Introduction

Technical Efficiency / Engineering Efficiency: Goods are produced using the minimum possible
resources.
Economic Efficiency: A condition where the ratio MU/MC is equal for all goods and services.
Traditional Economy: Resource allocation determined b social custom and habits established over
time.
Command Economy: Resource allocation determined b central planning.
Market Economy: Resource allocation determined b a competitive mar!et.
Opportunity Cost: "he best alternative foregone in order to produce a good or service.
Public Good: A good or service that# once purchased b anone# can of necessit be en$oed b
man.
Externality: A cost of goods or services that is borne b someone other than the recipient of those
goods or services.
oren! Cur"e: Graphs the percentage of households against the percentage of income received.
Ceteris Paribus #cet$ par$%& %hen anal&ing one variable# the convention that all other variables are
held constant.
Inferior Good: An inferior good is one for which the quantit purchased decreases when real
income increases.
Giffen Good: A good for which there is a range of prices for which quantit and price var directl#
not inversel.
'ependent (ariable: A variable whose value is determined b the model.
Independent (ariable: A variable whose value is fi'ed e'ternal to the model.
Complementary Good: A good whose demand curve shifts along with that of another good.
)ubstitute Good: A good whose demand curve shifts inversel with that of another good.
*ormal Profit: "he amount of profit $ust sufficient to !eep resources in the industr. (ncluded as
part of cost.
Coase+s Theorem: "he e'change solution to e'ternal costs.
,icardo+s Theorem: A proof that a a poor countr can trade to mutual advantage with a rich one#
despite having no absolute advantage in an area.
Okun+s a-: An equation relating the unemploment rate to the gap between actual and potential
output.
)hillips Curve: Graphs unemploment against inflation across a range of possible aggregate demand.
*'ogenous: A variable whose value is determined e'ternal to a given model.
Criticisms of the Market Economy
.
+. %rong goods and services: "oo man porn films and alcohol# too few hospitals and churches.
,. "he fallac of consumer sovereignt: Consumers bu what advertisers convince them the want.
-. "he pollution problem: .ree mar!et economies are the world/s worst polluters.
0. )overt amongst plent: 1ighl affluent mar!et economies still contain widespread severe
povert.
2. (nflation and unemploment: (f unemploment and inflation are a tradeoff# wh did we
e'perience 3stagflation4 in the late +567s and earl +587s9
Public Goods
"he problem with public goods is that the can lead to inefficient allocation of resources. (f there are
four houses in a neighborhood with a crime problem# each household# acting independentl# ma
conclude that it is worth paing for a securit patrol. :ut then we have four securit patrols# three of
which are unnecessar and economicall inefficient. Conversel# each ma wait for a neighbor to
pa for the patrols# and too few resources are emploed. "his problem cannot be solved through the
mar!et. Collective action is necessar.
Externalities
An e'ternalit e'ists when there is a mismatch between who pas for a good or service or consumes
a resource# and who benefits from same. *'ample: A factor pollutes a river# reducing the real
incomes of fishermen. "he factor en$os the full economic benefit from the resource of a clean
river. "his is another problem that cannot be solved through the mar!et and must be solved through
collective action. ;ote that if the factor bus the fishing rights to the river# there is no longer an
problem.
Economies of )cale
(f substantial economies of scale e'ist# then much less of societ/s scarce resources will be used to
produce a given level of output b a single firm than m two or more firms. 1owever# if a single
firm produces all of the good# it will have monopol power and will sell the good at a price above
that which a competitive situation would have produced. "his problem cannot be solved through the
mar!et and must be solved through collective action to regulate the monopol.
/
Income 'istribution
)ure mar!et forces ma produce a distribution of income that is considered un$ust or undesirable.
Mar!et forces will not correct this situation. Collective action is necessar if the distribution of
income desired is not similar to the distribution of income observed in a pure mar!et. "he 3right4
distribution of income is a value $udgment and not sub$ect
0
Tariffs and 1uotas
"ariffs and quotas are sometimes imposed to 3protect4 domestic industr from international
competition. "he effect of a tariff is similar to an other unit ta': "he suppl curve price at all
quantities is raised b the amount of the ta'.
