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Macroeconomics

Chapter 1
Economics is the study of choices that arise from scarcity. Without scarcity, there are no choices.
Economics is the study of how individuals and organizations allocate scarce resources among alternate uses to satisfy unlimited human needs Microeconomics: individual decision making households, firms, markets, resource allocation Macroeconomics: aggregate economic variables, GDP, unemployment, inflation, money supply, interest rates, exchange rates, balance of payments The Methodology of Economics: How do economists study the world? Model-building Complex reality simple model Economic decisions are made with the purpose of making the decision maker better off Economic goods goods that are scarce and have a positive price price > 0 Free goods goods that are abundant and have zero price price = 0 Land the physical topography used for production that includes not only the real estate where businesses are located, but also all of the timber, mineral, fossil fuel and other resources that are extracted from the land and utilized in production Labor the time and physical and mental efforts spent by humans in the production process Capital includes the physical objects that are actually used for production Entrepreneurship the willingness to take risks to combine resources in new ways, to invent original products, to find new ways of manufacturing old products or to combine old products in new ways

Inputs resources (labor, land, capital entrepreneurship) Use of resources in production

production process

Outputs products (goods and services)

Complex Reality Assumptions Simple Model Positive analysis concerned with what is Normative analysis concerned with what ought to be, involves statements of opinion Positive statements just descriptions of fact

Resource
Land (natural resources) Labor (physical and human effort) Capital (physical, ie machines)

Return
Rent (economic) Wage (health care, salaries, etc) Interest

recognize a problem

make assumptions

build a model

make predictions

test the model

The scientific method

Chapter 2
Opportunity cost the benefit foregone from not choosing the next best alternative Production Possibility Curve (ppc) a model that shows the maximum combinations of two goods that can be produced, given a certain quantity of resources and state of technology The Law of Increasing Cost as production of a good is increased, the opportunity cost of additional units of that good will also increase The Principle of Comparative Advantage each party to a trade should specialize in the production of that good in which is it relatively more efficient (or has a lower opportunity cost) Corollary mutual benefits arise from specialization and trade Absolute advantage when one party has a lower resource cost than another Comparative advantage when one party has a lower opportunity cost than another Terms of trade the rate at which both parties would be willing to make a trade. The terms of trade depend on opportunity costs PPC: Production Possibilities Curve shows all of the combinations that can be produced without trade, or if a party is self-sufficient and only consumes what it produces on its own CPC: Consumption Possibilities Curve shows all of the combinations that can be consumed through trade Free trade is an absence of trade barriers such as tariffs or quotas Tariffs are taxes on imports, while quotas are restrictions on the quantities of imports from a country

Fair trade is trade between countries with a goal of social and economic justice

Chapter 3
The demand side of a market shows how much consumers are willing and able to purchase at different prices. It is based on consumer preferences and income. The supply side of a market reflects how much producers are willing to supple at different prices. It is based on business expectations, technology and costs. Market is a collection of buyers and sellers where exchange takes place. Markets have three characteristics: 1. Time period 2. Geographic space 3. Product space Resource allocation mechanisms include: 1. Government edict let the government determine the criteria for distribution 2. Lottery a random allocation mechanism could be used, such as pulling names from a hat or assigning random numbers 3. First come, first served the first on line gets the resource 4. Markets resources are allocated to the highest bidder Demand is the relationship between the prices of a good or service and the quantity purchased in the market at those prices. It describes the quantity that consumers are willing and able to purchase at different prices. The demand curve is a model that shows the relationship between price and quantity demanded. Describes the behavior of consumers in a market. It can be represented by a graph, table or equation. The demand curve is downward sloping. How much are consumers willing and able to purchase at different price levels? Quantity demanded is a particular point on the demand curve. It shows the quantity that consumers are willing and able to purchase at a given price Ceteris paribus is a Latin phrase for everything else held constant (as to not interfere with supply and demand) On a demand curve, the price of the good (P) goes on the vertical axis and the quantity of the good (Q) on the horizontal axis

An increase in demand may be caused by:


1. 2. 3. 4. 5. 6. 7. An increase in the price of a substitute A decrease in the price of a complement An increase in income if the good is normal A decrease in income if the good is inferior An increase in tastes An increase in expectations An increase in population

Any of these changes will cause an increase/rightward shift of the demand curve. (if the supply curve is upward-sloping, then an increase in demand leads to increases in both price and quantity) Supply is the relationship between the prices of a good or service and the quantity produced and offered for sale in the market at those prices. It describes the quantity that suppliers are willing and able to produce at different prices. Supply curve is a model that shows the relationship between price and quantity supplied. Describes the behavior of producers in a market. It can be represented by a graph, table or equation. Since there is a positive relationship between price and quantity supplied, the supply curve is upward sloping. How much are producers willing and able to sell at different prices? Quantity supplied is a particular point on the supply curve. It shows the quantity that producers are willing and able to supply at a given price.

