Economics PDF

Topics in Demand And Supply Analysis
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LOS a Elasticities of demand

Price elasticity Sensitivity of quantity demanded to change in price
Income elasticity Sensitivity of quantity demanded to change in income
Cross price elasticity Sensitivity of quantity demanded to change in price of
related goods (compliment or substitute)
Price Income Cross price

elasticity elasticity elasticity
% ∆ in Qd % ∆ in Qd % ∆ in Qd
Pe = Ie = Pe =
% ∆ in P % ∆ in I % ∆ in Py
Pe > 1 = Demand is elastic Ie = +ve: Good is a normal good Pe = +ve: Good is substitute
Pe < 1 = Demand is inelastic Ie = −ve: Good is an inferior good Pe = −ve: Good is complement
Price
High Pe
e
Pe is close to 1
re
Low Pe
Quantity
Demand curve
nT
LOS b & c Substitution and income effects
Particulars Substitution effect Income effect
Normal good (P È 10%) Ç Qd 10% Ç Qd 10%
Inferior but not Giffen good (P È 10%) Ç Qd 10% È Qd 5%

Fi
Inferior and Giffen good (P È 10%) Ç Qd 10% È Qd 15%
Every Giffen good is an inferior good but every inferior good is not a Giffen good
For Giffen goods, income effect is more dominant than substitution effect
Veblen Good - Higher price makes goods more desirable

Eg. Louis Vuitton bag
May have a positively sloped demand curve

LOS d Diminishing marginal returns
Marginal returns refer to the additional output produced by using one more
unit of labor or capital while keeping the other constant
Total output
Marginal
product Marginal
decreasing product
negative
Marginal
product
increasing
Inputs beyond this quantity are said to

produce diminishing marginal returns
Quantity
of labor
LOS e Breakeven and shutdown points of production
Perfect Monopolistic
Monopoly Oligopoly
competition competition
e Imperfect
competition
re
Breakeven quantity - Breakeven quantity -
P = ATC, TR = TC TR = TC
In short run shutdown if, In short run shutdown if,

P < AVC TR < TVC, P < AVC
In long run shutdown if, In long run shutdown if,

nT
P < ATC TR < TC, P < ATC
ª P = Price
ª ATC = Average total cost
ª TR = Total revenue
ª TC = Total cost
ª AVC = Average variable cost
Fi
Cost
Marginal
cost curve
ATC curve
AVC curve
AFC curve
Quantity
LOS f Economies and diseconomies of scale
Quantity VC per unit TVC TFC TC MC

1 10 10 100 110 -
2 9 18 100 118 8
Economies of scale
3 8 24 100 124 6
4 7 28 100 128 4
5 8 40 100 140 12
Diseconomies of scale
6 9 54 100 154 14
7 10 70 100 170 16
Price
Short run
ATC curves
Long run
ATC curve
Economies of scale
e Diseconomies of scale
re
Quantity
Constant returns
to scale
nT
Long run ATC curve shows minimum ATC for each level of output
assuming that scale of the firm can be adjusted
Fi
The Firm And Market Structures
LOS a Characteristics of different markets
Characteristics Perfect Monopolistic Oligopoly Monopoly

competition competition
No. of sellers Many Many Few One
Product
Homogeneous Differentiated Homogeneous Unique
differentiation
Barriers to entry Very low Low High Very high
Pricing power of Some or

None Some Considerable
firm considerable
Advertising + Advertising +
Non price None Advertising
Product Product
competition
differentiation differentiation
LOS b Relationships between P, MR, MC, economic

profit and Pe under different market structures
Perfect
competition
Monopolistic
competition e Monopoly Oligopoly
re
In equilibrium,
In equilibrium,
In equilibrium, In equilibrium,
P > MR = MC
Pe > 1 P > MR = MC
P = MR = MC =ATC P > MR = MC
Pe > 1
Pe - Perfectly elastic Pe > 1
Economic profit -
+ve in long run Economic profit -
nT
Economic profit = 0 Economic profit = 0

+ve in long run
Profits may be zero
LOS c Firm’s supply function (Perfect competition)
Cost Cost Short run

Marginal market supply
cost curve curve
Fi
ATC curve
AVC curve
D = MR
Quantity Quantity
In the short run, MC curve is above AVC curve
In the long run, supply curve MC is above ATC curve
There is no well defined supply curve for other markets
Price
Marginal
cost curve
Demand
P1
curve MR = P × )1 − P1 )
e
Marginal
revenue curve
Quantity
Q1
Under monopolistic competition, oligopoly and monopoly, equilibrium

quantity is determined by the intersection of MC and MR
LOS d Optimal price and output for firms

Firms maximize profits by producing the quantity where MC = MR
In perfect competition P = MR
In monopolistic competition and monopoly, price is the intersection of

demand curve and profit maximizing quantity of output
LOS e Factors affecting long-run equilibrium under each market structure
e
An increase in demand will increase economic profits in the short run under all market structures
+ve economic profits result in entry of firms into the industry (except oligopoly and monopoly)
re
−ve economic profits result in exit of firms
When firms enter an industry, market supply increases, which causes decrease in market price
and an increase in equilibrium quantity
nT
Pricing strategies in oligopoly

