# Principle of Economics

###### tags: `notes` `181901`

# Chapter 5 Elasticity and its application

## Midpoint method for calculating the price elasticity

$$
\text{price elasticity} = \frac{\frac{1}{2}(P_2+P_1)\Delta Q}{\frac{1}{2}(Q_2+Q_1)\Delta P}
$$

Q is the quantity of the product
P is the monetary value or price

## Cross price elasticity of Demand

$$
\text{cross price elasticity} = \frac{\Delta \% Q_A}{\Delta \% P_B}
$$
>the percentage of change in quantity A
>the percentage of change in price B

This is to measure how the quantity demanded of one good responds to a change in the price of another one.

# Chapter 13 The costs of production
We assume that the firm's goal is to maximize revenue

Profit = Total revenue - total cost
Total revenue = price * quantity
Total cost = market value of the inputs a firm uses in production

From Mankiw's 10 principles : The cost of something is what you give up to get it

## Types of cost
- Explicit costs
- requires an outlay of money
- for example the wages to pay workers
- Implicit cost
- Do not require a cash outlay
- for example opportunity costs
- Total cost = Implicit cost + explicit cost

## Economic profit and accounting profit
- accounting profit
- total revenue - total explicit cost
- economic profit
- total revenue - total cost
- accounting profit ignores implicit costs, so it's higher than economic profit

## Marginal product
- Marginal product
- increase in output that arises from an additional unit of output
- slope of the production function
- Marginal production of labour
MPL = $\frac{\Delta Quantity}{\Delta Labour}$

## Diminishing marginal product labour
- Marginal product of an input declines as the quantity of the input increases
- Prodution function gets flatter as more inouts are being used
- the slope of the production function decreases


## Marginal product labour's importance
- because rational people think at the margins
- deciding the amount of worker that someone requires

## Marginal product labour decreases
- it diminishes as the amount of labour increases(L) whether the fixed input is land or capital

## Marginal cost
- Marginal cost, MC
- increases in total cost from an extra unit of production
- marginal cost = $\frac{\Delta \sum_{i=1}^{all} \text{cost}_i}{\Delta \text{Quantity}}$
- Increase in total cost from producing an additional unit of output

$$
MC = \frac{\Delta TC}{\Delta Q}
$$

## Fixed cost and variable cost
- fixed cost
- does not vary woth the quantity output
- variable cost
- vary with the quantity output
- total cost = fixed cost + variable cost
- average total cost
- $ATC = \frac{TC}{Q} = AFC + AVC$
- finding the minimum ATC


## Costs in the short run and long run
- Short run:
- some inputs are fixed
- the costs of these input are fixed costs
- Long run:
- all inputs are variables
- average total cost at any quantity is cost per unit using the most efficient mix of inputs for that Q
- firms can change in size in the long run but not in the short run
- Typical long run average total curve LRATC
- As ATC chnages as the scale of production changes

# Chapter 14 Firms in competitive markets

Deciding how much to produce, what prices, what costs, how many workers, how uch competition

## Perfectly competitive market
- Perfect substitutes exists because
1. Market with many buyers and sellers
2. Trading identical products
3. Firms can freely enter or exit the market
- Because of the first two each buyer and seller is a price taker

## Revenue of a competitive firm
- Total revenue
- TR = P * Q
- Average revenue
- AR = TR / Q
- Marginal revenue
- MR = $\Delta TR / \Delta Q$
- for competitive forms
- AR = MR = P

## Supply side revenue for competitive firms
- could increase its output without affecting the market price
- each unit increase in Q causes revenue to rise by P, which is MR = P

## Profit maximisation
- If MR > MC, increase Q to raise profit
- IF MR < MC, decrease Q to raise profit
- MR = MC $\leftarrow$ maximum profit

## Marginal cost and firm's supply decision

## Shutdown and exit
- Shutdown
- a **short run** decision not to produce anything because of the market conditions
- Exit
- a **long run** decision to leave the market
- Difference
- If shut down in short run, must still pay fixed cost
- If exit, zero cost

## Short run decision to shut down
- costs of shutting down = revenue lost = TR
- benefit of shutting dwn = cost savings = VC
- firms still need to pay TC
- shut down if TR < VC or P < AVC

## Competitive firm's short run supply curve

## The irrelevance of sunk cost
- sunk cost is the cots thart has been committed and cannot be recovered
- should ignore when making decisions
- must pay regardless of their choice
- in the short run, fixed cost are sunk cost

## Long run decision to exit or enter
- cost of existing market = revenue loss = TR
- benefit of exiting market = cost savings = TC
- ==FC = 0 in the long run==
- exit if TR < TC or P < ATC
- enter if TR > TC or P > ATC

## Long run supply curve for competitive firms

## Determining the profit
There will be a loss if the MR line is lower than the ATC curve

## Market supply: assumptions
1. all existing firms and potential entrants have identical costs
2. each firm's costs do not change as other firms enter or exit the market
3. number of firms in the market is
- fixed in the short run due to fixed cost
- variable in the long run due to free entry and exit

## Short run market supply curve
as long as P $\geq$ AVC, each firm will produce its profit-maximising quantity $\rightarrow$ MR = MC

## Short run market supply curve

## Entry and exit in the long run
in the long run, the number of firms can change due to entry and exit
- if firms earn positive conomics profit
- new firms enter, short run market supply shifts right
- price falls, reducing profit and slowing entry
- if firms incur a loss
- some firms exit, short run market supply curve shifts left
- price rises, reducing remaining firms' losses

## Zero profit condition
- long run equilibrium
- the process of entry and exit eventually hits a equilibrium and it is complete
- remaining firms earn zero economic profit
- Zero economic profit
- when P = ATC
- since firms produce where P = MR = MC
- the zero profit condition is P = MC = ATC
- since MC intersects ATC at minimum point of ATC
- in the long run, P = min ATC
- Reasons firms stay in business even if they make economic zero profit
- Total cost includes implicit costs
- So even if zero economic profit $\rightarrow$ still may have accounting profit

## Long run market supply curve

## Short run and long run effects of an increased in demand

## Long run supply curve
- is horizontal if
- all firms have identical costs
- costs do not change as other firs enter or exit the market
- might slope upwards if
- firms have identical costs
- costs rise as firms enter the market
- but firms do have different costs
- as price rises, firms with lower costs enter the market before those with higher costs
- further increases in price might make it worthwhile for higher costs firms to enter the market, increasing the market quantity supplied
- so, the ==long run market supply curve slope upwards==
- costs rise as firms enter the market
- in certain industries the supply fo a key input is limited
- so entry of new firms increases demand for that input, price of input increases
- hence, price increase is required to increase the market quantity supplied, so the supply curve is upwards sloping

## Efficiency of a competitive market
- profit maximisation is Q where MC = MR
- perfect competition P = MR
- competitive equilibrium P = MC
- competitive equilibrium is efficient
- maximises total surplus because P = MC

# Chapter 15 Monopoly
## Monopoly
- Firms that is the sole seller of a product without close substitutes
- Market power exists
- the ability to influence the market price of the product it sells 
- arise due to barrier to entry
- Other firms cannot enter the market
- Barriers to entry
1. Monopoly resources
- a single firm owns the key resources
2. Governmental regulation
- the government gives the firm exclusive rights
3. Production process
- natural monopoly
- a single firm can produce the entire market Q at lower cost than several firms
- 

## Monopolist's demand curve
In a competitive market the market demand curve is downward slopping however the individual demand curve is horizontal at the market price. The firm could increase quantity without lowering price. so marginal revenue = price. On the other hand, the monopoly is the only seller, thus the demand curve is similar to the market demand curve, to sell a greater Q, P must be reduced. Thus, MR $\neq$ P, rather MR < P but P = AR still holds true.

