- the study of how human beings coordinate their wants and desires, given the decision-making mechanisms, social customs, and political realities of the society
- the allocation of scarce resources
- distribution of the goods and services in the economy
- allocated through the combination interactions of millions of households and firms
- not enough of it to distribute to everyone who wants it
- the more scarce, the higher the price of a resource
- pricing system is used to decide who gets the resource (free market economy)
- anything available for use in production
- Crude oil, lumber, and iron ore
- Labor is principle resource used in production
- needed for production
- money (finance)
- means for acquiring capital but not capital (economics)
There Ain't No Such Thing As A Free Lunch
Economic Decision Rule
- if the marginal benefits of something something exceed the marginal costs, do it
- if the marginal cost of doing something exceed the marginal benefits, dont do it.
Branches of Economics
Microeconomics & Macroeconomics
- the study of how households and firms make decisions and how they interact in specific markets.
- the theory of the firm
- Study of economics from regional, national, and global perspectives.
- Economic growth, unemployment, and inflation
- Works with domestic and foreign policies
Factors of Production
- Capital (Plant, Equipment,Human)
- Entrepreneurial Ability
All natural resources
workers in the economy
- Plant - were economics take place
- Equipment - needed to make production possible and efficient
- Human- the managers and supervisors of production
Accountant's Definition of Cost
Cost is the sacrifice made, or the resources given up, measured in money terms to acquire some desired thing
Economist's Definition of Costs
Opportunity Cost is the cost of not choosing the next best alternative to the alternate that you have chosen
Production Possibilities Curve
A curve measuring the maximum combination of outputs that can be obtained from a given number of inputs
Result of an activity
What you put into a production process to achieve an out
Principle of Increasing Marginal Opportunity Cost
In order to get more and more of one thing, you have to give up every increasing quantities of something else
Concept of Demand
- Law of Demand
- Quantity Demanded
- To Be on The Demand Curve
Law of Demand
- When prices of goods rise, the quantity demanded of the good fails↑↓
- When price of goods fail, the quantity demanded of the good rises ↓↑
- Inverse Relationship
- The amount of a good that buyers are willing and able to purchase @ each price
- Quantity demanded is a function of price
- Price of the independent variable
To Be on The Demand Curve
Consumer must be willing and able to purchase the good.
Shift Factors of Demand
- Change in...
- Consumer's income or wealth
- Consumer's tastes
- Consumer's expectations
- Price of other goods
- Does not shift due to a change in the market price of the good being acquired
- quantity demanded will change according to the Law of Demand
Concept of Supply
- Law of Supply
- Quantity Supplied
- To Be on the Supply Curve
Law of Supply
- When the price of a good rises, the quantity supplied of that good also rises↑↑When the price falls, the quantity supplied of the good also falls↓↓Direct Relationship
- The amount that sellers are willing and able to sell at each price
- Quantity supplied is a function of price
- Price is the independent variable
To be on the Supply Curve
A seller must be willing and must be able to produce and sell the good
Shift Factors of Supply
- Prices of inputs to production
- Producer's expectations
- Taxes, fees, or subsidies
- Number of suppliers
- Supply curve does not shift due to the change in the market price of the good being produced.
Concept of Equilibrium
- Market equilibrium
- Equilibrium price
- Equilibrium quantity
The point at which the market supply curve and the market demand curve intersect
- The market price where the supply and demand curve intersect.
- Market Clearing Price - where the quantity supplied exactly equals the quantity demanded
Represents the quantity supplied and the quantity demanded in the marketplace where the supply and demand curve intersect
Efficiency in a Market Economy
Efficiency - achieving a goal with as little expenditure of resources and possible
Invisible Hand Theorem
Price mechanism will tend to allocate resource efficiently
Types of Economies
- Traditional Economy
- Market Economy
- Command Economy
- Mixed Economy
Allocation of resources depends of custom
Allocation of resources is determined by market prices based on the interaction of supply and demand
Allocation of resources is decided by government authorities and imposed by law
Vast majority of nations have mixed economies
- An economy in which principle resources are owned by private individuals or groups of private individuals organized as firms
- Free Market Economy
- An Economy in which the state owns the land and the capital stock.
