Economics: study of choice in a world of scarcity

• unlimited needs and wants
  • limited resources
    • problem of scarcity

three economic questions:

1. what to produce
2. how to produce
3. for whom to produce

• centrally planned
• mixed
• free enterprise systems

What is Microeconomics? §

individual choices

• households

  • consume?
  • work?
  • leisure?

  maximize utility

  cost vs benefit

• firms

  • meet demand
    • how much labor
    • how much capital

  maximize profit

What is Macroeconomics? §

aggregate, economy-wide

• income
• unemployment rates
• inflation

why?

• improve things

Mankiw’s Ten Principles §

People face trade-offs §

• efficiency vs equality

The cost of something is what you give up to get it §

• “opportunity cost”

  • direct (explicit) and indirect (implicit)

    whether or not there’s outlay of money

Rational people think at the margin §

Rational people: People who systematically and purposefully do the best they can to achieve their objectives.

Marginal change: small, incremental change in a plan of action.

Rational people compare marginal cost to marginal benefit (profit|utility).

“diamonds vs water”

the more of something you have, the less utility one more unit of that is going to bring you

Compare present options independently of previous choices and losses/profits

Try to make marginal benefit = marginal cost.

People respond to incentives §

Incentive: marginal cost > or < than marginal benefit? Act accordingly.

How can international trade make us better off? Specialization.

Trade can make us all better off* §

Trade: both specialize, break production possibility frontier.

Absolute advantage: ability to produce a good using fewer inputs than another producer

Comparative advantage: ability to produce a good at a lower opportunity cost than another producer. Driving force of specialization.

Having absolute advantage in all goods doesn’t mean one can’t benefit from trade. Trade isn’t driven by absolute advantage.

Price of trade: For both parties to benefit from the trade, the price at which they trade must lie between the two opportunity costs.

1. Different comparative advantages
2. Specialize
3. Trade
4. Profit

Markets are usually a good way to organize an economy §

Market economy is an economy that allocates resources through the decentralized decisions of many firms/households as they interact in the markets for goods and services.

The Invisible Hand: the ability of free markets to produce desirable outcomes in spite of the self-interest of market participants

As opposed to central economic planning.

Govts can sometimes improve market outcomes §

“facillitate the Invisible Hand”: enforce rules, maintain institutions key to a market economy

• Property Rights (?)
• Market failures
  • Externality. Tragedy of the commons. sustainability
  • Market power. Break up monopolies.

facillitate equality.

efficiency/equality trade-off.

A country’s standard of living depends on its ability to produce goods and services §

Productivity: quanatity of goods and services produced fromo each unit of labor input. Depends on:

• human capital
• physical capital
• natural resources
• legal/social framework
• technology

Price rises when the government prints too much money §

Inflation: increase in overall level of prices in the economy

Hyperinflation:

• Germany after WW1
• Zimbabwe
• Venezuela

Society faces a short-run trade-off between inflation and unemployment §

Or does it?

Recession: “two consecutive quarters of negative GDP growth” —BEA

$W^R = \frac{W^N}{P}$. $W^N$ is the nominal wage, $P$ is the avg price. $W^R$ is the real wage.

Real wage >> Nominal wage

Nominal wages are sticky^[1]. When prices increased, real wage decreases, marginal cost of labour decreases leading to more employment.

Stimulate employment growth by raising prices

Production Possibilities Frontier §

a graph that shows the combination of output that the economy can produce given the available resources and production tech

downward slope: trade-offs

production possibilities frontier:

• inside: feasible, but inefficient
• outside: impossible
• on: efficient

opportunity cost of $y$: how many $x$ do we have to give up to produce another $y$

bowed out shape because of specialized factors of production^[2]. good at making one, bad at another. specialized people taken away from their forte.

opportunity costs increase towards the extremes

Shifts in the frontier §

technological advancements.

more units of a commodity can be produced with the same resources.

graph changes shape. opportunity costs change.

a technological advancement in the production of $x$:

• decreases the opportunity cost of producing $x$
• increases the opportunity cost of producing $y$

Market forces, supply, demand §

Describe the relationship between prices, market demand, market supply

• Market demand and its relationship with price
  • What can shift the market demand curve (other than price)?
• Market supply and its relationship with price
  • What can shift the market supply curve (other than price)?
• How do we determine market equilibrium?