## Monopolists's marginal revenue
- For a monopolist, increasing Q has 2 effects on revenue 
- output effect: higher output raises revenue
- price effect: lower prices reduces revenue
- Marginal revenue MR < P 
- to sell a larger Q, the monopolists must reduce the price on all units it sells 
- is negative if price effect > output effect
- To maximise profit
- Through producing at the quantity where MR = MC
- Price is set at the price on the demand curve for that quantity

## Monopolist's profit

## Monopoly supply curve
A monopoly does not have a supply curve
- a competitive firm takes P as given but a monopoly is a price maker. So, the quantity does not depend on the price, rather both are jointly determined by MC, MR and the demand curve

## Welfare cost of monopoly
- monopoly equilibrium P > MR = MC
- The value to buyers of an additional unit (P) exceeds the cost of the resources needed to produce that unit (MC)
- Monopoly Q is too low - could increase total surplus with a larger Q
- So it results in a deadweight loss


## Price discrimination
- sell the same good at different prices to different buyers
- could increase firms profit by charging higher prices at buyers with higher willingness to pay
- need to identify everyone's WTP
- can raise economics welfare
- Perfect price discrimination
- charge each customer a different price
- monopoly takes the consumer surplus as profit
- no deadweight loss
- not possible in real life
- firms could however divide the customers into several groups based on several traits


## Public policies towards monopolies
- increase competition through antitrust laws
- regulation
- the behaviour of monopolists 
- set prices for them
- common in cases of natural monopolies
- MC < ATC at all Q
- Marginal cost pricing would result in losses
- Regulator might subsidise the monopolists or set P = ATC for zero economic profit
- public ownership
- normally less efficient than private owned
- do nothing
- auction off the market
- can use the revenue to subsidise the consumers

## Monopolistic competition
A type of imperfect competition such that many producers sell products that are differentiated from one another and hence are not perfect substitutes

# Chapter 16 Monopolistic competition
- two extremes
- perfect competition $\rightarrow$ perfect substitutes
- monopoly $\rightarrow$ no substitutes
- imperfect competition $\rightarrow$ in between the two extremes
- partial substitutes
1. Oligopoly
- only a few sellers offer similar or identical products
2. Monopolistic competition
- many firms sell similar but not identical products

## Characteristics
- many sellers with product differentiation
- not price takers, downward sloping demand curve
- free entry and exit
- zero economic profit in the long run

## Short run equilibrium
- profit maximisation
- Q where MR = MC
- take the price on the demand curve
- if P > ATC $\rightarrow$ profit


## Long run equilibrium
- If firms make profit in short run
- new entrants
- diluting demand, shifts demand curve left, price falls
- firm's profit
- If firms make losses in short run
- some firms will exit the market
- remaining firms enjoy higher demand and price


## Efficiency
It is less effective than perfect competition
- monopolistic competition
- excess competition: Q is not at the min ATC, it's one the downward slopping part of the ATC
- markup over marginal cost: P > MC
- perfect competition
- Q at min ATC <- efficient scale
- P = MC

## Welfare of society
- do not have all the desirable welfare properties of perfectly competitive market
- Inefficient
- markup of P > MC
- market quantity < socially efficient quantity
- deadweight loss of monopoly pricing
- Too much or too little entry / number of firms in the market
- product variety externality
- consumers get extra surplus from the introduction of new products
- business stealing externality
- losses incurred by existing firms when new firms enter market

## Advertising
- Incentives to advertise
- sell differentiated products and charge prices above marginal cost
- attract more buyers
- Percentage of spendings
- highly differentiated goods: 10-20% of revenue
- industrial products: little advertising
- homogenous products: no advertising
- act as a signal of quality
- little info about a specific product
- if the firm is willing to sell the product while advertising, firms are aiming for the long term, thus, the quality should not be that bad
- critique of advertising
- manipulative, it's more psychological than informative, to create desire
- impedes competition
- increase perception of products differentiation
- forster brand loyalty, higher markups
- makes consumers numbed towards the price difference
- defense of advertising
- provides useful info
- informed consumers could easily find and exploit price differences
- promotes competition and reduce market power

## Brand names
- Normally, they spend more on ads and charge higher prices than generic substitutes
- Critic
- products are not differentiated
- irrationality, consumers willing to pay more for certain brands
- Defense
- signal for quality, to the consumer
- firms have pressure to maintain quality to protect their reputation

# Chapter 17 Oligopoly
## Market concentration
- Concentration ratio
- percentage of total output in the market supplied by the biggest four firms
- Oligipolies are market structures that have a high concentration ratios

## Oligopoly
- it is a market structure in which only a few sellers offer similar or identical products
- strategical behaviour
- firms's decision about P and Q can affect other firms and cause them to react, and their actions will be considered by all firms
- game theory: the study of how people behave in strategic situations
- collusion
- agreement among firms in a market about quantities to produce or prices to charge
- firms would be be better off if they stick to the original agreement, but each firm has incentive to renege on the agreement
- hard for oligopoly firms to form cartels and maintain it
- cartel
- a group of firms acting in unison

## Equilibrium for Oligopoly
Nash equilibrium
- economic actors interacting with one another, each choosing their best strategy
- given the startegies that all other actors have chosen

When firms individually choose production to maximise profit
- Produce Q that is > monopoly but < competitve market
- Price is < monopoly but > competitive market P = MC

Increase the output has two effects
- Ouput effect: if P > MC, increase output raises profits
- Price effects: increase market quantity, reduce price and profit
- as the number of sellers in oligopoly increases, the price effect becomes smaller
- turns it into a competitve market, which means P approaches MC
- Market quantity approaches the socially efficient quantity

Dominant strategy $\rightarrow$ Game theory
- strategy that is best for a player in a game
- regardless of the startegies chosen by other players

Prisonner dilemma
- just an example of game theory
- real life examples, ad wars, arms race

## Welfare of society
Nocooperative oligopoly equilibrium
- may be bad for oligopolists, preventing them from achieving monopoly profit
- may be bad for society, ex. arms race
- may be good for society, quantity and price closer to optimal level

## Reasons for oligopolies to cooperate
- when the game is repeated many times, cooperations may be possible
- there are two strategies that may lead to cooperation
- if your rival reneges in one round, you renege in all subsequent rounds
- be a copycat

## Policies towards oligopolies
Government
- sometimes improve the market outcome

Policymakers
- try to induce firms in an oligopoly to compete rather than cooperate
- move the allocation of resources closer to social optimum

Antitrust laws
- prevent mergers and collusion

Opposition to regulation:
- Generally people agree it is good to restrict them, but there are business practices that are not necessarily harmful that is restricted by regulation
1. Resale price maintenance ("Fair trade")
- imposes lower limits on the prices retailers can charge
- often opposed due to the reduction of competition at the retail level
- however, any market power the manufacturer has is at the wholsale level
- no gains from restricting competition at the retail level
- legitimate objective: prevent discount retailers from free-riding on the services provided by full service retailers
2. Predatory pricing
- firms cut prices to prevent entry or drive a competitor out of the market
- it would charge monopoly prices eventually
- it is hard to identify whether it is predatory pricing or benficial to the consumer
- economists doubt that it is a good strategy
3. Tying
- manufacture bundles two products together and sells them for one price
- may use for price discrimination, and sometimes increase economic efficiency
- critics: it gives firms more market power by connecting weak products to strong ones
- others: it would not change market power as buyers are not willing to pay more for two goods together than for the goods separately

# Chapter 18 Markets for factors of production
## Factors of production
- input are used to produce goods and services, which are labour, land and capital
- capital is defined as the equipment and structures used to produc goods and services
- prices and quantities are determined by supply and demand in factor markets
- market for the factor of productions behave just like any market just that it's demand is a derived demand, which is derived from the firm's decision to supply a good in another market
- in this chapters, we assert two assumptions about markets
- all markets are competitive
-typical firms are price takers in the markets for the product they sell and the labour market
- firms care only about maximising profits, each firm's supply of output and demand for input's are derived from this goal

## Marginal product of labour MPL
- $MPL= \Delta Q / \Delta L$
- the increase in the amount of output from an additional unit of labour
- Q -> output, L -> labour

## Value of marginal product VMPL
- however output is measured with different units with wage
- $VMPL = P \times MPL$

## VMPL and labour demand

## Shifts in labour demand
Things that shift the demand curve
- change in output price, P
- Technological change - affects MPL
- Supply of other factors - affects MPL, ex. better equipment

## Input demand and output supply
- Marginal cost, is the cost of producing an additional unit of output
- $MC = W / MPL$
- Competitive firm's rule for demanding labor $P * MPL=W$

## Things that shift the labour supply curve
- change in tastes and attitudes regarding the labour-leisure trade off
- changes in alternative opportunities
- immigration

## Equilibrium in the labour market

## Monopsony
- a market wth one buyer
- a monopsony employer could use it's market power to increases its profits by paying lower wages
- below the socially optimal level, causing a deadweight loss
- rare in the real world

## Land and capital
Must distinguish between
- Purchase price: pays to own that factor indefinitely
- Rental price: pays to use that factor or a limited periods of time
- the determination of rental prices is analogous to the determination of wages

Determining the rental price of land

Determing the rental price of capital

Rental and purchase prices
- buying a unit of capital or land yields a stream of rental income
- the rental income in any period = the value of the marginal product VMP
- hence the equilibrium purchase price of a factor depends on both the current VMP and the VMP expected to prevail in future periods

## Linkage among the factors of production
Factors of production are used together that makes the productivity dependent on the quantities of the other factors
Example: if there's an increase in the quantity of capital, the marginal product and rental price of capital fall, having more capital makes workers more productive, MPL and W rise

## Conclusion
Neoclassical theory of income distribution
- factor prices are determined by supply and demand
- each factor is paid the value of its marginal product!

