1.

Circular-flow model of goods and incomes in an open economy

The circular flow of income or circular flow is a model of the economy in which the major
exchanges are represented as flows of money, goods and services, etc. between economic
agents. The flows of money and goods exchanged in a closed circuit correspond in value, but
run in the opposite direction. The circular flow analysis is the basis of national accounts and
hence of macroeconomics.
The model represents all of the actors in an economy as either households or firms (companies),
and it divides markets into two categories:

• Markets for goods and services

• Markets for factors of production (factor markets)

A circular flow of income model is a simplified representation of an economy.

In the basic two-sector circular flow of income model, the economy consists of two sectors:
households and firms.
The model assumes that there are no financial, government, foreign sectors. In addition, the
model assumes that through their expenditures, households:
1. spend all of their income on goods and services or consumption;
2. purchase all output produced by firms.
The three-sector model adds the government sector to the two-sector model. It excludes the
financial sector and the foreign sector. Flows from households and firms to the government are
in the form of taxes. The income the government receives flows to firms and households in the
form of subsidies, transfers, and purchases of goods and services.
The four-sector model adds the foreign sector to the three-sector model. (The foreign sector
is also known as the "external sector," the "overseas sector," or the "rest of the world.")
[19]

Thus, the four-sector model includes:

1. households,
2. firms,
3. government,
4. the rest of the world.
It excludes the financial sector. The foreign sector comprises (a) foreign trade (imports and
exports of goods and services) and (b) inflow and outflow of capital (foreign exchange).
The five-sector model adds the financial sector to the four-sector model.

The circular flow of income is significant in four areas:

1. Measurement of national income
2. Knowledge of Interdependence. Circular flow of income signifies the
interdependence of each activity upon one another. If there is no consumption, there
will be no demand and expenditure which in fact restricts the amount of production and
income.
3. Unending Nature of Economic Activities. It signifies that production, income and
expenditure are of unending nature, therefore, economic activities in an economy can
never come to a halt. National income is also bound to rise in future.
4. Injections and Leakages

Leakages and injections can occur in the financial sector, government sector and overseas
sector. In the overseas sector, the main leakage from this sector are imports (M), which
represent spending by residents into the rest of the world. The main injection provided by this
sector is the exports of goods and services which generate income for the exporters from
overseas residents. An example of the use of the overseas sector is Australia exporting wool to
China, China pays the exporter of the wool (the farmer) therefore more money enters the
economy thus making it an injection. Another example is China processing the wool into items
such as coats and Australia importing the product by paying the Chinese exporter; since the
money paying for the coat leaves the economy it is a leakage.

Summary of leakages and injections

Leakages:
1. Savings (S);
2. Taxes (T);
3. Imports (M).
Injections:
1. Investment (I);
2. Government Spending (G);
3. Exports (X).

2. Gross Domestic Product. Calculating GDP: three approaches

One of the most common ways to measure the size of an economy (the aggregate output of a
country) is by compiling the gross domestic product (GDP). It is defined differently by
international organizations.
1. As defined by the World Bank, GDP represents the market value of all final goods and
services produced within a country’s borders, during the course of one year.
2. OECD defines GDP as "an aggregate measure of production equal to the sum of the
gross values added of all resident and institutional units engaged in production and
services (plus any taxes, and minus any subsidies, on products not included in the value
of their outputs)"
There are three methods of calculating GDP.
1. The Production (output) approach
Also known as the Value Added Approach, it calculates how much value is contributed at each
stage of production. This approach mirrors the OECD definition given above.
Steps:
1. Estimate the gross value of domestic output out of the many various economic
activities;
2. Determine the intermediate consumption, i.e., the cost of material, supplies and services
used to produce final goods or services.
3. Deduct intermediate consumption from gross value to obtain the gross value added.
One major drawback of this method is the difficulty to differentiate between intermediate and
final goods. This is why some countries such as the United States and Japan prefer other
methods, like the income or the expenditure approach.
2. The Income approach
The second way of estimating GDP is to use "the sum of primary incomes distributed by
resident producer units" This method measures GDP by adding incomes that firms pay
households for factors of production they hire - wages for labour, interest for capital, rent for
land and profits for entrepreneurship.
 GDP = Compensation of employees + gross operating surplus + gross mixed income +
taxes less subsidies on production and imports
Compensation of employees measures the total remuneration to employees for work done. It
includes wages and salaries, as well as employer contributions to social security and other such
programs.
Gross operating surplus is the surplus due to owners of incorporated businesses. Often called
profits, although only a subset of total costs are subtracted from gross output to calculate GOS.
Gross mixed income is the same measure as GOS, but for unincorporated businesses. This
often includes most small businesses.

3. The Expenditure approach

The third way to estimate GDP is to calculate the sum of the final uses of goods and services
(all uses except intermediate consumption) measured in purchasers' prices.
The formula for calculating GDP, using the expenditure approach is the following:
GDP = C + I + G + (X- M)
• C = Private consumption expenditure
• I = Investment Expenditure
• G= Government Consumption Expenditure
• X = Value of Exports
• M = Value of Imports

3. GDP Nominal versus Real. Price indexes: GDP deflator, Consumer Price Index and
Producer Price Index
GDP refers to the economic value of goods and services produced within the nation’s
boundaries, in a particular financial year plus income earned by foreign residents locally less
income earned abroad by country’s residents.
When the GDP is estimated at current prices, it exhibits Nominal GDP, whereas Real GDP is
when the estimation is made at constant prices.

BASIS FOR
NOMINAL GDP REAL GDP
COMPARISON

Meaning The aggregate market value of
the economic output produced in
a year within the boundaries of
the country is known as Nominal
GDP.
Real GDP refers to the value of
economic output produced in a
given period, adjusted according
to the changes in the general price
level.

What is it? GDP without the effect of Inflation adjusted GDP

inflation.

Expressed in Current year prices Base year prices or constant

prices.

Value Higher Generally, lower.

 Uses Comparison of various quarters Comparison of two or more
of the given year can be made. financial years can be done
easily.

Economic Growth Cannot be analyzed easily. Good indicator of economic

growth.

A price index is a weighted average of price relatives for a given class of goods or services in
a given region, during a given interval of time. It is a statistic designed to help to compare how
these price relatives, taken as a whole, differ between time periods or geographical locations.

The GDP deflator is a measure of the level of prices of all new, domestically produced, final
goods and services in an economy in a year.
Like the consumer price index (CPI), the GDP deflator is a measure of price inflation/deflation
with respect to a specific base year; the GDP deflator of the base year itself is equal to 100.
Unlike the CPI, the GDP deflator is not based on a fixed basket of goods and services; the
"basket" for the GDP deflator is allowed to change from year to year with people's consumption
and investment patterns.

The nominal GDP of a given year is computed using that year's prices, while the real GDP of
that year is computed using the base year's prices.
The formula implies that dividing the nominal GDP by the real GDP and multiplying it by 100
will give the GDP Deflator, hence "deflating" the nominal GDP into a real measure.

A consumer price index (CPI) is a price index, the price of a weighted average market basket
of consumer goods and services purchased by households. Changes in measured CPI track
changes in prices over time.

The index is usually computed monthly, or quarterly in some countries, as a weighted average
of sub-indices for different components of consumer expenditure, such as food, housing, shoes,
clothing, each of which is, in turn, a weighted average of sub-sub-indices.

A producer price index (PPI) is a price index that measures the average changes in prices
received by domestic producers for their output.Its importance is being undermined by the
steady decline in manufactured goods as a share of spending.
The PPI is a measure of wholesale inflation, while the Consumer Price Index measures the
prices paid by consumers.
PPI indexes are calculated based on products and services, industries, and the buyer's economic
identity, which are used to calculate the overall monthly change in final demand PPI.

4. Aggregate Demand: definition and its elements. Aggregate Demand curve. Factors
affecting Aggregate Demand
Aggregate demand (AD) is the total demand for final goods and services in an economy at a
given time. It is often called effective demand, though at other times this term is distinguished.
This is the demand for the GDP of a country. It specifies the amount of goods and services that
will be purchased at all possible price levels. Consumer spending, investment, corporate and
government expenditure, and net exports make up the aggregate demand.

Elements
Aggregate Demand = C + I + G + Nx
C=Consumer spending on goods and services
I=Private investment and corporate spending on non-final capital goods (factories, equipment,
etc.)
G=Government spending on public goods and social services (infrastructure, Medicare, etc.)
Nx=Net exports (exports minus imports)
Aggregate Demand Graphically

If the price level increases the Aggregate Demand will decrease

If the Price Level decreases the Aggregate Demand will Increase.
And the negative relationship between the price level and the aggregate demand is called the
Aggregate Demand Curve.
Each point on this curve shows an equilibrium between the goods market and the money
market.
Factors that Affect Aggregate Demand
1. Net Export Effect When domestic prices increase, then demand for imports increases
(since domestic goods become relatively expensive) and demand for export decreases.
2. Real Balances When inflation increases, real spending decreases as the value of money
decreases. This change in inflation shifts Aggregate Demand to the left/decreases.
3. Interest Rate Effect Real Interest is the nominal interest rate adjusted to the inflation rate.
When inflation increases, nominal interest rates increase to maintain real interest rates. Lower
real interest rates will lower the costs of major products such as cars, large appliances, and
houses; they will increase business capital project spending because long-term costs of
investment projects are reduced.
4. Inflation Expectations If consumers expect inflation to go up in the future, they will tend
to buy now causing aggregate demand to increase or shift to the right.

