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1

Problem Explanation
Week 1
Voluntary exchange
Real-Nominal Principle
Determinants of Demand
Demand unction
Demand !ur"e
#ncome Effect
$ubstitution Effect
%iffen %oods
&and'agon Effect
$nob Effect
Veblen Effect
$upply
Determinants of $upply
(arket $upply
$upply !ur"e
$hift of D !ur"e
$hift of $ !ur"e
Voluntary exchange > both better off
One will not agree, until gain something off it
People interested in nominal values
But real values, i.e. !!! "nominal# $ %,!! "real#, incl. taxes
Prices of the good in &uestion "Px#,
Prices of related goods "Pr#,
'xpectations of Price (hanges "Pe#,
(onsumer )ncomes "*c#,
(onsumer +astes and preferences "+c#,
,dvertising ",#,
Others "government policy, demographics, etc#
-.x $ f "Px, Pr, Pe, *c, +c, ,, etc.#
-uantity demanded in relation to the Price
/alling price, causes people to feel richer $ people buy more
Other goods are consumed, prices fall, - increases
0ise in their prices ma1e people buy more
"rice and noodles in (hina, gasoline, parfum e.g.#
)ncreasing ., others buy the commodity as well
.ecreasing ., others buy the commodity as well
)ncreasing ., cause increasing Price "luxury cars, e.g.#
-uantities a /irm is willing to supply
Prices of the 2ood in -uestion "Px#
Prices of )nputs "Pf#
,vailability of )nputs "3f#
+echnology "+#
'nvironment "4#
2overnment Policy "2#
-3x $ f "Px, Pf, 3f, +, 4, 2#
-uantity 3upplied in relation to the Price of the (ommodity
"higher P, higher *5 lower P, lower *#
+o the 0ight6 )ncreasing ., )ncreasing * "Px constant#
+o the 7eft6 .ecreasing ., .ecreasing . "Px constant#
.own6 )ncreasing 3, .ecreasing Px
8p6 .ecreasing 3, )ncreasing Px
2
E)uilibrium *D+$,
(arket Price in
!ompetiti"e (arkets
-a' of Demand
-a' of $upply
Willingness to pay
!onsumer $urplus
.otal !onsumer $urplus
Willingness to accept
Producer $urplus
Producer $urplus
.otal $urplus
(arket E)uilibrium
.he #n"isible /and
Elasticity
*1, Point Elasticity
*0, 1rc Elasticity
*2, !alculus 1pproach
)ntersection of . and 3 (urve
8pward 3hift in ., shortage, increasing P
"new mar1et '&uilibrium#
8pward 3hift in 3, surplus, decreasing P
"new mar1et '&uilibrium#
9ax. amount you:re willed to pay
.ifference between your willingness and the price
"willed6 ;!<, paid6 <, consumer surplus6 <#
9easured by the area below '&uilibrium, above P
3um of consumer surpluses in the mar1et
9in. amount willing to pay $ marginal cost of production
.ifference between Price received and marginal cost
"cost6 ;!<, charges6 %!<, producer surplus6 ;<#
9easured by the area above '&uilibrium, below P
3um of surpluses earned by all producers
(onsumer = Producer 3urplus
>ighest possible 3urplus, therefore 'fficient
9ost efficient mar1et '&uilibrium, in case of6
";# ?o external Benefits "pollution#
"%# ?o external (osts "free riders#
"@# Perfect )nformation "statistics#
"A# Perfect (ompetition
9easures the degree of sensitivity of &uantity demanded,
or &uantity supplied to changes in any determinant
9easures the percentage change in the dependent variable
(aused by the percentage change in the independent variable
"determinant#, holding the values of other variables constant6
Y
X
X
Y
X X
Y Y

/
/
9easures ' at a specific point on the (urve
(alculates the ,verage ' between points on the (urve
2 1
2 1
Y Y
X X
X
Y
+
+