# Chapter 19 Earnings and discrimination
There are different things that affect productivity and wages
1. compensating differentials
2. Ability effort and chance
3. The superstar phenomenon
4. Human capital
5. The signaling theory of education

## Compensating differentials
Difference in wages that arises to offset the nonmonetary characteristics of different jobs, like the unpleasantness, difficulty and safety

## Ability, effort and chance
- Greater ability or effort
- normally, higher pay
- it increases workers marginal productivity, so they are more valuable to the firm
- wages are also affected by chance
- it is difficult to measure, so it is hard to quantify their effects on wages, but is still very important

## The superstar phenomenon
- superstars in their field
- great public appeal and astronomical incomes
- superstars appear in markets when
- everyone wants the good supplied by the best producers
- the good is produced with a technology that allows the producer to supply at a low cost

## Human capital
- the accumulation of investment in people, such as education
- the more educated the higher the wages
- suppliers of labour, i.e. workers are willing to pay for the cost of education if reward > cost
- if there's increase in international trade, demand for skilled labour is increasing and unskilled labour is decreasing

## The signaling theory of education
firms use education level to sort between high ability and low ability workers
- even tough the education itself -> university, doesn't impact productivity, but the difficulty of earning a degree demonstrates the graduates are highly capable
- increase general education attainment would not affect wages

## Above equilibrium wages
1. Minimum wages
may exceed the equilibrium wage of low skilled and experienced workers
2. Labour unions
- worker associations that bargain with employers over wages and working conditions
- unions: worker associations that bargain with employers over wages and working conditions
- union workers are generally higher paid
3. Theory of efficiency wages
- efficiency wages: above equilibrium wages paid by firms to increase worker productivity
- firms may pay higher wages to reduce turnovers, increase worker effort and attract better workers
- the effect: surplus of labour

## Economics of discrimination
Discrimination is the offering of different opportunities to similar individuals who differ only by personal characteristics.

The teacher has expressed that discrimination cannot explain all the differences in wages, and points to discrimination within the education system to be one of the problems.

### Discrimination by employers
- if one group in society receives a lower wage than another group with equal human capital and job characteristics
- but a profit motive policy may eradicate this problem
### Discrimination by consumers
if the market prefers a certain characteristic then the firms will adjust to employ people with that characteristic
### Discrimination by governments
some government policies mandate discriminatory practices or even prevent the market from correcting discriminatory wage differentials

# Chapter 20 Income inequaltiy and poverty

(Not within WTY syllabus)

## 20.1 Measures of inequality
1. Quantiles $\rightarrow$ dividing people by their income. For example, the bottom quantile has an income of $29,100 or below and the second quantile has a different income etc.
2. Quintiles ratio $\rightarrow$ income of the richest quintile divided by the poorest quintile
3. Poverty rate
4. Economic mobility, how easy it is to move between classes

Poverty rate
~ Percentage of the population whose family income falls below an absolute level called the poverty line
~ The poverty line is an absolute level of incmome set by the government for each family size below which a damily is deemed to be in poverty
~ As the poverty line is absolute than relative, more families are pushed above it year after year, however it has slowed down

### 20.1.1 Problems with measuring inequality
1. In-kind transfers are not held accounted for the monetary income of the dataset
2. The economic cycle. People can smmoth out their lives through previous savings or loans
3. Transitory and permanent income. People tend to consume with their permanent income, which is their normal/average income
In essence, data may not reflect the standard of living of people

In-kind trasnfers
~ Goods and services given to the poor, i.e. not monetary

Life cycle
~ the regular pattern of income variation over a person's life

## 20.2 Political philosophy bout redistributing income
- Utilitarian
- maximise the total utility for everyone as there is a diminishing marginal utility towards the poor
- rejects the complete equalisation of incomes
- Liberalism
- do whatever is justice, evaluated by an impartial observer behind a "veil of ignorance" $\leftarrow$ basically in the shoes of every class of people
- they would also, maximise the minimum utility $\leftarrow$ help the weakest $\leftarrow$ known as the maximin criterion
- reject the notion of an egalitarian society ~~kinda feels like this line is enforced by the author, but shrug~~
- allows us to consider trhe redistribution of income as a form of social insurance
- Libertarianism
- argue that only individuals could earn income and the government should not take income away from them
- argue that governments should punish crime and enforce voluntary agreement but not redistribute income
- enforced individual rights to ensur everyone has the same opportunity to use his talents and achieve success

Utility
~ a measure of happiness or satisfaction

Diminishing marginal utility
~ Poor people find $1 more useful than rich people

Egalitarian
~ believing in or based on the principle that all people are equal and deserve equal rights and opportunities

Social insurance
~ policy aimed at protecting people agaisnt the risk of adverse events

## 20.3 Policies to reduce poverty
|Policies|Remarks|
|---|---|
|Minimum wage law|Depends on the elasticity of the labour demand. Might hurt the people they are trying to help by reducing demand too much|
|Welfare||
|Negative income tax|collects revenue from high income households and gives subsidies to low income ones. May help lazy people|
|In-kind transfers|Enuring the poor of their needs and not addictions like drugs. May be inefficient and disrespectful|

## 20.4 Antipoverty programs and work incentives
Some people do need antipoverty programs to help them get by but there will also be people who abuse the system and free ride

# Chapter 22 Frontiers of microeconomics
## Asymmetric information
information asymmetry: a difference between two or three parties access to relevant knowledge. There are 3 types of information asymmetry
1. hidden characteristics
2. hidden action
3. hidden intention
### Hidden actions
one person knows more than another about an action he or she is taking
#### Moral hazards
tendency of a person who is imperfectly monitored to engage in dishonest or otherwise undesirable behaviour
#### The principle agent problem
Agent is the person who is performing the task one someone else's behalf. Principle is the person for whom this action is being performed
When the principle cannot perfectly monitor the agent behaviour, there is a risk/hazard that the agent may do something desirable/immoral but it could be solved through:
- better monitoring
- higher wages
- delayed payment -> paying bonuses late to not let them slack off

example: corporate management
The shareholders and the manager may not have the same goals, the principle is the shareholder. The shareholder might hire a board of directors to oversee management and create incentives for management to pursue the firm's goals instead of their own.
### Hidden characteristics
one person knows more than another about the attributes of a good he is selling
#### Adverse actions
happens when the seller knows more then the buyer about the product
### Market response to asymmetric information
The market itself is a response to hidden characteristics, it would act through:
1. signaling
actions taken by an informed party to reveal private information to an uninformed party
3. screening
actions taken by an uninformed party to induce informed party to reveal private information
### Public policy
Since asymmetric information may prevent market from allocating resources efficiently, public policy may be in place. However, the government may not be able to solve these problems as
- private markets are more informed then governments
- governments itself is a imperfect situation
- private markets can sometimes deal with the problem through signaling and screening

## Political economy
Applies the methods of economics to study how governments works
### Condorcet voting paradox
:::info
Link: **[Condorcet method](https://en.wikipedia.org/wiki/Condorcet_method)**

A Condorcet method is an election method that elects the candidate that would win a majority of the vote in all of the head-to-head elections against each of the other candidates, whenever there is such a candidate. A candidate with this property is called the Condorcet winner. Voting methods that always elect the Condorcet winner, when one exists, satisfy the Condorcet criterion.