A market is a group of buyers and sellers for a good or service.

Buyers collectively determine demand

Sellers collectively determine supply

Assumption: Markets are perfectly competitive:

• goods are identical

• several buyers and sellers

  no single buyer|seller can single-handedly influence the market price

Buyers and sellers are price takers. Must accept the price the market determines.

Demand §

Demand: amount of goods buyers are willing and able to purchase.

Law of demand: when prices fall, quantity demanded rises (all other things equal)

Demand curve: Price on $y$ axis, Quantity Demanded on $x$ axis. Negative slope.

Demand shifts: translate the demand curve to the left or right.

• prices go up: increases to the right

  “increases the quantity demanded at a given price”

• prices go down: decreases to the left

  “decreases the quantity demanded at a given price”

causes of demand shifts:

• changes in income

  1. normal goods: as income rises, demand rises (all else equal)
  2. inferior goods: as income rises, demand falls (all else equal)

• prices of related goods

  1. substitutes

     increase in price of one: increase in demand for other

     [replaced]

  2. complements

     increase in price of one: decrease in demand for other

     [go together. complement too expensive. one’d rather not]

• change in taste

• change in expectations

  • expectation of income e.g.

• change in number of buyers

  more buyers, more demand.

Supply §

Quantity of a good that sellers are willing and able to sell

Law of supply: higher the price, higher the supply

Supply curve: Positive slope (Price vs Quantity)

Supply shifts: Increase in supply is rightward, Decrease in supply is leftward

If a firm is FACED WITH this potential price, how much output will it be able to and willing to sell?

• Expectations.
• Number of sellers

Market Equilibrium §

Equilibrium: a situation in which the market price has reached the level where the \textrm{quantity_{supplied}} = \textrm{quantity_{demanded}}.

if price > equilibrium:
 supply > demand
 supply - demand: surplus

else if price < equilibrium:
 demand > supply
 demand - supply: shortage

Pressure towards equilibrium. Market forces. Adjustment. Equilibrium.

Shifts:

• Demand curve moves right/left along the supply curve. Equilibrium price increases/decreases accordingly
• Supply curve moves right/left along the demand curve. Equilibrium price increases/decreases accordingly

When both shift, magnitude.

Elasticity and its applications §

Calculate and interpret elasticity coefficient

• how much behavior changes when one of the factors it depends on changes.

• “elasticity of demand”

  • income elasticity of demand
  • cross-price elasticity of demand

• price elasticity of supply

• what affects elasticity?

• how do we calculate elasticity?

• relationship between {demand,revenue} price elasticity

  understanding this allows making informed decisions about price

What is Elasticity? §

Elasticity: measure of the responsiveness of a quantity to a change in its determinants

Price elasticity of demand: a measure of how the quantity demanded responds to change in price

Inelastic: tough to ditch

Elastic: easy to ditch

Determinants of elasticity of demand:

• availability of close substitutes

  goods with close substitutes are usually more elastic

• necessity vs luxury

  necessities are less elastic (inelastic) than luxury items

• broadness of the market

  specific markets are more elastic than b r o a d markets

  e.g. ice cream vs food

• time horizon

  inelastic in the short term, but elastic in the long term

  easier to change habits over time

• Perfectly inelastic ($= 0$)

• Perfectly elastic ($= \infty$)

• Unit elastic ($= 1$)

• Inelastic demand ($> 1$)

• Elastic demand ($< 1$)

when inelastic demand, raise price to raise revenue

when elastic demand, raise quantity to raise revenue

Price elasticity of demand §

$\textrm{Price elasticity of demand} = \frac{\textrm{\% change in demand quantity}}{\textrm{\% change in price}}$

• Unitless

• Absolute values

Issue with this naive formula: elasticity from $A$ to $B$ is different from the elasticity from $B$ to $A$ according this formula. That’s false. Denominator is causing the trouble.

