SUMMARY ALL ECONOMY

UNIT 1.
Concepts
GDP
Monetary measure of the market value of all final goods and services provided in a specific time period by a
country
• Nominal GDP: affected by inflation
• Real GDP: not affected by inflation. Takes a year as a base for prices so they do not change each year.
• GDP per capita: shows the level of wealth of a population
Price index (Laspeyres)
Measures change in between the base year and current period
Production function
Expression describing the amount of output that can be produced by any given amount of input
X axis = output; Y axis = input
Average product of labour
Average output per unit of input
Is the slope from the point to the origin
output
Average product =
input
Iso-cost lines
Line that represents all the combination of inputs that have the same costs
Iso-cost lines further from the origin are more expensive
As it is a function, it can be defined as:
y = ax + b
Costs = wages x labour + price of input x input
If labour = x and input = y
C = wage x + price y
Y = - w/p x + c/p

The slope of the iso-cost line is the wage-capital ratio -> - wage / price of input

History
Real wages were relatively stable between 1260-1850 -> Malthusian trap
Real wages started increasing -> Escape period
Malthusian model: model that explains the situation between 1260-
1850
1. Technological advances
2. Caused gains in average living conditions
3. These increased population
4. Dilute the average jmprove conditions

When we produce more food, the living

standards increase and as a result population
starts increasing
Imagine an agricultural economy
Point A = 50000/800 = 625 kg produced per farmer = AP
What happens when the population grows?
The more farmers there are, the more grain is produced, but up to a
certain point
From A to B inputs doubles but production less than doubled ->
Disminishing average product
As more farmers work the same amount of land, average product falls

So, living standards depend on the size of the population. Therefore, when populatkon increased, they would
push down incomes as a result of the disminishing average product of labour. Falling living standards would
slow population growth returning to the first point.

However, population does not fall back to the initial level so in the long run, an increase in productivity results
in a larger population but not higher wages.

Malthusian model cannot be used to explain the Escape period

UNIT 2.
Concepts
Marginal product
Change in output per unit change in input
Is the slope of the tangent of the production function at the point
ΔY Δ output
Marginal product = =
ΔX Δ input
Example: studying from 4 to 5 hours is 7 points difference -> MP = 7
Decreasing marginal product
Marginal product decreases as we move along the curve
For example: studying become less productive each hour you add. Studying from 4 to 5 hours increases 7 points
while studying from 10 to 11 increases 3 points
Opportunity cost
Opportunity cost of an action is the net benefit of the next alternative
Oportunity cost = benefit of the other alternative
Example: you have to decide between going to the theatre or to a park concert. If you decide to go to the
theatre, the foregone pleasure of going to the park concert is the opporutnity cost = 15€
Economic cost
Economic cost = monetary cost + opportunity cost
Economic rent
When taking some action results in a greater benefit than the next best option
Economic rent = monetary cost + subjective cost – economic benefit
Feasibility frontier
Maximum output that can be achieved with a given amount of input
Marginal rate of transformation
Represent the trade-offs that the individual faces
Is the slope of the fasibilkty frontier
Example: for having 14 hours of free time instead of 13, losese 3 points
(opportunity cost) -> MRT = 3
Indifference maps
Describe the preferences.
Shows all combinations that give the same utility or satisfaction
Indifference curves further from the origin produced more satisfaction
Marginal rate of substitution
Trade off a person is willing to make between two goods
Is the slope of the tangent of the indifference curve
Example: you are willing to lose 9 points to increase free time from 15 to 16
hours of free time -> MRS =9
Equilibrium point
Where MRS = MRT
Income effect
Change in choice when income changes, keeping opportunity costs constant
Substitution effect
Change in choice when opportunity cost changes