- Command Economy
- People who live in a political entity of specific geographical characteristics and who produce and consume goods and services
- Functions according to rules, customs, and laws that establish the institutions and framework under which the people live
Three Questions That Must be Answered in Every Economy
- What to produce?
- How to produce?
- For whom to produce?
What keeps a market economy growing?
What makes production possible?
Circular Flow of Money in a Market Economy
Gross Domestic Product (GDP)
The market value of all final goods and services produced within a country in a given year
Components of GDP (The Expenditure Model)
- GDP = C+I+G+(X-M)
- C= consumption (spending by households)
- I= Investment (spending by business + households purchases of new homes)
- G= Government Purchases (spending by local, state, and federal governments)
- (X-M)= Exports (X) of domestically produced goods and services to foreigner - imports (M) of foreign goods and services (X-M) is called "Net Exports"
Production of goods and services valued at current prices
Production of goods and services valued at constant base-year prices
Year for which GDP deflator is set to an index of 100
GDP Deflator = Nominal GDP x 100 ÷ Real GDP
Who Measures GDP
Estimated quarterly by the U.S. Dept of Commence, Bureau of Economic Analysis
increases at a rate of about 2% to 2.5% per year
increases at a rate of about 1% per year (increases in technology largely responsible for increases)
Secular Growth Trend
Line that tilts slightly upward indicating the 3% to 3.5% annual growth rate
Effects of Population Growth
- 1. Stretching natural resources (Thomas Robert Malthus)
- 2. Diluting the capital stock
- 3. Trying to force technological progress beyond capability
Determinants of Productivity
- 1. Increasing physical capital
- 2. Advancing human capital
- 3. Applying natural resources
- 4. Advancing technology
- Has been subject to business cycles for as long as the GDP has been measured
- Initiated by natural disasters or acts of war between nations
- Based on optimism or pessimism of consumers and investors
Phases of the Business Cycle
U.S. Labor Force
- Included: measures are based on the civilian non-institutional population 16 yrs or older
- Excluded: ppl under 16, ppl confined to institutions such as nursing homes and prisons, ppl in active duty, ppl not seeking work or able to work
Classical School of Economic Thought
- Classical economists believe that supply creates its own demand.
- Classical economists focus on the law of supply.
- Economic downturns are only temporary.
- Contraction of the economy is usually due to wages being too high. For prosperity to resume, workers must be willing to accept lower wages.
- The government should not interfere with the market place. A government policy of laissez faire should be practiced and maintained.
- The price system will make all the necessary adjustments to achieve economic prosperity.
- The federal budget must be balanced. The government must live within its means.
Keynesian School of Economic Thought
- Keynesian economists focus on the law of demand.
- Wage/price inflexibility can cause sustained reductions in aggregate supply. This can lead to increases in unemployment and reductions in aggregate demand.
- Effective demand may be too low. People may be expecting the economy to contract more.
- During periods of accelerating economic contraction, the government should step in and “prime the pump”; that is, engage in deficit spending.
- Government policies should seek to reduce excessive unemployment, stimulate economic growth, and prevent excessive inflation.
- Fiscal Policy is from the Keynesian School of Economic Thought.
POTENTIAL OUTPUT AND LONG-RUN EQUILIBRIUM
- Potential Output
- Contractionary Gap
- Expansionary Gap
POTENTIAL OUTPUT (ALSO CALLED “NATURAL RATE OF OUTPUT”)
- Potential Output is the output of the nation, measured as Real GDP, when all available resources are fully employed.
- When aggregate demand and aggregate supply are in equilibrium at Potential Output, the economy has achieved the target rate of unemployment (about 5.5% of the labor force in the U.S.) and the target level of capacity utilization (about 83% of all plant and equipment in the U.S.).