$\textrm{Price elasticity of demand} = \frac{\frac{Q_2 - Q_1}{(Q_1 + Q_2)/2}}{\frac{P_2 - P_1}{(P_1 + P_2)/2}}$

Midpoint method

Elasticity changes from region-to-region on the demand curve.

In the inelastic region:

• % change in quantity < % change in price
• raising price is stonks
• $\textrm{total revenue}\propto\textrm{price}$

In the elastic region:

• % change in quantity > % change in price
• raising price is not stonks
• $\textrm{total revenue}\propto\frac{1}{\textrm{price}}$

Unit elastic is neither inelastic nor elastic. $\textrm{total revenue} = \textrm{constant}$

Total revenue: $\textrm{price} \times \textrm{quantity}$

Constant slope but different elasticity? Elasticity depends on percentages. Different denominators.

Other demand factors §

• Income elasticity of demand

  $\textrm{IED} = \frac{\textrm{percent change in quantity}}{\textrm{percent change in income}}$

  Normal good: $\textrm{IED} > 0$ (num $+$ve when denom $+$ve)

  Inferior good: $\textrm{IED} < 0$ (num $-$ve when denom $+$ve)

• Cross-price elasticity of demand

  $\textrm{CPED} = \frac{\textrm{percent change in quantity demanded of }A}{\textrm{percent change in price of }B}$

  how the quantity demanded depends on the change in price of another (related) good

  Substitutes: $\textrm{CPED} > 0$ ($B$ gets more expensive: people substitute it with $A$, increasing $A$'s demand)

  Complements: $\textrm{CPED} < 0$ ($B$ gets more expensive: people substitute away from $A$ too, reducing $A$'s demand)

• …

Supply, demand, govt policies §

• How price ceilings|floors affect supply|demand
• How taxes affect supply|demand
• Who pays the taxes

Price ceiling §

Make something more affordable

Effective only when below the equilibrium price. Creates a shortage (demand > supply)

non-binding (above EP) vs binding (below EP)

short-run/long-run effects may differ.

• equilibrium price moves above or below the ceiling.
• or perhaps the magnitude of the shortage changes.

Price floors §

Goods market: households demand, firms supply

Labor market: firms demand, households supply

If minimum wage is above the equilibrium wage, unemployment (labor surplus)

Taxes §

Who pays? How much?

Cause change in behaviour.

Goods market §

tax on seller: leftward shift in supply curve: upward shift in prices, seller receives lower: tax wedge. passed-on from seller to buyer

tax on buyer: leftward shift in demand curve: lower prices. passed-on from buyer to seller.

$\textrm{tax} = \textrm{price}_{\textrm{buyers pay}} - \textrm{price}_{\textrm{sellers receive}}$

Labor market §

flipped: firms demand, households supply

$\textrm{tax} = \textrm{wage}_{\textrm{firms pay}} - \textrm{wage}_{\textrm{workers receive}}$

Always split regardless of who is taxed.

Tax incidence is the manner in which the burden of tax is shared among participants. Doesn’t depend on who is taxed.