5. Aggregate Supply. Aggregate Supply curve. Factors affecting Aggregate Supply.

Aggregate supply, also known as total output, is the total supply of goods and services produced
within an economy at a given overall price in a given period. It is represented by the aggregate supply
curve, which describes the relationship between price levels and the quantity of output that firms are
willing to provide. Typically, there is a positive relationship between aggregate supply and the price
level.

Aggregate supply curve:

The aggregate supply curve shows the total quantity of output—real GDP—that firms will produce
and sell at each price level.
The horizontal axis of the diagram shows real GDP—that is, the level of GDP adjusted for inflation.
The vertical axis shows the price level. Price level is the average price of all goods and services
produced in the economy. It's an index number, like the GDP deflator.

The price level shown on the vertical axis represents prices for final goods or outputs bought in the
economy, not the price level for intermediate goods and services that are inputs to production. The AS
curve describes how suppliers will react to a higher price level for final outputs of goods and
services while the prices of inputs like labor and energy remain constant.
If firms across the economy face a situation where the price level of what they produce and sell is rising
but their costs of production are not rising, then the lure of higher profits will induce them to expand
production.

Determinants of Aggregate Supply:

Factor Prices: Factor prices represent the cost of resources used to produce goods. This includes raw
materials such as lumber or steel, as well as energy or wages. This determinant effects Aggregate
because if factor prices rise, then firms will be able to supply fewer goods at a given price, and vice
versa if the fall.
Technology: Technology is a determinant of aggregate supply because it impacts productivity. If
productivity rises from the introduction of new technology, then firms will be able to produce more
good at the same aggregate price level. It's hard to envision a decrease or loss in technology which leads
to lower productivity, but a software virus could disable computers and automated production.
Labor Productivity: An increase in labor productivity can determine a firm's level of output. For
example, if the workforce becomes better educated, allowing them to work more efficiently, then goods
can be produced at higher rate at the same given price level.
Availability of Factors of Production: If the availability of factors of production increases, then firms
can produce more goods at a given price, and vice versa.
Capital Productivity: Capital productivity measure how efficiently capital is being used to produce
goods and services. If firms began to mismanage their capital, causing them to use it inefficiently, then
their level output or supply would drop at the same given price.
Government Rules, Taxes, and Subsidies:
o If there is a change in government rules such as new regulations on the treatment of livestock,
that would lower the output of meat factories.
o if the government increased subsidies for farmers that raised livestock, that would increase the
level of output.
o If income taxes rise, then the labor force will demand higher wages causing a decrease in output
at the same aggregate price level. Taxes can also affect firms more directly in the form of
corporate taxes.

6. Model of Aggregate Supply and Aggregate Demand (AS-AD) in macroeconomic

analysis.
The AD-AS (aggregate demand-aggregate supply) model is a way of illustrating national income
determination and changes in the price level. We can use this to illustrate phases of the business
cycle and how different events can lead to changes in two of our key macroeconomic indicators: real
GDP and inflation.
Key Features of the AD-AS model

o Two axes: a vertical axis labeled “Price level” or “PL” and a horizontal axis labeled “real
GDP.”
o A downward sloping aggregate demand curve labeled “AD.” An upward sloping short-run
aggregate supply curve labeled “SRAS.”

o An equilibrium price level and real GDP. These should be labeled as indicated in the question.

o A vertical long-run aggregate supply curve labeled “LRAS.” The LRAS should be vertical at
the full employment output. The placement of the LRAS curve will depend on whether the
economy has an output gap or is in long-run equilibrium. For example, the economy in the
graph shown here is in a recession
 Most common uses of the AD-AS model
Showing a recession, with Y1 representing current output and Yf full employment output. Note that
Y1 is less than Yf during a recession.

Showing an economy in long-run equilibrium, with Y1 representing current and Yf representing full
employment output. Note that Y1 equals Yf in long-run equilibrium.

Showing an economy producing beyond full employment output, with Y1 representing current output
and Yf representing full employment output. Note that Y1 is greater than Yf when an economy is
producing more than full employment output.
 7. Consumption, Saving, Investment in closed and open economies.
Consumption:
The main hypothesis of Keynes suggested that our disposable income which can be arrived at by
deducing tax liabilities from gross income influences our level of real consumption. Further
explanation on this is
C = f (Y) where C stands for consumption and Y stands for disposable income.
Keynes also held the view that people tend to enhance their consumption level along with a rise in
their disposable income.
However, the increase in disposable income is greater than the increase in consumption. This
hypothesis can be termed as our marginal propensity to consume and indicates a positive correlation
between these two variables.
This, if our income increases by one unit, our marginal propensity to consume increases by 0.8 units.
Hence the remaining 0.2 units are used for savings.
Y = C + S where Y stands for disposable income, C stands for consumption and S stands for savings.
It is also imperative to note here that propensity to consume and desire to consume are not similar in
nature as the former means effective consumption.
Both objective and subjective factors influence our consumption function. Tax policy, interest rate,
windfall profit or loss and holding of assets are some objective functions whereas subjective ones
relate to motives of foresight, precaution, avarice, and improvement amongst individuals.

Savings:
In plain words, savings refer to the excess of disposable income over consumption expenditure.
From a national level, the unconsumed part of the entire nation’s income comprising of all its
members can be termed as National Savings.
Total domestic savings, on the other hand, can be defined as the summation of savings of the
government, the business sector, and households.
Some of the biggest determinants of savings are
Income, as saving income ratio holds a proportionate relation with the rise in income. People also
have a tendency of saving the excess part of their income but not the entire bulk.
Distribution of income as the savings process is helped to a great extent by inequality of income
distribution. Our desire to showcase a superior standard of living in comparison to our neighbors often
steers us towards purchasing expensive goods which in turn declines the level of savings.
Psychological or subjective factors such as savings to safeguard ourselves from future insecurity and
uncertainty. The ultimate attitude of people is driven towards savings by their farsightedness. This, in
turn, boosts them up to enjoy a better standard of living both for themselves and their loved ones.
Prevalent financial instruments and rate of interest as a higher rate motivates greater savings.
Investment
Is change in capital stocks or inventories pertaining to a business venture between two different
periods or production of fresh capital goods such as plants and equipment.
Relation Between Savings and Investment In Classical System
According to this theory, Savings (S) gets equated with Investment (I) automatically which otherwise
alters the interest rate. If savings exceeds investment, the excess supply of funds brings down the rate
of interest.
This, in turn, reduces savings and increases investment for maintaining equilibrium.
However, this law of the market holds good when the entire amount of savings is invested.

8. Factors of economic growth. Production function.

Economists generally agree that economic development and growth are influenced by four factors:
human resources, physical capital, natural resources and technology. Highly developed countries
have governments that focus on these areas. Less-developed countries, even those with high
amounts of natural resources, will lag behind when they fail to promote research in technology and
improve the skills and education of their workers.
The Impact of Human Resources
The skills, education and training of the labor force have a direct effect on the growth of an economy.
A skilled, well-trained workforce is more productive and will produce a high-quality output that adds
efficiency to an economy.
A shortage of skilled labor can be a deterrent to economic growth. An under-utilized, illiterate and
unskilled workforce will become a drag on an economy and may possibly lead to higher
unemployment.

Investment in Physical Capital

Improvements and increased investment in physical capital – such as roadways, machinery and
factories – will reduce the cost and increase the efficiency of economic output. Factories and
equipment that are modern and well-maintained are more productive than physical labor. Higher
productivity leads to increased output.Labor becomes more productive as the ratio of capital
expenditures per worker increases. An improvement in labor productivity increases the growth rate of
the economy.

Quantity and Availability of Natural Resources

The quantity and availability of natural resources affect the rate of economic growth. The discovery of
more natural resources, such as oil or mineral deposits, will give a boost to the economy by increasing
a country's production capacity. The effectiveness of a county at utilizing and exploiting its natural
resources is a function of the skills of the labor force, type of technology and the availability of
capital. Skilled and educated workers are able to use these natural resource to spur the growth of the
economy.

Improvements in Technology
Improvements in technology have a high impact on economic growth. As the scientific community
makes more discoveries, managers find ways to apply these innovations as more sophisticated
production techniques.The application of better technology means the same amount of labor will be
more productive, and economic growth will advance at a lower cost.

Production function
Production function is the equation that expresses the relationship between the quantities of
productive factors (such as labour and capital) used and the amount of product obtained.

The following properties are characteristic of production functions:

1) The increase in output due to one production factor is always extremely high (a limited number of
workers can work in one shop).
2) Production factors are interchangeable (human resources are replaced by machine resources) and
complementary (workers need tools).

Types of production functions:

(1)Static production functions have the following form:
Y = f (x1,x2,…xn)

They do not include a time indicator, i.e. they do not contain time as a factor that changes the main
production characteristics of the studied dependence.
Among static production functions, linear functions (y = a0 + a1 x1 + a2 x2) and the Cobb-Douglas
function are the most common.

