Absolute Advantage

Balance of Trade
Individual: exists when a person can produce more of a certain good/ service that someone else in the same amount of time (or can produce a good using the least amount of resources)
National: exists when a country can produce more of a good/ service than another country can in the same period of time.

Comparative Advantage
Person or nation has a comparative advantage in the production of a product when it can produce the product at a lower domestic opportunity cost than a trading partner

• Input:
• ex. TVs produced per hour, miles per gallon
• Output:
• ex. number of hours to do jobs, number of acres to feed horses

Specialization and Trade
Gains from trade are based on comparative advantage, not absolute advantage.

• countries should trade if they have a lower opportunity cost

Mechanics of Foreign Exchange (FOREX)

FOREX

The buying and selling of currency 

• ex. In order to purchase souvenirs in France, it is first necessary for Americans to seek their dollars and buy euros 
• any transaction that occurs in the balance of payments necessitates foreign exchange 
• The exchange rate (e) is determined in the foreign currency markets 

Changes in e

e are a function of the supply and demand for currency 

• an increase in the supply of a currency will decrease the e of currency 
• A decrease in supply of a currency will increase the e of a currency
• An increase in demand for a currency will increase the e of a currency 
• A decrease in the demand for a currency will decrease the e of a currency 

Appreciation and depreciation

• appreciation of a currency occurred when the e of that currency increases
• Depreciation occurs when the e of that currency decreases 

Exchange rate determinants

• consumer tastes 
• Relative income 
• Relative price level
• Speculation 

Exports and imports

• the e is a determinant of both exports and imports
• Appreciation of the dollar causes American goods to be relatively more expensive and foreign goods  to be relatively cheaper thus reducing exports and increasing imports 
• Depreciation of the dollar caused American goods to be relatively cheaper and foreign goods to be relatively more expensive thus increasing exports and reducing imports 

Floating or flexible rates 

• depends upon supply and demand for that currency vs other currencies 
• Very sensitive to the business cycle
• Provides options for investments 

Fixed rate

• based upon a countries willingness to distribute currency and the ability to control the amounts 

The Balance of Payments

Measure of money inflows and outflows between the US and the Rest of the World (ROW)

• inflows are referred to as CREDITS
• outflows are referred to as DEBITS 

Current Account

balance of trade or net exports

• exports of goods/ services- import of good/services
• Exports create a credit to the balance of payments
• Imports create a debit to the balance of payments 

Net Foreign Income

• income earned by US owned foreign assets- income paid to foreign held US assets
• Ex. Interest payments on US owned Brazilian bonds- interest payments on German owned US Treasury bonds

Net Transfers (tend to be unilateral)

• foreign aid ->a debit to the current account 
• Ex. Mexican migrant workers send money to family in Mexico 

Capital/ financial account: the balance of capital ownership

• Includes the purchase of both real and financial assets 
• Direct investment in the US is a credit to the capital account
• ex. The Toyota factory in San Antonio 

• direct investment by US firms/ individuals in a foreign country are debits to the capital account 
• ex. The intel factory in San Jose, Costa Rica 

• purchase of foreign financial assets represent a debit to the capital account 
• ex. Warren Buffet buys stock in Petrochina

• purchase of domestic financial assets by foreigners represents a credit to the capital account 
• ex. the United Arab Emirates sovereign wealth fund purchases a large stake in the NASDAQ

RELATIONSHIP BETWEEN CURRENT AND CAPITAL ACCOUNT

• the current and capital accounts should zero each other out
• If the current has a negative balance (deficit) the capital should have a positive balance (surplus) 

Official reserves 

the foreign currency holdings of the United States Federal Reserve System 

• When there is a balance of payments deficit the fed depletes its reserves of foreign currency and credits the balance of payments 
• When there is a balance of payments surplus the fed accumulates foreign currency and debits the balance of payments 
• The official reserves zero out the balance of payments 

Active v passive official reserves

the US is passive in its use of official reserves. It does not seek to manipulate the dollar exchange rate

Supply Side Economics

AKA Reaganomics

Changes in AS, and not AD, are the main active force in determining the level of inflation, unemployment rates, and economic growth

• Supply side economists support policies that promote GDP growth by arguing that high marginal tax rates along with the current system of transfer payments such as unemployment compensation or welfare programs provide disincentives to work, invest, innovate, and undertake entrepreneurial ventures

Incentives to save and invest

1. High marginal tax rates reduce the rewards for savings and investments 
2. Consumption might increase but investments depend upon savings
3. Lower marginal tax rates encourage saving and investment

Laffer curve

A theoretical relationship between tax rates and tax revenues 

So as tax rates increase from zero, tax revenue increases from 0 to some maximum level and then declines

Three criticisms of the laffer curve

1. Evidence suggests that the impact of tax rates on incentives to work, save, and invest are small
2. Tax cuts also increase demand which can fuel inflation and demand may exceed supply 
3. Where the economy is actually located on the curve is difficult to determine

Phillips Curve

 

*Note that this graph is missing the Long Run Curve which would show the natural rate of unemployment

Long Run Phillips Curve

The LRPC exists at the NRU, structural changes in the economy the effect the NRU cause the LRPC to shift as well. 