"summary measure of all points#


8ses differential (alculus "derivatives# in measuring '
9easures ' by visual )nspection
3
*3, %eometric or %raphical
1pproach
Elasticity !oefficient
E 4 1
E 5 1
E 6 1
E 5 7
E 6 7
E 4 7
(ore Elastic
-ess Elastic
.otal Re"enue
*.otal $ales,
Elasticity !oefficient
E 5 1
E 6 1
E 4 1
Week 0
%o"ernmental #nter"ention
Price !eiling
Price loor
!onsumer !hoice
!onsumer E)uilibrium
Producer !hoice
Producer E)uilibrium
-a' of dim8 (9
Price:$upply:;utput Elasticity
8nitary 'lastic
'lastic "7uxury#
)nelastic "?ecessity#
B "?ormal# $ 3ubstitute
B ")nferior# $ (omplement
B 8nrelated
3ubstitutes, 9ultiple 8ses, 7arge Outlays, 7uxuries
(omplements, 7imited 8ses, 3mall Outlays, ?ecessities
+0 $ P C -
90 $ 3lope of +0 '&uation
"change in +0, when one more unit is sold#
+0 $ max when 90 $ !
'lastic "P increases, +0 falls5 P decreases, +0 rises#
)nelastic "P increases, +0 rises5 P decreases, +0 falls#
unitary"P increases, +0 max5 P decreases, +0 max#
Price (ontrols, +axes, (ontrolling -uantity
(auses .eadweight 7osses
Price below the '&uilibrium Price "shortage#
Price above the '&uilibrium Price "surplus#
9aximiDe satisfaction "combination of goods#
E and * goods that yield the same level of utility
)ndifference (urve
9arginal 0ate of 3ubstitution of * for E
98
E
F 98
*
+angency budget line and indifference (urve "highest possible#
9aximiDe Profits "combination of goods#
+wo inputs > specific level of output
)so&uant (urve
9arginal 0ate of 3ubstitution of 7 for G in producing
9P
7
F9P
G
+angency isocost line and iso&uant curve "highest possible#
'xtra 8tility you get for a certain commodity diminishes
as extra units are obtained, and increases attractiveness
of other commodities
'xtra productivity or addition to output obtained by a firm
4
-a' of dim8 (R
actors of Production
(arginal Product
1"erage Product
;utput Elasticity
;ptimal /iring Rule
#ncreasing Returns
!onstant Returns
Decreasing Returns
;ppurtuntiy !ost
Profit
Variable !osts *.V!,
ixed !osts *.!,
.otal !osts *.!,
1"erage ixed !osts *1!,
1"erage Variable !osts
*1V!,
1"erage .otal !osts *1.!,
Elasticity of .otal !ost *E
!
,
Diseconomics of $cale
by using an extra unit of variable input "7, G# diminishes
when combined with fixed &uantities of another input "0#
/ixed )nputs6 cannot change "land, buildings, factory#
Variable )nputs6 directly related to * "labor hours, machines#
(hange in total product per unit change in the variable input
9P
7
$ d+P F d7 or 9P
1
$ d+P F dG
+otal product divided by the &uantity used of variable input
,P
7
$ +P F 7 or ,P
G
$ +P F G
'
7
$ 9P
7
F ,P
7
'
G
$ 9P
G
F ,P
G
90P $ 90(
90P $ 9arginal 0evenue Product of the variable )nput
"=; wor1er $ =; sale#
90( $ 9arginal 0esource (ost of the variable )nput
"=; wor1er $ increase in total costs#
* increases greater then increase in )nputs "inc. slope#
* increases in same proportion as )nputs "const. slope#
* increases in a smaller proportion as )nputs "dec. slope#
*ou sacrifice ,, to get B "3lide H#
+otal 0evenue I +otal (ost
,ccounting Profits $ +0 B 'xplicit (ost
'conomic Profits$ +0 B 'xplicit B )mplicit (ost
(osts that are a function of Output
(osts that do not vary directly with Output "e.g. 0ents#
+( $ +/( = +V(
,/( $ +/( F -
,V( $ +V( F -
,+( $ +( F - $ ,/( = ,V(
9easures the percent change in +(, resulting from
a ;J change in Output -
'
(
$ "d+( F d-#F+( F - $ 9( F ,+(
4hen /irm increases its outputs, longBrun average cost
of production increases, two reasons6
a, coordination problems and b, increasing input costs
5
(arginal Product of -
(arginal Re"enue Product
of -abor *(RP,
;utput Effect
#nput-substitution-effect
Why Wages differ
-oren< !ur"e
%ini coefficient
WEE= 2
$tructure-
!onduct-
Performance-
(atrix
Perfect !ompetition *$83,
(hange in Output, from one additional unit of 7
'xtra revenue generated from additional unit of 7
90P $ marginal product x price of output
(hange in -uantity of 7abor demanded
resulting from a change in *
(hange in -uantity of 7abor demanded
0esulting from an increasing price of 7,
relative to the price of other )nputs
/ew people with re&uired 31ills
>igh +raining (osts
8ndesirable 4or1ing (onditions
,rtificial barriers to entry "e.g. .octors, licensing#
0acial .iscrimination
7earning 'ffect "learning s1ills, college graduates#
3ignaling 'ffect "information about s1ills, college graduates#
0epresents )ncome distribution
(umulative distributive /unction of a probability distribution
Percentage of >ouseholds6 EB,xis
Percentage of )ncome6 *B,xis
+herefore, measures social ine&uality
,rea between the line of perfect e&uality and the
observed 7orenD (urve, percentage change between both
the higher the coefficient, the more une&ual the distribution is
.escription of 1ey features of the mar1et "buyers, sellers#
.escription of the behavior of firms "pricing#
$ (ompetition among firm
.escription of the welfare effects "use of resources#
$ deadweightBlossesK
determines the behavior of firms
$ determines the various aspects of mar1et performance
no single /irm can influence prices "large number of firms#
perfect information6 buyersFsellers $ same )nformation
homogenous products "standardiDed#
mobility of sources
mar1et operates "buyersFsellers are price ta1es#
shortBrun profit, longBrun6 brea1Beven "see also 3. #
/irms produce, Price $ 7,( "lowest possible price for consumer#
7ongB0un6 resources are efficiently utiliDed, no idle capacity
+o 9aximiDe profits6 Produce when 90 $ 9(
Brea1B'ven Point6 +0 $ +(
6
!ontribution (argin
1"erage !ontribution
&reak-E"en Point *$8 00,
;peration of irms
$hort-Run !ur"e
$hort-Run E)uilibrium
-ong-Run E)uilibrium
-ong-Run $upply
1! increases
!onstant-!ost-#ndustry
$ymptoms of (arket ailure
#mperfect (arkets *$8 31,
(onopoly *$8 30,
>ow much of fixed costs is being recovered when a product
sells at a certain price6
+(9 $ +0 I +V(
.ifference between the selling price of the product
and the unit variable cost
,(9 $ P I ,V(
Profit $ ,rea below +0 and +(, after intersection of +0 and +(
maximiDing profits6
reducing fixed costs
reducing the average variable cots
raising the price
+0 > variable costs "firms operate#
+0 L variable costs "firms shutBdown# $ 9( $ ,V(
0elationship between mar1et price and the &uantity supplied
"by all firms in the shortBrun#
-uantity 3upplied $ -uantity .emanded
9aximiDation of Profits, given the mar1et price
both shortBrun conditions are met, plus,
each firm earns Dero economic profit
"no incentive for other firms to leave the mar1et, or to enter#
)ncreasing )nput Price "limited amounts drive up competition#
7ess Productive )nputs
,( of production $ constant