Whoever has the (relatively) less elastic curve, pays more of the tax:

• same change in quantity for both
• price changes more (behavior changes less) for the relatively inelastic curve
• $\therefore$ it bears more of the tax burden

Whoever is more desperate pays more of the tax

Consumers, producers, and efficiency of markets §

consoooom product

wtf is market efficiency

Welfare economics §

welfare economics: study of how the allocation of resources affects economic well-being

maximize total surplus

consumer surplus: max willing to pay - actually pay

$\textrm{consumer surplus} \propto \frac{1}{\textrm{price}}$

producer surplus: amount received by sellers - cost to sellers

profit = producer surplus - fixed cost^[3]

$\textrm{producer surplus} \propto \textrm{price}$

peak stonks (maximum total surplus) when consumer surplus = producer surplus

total surplus: consumer surplus - producer surplus

value to buyers - cost to sellers

“value to the marginal buyer = cost to the marginal seller” s/marginal/next/g

social planners may care about more than just efficiency (i.e. equality). economists are cold number-crunchers tho

deadweight loss (DWL): [inefficiency]. surplus we lose that we do not get back as tax revenue.

some people who value the product more than its price aren’t in the market anymore because of the tax wedge. DWL region.

when a tax is levied, the more elastic the S/D curves:

• the larger the deadweight loss
• smaller the tax revenue

if the curves are more elastic, then it’ll be easier for people to move to a different market, so the deadweight loss will be greater, and because of that, the tax revenue will be smaller

—Alia

$\textrm{DWL} \propto \textrm{tax size}^2$

Tax revenue first increases, reaches a max, then decreases with increase in tax size.

Wellbeing through trade §

Exporter §

World price is higher than the domestic price.

Increase the price.

Consumer surplus decreases, producer surplus increases^[4].

supply - demand exported.

Importer §

World price is lower than the domestic price.

Reduce prices

Consumer surplus increases^[5], producer surplus decreases

demand - supply imported

In both cases, total surplus increases.

Tariff: tax on imported goods

After tariffs: producers 📈, but consumers 📉

tax revenue, deadweight loss.

Other benefits of trade §

• increased variety of goods
• lower production costs through economies of scale
• increased comprehension
• enhanced “flow of ideas”

Arguments for restricting trade §

• job loss

  lower prices, specialization.

  specialization also creates new jobs (but what ab. those who lost their jobs?)

• national security argument

  some industries important for defense. want to avoid hurting those domestic industries through heavy trade.

• infant industry argument

• unfair competition argument

  “free” trade. fairness.

Externalities, public goods, common resources §

effects of externalities, related policies, relation to different types of goods.

externalities: uncompensated impact of one’s actions on the well-being of a bystander. e.g. pollution.

• negative: discourage
• positive: encourage

producers don’t consider externalities in their decision.

public policy

• command & control: direct regulations
• market-based: provide incentives
  • corrective tax.
  • tax breaks

market forces don’t account for externalities. social cost may be higher than market cost (social optimum quantity less than the market optimum quantity). “invisible hand needs guidance”

“make the private market internalize the externality”

DWL becomes social benefit.

want the tax to equal the external cost.

Subsidies §

Tradable pollution permits §

When optimal level known.

Types of goods §

• excludable?

  a person can be excluded from using the good

• rival in consumption?

  one person’s use diminishes other people’s use

• Private

  rival, excludable

• Public

  non-rival, non-excludable

  e.g. national defense

• Common

  rival, non-excludable

  e.g. fish in the ocean

• Club

  non-rival, excludable

  e.g. golf course

Public goods and common resources §

public goods: usually related to positive externalities. people receive sth without paying for it.

common resources: associated with negative externalities. tragedy of the commons. sustainability issues.

role for govt. encourage/discourage behaviors with taxes/subsidies.

free rider problem with public goods. person who receives benefits of a good but avoid paying for it. social value > private value. taxes, subsidies.

public goods:

• national defense
• basic research. public knowledge.

common resources:

• clean environment

Coase theorem: as long as bargaining costs are low, property rights to one party will solve the externality problem (regardless of who has the property rights)L

in the absence of govt:

• public goods are underprovided
• common goods are overused

Costs of production §

Total revenue, cost, profit §

profits:

• revenues
• cost.

$\mathrm{profit} = \mathrm{revenue} - \mathrm{cost}$

costs:

• explicit
• implicit

accountants: only explicit cash flows.

economists: indirect opportunity costs too. about decision-making. include implicit costs.

economic profit: total revenue minus total cost. accounting profit: total revenue minus explicit cost.