- By meeting these targets, the economy has achieved long-run equilibrium.
CONTRACTIONARY GAP (ALSO CALLED “RECESSIONARY GAP”)
The amount of output, measured as Real GDP, by which short-run equilibrium is below Potential Output.
EXPANSIONARY GAP (ALSO CALLED “INFLATIONARY GAP”)
The amount of output, measured as Real GDP, by which short-run equilibrium exceeds Potential Output.
WHICH BRANCH OF THE FEDERAL GOVERNMENT ESTABLISHES FISCAL POLICY?
The Legislative Branch. The United States Congress receives a proposed budget from the President. After much deliberation, the Congress revises that proposal to its liking and passes appropriation ordinances to put its revised proposal into law.
WHICH BRANCH OF THE FEDERAL GOVERNMENT APPLIES FISCAL POLICY?
The Executive Branch. The Office of the President, through the departments headed by the members of the President’s Cabinet, conducts fiscal policy.
THE TWO TOOLS OF FISCAL POLICY
- 1. Federal government spending
- 2. Federal taxation
CLOSING A CONTRACTIONARY GAP
- Fiscal policy can help to close a contractionary gap by increasing federal spending and/or decreasing federal taxes. This is called “expansionary fiscal policy.” Increased spending can be focused on those geographic parts of the nation where unemployment is highest.
- Decreased taxes is “across the board.” All intended groups (individual taxpayers and/or businesses) benefit to varying degrees depending on their tax brackets
CLOSING AN EXPANSIONARY GAP
Fiscal policy can help to close an expansionary gap by decreasing federal spending and/or by increasing federal taxes. This is called “contractionary fiscal policy.” By helping to close an expansionary gap, inflationary pressures are reduced.
HOW LONG DOES IT TAKE FOR FISCAL POLICY TO WORK?
- One to two years before the Congress recognizes the level of need for fiscal measures to be adopted, completes its deliberations, passes the necessary ordinances, and the measures are implemented.
- In response to urgent conditions, fiscal measures can be authorized in less than a year.
HOW MUCH SPENDING IS NEEDED TO CLOSE A CONTRACTIONARY GAP?
Desired Increase in GDP = Necessary Increase in Federal Spending x the Simple Spending Multiplier
MARGINAL PROPENSITY TO CONSUME (mpc)
- People have a “propensity,” i.e. a tendency, on average, to spend a certain percentage of each dollar they earn.
- Economists call the percentage of the next dollar earned that will be spent the “marginal propensity to consume (mpc).”
SIMPLE SPENDING MULTIPLIER
- When a person spends 95% of each dollar he or she earns, the amount spent becomes someone else’s income.
- That someone else will spend 95% of the original 95%.
- This chain of spending results in a large multiplication of the initial amount spent.
- The formula of the multiplier is: 1 ÷ (1 –mpc).
HOW MUCH TAXATION TO CLOSE A CONTRACTIONARY GAP?
Desired increase in GDP = Necessary Reduction in Net Taxes x Taxation Multiplier
- The Taxation Multiplier also uses the mpc in its formula: – mpc ÷ (1 – mpc)A reduction in Net Taxes means that the federal government experiences a loss in tax revenues. The Taxation Multiplier is structured to take that loss into consideration. Taxation Multiplier is always one less than the Simple Spending Multiplier.
OKUN’S LAW (A RULE OF THUMB)
- Economist Arthur Okun discovered that a 1% change in the unemployment rate is associated with a 3% change in output in the opposite direction.
- 1% change in the unemployment rate is associated with a 3% change in output in the opposite direction.
THE PHILLIPS CURVE
- There exists a short-run relationship between inflation and unemployment.
- Research done by economist A.W. Phillips showed this negative correlation: years with low unemployment tend to have high inflation, while years with high unemployment tend to have low inflation.
- This relationship held up well during the 1960s, but not in the 1970s.
- Since then, the Phillips curve has exhibited mixed results.