horiDontal longBrun supply curve


9icroeconomic 7evel

'xistence of imperfect mar1ets

presence of externalities

asymmetric information

provision of public goods


9acroeconomic 7evel

)ncome ine&ualities

'xistence of unemployment and business cycles

Perfect (ompetition $ ).',7

)mperfect (ompetition

9onopoly

Oligopoly

.uopoly

9onopolistic (ompetition
3ingle 3eller, product has no close substitutes
barriers to entry, control over mar1et resources, patents
Price > 90 "earns extraordinary profits#
produces where 90 $ 9(
+herefore, can increase profits and cause price discrimination
7
(onopolist>s ;utput
Dead'eight -osses *$8 3?,
Price Discrimination
$lides @@ A @B
Natural (onopoly
Price !ontrols
of (onopolies
1ntitrust Policy
produces less, charges higher prices "misallocation of 0#
?egatively sloping .emand (urve
to sell more, lower prices6 90 L P
90 curve is below the .emand (urve
'xtraordinary profits, because of ,( (urve "above 90#
2overnmental intervention "taxing profits#, or lower price
-uantity 3upplied $ )ntersection of 90 and 9(
Profits $ )ntersection of ,( and 9( up to .emand "3. A@#
- satisfies marginal principle, 90 $ 9(
.emand (urve determines the price associated with -
Profit per 8nit sold $ P I ,(
+otal Profit $ Profit per 8nit C ?umber of sold 8nits
, measure of the inefficiency from monopoly5
e&ual to the decrease in the mar1et surplus
(harging different Prices for different 2roups
Opportunity for Price .iscrimination, when

