GEM Review – Q2

Part review of the material we’ve covered this quarter, part exercise in
understanding capitalism and the permanent hold it has on us as
business school students. Yay?
Agenda
• Marginal Cost & Marginal Revenue
• Monopolistic vs Competitive Markets
• Formulas and the Fed
• Money Supply, Monetary Base, & Money Multiplier
• Monetary and Fiscal Policy
• IS/LM Curves
• AD/AS Curves
• Case Studies
Goal:
• Questions Make you better
• Appendix Overview decision makers
What’s giving you grief atm?
 The Basics –
Marginal Costs & Marginal Revenue
 Marginal Cost (MC) Marginal Revenue (MR)
additional cost incurred in the additional income generated from
production of one more unit of a the sale of one more unit of a
good or service good or service.
Why It Maters
Profit maximizing firm will produce up to the point where
Marginal Revenue (MR) = Marginal Cost (MC)
 The Basics –
Monopoly vs. Competitive
 Supply, Demand, & Equilibrium
• Price Takers
• In a competitive market, no firm has enough control over the economy to set
the price so Price for the Firm = Market Equilibrium Price (PE)
• Aka Price (P) is given by the market
• Quantity Supplied (Qs): Marginal Cost (MC) = P
• Monopolies
• In a monopoly:
• Qs : MC = Marginal Revenue (MR)
• P: P where Qs = Quantity Demanded (QD) on Market Demand Curve
Since competitive firms
Monopolies can set the price by
can’t set the price, they
produce up to the point providing more/less than the
the market price no longer market equilibrium with the goal
provides economic benefit of maximizing profit per quantity
Important Stuff
• Equilibrium: demand = supply
• Competitive Markets: typically result in a lower price point
• Lower MC, pushes the Supply curve → and the PE ↓ the Demand curve (single market)
• Perfectly competitive markets: everyone’s a price taker at the PE.
• Monopolies: due to restricted supply, price is higher than in competitive
market
Examples:
• Taxis in NY (monopoly) vs. Uber’s entrance (competitive)
• Q4 Paths to Power: welcome to the 2021 Bidding Wars
• Demand still restricts the prices: the max P may not equal max profit due to decreased
demand
• Plot Twist: the limit on greed DOES exist (sort of)
 The Basics –
Formulas and the Fed
To steal from Luann, this is the brussels sprout portion of the econ review
 The Formulas
GDP (aka Y)
•Y=
• C + I + G + NX
• C: individual consumption (ie holiday shopping)
• I: firm investment (ie building new factories to produce goods for holiday shopping)
• G: government spending (ie government building a road for Santa’s sleigh)
• NX: net exports (irrelevant til Q3 cause professors said so; sorry NAFTA)
• Y(A,K,L) [aka factors of production]
• A: technological growth and development (ie internet)
• K: capital (ie new computers)
• L: labor (ie coders in Silicon Valley)
• C(Y-t) + I(r) + G
• t: taxes
• Y-t: disposable income (ie money consumers actually have to spend)
• r: interest rate (ie cost of borrowing)
• f(A, uK, hL)
• uK: utilization of capital (ie how much you use your computers)
• hL: employment of labor (ie how much you use your workers)
• What Y Measures: total spending, production, or income received by producers
• Why You Care: high and/or rising GDP is typically correlated with good things (more money, better jobs, overall
satisfaction and happiness, etc.)
• Basically, money CAN buy you happiness. Enjoy business ethics next quarter
Important Equations
• C = C(Y-t, W, E(Y’- t’))
• W: wealth (very perception driven so being grateful is actually good for the economy. Keep that in
mind during finals so ya’ll don’t tank GDP)
• Y’: expected future income (people spend more when they think they’ll have more money in the
future)
• t’: expected future taxes (people spend less if they think future taxes will go up. Increases in G can
lead to increases in t’)

• I = I(r, E(π(K’)))
• K’ = expected future capital = K + I
• E(π): expected future profit

• YFE = f(A, ūK, ħL)

• ūK: optimal utilization of capital
• ħL: optimal employment of labor
 Shocks, Effects, & the Money Market

• ↑r =>↓I (costs more to borrow so firms don’t do it)