A Condorcet winner does not always exist in every election because the preference of a group of voters selecting from more than two options can be cyclic — that is, for each candidate it might be possible to select an opponent where the opponent would win a majority of the votes. The possibility of such cyclic preferences in a group of voters is known as the Condorcet paradox. Also, the Condorcet winner is not necessarily the utilitarian winner.
:::
The failure of majority rule to produce transitive preference for society.
Transitivity: if $(a,b) \in R$ and $(b,c) \in R$ then $(a,c) \in R$
For example in this diagram


The order of candidates running against each other would affect the outcome of the vote. If A runs against C first then B, then the winner is B; but if B run against C first then A, A is the winner.

We could conclude that
- democratic preferences are not always transitive
- The order on which it is voted could affect the results
- majority voting doesn't always reveal what the masses want
### Arrow's 4 desirable properties of voting systems
1. unanimity
if everyone prefers A over B then A should beat B
2. transitivity
if A > B, B > C, then A > C
3. independence of irrelevant alternatives
the rankings between any two outcome should not depend on whether a third option is available
4. no dictators
there is no person who always gets his way, regardless of everyone else's preferences
### Arrow's impossibility theorem
- a mathematical result showing under certain assumed conditions, there is no scheme for aggregating individual preferences into a valid set of social preferences
- proved that no voting system can satisfy all 4 properties
### Median voter theorem
- a mathematical result showing that [majority rule](https://en.wikipedia.org/wiki/Majority_rule) will always pick the outcome most preferred by the median voter
- implies that in a two party race, each party will move its position towards that of the median voter and minority views are not given much weight
### Conclude
Politicians are motivated by self interest just like firms and consumers. Economic policies is not made by benevolent leaders and sometimes fail to resemble the ideal situations.

## Behavioral economics
- subfield of economics that integrates the insight of psychology
- people aren't always as rational

Humans aren't always
1. rational
- There are overconfidence, heuristics and reluctancy in humans
- But the assumption that they are is usually a good approximation for economics modeling
- Sometimes they also care more about fairness than self interest
2. consistent
- people tend to prefer instant gratification, even when delaying would increase the gratification

# Chapter 23 Measuring a nation's income

Microeconomics
~ the study of how households and firms make decisions and how they interact in markets.

Macroeconomics
~ the study of economy-wide phenomena, including inflation, unemployment etc.

This is a basic diagram of how every consumer is also a producer

## 23.1 Define GDP

So to compare the various sizes of economy, a common way would be to compare the GDP of two countries.

Gross Domestic Product GDP
~ the market value of all final goods and services produced within a country in a given period of time
~ excludes all illicit transactions, all products consumed and produced outside the marketplace and transactions involving items produced in the past
~ within the geographic confines of the country

## 23.2 Measuring GDP

The equation for GDP (denoted as $\Upsilon$)
These are also the components of GDP

$$
\Upsilon = C + I + G + NX
$$

Side note:
The equation is an identity, an equation that must be true because of how the variables in the equation is defined. In this case, each dollar of expenditure included in GDP is placed into one of four components of GDP, the total of the four components must equal to the GDP.

Consumption
~ spendings by households on goods and services, with the exception of purchases of new housing

Investment
~ spending on business capital, residential capital and inventories. Also, new houses.

Governmental spending
~ spendings on goods and services by local, state and federal government

Net exports
~ exports minus imports

The growth rate of a variable X over an N-year period is $(\frac{X_{\text{final}}}{X_{\text{initial}}})^{\frac{1}{N}} - 1$

## 23.3 Real and nominal GDP

nominal GDP
~ the production of goods and services valued at current prices

real GDP
~ the production of goods and services valued at constant price
~ normally designate a year as a *base year*

### 23.3.1 GDP deflator

$$
\text{GDP Deflator} = \frac{\text{Nominal GDP}}{\text{Real GDP}}*100
$$

~~Kinda think that the *100 is unnecessary~~
This measures the change in nominal GDP from the base year that cannot be attributed to change in real GDP. For example, if quantity rises and price remains constant then nominal GDP and real GDP is rises at the same time so the GDP deflator is constant.

### 23.3.2 Inflation

It is a situation in which the economy's overall price level is rising

$$
\text{Inflation rate in year 2} = \frac{\text{GDP deflator}_{\text{year 2}} - {\text{GDP deflator}_{\text{year 1}}}}{\text{GDP deflator}_{\text{year 1}}}*100
$$

## 23.4 Issues about GDP

- unable to measure the all activity outside the market place
- excludes the quality of the environment
- says nothing about the distribution of income
- etc..

# Chapter 24 Measuring the cost of living

## 24.1 CPI

Consumer price index CPI
~ measure of the overall cost of goods and services bought by a typical consumer

### 24.1.1 Calculating the CPI

1. Fix the basket. Determine which goods and services are most important to the typical consumer. Set the weights through surveying.
2. Find the prices of various products for several years
3. Compute the basket's cost
4. Choose a base year and compute the index through

$$
CPI = \frac{\text{basket price}_{\text{ current year}}}{\text{basket price}_{\text{ base year}}} \times 100
$$

5. Compute the inflation rate by

$$
\text{Inflation rate}_{\text{year 2}} = \frac{CPI_{\text{year 2}} - CPI_{\text{year 1}}}{CPI_{\text{year 1}}} \times 100
$$

Inflation rate
~ the percentage change in the price index from the preceding period

In addition to the CPI for the overall economy, there's also the core CPI (and many others). Because food and energy prices show substantial short run volatility, the core CPI is better at showing ongoing inflation trends.

Core CPI
~ a measure of the overall cost for the consumer goods and services excluding food and energy

Except CPI's there's also

Producer price index PPI
~ a measure of the cost of a basket of goods and services bought by firms

### 24.1.2 Problems with measuring cost of living

1. Substitution bias. If a good becomes more expensive and has a (relatively similar) substitute then the substitute will be consumed instead of the original good
2. Introduction of new goods. It is unable to account for new goods that will/might be essential to everyone in the future. Also doesn't take into account the increase in spending power if the product becomes mainstream.
3. Unmeasured quality change. The quality of a product might change, given that the price doesn't change for said product then the value of the money would be changed as well.

### 24.1.3 GDP deflator vs CPI

1. GDP deflator reflects the prices of all goods and services produced domestically whereas CPI reflects the prices of all goods and services bought by economists
2. CPI compares the price of a fixed basket while GDP deflator compares the prices of current;y produced goods and services to the price of the same goods and services in the base year

## 24.2 Correcting economic variables for the effects of inflation

$$
\text{Amount in today's dollars} = \text{amount in year T} \times \frac{\text{price}_{\text{ today}}}{\text{price}_{\text{ year T}}}
$$

There will be price disparities between different places in the same country. Some disparities remain due to the costly way they have to transport. Like haircuts is just too costly to be imported so price disparities exists.

### 24.2.1 Indexation

Indexation
~ the automatic conversion by law or contract of a dollar amount for the effects of inflation

### 24.2.2 Real & Nominal interest rates

Purchasing power
~ the amount of goods and services a person could buy

The higher the rate of inflation, the smaller the increase in the person's purchasing power.

Nominal interest rates
~ the interest rate normally reported without a correction for the effects of inflation

Real interest rate
~ the interest rate corrected for the effects of inflation
~ Real interest rate = Nominal interest rate - inflation rate

# Chapter 25 Production and growth

The world's richest countries have no guarantee they will stay the richest and that the poorest are not doomed to remain forever in poverty.

