reaction function to
reduce inflation in LR There is a market for each currency to be various markets for particular currency
traded for other currency move tgt
International macroeconomics most exchange rates det. in markets
some used fixed exchange rayes
in short run (flexible exchange rates)
Foreign exchange market for dollars
Shift in supply/ demand curve for dollars
in foreign exchange market cause
exchange rates to change$z $
-bc of nominal rigidity, inflation dont
change
-r change, bc shift in reaction function ⬅️ Change Long run equilibrium
-PAE shift down
- y falls (more than downward shift bc
multiplier effect)
Now, Y < Y*so inflation starts falling -> Demand: Savers in Japan want to buy US
lower r -> shift PAE back up-> Y=Y* with Supply of dollars: More Americans want to bonds instead of Japanese bonds
lower inflation in LR travel to France and convert $ Supply: Savers in the US also want to buy
into Euros for given price: Supply shifts out US bonds instead of Japanese bonds
and dollar falls Both demand and supply effects increase
exchange rate: $ appreciates
monetary policy affect exchange rates
Real IR affected by monetary policy in SR neg relationship between r and NX
US r inc -> $ appreciate -> US export more
expensive -> NX dec
Y back at Y* where price in terms of other currencies is
Strong
high
Strong vs. Weak dollar
r rose sharply when adopt new reaction
Long run effects on real IR weak price in terms of other currency low
functino, then fell gradually.
overal change is not obvious accounting of supply/demand for dollars
used in int. transactions
equilibrium exchange rate: Q of $
labor demanded = Q of $ supplied
capital
to produce these, we need institutions or
social infrastructure: Long run level of income is potential GDP
technology Balance of payment
-rule of law
-property rights
It’s the level of output the economy could
-protection from government
produce if labor and capital were used at
normal/full-employment rates with
current technology.
So, NX=-NKI
track demand in expenditure components
short run level of income is actual GDP if export on net, need to buy assets
C + I + G+ NX abroad (capital outflow)
Review
if import on net, need to sell assets
abroad (capital inflow)
difference between actual: Y= C+I+G+NX
and potential: Y*
PAE determine short run actual gdp
fiscal/monetary policies try to shift Y
ex: if shock reduce PAE, can increase G or back to ŷ
cut T, or fed can dec r to raise I and raise Output gap
PAR
when demand Y > supply ŷ, typically raise
inflation
inflation moves with output gap
Screenshot 2025-11-20 at 18.04.42.png
comparative advantage & absolute having more of smt means having less of
advantage something else
Shifters of PPF scarcity principle someone or something faces constraint
diagram that shows combination of two outside of ppc shows scarcity--unattainable
types of goods that can be produced in an
economy using all available inputs take an action if and only if its benefit
cost benefit principle
chapter 1: scarcity and choice outweighs cost
ex: PPC of US economy divides production
slope is (minus) OC of goods on x axis
into consumption vs investment goods the value of what must be forgone to
undertake an activity
g/s. that satisfy some current want for
consumption goods
people reflects tradeoff in production process
each choice has cost--opportunity cost
g/s that makes us more productive in the OC of good brought in market is usually its
future price
ex: machines, infrastructure education, r&d investment goods includes out of pocket costs+forgone value
adding this shifts PPC production possibility frontier/curve (PPF,
PPC) slope up marginal cost rises as production rise
when it is impossible to produce more of
supply
something w/o decreasing production of productive efficiency
chapter 2 producers are price takers
smt else
time when unemployment is above
normal and economy is not producing at
full potential
recession
bc demand is marginal utility, which falls
not producing at full capacity displayed as a point in the PPC
demand slopes down
"willingness to pay", this dec as you get
more
discrete, only two people.