Types of costs §

fixed costs: costs that don’t vary with quantity

variable costs: costs that vary with quantity

average variable cost rises midway due to diminishing marginal returns.

marginal cost: change in variable cost

• teamwork effect
• diminishing marginal returns

Average cost §

Efficient scale: intersection of ATC and MC

Rising marginal costs §

…because of diminishing returns. Size of increases gets smaller as quantity increases.

Cost curves §

Why is ATC U-shaped?

• AFC decreases as output increases
  • decreases rapidly at first and then slowly
• AVC usually increases as output increases.
  • increases slowly at first and then rapidly

at low Q, AFC is rel. high and AVC is rel. low

initially, ATC declines because AFC decreases faster than AVC increases

then, ATC increases because AVC increases faster than AFC decreases for higher Q

MC and ATC: if the MC at a point is above the ATC, that sale increases the ATC. if the MC is below the ATC, that sale decreases the ATC. where $MC = ATC$, efficient scale. MC intersects ATC at the minimum ATC.

teamwork effect $\rightarrow$ logistical constraints $\rightarrow$

Short-term vs long-term ATC §

Economies of scale LT ATC falls as quantity rises

Constant returns to scale LT ATC remains const as quantity rises

Diseconomies of scale LT ATC rises as quantity rises

Firms in competitive markets §

Meaning of competition §

competitive market: many buyers and sellers with identical products. so many, that nobody has undue effect on the price. free entry and exit. everyone is a price taker.

market pressures towards zero-loss, zero-profit.

temp assumption: identical operating costs

• many buyers many sellers
• identical products
• everyone is a price taker
• free entry and exit

price same regardless of quantity

$\textrm{average revenue} = \mathrm{price}$ (as long as there’s no price discrimination). not unique to competitive market

$\textrm{marginal revenue} = \textrm{price}$. unique to competitive market.

price always equal to avg revenue (unless we price discriminate)

unique to perfectly competitive markets:

• price same regardless of quantity
• marginal revenue equal to price
• $P = \mathrm{AR} = \mathrm{MC}$

Visualizing competition §

stop when marginal cost eq marginal revenue

in the short run: MC curve is the supply curve (shows quantity supplied for any price). competitive.

shutdown short-run decision to halt production temporarily due to current market conditions. sunk fixed costs

if revenue >= variable cost (short run):
 stay in the market
else if revenue < variable cost (short run):
 shut down

exit long-run decision to leave the market.

if revenue > total cost (long run):
 exit (can get rid of fixed costs)

sunk cost: cost that has already been committed and can’t be recovered.

Supply curves for firms §

Monopolies §

price order:

1. monopoly
2. oligopoly
3. monopolistic competition
4. perfect competition

What and how §

A monopoly is a firm that is the only seller of a product without close substitutes.

Barriers to entry for firms:

1. monopoly resources

   a key resource required for production is owned by a single firm

2. govt-created (regulations)

   govt gives a single firm exclusive rights. patents or copy rights. incentivize R&D.

3. natural monopoly (production process)

   one firm can supply at lower costs than two or more can.

   happens when there’s high fixed costs, low variable costs.

   larger the market, higher the demand, more lucrative.

Monopoly vs competition §

With an increase in output:

1. output effect: tends to increase TR

   revenue gained from the sale of additional units

2. price effect: tends to decrease TR

   decrease in the price of each unit due to the increased quantity

alt terminology for elasticity

if we want to sell one more unit, we have to lower the price. thus $MR < AR$.

no supply curve for monopolies

When a monopoly is a monopoly no longer §

MR flattens out, collapses into D.