Tariff&
"ariffs can be defined as duties or forms of ta'es levied on goods for revenue and protective
purposes when the are transported from one customs area to another. "he can also be defined as a
comprehensive schedule or list of merchandise along with their rates which have to be paid for each
article according to the rules and regulations of the government.
(n simpler words# we can sa that tariffs are basicall the mone which is to be paid b a countr for
trading products# either e'ports or imports. "he price of the product being traded increases when
tariffs are imposed on the goods. "he collected incomes from tariff ta'es are called custom duties or
custom.
"ariffs are useful for a countr because the earn revenue for the government and raise the countr/s
G<). A protective tariff helps in controlling trade between two countries and helping their
undeveloped and non=competitive industries become more competitive and also encourages the
domestic industries. "ariffs are mostl imposed on imported goods and seldom on the goods which
are e'ported. "he usuall cost e'tra mone to the consumer. "he are restrictions in order to control
foreign goods from entering the domestic mar!et.
1uotas&
>uotas are the limitations imposed b the government on what can be traded# the quantit that can be
traded# how much needs to be paid for each item# and where the goods are being traded. "he do not
deal with limitations on how much is paid for the goods? thus# the have a neutral effect on the G<)
of the countr. %hen there is a loss in a consumer and producer surplus# the quota holders are
benefited. (t does not bring an revenue to the government and also encourages administrative
corruption and smuggling. *verone wants to have more quotas for trading. (f the are not obtained#
it can give rise to man evils.
.rom an economic viewpoint# the protection of domestic industr through tariffs and quotas is a poor
notion. "he resources used to produce goods domesticall must be drawn from other industries# so
domestic production is no better than it was. At the same time# the countr against which the tariff
was imposed will now have less of our currenc to trade bac! to us for our goods. *verone
2
eventuall suffers b paing more for both domesticall produced and imported goods# and total
world production is reduced. (n the short term# wor!ers in the 3protected4 industr benefit because
the do not have to be retrained. :ut the rest of societ is subsidi&ing these wor!ers at man times
their wages/salaries. (t would be cheaper to pa them not to wor!.
A quota is a somewhat different situation. (n this case# there is no ta' revenue for the government.
"he suppl and demand curves do not change. 1owever# the quantit e'changed is forced to a point
below equilibrium. @(f this were not the case# there would be no reason to impose the quota.A As a
result# trade occurs at a quantit where the price at which suppliers are willing to sell is substantiall
lower than the price at which purchasers are willing to bu. (mporters ma!e out li!e bandits because
the can bu at the low 3suppl4 price and sell at the high 3demand4 price. Bome method will have
to be found to allocate the quote between different importers.
(f an importer can negotiate an e'clusive agreement to suppl the domestic mar!et with the entire
quota of goods shipped from the foreign producer# then a question of economic rent arises. (f the best
use of the goods is to e'port up to the amount of the quota# then the ne't best use is to sell the goods
locall in the countr of origin. "he amount b which the demand price e'ceeds the suppl price#
times the quantit of the quota# is the economic rent of the goods. "he importer and the supplier will
have to negotiate who gets what percentage of this amount.
.rom a consumer point of view there is no difference between a tariff and a quota so long as the
result in the same final price. "he main difference is that under a tariff# the government gets all the
e'tra mone? but under a quota# the mone will wind up in a combination of the foreign
manufacturer# an import business# and perhaps the government if it insitutes some sort of program
li!e selling quota allocations to importers for a fee.
3
Types of Tariff and *on4Tariff 5arriers
)pecific 'uty: Bpecific dut is based on the phsical characteristics of goods. %hen a fi'ed sum of
mone# !eeping in view the weight or measurement of a commodit# is levied as tariff# it is !nown as
specific dut.
.or instance# a fi'ed sum of import dut ma be levied on the import of ever barrel of oil#
irrespective of qualit and value. (t discourages cheap imports. Bpecific duties are eas to administer
as the do not involve the problem of determining the value of imported goods. 1owever# a specific
dut cannot be levied on certain articles li!e wor!s of art. .or instance# a painting cannot be ta'ed on
the basis of its weight and si&e.
6d "alorem 'uty: "hese duties are imposed 3according to value.4 %hen a fi'ed percent of value of
a commodit is added as a tariff it is !nown as ad valorem dut. (t ignores the consideration of
weight# si&e or volume of commodit. "he imposition of ad valorem dut is more $ustified in case of
those goods whose values cannot be determined on the basis of their phsical and chemical
characteristics# such as costl wor!s of art# rare manuscripts# etc. (n practice# this tpe of dut is
mostl levied on ma$orit of items.