buyers are price takers
For whole population, it becomes bowed
out and continuous innovation that inc productivity
chapter 3
outward price of inputs needed going down
This explains why the PPC for a country is more producer enter industry
likely to be “bowed out” or concave shifters of supply
regulation dec productivity
role of comparative advantage in trade
inward price of inputs for prod. go up
S/D reveal welfare producers exit ind
difference between what consumer willing new complementary good released
to pay for a good and actually pay(market
price) price of substitute goes up
Consumer surplus
outward
are under demand curve, above price ppl richer
area under market price, above supply product more fashionable
curve shifters of demand
producer surplus price of compl. go up
difference between what producers
recieve for a good and min. price willing to inward price of sub. go down
accept (their cost)
product go out of fashion
total benefut society gets from market
economic surplus
transaction
Markets do not produce equitable
allocations rise in household income, shifts budget
constraint line out
Conditions for allocative efficiency
- good is produced where MB=MC in perfect market -> efficient allocation, CS
+ PS is maximized (allocative efficiency)
-Good allocated to consumers w/ highest
MB, producers w/ lowest MC
households face budget constraint
total amount household spends cannot
exceed its income. assume: spending =
income
does not realize all gains from trade Area of lost surplus relative to market
if price of one good inc, household will re-
equilibrium when quantity differs from
optimize. Red. spending on that good, inc.
efficient quantity
spending on other goods
Rational Spending Rule
households is maximizing utility if: MU
Chapter 5/6 from spending one more dollar on a good
is same for all good
dividing MU by price= MU per dollar spent
Deadweight Loss on good
Chapter 5: Households
costs more to producers than it creates households optimize choices so that each
benefit to consumers diff. goods have diff. marginal utility, and
marginal utility gained from last dollar
their marginal utility have diff. slopes
spent is same across goods
too little or too much production relative
implications
to efficiency creates deadweight loss
deadweight loss triangle points towards
efficient allocation. Grows outward to
current Q
Relationship between total/marginal utility
competitive equilibrium where supply
equals demand, maximize total economc
surplus (Efficiency) The competitive equilibrium maximizes
first theorum of welfare economics
economic surplus
competitive markets are efficient
willingness to pay depends on income
measure of welfare doesn't take into
account how consumers enter market Equity Issues
w/diff income
1st welfare theorum is blind to
distributional aspects
Utility from total consumption of all goods
tradeoff between equity and efficiency
must sacrifice some economic surplus to
get more equitable outcome equity VS efficiency trade off
reminder: maximized economic surplus =
allocative efficiency
max price, belowequilibrium
lead to shortage Price ceiling
Subtopic 3 price controls
min price, above equilibrium Price floor
this is assumption.
Reality: also care about workers,
community, customers
economic profit: total revenue-total cost
total cost= Opp. cost of All inputs Firms (objective) maximize profits
profits sign depends on whether p-atc is
profits= p x q - (atc x q) = P=(P-atc)xq
pos, neg, or zero
%change in qD / %change in price
Set MR=MC Condition
Firms do not have market power + free
entry/exist. -> Profits are competed down
to zero
each firm knows that it has no impact on
market price
occur in industry w/ many firm, each is
relatively small
and slope of demand curve: change in
When demand is flat, MR is also flat price over change in quantity
-MR is same at every quantity (equal to P) price elasticity of demand
relationship between slope of demand
and elasticity
0 is perfectly inelastic, inifinity is perfectly
elastic
Demand curves in a perfectly competition price might change
graph for a perfectly competitive firm market
aka revenue total expenditure depends on how
maximize profit conditions: quantity responds: elasticity
MC=MR
P=MC inelastic when there is resource constraint -
- usually short run
Price elasticity of supply
Supply is elastic when there are no hard
resource constriats -- usually long run
elasticity is inverseley prop to slope. E=
Revenue, cost, profits on graph 1/slope x p/q
Perfect competiton
-0 profits for all firms (p=atc)
-p=mc=atc
-supply curve perfectly elastic
chapter 6: Firms and Profit Effects of tax
when all firms are identitcal
Maximimization
both supplier and demanders feel effects
Chapter 4: Elasticity
Long Run Industry SUPPLY CURVE
-firms produce p=mc
-least productive firm makes 0 profits
when firms differ in productivity
-other firms make pos. profits
-supply curve upward sloping
market supply curve= mc curve for whole
industry & also = horizontal sum of ind.