• ↓I => ↓GDP (Y)
• ↑ A, K, or L (factors of production) => ↑Y (more productivity occurring in the economy)
• ↑t => ↓(Y-t) =>↓Y
• ↑C, I, G, or NX => ↑Y

***
• P = price level 
• M = money in the economy 
• M/P = real money balance 
• (M/P)d = L(r,Y): money market, guides LM curve
• ex) ↑ M/P = ↓ r= ↑I = ↑Output = ↑Income = ↑Consumption
Ok, shake it off. Ya’ll survived
Questions?
 The Basics –
Money Supply, Monetary Base, Money Multiplier
• Money Supply (M): quantity of money available in an economy for immediate
use.
• = currency held by the public + demand deposits at banks; cash + deposits
• Demand Deposit: money that can be withdrawn without prior notification

• Monetary Base (Base) = total currency in circulation + amount held by banks as

reserves
• Central Bank controls

• Money Multiplier: initial deposit can result in increase in the money supply
because the % stays constant while the deposit doesn’t
• = (M)/(Base) = 1/(required reserve ratio)
 You deposit money in a bank.
The bank has two options about what to do with that $$$

Loan it out to consumers (who Hold on to it in reserve (at

then deposit it in another bank) OR the % required by law

Money sitting in reserve doesn’t make the bank money (no interest), so they don’t
like lifting this %

Initial Deposit at
Bank #1
Money Multiplier:
$$$ Loaned Out
Reserve Requirement
1
From Bank #1
% Reserve Ratio
$$$ Loaned Out Example: If rr = 10%
Reserve Requirement
From Bank #2 MM = 1/.10 = 10
%
Initial Increase in Monetary Base= $2B
(MM)(M) = (10)($2B) = $20B
$$$ Loaned Out
Reserve Requirement An initial investment of $2B becomes $20B in
From Bank #3
% the economy
 The Basics –
Monetary vs Fiscal Policy
 Monetary Policy vs. Fiscal Policy
Monetary Policy (The Fed) Fiscal Policy (The Gov)
What: trying to adjust AS, AD
What: controlling the monetary base
Pros: basically immediate (when implemented)
Pros: quick decision making (no political nonsense)
Cons: political infighting tends to slow things down to the
Cons: takes longer to go into effect
complete surprise of everyone involved
Goal: Dual Mandate - keep inflation at ~2% and
Goal: maintain full employment, reach a high rate
maintain full employment
of economic growth, and to keep prices and wages stable

2 Tools Gov Can Use to Adjust Economy

4 Tools Fed Can Use to Adjust Economy
Taxes: brings in more money for the gov to spend, but pulls it
Reserve Requirement: how much money banks are required to away from the consumers/investors
hold 
Government Spending: inserts money directly into the economy,
Reserve Interest Rate: rate paid on money kept in reserve  but leads to either higher taxes or gov debt
Discount Rate: rate charged to banks to lend them Fed money
Open-Market Operations: selling/buying US treasury securities
(gov. bonds) Expansionary Policy Contractionary Policy
Increase money supply: buy securities (increases monetary base) Decrease Taxes + Increase Increase Taxes +
Government Spending Decrease Government
Spending
 France and Japan
• Removing Barriers to Growth (France)
• Takeaways:
• Though government spending can quickly spur the economy, it can have negative effects if it crowds out private spending and
investment
• Public safety nets can be good for a society (part of why France bounced back so quickly from the recession), but, if they’re too
generous, they can be reduce incentive to participate in the labor workforce
• If proposed changes to gov programs don’t align with the country’s culture, they may not be sustainable even if they’re
successfull
• Maintaining and Sustaining Growth (Japan)
• Takeaways:
• Consumers and Firms are good poker players and will call your bluff: if you’re not committed to solving the issue, they won’t
believe you
• Similarly, if they’ve grown accustomed to something (like not raising prices), they won’t suddenly start doing it
• Aging Population + Low Birthrates: will lead to LT decrease in GDP if not balanced out with increase in A or L from immigration
• Technology: 2 fold issue
• Bad: Lack of Transformative Innovations (which is what boosted Japan during the Stage 1): engines, internet, smartphones, etc.
• Good: Technological infrastructure in Japan may be undervalued (but does GDP capture this)
• Low Aggregate Demand: people not buying stuff but interest rates already near 0 
• Consumers are unsure about future prospects: decreases C
• How can governments affect this?
• Liquidity Trap: interest rates are low, savings rates are high = monetary policy is ineffective
Monetary Policy
Questions?
The Basics – IS/LM
IS/LM Curve
• IS = "investment-savings"
• r -> I -> Y : the higher the interest rate, the least likely you are to invest