Combined or Compound 'uty: (t is a combination of the specific dut and ad valorem dut on a
single product. .or instance# there can be a combined dut when +7C of value @ad valoremA and Re
+/= on ever meter of cloth is charged as dut. "hus# in this case# both duties are charged together.
)liding )cale 'uty: "he import duties which var with the prices of commodities are called sliding
scale duties. 1istoricall# these duties are confined to agricultural products# as their prices frequentl
var# mostl due to natural factors. "hese are also called as seasonal duties.
Counter"ailing 'uty: (t is imposed on certain imports where products are subsidised b e'porting
governments. As a result of government subsid# imports become cheaper than domestic goods. "o
nullif the effect of subsid# this dut is imposed in addition to normal duties.
7
Types of 1uotas
The Tariff 1uota:
"he tariff or customs quota is a widel acclaimed measure. Under this sstem# import of a
commodit up to a specified quantit is allowed to be imported dut=free or at a special low rate of
dut. :ut imports in e'cess of this fi'ed limit are charged a higher rate of dut. "he tariff quota thus
combines the features of a tariff with those of quota. .le'ibilit is another advantage of this sstem.
8o-e"er9 the system has the follo-ing dra-backs&
@iA %hen imports tend to be more than the fi'ed limit assigned under low dut rate# the entire gains
from the low rate are shared b the e'porting countr.
@iiA (t brings a rush of imports in the beginning of each new tariff quota# which ma disturb domestic
price levels of the importing countr.
The :nilateral 1uota:
Under this sstem# a countr places an absolute limit on the importation of a commodit during a
given period. (t is imposed without prior negotiation with foreign governments.
"he quota so fi'ed ma be either global or allocated. Under global quota# the commodit can be
imported from an countr up to the full amount of the quota. Under an allocated quota sstem#
however# the total of the quota is distributed among specified suppling countries.
"he global quota sstem# however# cannot be treated as a ver satisfactor device# as it invariabl
tends to favour nearb supplier countries as against the distant ones. (t also tends to operate against
the smaller or less organised supplier countries. (t ma periodicall cause over suppl and greater
price fluctuations as it provo!es a race among importers to fill up the quota.
.urther# it does not provide regular protection to domestic producers.
"he sstem of allocated quota tries to overcome these defects of global quota. :ut it has other
defects li!e: @iA it imposes an undesirable rigidit as to source of suppl# @iiA it does not consider
costs and other aspects of suppl conditions abroad# @iiiA it gives rise to monopol=li!e action among
those e'porters who are assured of a specific share of the quota# and @ivA it involves large economic
and administrative difficulties in allocating quotas.
The 5ilateral 1uota:
Under this sstem# quotas are set through negotiation between the importing countr and the
e'porting countr @or foreign e'port groupsA.
It has the follo-ing merits&
@iA >uotas are decided b mutual agreement?
@iiA (t minimises the suspicion of discrimination?
@iiiA (t avoids e'cessive fluctuations in imports?
;
@ivA (t is e'cludes e'port monopolies b agreement?
@vA (t is less arbitrar# and# therefore# arouses less or no opposition from the e'porting countries.
"hus# it provo!es no retaliation activit.
8o-e"er9 the principal ob<ections raised against the system are&
+. (t tends to fall into the clutches of e'isting international cartels.
,. (t also opens the wa to corruption on a large scale.
-. (t has a tendenc to raise prices in the e'porting countr# so that the importing countr ma lose.
0. (t is a device for an open invitation to monopol in the e'porting countr.
The Mixing 1uota:
(t is a tpe of regulation which requires producers to utilise a certain proportion of domestic raw
materials along with imported parts to produce finished goods domesticall.
(t thus sets limits on the proportion of foreign=made raw materials to be imported and used in
domestic production. (n :ra&il# for instance# there is a stipulation that a certain percentage of bread
weight must consist of domestic mandioca flour.
)uch mixing regulations ha"e t-o broad ob<ecti"es&
@iA "o assist domestic producers of raw materials# and
@iiA "o save scarce foreign e'change.