(2)Dynamic production functions have the following form:

y = f (t , xi (t) ...nn(t)), where:

xi (t) – represents the dynamics of changes in a certain production factor depending on time;
t – is a temporary independent variable that implicitly reflects the impact of all unaccounted factors on
the effectiveness of the indicator y.

The graph of the two-factor function Q = f (L,K) is an isoquant, which is a line of constant output
level. I.e., an isoquant is a curve of equal product or a set of possible combinations of labor and
capital factors, at which the same output is achieved.
The further from the origin the curve is located, the greater the output.
The isoquant map is a set of isoquants, each of which shows the maximum volume of output when
using a certain combination of factors of production.
 The properties of isoquants include:
1) negative slope; 2) concavity to the origin; 3) never intersect; 4) show different levels of production.
The further from the origin the isoquant is located, the greater the volume of output it shows.

9. Economic cycle and dynamics of major macroeconomic aggregates. Potential

GDP

The economic cycle is periodically recurring fluctuations in economic activity,

consisting of economic downturns and upturns.

The current economic situation determines the cycle through fluctuations in

the size of the gross product and the level of employment. It is considered
that they affect other variables in the economy:

· The volume of consumption.

· Investment fund.

· The rate of price growth.

The economic cycle consists of four phases

1. Economic growth. There is an increase in total income, production increases

output, and employment increases. During the period of growth, the price level
may rise, this is due to an increase in consumption and productivity.

2. Peak of economic growth. It is characterized by the maximum employment of

factors of production. During this period, the interest rate is too high, so
investments become unprofitable. But it is impossible to achieve full
employment and capacity utilization in practice.

3. The recession is characterized by a decline in business activity. The volume

of production is falling, which leads to the release of factors of production,
including labor. Decline in the level, quality of life, investments, many
enterprises cease to function. Only the fittest remain, able to work in difficult
conditions.
4. Bottom or depression. Business activity during this period is minimal. The
bank's interest rate becomes low, which activates investment activity, and
therefore spurs business activity.

The following aggregates are used as generalizing indicators in the framework

of macroeconomic analysis:

• Gross domestic product (GDP) characterizes the cost of products in end-

user prices produced by economic units forming sectors of the domestic
economy, considering the consumption of fixed capital.

The final product is determined by the goods that are used for final
consumption, accumulation and export. The final product does not include
intermediate goods consumed in the production process in the form of raw
materials, materials, fuel, electricity, etc. The use of the term "gross" means that
when calculating GDP, consumption of fixed capital is not excluded from its
value.

• net domestic product (PMT) determines the cost of products in the prices
of the final buyer, produced by economic units forming sectors of the domestic
economy, without considering the consumption of fixed capital.

• National income (ND) characterizes the primary income of economic units

because of their participation in economic activities or ownership of assets that
can be used in economic activities.

ND can be calculated on a gross or net basis, as a result of which aggregates

such as gross national income (GNI) and net national income (NNI) are used in
the framework of macroeconomic analysis.

Potential GDP is the maximum volume of possible output of goods and

services in a country over a certain time, through the use of all available
resource potential, organizational and managerial capabilities.
For potential GDP to grow, the following conditions must be met:

· The availability of modern technologies. They require regular checking,

updating, restructuring.

· Availability of a sufficient number of factors of production: material, labor

and production resources.

· Availability of a system of planning and management of production activities,

mechanisms for the implementation of production processes.
Knowing these indicators, it is possible to determine the potential GDP for a
certain time period, its dynamics and the possibility of achieving the same level
of actual GDP.
10. Labor market. Unemployment and its types. Natural level of unemployment. Causes of
unemployment.
The labor market is a set of economic relations regarding the purchase and sale of a specific
commodity - labor; the market in which the exchange of labor for wages takes place.
The labor market generates demand, supply and price for labor and, consequently, for
labor services. The subjects of economic relations in the labor market are entrepreneurs –
large monopolies, medium and small businessmen, the state, and other individual workers
or their associations (labor unions).
The prices emerging in the labor market represent wage rates, which are the monetary form
of the cost of labor.
The labor market performs a specific function of distribution and redistribution of labor
resources by spheres, industries, regions, professions, specialties, qualifications according to
the law of supply and demand.
1. A characteristic feature of the labor market is the constant excess of the supply of labor
over the demand for it.
2. In the labor market, there is a competitive struggle between employees for vacant jobs. In
this struggle, the winner is the one who can provide more profit to the owner of capital with
his work.
Unemployment is a socio—economic phenomenon in which the supply of labor in the
market exceeds its demand.
Consider the main types of unemployment:
1. Frictional unemployment - unemployment caused by labor migration, people changing
their place of residence, leaving their previous places of work and actively seeking new
employment.
2. Cyclical unemployment - appears in a crisis in the economy, due to the cyclical nature of
the economy. This type of unemployment declines as the recovery begins.
3. Structural unemployment - is the result of technological progress in the economy,
changes in technology and production structure. This type of unemployment is long-term.
4. Regional unemployment is due to a large difference between the demand for labor and its
supply in a particular territory. This type of unemployment may be caused by uneven
economic development in the territories, for example, the lack of jobs in the provinces and
the abundance of labor demand in the major cities.
Natural level of unemployment - the sum of frictional and structural unemployment and
corresponds to the real state of the economy with full employment of resources. Currently, in
developed countries, the natural unemployment rate is about 5-6% of the total labor force.
Causes of unemployment:
1. Structural changes in the economy associated with the introduction of new technologies
and equipment, which leads to the reduction of excessive labor force.
2. Economic recession or depression that forces employers to reduce the need for labor.
3. Government and trade union pay policy: Higher SMIC increases production and handling
costs and thus reduces demand for labor.
4. Seasonal changes in the level of production in certain sectors of the economy.
5. Changes in the demographic structure of the population, i.e., as the number of people of
working age increases, the likelihood of unemployment increases.
11. Money and its functions. Types of money. Velocity of money circulation.
Money is a financial asset that serves to make transactions - to buy goods and services.
 The money market is a segment of the financial market. The second segment is the securities
market. The peculiarity of the financial market is that financial assets are sold and bought on
it.
Modern economics identifies five functions of money.
1. A measure of value. Money allows you to estimate the value of goods by setting prices
2. Medium of circulation. Money plays the role of an intermediary in the exchange process
3. Means of payment. The money function, which allows the payment time to not coincide
with the payment time, that is, when goods are sold on credit
4. A means of accumulation and savings. The ability of money to participate in the process of
formation, distribution, redistribution of national income, formation of savings of the
population
5. The function of world money. It is manifested in the relationship between economic
entities: states, legal entities and individuals located in different countries
Money can be of the following types:
· In cash, which are coins and bank notes (banknotes and treasury notes). Only the central bank
of the country has the right to issue cash.
· Non-cash, that is, funds stored on settlement accounts and deposits in banks, as well as
certificates of deposit and government securities. Non-cash money can turn into cash at any
time.
· Commodity (natural). They have their own value and usefulness. Such money could be furs,
cattle, grain, gold, pearls, etc
· Secured (exchange, representative). They could exchange for commodity money on demand.
For example, upon presentation of a banknote, the bank could issue the number of gold coins
specified in it.
· Fiat (paper, symbolic). They can perform the functions of money only with the support of the
state, since they themselves have no value, as well as guarantees of exchange for gold or
other valuable equivalent. Now such money is banknotes and funds in bank accounts.
· Credit cards. Specially issued debt obligations or claims, usually issued in the form of a
security. The loan money must be paid within the specified period. Example: promissory
note, check.
The velocity of money circulation (V) is calculated as the ratio of annual GDP (Y) to the
average annual mass of money (M): V=Y/M.
In the short term, the speed indicator is constant, in the long term it is a variable value that
can be adjusted. The speed of money circulation is affected by:
· banking infrastructure of the country;
· technical equipment of institutions participating in monetary schemes;
· economic activity.
The more advanced satellite, computer communications, and technical equipment of banking
structures are, the more intensively money is turned around and less is required for the stable
functioning of the economy.
12. Monetary base, money supply and monetary aggregates.
The monetary base - funds that are located outside the banking system, they are stored in the
Central Bank, in addition to cash, short-term liabilities belong to this category
MB = C + F + R, where:
C – cash
F – funds on correspondent accounts in commercial banks
R– mandatory reserves in the Central Bank
The monetary base allows the Central Bank to fulfill its main obligations to commercial
banks and government agencies.
The monetary base includes the following characteristics:
1. Cash balances in the cash desks of credit institutions and cash that has been released into
circulation,
2. Balances on reserves that have been attracted by credit institutions,
3. Funds that are present on correspondent accounts,
4. Investments made by credit institutions in bonds of the Central Bank,
5. Other obligations of the Central Bank to credit institutions.
The amount of money circulating in the economy is called the money supply and represent
the amount of money supply, which is measured using monetary aggregates.
The principles of building a system of monetary aggregates in all countries are the same:
· each subsequent aggregate includes the previous one;
· the liquidity of aggregates increases from the last to the first;
· the profitability of aggregates increases from the first to the last.
In the USA, the following monetary aggregates are allocated.
• the monetary aggregate M0 includes cash outside the banking system (paper and metal --
banknotes and coins in circulation), which have the property of absolute liquidity.
• the M1 monetary aggregate, in addition to cash, includes funds in current accounts –
check deposits or demand deposits, as well as traveler's checks:
M1 = Cash + Funds in current accounts + Traveler's checks.
These are highly liquid assets, as funds from current accounts can be withdrawn at any time.
Therefore, in macroeconomics, money is understood as the M1 monetary aggregate, which
most reflects the definition of money as a universal means of payment and their main
function as a medium of circulation.
• the M2 monetary aggregate:
M2 = M1 + Funds in non-check savings Accounts + Small term accounts (less than 100
thousand dollars) + Money market mutual funds + Eurodollar accounts.
Deposits on savings and small term accounts are more profitable, but less liquid than on
current accounts, since withdrawal of funds from them requires prior notification or the
expiration of a certain period.
• the M3 monetary aggregate:
M3 = M2 + Large term deposits + Term accounts in Eurodollars + Certificates of deposit.
Deposits on large term accounts are even more profitable, but less liquid, since the conditions
for receiving funds are even more stringent.
• Monetary aggregate L:
L = M3 + short-term government securities (mainly Treasury bills) + Other less liquid assets.
Thus, the liquidity of monetary aggregates increases from L to M0, and the most liquid
asset is cash, while the profitability of monetary aggregates increases from M0 to L.
Therefore, the monetary aggregates M2, M3 and L reflect the function of money as a store
of value.
13. Quantity theory of money demand. Contemporary theory of money demand.
Quantitative theory of money is one of the popularest and based on the position that the
purchasing power of a monetary unit, as well as the price level in the market are determined
by the amount of money in circulation. Representatives: J. Boden, D. Hume and J.Mill