firm's supply curve/MC curve ⬇️
If firms are making positive profits, entry of welfare analysis of tax
new firmsd rives price down and so drives
profits down
• If firms are making negative profit, exit of summary
firms drives price up and so drives profit up
• In the long-run, profit is zero for the
marginal firm: p = atc = mc
Short run choice of output: How much to
produce w/ existing set up
- tax extracts Consumer/producer surplus
Long run choice of output: Expand, -no misallocation, still allocated acc. to
contract? Exit/Enter industry? Decisions of firm willingness to pay
-Dwl is larger when demand/supply is
Both short/Long run--choice of input mix: elastic
What combo of inputs (labor, capital, raw
materials etc...) to use to produce output
cost that don't vary w. quantity produced Fixed
cost that vary w. quantity produced Variable
sum of fixed & variable Welfare analysis of Subsidy
Total cost
ATC x quantity
Change in total cost from producing add. subsidy distorts production above
unit competitive equilibrium-> resulting level of
Marginal cost production and consumption is MB<MC
FC don't change w/ add. unit. MC = change
in VC from producing add. unit
total cost/ quantity
Types of cost
Average total cost
As a firm scales all inputs up, average cost
economies of scale
per unit falls.
Beyond some size, average cost per unit
diseconomies of scale
rise
but we assume upward mc for perfectly
competitive model
only one producer of a differentiated good
Monopoly
choose quantity to maximize profits, takes
into acc. how demand slopes down
when one producer can supply whole
market at lower avg cost
Natural monopoly
MC very low, efficient for firm, allow it to
price low
high fC
patents & legal protections Barriers to entry
licensing/forms of gatekeeping
Profit max, set quantity supplied where
MR=MC
set price off demand curve, and quantity add. cost/benefits triggered by market
supplied where mc=mr activities that aren't paid or enjoyed by
market participants that effect third parties
Raise SMC above PMC
negative externalities
ppl in market choose to produce where
MR curve of monpolist PMC=PMB but society is better off if
market produce/consume less at SMC=SMB
raise social marginal benefit above PMB
Mr is twice as steep as demand positive externalities
ppl in market choose to produce where
monopolist doesn't take price as given, PMC=PMB, but society would be better off
constrainted by demand curve but can if produce/consume more at SMC=SMB
choose any point along it
add. cost to third parties when one more
external marginal cost
for demand curve, only one quantity unit is produced/consumed
monpolist willing to supply
special aspects of monpoly add. benefit to third parties when one
doesnt really have a supply curve terms external marginal benefit
A monopolist sets quantity, not price, by more unit is produced/consumed
the rule MR=MC. Then it reads price off the
demand curve at that quantity. PMC + EMC
social marginal cost/benefit
PMB+EMB
Does not produce where MC=P aka MC=MB
private markets overproduce neg.
sum of CS & PS where total surplus is large externalities and underproduce positive
externalities.
negotiation & compensation
Allocative Efficiency
private solutions social sanction
educaton
gov regulation fines
chapter 8: monopoly and
emitters can trade their emission
reminder, CS/PS part above/below price
market power emission permits and trading~cap & trade
allowance
Remedies for externalities
Chapter 11: Externalities and
climate change
tax for neg externality, vice versa for subsidy
corrective tax, subsidy
idea to internalize externality by
incorporating it in the price
MC = Atc at minimum
recall profit = (p-atc)xq
set tax equal to EMC
Long Run Profit Maximization
neg. econ. profits
dwl points towards socially opt
DWL, points towards socially optimum
Profits 0
monpolist want to leave industry Neg. profits
less livable--droughts, heatwaves
Opp cost will be covered Zero profits
How Monpoly respond to Profits
agricultural production disruptions, risk for
Monpolist can make pos. econ. profits in Costs of global warming
food security--famines
long run by definition-- must have barriers
to entry if monpoly exist impact on biodiversity--mass extinction
patent protection--pharmaceutical dev Patents
choice of qs affect price
profit max results in: When firm have market power
-quantity too low
-price extracted too high
-dwl
arise due to either large fixed costs,
barriers to entry, or patent protection
market power
solutions: usually involve gov actions
market outcomes don't mazimize total
surplus
market fazilure
gov intervention make things better
rising demand for firms product raise labor
demand, falling demand reduces it
firms are demanders of labor: choose how
technology/capital makes some workers
much to employ based on profit
more productive, shifts labor demand out
maximization
technology and machines could replace
workers
Opportunity inequality
Wealth inequality
shift MRP for high skilled workers bc MP
price of labor=wage inc
profits maximized where MR=MC
extra revenue generated by one more
worker
mrp= mp x mr skill biased tech. doesn't affect wage of
low skill worker-> inc inequality
mp: extra output produced by one more
worker Marginal revenue product (MRP) When MP increase faster than price of When workers MP cannot compensate for
services fallen, lifting MRP. (Graph: falling prices. MRP and labor demand falls
mr: extra revenue from selling one more computer & service)
skill biased technological change
unit
mr=p, so mrp= mp x p
special case: perfect comp
mp x p is the value of the marginal
product of labour
bc mrp= mr x mp
tech. change tend to benefit high skilled
mp declines bc of diminishing returns workers
mr is either constant (comp. firm) or skill based tech. change increase inequality
declining mrp declines as L (employement inc) -> inc in education decrease inequality
US has comparative advantage in goods
that use high skilled labor, vice versa
Labor and wages rising labor income inequality
Tend to specialize/export in high skilled
labor goods, and import low skilled labor
goods
globalization Increased Trade
Inequality
firms hire labor to where mrp=W (wage)
Profit maximization
changes in relative wages of low/high skill
workers parallel trends in rising income
ineq.