• LM = "liquidity preference-money supply"

• Y -> Spending -> r: the higher the GDP, the less loose money there is

• X-Axis: Y (output in the economy)

• Y-Axis: real interest rate

What is the IS/LM Model: macroeconomic model that shows how the market for
economic goods (IS) interacts with the loanable funds market (LM) or money market.
LM Curve
• What It Is: demand for money relative to supply of money; L(r,Y)
• Affected By: M/P (aka real money balance) and Liquidity Demand for Money
• M: supply of money
• P: price levels
• Plots r and Y at equilibrium: where demand for money (L(r,Y)) equals the real money
balance (M/P)

• Shocks
• Ratio Increases (+M):
• M/P moves out
• LM moves out
• Ratio Decreases (-M):
• M/P moves in
• LM moves in

Move from M/P to LM

 IS Curve
• What It Is: shows how much output
there is in the economy for each level
of the interest rate
• Shocks:
• Moves out IS Curve
• ↑G
• ↑ Factors of Production
• ↑ Wealth
• ↑ E(Y’-t)
• ↓t
• ↑ E(π)
• Moves in IS Curve
• Reverse of above
• ↑ U(π(K’))
Employment
• Y < YFE : slack in the economy
• Feels either like recovering from a recession or growing
into a modern economy
• Policy initiative focused on increasing Y Signs Y > YFE
• Y > YFE : overheating economy • Output gap
• Feels good in the moment but heading towards a crash • Unemployment
(like skipping LT to go out with friends and forgetting rate below natural
Darden professors can smell fear and a lack of rate (~4%)
preparation) • Rising inflation
• Inflation likely
(indirect measure)
• Y = YFE : happy economy 
Questions?
The Basics – AD/AS
AD/AS Curve
• AD = “aggregate demand” = total amount of demand for all finished goods and services produced in
an economy
• Downward Sloping because an increase in price means fewer people want to buy the product
• High p = low real money balance & higher real r = low investment and low Y
• P -> AD -> Y (AD Curve): higher the price, lower the demand for goods

• AS = “aggregate supply" = total supply of goods and services produced within an economy at a given
overall price in a given period
• Upward Sloping because it becomes higher prices mean more suppliers can/will make the good
• Wage contracts include overtime pay
• P -> AS -> Y (AS Curve): higher the price, higher the willingness to supply goods

• X-Axis: Y
• Y-Axis: prices

What is the AD/AS Model: shows how the demand for goods in the economy (AD) interacts with the
willingness to supply goods (AS) to affect the quantity supplied and the price level
Move From the IS/LM to
AD/AS
 Shifts Cheat Sheet

IS/LM AD/AS
Questions?
 Case Studies
Not going to cover these during this review session BUT
they’ll be in the deck that’s sent out to you

If you’re struggling and really want to talk about them, email me at

JohnsonC21@darden.virginia.edu
Cases Included
• Stagflation (Brazil)
• Global Financial Crisis (2008)
• France (Social Safety Net)
• Japan (Abenomics)
• Jerome Powell (US economy in 2019)
Additional Stuff in Appendix
Extra Resources Money Multiplier Example
• Visual Learners
• Crash Course
• Khan Academy
• Audio Learners
• Planet Money
 And now you know
everything!
(Except exports but that’s a Q3 problem)

Questions?
Appendix
• Extra Resources
• Case Studies
• Money Multiplier Example
Extra Resources – Video & Audio
• Crash Course • Planet Money: Markets & Pickles
• Khan Academy
• Planet Money: Tariffs & Santa
•Planet Money: Taxes & Donald D
uck
Cases Included
• Stagflation (Brazil)
• Global Financial Crisis (2008)
• France (Social Safety Net)
• Japan (Abenomics)
• Jerome Powell (US economy in 2019)
 Stagflation (Brazil)