The main provisions of the theory:

• money is only a means of circulation;
• the real value of money and the prices of goods change due to the collision of money
and commodity masses;
• the price level is proportional to the amount of money in circulation.
However, economic theory is changing over time. And due to its constant evolving, existing
change with it. So, another popular theory, monetary, have changed as well. Nowadays, in
developed countries, a synthesis of monetarism and Keynesianism is used to regulate the
economy.

This is how that works: Most modern economists recognize the need for state influence on
the economy in times of crisis and the use of Keynesian methods, but insist on the need for
self-regulation of the money market after overcoming crisis situations and switching to the use
of modern monetarism methods.
So, use combine 2 methods and, as a result, become a system, which is appropriate for current
economic conditions.

14. Central Bank and money Instruments of money supply regulation.

The modern banking system is two-tiered: the first level is the central bank; the second level
is the system of commercial banks.

The Central Bank is the main Bank of the country: in the United States, its counterpart is the
Federal Reserve System, in the UK is the Bank of England, German Federal Bank
(Bundesbank), in Sweden, the Riksbank, in Russia - the Bank of Russia, etc.

The Central Bank performs the following functions:

• conducting monetary policy is the most important function of the central bank:
• control and regulation of the activities of commercial banks and other financial
institutions the central bank issues and revokes banking licenses to commercial banks,
monitors their compliance with banking legislation, sets the required reserves rate for
them and can store their mandatory reserves, thus, commercial banks are clients of the
central bank (the function of the bank of banks);
• providing loans to commercial banks and other financial institutions at an interest rate
called the discount rate of interest or the refinancing rate (the function of the lender of
last resort);
• providing banking services to the government - servicing financial transactions of the
government, mediation in treasury payments and lending to the government (the
function of the government banker);
• the emission of paper money and coins into circulation is the possession of a monopoly
right to issue banknotes, which provides it with constant liquidity (the function of the
country's issuing center);
• provision of financial services to commercial banks and other financial institutions
(function of the interbank settlement center);
• storage of the country's gold and foreign exchange reserves and regulation of the
exchange rate of the national monetary unit - servicing the country's international
financial transactions, monitoring the balance of payments, playing the role of buyer
and seller in international currency markets, i.e. conducting interventions in the foreign
exchange market.

Balance sheet of bank has liabilities and assets.

Instruments of money supply:

• key rates;
• reserve requirements and management;
• open-market operations;
 • refinancing of credit organizations;
• currency interventions;
• money amounts targeting.

15. Deposit Multiplier. Credit Multiplier. Money multiplier.

The deposit multiplier shows the total amount of deposits that the banking system can create
from each monetary unit invested in a commercial bank account (the amount of money supply
created by 1 rub of deposits)

The multiplier works both ways. The money supply increases if money enters the banking
system (the amount of deposits increases), which leads to deposit expansion, and decreases if
money leaves the banking system (they are withdrawn from accounts), which leads to deposit
compression. However, as a rule, in the economy, money is simultaneously invested in bank
accounts and withdrawn from accounts, so the money supply cannot change significantly. A
change in the value of the deposit multiplier can occur only if the central bank changes the rate
of mandatory reserves, which will affect the credit capabilities of banks. It is no coincidence
that the change in the rate of mandatory reserves is one of the instruments of the monetary
policy of the central bank - the policy of regulating the money supply.
Since the change in the money supply occurs due to the issuance of loans by commercial
banks, this change can be calculated as the sum of loans issued by all banks in the economy:

Credit multiplier can be calculated using deposit multiplier.

The credit multiplier shows a change in the money supply as a result of change in deposits
per monetary unit.

The analysis of the deposit expansion process was based on the assumption that, firstly, money
does not leave the banking sector and does not settle in the form of cash, and therefore the
supply of money is determined only by the behavior of the banking sector, and secondly, that
commercial banks do not keep excess reserves and fully use their credit capabilities

In reality, the amount of money supply is influenced by the behavior of households and firms
(non-hanking sector), which decide in what ratio to divide money between cash and funds in
bank accounts. In addition, as a rule, commercial banks keep excess reserves to ensure
solvency, in order to always be able to issue the amounts required by depositors without
borrowing funds from the central bank or other commercial banks. Under such conditions, the
change in the amount of deposits also has a multiplicative effect, but not a deposit multiplier,
but a money multiplier will act.
16. Reserves of commercial banks.

There are the following types of reserves of commercial banks: required, excess and actual.

Required reserves (Rrec) of a commercial bank represent the amount of funds that the bank
has no right to lend and the amount of which can be calculated by multiplying the amount of
deposits by the rate of mandatory reserves:

Required reserves = Deposits x The rate of required reserves,

With a full reservation system, the rate of mandatory reserves is equal

to 1, and with a partial reservation system 0 < rrr <1.
Excess reserves (Rexs) this is the difference between the amount of deposits and mandatory
reserves; they characterize the credit capabilities (K*) of a commercial bank, since the bank
can potentially issue these funds on credit:

Excess reserves = Deposits - Required reserves,

If the bank issues all these funds on credit, then it uses its credit capabilities fully. However,
the bank may keep part of the funds that it could lend out in the form of reserves. Banks can
keep excess reserves so that if they suddenly need funds, they do not resort to loans from the
central bank or other commercial banks.

The actual reserves are the sum of the mandatory and part of the excess reserves, for some
reason not issued on credit:

Actual reserves = Required reserves + Excess reserves + Loans issued by the bank + Deposits

17. Commercial banks, sources of their profits. Banking (deposit) multiplier

Commercial banks are private organizations (firms) that have the legal right to attract free
funds and issue loans in order to make a profit.
Therefore, the two main types of operations performed by commercial banks are passive
operations - to attract temporarily free funds for deposits - and active operations - to issue
loans. In addition, banks conduct a number of other operations:

• cash settlement; trust (trust);

• interbank (credit - for issuing loans to each other and transfer - for transferring money);
• with securities;
• with foreign currency, etc.