in labor market, Demand is MRP
Income inequality
households like leisure, mu of leisure demand =mrp (mp x mr)
P(leisure) is wage
declines as q inc Household are supplier of labour: choose
how much to supply based on utility
maximization
condition for utility maximization
poverty & income ineq. correlated
labor income inequality start rising in early
1970s
substitution effect: when wage inc,
consumer sub. away from leisure
share of income going to very top of
effect of inc in wage
income dis. risen quickly
income effect: when wage rise, consumer
is richer and wants more leisure (work less)
current trend of rising ineq. due to inc
inequality of labor income
ambiguity between which dominates;
assume substituion effect dom. so labor Education won't change inequality quickly, long term
supply slope up
-program help workers who lose jobs bc
of trade
Trade adjustment assistance:
-Job training, help, unemployment
benefits, wage subsidy
Targeted policies to groups hurt by skill
biased tech change and globalization tax benefit, subsidies, incentives for
inc unemployement; firm cut employers for employing troubled locality
effect of negotiated wage Remedies Place based policies
employement to L d1 ; supply> demand
Funds, training program
Minimum wage
acts like price floor
Policies that raise incomes at bottom of earned income tax credit, wage subsidy
income distribtuion
capital: physical stuff that helps produce Labor & capital are two main physical
other things; durable factor inputs to production
market interest rate as 'price' of capital
direct cash payments--universal basic
income
quantity of capital firm wants to rent
depends on profit max.
mrp declines as more machines are rented world relative price & terms of trade is the
relative price of a country's export
Demand for capital goods slope down;
demand: mrp= mr x mp
factor= inputs to production
country tend to have comparative
advantage in goods that use inputs that
Factor Abundance are in abundance
ex: -minerals & early US industrialization
-climate/soil w/ coffee production
rental equipment demand--MRP -capital & skilled labor to determine what
US has comp. advantage today
Investment is the flow of new capital into New capital--investment spending-- is part -Many developing country have
the capital stock of national income--> national spending abundance of less skilled labor & CA in low
tech manufac. good
ppl prefer things today to things tmr
time preference some ca isn't inherent but acquired
this is why banks pay interest
Dynamic comparative advantage
by doing smt or getting early start, country
what a payment to be recieved in the may become the low opp. cost producer of
future is worth to you today a good
aka present discounted value terms at which the goods trade in the
world market
ex: US export soybeans, so its TOT are
washing machines per ton of soybeans
it is the relative price of its exports
Terms of trade & World relative price
bc TOT depends on world prices, we also
call it world relative price
PV single payment
Capital and Interest
Present value
using soybean ex: TOT must be between 1
and 2 washing machines per ton of
soybean
Terms of trade must be between the
opportunity cost of producing the good in
the two countries
PV stream of payment
Trade
suppose price of soybean= 200, Price of
profit maximizing where PV(stream of
WM=300
mrp)=price of machine
International trade then, 1 ton Soybean trade for 2/3 WM
market force move world prices
capital worth
China OC: 1 s = 2 WM
US OC: 1s = 1 WM
Investment
shows combination of the two goods that
a country can have w/ trade
The line w/ slope being (-)TOT, tangent to
relationship between interest rate and
PPC
present value and quantity bought
physical: man made aids to production Subtopic 7
process: machines, buildings, trucks,
computers
To raise financial capital
Physical & Financial capital
with a linear PPC, the line with slope equal
Issue bonds: borrow funds in return for a
to (-) TOT touches the PPC at one of the
promise to repay later with interest