UNIT 3.
Concepts
Social interactions
Situations involving more than one party, where one’s actions affect both their own and other people’s
outcome
Social dilema
What is best for an individual may be worst for society
Best response
Strategy that gives you the highest payoff given a strategy from the other player
Ex: if Bala chooses Cassava, Anil’s best response is rice
Dominant strategy
A strategy which is the best response independently of the other players’ strategies
Ex: if Bala chooses Cassava, Anil’s best response is rice. if Bala chooses rice, Anil’s best response is rice.
Therefore, Anil’s dominant strategy is rice
Nash equilibrium
Set of strategies where each player’s strategy is the best reponse to the strategies chosen by everyone else. In
such case no plater has an incentive to derivate
Prisioners’ dilemma
Game with a dominant strategy equilibrium in which playing the dominant strategy yields lower individual and
total payoffs compared to other strategies
Why does this happen?
- Players are selfish
- Nobody can impose players consequences
- Players could not coordinate beforehand
Solutions for better social outcomes?
- Altruism
- Repeated games
- Negotiations and fairness
Altruism
If Anil is completely selfish he has vertical indifference curves. The one more far away
from the origin gives him highest utility
If he is somewhat altruistic, he has downward slopping indifference curves. Point B gives him now the highest
utility
Repeated games
Games played more tha once. This may lead to better outcomes due to social norms, reciprocity and peer
punishment
Also, behaving selfishly may have consequences in the future
Public good games
Example:
- Contribution cost -10€
- Benefits +8€ per contributor
Everyone is better off by not contributing -> Two farmers contribute. If Kim contributes: 14€, if Kim does not
contribute: 16€
In repeated public goods games a pattern of reduction in constributions have been identified:
- Each round contributors decided to lower contributions because some are not contributing
How to solve it? Peer-punishment
With punishment contributions do not decline with repetition, some even increase
Negotiations and fairness
Example: game, proposer chooses a quantity to give the responder between 0 and 10 and the rest shee keep it.
If the responder accepts it then they split the money, if not, the money is not given to anybody
This have several solutions
Judging game solutions: efficiency
Pareto efficiency: one allocation is efficient if there are at least one inndividual is better off wothout nobody
else being worse off
Judging game solutions: fairness
Two concepts of fair:
- Substantive fairness: equality in material and non-material outcomes (what matter is the outcome)
- Procedural fairness: what matters is the procedure, not the outcome
One operationalization: An allocation is fair if we accept before knowing which role we play:
- The Veil of Ignorance (John Rawls): veil of ignorance prevents us from judging fair outcomes based on
own own biases towards our outcomes.
Judging game solutions: inequality
Focus on how unequal a solution is
How can we measure inequality?
- Lorenz curve: shows how much disparity there is in income or any other measurement accross the
population
Shows the population lined up along the horizontal axis from the poorest to the richest. The height of
the curve at any point on the horizontal axis indicates the fraction of total
income or other measure received by the fraction of the population given by
that point on the horizontal axis.
Example: a village with 10 landowners, each owning 10 hecatares, and 90
others who farm the land but who own no land
Lorenz curve is the blue line: 90% own nothing and remaining 10% own
100%
If instead each member owned one hactare then the curve would be a line at
a 45 degree angle
Lorenz curve allows us to see how far a distribution departs from this line of
perfect equality
- Gini coefficient: numerical measure of inequality, from 0 [perfect equality] to 1 [maximum inequality]
We can calculate the Gini for land ownership in the last figure as area A, between the Lorenz curve and
the perfect equality line, as a proportion of area (A + B), the triangle under the 45-degree line:
Gini = A / (A + B)
Judging game solutions: inequality and government
Government policies can help to mitigate inequality
- Taxes and transfers can lead to a more equal distribution of disposable income
UNIT 4.
Concepts
Employment rent
Employment rent = cost of job loss
Cost of job loss may include: lost income, cost required to start a new job, loss non-wage benefits, social costs…
Reservation wage
Amount of many that makes workers indifferent between working or not
Example of Maria
- Wage 12€ per hour
- Expected duration of unemplotment: 44 weeks
Economy with no unemployment benefits
- Employment rent = wage – disutility of effort = 12€ - 2€ = 10€
- Total employment rent = 10€ x 1540 = 15540€
Economy with unemployment benefits
- Employment rent = wage – reservation wage – disutility of effort = 12€ - 6€ - 2€ = 4€
- Total employment rent = 4€ x 1540 = 6160€
Larger employment rent can stimulate higher effort
How can firms induce more effort?
They can increase wages (which increase the employment rent)
Labour discipline model: worker’s side
Worker decide effort given the wage rate. The feasible set of choices can be
represented in a graph
Labour discipline model: firm’s side
To maximize profits, firms want to minimise production costs
Profits = revenue – costs
= (output x price) – [(hours of labour x hourly wage)+ other costs]
= [(effort x hours of labour) x price] – [ (hours of labour x hourly wage) + other costs]
So, there is a trade off between wages and effort
Isocost lines: all combinations of effort and wages that cost the same – more vertical lines
are associated with a lower cost
Slope of each iso-cost curve is the MRS
Labour discipline model: equilibrium
Profirs are maximized where MRS = MRT
Involuntary jnemployment
Being out of work, but preferring to have a job, given wages/working conditions that
identical employed workers have
Why is it necessary?
- Maria can find a job inmediately after being fired with same wage and working conditions
- Unemployment rent = 0
- Then, her best response is to exert zero effort – firms will not pay for an employer that does nothing
Wage and involuntary unemployment have to be high enough to ensure employment rent is high enough for
workers to put in effort
Best response changes
Best respon may change in reaction to changes in:
- Utility of things the wage can buy
- Disutility of effort
- Reservation wage
- Probability of getting fired at each effort level
Incomplete contracts
Employment contracts cannot predict all contingencies (does not know what it might want the worker to do in
the future). Also, it is very costly and impossible to observe the worker’s effort
Incomple contracts arise when
- Information is not verifiable
- Relationship covers a period of time
- There is uncertainty
 - There are difficulties in measurement
- Judiciary enforcement is jot available or very hard
- There are preferences for omitting some information
Principle-agent models
Describe interactions of parties under incomplete contracts
- Emplotment contracts
- Investments
- Elections

UNIT 5.
Concepts
Profits
Profits = revenue – costs
Constrained optimization
Characteristics:
- Decision maker choose values of one or more variables to achieve a
goal
- Objective is to optimize something
- Decision maker faces a contraint, which limits what is feasible
Demand curve
Curve that gives the quantity consumers will buy at each possible price
Total cost function
Curves that represents the total costs of a firm depending on the output
produced
Costs = Fixed costs + Variable costs x Quantity
Average costs
How much it costs on average to produce one unit
Average costs = Total costs / Quantity
It is the slope of the line that connect the origin to the given point
Average costs function
Usually U shaped
Marginal costs
The cost of producing one more unit
Slope of the tangent to the total cost function
ΔY Δ costs
Marginal costs = =
ΔX Δ output
Marginal cost function
Usually upward sloping
If it is not a straight line, then increase
Ing production has different impacts on total costs

Relationship between Average cost and Marginal cost

- If AC > MC then AC is decreasing
- If AC < MC then AC is increasing
The MC curve always intersects the AC curve at its lowest point
Isoprofit curves
Curve that joints all points that give the same level of total profit
Isoprofit curves further away from the origin represents higher porfit levels
MC − P
Slope of Isoprofit curve =
Q

Maximize profit with isoprofit and demand

Where MRS = MRT, where isoprofit is tangent to the demand curve
Profit function
Profit you woild achieve if you choose to produce a quantity
Marginal revenue
Increase in revenue obtained by increased in quantity
ΔY Δ revenue
Marginal revenue = =
ΔX Δ output
Usually a downward slopping line
Maximize profit with Marginal Renue and Marginal cost
Profit maximizing point is where MR curves crosses the MC curve

Consumer surplus
Difference between willingness to pay and market
Producer surplus
Difference between revenue and marginal cost
Total surplus
Sum of consumer surplus and producer surplus
Deadweight loss
Is the area of the white triange
Gives a measure of the consequences of market failure: unexploited gains from trade
If there is deadweight loss = allocation is not Pareto efficient
This is common when firms have market power
Price elasticity of demand
Measures the degree of responsiveness of demand to a price change
Δ demand
Elasticity =
Δ price
If the demand curve is quite flat = quantity changes a lot in response to a change in price = high elasticity
If the demand curve is steeper = low elasticitt
The firm always choose a point where elasticity js greater than one
Economies of scale
If we increase all inputs by a given proportion, outputs increase more than proportionally, it has increasing
returns to scale
Diseconomies of scale
If we increase all inputs by a given proportion, increases output less than proportionally, then the technology
exhibits decreasing returns to scale
Constant returns to scale
If we increase all inputs by a given proportion, increases output proportionally