1 Kinked demand curve
Price More elastic
Kink
Fi
Less elastic
Quantity
Increase in a firm’s product price will not be followed by its competitors, but a decrease in price will
Kink is the price above which the demand is elastic and below which the demand is inelastic
2 Cournot model
Considers a duopoly i.e. two firms with identical and constant marginal cost of production
Price -
Perfect Monopoly
competition
Quantity -
Monopoly Perfect
competition
3 Nash equilibrium
Nash equilibrium is reached when the choices of all firms are such that there
is no other choice that makes any firm better off. Eg. prisoner’s dilemma
A - Low price: 500 A - High price: 300

Firms - A & B
B - Low price: 500 B - Low price: 1300
Choices:
High price
A - Low price: 1400 A - High price: 1000
Low price
B - High price: 100
4
eB - High price: 700
re
Dominant firm model
One firm has significantly large market share because of its greater scale and lower cost
structure (Dominant firm)
Market price is determined by the dominant firm and other firms take this price as given
Firm’s decisions are interdependent

nT
If there is a price war, then dominant firm’s market share Ç
If there is no price war, then over time dominant firm’s market share È
Natural monopoly - Single firm supplying the entire market demand for the product
Fi
LOS f Pricing strategies
Firms under any market maximize profits by producing the quantity where MC = MR
In perfect competition P = MR = AR =MC = ATC
In monopolistic competition, oligopoly and monopoly, price is the intersection of

demand curve and profit maximizing quantity of output
Pricing strategies under oligopoly - Kinked demand curve, Cournot model, Nash
equilibrium, dominant firm model
LOS g N-firm concentration Herfindahl-

ratio Hirschman Index
Eg. N = 4 Eg. N = 4
Add up the market share of 4 largest Add up the square of market shares of
companies in the industry 4 largest companies in the industry
It captures the merger effect
Limitations :
Œ Does not comment on pricing power Limitations :
Does not capture the merger effect Œ Does not comment on pricing power
Both the ratios are used to measure the degree of monopoly or market power of a firm
None of the ratios consider barriers to entry
LOS h Identifying the market structure in which firm operates
Œ Examine no. of firms in the industry, check if products are homogeneous or differentiated,
see barriers to entry/exit and check if there is any non price competition
Compare these with the characteristics that define each market structure
e
re
nT
Fi
Aggregate Output, Prices And Economic Growth
LOS a GDP using expenditure and income approach

ª Gross domestic product (GDP) is the total market value of final goods and
services produced within a country during a certain time period
ª It is most widely used measure of the size of a nation’s economy
ª It includes only purchases of newly produced goods and services
ª Sale or resale of goods produced in previous periods is excluded
ª Goods and services provided by government are included in GDP (valued at cost)
ª Value of owner-occupied housing is also included in GDP (value is estimated)
Expenditure approach - Total amount spent on goods and services produced

during the period
Calculated as;
Consumption (C) + Investment (I) + Government
expenditure (G) + [Exports − Imports] (X − M)
Income approach - Total income earned by households and companies
e
during the period
Calculated as;
Consumption (C) + Savings (S) + Taxes (T)
re
LOS b Expenditure approach
Sum of value Value of final

added output
nT
GDP is calculated by adding GDP is calculated using only

the value created at each the final value of good and
stage of production services
LOS c
Fi
Nominal GDP Real GDP
Output - Current year Output - Current year

Prices - Current year Prices - Base year
Nominal GDP
GDP deflator - Real GDP
× 100
LOS d National income - Compensation to employees
+ Corporate and govt. profits before tax
+ Non corporate business income
+ Rent
+ Interest
+ (Indirect taxes − Subsidies)
Personal income - National income

+ Transfer payments by govt.
− Corporate and indirect taxes
− Undistributed corporate profits
Personal disposable income - Personal income

− Personal taxes
GDP under income approach can also be calculated as :
National Capital consumption Statistical

+ +
income allowance discrepancy
Depreciation of Adjustment for difference
e
physical capital between GDP under
income and expenditure
approach
re
LOS e Fundamental relationship among C, S, T, I, G and (X − M)
Total income must equal total expenditures

GDP under income approach = GDP under expenditure approach
C + S + T = C + I + G + (X − M)
S = I + (G − T) + (X − M)
nT
Fiscal Trade
deficit surplus
(G − T) = (S − I) + (M − X)
Fiscal deficit must be financed by
some combination of trade deficit or
Fi
excess of savings over investment

LOS f IS and LM curves
IS - Investment and Savings
LM - Liquidity and Money supply
Real interest Real interest

rate (r) rate (r)
Real Real
income income
Œ +ve relation
Assumption -
r and (S − I)
Real money
supply is
−ve relation
constant
y and (S − I)
Therefore,
−ve relation b/w
r and y
(S − I) = (G − T) + (X − M) eŸ y Ç = Precautionary & transaction demand Ç