$Q_{mono} < Q_{comp}$

$P_{mono} > P_{comp}$

monopoly: deadweight loss

Price discrimination §

price discrimination: selling the same good at different prices to different people

• rational strategy.
• need info
• can increase economic welfare
  • increases quantity sold
  • decreases deadweight loss

demand curve: marginal revenue curve

zero consumer surplus.

total surplus = profit.

some profit is better than no profit

e.g. movie tickets, airline prices, online advertising profiles, discount coupons, fin aid

Monopolistic competition §

Oligopoly: few sellers offering identical products

Monopolistic competition: many sellers offer differentiated products (similar, but not identical)

Monopolistic competition §

• many sellers
• product differentiation (unlike perf competition)
  • brand loyalty
  • power over price (not price takers)
    • increase/decrease depending on elasticity
  • downward-sloping demand curve
• free entry and exit

Curves §

Mono Comp: no in the long run. profit/loss possible in the short run.

• excess capacity. the perf comp firm produces at the efficient scale: ATC minimized. the mono comp firm produces at less than efficient scale. DWL.
• markup over MC. in perf comp, price = MC. in mono comp, price > MC.

Welfare §

“it’s complicated”

inefficient because Price > MC. regulation challenges:

1. too many firms
2. will have to offset firms’ losses with tax-funded subsidies
3. no profit motive: no incentive to lower costs

number of firms may not be ideal wrt societal welfare. firms only consider profits when entering, ignoring externalities:

• product variety externality

  +ve externality on consumers. consumer surplus

• business-stealing externality

  -ve externality on existing firms. they lose customers and profit.

inefficient. hard to measure, hard to fix.

Advertising §

is it worth it? or are we wasting resources?

• it’s psychological more than it’s informational

• may hurt competition

  makes d-curve more inelastic: more dwl

• can be informational

• may foster competition, reducing market power

• spending on ads, in itself, can be a signal of quality (?)

brand names:

• artificial differences
• “signal of quality”

Oligopolies §

oligopoly: a market structure in which few firms sell identical products

duopoly: two-firm oligopoly

• game theory: study of how people behave strategically

• collusion: agreement among firms about quantities to produce or prices to change

  not easy—incentive to cheat

• cartel: a group of firms acting in unison

at nash equilibrium nobody has any incentive to deviate

Game theory §

Prisoner’s dilemma

“incentive to cheat”

cooperation difficult

• good
• bad

Antitrust §

resale price maintenance

predatory pricing

tying: selling one product/service as a mandatory addition to another product/service

Consumer choice §

Affordance §

Budget constraint: limit on the consumption bundles a consumer can afford

Indifference curves §

Indifference curve: curve of consumption bundles that give the consumer the same level of satisfaction

Marginal rate of substitution: rate at which the consumer is willing to trade one good for another. slope of the indifference curve.

1. higher indiff curves > lower indiff curves

   higher total satisfaction

2. downward sloping

   one increase, other decrease. same level of satisfaction in total.

3. don’t cross

4. bowed inward

   diminishing marginal utility. MRS.

extremes:

• perfect substitutes: parallel diagonals

  e.g. $2x$ nickels | $x$ dimes

• perfect compliments: nested "L"s

  e.g. left shoe | right shoe

Consumer’s optimal choices §

at optimum point, budget constraint tangent to indifference curve.

$\mathrm{Slope} = \mathrm{MRS}$

$\frac{P_A}{P_B} = \frac{MU_A}{MU_B}$

$\frac{MU_A}{P_A} = \frac{MU_B}{P_B}$

• substitution effect moves along the indiff curve to a point with a new MRS
• income effect moves consumer to a new indiff curve

Labor vs leisure §

• leisure → utility
• labor → consumption → utility|survival

leisure is a normal good

wage increase:

• substt effect

  tends to decrease leisure. increase in labor supply

• income effect

  tends to increase leisure

GDP §

GDP and GNP §

GDP: market value of final goods, services produced within a country’s borders during a specified time period.