THE ARITHMETIC EFFECT AND THE ECONOMIC EFFECT
- •Changes in tax rates have two different effects on the amount of tax revenue received by the federal government: (1) the arithmetic effect and (2) the economic effect.
- •The arithmetic effect is that if tax rates are lowered, then tax revenues will be lowered, and vice versa.
- •The economic effect is that lowering the tax rate provides a positive incentive to increase production, output, and employment.
- Raising the tax rate yields a disincentive by penalizing production, output, and employment so that these activities tend to decrease.
THE ARITHMETIC EFFECT AND THE ECONOMIC EFFECT
- Changes in tax rates have two different effects on the amount of tax revenue received by the federal government: (1) the arithmetic effect and (2) the economic effect.
- The arithmetic effect is that if tax rates are lowered, then tax revenues will be lowered, and vice versa.
- The economic effect is that lowering the tax rate provides a positive incentive to increase production, output, and employment. On the other hand, raising the tax rate yields a disincentive by penalizing production, output, and employment so that these activities tend to decrease.
AN ASSOCIATED EFFECT: THE EXPENDITURE EFFECT
Taxcuts not only create an incentive to increase production, output, and employment they also help to balance the federal budget by reducing the dependence on unemployment insurance, food stamps, and other social welfare programs
PROS AND CONS of LAFFER CURVE
- PROS – Lower tax rates stimulate incentives to work, to save and invest, and to accept business risks.
- The result of these incentives is expansion of real output (production), employment (jobs), and income (money).
- When tax rates are lowered tax avoidance (legal) and tax avoidance (illegal) are reduced.
- More people pay their fair share of federal income tax.
- CONS – Skeptics say there is empirical evidence that the reductions in tax rate is small, uncertain, and slow to emerge.
- Some people work more, but others work less.
- Decrease in tax rates increase aggregate demand beyond aggregate supply.
- The result would be a significant increase in the inflation rate, for which the Federal Reserve would use a contractionary (tight) monetary to counteract.
POINTS TO REMEMBER REGARDING TAXES
- The 16th Amendment to the United States Constitution allows Congress to levy income taxes. Consequently, paying federal taxes is a necessary and essential part of being a citizen of the United States.
- .However ... people do not work or invest to pay taxes. People work and invest to earn income. Although many (probably most) people are not concerned with tax rates, they are highly concerned with how much money they have left after they pay their taxes.
THREE METHODS OF MANAGING THE DEBT
- Balanced Budget
- Full Employment Budget Surplus
- Functional Finance
The method was endorsed by the Classical school of economic thought and used by the federal government until World War II. This method worsened periods of economic contraction, because as federal tax revenues declined due to the sagging demand for goods and services and for labor, the federal government reduced its spending. This method added misery to countless U.S. businesses and households, especially during the Great Depression.
FULL EMPLOYMENT BUDGET SURPLUS
This method would set the income tax rates high enough to result in a surplus of tax revenue during periods of full employment. The surplus would be used during of periods of economic decline to help stimulate the economy through increased federal government spending.
- Some economists refer to this as “dysfunctional finance,” since what happens under this method often lacks prudence and accountability.
- This method has been used since the Keynesian school of economic thought reached its heyday in the early 1960s. Until the early 1970s, the method was overused to try to correct every little bump in the economic roadway. In many cases, the usual delays in authorizing fiscal measures caused the correction to be too late and too much. If the economy was already in the process of self-correcting, the result was to replace high unemployment with high inflation. In such situations, Congress was faced with attempting to make new corrections in the opposite direction.
DEFINITION OF MONEY
Money is defined as anything that is generally acceptable for the purchase of goods and services and for the payment of debts.
FUNCTIONS OF MONEY
- Medium of Exchange
- Unit of Account
- Store of Wealth
Medium of Exchange
Makes possible the trade of goods and services for money instead of barter (i.e. for other goods and services).
Unit of Account
Provides the relative values of different goods and services (e.g. the value of a pencil vs. a hamburger).