Mi'ing quota sstem is# however# criticised on the ground that it contributes to a poorer utilisation of
the world resources and high domestic prices of low quantit products and as such it inhibits the
optimal allocation of resources in terms of comparative advantages.
Import icensing:
"he mechanism of import licensing has been evolved as a sstem devised to administer quota
regulations. Under this# prospective importers are required to obtain a licence from the proper
authorities for importing an quantit within the specified quotas. Dicences are generall distributed
among established importers !eeping in view their share in the countr/s import trend.
Import licensing has become a leading type of =uantitati"e restriction during the post4-ar
period9 thanks to its follo-ing merits&
@iA (t provides much closer control over the volume of imports.
@iiA (t tends to minimise speculative activit.
@iiiA (t reduces e'cessive fluctuations in prices produced b the scramble to import before the quota is
filled @in the absence of licensing sstemA.
@ivA (t allows an even suppl# which leads to continuit in availabilit of reasonable prices so that
internal prices ma be stabilised.
@vA (t allows a high degree of fle'ibilit in the restriction of imports.
>
@viA (t permits a countr to control the demand of its nationals for foreign e'change.
icensing system has some dra-backs9 such as&
@iA (t creates a sort of monopol among importers?
@iiA (t leads to corruption in obtaining licences? and
@iiiA (t leads to blac!=mar!eting in imported goods b selling the licences at high premium rates.
?
)upport for Trade ,estrictions
There are some economically "alid arguments in fa"or of trade restrictions$ The ma<or ones
are:
- Infant Industry: <eveloping nations need to protect their local industr until it can grow to a
scale where it is able to compete internationall.
- 'umping: <umping is the practice of selling goods in a foreign mar!et at a price lower than that
which prevails in the domestic mar!et. "he intent is @presumed to beA to drive domestic producers
out of business# after which a price hi!e can be e'pected.
- Counter"ailing 'uties: (f goods are produced in a nation where the industr is subsidi&ed# and
then sold in a nation where no such subsid e'ists# then domestic producers will be at a competitive
disadvantage to imports from the subsidi&ing nation. %here such an imbalance e'ists# it is acceptable
to impose a tariff intended to $ust equal the advantage provided b the subsidi&ation.
- )=ueaky @heels: %hile on average everone benefits from free trade# individuall some people
lose badlEbecause the are laid off# or their business cannot compete# or what have ou. (t is
difficult to build a political organi&ation a large number of small gainers# but it is relativel eas to
build a political organi&ation around a small number of big losers? sa# unemploed steel wor!ers in
)ennslvania. %hile theoreticall it is possible for the losers to be compensated from the benefits of
the gainers# in practice this rarel @if everA happens.
.A
Boreign Exchange
%hen an individual in one countr wants to bu products from another# the must first bu some of
the currenc of the other countr. "he e'change rate between countr A and countr : @in a two=
countr modelA is the same as a price in an competitive mar!et. "he demand curve for A/s currenc
is determined b the people who want to bu products produced b A# and the suppl curve is
determined b the people from A who want to bu products produced in :. As the e'change rate
fluctuates# goods produced in countr A will seem more or less e'pensive to residents of countr :
and vice versa# altering the quantit demanded and supplied. "his is called a fle'ible e'change rate.
Bome countries adhere to a fi'ed e'change rate polic# under which the governments of the nations
involved agree to bu or sell enough of the currencies involved to !eep the e'change rate at an
agreed=upon value. "he governments involved must add or subtract to demand and suppl b
amounts $ust sufficient to push the intersection to the price point desired. "his involves adding to or
subtracting from a currenc reserves account# which will eventuall run out of mone. Bo fi'ed
e'change rates cannot be maintained under all conditions.
"he movement from fi'ed to fle'ible e'hange rates was actuall intended to stabili&e prices. Under
fi'ed e'change rate policies# large devaluations and revaluations occurred b when the official
e'change rate was altered b government fiat. 1owever# stabilit has not emerged. "his is because
the demand for a countr/s currenc does not depend e'clusivel on that nation/s e'ports.
..
5alance of Payments
A nation/s balance of paments is a comple' set of accounts. "here are three ma$or accounts
involved:
Current Account @a!a "rade AccountA: (mports and e'ports of goods and services.