Ÿ Demand for money Ç = Cost of money Ç
re
y Ç Fiscal deficit & Trade surplus È = (S −I) È
Ÿ rÇ=yÇ
Aggregate demand curve

Real interest
rate (r) LM2 Price Real money supply -
nT
‘Constant’
IS LM1 P Ç = MS/P È
If MS/P È then, LM curve

shifts to the left (increases
real interest rate)
IS curve - −ve relation (r & y)

LM curve - +ve relation (r & y)
Fi
Output Output
(y) (y) Aggregate demand curve -
−ve relation (p & y)
ª Marginal propensity to save (MPS) - Proportion of additional income that is saved
ª Marginal propensity to consume (MPC) - Proportion of additional income spent on consumption
ª MPS + MPC = 100%

LOS g Aggregate supply curve
Price
LRAS
SRAS
VSRAS
Potential GDP
è VSRAS - Firms adjust output without changing price. VSRAS curve is perfectly elastic
è SRAS - When prices increase, input costs (such as wages) do not increase as they
are fixed in the short run
è LRAS - All input prices are variable in the long run. LRAS curve is perfectly inelastic
and it shows the level of potential GDP
è Price level has no long run effect on aggregate supply
LOS h Causes of movements along and shifts in aggregate

demand and supply curves
Price
e Price
re
P2
P1
Output Output
Q2 Q1
nT
Movement along the curve Shift in curve

Reasons : Reasons
Change in price (all other
factors keeping constant)
Aggregate demand curve Aggregate supply curve
ª Increase in consumers’
Fi
wealth
ª Optimistic business ª Increase in productivity
expectations ª Increase in supply and
ª High future income quality of labor
expectation by consumer ª Increase in supply of
ª High capacity utilization natural resources
ª Expansionary monetary ª Increase in the stock of
policy physical capital
ª Expansionary fiscal policy ª Technology improvement
ª Home currency ª Currency appreciation
depreciation
ª Global economic growth
LOS i, j & k
Short-run effects of changes in aggregate demand and supply
Type of change Real GDP Unemployment Price level
Ç Aggregate demand Ç È Ç
È Aggregate demand È Ç È
Ç Aggregate supply Ç È È
È Aggregate supply È Ç Ç
Price Price Price Price
P1 P1
P0 P0 P0
P0
P1 P1
Output Output Output Output

Q0 Q1 Q1 Q0 Q1 Q0 Q1 Q0
Recessionary gap Potential GDP > Real GDP

Inflationary gap Real GDP > Potential GDP
e
Stagflation High inflation combined with slow economic growth
and high level of unemployment
re
LOS l Short-run effects of shifts in both aggregate demand and supply
Aggregate Aggregate Real GDP Price level

demand supply
Ç Ç Ç Ç Or È
È È È Ç Or È
nT
Ç È Ç Or È Ç
È Ç Ç Or È È
LOS m Sources of Sustainability of

economic growth economic growth
Fi
ª Labor supply
ª Rate of increase in
ª Human capital
the labor force
ª Physical capital stock
ª Rate of increase in
ª Technology
labor productivity
ª Natural resources
LOS n & o Production function
Describes relationship between output and labor, capital and total factor productivity
Total factor productivity (TFP) - It is a multiplier that quantifies the amount of output
growth that cannot be explained by the increases in labor and capital. Increase in total
factor productivity can be attributed to advances in technology
∆Y = TFP + α × ∆K + (1 − α) × ∆L
Residual income Growth of

that explains capital
the effect of
technology
Growth Share of growth Growth of labor

in GDP explained by the
capital
Growth in potential GDP Growth in per capita potential GDP
Growth in technology Growth in technology

+ WL (Growth in labor) + WC (Growth in capital)
+ WC (Growth in capital)
e
Above model is on neoclassical economics
re
nT
Fi
Understanding Business Cycles
LOS a Business cycle and its phases
Real GDP
Trend
Cycle
ak gh
Pe ou
Contraction Tr
sion
Expan
Time
ª Expansion - Increase in output, employment, consumer spending, business investment and inflation
ª Contraction - Decrease in output, employment, consumer spending, business investment and inflation
ª Peak - Inventory/sales ratio is highest
ª Trough - Inventory/sales ratio is lowest
e
ª Business cycles recur but not at regular intervals
ª Beginning of expansion/contraction - 2 consecutive quarters of growth/decline in real GDP

re
LOS b Fluctuations in sector as economy moves through the business cycle
ª Firms are slow in laying off employees in early contraction period
ª Firms are slow in hiring employees in early expansion period
ª Housing activity decreases if home prices rise faster than income

nT
ª Firms use their physical capital more intensively during expansion and
less intensively during contraction
ª Imports increase during expansion