Financial: Funds used to purchase, rent, or extreme-> complete specialization
build physical capital
stock price= PV(stream of expected future
dividens) you expect to gain from it the gains from trade are captured by the
Issue stocks: sell people a share of the
Consumption Possibilities Curve fact that the CPC lies outside the PPC
change in interest rate company. In return, they are entitled to a
-dec. in IR inc. stock price, all else equal share of future profits (dividends)
limitations: in real life, countries rarley
Movers of stock price specialize completely
Change in expected future dividends
-if expect lower future dividends-> lower
stock price
bowed ppc with linear trading constraint,
a CPC, shows exports & imports
Openness to trade changes prices and
consumption, shifting MRP of labor
-has to be feasible point on or inside PPC
if green line don't touch: total value is too
Optimal Specialization w curved PPC
high for this country to afford with its
gains from trade current resources/technology. PPC need to
shift out to consume @ that level
country can trade diff. combo of goods at
point of tangency along CPC
line w/ slope (-) TOT of trade, tangent to Total value doesn't change
PPC
CPC w/ trade Trade allows country to CONSUME more,
Shows combo of two goods that country not more total value. --It means you get a
can consume if it produce at point of better combo/mix using the same total
tangency and trade at world prices value
S/D for exports
Supply is upward sloping, reflect rising OC GDP measures total income in a country in
gdp per person is average income
-world price is world relative price a year
assume world demand/world supply at
world relative price are perfectly elastic. Total income= total spending = total
total spending, gdp is Y= C + I +G + EX - IM
-here, US is price taker production of new g/s
Price level (P) is different for diff.
consumers, so it means the expenditure
S/D w/ trade weighted avg. price for the avg. consumer
Consumers purchase a basket of g/s in a prices of g/s change, consumers also
S/D for imports
period. change basket
Inflation
W/ rising OC, get incomplete specialization
measured in terms of dollars
intersection between world price line and Nominal GDP
supply correspond to point of tangency in market value of final g/s newly produced,
PPC/CPC diagram within the country, in some period of
time not adjusted for price changes
measured in terms of g/s rather than
market value of final g/s newly produced dollars
within the country, in some period of
time, adjusted for price changes. remove effects of changing price
the domestic price gets pulled
up toward the world price when 1. choose base year
trade open Trade policy 2. Use prices from base year to multiply
Real GDP
quantities
calculation
Macroeconomic measurement
Price & Employment effects of trade
percentage change in real gdp from one
year to the next
Growth rate
trade rearranges jobs, rather than raise or
lower employment overall
employment expands in export industries
and contracts in import industries employment effects use market price & quantities of final goods
expenditure
Rearrangement is painful for those who divided into consumption (C), investment
lose jobs, or those that don't have skills to (I), gov. purchases (G), net exports (ex-im)
move to industries where jobs are available
3 approaches to measuring GDP production(value added) follow goods thru each stage of production
no barriers to international trade Free trade
income from producing new g/s within the
country put limits on trade country
Income
divided into labor income & capital
income
growth in avg/overall level of prices
calculation: 1. choose base year
2. Use quantities for each good at base years to
multiply prices (quantity are weights)
Consumer price index (CPI)
raise employment in protected industry, tarrif: tax on import
not total employment Protection now ( using old quantity) over old
Inflation
trade retaliation may reduce foreign
demand for g/s
Inflation is the percent change in price
Currency might appreciate, tarrifed index
countries may depreciate.