/irm got mar1et Power

.ifferent (onsumer 2roups

0esale is not possible


)dea6 0educe .eadweight 7oss arising from monopoly
and recapture loss in (onsumer 3urplus
(onsumer:s 7oss causes increasing Producer:s benefit
'xamples6 airline tic1ets "discounts#, discount coupons, etc.
, mar1et in which large economies of scale ensure that
only a single large firm can survive
2overnment can intervene by regulating the price
, monopoly can sometimes be better for efficiency reasons
Output 7evel6 90 $ 9(
, 3econd /irm won:t enter the mar1et, because
its demand curve will always lie below the 7ongB0un ,(
Price (ontrols, ,ntitrust 7aws

Brea1ing 8p 9onopolies

Bloc1ing 9ergers

0egulating business practices

.eregulation and privatiDation


e.g. ,( Pricing Policy6
. (urve intersects the longBrun ,( (urve
"$governmental intervention, new prices#
+o brea1 up dominant firms, prevent some corporate mergers,
and regulate business practices that reduce competition
1, e.g. brea1 up one firm into several smaller firms
+rust $ arrangement under which the owners of several firms
transfer their decisionBma1ing powers to small group of trustees
8
(onopolistic !ompetition
*brand markets,
$hort-Run
-ong-Run
(onopolistically !om-
petiti"e (arket
Effects of (arket Entry
Entry-$topsC
-ong-Run E)uilibrium
(onopolistic "s8
Perfect !ompetition *1,
*$8 D@,
(onopolistic "s8
Perfect !ompetition *&,
*$8 DE,
0, to bloc1 mergers that would reduce competition and lead to
higher prices "merger $ one or two firms combine operations#
2, +ieBinB3ales "buyers are forced two buy a second product#
2, Predatory Pricing "firm decrease price to drive out rivals#
$ both will practices will be supervised by government
9any firms selling a differentiated product
ease of entry
blend of competition and monopoly "brand loyalty#
availability of close substitutes limits monopoly power
firms engage in nonBprice competition ",dvertising# to
raise mar1et share
clustering of prices
firms misallocate resources but to lesser degree "since
demand is elastic#
more variety of consumers, but advertising and product
differentiation may be excessive and wasteful
?egatively sloped .emand (urve "more elastic due to
available substitutes#
9aximiDation of Profits at 90 $ 9( but P > ,V(
/irms are attracted, because of shortBrun profits
or leave, faced with losses until . (urve of remaining
firm is tangent to ,( and firms brea1 even "P$,(# "3. HM#
'ach firm produces a slightly different product
"narrowly defined monopoly#
Products sold by different firms are close substitutes
"1een competition between firms for consumers#
.ecreasing Profits, due to