ª Exports increase during contraction
LOS c Theories of the business cycle

Fi
Classical economics
GDP Ç
Economy Subsistence
neutral stay Wages Ç
Population
Wages È
explosion
Supply
Ç
(labor)
Neoclassical school
Economists believe that shifts in ADC and ASC are
caused by changes in technology
They also believe business cycles are temporary
Keynesian school
Economists believe that shifts in aggregate demand are due to changes in
expectations
Keynesian economists believe that wages are downward sloping
Policy prescription - Increase aggregate demand directly, through

monetary policy or fiscal policy
New Keynesian school

Adds the assertion that inputs as well as wages are sticky
Monetarist school
Business cycles are caused by inappropriate decisions by the monetary authorities
They suggest, the central bank should follow a policy of steady and predictable
e
increases in money supply
Austrian school
re
They believe that business cycles are caused by government intervention
New classical school
These economists introduced real business cycle theory (RBC)
RBC emphasizes the effect of real economic variables such as change in technology
nT
and external shocks
RBC holds that policymakers should not intervene in business cycles
LOS d Types of unemployment
Frictional Structural Cyclical

Fi
Caused by changes in
Caused by long-run
general level of economic
Time taken by employees changes in the economy
activity
to find the jobs that fit
them Workers lack requisite
+ve in contraction & −ve
skills
in expansion
Labor force = Workers employed + workers unemployed
Workers unemployed
Unemployment rate =
Labor force
Underemployed worker - Worker employed at a low paying job despite being qualified
Labor force
Activity ratio/Labor force participation ratio =
Working age population
Discouraged worker - Workers who are not actively seeking work. They are not
considered as a part of unemployed workers and therefore not a part of labor force
LOS e Inflation, hyperinflation, disinflation and deflation

10% 13.36% 20%
Inflation - 100 110 125 150
10% 6.36% 5.98%

Disinflation - 100 110 117 124
Deflation - 100 90 80 70
ª Hyperinflation - Inflation that accelerates out of control
ª To consider a situation of rising prices as inflation, the prices of almost all goods should rise
LOS f
e
ª Inflation erodes the purchasing power of currency
ª Inflation favors borrowers at the expense of lenders
Construction of indices used to measure inflation

re
Cost of basket at current prices
Consumer price index (CPI) - x 100
Cost of basket at base prices
ª Weights assigned to each good and service in CPI basket can differ significantly across
countries and regions
ª Headline inflation - Price indexes for all goods

nT
ª Core inflation - Price indexes that exclude food and energy (because their prices are volatile)
LOS g Inflation measures
Laspeyres price index Paasche price index Fisher price index

Fi
Quantity - Quantity -
Base year Current year
Price - Price - It is geometric

Base year Base year mean of a LPI
and PPI
LPI : PPI :
P1 × Q 0 P1 × Q 1
× 100 × 100
P0 × Q 0 P0 × Q 1
Hedonic pricing is used to measure the upward bias present

LOS h Cost-push inflation Demand-pull inflation

Caused by increase in
aggregate demand
Aka wage pushed inflation
Increases price level and
Caused by decrease in temporarily increase real GDP
aggregate supply above nominal GDP
Initially decreases GDP Central bank can try to bring
economy back to potential GDP
LOS i Economic indicators
Leading Coincident Lagging
Manufacturers’ new orders for

consumer goods and materials
Inventory-sales ratio
Manufacturers’ new orders for
non-defense capital goods ex-
aircraft
Building permits e
Real personal income
Index of industrial production

Labor cost per output
Average prime lending rate
Change in consumer price

re
S&P 500 equity price index Manufacturing and trade sales index
10-year T-bonds less federal Average duration of

funds unemployment
Consumer expectations
nT
Fi
Monetary And Fiscal Policy
LOS a Fiscal policy Monetary policy

Undertaken by country’s central
Undertaken by government bank
Budget surplus = (T − G) > 0 Expansionary (accommodative) -

When the central bank increases
Budget deficit = (G − T) < 0 the quantity of money and credit
Can also be used as a tool for Contractionary (restrictive) -

redistribution of income and When the central bank reduces
wealth the quantity of money and credit
LOS b Functions and definitions of money

ª Money - Generally accepted medium of exchange
ª Primary functions -
Ÿ Serves as a medium of exchange
Ÿ Serves as a unit of account
Ÿ Provides store of value
LOS c
e
ª Narrow money = Currency and coins in circulation + Balances in checkable bank deposits
ª Broad money = Narrow money + Amount available in liquid assets
Fractional reserve banking system

re
New deposit 1
Total amount of money created - Money multiplier -
Reserve ratio Reserve ratio
Quantity theory of money

Money supply × Velocity = Price × Real Output
nT
Quantity of money Total spending
Money neutrality - Money Supply « ¢ Price «

Velocity - Average number of times a unit of currency changes hands
Monetarists believe that money is not neutral in the short run
Fi
LOS d Demand for money

ª Transaction demand - Money held to meet the need for undertaking transactions
GDP « ¢ Transaction demand «
ª Precautionary demand - Money held for unforeseen future needs

GDP « ¢ Precautionary demand «
ª Speculative demand - Money that is available to take advantage of investment opportunities in future
Opportunity cost » ¢ Speculative demand «
Supply of money
Nominal Nominal
interest rate interest rate
Excess of
Money supply
supply
Excess of
r1
demand
r2
r3
Money
demand
Quantity Quantity
Money
supply
Supply of money is determined by central bank and is independent of interest rate