Quota: limit on quantity of imports
Subsidies for domestic production
Adjusting variables for price changes
example:
countries policies towards trade Trade policy
trade policy
Shippng cost
improved logistics make trade easier Determinants of trade
better communication makes trade in
services possivle
real activity responds to the real interest
rate r -> also equals nominal interest rate
minus rate of inflation ( i - pi )
stated IR, measured in terms of dollars w.
no adjustment to prices
Nominal interest rate
nominal IR is i = r + pi denoted by i
and thus, r = i - pi
- i is expected rate of inflation, not actual IR measured in terms of purchasing
power, adjusted to price
Real interest rate
denoted by r
real interest rate is price of spending
today, the opp cost of what you forgo tmr
by spending today
real IR can be negative-> price spending
low to get ppl to inc spending
Keynesian Cross shows how
macroeconomic spending shocks
reverberate thru econom
Investment price = r
Savings are supply of funds for investment
PO determine by normal capital, labor,
technology in long run, output (gdp) = potential (LR)
output Y
can be thought of as 'supply'
determined primarily by demand: what
consumer, firms, gov are purchasing
prices don't change quickly enough to
keep output at potential in short run, output can be below, above,
or equal to potential output
limited info, long term contracts, etc Determinant of output in short run
Causes of growth
MRP= P(MR) x MP
increase when
1. trade inc global demand, raising TOT
(export price).
2. Capital or tech. makes labor more
analogy productive
aka normal output
Potential output (Y*): amount of outputs
the economy produces when using key determinants of potential output:
resources at normal rates -Labor
refer to total amount that ppl/business/gov
-Capital
plan to buy
planned agg. expenditure = planned -Technology
spending = planned agg. demand
Short Run-> if PAE changes, output physical capital & human capital
changes capital
aids to production process
Y= actual production
PAE= Planned spending
Labor
Key determinants of potential output
everything that affects how much output
per worker we produce using given
amount of capital per worker
technology
components: production/management
techniques, econ. institutions, local culture
I=Ip+unplanned inventory investment.
-inc in r reduces planned investment Real IR (r)
Expectations about future demand
determinants of planned investment (Ip)
planned investments--we leave out unplanned investment in average labor productivity
inventories when PAE different from actual output. Y /= PAE (inventory
goods still counted as investment) product of normal employment to pop.
ratio and normal output per worker
politics
normal output per worker depends on
wars, natural disasters, crisis determinants of government purchase normal capital per worker and technology
Short run macro fluctuations
We take G as given inc can raise Y*/POP, but N*/POP doesn't
Planned aggregate expenditure
change much & contribution limited by
r: inc in r reduces current consumption diminishing returns
Long run economic growth
(inc cost of borrowing, better to save)
N*/POP
expectation of future income
determinants of Consumption
Wealth (inc wealth inc c) changes in normal employment to pop
ratio are not very important
disposable income: rise also inc c
inc will raise Y*/POP, important to growth
PAE can be more, less, or equal to Y*
potential output per person
(long-run / potential output) increase in normal capital per worker are
K*/N* somewhat important
do not change price or capital, mainly Short run
adjust quantity and employment Diminishing returns-> doubling K*/N* less
output respond to match PAE than doubles Y*/POP
change Y when see inventory moving
wrong way SR vs. LR argument by elimination: if its not N*/POP
Output = Y* (determined by normal or K*/N*, then it must be T
capital, labor, tech)
inc edu
PAE adjust to equal Y* Long run
T Technological change is a key Policies to encourage technological
subsidize r&d
movement in r* (long run IR) brings this determinant of economic growth process
about
make property rights more secure
Aggregate income: aggregate output (Y)
Improvement in technology is responsible
agg net tax payment = gov net tax revenue for 2/3 of overall growth
(tax-transfer back)
Level of po/person is indicator of standards of living
agg disposable income= Y - T
small difference in normal growth can
the growth rate of po/person over time have large impacts on standards of living
part of consumption that does not vary
Autonomous consumption (C cap) over time
with income (C cap) Consumption & Disposable Income
market based system for allocating
Change in consumption due to change in
resources
disposable income.
Features of inst. for high normal output
Gov protection of property from others
Poor have higher MPC Between 0 and 1 per person
MPC (marginal propensity to consume)-- c Protection of propoerty from gov.
it is the slope in formula for PAE
corruption, theft, arbitary taxation
ex: mpc=0.6 -> for each extra $1 of income,
households spend $0.60 on consumption
Consumption function
(and save $0.40).