mar1et price drops

&uantity produced decreases

firm:s ,( of production increases


/irms enter the mar1et until such point that prices are
e&ual to ,( "brea1 even#. +hereafter, firms will neither
enter nor exit the )ndustry "3. N@#
Perfectly competitive mar1et, firmBspecific . (urve
is horiDontal at the mar1et price, and 90 e&uals Price.
'&uilibrium6 Price $ 9( $ ,(
+he '&uilibrium occurs at the minimum of the ,( (urve
9onopolistically competitive mar1et, firmBspecific . (urve
is negatively sloped and 90 L Price.
'&uilibrium6 90 $ 9( and Price $ ,(
9
WEE= 3
;ligopoly
!ournot Duopoly *$8 @,
&ertrand Duopoly *$8 E,
Edge'orth Duopoly *$8 B,
$'ee<y ;ligopoly *$8 D,
;ligopolistic &eha"ior
%ame .heory *$8 11,
/ew sellers
Products may be homogeneous or differentiated
'ntry Barriers exist "(artels, established firms lower prices#
/irms are mutually interdependent
/irms engage in nonBprice competition ",dvertising#
/irms collude on what prices to charge or
how to divide the mar1et to prevent new entrants
Prices tend to be rigid
/irms misallocate resources and can earn profits in the
longBrun because of restricted entry
'xcessive ,dvertising and differentiation, spend on 0O.
)nvolves 8ncertainty about 0eaction of the (ompetitor
+wo firms react to each other:s output changes until
both reach an e&uilibrium position
0eaction continue until both firms have e&ual output
+wo firms react to each other:s output changes until
both reach an e&uilibrium position
Both firms set prices, assuming the other firm:s price
is independent of its own choice of output
)f both firms set e&ual Prices > 9(, outbalanced mar1et share
but, if one lowers, it gains the whole mar1et
Both are therefore tempted to lower prices
/irm won:t P L 9(, otherwise loss
)ntersection of both, P $ 9(
/irms act as a monopolist, Profit 9aximiDation 90 $ P
(haracteriDed by price undercuttings
Price undercutting continues until both reach 9ax. Output
Gin1ed .emand (urve
. (urve is bent at the prevailing mar1et Price "1in1#
price increase6 other firms won:t change their prices
"&uantity will decrease by large amount, elastic#
price decrease6 other firms will also decrease their prices
"&uantity will increase by small amount, inelastic#
0esponses to 8ncertainty
!artel Pricing
1, (artel $ group which coordinates pricing decisions
"often charging the same price for a particular good#
0, ,rrangement under which the two firms act as one
"coordination their pricing decisions $ price fixing#
3tudy strategic behavior of oligopolists, study of decisionB
ma1ing in strategic situations
Basic 'lements

Players "Parties#

3trategies "Possible ,ctions#


10
Duopolists> Dilemma
%uaranteed Price (atching
;"ercoming the Dilemma
*$8 0E,
Price -eadership
-imit Pricing
/o' to measure (arket
Po'erF
1G -erner #ndex
*$8 2@,
0G /erfindahl #ndex
*$8 2E,

Payoffs "'ach receives for following a strategy#


dominant strategy $ yields a higher payoff, no matter what
the other player chooses
dominated strategy $ leads to a lower payoff than an
alternative choice, regardless of what the other chooses
,lthough both firms would be better off if they chose the
high price, each firm chooses the low price "33. ;M I ;H#
occurs because the two firms are unable to coordinate
their pricing decisions and act as one "s.a. Prisoner:s dilemma#
3trategy where a firm guarantees it will match a lower price
by a competitor
'liminates the duopolists: dilemma and ma1es cartel profits
and pricing possible, even without a formal cartel
7eads to higher price
B8+, guarantees that consumers will pay the high price
1, duopoly pricing strategy
0, grimBtrigger strategy
i.e. firm responds to underpricing by choosing a price so low
that each firm ma1es Dero economic profit
2, titBforBtat strategy
i.e. one firm chooses whatever price the other firm chose
in the preceding period
One Oligopolist $ Price 7eader
sets a price, while expecting that other firms will match the Price
but, signals may be misinterpreted
1, change in mar1et conditions, Pust match the price, but
price fixing continues
0, under pricing, price war may be triggered, result6
destroying the priceBfixing agreement
Pic1ing a price which is lower than normal monopoly Price
1, 7erner )ndex
0, >erfindahl )ndex
)ndicator of monopoly Power, defined as6
7 $ "P I 9(# F P
Perfect (ompetition6 P $ 9( "value of Dero#
P > 9(, )ndex varies between ! and ;
+he closer to ;, the greater the degree of 9onopoly
)ndex measures industrial mar1et concentration
individual mar1et share of each firm in fractional terms
is s&uared
the >Bindex is given by the sum of the s&uared terms6
> $ Q s
i
%
"s
i
$ mar1et share of the firm#
>B)ndex ta1es into account the number of firms,
and their siDe differences
11
!oncentration Ratios
ExercisesC
$lides 30 A 3@
(onopsony *$8 3B,
(onopoly "s8 (onopsony
*$8 @7,
WEE= @
(acroeconomic %oals
(acro- #nstruments *$8 2,
!ircular lo's of #ncome
$lides 3 A ?
Dual %ap 1nalysis
Real $ector #ndicators
?Be&ualBsiDed firms $ ;F?, 9onopoly $ ;, tend to one when few
firms andFor greater degree of ine&uality in mar1et shares
9easure )ndustry (oncentration, degree of mar1et control
0atio $ Proportion of total Output produced by the firms,
focusing on the largest firms " >>), focus on entire industry#
e.g. ratio over R!J of industry:s output produced by the four
or the eight largest firms, indicates oligopolistic mar1et
structures, significant mar1et control "3. @N#
One single buyer of a product
e.g. government mar1eting board buys all * of /armers
Positively sloped mar1et supply of labor
to hire more wor1ers, pay higher wages
"9arginal 7abor (osts > 4age#
>ire more wor1ers6
9arginal Benefit of 7abor $ 9arginal 7abor (ost
9onopoly6