Therefore MS is always perfectly inelastic
LOS e Fischer effect

@ 10% p.a.
100 110
Consumption cost -
107
e True saving -
3
re
Inflation Real rate of
return
Nominal risk-free rate = Real risk-free rate + Expected inflation
Nominal risk-free rate = Real risk-free rate + Expected inflation + Risk premium
nT
Investors require risk premium for expected inflation
LOS f Roles and objectives of central banks
Roles Objectives
Fi
è Sole supplier of currency

è Banker to the government and other
è Primary objective - Control inflation
banks
è Regulator and supervisor of payments è Stability in exchange rates with
system foreign currencies
è Lender of last resort è Full employment
è Holder of gold and foreign exchange è Sustainable positive economic growth
reserves è Moderate long-term interest rates
è Conductor of monetary policy
LOS g Costs of expected and unexpected inflation
When inflation is higher than expected, borrowers gain at the expense of lenders
Unexpected inflation can increase the magnitude and frequency of business cycle
LOS h Tools used to implement monetary policy

ª Policy rate/discount rate/refinancing rate/2-week repo rate
ª Reserve requirements
ª Open market operations
Expansionary policy Contractionary policy
» Policy rate « Policy rate

» Reserve ratio « Reserve ratio
Buying securities Selling securities
LOS i Monetary transmission mechanism
Monetary policy
(increase in official interest rate)
Market interest rates

(increase)
Asset prices
(fall as discount rate for
e Growth expectations
(decrease)
Exchange
(appreciate)
(foreign investors might
re
future CFs increase)
want to invest)
nT
Net external demand

Domestic demand (decreases)
(reduces) (Exports decrease,
Imports increase)
Inflation rate
(decreases)
Fi
LOS j Qualities of effective central bank

Independence Central bank is free from political interference
Operational independence - Central bank is allowed to
independently determine the policy rate
Target independence - Central bank sets the target inflation level
Credibility Central bank follows through on its stated policy intentions
Transparency Central bank discloses the state of economic environment by

issuing inflation reports
LOS k Effects of changes in monetary policy
Contractionary Expansionary
» Economic growth « Economic growth
« Market interest rates » Market interest rates
» Inflation « Inflation
« Domestic currency » Domestic currency
« Imports » Imports
» Exports « Exports
LOS l Interest rate targeting Exchange rate targeting
Most widely used method for making Greater volatility of money supply to
monetary policy decisions maintain stable foreign exchange rate
Increasing money supply when specific Developing countries target a foreign

interest rates rise above the target band exchange rate between their currency and
and decreasing money supply when rates another (often the U.S. dollar), rather than
LOS m
fall below the target band
e targeting inflation
Determining whether a monetary policy is expansionary or contractionary

ª Neutral interest rate - It is the rate of interest that neither spurs nor slows the economy
re
ª Neutral interest rate = Real trend rate of growth + long run expected inflation
ª Expansionary policy - Policy rate < Neutral interest rate

ª Contractionary policy - Policy rate > Neutral interest rate
LOS n Limitations of monetary policy

nT
! Monetary policy changes may affect inflation expectations to such an extent that long-term
interest rates move opposite to short-term interest rates
! Individuals may be willing to hold greater cash balances without a change in short-term rates
(liquidity trap)
! Banks may be unwilling to lend greater amounts, even when they have increased excess reserves
! Short-term rates cannot be reduced below zero
! Developing economies face unique challenges in utilizing monetary policy due to undeveloped
Fi
financial markets, rapid financial innovation, and lack of credibility of monetary authority
LOS o Roles and objectives of fiscal policy
Roles Objectives
è Determining taxation policies and è Influencing the level of economic

government spending to meet activity
è Redistributing wealth or income
macroeconomic goals
è Allocating resources among industries
LOS k Fiscal policy tools
Spending tools Revenue tools
Transfer payments, current Direct taxes (levied on income

spending (goods and services or wealth)
used by government), and
capital spending (investment Indirect taxes (levied on goods
projects) and services)
1
Fiscal multiplier -
1 − MPC (1 − t)
If tax rate « then, fiscal multiplier »
If MPC « then, fiscal multiplier «
LOS q Arguments about size of fiscal deficit
Arguments for Arguments against

Debt may be financed by domestic citizens
Deficits for capital spending can boost

Higher future taxes lead to disincentives to
work
Fiscal deficits may not be financed by the

e productive capacity of the economy
Fiscal deficits may prompt needed tax

reform
re
market when debt levels are high Defecits aid in increasing GDP and
unemployment
Crowding-out effect as government
borrowing increases interest rates and Ricardian equivalence may prevail
decreases private sector investment
When the economy is operating below full
employment, deficits do not crowd out
nT
private investment
Recardian equivalence - Taxpayers increase savings in order to offset the

expected cost of higher future taxes
LOS r Implementation of fiscal policy and difficulties of implementation

ª Delays in realizing the effects of fiscal policy changes limit their usefulness
Fi
ª Causes of delay;
Ÿ Recognition lag
Ÿ Action lag
Ÿ Impact lag
ª Additional macroeconomic issues;