An increase in supply may be caused by:


1. 2. 3. 4. 5. A decline in resource prices An increase in technology An increase in business expectations An increase in the number of firms A decrease in the prices of related goods

Equilibrium is a situation that will tend to persist over time Prices might be too high or low at first but will eventually settle at equilibrium If the price is too high, then a surplus will exist in the market. If a price is too low, then a shortage in the market will exist. Once the market reaches equilibrium, there is no reason for the price to change, unless there is a change in demand, a change in supply or government intervention in the market. A market will tend to stay at equilibrium unless there are changes in either demand or supply or both. If either of them shift, the market will eventually adjust to the new equilibrium. Lessons: 1. Law of demand there is an inverse relationship between the price of a good and the quantity demanded of that good, ceteris paribus 2. Equilibrium occurs at the intersection of the supply and demand curves 3. Markets allocate resources to their most valuable uses 4. Markets are efficient regardless of the distribution of income (efficiency v. equity)

Chapter 4
How markets work Markets respond to changes in consumer preferences (if consumers want to purchase more of a product demand increases leads to increase in the price of the good suppliers can earn more revenue which signals firms to increase output in order to increase profits Resource allocation in markets, prices and profits act as signals to firms to guide resources to their most valuable uses. Firms will produce more in markets where prices and profits are increasing and less in markets where prices and profits are declining. Resources shift from markets where profits are declining to markets where profits are increasing. Consumer sovereignty markets respond to changes in consumer preferences. Markets are relentless in giving consumers what they want The market provides more effective incentives than government regulation does o The power of consumers in markets is often underestimated. Social change rarely comes without the exercise of consumer power (boycotts, etc) Adam Smith Wrote The Wealth of Nations in 1776. Was interested in the struggle between altruism and self-interest o Self-interest: Smith believed that a society would be more productive if individuals pursued their own self-interest rather than looking out for the welfare of others. If people are free to choose their own occupations, then they will chose where they can earn the most money and contribute the most to the economy (absolute advantage they will choose the occupation where they are better off) o Invisible Hand: individuals that have economic freedom to pursue their own selfinterest and trade with each other in free markets will produce more and result in a wealthier society Laissez-faire the government should have the economy, markets and individuals alone to increase the wealth of the nation o Division of labor/specialization: if production tasks were divided up, and individuals were allowed to specialize in these tasks, then production would be greatly increased Economic and Political Freedoms Thomas Jefferson political freedom Adam Smith economic freedom o Ideas of John Locke and Thomas Hobbes (early philosophers, natural rights and social contracts) Both political and economic freedom is dependent on one another o I.e.: You cannot find your best occupation if you do not have the freedom to choose where to live. You must have the freedom to provide for yourself economically before you can enjoy your political freedoms. Four Basic Economic Questions What and how much to produce? Any economic system must choose a point on its PPC How to produce? must determine the optimal mix of resources in production For whom to produce? must determine the distribution of income, who gets what in the economy When to consume? must determine the rate at which resources are used up Types of Economic Systems Traditional Economies: economic decisions are based on custom or what was done in the past. Disadvantage: lack of technological progress Advantage: stability

Command and control (centrally planned): Economic decisions are made by government bureaucrats Disadvantage: lack of personal freedom and inefficiency, planners lack information/insight (impossible to gather enough information to make efficient choices) Advantages: personal security, everyone gets a place to live, food, job. The government directs resources in the manner they deem best Capitalism (market economy): capital is privately owned rather than owned by the state or government. Can lead to the efficient allocation of resources, economic freedom, specialization and division of labor. Economic decisions are decentralized and based on price Disadvantage: lack of equity no guarantee that everyone will have enough means Advantage: efficiency and personal freedom Centrally planned economics v. market economies = equity v. efficiency Why Government? Without government to create the conditions needed for the existence of markets, markets could not function effectively. There are situations where markets can fail to allocate resources efficiently for some reason or another. These cases are collectively known as market failure. At the same time there may be many examples of government failure. Relying on government may be no better than using markets to solve social problems Necessary Conditions for the Existence of Markets In the absence of these conditions, markets do not have the ability to allocate resources effectively, function effectively or even exist. 1. Establishing property rights Markets cannot function without the ability to assign and transfer property rights. Property rights provide the incentives necessary to produce and consume. Property rights allow the producers to sell the good and transfer the property right with it. Without a property right, the consumer cannot determine how the good is disposed as. If you cannot control how the good is used, then there is no reason for production and consumption to occur. 2. Maintaining law and order Producers and consumers must feel safe in making decisions and carrying out their activities. It also applies to the nation as a whole. A nation must be able to protect itself from foreign aggression. Law and order also promotes political stability. If a nation has a stable political system, it will attract more economic growth. 3. Enforcing contracts Contracts help to increase certainty in markets and they also allow for the process of lending and borrowing. Contracts are also an important feature of legal markets. These three conditions provide a minimal rationale for government intervention in the economy. Even the most conservative ideologues would agree that government intervention is necessary in these areas so that markets can function effectively. A basic purpose of government is to provide these necessary conditions for markets to exist. Market Failure Public finance is a field of economics that examines how economic principles can be applied to political decision-making. Market failure occurs when a market fails to allocate resources efficiently. When markets fail, government intervention may be justified. 1. Monopoly Power