single seller of output

high price of output

small &uantity of output

monopolist uses mar1et power to increase P


9onopsony6

single buyer of input

low price of input

small &uantity of input

monopsonist uses mar1et power to decrease wages,

or other input prices

achieve sustainable economic growth "2.PF2?P#

contain inflation to moderate levels

provide employment F reduce unemployment

attain external balance

distribute fruits of growth e&uitably


9onetary Policy "money supply, interest rates, etc.#
/iscal Policy "taxation, expenditures, etc.#
'xternal Policy "exchange rate, debt management#
/inancial 3ector 2ap6 3 I )
2overnment 3ector 2ap6 + I 2
'xternal 3ector 2ap6 E I 9
"3 I )# = "+ I 2# $ "E I 9#
2.P F 2?P "nominal, real, per capita#
Price )ndicators "(P), PP), 4P), 0P), 2.P deflator#
12
National 1ccounts
%DP
Real %DP
Nominal %DP
/o' to measure
National #ncome
Pri"ate #n"estment
'mployment "7abor force, employment rate, unemployment#
Business (ycle )ndicators "leading, coBincident, lagging#
1, 2ross .omestic Product "2.P#
$ final output produced in a given country
0, 2ross ?ational Product "2?P#
$ final output produced by nationals of a country, including
those who are abroard5 2.P = income from abroad $ 2?P
2, ?et ?ational Product "??P#
3, 2ross ?ational )ncome "2?)#
@, ?et ?ational )ncome "??)#
$ 2?P less depreciation
E, .isposable )ncome ".)#
B, ?ational )ncome
$ ??P less indirect taxes
+otal mar1et value of all the final goods and services produced
within an economy in a given year
total mar1et value $ - C P
only newly produced goods are included in 2.P
+a1es into account Price changes
measure of total output does not increase Pust because prices
increase, uses prices as of a base year, prices are therefore
1ept constant, i.e. only - changes
current prices to measure 2.P
Prices can increase due to higher costs of Production
1, production approach
measuring value added in all firms and industries
2.P by industrial origin
three maPor groupings6 agriculture, industry and services
value added $ additional value at each stage of production
final products are counted5 intermediate inputs
0, income approach
measuring value added contributed by economic factors
adding up all rewards for factor incomes6

wages "labor income#

profits and dividends "firm:s income#

interest income "on savings#

rent "landlord:s income#


2, expenditure approach
measuring all components of aggregate demand
adding up all demand in the economy, consisting of