The main part of the income of a commercial bank is the difference between interest on loans
and interest on deposits. Additional sources of income of the bank may be commissions for
the provision of various types of services (trust, transfer, etc.) and income from securities. Part
of the income goes to pay the bank's expenses: salaries of bank employees, costs of banking
equipment and its use, rent of premises, etc. The amount remaining after these payments is the
profit of the bank, tax is paid from it to the state, dividends are accrued to the holders of the
bank's shares and part of it can go to expand the bank's activities.
Like the balance sheet of the central bank, the balance sheet of a commercial bank has two
sides: liabilities (sources of funds), including liabilities (primarily deposits) and the bank's
equity, and assets (areas of use of depositors' funds).
The process of money creation by commercial banks is called deposit expansion. It occurs if
money enters the banking sector and deposits of a commercial bank increase, some of which
the bank issues on credit and which, in turn, are credited to another bank account in the form
of a deposit, etc. If deposits decrease (the client withdraws money from his account), then the
opposite process occurs deposit compression. Commercial banks can create money only with
a partial reserve system.
The deposit multiplier shows the total amount of deposits that the banking system can create
from each monetary unit invested in a commercial bank account (the amount of money supply
created by 1 rub of deposits)
18. Equilibrium in money market. Interest rate and its role in economy.
Macroeconomic equilibrium means the optimal choice in the economy, assuming a
balanced use of limited production resources and their distribution among members of
society, i.e. a balance of production and consumption, resources and their use, supply and
demand, factors of production and its results, material and financial flows. Any economic
system strives to achieve an equilibrium state and preserve it. Economic equilibrium acts as a
correspondence between resources and needs, as a way of using limited resources to create
market goods and services and redistribute them among members of society.
In the money market, equilibrium means that the demand for money from economic
entities, i.e. their desire to keep money in the form of cash or bank deposits, is equal to the
supply, i.e. the amount of money issued by the banking system - the balance between them is
ensured by a flexible interest rate.
Equilibrium in the money market is established when the demand for money is equal to
its supply, which can be achieved at a certain bank interest rate. The equilibrium in the
money market will be maintained when the interest rate changes in the same direction as
income. For example, if incomes in the economy increase, this will lead to an increase in
demand for money, and consequently, to an increase in the interest rate, in this case, the
opportunity cost of storing money will increase and the securities exchange rate will
decrease, which will reduce speculative demand for money, increase the purchase of financial
assets by firms and households and make it possible to maintain monetary the market is in an
equilibrium state.
The interest rate is one of key variables, which in the view of the classics is flexible
quantities, provide equilibrium in the capital market, labor market and money market. The
interest rate balances the supply and demand of investment funds. In equilibrium the interest-
rate will be such that the supply of bonds is equal to the demand for bonds and this according
to Walras’ law means that the supply of money is equal to the demand for money. If the
interest rate rises above the equilibrium level, there will be an increase in the alternative cost
of storing money. The demand for money will fall. If the interest rate falls below the
equilibrium level, then the opportunity cost of storing money will decrease, the demand for
money that will be lacking will increase.
Money market is in equilibrium at a rate of interest when demand for money is equal to
the fixed money supply. Thus money market is in equilibrium when MS = MD. Money
demand (MD) is determined by the level of income and rate of interest.
Graphically, equilibrium of the money market is established at the intersection of the
vertical curve of the real money supply with a negative slope of the demand curve for real
money balances. The coordinates of the intersection point of the course of real management
and the real minus supply corresponds to the level of the equilibrium interest-rate and the
equilibrium value of the real money supply.Comparing the demand for money and the
supply, we find the equilibrium of the money market. Point E is located at the intersection of
the supply and demand curves of money and determines the equilibrium interest rate, i.e. the
alternative cost of storing non-interest bearing money.

19. Inflation: expected and unanticipated inflation. Measurement of inflation.

Demand-pull inflation and cost-push inflation. Causes of inflation.
Inflation (inflation from Italian inflatio — bloating) is a steady upward trend in the overall
price level. In this definition:

· steady trend: inflation is a long—term phenomenon, a long-term process and therefore

it should be distinguished from a jump in prices;
· the general price level: inflation does not mean an increase in all prices in the economy
— prices for different goods can behave differently - rise, fall, remain unchanged — it
is important that the general price level, measured by the GDP deflator or the
consumer price index (CPI), rises.

Measuring inflation:
· The main indicator of inflation is the rate of inflation (rate of inflation), which is
calculated as a percentage of the difference between the price levels of the current
year Pt and the previous year Pt-1 to the price level of the previous year:

Thus, it characterizes the increasing rate of the general price level. If the indicator of
the inflation rate n is negative, then this means deflation.
· The GDP deflator or consumer price index (CPI) is used as an indicator of the overall
price level P.
· the GDP deflator. It measures the cost of a basket of goods and services, including the
prices of all final goods and services produced in the country's economy, weighted by
their quantity. When calculating it, the basket of goods includes the prices of goods
that consumers do not buy, but excludes the prices of goods purchased by consumers.

Causes of inflation:

· Excessive expansion of the money supply due to mass lending.

· The growth of public spending, for the financing of which the state resorts to monetary
emission, increasing the money supply in excess of the needs of commodity turnover.
· Reduction of the real volume of national production
 · The monopoly of large companies on setting prices and determining their own
production costs,
· The monopoly of trade unions in determining the level of salaries.
· The growth of taxes, duties, excises.
· Depreciation of the national currency).

expected and unanticipated inflation:

In the case of expected inflation, the recipient of income can take measures to reduce its
possible negatives, for example, spend money on the necessary deferred purchases.
Unforeseen inflation leads to a decrease in all types of fixed incomes, at the same time
subsidizes those economic agents whose nominal incomes are growing faster than the
average price level.
Demand-pull inflation and cost-push inflation.
According to the criterion of the predominance of monetary and non-monetary factors
in the economy, inflation is subdivided into supply and demand inflation (from-supports). In
this case, demand inflation is a product of monetary factors (prices rise due to the excess of
aggregate demand over aggregate supply). Supply (cost) inflation is caused by non-monetary
factors and is a process of price growth due to an increase in production costs.
20. Phillips Curve in the short run and in the long run: original and modern
versions.
Phillips found that increase in an employment over 2,5- 3% leads to a shop slow down
in the growth of prices and wages. here’s the graphical representation of the inverse
relationship between inflation and unemployment that’s called Phillips curve.

the Phillips curve was considered as a «menu of alternative government policies. For
example, if the unemployment rate was assessed by the government as very low, a
stimulating policy was carried out: public procurement or money supply increased,
which led to an expansion of aggregate demand. The growth of aggregate demand led
to an increase in output, i.e. aggregate supply and, consequently, employment The
price of employment growth is an increase in demand inflation.
 in the 70s of the twentieth century, processes took place in all counries and
almost at the same time, which became a convincing refutation of the Phillips curve.
This period of time is characterized by the simultaneous existence of unemployment
and inflation. In economics, this phenomenon is designated by the temis stagflation (a
combination of stagnation and inflation) and slampflation (the coexistence of rising
unemployment (decline in production) and rising inflation rates).

A new look at the Phillips curve was based on its differentiation in short and long
term periods.
To describe the Phillips curve in a short term period, firstly, the Oaken law is used
and, secondly, the equation of the short-term curve of the aggregate supply.
If the short-term aggregate supply curve is represented as:

Using Oaken's law,we get:

The modern interpretation of the short-term Phillips curve assumes that the inflation
rate is due to three factors:
• expected inflation
• deviations of actual unemployment (U) from its natural level (U*);
• supply shocks caused by an increase in commodity prices (E).
Changes in the expected inflation rate and supply shocks can cause shifts in the
Phillips curve.
To explain the long-term Phillips curve, the concept of the natural unemployment rate
was used, the foundations of which were developed by American economists E.
Phelps and M. Friedman.
It follows from the hypothesis of the natural unemployment rate that the traditional
Phillips curve is valid only for short-term periods, and its type depends on the nature
of the behavior of economic entities, their expectations. In the long term, the Phillips
curve does not exist at all, since the relationship between inflation and unemployment
is represented by a vertical line.
21. Monetary policy: goals and instruments. Central Bank targets. Efficiency
problems in monetary policy implementation.
Monetary policy is the policy of managing the money supply and interest rates.
The main goal is to ensure price stability and low inflation. The lower the inflation rate, the
more favorable the conditions for living and doing business. Maintaining price stability helps
to solve several urgent problems for the state at once:

· to protect citizens' savings in the national currency from depreciation;

· increase the availability of credit financing for legal entities;
· simplify strategic planning for business;
· increase confidence in the national currency;
· protect low-income citizens.

Tools:

· Key interest rate

 · Regulation of official reserve requirements
· State operations on the "open" market of buying and selling currency to stabilize the
ruble exchange rate;
· introduction of restrictions on operations of credit institutions;
· Central Bank bond issue;
· installing financial indicators and tracking their dynamics;
· refinancing of credit institutions.

Problems of monetary policy implementation

Liquidity trap problem, stabilization policy deceleration effect, deregulation effectiveness of
monetary policy, cyclical symmetry problems, change in money supply turnover rate,
investment effect, interest income effect, inflation problems
The central bank is a state body that manages the banking system and is responsible for
conducting monetary policy.
When conducting monetary policy, the Central Bank has certain goals, or final benchmarks,
such as:
1) achieving a high level of employment;
2) economic growth;
3) stabilization of financial and currency markets;
4) price stability and control over the rate of inflation.
To achieve these goals, the Central Bank can use monetary policy instruments: open market
operations, foreign exchange market interventions, refinancing rate, mandatory reserve rate.
22. State budget: revenue side and expenditure side. Budget deficit
and public debt
The state budget is an estimate of the income and expenses of the state for a certain
period of time, most often for a year, compiled with an indication of the sources of receipt of
state revenues and the directions of channels for spending funds.
The State budget is drawn up by the Government, approved and adopted by the
highest legislative bodies.
In the process of budget execution, there may be a partial revision of the budget.

The revenue part of the state budget includes:

· taxes,
· excise duties,
· customs duties,
· income from state property,
· the receipt of money from social insurance funds, pension and insurance funds, loans,
· the issue of money.