Ÿ Misreading economic statistics
Ÿ Crowding-out effect
Ÿ Supply shortages
Ÿ Limits to deficits
Ÿ Multiple targets
LOS s Determining whether a fiscal policy is expansionary or contractionary
» in surplus - Expansionary
« in surplus - Contractionary
» in deficit - Contractionary
« in deficit - Expansionary
LOS t Interaction of monetary and fiscal policy
Monetary policy Fiscal policy Interest rate Output Private sector Public sector
spending spending
Contractionary Contractionary « » » »
Expansionary Expansionary » « « «
Contractionary Expansionary « « » «
Expansionary Contractionary » Varies « »
e
re
nT
Fi
International Trade And Capital Flows

Gross domestic Gross national
LOS a product (GDP) product (GNP)
Total market value of goods Total market value of goods

and services produced within and services produced by
a country during a certain labor and capital of a country
time period (can be within the country or
outside the country)
LOS b Benefits and costs of international trade
Benefits Costs
One country can specialize in
Costs of trade are primarily
the production of one good and
borne by those in domestic
benefit from economies
industries that compete with
of scale
imported goods
There is more product variety,
Unemployment increases,
more competition, and more
income inequality
efficient allocation of resources
LOS c
e
Benefits of trade > Costs of trade for economy as a whole
Comparative advantage and absolute advantage

re
Absolute advantage - Lower cost in terms of resources
Comparative advantage - Opportunity cost in terms of other goods
Country A Country B
nT
Food 4 8
Drink 6 7
Opportunity cost of good x - Quantity of ‘X’ should be in the denominator
6
Opportunity cost of food for Country A = = 1.5
Fi
7
Opportunity cost of food for Country B = = 0.875
8
Since opportunity cost of Country B is lower, it has comparative advantage in producing food
Country B has absolute advantage in producing both food and drink because it is able to
produce more than Country A
Country B should produce (and export) food and Country A should produce (export) drink
LOS d Ricardian Heckscher–Ohlin

model model
Two factors of production - labor

and capital
Only one factor of production - Comparative advantage -

labor Differences in relative amounts of
each factor
Comparative advantage -
Differences in labor productivity Country that has more capital will
specialize in capital intensive good
and trade for less capital intensive
good
Heckscher-Ohlin model
ª This model says price of scarce factor of production in each country will increase
ª The good that country exports will rise in price

ª The good that country imports will fall in price
LOS e Types of trade and capital restrictions

Arguments that have support for capital restriction
Infant industry Protection from foreign competition is given to new industries
e
National security It is in the best interest of a country to protect producers of
goods crucial to it’s national defense so that those goods are
available domestically in the event of conflict
re
Arguments that have little support for capital restriction
Protecting domestic jobs Some jobs are lost, some jobs are created and prices for
domestic consumers will be less without import restrictions
Protecting domestic industries Firms often use political influence to get protection from
foreign competition to the detriment of consumers, who pay
higher prices
nT
Types of trade restrictions

Tariffs Quotas VER
Voluntary export restraint
Taxes on imported good Restriction on quantity of goods to be imported
Agreement by a govt to
Ç in domestic price If domestic government collects the full value
voluntarily unit the quantity
of import license, result is same as for a tariff
È in quantity imported of good to be exported
If domestic government does not charge for the
Domestic producers gain No capture of quota rents
Fi
import licenses, there would be gain to

Foreign exporters lose importers, this is referred to as quota rent Protects domestic consumers
in importing country
Export subsidy
Payment by government to its exporters
Generally export subsidies will benefit the producer (exporter)
Generally it will result in increase of price and reduction of consumer surplus in the exporting country
In a small country, price will increase by the amount of subsidy to equal world price + subsidy
For a large country, world price decreases and some benefits from subsidy accrue to foreign
customers while foreign producers are negatively affected
Capital Restrictions
ª Prohibition of investment in the domestic country by foreigners
ª Prohibition of or taxes on the income earned on foreign investments by domestic citizens
ª Prohibition of foreign investment in certain domestic industries
ª Restrictions on repatriation of earnings of foreign entities operating in a country
LOS f Trading blocs
Free Trade Areas No barriers

Eg. NAFTA
No barriers among member countries

Customs Union
Countries adopt common set of trade
restrictions with non-members
$ No barriers among member countries

$$
Common Markets
e Countries adopt common set of trade

No barriers to the movement of labor and
capital goods among member countries
re
$ $$ Countries adopt common set of trade

Economic Union
nT
capital goods among member countries
Member countries establish common

institutions and economic policy for the
union
Eg. European union (EU)
E
Fi

Countries adopt common set of trade
Monetary Union capital goods among member countries
Member countries establish common

institutions and economic policy for the union
Member countries adopt a single currency
Eg. Euro-zone
LOS g Common objectives of capital restrictions
è Reduce the volatility of asset prices (domestic )

è Maintain fixed exchange rates
è Keeping domestic interest rates low
è Protect strategic industries (eg. defense industries)
LOS h Balance of payments (BOP)
Current Capital Financial