UNIT 6.
Concepts
Price setting firms
Firms with market power who can set their own price
They do not choose the price but they choose the quantity to produce
Supply curve
Total quanity all firms are willing to sell at any given price
Shows the willingness to accept (WTA)
Demand curve
Total quantity all consumers are willing to buy at any given price
Shows the willingness to pay (WTP)
Equilibrium price
It is determined by the intersection of the supply and demand curves
At the equilibrium price, supply equals demand
- If the price is above, sellers would want to sell large quantities but few
people would want
to buy
- If the price was below, sellers would prefer to wait rather than sell at that price
Any other price is not a Nash equilibrium
- If P>P* there is excess supply, so some suppliers could benefit from charging lower price.
- If P<P* there is excess demand
Market clearing price
Price where there is no excess supply or demand

Price taking firms

Firms that are stuck with the price determined by the market, so:
- Cannot benefit from choosing a different price
- Cannot influence price
- If they try to charge a higher price, they will sell nothing
Firms that produce identical products with much competition
Equlibrium price
In price taking firms the demand curve is completely flat
And firms maximize profits when P=MC
At this point, MRS = MRT = 0
Individual supply functions
For each possible price level the firms will be willing to supply the amount that maximizes profits (MC=P)
Then the price determined by the whole market will identify the equilibrium quantity supplied by each firm
Competitive market equilibrium
If
- All buyers are price takers
- All sellers are price takers
- Contracts are complete
- Transactikns only affects buyers and sellers
Equilibrium in a competitive market is when supply=demand, and it is Pareto
efficient
In this equilibrium all the gains from trade are exploited: no deadweight loss
This does not mean it is fair (consumer surplus > produce surplus)
Distribution of total surplus depends on the shape of demand and supply
curves (share of taral surplus is inversely related to elasticity)
Exogenous shocks
Lead to shifts of the demand or supply curve and a new equillibrium is
obtained
Example, in the market bread, technology increases productivity
- Supply of bread increases
- At the initial price there is excess supply
- Consumers and producers move until a new equilibrium is achieved
Taxation
Taxes shift the supply/demand curve because they increase prices at each quantity
Example
- Sales tax of 30% per kilo
- Supply shifts to the left
- New equlibrium, less quantity at a higher price
It generates a deadweight loss

Perfect competition
A perfectly competitive marker has the following properties:
- Good or services exchanged is homogenous
- There is a very large number of potential buyers and sellers who act independently
- There are no barriers to enter or leave
- Price information is easily available to buyers and sellers
As a result
- Law of one price: all transactions take place at a single price which clears the market (supply = demand)
- Buyer and sellers are all price takers
- All potential gains from trade are realized

UNIT 7.
Concepts
Imperfect competition
When firms have market power and then sell goods at a price above marginal cost
Firm’s market power may arise because
- There is limited competition
- Market entry barriers
- Product are differentiated
- Natural monopolies
DWL may be eliminated thorugh
- Price discrimination
- Competition policy
Externality
Positive or negative effect of production, consumption or other economic decion on another person or people,
that is not specified as a benefit or liability in a contract
Measuring externalities

Negative externalities occur when MSC > MPC

We can represent these three concepts in a diagram
We expect marginal external cost to be below marginal private cost at least
for low amounts and to increase faster than the marginal private cost
Knowing the price market,
equilibrium quanitity
produced is where P=MPC
But, the Pareto efficient level is
P=MSC
Example: producing 80k units
is not Pareto efficient:
marginal external cost is 270€ per unit
Fishermen would be willing to pay up to 270€ to farmers for
them to reduce production by 1 unit
Why do externalities exist?
External costs cause maerket failure because of incomplete
contracts
Incomplete contracts do not specift all the aspects of the exchange and their effects.
Reflecting al, external costs is very complicated as relevant information is asymmetric or not variable
How to address externalities?
Four possible alternatives
- Bargaining
- Regulation of production
- Pigovian tax
- Enforcing compensation for affected parties
Bargaining
Bargaining requires private sector agents reach an agreement about the decision to be made, allowing for the
incorporation of previously external costs into it.
Private bargaining between the parties involved will lead to a Pareto-efficient allocation, regardless of which
party owns the property rights, in the absence of transaction costs.
Limitations:
- Impediments to collective actions: need to find a representative
- Missing information: calculating the exact costs imposed
- Enforcement: difficult for judiciary authoroties to determine if they have
complied
- Limited funds: not enough money to pay compensation
Example
- Farmers are willing to accept an offer that at least matches the lost
profits
- Fishermen are willing to pay at most the amount of social gains
Regulation of production
Govenment ideally restricts maximum allowed output – production quotas
What is the ideal amount of allowed productions? Where P=MSD
Limitations:
- Amount difficult to determine
- Enforcing quotas to individual producers is difficult
Pigouvian tax
Government impose a per unit tax that reduces the prices received by
decision makers
Taxes force producers to face the full cost of their decision
How much should this tax be?
- Equal to the MEC at the pareto efficient quantity
- Then the farmers will choose a quantity such that P=MPC=MSC
Compensation
Government may require producers to pay a compensation for the
external costs
Compensation represents an additional cost to farmers
It hould be equal to the difference between the MSC and MPC
Fishermen are fully compensated and producers choose the socially
optimal level of output
Similar effect that pigouvian tax but fishermen are better off (receive a
compensation directly)
Government policies limits
- Missing information: exact compensation
- Measurement
- Lobbying: government may favour the more powerful group which could impose a Pareto efficient
outcome that is unfair

Imperfect information
Information is asymmetric when one party knows something relevant to the transaction that the other does not