Store of Wealth
Allows the holder to purchase goods and services in the future; however, money is subject to future changes in value.
Problems with Price Level
- Continual, sustained rise in the price level. The main causes are too much money chasing too few goods (demand-pull inflation) and/or significantly increased costs of inputs to production (cost-push
Continual, sustained decline in the price level. Economists consider this to be a worse condition than inflation. As consumers put off purchasing goods and services, thinking that prices will decline more, production becomes adversely impacted and workers are laid off
- Condition when falling output and raising prices exist in the economy at the same time. The United States experienced severe stagflation in the middle to late 1970s and in the early 1980s, when the
- unemployment rate reached between 8% and 10% and inflation reached between 12% and 14%.
WHICH AGENCY ESTABLISHES AND APPLIES MONETARY POLICY?
Federal Reserve System
Federal Reserve System
- Central Bank of the U.S.
- Created in 1913
- 1. Establish and conduct monetary policy
- 2. Supervise, regulate, and serve as lender of last resort to financial
- 3. Provide banking services to the federal government
- 4. Issue currency and coin
- 5. Provide check clearing and other services to commercial banks, savings
- and loan associations, and credit unions
Three Tools of Monetary Policy
- Changing the Discount and Federal Funds Rates
- Changing the Reserve Requirement
- Conducting Open Market Operations
Discount and Federal Funds Rates
- These are the only interest rates that are directly established by the Fed.
- 1. The Discount Rate (currently
- set at 0.75%) is the interest rate charged by the Fed to financial institutions
- (primarily commercial banks) for money loaned to them.
- 2. The Federal Funds Rate (currently set at 0%-0.25%) is the interest rate charged by one bank to another bank for overnight loan of money (called “reserves”). The borrowing is necessitated when the borrowing bank does not have enough reserves to meet the reserve requirement
- A change in these rates also serves as an indicator of the direction that the Fed’s monetary policy is going to take.
- This establishes the minimum amount of
- reserves that banks must hold against transaction deposits. This
- tool of monetary policy is seldom used. It is currently set at 10%.
Open Market Operations
- Conducted by the Federal Open Market Committee (FOMC),
- consisting of all seven members of the Federal Reserve Board of Governors plus
- presidents of 5 of the 12 Federal Reserve regional banks
- Most frequently used by the three tools of monetary policy
Compenents of M:
- When the Fed controls the money supply,
- the Fed controls the amount of M1 in
- circulation. What is included in M1?
- 1. Currency (≈ 50%)
- 2. Demand Deposits, i.e. Checking Accounts (≈49%)
- 3. Travelers Checks (≈1%)
- These are the most liquid forms of money
- in circulation.
- Other forms of money, such as and Savings
- Accounts, Money Market Accounts, and Certificates of Deposit are not included in M1.
CLOSING A CONTACTIONARY GAP
Although fiscal policy is often considered the main policy for reducing unemployment during periods of severe economic decline, monetary policy can provide valuable assistance by increasing the amount of money in circulation and, thereby, reducing a broad family of mortgage, commercial loan, and other interest rates paid by U.S. citizens.
CLOSING A CONTACTIONARY GAP
- The process of increasing the money
- supply is called “expansionary
- monetary policy.” Here is what happens:
M1 ↑ → i ↓ → I ↑ → GDP↑
CLOSING AN EXPANSIONARY GAP
Monetary policy is usually the main policy used to close an expansionary gap. The Fed decreases the amount of money in circulation, so that the process shown above is reversed. This is called “contractionary monetary policy.”
M1 ↓→ i ↑→ I ↓→ GDP ↓
HOW LONG DOES IT TAKE FOR MONETARY POLICY TO WORK?
- The Federal Reserve constantly monitors
- the economy for inflationary and deflationary pressures. The Fed, using its
- monetary policy tools, especially its open market operations tool, takes action
- quickly when action is deemed to be necessary. It usually takes from 3
- months to 9 months before the intended effects of monetary policy are achieved.