GDP per capita: GDP $\div$ population

GNP: GDP + domestically-owned factors located overseas $-$ foreign-owned located domestically

• we avoid double-counting by excluding intermediate goods and services

• excludes resold, used goods

• income approach

  $Y = W + R + I + PR$

  wages, rent, interest, profits respectively

• expenditure approach

  $Y = C + I + G + NX$

  consumption, investment, government purchases, net exports (exports $-$ imports)

  $NX = X - M$

GDP Components §

Consumption §

70% of US GDP apparently

consumption: spending by households on goods and services. doesn’t include new structures|home purchases

Investment §

Spending on:

• capital equipment — final. not destroyed upon production.
• inventories
• new structures (incl. household purchases)

when inventory is sold, consumption positive and inventory negative

diff. from intermediate goods.

Government §

government purchases: spending by local state and national governments

• salaries to public workers
• government goods
• public services

doesn’t include transfer payments e.g. health care, social security, …

Net Imports §

Exports minus imports

exports: spending on domestically produced products

imports: spending on foreign products by domestic residents

imports cancel out with part of purchased household goods

Shortcomings §

• doesn’t include household production

  goods and services people make for themselves

• doesn’t include the underground economy

• doesn’t account for leisure

• negative externalities

• crime and social problems

• inequality

Calculating GDP §

• nominal GDP: in terms of current prices

• real GDP: adjusted for inflation

  especially useful when comparing data across time

$\textrm{Nominal GDP} = \textrm{current prices} \times \textrm{current quantity}$

$\textrm{Real GDP} = \textrm{constant prices} \times \textrm{current quantity}$

GDP Deflator §

measure of price level. ratio of nominal gdp to real gdp.

$\textrm{GDP Deflator} = \frac{\textrm{Nominal GDP}}{\textrm{Real GDP}} \times 100$

$\textrm{Inflation Rate}_t = \frac{\Delta \textrm{GDP Deflator}}{\textrm{GDP Deflator}_{t-1}}$

CPI §

consumer price index.

Inflation: increase in the overall price levels

Core inflation: Inflation from CPI minus food, energy

$\textrm{CPI} = \frac{\textrm{current}}{\textrm{base}} \times 100$

Measuring the CPI §

1. fix the basket
2. find the prices
3. compute basket

Indexing §

indexing: increasing nominal quantity by an amount equal to % increase in some price index

$\textrm{RP} = \frac{\textrm{NP}}{\textrm{Income}}$

Shortcomings §

overstates inflation

• substitution bias

  people substitute away from goods when they get too expensive

• quality adjustment bias

  quality usually gets better over time.

• introduction of new goods

  CPI doesn’t allow for changes in baskets

Costs of inflation §

1. shoe leather costs

2. distortions in the tax system

3. unexpected redistribution of wealth

   $i = r + \pi_e \implies r = i - \pi$

4. noisy signal

Too much inflation §

Excessive money supply.

Money printer go brrr

Price level $\propto$ Money supply

Unemployment §

Defining measures §

$UR= \frac{U}{U+E} = \frac{U}{LF}$

$\frac{U}{UR} = \frac{E}{ER}$

$PR = \frac{LF}{WAP}$

Types of Unemployment §

• frictional unemployment

  job search process. meh

• structural unemployment

  mismatch between workers’ skills and firms’ requirements

  policy implications

Natural unemployment rate: “normal” rate of unemployment. long-term.

$\textrm{NR} = \textrm{Structural Rate} + \textrm{Frictional Rate}$

Cyclical unemployment rate

$\textrm{CR} = \textrm{Actual Rate} - \textrm{Natural Rate}$

• marginally attached
• discouraged workers

Shortcomings §

• marginally attached
• discouraged workers
• involuntar(il)y (just) part time workers
• chronically unemployed

Duration of unemployment §

• unemployment spells — usually short
• most people who are unemployed at any given moment are chronically unemployed

Costs of unemployment §

Direct §

• lost personal income
• eroded skills
• govt loses unemployment benefits, welfare money, tax revenue, …

Indirect §

• psychological costs

• social costs

  crime, homelessness, substance abuse, social tensions.