When a potentially mutually beneficial exchange could be implemented but it is not due to information
asymmetries, we say we have a missing market
Health issue insurance
Asymmetry of information
- Customers know their health status, more likely to buy the health insurance if they are less healthy
- Insurance companies does not know (hidden attribute)
To keep business profitable company must charge high enough prices, but, thus will make more costly for
healthy people to buy insurance
This creates an adverse selection problem: the people more likely to buy the insurance are those who already
have an health problem.
There is a missing market: many (healthier) people who would like to buy insurance will remain uninsured.
Car insurance
Asymmetry information
- Insurance companies do not observe the day-to-day behaviour of drivers [hidden action]
- Insured drivers may have an incentive to be less careful.
Insurance companies mitigate this by imposing limits in the contract, however the company cannot enforce
different behaviour from drives – they can’t make drivers drive slower.
This is a moral hazard problem
Banking system
Borrower’s decisions have external effects on the lender
- Some clients may be less financially prudent, which limits their ability to repay debts
 - Banks impose conditions on access to credit to limit non-compliance or credit defaults
- As a result, poor borrowers are often credit-constrained (or even excluded) leading to a credit market
failure (missing market)

On the other hand, banks and investors may experience external effects due to the behaviour of other financial
institutions:
- Some banks may impose less lending restrictions, this will make their asset portfolio more risky.
- If they go bankrupt, this is likely to represent a systemic risk for the other institutions.
- When Governments bail out banks that are “too big to fail”, they incentivizes risk.

Public goods
A good is non-rival if the use by one person does not reduce its availability to others.
A good is non-excludable if it is impossible to exclude anyone from having access to it.

Market usually allocate private goods

For other cases, market allocarion is likely to fail
- Non rival goods have a marginal cost of zero (the good doesn’t wear off because it has been consumed)
So we cannot set P=MC, unless provision is completely subsidised.
- Non-excludable goods cannot be priced:
The price is a tool to exclude people who have not paid, but in this case exclusion is not possible.

UNIT 8.
Concepts
Unemployed person
People who are:
- Not in paid employment / self-employment
- Available for work
- Actively seeking work
Unemployment rate
Unemployment rate = unemployed / labour force
Participation rate
Participation rate = labour force / population of working age
Employment rate
Employment rate = employed / population of working age

Real wage
Real wage = nominal wage (W) / price level (P)
Profit maximizing firms
Profit maximizing firms determine wages, prices, quantity of outputs and number of workers
 1. Nominal wage = f (other firms’ prices and wages, unemployment rate)
2. Price = f (own nominal wage, demand for our product)
3. Output = f (price, demand curve)
4. Number of employees = f (output, production function)

Wage setting curve

Wage and employment combinations tha maximize worker’s effort
Vertical axis: real wage
Horizontal axis: employment rate
Vertical dashed line; labour force
Unemployment rate: horizontal distance between labour force and
employment rate

There is a positive relation between

employment and real wage: higher real
wage = higher employment
Why?
- Firms aims at steepest iso-cosr line given the worker’s best response
function
- Changes in reservation wage shift the worker’s best response functiom
Therefore
- Employment increases – best response function shifts to the right
(reservation wage increases)
- This lead to anew equilibrium were real wage is higher

Point in and above the wage setting curve are feasible

Below the wage setting curve workers do not work, real wage is too low

Price-setting curve
Wage implied by the firms’
profit maximizing decision
about the price of output
Firms decide the optimal price where demand is tangent to
isoprofit curve which also determines the optimal output level
Given the technology available this determines necessary
employment
Markup is the difference between the proce charged and the
marginal costs
The price of a product can be divided in two components:

For exonomy as a whole, this translates into how revenues are distributed between firm owners and workers
Price-setting curve is the real wage paid to workers
when they choose profit maximizing price
Price setting curve is a constant value that is:
- The real wage consistent with the markup over
labour costs when all firms set price to
maximize proftis
- It does not vary with the employment level of
the whole economy
The level of price-sertting curve depends on
- Competition, which determines markup
- Labour productivity, which determines real
wage for a given markup
Labour market equilibrium
Equilibrium wage and employment is where the wage setting curve and price setting curve intersects
A point X, this is the Nash equilibrium of the labour market
All the parties are doing the best they can, given what everyone
else is doing
- Firms are offering lower possible wage to ensure effort
- Employment is highest possible given wage
- Workers cannot ask for a higher wage or to work less
- Unemployed cannot persiace firms to work by accepting
lower wage
Involuntary unemployment
Unemployment = excess supply in the labour market
- No unemployment = no cost of losing the job, so no effort – unemployment is necessary
Factors that can change the labour market equilibrium
1. Unemployment -> government
2. Changes in labour supply
Unemployment
Unemployment depend on firm’s labour demand which, in turn, depends on aggregate demand
Demand-deficient unemployment: increase in unemployment motivated by a reduction in aggregate demand
Low aggregate demand moves the economy from X to B
- B is not an equilibrium
o Firms could lower wages with no reduction in effort
o Lower production costs allow for price reductions
o Declines in prices stimulate demand and output rises
o To produce more, firms hire more workers
o Employment go back to X
This suggest unbalances in the labour market are self correcting
Is the self correcting mechanism real?
No
- Workers resist to nominal wage cuts
- Lower wages means aggregate demand reduces
- Lower prices may lead consumers to postpone purchases
Economy may be stuck below equilbirium employment
Role of government
To solve this, the government could intervent
- Fiscal or monetary policy to induce aggregate demand:
 o Increase public consumption
o Reduce taxes
o Devalue currency to stimulate exports
Changes in labour supply
- Labour supply increases due to immigration
- Increases unemployment
- Employment rents increase, lower cost of effort and wage
setting curve shifts to the right
- Initial employment is not optimal (B)
- Firms hire more workers so employment increases and
unemployment decreases
Inequality in the division of output
The labour market determines the divisions of economy’s
output between employed, unemployed and owners
Inequality in the division of economy’s output can be
measured by the Gini coefficient
Gini coefficient rises with:
- Higher unemployment rate
- Lower real wage
- Higher markup
- Higher productivity (no changes in real wage)
Role of labour unions
Labour unions are organization that represent the interests of employees. They try to improve wages and
working conditions for their members
If union are strong wages are negotiated between the union and the
firm
In some cases, bargained wage may be above the wage setting curve
- Higher eage = increase costs for firms
- Shifts the wage setting curve to the left
- The new equilibrium lead to lower employment
Effect of labour unions:
- Wages do not change
- Employment declines
- Firm’s profit likely decrease
However, data does not suggest this outcome. This can be explained by the union voice effect