private consumption

private investments

government spending

net exports "exports less imports#


3pending on new plants and e&uipment
?ewly produced >ousing
,dditions to )nventories during the current year
13
Net Exports
.rade Deficit
.rade $urplus
%DP E)uation
Personal disposable
#ncome
luctuations in %DP
*$8 23,
#nflation Rate
!P#
*$8 2?,
!osts of #nflation
/o' to measure
9nemployment
-abor orce
!yclical 9nemployment
rictional 9nemployment
$tructural 9nemployment
$easonal 9nemployment
#ncome-Expenditure-(odel
?ew investment expenditures $ gross investment
?et )nvestment $ 2ross )nvestment I .epreciation
+otal 'xports I +otal )mports
)mport > 'xport
)mport L 'xport
*
2.P
$ ( = ) = 2 = ?E
2.P $ (onsumption = )nvestment = 2overnment Purchases
= ?et 'xports
)ncome of household after paying income taxes
1, Pea1
output starts to decline6 recession starts
0, +rough
output starts to increase6 recession begins to end
2, 'xpansion
recovery period
3, 0ecession
six consecutive months of declining real 2.P
dPFP "percentage rate of change of a price index#
9easures changes in a fixed bas1et of goods
(P) in year G $ "cost of bas1et in year G#F"in base year# C ;!!
(reates 4inners and 7osers
)ndividuals and )nstitutions will change behavior
=!JFmonth6 >yperinflation "s.a. 3cooter I >yper >yper#
unemployment rate $ unemployed F labor force
'mployed = 8nemployed
accompanies fluctuations in real 2.P
occurs because it ta1es time to find a Pob F hire wor1ers
occurs when Pobs are eliminated and new Pobs are created
harvest season, winter season, etc.
.eveloped by S. 9. Geynes
>igher 'xpenditures $ generate higher levels of income
'&uilibrium Output $ yC $ ( = ) $ planned expenditures
Geynesian (ross "3. MA#
14
!onsumption unction
$a"ings unction
.he (ultiplier
*$8 B2,
%o"ernment $pending
and .axation
iscal (ultipliers
Output > .emand "glut#, production would fall
Output L .emand "shortage#, production would rise
0elationship between (onsumption spending and
the level of )ncome
( $ (
a
= by
(
a
$ autonomous consumption, does not depend on income
by $ 9arginal Propensity to (onsume "9P(#
i.e. the fraction of additional income that is spent
)ncreaseFdecrease in (
a
shits the entire function upFdown

increase in consumer wealth, increasing (


a

increase in consumer confidence, increasing (


a
)ncreaseFdecrease in 9P( increasesFdecreases the slope
'&uilibrium Output6
( = ) intersect AT line, at that level of output,
yC $ desired spending e&uals output
0elationship between level of saving and 7evel of )ncome
)ncome is either spent "(# or saved "3#
+herefore, 9arginal Propensity to 3ave $ ; I 9P(
; $ 9P( = 9P3
'&uilibrium Output $ ) $ 3
7evel of 3avings fixed, depends on 2.P
/raction to save determined by 9P3
4hen )nvestment increases by ) from )
!
to )
;
,
'&uilibrium output increases by U* from *
!
to *
;
.he ResultC U* > U)
2overnment 3pending and 7evel of +axation
affect the level of 2.P in the 3hortB0un "influence on .#
Geynesian /iscal Policy6
+axes and spending to influence the level of 2.P
Planned expenditures including government $ ( = ) = 2
multiplier for government spending6
MPC 1
1
or the (onsumption /unction with +axes is6
( ) T y b C C
a
+ =
.isposable income is6 yB +
+ax 9ultiplier6
15
1utomatic $tabili<ers
1ggregate Demand
*$8 DB,
E)uilibrium ;utput
(ultiplier for
#n"estment
MPC
MPC

1
or
MPS
MPC

,utomatic 3tabiliDers are taxes and transfer payments that


stabiliDe 2.P without re&uiring policyBma1ers to ta1e explicit
actions6

when income is high, 2 collects more taxes, and pays


out less transfer payments, decreasing consumer spending

when output is los, 2 collects less taxes, and pay


out more in transfer payments, increasing consumer spending
,. (urve shows the combination of prices and
'&uilibrium Output
Prices /all > 'xpenditures )ncrease > * increases "3. NH#
2 increases > 'xpenditures )ncrease > * increases "3. NN#
)ncreasing 2 3pending shifts the ,. (urve 8p
Output $ planned expenditures $ ( = )
Output $ ( = )
!onsumption unction
( ) by C C
a
+ =
( ) I by C y
a
+ + =
I C by y
a
+ =
( ) I C b y
a
+ = 1
b
I C
y
a