The expenditure part of the state budget includes:

· expenses for the maintenance of the state apparatus, police, justice,
· expenses for the material support of foreign policy, for the maintenance of diplomatic
services,
· defense expenses,
· expenses for education, health, social sphere,
· expenses for financing various sectors of the economy, investments in infrastructure,
subsidies,
· the costs of providing subsidies and loans to other countries, servicing both internal
and external debts of the state.
The budget deficit is the amount of money by which budget expenditures in a given period
exceed its revenues.
The reasons for the formation of the budget deficit are primarily negative components:
• Reduction of state budget revenues during the economic crisis.
• Extraordinary circumstances (wars, riots, major disasters, natural disasters)
• Inefficiency of the financial system of the state.
• Corruption in the public sector.
• Inefficiency of tax policy, causing an increase in the shadow sector of the economy.
However, the deficit can be the result of some positive (neutral) event:
• The growth of government spending due to the structural restructuring of the
economy and the need for industrial development.
• Overstated expenses for the implementation of adopted social programs
The state budget deficit can be financed in three ways:
· by issuing money
· at the expense of a loan from the population of their country (internal debt)
· by borrowing from other countries or international financial organizations (external
debt).
Public debt is the borrowing of the state in order to cover the budget deficit.It usually
consists of the external and internal debts of the government. This also includes the
obligations of municipalities and regions. Net public debt is the amount that remains if all
creditors demand repayment of the debt at the same time.
The consequences of public debt:

· shifting the tax burden to future generations;

· redistribution of income of the population;
· displacement of private deposits (issuance of government securities).

23. Fiscal policy of the government. Its goals and instruments. Automatic stabilizers and
discretionary policy. Efficiency problems.
The fiscal policy of the state - is understood as the system of regulating the economy
through government spending and taxes, i.e., it is reduced to the manipulation of taxes and
government spending.
The following objectives of fiscal policy are distinguished:
• smoothing out fluctuations in the economic cycle
• ensuring sustainable economic growth
• achieving a high level of employment at a moderate rate of inflation.
General fiscal policy is divided into two types:
• discretionary
• non-discretionary (automatic) fiscal policy.

Discretionary fiscal policy is caused by conscious decisions of the government in the field
of public spending and taxes in order to affect the real volume of national income,
employment and inflation. In this case, new laws are usually adopted.
The main instruments of discretionary policy are:
1. changes in tax rates
2. public works projects
3. employment of the population.
This is an active fiscal policy of the state.
Discretionary fiscal policy, implemented in order to smooth the economic cycle, is of two
types:
1. Expansionary (stimulating)
• is associated with an increase in government spending and tax cuts, or combines these
measures (since the multiplier effect of government spending is greater than from tax
cuts). In the short term, such a policy reduces the decline in production due to deficit
financing.
2. Restrictive (contractionary), or restraining
• is associated with an increase in taxes and a reduction in government spending, or
combines measures to limit the inflationary growth of the economy.

Non-discretionary (automatic) fiscal policy does not require special decisions of the
government, as it is based on the action of built-in stabilizers that lead to automatic changes
in tax revenues to the state budget and public expenditures. This is passive fiscal policy.

Automatic stabilizers
The built in (automatic) stabilizer - is an economic mechanism that automatically reacts to
changes in the economic environment.
Automatic stabilizers maintain economic stability based on self- regulation. The built-in
stabilizers are: progressive income tax, unemployment benefits, poverty benefits, subsidies to
farmers, as well as a profit sharing system. With the help of built-in stabilizers, depending on
the economic situation, tax revenues and government transfers change, so they smooth out
cyclical fluctuations, not eliminate them.
During recession, built-in stabilizers lead to a decrease in tax revenues to the state budget, an
increase in social payments and a state budget deficit. During the ascent, the reverse process
occurs.
Efficiency problems. (The effectiveness of fiscal policy in the IS-LM)
The efficiency influenced by 2 factors:
1- the degree of sensitivity of the investment function to the dynamics of the market interest
rate (d)
2 - the degree of sensitivity of the demand for money to the dynamics of the market interest
rate (h)
Graphically, the same 2 factors determine, respectively: 1- the slope of the IS curve (d) 2-
the slope of the LM curve (h)
Rule for efficiency: If the effect of displacement is less than the effect of output growth,
then all other things being equal, fiscal policy is effective, and vice versa.
Left pic. - IS has a steeper slope (d is rather small) - the policy is effective
Right pic. - IS has a more gentle slope (d increases) - the policy is ineffective
Moreover, fiscal policy is most effective if:
• autonomous expenditures (investments) are weakly sensitive to the interest rate
• the demand for money is highly sensitive to the interest rate and weakly sensitive to
changes in output

24. Public sector of economy: production of public goods and so called “market failures”.
The public sector of the economy represents all State institutions and agencies. This sector:
• organizes the production of public goods
• carries out social payments
• redistributes the national income of the country between individual sectors of the
economy
• ensures the supply of funds in the national economy
• conducts another set of measures to regulate the country's foreign economic relations.

The public sector is used as a tool for regulating a wide range of socio-economic goals and
objectives. It acquires the greatest importance in the conditions of deteriorating market
conditions, depression or crisis.
Indicators for quantifying the impact of the public sector on the economy are:
a. the share of GNP, GDP created in the public sector
b. the number of workers and employees employed in it
c. the number of public sector enterprises in general and by individual sectors

Production of public goods

Public goods - are a set of goods and services that are provided to the population free of
charge, at the expense of state funds. (e.g., roads, healthcare,education, and services provided
by state and municipal authorities)

C. Fischer emphasizes that "the state should not produce public goods; it should only
determine how much each of these goods should be produced. To ensure real production, it
can rely on private contractors".
Regarding the mechanism of distribution of public goods, the laws of the national economy
are powerless – they are not able to work effectively in this area of the market. Therefore,
objectively, this task is assumed by the state – the state apparatus.

The problems of identifying the real demand for public goods create serious difficulties in
determining the optimal supply volumes and financing. The theoretical solution was proposed
back in the 50s of the 20th century and was called the Samuelson general equilibrium
model. Optimum condition for an economy with a public good:

where MRS - is the marginal rate of substitution

MRT – the marginal rate of transformation
I- is the number of consumers.
Market failures:
Market failures - are situations in which the free action of market forces does not ensure the
efficient use of resources. Among them are:
• The presence of monopolies, as well as oligopolies in certain sectors of the economy.
• Information asymmetry between producers and consumers
• External effects
• Public goods
There are pure public goods that the market does not produce at all (national defense), and
mixed public goods (club, socially significant and quasi-public goods) that the market can
produce, but in insufficient quantities.

Central problem of production of public goods - the problem of a stowaway.

The stowaways underestimate the value of a purely public good, and this leads to a lower
volume of its production compared to the effective volume. Thus, the possibility of free
consumption of purely public goods causes the inefficiency of their production.

25. Exchange rate regimes: fixed, free float and managed float.
The exchange rate - is the ratio by which the currency of one country is exchanged for the
currency of another country. This is the price of a foreign currency expressed in the national
monetary unit.

The exchange rate regime - is the way in which the monetary authority of a country or
monetary union manages a currency in relation to other currencies and the foreign exchange
market.
Fixed exchange regime:
A fixed exchange rate - is an officially established ratio between national currencies based
on mutual parity. Under the fixed exchange rate regime, the central bank sets the exchange
rate of the national currency at a certain level in relation to the currency of any country to
which the currency of this country is "tied", to the currency basket or to the international
monetary unit.
• A change in the fixed exchange rate occurs as a result of its official revision
(devaluation – decrease or revaluation – increase). The fixed exchange rate regime is
usually established in countries with strict currency restrictions and non-convertible
currency.
Free float:
Free floating - is a system in which the exchange rate is determined solely by supply and
demand in the foreign exchange market. The regime is based on the ideology of laissez-faire
– perfect competition, non-interference of the state, market self-regulation.

The most illustrative example is the United States, where the exchange rate is not regulated
and is not targeted even at the level of statements and comments of the monetary authorities.

The free-floating system is effective in conditions of economic and political stability, and a
low inflationary background.

The disadvantages of a floating exchange rate are that: this course is unpredictable and it has
a large range of fluctuations negatively affects the inflow of foreign capital into the country

Managed float:
The managed or "dirty" floating system - means that the Central Bank does not fix the
exchange rate, but allows currency interventions to prevent sharp fluctuations in the
exchange rate.
**In addition, in some countries, the managed floating system implies the mandatory sale of
part of the foreign exchange earnings of exporters of the Central Bank.

Advantages: Regulated changes in the exchange rate make it possible to eliminate persistent
deficits or active balance of payments balances.

26. Balance of payments and exchange rate regime.

The balance of payments - is a systematic record of all economic transactions between residents of a
given country and the rest of the world (non-residents) that occurred during a certain period of time
(usually a year).

The balance of payments is based on a double entry: each transaction is reflected twice - on the credit
of one item and the debit of another. The credit refers to those transactions, as a result of which there
is an influx of currency into the country. Debit refers to those transactions as a result of which the
country spends currency.
The balance of payments consists of three main parts:
1. current account
reflects the sum of all transactions of a given country with other countries related to trade in goods,
services and transfers and therefore includes:
• export and import of goods (visible)
• export and import of services (invisibles), for example, international tourism.
• net income from investments (otherwise called net factor income or net income from credit
services)
• net transfers, which include foreign aid, pensions, gifts, grants
The current account balance in macroeconomic models is reflected as net exports: Ex – Im = Xn = Y
– (C + I + G)
where Ex is exports, Im is imports, Xn is net exports, Y is the country's GDP,

2. capital account (articles reflecting the movement of capital)

• capital inflows and outflows are reflected, both for long-term operations and for short-term ones
• The export of capital is carried out in two forms: entrepreneurial and loan (in the form of loans,
credits, etc.).