Union voice effect

Suggests that giving a voice to employees may induce higher involvement
and effort for the same wage
- Bargaining wage curve shift to the right
- Higher equilibrium employment
Labour market policies
Some policies may affect the equilibrium in the labour market by shifting
the curves
- Shift in price setting curve
o Increase in labour productivity for example with education and training
o Reduce production costs for example with wage subsidization
- Shift in the wage setting curve
o Decrease reservation wage for example lower unemployment benefits
- Shift in the labour supply
o Increase labour supply for example with inmigration or childcare provision

UNIT 9. Parte de la clase falta y falta tb lo de core

Concepts
Money
Medium of exchange consisting of bank notes and bank deposits or anything else that can be used to purchase
goods and services and is accepted as payment because others can use it for the same purpose
It is important the fact that can be used as a payment for other as it distinguishes it from barter exchange
Money requires trust to function
Barter exchange
Example of barter economy: I exchange apples for oranges, but, I cannot use oranges to pay my rent
Wealth
Largest amount you could consume without borrowing after having paid off debts and collected money owed
to you
It is a stock (quantitt measured at a point in time) variable, it has no time dimension

Wealth = Lands,buildings, machinery, etc. – debts owed + debts owed to you

Income
Amount of money received over some period of time
It is flow (quantitt measured per unit) variable
Disposable income
After tax income
Depreciation
Reduction in the value of wealth due to use or passage of
time
It is a negative flow
Net income
Gross post tax income less depreciation
Gross income
Income
Expenditure
Reduces wealth
Borrowing and lending
Allows to rearrange the capacity to buy goods and services across time

Borrowing Lending

Increases income available for Decreases income available for

Today
consumption today consumption today

Decreases income available for Increases income available for

Later
consumption in the future consumption in the future

Decisions to borrow and lend are affected by:

- Expectations about future income and inflation
- Interest rate
- Preferences
Borrowing decisions: fesibility set
Example Julia
- Period 1 (t): no income today
- Period 2 (t+1): 100€ of income
With no borrowing consumes zero today and spends 100€ later
When borrowing consumes today but less consumption later

To borrow she needs to pay an interest rare

(1+r) measures the trade-off between current and future consumption
(MRT)
Borrowing decisions: consumer preferences
Consumer preferences:
- Consumption smoothing: avoid big changes in consumption over time
- Impatience: prefer consuming today
Assume there are disminishing marginal returnt to consumption, which means that
the value of an additional unit of consumption declines the more consumption you
have
Point F provides higher utility
The indifference curve represents the trade-off between the value of consumption
today and later
These trade-off depends on the degree of impatience, which can be driven by two forces:
- Myopia: current satisfaction more value than same sarisfaction later
- Prudence: people may not be around later sl they favour current consumption
We measure impatience using the discount rate (𝜌)
- High 𝜌 means tou discount the future a lot (impatient consumer)
- Low 𝜌 means you discount future little (consumption smoothing)
Borrowing decisions: equilibrium
Equilibrium is the tangency point where:

Saving decisions
Marco
- Period 1: 100€ of grain
- Period 2: no additional income
Marco decisions
- Consume 100€ today and nothing later
- Save and consume a positive amount later
o Store a portion of his grain for future consumption
▪ Depreciation of 20%: if he save 100€ of grain today,
he can only obtain 80€ later
▪ Given his preferencies H is the equilibrium
▪ He consumes 68€ today and 26€ tomorrow (6€ lost
due to depreciation)
o Sell all grain today, consume a portion of his income and lend
the rest
▪ Earns an interest rare of 10%: he lends 100€ today
and consume 110€ later
▪ J is the equilibrium
▪ He consumes 65€ today and 39€ tomorrow (4€ more than
the initial quantity)

Difference between indifferences curves

Difference between Julia and Marco
- Julia future endowment of 100€
- Marco current endowmenr of 100€
Combinations of current and future consumption that would yield the same utility

Investment decisions
Marco invest 100€ of grain today in:
- Improving his farming technology so he can collect 150€ of grain later (investment return = 50%)
Equilibrium is now K, consumes 60 and invests 40, the 40€ turn into 60€ in the next period which is his future
consumption
He could also combine borrowing and investing
- Borrow ar 10% interest rate today so he can increase investment and
consumption today
- He know he will get 150€ from his investment so he can borrow up to 36€
Point L is the new equilibrium: consumes now 80€ and 62 later

Individual’s balance sheet

A balance sheet summarizes what the household or firms owns and owes to other

If Assets > liabilities, net worth > 0 you own more than you owe
If assets < liabilities, net worth < 0 you owe more than you own
Lend, borrow and balance sheet
Wealth does not change when you lend or borrow
A loan adds both assets and liabilities to the balance sheet:
- Borrowed money is an asset
- Debt is the liability

Example: Julia has no money now and borrow 58€

She faces an interest rate lf 10%
Later she has to repay 64€
Since she consumes 36€ later her final net worth is 0

Banks
Firm that makes profits by lending and borrowing
Central bank
Sovereign body that issues currency, regulates banking system and defines monetary policy
Commercial banks
Banks that interact with other economic agents like consumers and firms
They receive deposits from consumers, loans from the Central Bank or other Commercial banks and lend
money
Base money

Legal tender
Can only be created by central banks
Bank money
Money creared by banks by making loans

UNIT 10. Only class

Concepts
Business cycles
Periods of positive and negative fluctuations in the GDP per capita
- Booms: output is increasing or above potential
- Recesion: output is decreasing or below potential
Unemployment and GDP
There is a negative relation between unemployment and GDP growth
Increase in unemployment = decrease in GDP per capita
GDP approaches
- Expenditure approach: Total spending on domestic products
- Production approach: Total domestic production in value added terms
- Income approach: Total domestic income
Expenditure GDP approach
GDP = consumption + investment + government spending + Net exports (exports minus imports)
GDP = C + I + G + X – M