## 25.1 Role and determinants of productivity

Productivity
~ the quantity of goods and services produce from each unit of labour input
~ a nation can generally enjoy a high standard of living only if it can produce a large quantity of goods and services

Productivity is determined through 4 main things

1. physical capital
2. human capital
3. natural resources
4. technological knowledge

Physical capital
~ the stock of equipment and structures that are used to produce goods and services
~ people are generally more productive if they have the tools which to work
~ capital is a produced factor of production

Human Capital
~ the knowledge and skills that workers acquire through education, training and experience

Natural resources
~ the inputs into the production of goods and services that are provided by nature

Technological knowledge
~ society's understanding of the best way to produce goods and services

If the **production function** has a returns to scale, for any positive number x

$$
xY = AF(xL,xK,xH,xN)
$$

if x = 1/L then it is per worker

- Y is quantity of output
- A reflects the available production technologies
- L denotes the quantity of labour
- K denotes the quantity of physical capital
- H denotes the quantity of human capital
- N denotes the quantity of natural resources

## 25.2 Economic growth and public policy

### Political stability

Less fuss, better business

### Encourage private domestic investment

- one way to raise future productivity is to invest more current resources in the production of capital
- raises saving rate and increases independence but normally it creates inequality and unfairness

### Diminishing returns and the catch up effect

- Capital to subject to diminishing returns
- an increase in the saving rate leads to higher growth for a while
- in the long run, the higher saving rate leads to a higher level productivity and income but not to higher growth in these variables
- observed by the **catch-up effect**, countries that start off poor tend to grow more rapidly than countries that start off rich

### Investment from abroad

There are two types

1. Foreign Direct Investment, increases capital without shrinking consumption and able to learn from others, but it discourages domestic saving and investment and it seems like neo-imperialism
2. Foreign Portfolio Investment, increases capital without shrinking consumption and gain foreign capital without foreign control, but it is hot money and there is less potential learning

- Both of these will affect **GNP**, which is gross national product, measures the total income of residents both home and abroad
- Learn technologies from abroad
- Would need to remove borders or sanctions

### Government investment (SOE)

- it appears more equal and it drives human capital development, but it is more inefficient because of the bureaucracy and there's a high concentration of power
- this could be done through education and health policies
- one problem facing education for poorer countries would be that it might face brain drain

### Education

- Human capital conveys positive externalities
- May face *brain drain*, people moving away from country for better standard of living
- Is a type of investment with diminishing rates of return

Externality
~ the effect of one person's actions on the well being of a bystander

### Health care

- expenditures lead to a healthier lifestyle

### Research and development

- knowledge is a public good in the sense that once it is found then it is for the whole community to be used
- patents and intellectual property rights would incentivise private entities to do more research

### Freer trade policies

|For free trade|Against free trade|
|---|---|
|manoeuvre comparative advantage|protect infant industries|
|economics of scale|political arguments, such as national security, international bargaining|
|learn from challenges||

There are two types of trade policies

1. [Inward-orientated](http://jshet.net/docs/conference/75th/chang_peng.pdf), are usually defined as that economic independence or self-reliance by developing countries
2. Outward-orientated, is just the opposite of inward

### Institutional change

- Improve how rules and how they're enforced

## 25.0x800 Neo insitutionalism

There are 3 types of costs

1. Information cost, things that let you get better outcomes
2. Bargaining cost, share or split
3. Enforcement cost, enforces contractual matters

## 25.0x801 The 3P's of development

1. Predation
2. Production
3. Protection

# Chapter 26 Saving investment and the financial system

## 26.1 Financial systems

Financial systems
~ the group of institutions that help to match one person's savings with another person's investment
~ it is made out of various financial institutions

Financial systems can be grouped into 2 categories

1. Financial markets
2. Financial intermediaries

### 26.1.1 Financial markets

Financial markets
~ financial institutions through which savers can directly provide funds to borrowers
~ two of the most important financial market are **bonds** and **stocks**

#### Bonds

- a certificate of indebtedness
- there is a **date of maturity**, which is the time that the loan will be repaid with interest paid periodically and the **principle** (the original borrowed amount) paid back when the bond matures
- the buyers of bonds could either hold the bond until it matures or sell it
- the sale of bonds to raise money is called **debt finance**
- a failure to pay is called a **default**

There are 3 characteristics that distinct each bond

1. **Term**, the length of time until the bond matures. However, there does exists *perpetuity* which are bonds that pay interest forever but the principles is never repaid. It is also worth noting that since long term bonds have greater risk, thus it normally has a higher interest rate
2. **Credit risks**, the probability that the borrower can't pay back. A failure to pay is called a *default*. Borrowers can default on their loans by declaring bankruptcy. When a credit risk is really high, the borrower might consider releasing *junk bonds* (very high interest rate).
3. **Tax treatment**, the way the tax law treats the interest earned on the bond. The interest on most bonds is taxable income, but *municipal bonds*, issued by state and local governments, are exempted of tax collection.

#### Stocks

- a claim to partial ownership in a firm
- the sale of stocks to raise money is called *equity finance*
- After the stocks are issued to the public, they are traded on organised stock exchanges
- stocks also generally reflect the public's reception of the financial state of the company
- a **stock index** is the computed average of a group of stock prices

### 26.1.2 Financial intermediaries

- financial institutions through which savers can indirectly provide funds to borrowers
- the two biggest types of this are banks and mutual funds

#### Banks

- ==primary job==: take in deposits from savers and use it to make loans to borrowers
- secondary job: facilitate purchases of goods and serviuces by allowing people through creating a special asset (i.e. checks and debit cards) as a *medium of exchange*. A medium of exchange is an item that can be used to engage in transaction.
- stocks and bonds are, like banks deposits, a possible store of value

#### Mutual Funds

- an institution that sells shares to the public and uses the proceeds to buy a portfolio of stocks and bonds
- allows people with small funds to diversify their holdings
- it is done by the public buying shares in the mutual fund, being charged by the mutual fund and been given a return of investment
- allows people to access the skills of a professional money manager. This point is disputed as it is generally hard to beat the market and *index funds* (mutual funds that buy all the stocks at a given stock index) performs better on average than one with a professional money manager

## 26.2 Saving and investment in the national income accounts

Accounting
~ how various numbers are defined and added up

In this chapter, the economy discussed is a closed economy

Closed economy
~ an economy that does not interact with other economies
~ in the equation $\Upsilon = C + I + G + NX$, $NX$ (net exports) is 0

Let $T$ denote the amount the government collects from the household in taxes minus the amount it pays back to households in the form of transfer payments

National savings
~ the total income in the economy that remains after paying for consumption and government purchases
~ or just called savings, denoted as $S$
~ could be seen as an addition of private savings $(\Upsilon - T - C)$ and public savings $(T - G)$

Private savings
~ the income that households have left after paying for taxes and consumption

Public savings
~ the tax revenue that the government has left after paying for its spending

Budget surplus/deficit
~ an excess/deficit of tax revenue from government spending
~ happens when either $T > G \rightarrow$ surplus or $T < G \rightarrow$ deficit
~ it is a *balanced budget* when government spending is equal to tax revenue

$$
\begin{split}
\because& \Upsilon = C + I + G \\
\because& S = I \\
\therefore& S = \Upsilon - C - G \\
\text{or }& S = (\Upsilon - T - C) + (T - G)
\end{split}
$$

$S = I$ holds true when it is in the context of the closed economy as a whole due to financial institutions but may be false when the it is in on an individual level. In a closed economy, the people who save, save in a financial institution which will loan out the money for investment.

Just to clarify about the different types of savings

$$
\begin{split}
S_{private} &= \Upsilon - C - T \\
S_{public} &= T - G \\
S_{national} &= \Upsilon - C - G \\
S_{national} &= I
\end{split}
$$

T is for taxes and S is for savings

## 26.3 Market for loanable funds

General assumption: the economy has only one financial market, which is the market for loanable funds. It is an unrealistic assumption but this is economics

Market for loanable funds
~ the market in which those who want to save supply funds and those who want to borrow to invest demand funds

Loanable funds
~ all income that people have chosen to save and lend out rather than use for their own consumption, and to the amount that investors have chosen to borrow to fund new investment projects

In this market, the saving or investments are the sources of the supply of loanable funds. The price of a loan is the interest rate and there are 2 types of interest rates, *nominal interest rates* and *real interest rates*. Nominal interest rates is the monetary return of savings. Real interest rate is adjusted for inflation and thus more immune to erosion of inflation.

In the textbook, it identifies that there are 3 types of policies to alter the loanable funds market.

### Policy 1: Saving incentives

Saving incentives like Individual Retirement Accounts allow people to shelter some of their savings from taxation, could be done through reforming the tax code to encourage greater saving. This tax change would alter the incentives for household to save at any given interest rate, thus changing the amount of loanable funds.


When the tax reforms are in favour of savings, this would increase the public to save more and shift the supply of loanable funds to the right. Thus, raising the amount of loanable funds and reduces the equilibrium interest rate. This would not shift the demand as these tax reforms do not increase the likelihood of loaning. In short, ==if a reform in tax encourages savings, the result would be lower interest rates and greater investment==.