Long run consequences of small compounds over time, significant change
differences in growth rates in long run
Capture equilibrium condition that Y=PAE
Fed charged w/ maintaining low and
stable inflation & full employment
reflects the empirical reality that output
responds to planned spending in the short Feds key policy is real interest rate
run. FED (federal reserve)--central bank of US-
45 degree Line When fed raise real IR, it reduces
- conducts monetary policy
output entireley demand driven in SR autonomous investment (I) and
Consumption (C)
cutting real IR can temporarily raise
spendin
Out put in SR determined by the Monetary policy: actions by fed to affect
shows how planned spending varies w/ nominal and real IR
keynesian cross
output more shifters of PAE
-show that in SR, output (Y) purley
determined by demand Disruptions in fancial markets: like
any other than output/income, will shift financial crisi
-Equilibrium where Y=PAE
the curve
ex: fall in autonomous consumption! depends on: riskiness of the bond or loan
& maturity (time horizon(
The Multiplier effect: A change in PAE Interest rates
changes output by more than the different nominal interest rates generally
initial change in PAE. move together.
response from change in inventory
fed only inst. allowed to put money into
expenditure line circulation
print money
FED & monetary policy
trade money for financial assets (short open market operations
term US gov debt) -isnt adding to gov spending or transfer
payments to ind/banks. (not fiscal)
these open market op change supply of
reserves
1/1-c (c is marginal propensity to
consume/slope) changes in IR that Fed put on banks
reserves
Multiplier FED & affect nominal IR
changes in supply of reserves (through
open market op.)
y= actual gdp/output
nominal IR= i
Fiscal policies are tax rates, cash and Fed & real IR (short run)
other transfers, and direct government
pi= inflation
purchases of goods and services
When fed changes i, it changes r
- Stimulating an economy in recession; Fed can affect real IR in short run, but in
-cooling off an overheating economy long run, r must equal R* at level where S*
equates I*
• Fiscal policy can be an effective tool for
- Creating investments themselves or
creating the circumstances for
investments in types of capital that
produce long-run benefits potential Investment lower when r is
higher
governments face legal or market
constraintson on borrowing; they can’t saving higher when r higher & C lower
spend more than they tax forever when r higher
inc in gov debt raise IR Real IR & PAE higher r -- lower NX
gov debt that rise too high as share of gdp
can trigger debt crisis-- investors loose
confidence debt (Reflect of this measure)
gov debt can be serviced, rather than paid
off Increase in r reduces PAE at a given Y
-our children/grand children will need to
pay more
Fiscal Policy
actions taken by central bank to affect
Monetary Policy nominal and real interest rates
Determination of short run output
contractionary monentary policy fed actions to increase i and r IR
in this model the price level is assumed
fixed in the short run. Monetary policy expansionary monetary policy fed actions to dec i and r IR
Y is real GDP (real income)
offset other force shifting PAE
change in c > change in autonomous
spending > tax cuts why use expan & cont. monetary policy persue other objective like inflation
a mistake (ex: monetary policy in great
depression)
when i is already ~0, the Fed can’t use its
main motivation: ( i )can't go much below
normal tool (cutting i more), so it switches
zero
to “unconventional” tools.
100 billion inc in G increase PAE by 100
billion; forward guidance: statement or actions
100 billion tax cuts inc PAE by MPC x 100b composition "unconventional monetary policy" that influence expectations about future
nominal IR
Different types of stimulus effect
economy w/ different speeds quantitative easing: buying bonds other
than short term gov debt with reserves
need forcast of how long PAE depressed
How long it last process of getting savings into productive
if more than a year, fiscal stimulas also Fiscal Stimulus investment
need to last more than a year financial intermediation
banks, money markets mutual funds,
pension funds etc
number of financial institutions in danger
of failing
2009 financial crisis recovery act
due to limited info, menu costs, long term
inflation (pi) is fixed
contracts, etc financial crisis
short run
fed can choose real interest rate by setting
nominal interest rate
ppl lose confidence in many financial ins.
result: widespread disruption of financial
intermediation
inflation changes with the output gap
raise credit spreads (amount IR on risky
So Iᵖ falls, C falls → PAE down.