Hoisehold’s reactions to shocks

Two strategies:
- Self-insurance: saving and borroing
- Co-insurance: support from social network or government
Household’s consumption smoothing
Household make lifetime consumption depending on expectations
Consumption smoothing acts as a basic source of stabilization in an
economy: avoids shocks to be very pronnounced however, in many
cases, is not enough
Depending on persistence of the shock they mat react differently:
- Permanent shocks: readjust long run consumption
- Temporary shocks: not alter long run consumption
Limitations to consumption smoothing: credit constraints
Credit constraints limits the amount borrowed or the ability to borrow.
Limitations to consumption smoothing: weakness of will
Weakness of will is the inability to commit to beneficial future plans

Volatility of investments
Investment adjust to temporary and permanent shocks
- Temporary: high demand → high capacity utilization→ high investment → even higher demand
- Permanent: investment also depends on firms’ expectations about future demand
Investment coordination
Determinant of investment is what other firms are doing:
Coordination would ensure the best social and individual outcome
Firms are better off by investing when other firms do the same
Investment and aggregate economy
When everybody is investing, you invest more → amplifies booms
When no one is investing, you invest less → amplifies busts.
Net exports and government spending
Net exports affect GDP fluctuations:
- Exports depend on demand from other countries so will fluctuate according to the business cycles
of major export markets
- Imports depend on domestic demand, they have a negative effect on GDP

Government spending has two policies

- Counter-cyclical policy: decrease spending to reduce boom and increase to reduce burst
- Pro-cyclical policy: increase spending to reduce boom and decrease to reduce burst

Economic fluctuations and inflation

Inflation is an increase in the general price level in the economy
Prices tend to accelerate in booms and slow down in busts

UNIT 11. Only class

Concepts
Private consumption function
Private consumption has two components
𝐶= 𝐶0+𝐶1𝑌
- Autonomous consumption (independent of income): Reflect the expectations about future income
- Induced consumption (varies depending on current income)
o 𝐶1 is the slope of the consumption function, or the marginal propensity to consume (MPC)
[typically 0<𝐶1<1]
o MPC differs accross people:
▪ Poor households react a lot to changes in current income [large MPC]
▪ Wealthy households’ current consumption reacts little to changes in current income
[small MPC]
Household wealth
Household wealth affects autonomous consumptions and has several
concepts
- Value of the house = debt + home equity
- Financial wealth: savings and other investments
- Expected future earnings from employment
- Target wealth: level of wealth the household aims to maintain
Shocks in household wealth = changes in consumption – households
increase savings to restore wealth to target level (precautionary savings)

Private investment function

We assume investment is autonomous (does not depend on income)
Level of investment in an economy depend on three factors:
- Owner’s discount rate (𝜌)
- Interest rate on assets (r )
- Net profit rate on investment (Π)
If
- 𝜌 > 𝑟 ≥ 𝛱, owner discounts future consumption a lot, so consume extra income, dividends [less
investment]
- 𝑟 > 𝜌 ≥ 𝛱, interest rate is high, so save extra income or repay debts [less investment]
- 𝛱 >𝜌 ≥ 𝑟, investment is high so invest profits in further production activity [higher investment]
Investment increases with:
- Lower interest rate
- Higher expected rate of profit
- Improvement in business environment
Aggregate investment function
Investment is negatively correlated with interest rates
- Investment curve is downward sloping: higher interest rate =
lower invesrment
If profit expectations are high, investment function shifts to the left
- Same interest rate but profits of investment are higher so
more investments

Goods market
equilibrium
Aggregate demand
model includes consumption and investment
𝐴𝐷  =  𝐶  +  𝐼  =  𝐶0   +  𝐶1 𝑌 +  𝐼 
When Y=AD we say goods market is in equilibrium (production is
equal to aggregate demand)
The 45 line represents the points where Y=AD
The equilibrium of the model is where AD curve intersects the 45
line (point A)

Multiplier effect
Goods market is initially at point A
- Investment falls [I → I’]
o Aggregate demand declines [AD shifts
downwards]
o At the old production level, AD < Y so point B
is not an equilibrium
- Income declines to 45 line [B→ C]
o For this output level AD < Y so income
decline further [C→ E]
- The process continues until we reach Z the new
equilibrium
Multiplier effect: investment fell 1.5 billion € and output fell
3.75 billion € (multiplier = 2.5)
Due to the multiplier effect, the total change in output from a change in aggregate demand can be higher than
the initial change in demand.
- Multiplier > 1 Change in AD lead to more than proportional change in GDP
- Multiplier = 1 Change in AD lead to a proportional change in GDP
- Multiplier < 1 Change in AD lead to less than proportional change in GDP

Size of the multiplier

- Slope of the AD curve: marginal propensity to consume
o Marginal propensity to consume depends on credit constraints and consumption smoothing
preferences
Role of government
Government enters AD in three ways:
- Government spending: shifts AD upwards
- Consumption: income taxation reduces disposable income and induced income
o 𝐶= 𝐶0+𝐶1(1−𝑡)𝑌
- Investment: depends on interest rate and after tax profit
o High tax reduces investment
External trade
Enters AD in two ways
- Exports: shift AD upwards
- Imports: proportional to income, I = mY (m: marginal propensity to import, fraction of each additional
unit of income spent on imports)
Aggregate demand
𝐴𝐷= 𝐶+ 𝐼+ 𝐺+ 𝑁𝑋= 𝐶0+𝐶1(1−𝑡)𝑌+ 𝐼+ 𝐺+ 𝑋− 𝑚𝑌 =
= 𝐶0+ 𝐼+ 𝐺+ 𝑋+[𝐶1(1−𝑡)− 𝑚]𝑌
Autonomous components Exagenous components
What reduces aggregate demand?
- Saving, C1 how much income goes to consumption and savings
- Taxation, t, how much income goes directly to the government as taxes
- Imports, how much of income is used to buy goods abroad
Stabilizing role of the government
Government stabilizes economic through:
- Government spending
- Tax rates
- Unemployment insurance
- Fiscal policy changes
Paradox of thrift
In a recession, a family can cuts spendings and save more
However, in the economy as a whole, spending and earnings go together
• If consumption drops, so does the firms’ outputs
• This translates to lower investment and employment
• Further reduction of household income and consumption
Paradox of thrift: the aggregate attempt to increase savings leads to a fall in aggregate income
The paradox of thrift is an example of the Fallacy of composition: what is true for one part of the economy (a
single household) is not necessarily true for the rest for the whole economy