### Policy 2: Investment incentives

Investment incentives like investment tax credits, which gives a tax advantage to firms who construct a new infrastructure or buy new equipment. This would boost the demand for loans. The demand curve shifts to the right, the interest rate increases and the quantity of loanable funds increase.


In short, ==if a reform of the tax laws encourage investment, higher interest rate and greater savings would ensue==.

### Policy 3: Government budget deficit and surpluses

There could be two sources of budget deficiencies, either increase in governmental spending or a tax cut.

In the instance of governmental spending, the national saving -the source of supply for loanable funds-, is composed of public and private savings. Any alteration to governmental spendings affects the amount of public savings, thus the supply of loanable funds are changed as well. If say the government runs a budget deficit, the amount of public savings decrease and the supply for loanable funds decrease as a consequence. This would shift the supply curve of the loanable funds to the left and increase the equilibrium interest rate while decreasing the quantity of loanable funds. The higher interest rate would result the investors have less incentives to borrow and lead to crowding out.

Crowding out
~ a decrease in investment that results from governmental borrowing


We could shortly conclude that when the government reduces national savings by running a budget deficit, the interest rate rises and investment falls, crowding out the investors. In the instance of tax cuts, public saving $T - G$ is reduced, while private saving $\Upsilon - T - C$ is increased. However, as long as households consume more due to the lower taxes, the rate of decrease of public saving should be greater than the increase in private savings. Thus national savings is decreased.

==In both cases, a budget deficit would reduce the supply of loanable funds, increase the interest rate and reduce the amount of investment. A reduction in investment would mean fewer capital accumulation and slower or even negative economic growth==.

# Chapter 27 Basic tools of finance

Finance
~ the field that studies how people make decisions regarding the allocations of resources over time and the handling of risks

## 27.1 Time value of money

Present value
~ the amount of money today that would be needed, using prevailing interest rates, to produce a given future amount of money

Future value
~ the amount of money in the future that an amount of money today would yield with prevailing interest rates

Compounding
~ the accumulation of a sum of money, where the interest earned remains in the account to earn additional interest in the future

- Money today is more valuable than the same amount in the future
- If $r$ is the interest rate then an amount of $X$ amount to be received in $N$ years has a present value of $\frac{X}{(1+r)^2}$
- The process of finding a present value of a future sum is called **discounting**. It is called that because the future value is nominally greater than the present value.

Rule of 70
~ a quick (and not exact) method of getting the amount of time to double the present value with the given interest value is $\frac{70}{r}$

- There are 2 types of interest rates. Market interest rates and the personal interest rate. The personal discount rate would be $\frac{1}{(1+r_p)}$ ~~not sure what this is supposed to be~~

## 27.2 Risk aversion, insurance and diversification

Risk aversion
~ a dislike of uncertainty
~ most people are risk averse
~ The concept of risk aversion is developed using the concept of utility $\leftarrow$ a person's subjective measure of well being or satisfaction

- Insurance: for a fee paid today, an insurance company will pay the customer an **annuity** - a regular income every year until the customer dies
- Insurance in some sense actually spreads risk, because for 10,000 people to bear the 1/10,000 chance ~~wait what, isn't this the same~~ In this sense, the risk is pooled, which more predictable
- Insurance companies face two problems to spread risk:
- Adverse selection: people who are likely to buy are high risk people
- Moral hazard: people would do dumb and lazy shit when they are insured. What's the worst that could happen?

Diversification
~ the reduction of risk achieved by replacing a single risk with a large number of smaller unrelated risk
~ basically, don't just invest big in one stock, rather, invest small in several stocks. So, you won't get fucked when that one big one goes ballistic

- Risk for portfolios of companies are normally measured in standard deviation
- The smaller the standard deviation the better
- Diversification could eliminate firm-specific risk but not market risk

Firm specific risk
~ risk that affect only a single company

Market risk
~ risk that affects all companies in the stock market

- Even though most people are risk adverse, but stock markets provide a much higher rate of return than alternative financial assets, so there's still people who want to buy stocks

## 27.3 Asset valuation

- two building blocks of finance: time and risk
- Everyone should aim for the undervalued stocks

Fundamental analysis
~ the study of a company's statements and future prospects to determine its value
~ such as the dividends, the price that shareholders sell their stock etc.

Efficient market analysis
~ the theory that asset prices reflect all publicly available information about the value of an asset

- The efficient market theory is based upon the acknowledge that each company listed on a stock exchange is followed closely by many money managers and that the stock markets exhibits a **informational efficiency**
- one implication of the efficient market theory is that the stock prices should follow a **random walk**, which means that the changes are impossible to predict
- it is a random walk because news are unpredictable

Informational efficiency
~ asset prices that rationally reflect all available information

Random walk
~ the path of a variable whose changes are impossible to predict

- The correlation between how well a stock performs this year has little indication about how it would perform next year
- In practice, active managers usually fail to beat **index funds**, because they trade more frequently, incurring greater trading costs as they charge a higher fee for their expertise
- whenever the price of an asset rises above what appears to be its fundamental value, the market is said to be experiencing a **speculative bubble**

Index funds
~ mutual fund that buys all the stock in a given stock index

# Chapter 28 Unemployment

Natural rate of unemployment
~ the normal rate of unemplyment around which the unemplyment rate fluctuates
~ does not go away on it's own

## 28.1 Indetifying unemployment

Adult is defined as 16 or above.

There are 3 types of people:

1. Employed: paid, unpaid, full / half time or even people who are temporarily not at work due to sickness, holiday etc.
2. Unemployed: Available for work but not employed or find work during unemployment for the last 4 weeks
3. Not in labour force: not 1 or 2. Full time students, homemakers etc.

**Labour force** is defined as the total number of workers. It is counted by

$$
\text{Labour force} = \text{# employed}+\text{# unemployed}
$$

\# $\leftarrow$ the number of

**Unemployment rate** is defined as the percentage of the labour force that is unemployed. It is counted by

$$
\text{unemployment rate} = \frac{\text{# unemployed}}{\text{Labour force}}
$$

**Labour-force participation rate** is defined as the percentage of the adult population that is in the labour force
$$
\text{LFPR} = \frac{\text{Labour force}}{\text{Adult population}}
$$
**Cyclical unemployment** is the year to year deviation of unemployment from its natural rate.

Unemployment rate sometimes doesn't give us what we want as

1. Statistics on unemployment are difficult to interpret
2. Some people want their government benfits and don't actually want to find work
3. There exists **discouraged workers**, who are individuals who would like to work but have given up looking for a job

- **Marginally attached workers** are workers who have given a job-market-related reason for not currently looking for a job
- Most spells of unemployment are short, but most unemployment observed at any given time is long-term. This is because the short-term unemployment are quick to get over with and long term ones are more likely to be spotted.

There are 4 reasons to site unemplyment in the long run.

1. Job search
2. Minimum wage law
3. Unions and collective bargaining
4. The theory of efficiency wage

The first one is resulted from frictional unemployment while the other 3 are structural unemployment.

**Frictional unemployment** is unemployment as result of people to find jobs they like + suit and it is normally short spells of unemployment.

**Structural unemployment** is unemployment as a result of lack of jobs provided and is normally long spells of unemployment.