Account Account Account
Goods and Income Unilateral Government- Foreign-owned

services receipts transfers owned assets assets in the
abroad country
Import/ Dividend Money

export of and interest received Include domestic
goods and income on from those Include gold,
securities, domestic
services foreign working foreign currencies,
currencies, domestic
securities abroad foreign securities,
liabilities to
reserve position in
foreigners reported
IMF etc.
by domestic banks
e Sales and
re
Capital
purchases of non-
transfers
financial assets
Include rights to
Include transfer of natural resources and
title to fixed assets, intangible assets,
nT
debt forgiveness such as patents,

copyrights etc.
ª Current Account is similar to Income statement
ª Capital Account is similar to Balance sheet
ª Current Account deficit - Imports > Exports

Fi
ª Any surplus in the current account must be offset by a deficit in the capital
and financial accounts (vice versa)
LOS i Effect of decisions by consumers, firms, and governments on BOP

X – M (trade deficit) = Private savings + Government savings – Investment
If a country’s net savings (both government and private) are less than the amount of investment
in domestic capital, this investment must be financed by foreign borrowing.
Foreign borrowing results in capital account surplus (trade deficit)

LOS j International organizations that facilitate trade
International Monetary World Trade

World Bank
Fund (IMF) Organization (WTO)
Vital source of financial and

technical assistance to
developing countries
Promoting international
monetary cooperation
Provides resources,
knowledge and helps form Only international
Facilitating the expansion
partnerships in public and organization that deals
and balanced growth of
private sectors with global rules of trade
international trade
between nations
Also provides loans at low
Promoting exchange
interest rate, interest-free Goal - Ensuring that trade
stability
credits, and grants to flows as smoothly,
developing countries predictably and freely as
Assisting in the
establishment of a possible
Made up of two
multilateral system of
development institutions - Multilateral trading system
payments
- Agreements that have
International Bank for legal ground-rules for
Making resources available
(with adequate safeguards)
to members experiencing
BOP difficulties
e
Reconstruction and
Development
(IBRD) - Reduce poverty in
middle income countries
international commerce
and guarantee member
countries important trade
rights
re
International Development
Association (IDA) - Focus
on world’s poorest
countries
nT
Fi
Currency Exchange Rates

LOS a,b & c
Exchange rate Price of one unit of currency in terms of another
Spot exchange rate Exchange rate for immediate delivery
Forward exchange rate Exchange rate for a transaction to be done in future

Real exchange rate Measures changes in relative purchasing power over time
Leveraged account Investment firms that use derivatives/leverages
Real exchange rate (d/f) = Nominal exchange rate (d/f) x CPI(f)

CPI(d)
$3 Price currency
€ Base currency
€ - Depreciated $2 $3 $4 € - Appreciated
$ - Appreciated € € € $ - Depreciated
Eg. ZAR 52 ZAR 57

$ $
% Appreciation -
Closing value
Opening value
−1
$ - Appreciated -
57
e−1
% Depreciation -
= 9.62%
Opening value
Closing value
−1
re
52
52
ZAR - Depreciated - −1 = 8.77%
57
Functions of and participants in the foreign exchange market

nT
Sell side - Originators of forward foreign exchange contracts. Usually large

multinational banks
Buy side - Include corporations, governments and government entities, investment

fund managers, hedge fund managers, investors and central bank
Transaction cycle for forex in spot market is T + 2

Fi
LOS d Cross currency rates

Eg. 1.03 SW $0.002 6500 Dong Dong
Find
ZAR ZAR $ SW
1 12.62 Dong
× 0.002 × 6500 = SW
1.03
LOS e Points in Percentage (PIP)
1
1 PIP =
10,000
Eg. ₹66.1215
+ 3 PIPS
$
₹66.1215 + 3
= 66.1218
$ 10,000
LOS f, g & h Interest rate parity

International Fischer relationship (precise)
1 + Nominal interest rate = (1 + Real interest rate) × (1 + Expected inflation)
Eg. #1 USA India

2% ₹50 10%
$
$1mln ₹50mln
.
int
2%
10%
n+
e
ml
$1
₹55mln 55 ₹55mln
$1.02mln 53.92
53.92 1.02
re
(1 + Int. rate)n
Forward rate = S ×
(1 + Int. rate)n
(1 + 10%)1
Forward rate = 50 ×
(1 + 2%)1
nT
= 53.92
Eg. #2 Interest rate parity