3. financial account (changes in foreign exchange reserves)

Reflection of operations related to the maintenance of the national currency exchange rate and the
alignment of the balance of payments.
• A negative balance shows a net increase in foreign assets of residents and/or a net decrease in
their foreign liabilities.
• On the contrary, a positive balance - a net decrease in foreign assets of residents and/or an
increase in their liabilities to non-residents.

All in all, Balance of payments equilibrium is achieved by: Xn+ (I- Sn)=0
where Xn - current account balance
(I - Sn) - balance of the account of operations with capital and financial instruments (without
changes in official reserves - Sn)

How does the exchange rate affect the balance of payments?

The growth of the country's exchange rate leads to the fact that it will increase imports,
reduce exports, which, in turn, will lead to a negative trade balance of this country, which
cannot be maintained for a long time, otherwise it will undermine its gold and foreign
exchange resources.

If, on the contrary, the currency becomes cheaper. The goods of the country have become
more competitive, which may lead to an increase in sales markets. In the event of an increase
in exports and a reduction in imports by the country, the trade balance will be positive.
However, this situation cannot continue permanently, since the export-import operations of
countries are interconnected. Other countries, in order to keep the trade balance positive, may
raise customs duties or introduce licenses for the import of goods, limiting imports.
 27. IS-LM model: equilibrium in goods and money markets.
IS–LM model, or Hicks–Hansen model, is a two-dimensional macroeconomic tool that
shows the relationship between interest rates and assets market (also known as real output in
goods and services market plus money market). The intersection of the "investment–saving"
(IS) and "liquidity preference–money supply" (LM) curves models "general equilibrium"
where supposed simultaneous equilibria occur in both the goods and the asset markets. Yet
two equivalent interpretations are possible: first, the IS–LM model explains changes in
national income when the price level is fixed in the short-run; second, the IS–LM model
shows why an aggregate demand curve can shift. Hence, this tool is sometimes used not only
to analyse economic fluctuations but also to suggest potential levels for appropriate
stabilisation policies.
The model was created, developed and taught by Keynes.However, it is often believed that
John Hicks invented it in 1937,and was later extended by Alvin Hansen,as a mathematical
representation of Keynesian macroeconomic theory.(дополнительная информация)
The basis of the IS-LM model is an analysis of the money market(LM) and an analysis of
the goods market(IS), which together determine the equilibrium levels of interest rates and
output in the economy, given prices. The model finds combinations of interest rates and
output (GDP) such that the money market is in equilibrium. This creates the LM curve. The
model also finds combinations of interest rates and output such that the goods market is in
equilibrium. This creates the IS curve. The equilibrium is the interest rate and output
combination that is on both the IS and the LM curves.

Formation:The point where the IS and LM schedules intersect represents a short-run

equilibrium in the real and monetary sectors (though not necessarily in other sectors, such as
labor markets): both the product market and the money market are in equilibrium. This
equilibrium yields a unique combination of the interest rate and real GDP.
IS (investment–saving) curve
The IS curve shows the causation from interest rates to planned investment to national
income and output. For the investment–saving curve, the independent variable is the interest
rate and the dependent variable is the level of income.
The IS curve also represents the equilibria where total private investment equals total saving,
with saving equal to consumer saving plus government saving (the budget surplus) plus
foreign saving (the trade surplus). The level of real GDP (Y) is determined along this line for
each interest rate. Every level of the real interest rate will generate a certain level of
investment and spending: lower interest rates encourage higher investment and more
spending. The multiplier effect of an increase in fixed investment resulting from a lower
interest rate raises real GDP. This explains the downward slope of the IS curve. In summary,
the IS curve shows the causation from interest rates to planned fixed investment to rising
national income and output.
The IS curve is defined by the equation:

LM (liquidity-money) curve
The LM curve shows the combinations of interest rates and levels of real income for which
the money market is in equilibrium. It shows where money demand equals money supply. For
the LM curve, the independent variable is income and the dependent variable is the interest
rate.
In the money market equilibrium diagram, the liquidity preference function is the willingness
to hold cash. The liquidity preference function is downward sloping (i.e. the willingness to
hold cash increases as the interest rate decreases). Two basic elements determine the quantity
of cash balances demanded:
1.Transactions demand for money: this includes both (a) the willingness to hold cash for
everyday transactions and (b) a precautionary measure (money demand in case of
emergencies). Transactions demand is positively related to real GDP. As GDP is considered
exogenous to the liquidity preference function, changes in GDP shift the curve.
2.Speculative demand for money: this is the willingness to hold cash instead of securities as
an asset for investment purposes. Speculative demand is inversely related to the interest rate.
As the interest rate rises, the opportunity cost of holding money rather than investing in
securities increases. So, as interest rates rise, speculative demand for money falls.
Money supply is determined by central bank decisions and willingness of commercial banks
to loan money. Money supply in effect is perfectly inelastic with respect to nominal interest
rates. Thus the money supply function is represented as a vertical line – money supply is a
constant, independent of the interest rate, GDP, and other factors. Mathematically, the LM
curve is defined by the equation
M/P=L(i,Y), where the supply of money is represented as the real amount M/P (as opposed to
the nominal amount M), with P representing the price level, and L being the real demand for
money, which is some function of the interest rate and the level of real income.
An increase in GDP shifts the liquidity preference function rightward and hence increases the
interest rate. Thus the LM function is positively sloped.

28. Application of IS-LM model for economic policy analysis in open

economies.
The Mundell–Fleming model, also known as the IS-LM-BoP model (or IS-LM-BP model), is
an economic model first set forth (independently) by Robert Mundell and Marcus Fleming.
The model is an extension of the IS–LM model. Whereas the traditional IS-LM model
deals with an economy under autarky (or a closed economy), the Mundell–Fleming
model describes a small open economy.
The Mundell–Fleming model portrays the short-run relationship between an economy's
nominal exchange rate, interest rate, and output (in contrast to the closed-economy IS-LM
model, which focuses only on the relationship between the interest rate and output). The
Mundell–Fleming model has been used to argue that an economy cannot simultaneously
maintain a fixed exchange rate, free capital movement, and an independent monetary policy.
An economy can only maintain two of the three at the same time. This principle is frequently
called the "impossible trinity
Basic assumptions of the model are as follows:
· Spot and forward exchange rates are identical, and the existing exchange rates are
expected to persist indefinitely.
· Fixed money wage rate, unemployed resources and constant returns to scale are assumed.
Thus domestic price level is kept constant, and the supply of domestic output is elastic.
· Taxes and savings increase with income.
· The balance of trade depends only on income and the exchange rate.
· Capital mobility is less than perfect and all securities are perfect substitutes. Only risk
neutral investors are in the system. The demand for money therefore depends only on income
and the interest rate, and investment depends on the interest rate.
· The country under consideration is so small that the country cannot affect foreign incomes
or the world level of interest rates.
Mechanics of the model
The model's workings can be described in terms of an IS-LM-BoP graph with the domestic
interest rate plotted vertically and real GDP plotted horizontally. The IS curve is downward
sloped and the LM curve is upward sloped, as in the closed economy IS-LM analysis; the
BoP curve is upward sloped unless there is perfect capital mobility, in which case it is
horizontal at the level of the world interest rate.
In this graph, under less than perfect capital mobility the positions of both the IS curve and
the BoP curve depend on the exchange rate, since the IS-LM graph is actually a two-
dimensional cross-section of a three-dimensional space involving all of the interest rate,
income, and the exchange rate. However, under perfect capital mobility the BoP curve is
simply horizontal at a level of the domestic interest rate equal to the level of the world
interest rate.
Summary of potency of monetary and fiscal policy
As explained below, whether domestic monetary or fiscal policy is potent, in the sense of
having an effect on real GDP, depends on the exchange rate regime. The results are
summarized here.
Flexible exchange rates: Domestic monetary policy affects GDP, while fiscal policy does not.
Fixed exchange rates: Fiscal policy affects GDP, while domestic monetary policy does not.
Some of the results from this model differ from those of the IS-LM model because of the
open economy assumption. Results for a large open economy, on the other hand, can be
consistent with those predicted by the IS-LM model. The reason is that a large open economy
has the characteristics of both an autarky and a small open economy. In particular, it may not
face perfect capital mobility, thus allowing internal policy measures to affect the domestic
interest rate, and it may be able to sterilize balance-of-payments-induced changes in the
money supply (as discussed above).
In the IS-LM model, the domestic interest rate is a key component in keeping both the
money market and the goods market in equilibrium. Under the Mundell–Fleming framework
of a small economy facing perfect capital mobility, the domestic interest rate is fixed and
equilibrium in both markets can only be maintained by adjustments of the nominal exchange
rate or the money supply (by international funds flows).