• Stagflation: persistent high inflation combined with high unemployment

and stagnant demand
• Why It Sucks: self-perpetuation, if people think prices will be more expensive in the
future, they want higher wages, which pulls AS curve in, increasing expected future
prices and increasing unemployment since L is expensive
• How to Get Out:
• Increase M: shift out LM curve to increase AD
• Result: increase P and Y: perpetuate inflation
• Do Nothing: hope economy sorts itself out
• Result: might work but takes time
• Decrease M: shift in LM = increased AS (decreased L’(wages))
• Result: decrease P and Y: breaks inflation expectations E(P’)
Global Financial Crisis
• Set Up:
• Asset prices increasing exponentially to match increased
demand and future perception
• Belief that the housing assets will always be a good
asset: even if the person defaults, you get the house
which would be (hypothetically) worth a lot
• Price exceeds market demand and stalls + people begin
to default on their home loans = empty houses with no
buyers
• Shocks:
• ↓W + ↓E(π’) + ↑U(π’) + ↓m = ↓Y
• Path: ↓W = ↓C = ↓Y = ↓employment = ↓r = ↓I
• Shifts IS in
Global Financial Crisis - Response
• Investment in housing continued to fall into 2008
• In mid-2008, broader consumption and investment was also declining
• Rising delinquency rates on residential mortgages (defaulting on loans), affected balance
sheets of financial institutions
• Uncertainty over the value of mortgage-backed securities; investors withdrew from
financial institutions, similar to a “bank run”
• Lehman Brothers filed for bankruptcy causing a contraction in the banking system
• Stock market began falling in early 2008, and plunged over 20% between October and
September
• Depressed asset prices before the financial crisis – banks stopped lending because they
were unable to determine which borrowers were creditworthy; without access to credit,
many households and firms defaulted on pre-existing loans (which depressed asset prices
even more)
Fed Response
• Summer of 2007, the federal funds rate [interest rate the Fed pays you to hold money in the reserve] was at
5.25%;
• Bernanke lowered it to near 0% aka not paying out any money to hold money -- essentially an incentive to spend money
• Monetary loosening: Fed made massive purchases of US Treasury bonds, and raised the monetary base to
unprecedented levels
• Fed purchased more than $1 trillion in mortgage-backed securities and Treasury securities [called credit
easing or quantitative easing]
• Mortgage Backed Security = we’ll pay you XY, because people have to pay their mortgages, so invest in this security
• Fed bought mortgage backed securities to instill confidence in these securities again
Gov. Fiscal Stimulus
• “American Recovery and Reinvestment Act (ARRA)”: $800 billion stimulus package, included tax cuts (t) and
direct spending (G)
• By 2010, the economy had emerged from the recession, but in 2011 the economy hit a soft patch; the ARRA
stimulus was wearing off and government spending had stopped growing for the first time in decades
Continued Monetary Stimulus:
• In response to this slow growth (2011), Fed did a second round of “quantitative easing” [QE2], purchasing
another $600 billion in Treasury securities
• (2012) QE3, increase holdings of longer-term securities by $85 billion per month
• Despite this expansion of the monetary base, the policies didn’t gain traction initially
France, Macron, and the Social Safety Net
Reforms:
Unemployment = (Looking for Work)/(Labor Force) • Decrease corporate tax rate
• Unemployment Types: • Decrease regulation
• Structural: lack of demand for skillset in the economy • Decrease social safety net protections
• Ex) Increased automation (inc A): adjusts the L in YFE
• Cyclical: Y < YFE ; affect of the economic boom-bust cycle Pros
• could be caused by not enough demand in the economy • Easier to do business
• Frictional: short-term as people move from one job to • Increase YFE, Increase GDP
another • Decrease deficit, decrease debt
• Ex) move to another state, leave job to find better one, enter
workforce after B school
• Increase efficiency
• Increase labor force participation
• Labor Force Participation Rate = (Labor
Force)/(Population) Cons
Status Quo vs. Growth • Changes social fabric
• Stabilization: job of the central bank • Increases inequality
• Affects LT social good programs
• Keep economy near YFE
• More short-term: adjustments in rate, money supply
• Increases severity of individual hardship
during recessions
• Growth: goal of the elected government
• Improvements could be centralized at the
• Expand YFE
top of the income bracket
• More long-term since actions take time to move Y FE
Japan, Abe, and an Aging Population