## 28.2 Job search

- the process by which workers find appropriate jobs given their taste and skills
- frictional unemployment is inevitable (often) as a result of changes in the demand for labour among different firms
- these changes in the composition of demand around industries or regions are called *sectoral shifts*
- this is only temporary
- the faster the information flow about job availability,the more rapidly the economy can march workers and firms, sometimes the government facilitates this.
- advocate: provide more information to people
- critic: private market better and more suited for individuals
- a government program that increases the amount of frictional unemployment without intending to do so is **unemployment insurance** which is a program that partially protects workers' income when they become unemployed
- advocate: workers more capable to find suitable work
- critic: provides incentive to not work

## 28.3 Minimum wage law

- not pre-dominant reason for unemployment
- it matters most to low skilled or low experienced labour
- if the wage is kept above the equilibrium level for any reason, the result is unemployment

## 28.4 Unions and collective bargaining

- **Union** is a worker association that bargains with employers over pay, benefits and working conditions
- **Collective bargaining** is the process by which unions and firms agree on the terms of employment
- If an agreement is not struck then a strike might ensue. **Strike** is the organised withdrawal of labour by a firm by a union
- Unions causes conflict between insider and outsider. Workers in unions reap the benefits, while workers that aren't in it bear some of the cost
- Advocate: Keep a happy and productive workforce
- Critic: Push wages above equilibrium, causes unemployment

## 28.5 Theory of efficiency wages

- **Efficiency wages** is above equilibrium wages paid by the firm to increase workers productivity
- This theory states that minimum wage laws and unions in unnecessary in many cases because firms may be better off keeping wages above the equilibrium level
- This is because it helps with the following four:
1. Workers health, this is more prevelant in low income countries
2. Worker turnover, as it is costly for fiorms to hire and train new workers
3. Worker quality, better workers
4. Worker effort

# Chapter 29 Monetary system

## 29.1 Meaning of money

- **money** is the asset in an economy that people regularly use to buy goods and services from others
- money saves the issue of *barter* as it would need a double coincidence of wants

Functions of money are:

1. medium of exchange
2. unit of account
3. store of value
4. liquidity

Types of money

1. **Commodity money**: money that takes the form of a commodity with intrinsic value, which is something that has vakue even if it's not used as money
2. **Fiat money**: money that has not intrinsic value

- **money stock** is the quantity of money circulating in the economy
- **currency** is the paper bill and coins in the public
- **demand deposits** balances in bank account that depositor's can access on demand by writing a check
- not easy to draw between monetary and non-monetary assets but they are still divided into M1 and M2

## 29.2 Central bank

**Central bank** is an institution designed to oversee the banking system and regulate the quantity of money in the economy

Normally has 3 jobs

1. regulate banks and ensure the health of the banking system
2. bank's bank. The last resort lender
3. control the quantity of money that is made available in the economy

- **monetary policy** is the setting of the money supply by policy-makers in the central bank
- the central banks primary tool is the **open market operations** which is the purchase and sale of government bonds
- this influences the market by increasing the money supply as the central bank. would buy or sell bonds from the public
- money supply would affect the inflation rate

## 29.3 Bank and money supply

- **reserves** are deposits that banks have received but have not loaned out
- We could express the national account with a T account

| Asset | Liabilities |
| :-----------: | :-----------: |
| Reserves $100 | Deposits $100 |

- The T account must always be balanced
- if the bank holds all the deposits in reserves, the bank does not influences the money supply
- most banks are **fractional reserve banks** which holds only a fraction of the deposits
- **reserves ratio** is the fraction of deposits that banks hold as reserves
- the central bank would set a minimum reserve which is a **reserve requirement**
- however, banks normally have a **excess reserve** to prevent running short of cash
- even though fractional reserve banks would create money but it does not create wealth
- the **money multiplier** is the amount of money the banking system generates with each dollar of reserves

- it is normally counted by taking the reciprocal of the reserves ratio R.

$$
M = \frac{1}{R}
$$

- **bank capital** is the resources a bank's owners have put into the institution, which is also called the owner's equity

| Assets | Liabilities and equity |
| :-------------: | :--------------------: |
| Reserves $200 | Deposits $800 |
| Loans $700 | Debt $150 |
| Securities $100 | Capital $50 |

- many business rely on **leverage** which is the use of borrowed money to supplement existing funds for purposes of investment
- the **leverage ratio** is the ratio of assets to bank capital
- an **insolvent** bank is one that is unable to pay off its debt holders and depositors in full
- a **credit crunch** is the shortage of capital induces the banks to reduce lending

## 29.4 Central banks tools of monetary control

Normally two tools:

1. Open market operations
2. Making loans to the banks
3. Change the reserve ratio

- **open market operations** are easy to conduct and if the government wants to boost the money supply, it buys bonds from the public
- banks normally loan from the central bank in the **discount window** and pay an interest called the **discount rate**
- the central bank would alter the money supply by altering the discount rate
- the central bank also does this when a financial institution when they are in trouble
- the central bank could also change the reserve requirements, which is the minimum requirement reserves that the bank must hold
- is less effective as banks normally hold excess reserves
- another way is to provide interest on reserves each bank holds and altering that interest rateincrea
- increase interest rate $\rightarrow$ increase the reserve ratio, lower the money multiplier, lower money supply
- it is hard to change the money supply as
- the amount of money the public wants to deposits is uncontrollable
- the amount the bankers want to lend is uncontrollable
- **federal fund rate** is the short term interest rate that banks charge one anther for loans
- the central bank would set the target, and use open market operations to influence it

# Chapter 30 Money growth and inflation

**Inflation** is the increase in overall level of prices. **Deflation** is the opposite. An extra-ordinary high rate of inflation is **hyperinflation**,

## 30.1 Classical theory of inflation

- when the overall price level rises, the value of money falls
- value of money is expressed as $1/P$
- Fundamentally, the demand for money reflects how much wealth people want to hold in liquid form
- The higher prices are, the more money the typical transaction requires and the more money people will choose to hold in their checking accounts. That is, a higher price level (lower value of money) increases the quantity of money demanded
- In the long run, money supply and money demanded are brought into equilibrium by the overall level of prices


- When an increase in the money supply makes the dollar more plentiful, the result is an increase in the price level that makes each dollar less valuable
- **Quantity theory of money** a theory asserting that the quantity of money available determines the price level and that the growth rate in the quantity of money available determines the inflation rate
- Hume proposed that economic variables should be devided into 2 groups
- **Nominal variables** - variables measured in monetary units
- **Real variables** variables measured in physical units
- This separation is called **classical dichotomy**
- The **relative price** of something is the price of something compared to another

- Dollar prices are nominal, relative prices are real
- Changes in the supply of money, affect nominal variables but not real ones, according to classical analysis
- **Monetary neutrality** is the proposition that changes in the money supply do not affect real variables
- **Velocity of money** is the rate at which money changes hands
- $P$ is the price level (GDP deflator), $\Upsilon$ is the quantity of output (real GDP), $M$ is the quantity of money
- the velocity of money is relatively stable over time
- As the velocity of money is relatively stable over time, when central bank change $M$, proportionate change in the nominal value of output $(P\times \Upsilon)$
- $\Upsilon$ is primarily determined by factor supplies and available production technology. Money is neutral thus does not affect output
- With $\Upsilon$ determined by factor supplies and technologies, when the central bank alters $M$ and induces proportional changes in the nominal value of output $(P\times \Upsilon)$ these changes are reflected in $P$
- When central bank increases the money supply rapidly, the result is high rate of inflation

$$
V = (P\times \Upsilon) / M \\
M\times V = P \times \Upsilon
$$

- **Inflation tax** is the revenue the government raises by creating money
- When government prints money, the price level rise and money value decrease
- **Fisher effect** is the 1-1 adjustment of nominal interest rate to the inflation rate
- ==Nominal i.r. = Real i.r. + inflation rate==
- When the central bank increases the rate of money growth, the long run result is higher inflation rate and nominal interest rate

## 30.2 Costs of inflation

- Inflation does not in itself cause the reduction of purchasing power. This is a depreciation of the principle of monetary neutrality

Costs include:

1. **Shoe-leather costs** - the resources wasted when inflation encourages people to reduce their money holdings
2. **Menu cost** - the costs of changing process
3. Relative price variability and the mis-allocation of resources - difficult to judge the costs of the confusion and inconvenience that arises from inflation. This makes investors less able to sort successful businesses from unsuccessful ones
4. Arbitrary redistribution of wealth - unexpected changes in prices redistribute wealth among debtors and creditors

# Chapter 31 Macroeconomics basics

- Most macro economist assume a **closed economy**, to make the model simple. A closed economy is one that does not interact with other economies in the world
- **Open economy** is an economy that interacts freely with other economies around the world