29. Macroeconomic policy of the state in a market economy.

The instability inherent in a market economy and manifested in the inequality of aggregate demand
and aggregate supply, entailing overproduction or underproduction of goods and services,
underemployment of all resources, etc., necessitates the state to take measures to smooth out these
manifestations.
The macroeconomic policy of the state is a system of measures and measures aimed at maintaining
the functioning of the economy, creating and improving conditions for its development.
The main objective of the implementation of macroeconomic policy is to maximize public welfare.
The achievement of this goal is associated with the setting of lower-level goals that clarify and specify
the areas of activity, which can include:
– ensuring sustainable economic growth;
– full employment of resources;
– price level stability;
– balance of the state budget;
– smoothing of cyclic fluctuations;
– regulation of the money supply, etc.
All objectives of macroeconomic policy can be classified according to the following criteria:
1) priorities:
– strategic (final),
– tactical (intermediate, focused on achieving strategic goals),
– operational (aimed at solving current tasks that contribute to the implementation of tactical and
strategic goals);
2) scale:
– general (for the whole system),
– private (for subsystems);
3) time:
– long–term,
– medium-term,
- short-term.
To achieve these goals, the institutional and legal foundations of the economic environment can be
adjusted and changed, as well as various tools can be used:
1) economic:
– fiscal - regulation through taxes and government expenditures in order to influence aggregate
demand and aggregate supply,
– monetary – changes in the money supply, refinancing rates, reserve rates, conducting operations on
the open market, etc.,
– foreign trade – regulation of customs tariffs, quotas and the use of non-tariff methods in order
to increase or restrain the export and import of goods and services,
– state entrepreneurship: the state is an economic entity directly involved in production and
commercial operations,
- social – establishment of minimum wage rates, payment of unemployment benefits, etc.,
– state programming, indicative planning;
2) administrative: the introduction of prohibitions, permits (licensing), standards and regulations
governing activities in various industries and sectors of the economy;
3) legal: on the basis of normative legal acts, rules and principles of conducting economic activity are
established.
Directions of the macroeconomic policy of the state:
Fiscal-Regulation of the revenue and expenditure parts of the budget, stimulating demand or supply,
etc.
Monetary-The impact on the amount of money in the market
Investment-Raising capital to expand production opportunities in developing industries
Structurally sectoral-Taking measures and developing measures to improve intersectoral and intra-
sectoral proportions, stimulating the development of industries that ensure scientific and technological
progress, increasing the competitiveness of domestic products
Ecological-Rational use and reproduction of natural resources
Innovative-Development of scientific and technical potential of the country
Antimonopoly-Restriction and prevention of monopolization of markets, promotion of competition
Foreign economic-Regulation of foreign trade, promotion or restriction of exports and imports
Social-Maintenance and improvement of living conditions of the population
 30. Joint equilibrium in the markets of goods, money and securities.
The IS-LM model.
IS–LM model, or Hicks–Hansen model, is a two-dimensional macroeconomic tool that
shows the relationship between interest rates and assets market (also known as real output in
goods and services market plus money market). The intersection of the "investment–saving"
(IS) and "liquidity preference–money supply" (LM) curves models "general equilibrium"
where supposed simultaneous equilibria occur in both the goods and the asset markets. Yet
two equivalent interpretations are possible: first, the IS–LM model explains changes in
national income when the price level is fixed in the short-run; second, the IS–LM model
shows why an aggregate demand curve can shift. Hence, this tool is sometimes used not only
to analyse economic fluctuations but also to suggest potential levels for appropriate
stabilisation policies.
The basis of the IS-LM model is an analysis of the money market(LM) and an analysis of
the goods market(IS), which together determine the equilibrium levels of interest rates and
output in the economy, given prices. The model finds combinations of interest rates and
output (GDP) such that the money market is in equilibrium. This creates the LM curve. The
model also finds combinations of interest rates and output such that the goods market is in
equilibrium. This creates the IS curve. The equilibrium is the interest rate and output
combination that is on both the IS and the LM curves.
Combining the discussion of the LM and the IS curves will generate equilibrium levels of
interest rates and output. Both relationships are combinations of interest rates and output.
Solving these two equations jointly determines the equilibrium. This is shown graphically in
Figure:

This just combines the LM curve and the IS curve. The crossing of these two curves is the
combination of the interest rate and real GDP, denoted (r*,Y*), such that both the money
market and the goods market are in equilibrium.

31. Macroeconomic equilibrium in an open economy. Concepts of

international trade: mercantilists, physiocrats, classical theories of A.
Smith, D. Ricardo, J. S. Mill, neoclassical theory of Heckscher-Olin-
Samuelson.
The macroeconomic equilibrium of an open economy illustrates a situation in which
simultaneous equilibrium is achieved in the commodity, monetary and foreign markets. The
modern open economy equilibrium model is based on the synthesis of traditional classical
and Keynesian approaches.According to the Keynesian approach, everything produced in a
closed economy is used for domestic consumption by households (C), businesses (I) and the
state (C). In an open economy, GDP is determined by the sum of domestic spending and net
exports. This means that the problems of macroeconomic equilibrium have an external
economic aspect and their solution requires the use of tools to restore balance between
national output and total expenditures.

It follows from the identity of the national accounts that the growth of national production,
and consequently, employment, income and foreign exchange reserves contributes to the
growth of exports. At the same time, imports are considered as a function of the national
income of the importing country. Consequently, an increase in imports leads to a reduction in
domestic spending, which means a decrease in national production and foreign currency
reserves. As a result, the equilibrium output of national production will be influenced by the
indicator of net exports NX = Y – (C + I + G).

The impact of net exports on the equilibrium output volume can be estimated using the
"Keynesian cross" model

The pioneer theory of international trade is traditionally considered mercantilist theory, the
foundations of which were laid in the works of A.Moncretien, T.Mana, J.D.-Stewart. Drawing
attention to the fact that the export of industrial and handicrafts is the source of the country's wealth,
and foreign goods are the reason for its outflow, the founders of mercantilism declared trade a source
of enrichment of the state, recommending that states strive to promote exports and restrict imports to
ensure the inflow and accumulation of income. The main factors of economic prosperity were
recognized as the state's stimulation of the production and export of finished products, protectionism
against importers, ensuring the inflow of funds into the country through a ban on their export.
The key assumptions of mercantilism became a reflection of the pre-industrial period of development,
the main sign of wealth of which was the accumulation of gold. Mercantilism did not envisage that an
active trade balance provides not only an increase in the amount of money in the country, but also
leads to an increase in domestic prices. As a result, goods produced in the country become more
expensive and lose competitiveness in the foreign market. A decline in exports, in turn, can lead to a
negative trade balance and an outflow of money from the country. Criticism of mercantilism became
the starting point for new economic theories.

The first such theory was the theory of absolute advantages (D.North, D.Hume and A.Smith),
according to which it is advantageous for each state to export those goods whose production costs in
the country are lower than in other countries (the absolute advantage of the exporting country), and
import those goods whose production costs are relatively higher (the absolute advantage of countries-
importers). In other words, trade between states can be mutually beneficial. The main prerequisite for
mutually beneficial trade is differences in production costs in different countries. And the prerequisite
for economic development is non–interference in the economy by the state and the development of
production through the division of labor and competition.

The answer to the question of why countries trade without having an absolute advantage in the
production of certain goods was the theory of relative or comparative advantages formulated in
1817 by D. Ricardo. Its main difference was the postulate that exports and imports can be profitable
even in the absence of absolute advantages. Namely: in situations where the production costs of
imported goods are higher than the production costs of exported goods. As a result, imports are
favorable for the country even in cases when imported goods can be produced domestically at lower
costs than abroad. And participation in world trade is advantageous for all its subjects
According to the theory, it is advantageous for participants in trade relations to specialize in the
production and export of those goods whose opportunity cost (the cost of producing a unit of one
product, expressed in terms of the cost of producing a unit of another product) is less than the
opportunity cost of production in the country importing this product. This principle also applies to
situations in which one country has an absolute advantage in the production of all goods.
D. Ricardo's theory requires certain conditions for its application: the same cost of labor in trading
countries, the absence of restrictions in trade relations, zero transport costs, full employment,
immobility of factors of production between countries, labor costs are the only production costs,
production costs are constant, etc.

The foundations of the theory of market equilibrium were laid in the works of J.S.Mill and Luvalras,
and she found her classic look thanks to A. Marshall. This theory proceeds from the idea that the
markets of goods and services tend to an equilibrium state between the volumes of supply and
demand for these goods and services. The magnitude of supply and demand is directly determined by
prices: the lower the price, the higher the demand and lower the supply, and vice versa. The final price
for a product or service is set when the volumes and prices of supply and demand coincide.
Deviations from equilibrium states in the market - exceeding either demand or supply - are possible,
but temporary. The economy always strives for a state of equilibrium in all markets – goods and
factors of production, internal and external. This equilibrium is not stationary and changes following
changes in the structure and volume of supply and demand.

The Heckscher-Ohlin-Samuelson theory of trade

Production functions are identical in all countries and show constant returns to scale. If the
two factors are land and labor, commodities are distinguished by their factor intensities, such
that one of them is more labor-intensive than the other at all factor prices.
This theory proceeds from the assumption that the price of factors of production in a country
is directly determined by their excess and, as a result, goods in the production of which
excessive and relatively cheap factors of production prevail will be relatively cheaper. As a
result, countries export goods produced using factors of production that are excessive for
them, and import those goods in the production of which the factors of production that they
are endowed with are worse. This statement was called the Heckscher-Ohlin Theorem, and
the theorem itself became the core for the theory of the ratio of factors of production – a set
of theoretical tools that extend the Heckscher-Ohlin theorem