Fiscal stimulus
Fiscal stimulus of the governmenr examples:
- Increase spending - direct effect
- Cut taxes – encourage private spending, indirect effect
Financing fiscal stimulus
Fiscal stimulus require higher spending which penalizes
government budgets
• Government budget surplus when revenue > expenditure
• Government budget balance when revenue = expenditure
• Government budget deficit when revenue < expenditure

In our model
- Govern revenue comes from taxes collected (T)
- Government expenditure is the government spending (G)
Government budget balance = T – G
In general governement stimulus generates a deficit, can be funded by public debt
Austerity policy
In a recession, Government deficit is likely to increase due to automatic stabilizers:
- Tax revenue will decrease as output is lower
- Unemployment benefits is likely to increase
If government has high levels of public debt:
- Stimulus policies may not be possible
- May be unsustainable if cost of debt is too high
As a result, government may be forced to implement austerity policy
(point C) in which there is a decrease in government spending or
increase in taxes
In this context, this is a pro-cyclical policy
Government’s debt
Total outstanding government debt is the sum of all bonds sold over
time to finance budget deficits
There is no point at which the stock of debt has to be repaid – government can issue more bonds
An ever increasing debt-to-GDP ratio is unsustainable, but there is no rule that determines a specific limit
Debt-to-GDP ratio can fall if:
• Primary budget balance is positive (surplus can be used to pay debt)
• GDP is growing faster than government debt
• Inflation is high (real value of debt falls)

UNIT 12. Only class

Concepts
Inflation
Increase in the general price
Typically measured by the change in price index

Zero inflation
Constant price level each year [𝜋𝑡 = 0]
Deflation
Decrease in general price level [𝜋𝑡 < 0]
Desinflation
Decrease in the rate of inflation from a previous period [𝜋𝑡 < 𝜋 𝑡 − 1] (prices are still increasing but at a slowe
rate)
Real variables
- Real interest rate = nominal interesr rate – inflation rate
- Real wage growth = nominal wage growth – inflation rate
High inflation consequences
- High inflation is very volatile, unpredictability increases uncertainty
- Harder for producers to distinguish changes in relative prices and inflation
- Menu costs as firms have to update prices more frequently
Low inflation consequences
- Household postpone consumption expecting future drop prices
o Reduces demand – even lower prices – reduce production – more inemployment
- Increase the real debt burden
o Rise in real debt – save more – drop aggregate demand – lower prices
This situations are called deflationary spirals
For all this, economist generally agree some inflation (=2%) is good, as long as it remains stable
Causes of inflation
There are two causes:
- Increase in bargaining power of firms over consumers
o Lower competition – higher prices – decline price setting curve – reduction of real wage
- Increase in bargaining power of workers over firms
o Higher labour union power or employment levels – wage setting curve vertical shift (higher real
wage for same employment level) – movement along the curve
Phillips curve
Higher employment may result in inflation:
Positive relation between employment and inflation
Consequences
- Booms are associated with rising inflation
- Real wages remain unchanged but nominal wages and prices keep
increasing – inflation spiral
This positive relation between employment and inflation is known as the Phillips curve
This relation suggests that no employment level guarantees no
inflation
Also fluctuations in employment are associated to inflation or
deflation
You cannot have at the same time, high employment and low
inflation

When the labour market is in equilibrium unemployment and

prices are stable – this ensures inflation of zero
Bargaining gap
Difference between real wage required to incentivize effort and real
wage that gives firms enough profits to stay in business
Difference between the real wage firms wish to offer (wage setting
curve) and the real wage that allows firms the markup on costs (price
setting curve)

If we denote (U*,E*) as the equilibrium levels of unemployment and

employment, we can distinguish between 3 cases:
- Employment above equilibrium: U<U*, E>E* then the bargaining
gap >0 so prices are increasing (inflation)
- Equilibrium U=U*, E=E* then bargaining gap =0 so prices are
stable
- Employment below equilibrium: U>U*, E<E* then
bargaining gap <0 so prices are decreasing (deflation)
Choosing inflation rates
Optimal inflation rate by combining:
- Preferences of policymakers
- Feasible combinations of inflation and unemployment
(Phillips curve)
Equilibrium where Phillips curve is tangent to IC
- Phillips curve – feasible combinations, MRT
- Indifference curves – preferred combinations, MRS
Changes of phillips curve
Trade off between inflation and unemployment is not permanent,
changes over time
If governmenr tries to keep unemployment ‘too low’ the result will be
not just higher inflation but rising inflation as well
Role of expectations
Expectations of future prices can lead to changes in the Phillips curve
- Suppose expected inflation is 𝜋𝑒 = 3%:
o If labour market is in equilibrium, bargaining gap is
zero: 𝜋 = 𝜋𝑒 = 3% [pointA]
o If positive demand shock creates (unexpected) 2%
bargaining gap:
▪ 𝜋 = 𝜋𝑒 +bargaining gap =3%+2%=5%[point B]
 ▪ Negative surprise: people expected 3%
inflation got 5%
- As a result, in the next period, expected inflation increases,
leading to shift in Phillips Curve.
If 𝜋𝑒 = 5% and bargaining gap = 2%:
o 𝜋 = 𝜋𝑒 + bargaining gap=5%+2%=7%[pointC]
As long as there is a positive bargaining gap, there will always be
surprise inflation and inflation will keep increasing
Inflation-stabilizing rate is the unemployment rate which keeps
inflation constant.
Supply shocks
Another cause of high and rising inflation is a supply shock
Supply shock shift the Phillips curve by affecting labour market equilibrium
For example, a decrease in the supply of il:
- Increase in prices
- Downward shift of price setting curve
- Real wage falls
- Positive bargaining gap opens
- Persistently higher inflation

Monetary policy
Central banks are typically responsible for setting monetary policy
Two dimensions they can control
- Policy interest rate
- Money supply