eventually, over time bonds exceed IR on safe assets)
firms operate above capacity, so they raise raise lending standards or reduce
price relative to other firms to compensate availability of loans
Y> Y*
with many firms doing this, inflation rises harm consumer/firm confidence
effect of financial crisis on PAE
firms produce below capacity; weak
Y<Y*
demand reduces price-- deflation
inflation remain same
Y=Y* Reduce PAE at given Y
raise prices to keep up with expected
inflation
A sudden jump (usually upward) in a
small set of prices (often the price of oil) for
reasons unrelated to how Y compares with
Y*. Inflation Shocks
cause immediate change in inflation
when inflation rise: The nominal exchange rates is the price
-fed raise IR of a currency
-reduce planned spending, lowers output
(Y) Demand for currencies determine
exchange rates in the SR
inflation responds to output over time, so
inflation decrease Demand for a countrys currency increase
Central bank & inflation
when
In the short run its domestic real IR increase
global uncertainty. prompts investors to
demand safe haven currencies
demand for the countries exports increase
increased demand -> inc exchange rate =
in ex: y<y*, inflation falls over time, inflation respond to output gap appreciation or stronger
in ex: as inflation fall, lower r Currency appreciation raises export
so inc IR reduces NX
fed respond to changes in inflation by Inflation & return to potential prices and reduce exports
changing r
reduction in r increases C and Ip at given Y output
shifting PAE up, raise Y ⬇️
Ought to see law of one price prevail in LR
for traded goods
Idealic, w/no tax or transportation cost
Net exports represent net capital flows
internationally
Long run equilibrium In the long run
if countries investment exceeds savings, it
must import capital and run trade deficit
chinas trade surplus reflects high domestic
⬅️ saving
foreighners who want to buy american
as long as y =! y*, inflation continues to
goods, services, assets
change until Y=Y*
Demanders of dollars
They need to convert their currency into
dollars to buy
reaching long time equilibrium
americans who want to buy foreign goods,
service, assets.
Suppliers of dollars
Convert dollars into foreign currency
price of dollars in terms of foreign currency
Exchange rate
Long run equilibrium
= s/d for dollars used in int. transaction
require shifting reaction function to
reduce inflation in LR There is a market for each currency to be various markets for particular currency
traded for other currency move tgt
International macroeconomics most exchange rates det. in markets
some used fixed exchange rayes
in short run (flexible exchange rates)
Foreign exchange market for dollars
Shift in supply/ demand curve for dollars
in foreign exchange market cause
exchange rates to change$z $
-bc of nominal rigidity, inflation dont
change
-r change, bc shift in reaction function ⬅️ Change Long run equilibrium
-PAE shift down
- y falls (more than downward shift bc
multiplier effect)
Now, Y < Y*so inflation starts falling -> Demand: Savers in Japan want to buy US
lower r -> shift PAE back up-> Y=Y* with Supply of dollars: More Americans want to bonds instead of Japanese bonds
lower inflation in LR travel to France and convert $ Supply: Savers in the US also want to buy
into Euros for given price: Supply shifts out US bonds instead of Japanese bonds
and dollar falls Both demand and supply effects increase
exchange rate: $ appreciates
monetary policy affect exchange rates
Real IR affected by monetary policy in SR neg relationship between r and NX
US r inc -> $ appreciate -> US export more
expensive -> NX dec
Y back at Y* where price in terms of other currencies is
Strong
high
Strong vs. Weak dollar
r rose sharply when adopt new reaction
Long run effects on real IR weak price in terms of other currency low
functino, then fell gradually.
overal change is not obvious accounting of supply/demand for dollars
used in int. transactions
equilibrium exchange rate: Q of $
labor demanded = Q of $ supplied
capital
to produce these, we need institutions or
social infrastructure: Long run level of income is potential GDP
technology Balance of payment
-rule of law
-property rights
It’s the level of output the economy could
-protection from government
produce if labor and capital were used at
normal/full-employment rates with
current technology.
So, NX=-NKI
track demand in expenditure components
short run level of income is actual GDP if export on net, need to buy assets
C + I + G+ NX abroad (capital outflow)
Review
if import on net, need to sell assets
abroad (capital inflow)
difference between actual: Y= C+I+G+NX
and potential: Y*
PAE determine short run actual gdp
fiscal/monetary policies try to shift Y
ex: if shock reduce PAE, can increase G or back to ŷ
cut T, or fed can dec r to raise I and raise Output gap
PAR
when demand Y > supply ŷ, typically raise
inflation
inflation moves with output gap
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