• Increases in the NRU will shift LRPC -->
• Decreases in the NRU will shift LRPC <--

Short Run Phillips Curve

There is a trade-off between inflation and unemployment

• as one increases, the other decreases and vice versa
• determinants are the same as AS: produtivity, input costs, legal institutions

Long Run Phillips Curve

There is no trade-off between inflation and unemployment as the line is always vertical at NRU.

• will only shift is LRAS shifts

Major LRPC Assumption

More worker benefits create higher NR's and fewer worker benefits create lower NR's

Supply Shocks

Rapid and significant increases in resource cost

• causes SRAS to shift
• SRAS shifts downward, SRPC shifts outward

Misery Index

The combination of inflation and unemployment in any given year

• single digit misery is good
• Used to determine what's going on in with the economy

Extending the Analysis of Aggregate Supply

SRAS 

Period when wages and other input prices remain fixed as price level increases or decreases 

Effects over SR

Price level changes allow companies to exceed normal outputs and hire more workers because profits are increasing while wages remain constant 

• In the long run wages will adjust to the price level and previous output levels will adjust accordingly 

Equilibrium 

The LRAS curve is represented with a vertical line at full employment level of real GDP 

Demand pull inflation in AS model

Prices increase based on increase in AD

• In the short run, demand pull will drive up prices and increase production 
• In long run increases in AD. Will eventually return to previous levels 

Cost push inflation  

Arises from factors that will increase per unit costs such as increase in the price of a key resource 

Dilemma for the Gov't

In an effort to fight cost-push the gov't can react in two different ways:

1. Action such as spending by the gov't could begin an inflationary spiral 
2. No action however could lead to recession by keeping production and employment levels declining 

Misery Index

A combination of inflation and unemployment in any given year 

• Single digit misery is good

Supply shocks 

Rapid and significant increase in resource cost 

Inflation

A general rise in prices 

Deflation 

General decline in prices

Disinflation 

reduction in inflation from year to year (found in LRPC)

Stagflation 

Unemployment and inflation rise/ increase at same time

What Do Banks Do?

• a bank is a financial intermediary

• uses liquid assets (i.e. Bank deposits) to finance the investments of borrowers

• process is known as Fractional reserve banking

• a system in which depository institutions hold liquid assets less than the amount of deposits 
• Can take the form of:

1. Currency in bank vaults 
2. Bank reserves- deposits held at the federal reserve 

• T-Account (balance sheet)

• statements of assets and liabilities

• assets ( amount owned)

• items to which a bank holds legal claim
• The use of funds by financial intermediaries 

• liabilities( amounts owed)

• the legal claims against a bank
• The sources of fund for financial intermediaries 

Federal reserve bank

• 12 district federal reserve banks
• Each are quasi-owned

• Functions of the fed

• issues paper currency 
• Sets reserve requirements and holds reserves of the bank 
• Lends money to the banks and charged them interest 
• They are a check clearing service for banks 
• Act as a personal bank for the government 
• Supervise member banks
• Control money supply in the economy 

Tools of Monetary Policy

3 tools of monetary policy

• the reserve requirement

• only small amount of deposit is in the safe. Rest is loaned out "fractional reserve banking"
• F'ed sets the amount banks must hold
• The rr (reserve ratio)is the %  of deposits that banks must hold in reserve and not loan out
• When f'ed increases ms it increases amount of money held in bank deposits 

1. If in recession what should fed do to reserve requirement 

Decrease reserve ratio

• banks hold less money and have more excess reserves 
• Banks create more money by loaning out excess 
• Money supply increases, interest rates fall, AD goes up 

1. If in inflation what should fed to to reserve requirement

Increase reserve ratui

• banks hold more money and have less excess reserves
• Banks create less money 
• Money supply decreases, interest rates up, AD goes down

The discount rate

• the interest rate that the fed charges commercial banks

To increase the ms, the fed should decrease the discount rate( easy money policy)

To decrease the ms, the fed should increase the discount rate (contractionary policy)