Policy interest rate

Policy interest rate has 4 transmission channels
- Market interest rates
o Affect saving and borrowing, and therefore, consumption and investment
- Asset prices
o Interest rate goes down, prices of financial assets (bonds, shares, etc) go up:
▪ Mainly because of substitution effect
o Households who own assets become healthier – increase consumption
- Expectations/confidence
o Key to determine investment decisions and consumption
- Exchange rate
o Is the number of units of home currency that can be exchanged for one unit of foreign currency
o Example: exchange rate AUD = number of AUD / one USD
If exchange rate = 1.07, you need 1.07 AUD to buy 1 USD
A t-shirt thar costs 20 AUD can be bought with 18.69 USD (20/1.07)
If exchange rate was 1.07 yesterday and today:
▪ It is 1.00 – exchange rate appreciation AUD is worth more today compared to USD
▪ It is 1.25 – exchange rate depreciation AUD is worth less today compared to USD
o Interest rate affect demand for home currency in the foreign exchange market, leasing to
changes in the value of currency, which in turn affect net exports
These influence
- Domestic aggregate demand
- Net exports
- Import prices
Which, in turn, conditions the average price level in the economy
Monetary policy and the multiplier model
Economy is initially in equilibrium (A)
- Autonomous consumption declines
o AD shifts downwards
o New equilibrium with lower output
- Stablize the economy, central bank can:
o Decrease interest rate
o This will increase investment
o Shifts AD upward: new equilibrium at A
Monetary policy limitations
- Can erode Central Bank credibility: interest rate high
today and drops tomorrow, investors may refrain from
investing
- Interest rate cannot go below zero and zero may not be enough to stabilize the economy
o Alternative is quantitive easing: central bank purchases financial assets to reduce yields and
boost investment
- Some countries have no monetary policy autonomy
Demand shocks
In response to a drop in autonomous consumption AD will drop
Governements could
- Decrease the nominal interest rate [Monetary policy]
- Cut taxes/increase government spending [Fiscal Policy]
Joint use of both can reduce stabilization cost
Central bank credibility
Discretionary monetary policy may reduce the credibility of the Central
Bank
An alternative is to define a rule and stick to it:
Inflation targeting is a monetary policy regime where the central bank uses
policy instruments to keep the economy close to an inflation target.

UNIT 13. Only class

Concepts
Technological improvement effect
Technological improvement in the production process allows to obtain innovation rents – firms that cannot
keep up eventually fail, creative destruction
Technological progress:
- Shifts production function upwards
- Increases the Average Productivity of labour
- Increases profitability of further invesrment, leading to higher capital intensity
Increasing capital intensive production could have had sharp negative impact on employment
However, labour saving tech improvements can also create jobs elsewhere. E.g. reallocation of work from low
to high productivity firms
Beveridge curve
Job creation is pro-cyclical: increases in booms and reduces in busts
While job destruction is mostly counter-cyclical
The beveridge curve shows relation between jobs available and unemployment rate
- Recessions: high unemployment, low job vacancy rate
- Booms: low unemployment, high job vacancy rate
Labour market matching issues
Labour market mismatch occurs when jobs available do not suit unemployed workers because
- Workers may not have the necessary skills
- Regional disparities
- Jobsekers and employers may not know about each other
Industry specific shocks increase the mismatch
 Beveridge curve differences
Germany: closer to the origin due to guidance to unemployed workers and reduction in
unemployment benefits
US: shifted away from the origing due to skill-based mismatch and limited worker
mobility

Long run labour market model

Difference with short run:
- Firms can enter/exit the market
- Capital stock can change
Long run employment rate depends on how well policies and institutions deal with:
- Work incentives
- Investment incentives
Long run equilibrium in the labour market occurs when wages, employment and the number of firms are
constant
Number of firms in the market
Profit rate determines the number of firms:
- Markup is high: firms enter
- Markup is low: firms exit
It is a self correcting process
- Increase firms – increase competition – increase elasticity of demand –
decrease markup – decrease firms
Real wage
Real wage depends on:
- productivity (𝜆)
- equilibrium profits/markup (𝜇∗)
Price setting curve is higher if:
- Output per worker is high
- Markup is low
Effect of technologixal improvement in real wages and long run
employment
Technology increase real wages and employment in the long run
- Economy starts an unemployment rent of 6%
- New technology increases output per worker
o A → D: new technology increases unemployment
o D→ E: high profits induce firm entry and increase
employment
o E → B: lower unemployment increases real wage
o B: long run unemployment 4%.
Adjustment takes time and may involve job destruction in the short-run
- Adjustment gap: lag between some outside change in labour market conditions and the movement
to new equilibrium
- Diffusion gap: time it takes for the whole economy to adopt the
innovation
However, unemployment does not necessarily falls progressively with
technological progress:
- Wage-setting curve may shift upwards, limiting unemployment
decline.
Technological change can affect wage setting curve due to:
- Fair shares bargaining by unions
- Policies
- Greater disutility of effort
- Improvement of reservation wage
Technological improvement: effect on inequality
In this example, technological change
- Increase inequality in the short run
- Reduce inequality in the long run
In the Lorenz curve:
- A: initial equilibrium
- D: short run outcome
- B: long run equilibrium

Role of institutions and policies

Policies and institutions can influence on how long does it take to get to the long
run
They should:
- Ensure price-setting curve shifts up more than wage-setting curve
- Adjustment should be rapid and complete
Following characteristics that might help:
- Institutions: inclusive trade unions
- Policies: well designed unemployment insurance schemes and job placement services
Changes over time in the economic structure
As countries get richer, share of labour devoted to manufacturing
declines and increase in services
Example:
- In point A people consumed the same share of goods and
services (50% each)
- The increased (industrial) productivity expands the feasibility
set
- You can now produce more goods with the same inputs. [no
change in productivity of services]
- If consumption patters don’t change, economy moves to
point B.
- Labour shifted from the production of goods to services:
Before 1/2 goods 1⁄2 services , now 1/3 goods, 2/3 services.

Important factors not included in the previous model

- Productivty increased in some services
- Substituion of consumption of services by goods
- Increase in relative demand for services
- Import and export patterns