Int. rate (India) = 20%
Int. rate (USA) = 10%
Fi
(1 + Int. rate)n
F = S × = ₹54.54
₹50 (1 + Int. rate)n
$ Expected
(1.1538)
spot rate = 50 × = ₹54.54
(1.0576)
Real int.
Inflation rate
rate = 4%
(1 + 20%)
India = = 15.38%
(1 + 4%)
(1 + 10%)
USA = = 5.76%
(1 + 4%)
Arbitrage profit
₹60 ₹58
Eg. Interest rates - India - 10% USA - 2% Spot = 1 Yr. forward =
$ $
1.1
No arbitrage price = ₹60 ×
1.02
= ₹64.7
There is arbitrage because ‘No arbitrage price’ ≠ Forward price
Forward discount/premium
Eg. ₹55 ₹57
Spot = 1 Yr. forward =
$ $
Forward price
Forward premium on USD = − 1
Spot price
57
= − 1
55
= 5.45%
LOS i Exchange rate regimes
Countries that do not issue

their own currencies
e Countries that issue their

own currencies
re
Formal Monetary
dollarization union
Managed
Conventional
Crawling peg floating
fixed peg
exchange rates
Country uses
the currency of Several
nT
another country countries use Exchange rate Monetary

and does not common Country pegs is adjusted authority
have its own currency its currency periodically, to influences the
monetary policy within margins adjust for exchange rate
of ±1% versus higher inflation in response to
another versus the specific
currency currency used indicators, such
in the peg as BOP
Fi
Management
Currency board Peg with Independently
within crawling
arrangement horizontal bands floating
bands
Explicit Exchange rate is

Permitted Width of bands
commitment to market determined.
fluctuations in that identify
exchange Intervention is
currency value permissible
domestic currency used only to slow
relative to another exchange rates is
for a foreign the rate of change
currency is wider increased over
currency at a fixed and reduce short
eg. ±2% time
exchange rate term fluctuations
LOS j Effects of exchange rates on international
trade and capital flows
Marshall-Lerner condition
WX EX + WM(EM − 1) > 0
Pe of Pe of
Export Import
Export Import
proportion proportion
Elasticities (E) of export and import demand must meet Marshall-Lerner condition for
depreciation of domestic currency to reduce existing trade deficit
Export If INR Import

(Gems and Jewelry) depreciates (Cars)
from 65 to 80
Pe of demand Ç Pe of demand Ç
USD price È e INR price Ç

re
Qd Ç Qd È
Exports Ç Imports È
nT
J-Curve effect
Balance of
trade
0
Fi
Before
currency
depreciation
After currency
depreciation
Time
Currency depreciation may worsen trade deficit initially. Importers adjust over time by
reducing quantities. Marshall-Lerner conditions take effect and the currency
depreciation begins to improve the trade balance
Absorption approach
It is a macroeconomic technique that focuses on capital account
Balance of trade = National income − Total expenditure
e
re
nT
Fi

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Topics in Demand And Supply Analysis

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LOS a Elasticities of demand

Price Income Cross price

LOS b & c Substitution and income effects

Particulars Substitution effect Income effect

Normal good (P È 10%) Ç Qd 10% Ç Qd 10%

Inferior but not Giffen good (P È 10%) Ç Qd 10% È Qd 5%

Inferior and Giffen good (P È 10%) Ç Qd 10% È Qd 15%

Veblen Good - Higher price makes goods more desirable

May have a positively sloped demand curve

Inputs beyond this quantity are said to

LOS e Breakeven and shutdown points of production

In short run shutdown if, In short run shutdown if,

In long run shutdown if, In long run shutdown if,

P < ATC TR < TC, P < ATC

Quantity VC per unit TVC TFC TC MC

LOS a Characteristics of different markets

Characteristics Perfect Monopolistic Oligopoly Monopoly

No. of sellers Many Many Few One

Barriers to entry Very low Low High Very high

Pricing power of Some or

LOS b Relationships between P, MR, MC, economic

Economic proﬁt = 0 Economic proﬁt = 0

LOS c Firm’s supply function (Perfect competition)

Cost Cost Short run

Under monopolistic competition, oligopoly and monopoly, equilibrium

LOS d Optimal price and output for ﬁrms

In monopolistic competition and monopoly, price is the intersection of

LOS e Factors affecting long-run equilibrium under each market structure

Pricing strategies in oligopoly

Price More elastic

A - Low price: 500 A - High price: 300

B - High price: 100

Firm’s decisions are interdependent

If there is a price war, then dominant ﬁrm’s market share Ç

LOS f Pricing strategies

In perfect competition P = MR = AR =MC = ATC

In monopolistic competition, oligopoly and monopoly, price is the intersection of

LOS g N-ﬁrm concentration Herﬁndahl-

None of the ratios consider barriers to entry

LOS h Identifying the market structure in which ﬁrm operates

LOS a GDP using expenditure and income approach

ª It is most widely used measure of the size of a nation’s economy

ª It includes only purchases of newly produced goods and services

ª Sale or resale of goods produced in previous periods is excluded

ª Value of owner-occupied housing is also included in GDP (value is estimated)

Expenditure approach - Total amount spent on goods and services produced

Income approach - Total income earned by households and companies

Sum of value Value of ﬁnal

GDP is calculated by adding GDP is calculated using only

Nominal GDP Real GDP

Output - Current year Output - Current year

Personal income - National income

Personal disposable income - Personal income

GDP under income approach can also be calculated as :

National Capital consumption Statistical

Depreciation of Adjustment for difference

Total income must equal total expenditures

excess of savings over investment

Real interest Real interest

(S − I) = (G − T) + (X − M) eŸ y Ç = Precautionary & transaction demand Ç

Aggregate demand curve