Open market operations 

• the fed buys/ sells gov't bonds (securities) 
• Most important and widely used 

To increase the ms. The fed should buy gov't securities

To decrease the ms, the fed should sell gov't securities 

Federal funds rate is where FDIC meme we banks loan each other overnight funds 

Prime rate the interest rate banks charge their most credit worthy customers 

Money

I. What are the three uses of money?

1. A medium of exchange (to barter/ trade)
2. Unit of account (establishes economic worth in the exchange process)
3. Storage value (money holds its value over a period of time)

II. What are the three types of money? 

1. Commodity money (gets its value from the type of material from which it is made)
2. Representative money (paper money backed by something tangible that gives it value) 
3. Fiat money (type of money used in US. It is money because the government says so)

III. Characteristics of money

1. Portable 
2. Durable
3. Divisible 
4. Limited supply 
5. Acceptable 
6. Uniform

IV. Money supply 

• M1 money: consists of currency in circulation, checkable/ demand deposits (checking account), and travelers' checks. ( accounts for about 75%) held as a medium of exchange. "Most liquid" 
• M2 money: consists of M1 money, savings accounts, money market accounts, and deposits held by banks outside of the US
• M3 money: consists of M2, certificates of deposits

Time Value of Money

• is a dollar today worth more than a dollar tomorrow 

• yes

• why?

• Opportunity cost and inflation
• This is the reason for charging and paying interest 

• let v= future value of the dollar 
• P= present value of the dollar 
• r= real interest rate (nominal rate- inflation rate) expressed as a decimal 
• N= years 
• K= number of times interest is credited per year 

• simple interest formula 

• v=(1+r)^n*p

• the compound interest formula 

• V= (1+ r/k)^nk*p

Assume that inflation is to be 3% and the nominal interest rate on simple interest savings is 1%. Calculate the future value of the dollar after 1 yr.

• step one: calculate real interest rate

• -2%

•step two: Use the simple interest formula to calculate the future value

• $.98 

  

Demand for money has an inverse relationship between nominal interest rates and the quantity of money demanded

1. What happens to the quantity of money demanded when. Interest rates increase 

• quantify demanded falls because individuals would prefer to have interest earning assets instead of borrowed liabilities 

1. What happens when interest rate decreases?

• Increases . There is no incentive to convert cash into interest earning assets

Financial institutions 

Financial assets v. Financial liabilities

Assets: stocks and bonds whose benefit to the owner depends upon the issuer of the asset meeting certain obligations 

Liabilities: liabilities incurred by the issuer of a financial asset to stand behind the issued asset 

Interest rate: the price paid for the use of a financial asset

Stocks v bonds

Stocks:financial asset that conveys ownership in a corporation 

Bonds: a promise to pay a certain amount of money plus interest in the future 

Macroeconomics Video Assignment

Description of Federal Funds Rate and Explanation of OMO situation

Relating the Money Market, Loanable Funds, and AD-AS

Summary:

Increase in government spending results in an increase in interest rates in the money market and loanable funds. This results in an increase in Aggregate Demand. Increasing Aggregate Demand increases price level and GDP. The Fisher Effect has a 1:1 ratio so that if the interest rate increases the price level must increase the same amount

Money Creation and Multiple Deposit Expansion

Summary:

Banks create money buy lending money. The initial loan multiplied by 1/ RR will give you the maximum amount of loans the bank can make. If any banks hold excess reserves it reduces the total amount of loans possible. The process of money being redeposited multiple times is Multiple Deposit Expansion.

Loanable Funds Market

Summary:

The supply of loanable funds depends on how much people have in banks. The more incentive people have to save, the more loanable funds there are. Increasing the demand for money in the money market increases the demand for loanable funds. An increase in the demand for loanable funds also increases the interest rate.

The FED- Tools of Monetary Policy

Summary:

The Reserve Requirement (RR) is the percentage of money from deposits that the bank must keep either as vault money or on reserve with a Fed branch. Altering the RR changes the money supply; the absence or lowering of the RR had a great impact on the cause of the Great Depression. Lowering the discount rate, or the interest rate the Fed charges commercial banks they have loaned money to, should increase the Fed’s loan activities. “Buy Bonds= Big Bucks”, if the Fed buys bonds, it means more money for the people which will ultimately raise the money supply.

Money Market

Summary:

Demand for money is downward sloping because as price level is higher, the quantity demanded is going to be lower. Increasing demand puts upward pressure on interest rate. Supply of money is not related to interest rate and is always constant; without a slope. Shifting the supply of money to the right, then they stabilize interest rate which is helpful in a recession.

Types and Functions of Money

Summary:

The most primitive type of money is commodity money. This is considered items used in place of money. Representative money is the type we use today and fiat money is like I.O.U. Money also has three functions. Money is a medium of exchange, a way for us to get things that we want. Money is also a unit of account in that we equate higher price to higher value or quality.