• political costs

… §

Evolving Standards of Living §

$y_t = y_0 (1 + g)^t$

Factors of Growth §

• physical capital
• human capital
  • education
  • health
• natural resources
• entrepreneurship
• social, legal framework
• technology

Neo-classical or Solow model §

$Y = Af(K,L,H,R)$

• $A$: total factor productivity
• $K$: physical capital, $L$: labor, $H$: human capital, $R$: natural resources

$y = \frac{Y}{pop} = \textrm{average labor productivity}\times PR$

participation rate problems:

• has an upper bound
• leisure good

$Y = AK^\alpha L^{1-\alpha}$, $0 < \alpha <1$

$y = Ak^\alpha$ ($pop \approx L$, $k=\frac{K}{L}$ capital-to-labour ratio)

Where does physical capital come from? §

$y = c + i$

money that’s left over after we consume (savings). used for investment.

$s = y - c = i$

$i = sy = sAk^\alpha$ ($s := $ savings rate)

$c = (1 - s)y = (1 - s)Ak^\alpha$

$\Delta k = i - (\eta + \delta )k$

$k_{ss} = \left[\frac{sA}{n+\delta}\right]^{\frac{1}{1 - \alpha}}$

$g_k = \frac{\Delta k}{k} = sAk^{\alpha - 1} - (n + \delta)$

Convergence §

will poorer countries catch up to richer ones?

• unconditional convergence

  (chad) yes.

• conditional convergence

  yes but iff they share “similar characteristics”—$s$, $A$, $n$, $\delta$ (from the $k_{ss}$ formula)

Savings and Investment §

NCO = Purchase of foreign assets by domestic residents - Purchase of domestic assets by foreign residents

Financial Systems Savings and Investment §

In a closed economy,

• $S = I$

• $S_N = Y - C - G = I$

• $S_N = (Y - C - T) + (T - G) = S_{\textrm{private}} + S_{\textrm{public}}$

$\begin{cases}\textrm{surplus} & S_{\textrm{public}} > 0 \\ \textrm{deficit} & S_{\textrm{public}} < 0\end{cases}$

In an open economy,

• $S_N = I + NX = I + NCO$

The “demand side” §

$UCC = P_k(r + \delta)$

Day 20 §

Shifting the curve §

Crowding out: government spending increases, decreasing public savings, decreasing national savings, shifting the (loanable funds) supply curve to the left, decreasing investment. increase in government spends crowds out private investment.

Day 21 IG §

Money §

• medium of exchange

• unit of account

• store of value

• commodity money — intrinsic value

• fiat money — no intrinsic value; govt decree

Money supply §

Money supply = currency held by public + deposits

Mechanisms for controlling money supply §

• open market purchasing/selling bonds
  • purchasing: expansionary. increases money supply.
  • selling: contractionary. decreases money supply.
• reserve requirements
  • decrease: increases money supply
  • increase: decreases money supply
• discount window lending
  • increase discount (interest) rate: decreases money supply
  • decrease discount (interest) rate: increases money supply

Purchasing Power Parity §

be like: a unit of any given currency should be able to buy the same goods in all countries.

real exchange rate = 1

$1 = e\frac{P_d}{P_f}$

$e = \frac{P_f}{P_d}$

Limitations:

• may be difficult/expensive to trade
• may not be perfect substitutes

Policy §

Business Cycles §

fluctuations in aggregate economic activity. recurrent, but not periodic.

Aggregate Demand §

$LRAS = Y = Af(K,L,H,R)$

$SRAS = Y = Y^* + a(P - P_E)$

1. wealth effect
2. interest rate effect
3. exchange rate effect

Government Policies §

accommodating monetary policy, e.g. open market purchasing of bonds

$GM = \frac{1}{1 - MPC}$

Corporate tax cuts §

$TM = \frac{MPC}{1 - MPC}$