+
=
1
*
/or a new 7evel of )nvestment )
!
, we have
/or a new level of )nvestment )
;
, we have
3ubstituting for the levels of Output, we have
16
%o"ernment $pending
and .axes
*$8 ?3,
$ummary
Because ")
;
I )
!
# is the (hange in )nvestment, we can write6
2overnment 3pending and +axes6
2overnment 'xpenditure6 ; F 9P3
+ax 9ultiplier6 B9P( F 9P3
Balanced Budget6 ;
4ith +rade6 ; F "; I 9P( = 9P9#
4ith +ax and +rade6 ; F "; I 9P( "; I t# = 9P9#
9P( $ 9arginal Propensity to (onsume
9P3 $ 9arginal Propensity to 3ave
9P9 $ 9arginal Propensity to )mport
t $ +ax 0ate
17
WEE= E
Phillips !ur"e
$tagflation
riedman
Rational Expectations
Natural Rate of
9nemployment
Velocity of (oney
Huantity .heory of
(oney
(oney as a "eil
?egative 0elationship btw. wages and unemployment
"wages were indicators of )nflation#
)ncreasing 9oney 3upply leads to decreasing 8nemployment,
but increasing )nflation
3tagnation "0ecession# combined with )nflation
tradeBoff between unemployment and )nflation "Phillips# is
no longer observed
.emandBPull )nflation6
3hifting . (urve6 8nemployment dec., )nflation inc.
(ostBPush )nflation
3hifting 3 (urve6 8nemployment inc., )nflation inc.
)ntroduced the idea of adaptive )nflation expectations
'xpectations Philips (urve6
0elationship between 8nemployment and 'xpectations,
when ta1ing into account expectations of )nflation
8nemployment varies with unanticipated )nflation
4hen economy experiences a boom
8nemployment is below natural rate,
)nflation is higher than expected
4hen economy experiences a recession
8nemployment is above natural rate,
)nflation is lower than expected
People loo1 at all variable information in ma1ing Pudgments
policy $ ineffective, people will outguess government
People will realiDe trend in policies and incorporate this in
their expectations
Public forecasts the future correctly, on average
0ate of 8nemployment can shift

demographics, composition of wor1force

institutional changes

state of the economy

changes in growth of labor productivity


velocity of money $ nominal 2.P F money supply
9 C V $ P C *
)ncrease in 9oney 3upply leads to an increase in Prices
18
(oney is desired as
a commodity
(oney Neutrality
(oney Dichotomy
isher>s E)uation
/yperinflation
Price stability according
to riedman
=eynes "s8 riedman
iscal Policy
Expansionary and
!ontractionary Policies
riedman
!ontributions *$8 2D,
%o"ernment $pending
9oney has a neutral effect on physical or real &uantities
of output
temporary abode of purchasing power and store of wealth
(hange in 3upply of 9oney will not change * in the longBrun
.istinction between nominal and real values5
money is a veil in the longB and the shortBrun
9 C V $ P C +
"V, + $ constant, change in 9 will increase P#
,rises when 2overnment allows money supply to grow in
order to finance the gap between government spending
and revenues I the budget deficit
2overnments could use a mix of borrowing funds from the
public and printing money to cover the deficit
2overnment is forced to print new money
to stop >yperinflation, eliminate 2 deficit $ stop printing
0ate of growth of money supply e&ual to longBrun rate of
economic growth $ price stability
9V $ 2.P
3lide A!
9onetarism vs. /iscal

,llocation "provision of goods and services#

.istribution "altering distribution of income#

3tabiliDation "address problems of unemployment#

0egulation "legal framewor1#


'xpansionary6 increase ,.
(ontractionary6 decrease ,.
7ags6 )nside "Problem I )mplementation#
versus Outside 7ags "Policy I )mpact#
(onetary6
)nside 7ag "3hort# )mmediate )mplementation of Ban1s
Outside 7ag "7ong# ;B@ years for interest rates or money
supply to have an impact on inflation
iscalC
)nside 7ag "long# 2overnment ta1es time to enact tax measures
Outside 7ag "3hort# +axes are raised, immediate impact
19
WEE= B
$piderpigG $piderpigG
does 'hate"er a
$piderpig doesI

general public services

defense

education

health

social security and welfare

debt servicing, economic services


(an he swing from a webK ?o, he can:t, he:s a pig.
7oo1 OutV >ere is a 3piderpigV

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