Fiscal Policy

Changes in expenditures or tax revenue as of the federal government 

2 tools: 

• Taxes - gov't can increase or decrease taxes
• Spending - government can increase or decrease spending 

Deficits, surpluses and debt 

Balanced budget:

• Revenues=expenditures

Budget deficit:

• Revenues < expenditures

Budget surplus:

• Revenues> expenditures

Gov't debt:

• Sum of all deficits- sum of all surpluses 

Gov't must borrow money when it runs a budget deficit from:

• Individuals 
• Corporations
• Financial institutions
• Foreign entities or foreign gov't 

Fiscal policy has two options 

• discretionary fp ( action) 

a.        Expansionary- think deficit 

2. Contractionary- think surplus 

• Non discretionary (no action)

Discretionary v automatic 

Disc: increasing or decreasing gov't spending and/or taxes in order to return the economy to full employment.

Disc policy involved policy makers doing fp in responds to an economic problem 

Auto: unemployment compensation and marginal tax rates are examples of automatic policies that help mitigate the effects of recession and inflation. Auto fp takes place without policy makers having to respond to current economic problems.

Expansionary: combat a recession, gov't spending increase, taxes decrease

Contractionary: combat inflation, gov't spending decrease, taxes increase

Investment Demand Graphs

Real (r%) v. Nominal (i%)

what's the difference?

• Nominal is the observable rate of interest. Real subtracts our inflation (pi%) and is knot ex post facto

How do you compute the real interest rate (r%)? 

• r%=i% - pi%

What then, determines the cost of an investment decision?

• The real interest rate (r%)

Investment Demand Curve (ID)

what is the shape?

• Downward sloping

Why?

• When interest rates are high, fewer investments are profitable; when interest rates are low, more investments are profitable 

Shifts in ID

cost of production:

• Lower costs shift ID ->
• Higher costs shifts ID<-

Business taxes:

• Lower bus taxes shift ID ->
• Higher <-

Technological change:

• New technology- >
• Lack of technological change <-

Stock of Capital:

• If an economy is low on capital, then ID ->
• If Econ has much capital then <-

Expectations:

• Positive expectation ->
• Negative expectations <-

Investment Demand

What is investment?

money spent or expenditures on: 

• New plants (factories)
• Capital equipment (machinery)
• Technology (hardware and software)
• New homes 
• Inventories (goods sold by producers)

Expected rates of return

How does business make investment decisions?

• Cost/ benefit analysis

How does business determine the benefits?

• Expected rate of return

How does business count the cost?

• Interest costs

How does business determine the amount of investment that they undertake?

• Compare expected rate of return to interest cost 

-if expected return > interest cost, then invest

- if expected return < interest cost, then do not invest

AD/AS Graphs

Full employment

• Full employment equilibrium where AD intersects SRAS and LRAS at the same point 

Recessionary Gap

• A recessionary gap exists when equilibrium occurs below full employment output

Inflationary Gap

• an inflationary gap exists when equilibrium occurs beyond full employment output 

Aggregate Supply

The level of Real GDP (GDP_r) that firms will produce at each price level (PL)

Long Run Aggregate Supply (LRAS): 

• period of time where input prices are completely flexible and adjust to changes in the price level 
• in the long-run, the level of GDP_r supplies is independent of price-level
• the LRAS marks the level of full employment in the economy (analogous to PPC)
• Because input prices are completely flexible in the long-run, changes in price-level do not change firms' real profits and therefore do not change firms' level of output. This means that the LRAS is vertical at the economy's level of full employment.

Short Run Aggregate Supply:

• period of time where input prices are sticky and do not adjust to changes in the price-level
• In the short run, the level of GDP_r supplied is directly related to the price level 
• 

Changes in SRAS 

1. an increase is seen as a shift to the right
2. A decrease is seen as a shift to the left 
3. The key to understand the shift is per unit cost of production 
4. Per unit cost of production= total input cost/ total output cost 

Determinants of SRAS shifts

1. Input prices
2. Productivity 
3. Legal institutional environment 

Input prices 

• domestic resources prices:
• Wages (75% of all business costs)
• Cost of capital
• Raw materials (commodity prices)
• Foreign resource prices:
• Market power:
• Increases in resource prices will cause shifts to the left
• Decreases will cause shifts to the right 

Productivity = total output/ total inputs

• more productivity = lower unit production cost= SRAS shifts right 
• Lower productivity = higher unit production cost= shift to the left 

Legal-Institutional Environment 

·         taxes and subsidies:

·         Taxes ($ to gov't) on business increase per unit production cost = shift left

·         Subsidies($ from gov't) to business reduce per unit production cost = shift right 

·         Government regulation:

·         Gov't regulation created a cost of compliance = shift left 

·         Deregulation reduced compliance costs = shift right