A monopoly is a market that consists of only one firm. Monopoly power is when a firm has control over the market price, which is detrimental to markets (less people will purchase the good) 2. Information asymmetries In some markets, one party to a trade has more information about the product (buyer v. seller) o Adverse selection occurs before a transaction, when the costliest customers are those most likely to seek a good or service o Moral hazard occurs after a transaction, when the costs of an action can be transferred to third parties so incentives are charged (driving rental cars more recklessly, visiting doctors more often w/ health insurance) 3. Externalities Cost or benefits that accrue to individuals not directly involved in the transaction Externalities can be either negative or positive (air pollution v. education benefits) An important government remedy for positive externalities is subsidies (tax cuts for renewable energy, 4. Public goods National defense, roads and bridges, public parks, police and fire protection (money comes from taxes) o Public Good a good that is non-rival in consumption (ones consumption does not detract from anothers consumption) and non-excludable (once a good is provided, it is provided to everyone and it is impossible to exclude an individual from consuming that good) o Free rider problem since public goods are non-excludable, individuals can consume a public good once it is provided without having to pay for that good 5. Equity There is nothing to guarantee that a private market economy will provide an equitable distribution of income. The government can help to supplement income so that the poor can participate and survive in a market economy 6. Macroeconomic ability A market economy may not lead to stable rates of growth with low rates of inflation and unemployment the government can use its economic policy tools to help promote and sustain a stable economy (occurs when the market fails to allocate resources efficiently or fails in meeting some other social good such as equity and stability Government Failure The government may be no better than markets in allocating resources efficiently 1. Political influence Political decisions tend to favor producers over consumers (wealthier dominate) 2. Price floors and price ceilings (price controls) The government use price controls to prevent the markets from rationing the available supply of the good among demanders in that market o Price Floor occurs when the government sets a minimum price above the equilibrium price = Surplus o Price ceiling occurs when the government sets a price below the equilibrium price = Shortage 3. Taxes Excise tax on producers

o Excise Tax tax per unit Decrease in 4. Majority rule voting paradox Majority rule may not always provide consistent decision making 5. Myopic viewpoint Short-sightedness Assume politicians seek to 3maximize their chances of getting re-elected 6. Illegal markets

Chapter 5
Macroeconomics is the study of the relationships between aggregate economic variables and the choices made by policy makers to influence those variables (output, inflation, unemployment, the international economy, the monetary system) Output Inflation The most important measure of output in the economy is Gross Domestic Product Business cycle the tendency of the GDP to fluctuate around a trend Nominal GDP output produced within a country using current prices Real GDP output produced within a country using constant (base year) prices Gross National Product output produced by a nations resources around the world

Inflation a sustained increase in the average level of prices in an economy over time A decrease in the value (or purchasing power) of money Bureau of Economic Analysis (BEA) publishes the GDP Price Deflator (measures the change in prices of all goods and services included in consumption spending) Bureau of Labor Statistics (BLS) provides two measures of inflation Consumer Price Index (CPI) retail prices in households Producer Price Index (PPI) wholesale prices received by producers Unemployment The unemployment rate is a measure of the percentage of the labor force that is actively seeking but not finding work number actively seeking but not finding work x 100 number in labor force The unemployment rate may underestimate It is calculated using a house-hold Current Population Survey (telephone) Ignores those underemployed Ignores discouraged workers The International Economy The Balance of Payments is the record of a countrys flows of goods, services, income, gifts, capital and financial assets with the rest of the world The Current Account is a subset of the Balance of Payments that is used to measure a countrys trade deficit or surplus. It measures the flows of goods, services, gifts and income with the rest of the world. Positive = surplus, negative = deficit The Balance of Trade is a countrys position in the current account. The country has a trade deficit if its balance of trade is negative, so that imports and income payments are greater than exports and income receipts. On the other hand, if the balance of trade is positive, then the country is experiencing a trade surplus

Exchange rate is the value of one countrys currency in terms of another countrys currency. Currency is traded in currency markets or foreign exchange markets, which exist in the largest banks in major cities around the world The Monetary System Interest rate the price of money, or the cost of borrowing funds and the benefit of lending funds Money supply the quantity of money in circulation at a given point of time. The rate of change in the money supply is an important determinant of several economic variables Macroeconomic Policy Goals The three major macroeconomic policy goals are: A stable rate of GDP growth High employment (or low unemployment) A stable price level (or low inflation) To achieve these goals the federal government possesses two important policy tools, fiscal and monetary policy Fiscal Policy A change in government spending or taxes to influence a macroeconomic variable, such as GDP inflation. It is a tool used by the administration used to increase disposable income and consumption spending in the economy Monetary Policy Is a change in the money supply or interest rates to influence a macroeconomic variable. Monetary policy is exercised by the Federal Reserve System (Fed) Gross Domestic Product