- The fraction of deposits that a bank must
- hold as reserves is called the “Reserve Ratio (R).” The minimum amount that a
- bank must hold is the reserve requirement rate, which is set by the Fed. By
- keeping a fraction of their deposits in reserve, banks engage in what is called
- “Fractional-reserve Banking.” The existence of a Reserve Ratio in Fractional-reserve Banking creates a “money multiplier.” An example using the money multiplier
- appears on the next slide.
EXAMPLE USING THE MONEY MULTIPLIER
If R = 10%, then (1/R) = (1 / 0.10) = 10.
- Because money that has been deposited can be loaned (less the amount that must be kept in reserve) and the loaned money
- may be deposited elsewhere, and that second deposit can be further loaned and
- further deposited, the sequential depositing of money has the effect of increasing the money supply. The amount of that increase is equal to the amount of the initial deposit times the reciprocal of the Reserve Ratio (1/R).
EQUATION OF EXCHANGE
- The equation of exchange is used to
- explain how changes in the money supply (M1) can affect the nation’s output
- and/or the price level. The equation is:
- M1 x V = P x Q
- M1 = is the money supply
- V = is the “velocity” of money, i.e. the
- number of times in a year that a dollar is spent,
- P = is the price level
- Q = is the output of the nation (Real GDP)
- *Note that whereas Q is Real GDP, Q x P is
- Nominal GDP.*
PRINCIPLE OF ABSOLUTE ADVANTAGE
- A country that can produce a good at a
- lower cost than another country has what is called an “absolute advantage” in
- the production of that good. When two countries each have absolute advantages
- over two different goods, then there are potential gains from trade available
- to both countries.
PRINCIPLE (OR LAW) OF COMPARATIVE ADVANTAGE
- As long as the relative opportunity costs
- associated with the production of goods, i.e. giving up one good to get another
- good, differs among countries, then there are potential gains to be made from
- trade between those countries. The most fundamental economic reason for
- a country to engage in international trade is explained by the country’s
- comparative advantage in the production of one or more of its goods.
TARIFFS AND QUOTAS
- A tariff is a tax that one country can
- put on a good imported from another country. A quota is a limit placed on the
- quantity of a good imported from another country.
Reasons for Restricted Trade
- Unequal distribution of gains from trade among producers and workers.
- Haggling by producers over gains from trade.
- Haggling by countries over gains from trade,
- Specialized (often costly) production, when costs can be reduced by economies of scale.
- Potential impacts a country’s rates of unemployment and inflation.
- Potential risk on national security.
- Disagreements between nations over political issues.
- Increased tax revenue received from the imposition of tariffs
BENEFITS OF FREE TRADE
- free trade is the best policy. The
- benefits are widely distributed throughout the population. The costs of free
- trade usually fall on small groups who stand to lose competitive ground. Often
- these groups operate production facilities which use old, less efficient
A trade deficit occurs when, in a given year, the market value of a nation’s imports exceeds the market value of its exports.A trade surplus occurs when, in a given year, the market value of a nation’s exports exceeds the market value of its imports.
- The United States has not always run a
- trade deficit. Following World War II, the U.S. ran a trade surpluses with
- other countries. This gave the U.S. the status of an international lender.
BALANCE OF TRADE & BALANCE OF PAYMENTS
- The balance
- of trade
- is the difference between the market value of all goods and services exported
- and imported. The balance of payments is a
- nation’s record of transactions between its residents and the residents of all
- other nations. The balance of payments includes a current account (short-term
- flows of payments) and a capital account (long-term flows of payments).
NOMINAL EXCHANGE RATES
A nominal exchange rate is the rate at which a person can trade the currency of one country for the currency of another country.
REAL EXCHANGE RATE
- The real exchange rate is the rate at which a person can trade the goods and services of one country for the goods and services of another country, given the differences in the
- prices of those goods and services between the two countries.
Real Exchange Rate = Nominal Exchange Rate x Domestic Price ÷ Foreign Price