Abenomics: combat low growth with 3 pronged program:

Expansionary Monetary Policy:
• Release money and credit into the market Effects of Abenomics
• By decreasing gov borrowing costs, hope to increase the money supply which would • GDP increased 0.5%
then increase employment, inflation, & growth
• Corporate earnings and dividends increased:
• 2% inflation target 
corp. profits improving
Expansionary Fiscal Policy: (not utilized) • Unemployment decreased to 1977 levels
•  Increase spending and employment (yay!)
• Post quake reconstruction and disaster prevention
• More women + foreign workers in workforce 
• Promote R&D and innovation
• Promote tourism
• Rising nominal wages
• Reduce personal income taxes = increase disposable income  • Consumer prices rising, but inflation within
• Restraints: high public debt (Ex 11) made this unappealing, didn’t use it goals
• Problem: labor cost increased = cut
Structural Reforms 
worker hours instead of raise prices 
• Goal: expand productive powers and boost potential growth
• Public perception that you don’t raise
• Actions: close corruption loopholes 
• Deregulation around “bedrock” regulations (health care, energy, agriculture)
prices
• Increase business ability to hire/fire
• Special Economic Zones: “guest workers” from other countries were allowed to work
in these areas 
• Corporate Tax Rate: decreased 
• Workforce Shortage: encourage women to participate in the workforce
• How: changing public attitudes, new government policies and economic anxiety
 Jerome Powell’s Life Choices
State of the US Economy
• Low unemployment
• Low inflation < 2%: could be due to
• Increases in A
• Prices less responsive to wage increases
• Low inflation expectations
• Overtime not readily factored into contract
negotiations
• Modest GDP growth ~2.3%
• Output gap: potential overheating of the
economy
What To Do
• Loosen
• Stave off potential inflation if recession is coming
• Tighten
• Build up funds rate to have more wiggle room if a recession does happen
• Wait & See
• It’s hitting targets: hang out
That was a lot. Let’s try something more
familiar
A Case Problem!
• You: Master of Coin in Dardentopia
• You issue Section Coins which are backed 100% by gold in Dean
Beardsley’s vault (C = coins)
• You create a Master Section Vault where people can deposit their
coins and receive certificates in exchange because coins are heavy
and what are we? Europe? (D = deposits and their certificates)

Money supply = C + D
A Case Problem
• Dean Beardsley demands that the Master Section Vault keeps a certain %
of its Section Coins in the vault in case the economy collapses because no
one buys the Abbott lunches or the law school gets bored and invades
• The Section Coins kept in the Master Section Vault are your bank reserves
(R)

Monetary Base = C + R

• If Dean B demands that we keep 100% of our deposits in reserve then:

• R=D
• Money Supply = Monetary Base
A Case Problem
• Luckily though, Dean B is smart and wants Dardentopia to make that IB-
level $$$

• He sets the reserve requirement at 20% so:

• 20% of our Section Coins sit in the vault in case of law school invasion
• 80% get lent out to the economy

• There are 1M Section Coins

• You lend out 800K @ 10% interest
• You make 80K for Dardentopia!
A Case Problem
• Turns out, you’re the only bank in town, so that 800K you lent out got
redeposited into the Master Section Vault
• Increase in deposits = 800K = D1

• You decide to lend out D1

• Keep 20% of 800K = 160K (because of reserve requirement)
• Lend out 80% of 800K = 640K (D2)

• You decide to lend out D2

• Keep 20% of 640K = 128K
• Lend out 80% of 640K = 512K (D3)
That’s the Money Multiplier (MM)
MM = (Money Supply)/(Monetary Base) = (C+D)/(C+R) = 1/(reserve ratio)

MM in Dardentopia:
MM = 1/(reserve ratio) = 1/(20%) = 5

Money Supply = (MM)(Money Base)

= (5)(1M)
= 5M Section Coins!
With that money, you buy Dardentopia