## 31.1 International flows of goods and capitals

- **Exports** are goods and services produced domestically and sold abroad
- **Imports** are goods and services produced abroad and sold domestically
- **Net exports** = value(exports) - value(imports). It is also called the **trade balance**
- **Trade surplus** is an excess of exports over imports, **trade deficit** is the opposite.
- **Balanced trade** is a situation in which exports = imports
- Things that affect the nation's exports, imports and net exports
- Taste of consumers
- Prices of goods
- Exchange rate
- Income of consumers
- Cost of transporting goods
- Government policies
- **Net capital flow** = purchase of foreign assets by domestic residents - purchase of domestic assets by foreigners
- **Net capital outflow**, or called net foreign investment, if positive net capital flow. Else, net capital inflow. Things that affect this are:
- Real interest paid on foreign assets
- Real interest paid on domestic assets
- Perceived economic and political risks of holding assets abroad
- Government policies that affect foreign ownership of domestic assets
- Net capital outflow (NCO), Net exports (NX)
$$
NCO = NX
$$
- Also in a open economy: $I$ is domestic investment

$$
\begin{split}
&\because \Upsilon = C + I + G + NX \\
&\therefore \Upsilon - C - G = I + NX \\
&\therefore S = I + NX \\
&\therefore S= I + NCO
\end{split}
$$

| Trade deficit | Balanced trade | Trade Surplus |
| :---------------------: | :---------------------: | :---------------------: |
| Exports < Imports | Exports = Imports | Exports > Imports |
| $\Upsilon < C + I +G$ | $\Upsilon = C + I +G$ | $\Upsilon > C + I +G$ |
| Saving < Investment | Saving = Investment | Saving > Investment |
| Net capital outflow < 0 | Net capital outflow = 0 | Net capital outflow > 0 |

- Trade deficits could be explained by:
- Unbalanced fiscal policy
- Investment boom
- Economic downturn and recovery

## 31.2 Real and nominal exchange rate

- **Nominal exchange rate** is the rate at which a person can trade the currency of one country for the currency of another
- **Appreciation** is an increase in the value of a currency as measured by the amount of foreign currency it can buy. When the currency appreciates, it is said to *strengthen* as it could buy more foreign currency. **Depreciation** is the opposite.
- **Real exchange rate** is the rate at which a person can trade the goods / services of one country for the g/s of another.

$$
\begin{split}
\text{Real exchange rate} &= \frac{\text{Domestic price}}{\text{Foreign price}}\times \text{Nominal exchange rate} \\
&= \frac{eP_{D}}{P_{F}}
\end{split}
$$

- $P_D$ is the price index for a domestic basket, $P_F$ is the price index for the foreign basket, $e$ is the exchange rate between domestic and foreign

## 31.3 Purchasing power parity

- One theory of exchange rate changing
- **Purchasing power parity** is a theory of exchange rate whereby a unit of any given currency should be able to buy the same quantity of goods in all countries
- This theory is based on the *law of one price*, which says a good must sell for the same price in all locations otherwise there would be opportunities for profit left unexploited
- The process of taking advantage of price advantage for the same item in different markets is **arbitrage**
- All this implies that the nominal exchange rate between countries depend on the <u>price level of in those countries</u>
- When the central bank prints too much money, then money loses its value in terms of g/s it could buy and the amount of other currencies
- Generally, higher interest rates increase the value of a country's currency. Higher interest rates tend to attract foreign investment, increasing the demand for and value of the home country's currency.
- However there are still limitations to this:
- Many goods are not easily traded
- Tradable goods aren't always perfect substitutes
- It works better as a approximation

### Mathematical indications

$P_D$ is the price index for a domestic basket, currency: DM

$P_F$ is the price index for the foreign basket, currency: FM

$e$ is the exchange rate between domestic and foreign, $\frac{F}{D}$

1. Domestically the price level is $P_D$, then the purchasing power of DM 1 would be $1/P_D$. Applying the same logic, purchasing power abroad would be $e/P_F$.
2. We know that they are equal: $1/P_D = e/P_F$
3. With arrangement: $1=eP_D/P_F$. The left side is constant, right is real exchange rate.
4. Thus, if the purchasing power of the dollar is always the same at home and abroad, then the real exchange rate (relative price of foreign and domestic g/s) cannot change.
5. 2^nd^ arrangement: $e = P_F/P_D$. According to this theory, the nominal exchange rate between the two countries must reflect the price levels in those countries

# Chapter 33 Aggregate supply and demand

- **recession** is a period of declining real income and rising unemployment
- **depression** is a severe recession

## 33.1 Three Facts about fluctuations

1. Economic fluctuations are irregular and unpredictable
- fluctuations in the economy are often called the business cycle
- fluctuations correspond to the changes in business cycle
- Real GDP rise, business is good, economy expand, more customers, profits increase
2. Most macroeconomics quantities fluctuate together
- For short term, most macroeconomic variables that measure some type of income, spending or production fluctuate closely together
3. As output falls, unemployment rises
- when firms supply decrease, they lay off workers

## 33.2 Explain short run fluctuations

- In previous chapters, we assume: the classical dichotomy and monetary neutrality. However the classical theory could only describe the world in the ling run but not in the short run. This is because microeconomic substitution from one market to another market is impossible for the whole economy (at least for the short term)
- Model of aggregate supply and demand is better for understanding the short run fluctuations
- **Aggregate demand curve** is a curve that shows the quantity of goods and services that households, firms, the government and customers want to buy at each price level

## 33.3 Aggregate demand curve

- As the price level falls, real wealth rises, interest rate falls, exchange rate depreciates. This stimulates spending on ==consumption, investment and net exports==. Increased spending on any or all of these means a larger quantity of goods and services demanded

Below are the three reasons why the AD is slopping downwards

1. **Wealth effect** (deals with consumption) - a decrease in the price level raises the real value of money and makes consumers wealthier, which in turn encourages them to spend more $\rightarrow$ quantity of goods and services demanded increase
2. **Interest effect** (deals with investment) - When price level decreases, household try to convert some of their money into interest bearing assets, they drive down interest rates. So, a lower interest price level reduces the interest rate, encourages greater spending on investment goods and thereby increases the quantity of goods and services demanded
3. **Exchange rate effect** (deals with net exports) - When a fall in the domestic price level causes the domestic interest rate to fall, the real value of the domestic currency declines in foreign exchange markets. This depreciation stimulates the domestic net exports and thereby increasing the quantity of goods and services demanded

AD shifts because of 4 reasons

1. **Changes in consumption** - an event that causes consumers to spend more at a given price level (tax cut, stock market boom etc) shifts the AD curve to the right.
2. **Changes in investment** - An event that causes firms to invest more at a given price level (optimism about future, fall in interest rate because of increased money supply) shifts AD to the right.
3. **Changes in government purchase** - An increase in government (defence, railways etc) spending shifts the AD to the right
4. **Changes in net exports** - An event that raises spending on net exports at any given price level (boom overseas, speculation about domestic currency depreciation) shifts AD to the right

## 33.4 Aggregate supply curve

- <u>The **Long run supply curve** is vertical</u> because in the long run, an economy's production of goods and services (real GDP) depends on its supplies of labour, capital, natural resources and technology used to turn these factors of production into goods and services. Since the price level doesn't affect the long run determinant of real GDP, the LRAS is vertical.
- The long run level of production is also called the **potential output** or **full employment**. To be more precise, it is the **natural level of output** because it shows what the economy produces when unemployment is at its normal rate
- Any change in the economy that alters the natural level of the output shifts the LRAS. The means of altering the natural level of production are:
- Labour
- Capital
- Natural resources
- Technological knowledge
- If production could go up then the LRAS would be shifted to the right
- The short run fluctuations in output and the price level that we will be studying should be viewed as deviations from the long run trends of output growth and inflations
- In the long run, technological progress would shift the LRAS to the right and growth in the money supply shifts the AD to the right. Thus leading to growth and ongoing inflation. ==picture==
- The **short run supply curve** slopes upwards - increase in the price level increases the quantity of goods and services supplied in the short run. There are 3 possible reasons:
- **Sticky wage theory** - nominal wages are slow to adjust to changing economic conditions. This prolonged adjustment may be attributable to slowly changing social norms and notions of fairness that influence wage settings. Unexpected low price raises real wages, fewer workers and lower product.
- **Sticky price theory** - the prices of some goods and services adjust slowly in response to changing economic conditions. This process is slow because there is a cost in adjusting prices: **menu costs**. Unexpected low price leaves some firm with higher price, depress sales and low product.
- **Misperception theory** - changes in the overall price level could temporarily mislead supplier about what is happening in the individual markets in which they sell their output. Unexpected low price lead some people to think their relative price has dropped, lower production.
- All of the 3 reasons share a common theme which is the <u>quantity of output supplied deviates from its long run or natural level when the actual price level in the economy deviates from the price level people expected to prevail</u>

$$
Q_{\text{Output supplied}} = \text{Natural level of output} + \alpha (P_{\text{Actual}} - P_{\text{Expected}})
$$

- In the long run, the wages and prices are flexible
-