Capital Account: Records all trades which affect the amount of claims the nation has abroad#
both for and against. Fr in other words# all borrowing and lending activit.
Ffficial Bettlements Account: Records the changes in currenc reserves held in all foreign
currencies.
"hese three accounts sum to &ero. "he total import and e'port activit# plus the net effect of
borrowing and lending# must equal the change in currenc reserves. "he term 3balance of trade
deficit4 refers to the current account# and the term 3balance of paments defecit4 refers to the capital
account. A balance of paments defecit can be thought of as the e'cess suppl of a countr/s
currencEthis is the amount of foreign currenc that the government must bu if the e'change rate
is to be preserved. (f the government does not act# a defecit in this account will result in a currenc
devaluation.
"he total value of world trade is more than - trillion dollars a ear# but this is a small amount
compared to the total value of worldwide currenc trading. (f currencl fluctuations onl occurred as
a result of trade# currencies would be quite stable. 1owever# currencies are not stable# because
fluctuations also occur due to currenc trading that has nothing to do with goods or services trading.
.or e'ample# if our interest rates are higher than another nation/s# then citi&ens @and fund managersA
in the other nation can improve their returns b buing our currenc. *'pectations about the future
appreciation or depreciation of our currenc will also ma!e it more or less attractive to bu. As a
result# it is ver difficult to predict how e'change rates will change with time. ;ote that the suppl of
our currenc will affect these e'pectations and so the suppl and demand of our currenc are not
entirel independent.
./
Economic Output using Tariffs and 1uotas
1ow large total output could possibl be for an econom is determined b the quantit and qualit of
capital stoc! and labor force. Capital stoc! includes natural and man=made resources such as rivers#
factories# mineral deposits# etc. "he labor force includes that portion of the population willing and
able to wor!. "he qualit and quantit of capital stoc! and labor force available varies widel across
different nations. "he ma'imum output possible given these resources is called potential output.
(f some portion of the available capital stoc! or labor force is idle @unemploedA# then acutal output
will be lower than potential output. %hen resources are idle# some amount of output is lost and gone
forever. Actual output will equal potential output when full emploment occurs. 1owever# there will
alwas be some amount of unavoidable 3frictional4 unemploment. Bince this level of
unemploment is unavoidabe# it is ta!en into account in potential output as the 3full emploment
level of unemploment4 and corresponding full emploment rate of downtime of equipment# tools#
factories# etc.
)otential emploment grows over time. "his e'pansion is caused b:
Growth in the qualit and quantit of labor available
Growth in the qualit and quantit of capital stoc! available
"echnological advances
(n an given period# some amount of output will be dedicated to the production of new capital goods
such as new factories. "his will increase the level of output in subsequent periods. (n addition# the
newl produced capital goods will embod the latest technological advantages. Bo a nation which
devotes a high percentage of current output to the production of new capital goods will win on two
counts. Bimilarl# the higher the proportion of current output applied to the training and improvement
of labor# the higher output will be in future periods.
"he cruel dilemma facing impoverished nations is that current output alread fails to provide
adequatel for the e'isting population# so diverting some resources to investment rather than current
consumption will create even more widespread problems of starvation and povert.
(n the short run there is little or nothing a government can do to affect a nation/s potential output.
Changes in potential output are long=run occurrences. 1owever# actual output can certainl be
affected in the short run. "he actual output or G;) is the sum of the values of all final goods and
.0
services produced in the econom in a ear. "here is also a corresponding flow of income to resource
owners matching the value of all final goods and services produced. (n a simple model# ignoring the
government and international sectors# all resources are owned b households and all goods are
produced b firms. "he firms hire resources owned b households# and produce goods and services#
which are then sold to the households. "his results in a circular flow of income.
G;) is the value of all final goods and services produced. G;* @Gross ;ational *'penditureA is the
value of total spending b the households. G;( @Gross ;ational (ncomeA is the value of the factors of
production used b all firms. Bince these are all measuring the same thing# the must all be equal.
"he smbol G is used for the value of G;)/G;*/G;(.
(n this simple model# firms can onl produce two !inds of goods# consumption goods and investment
goods: G;) H C
.
I (. 1ouseholds can also onl spend their mone in two was# consumption and
spending: G;( H C
1
I B. C
.
is the amount of consumption goods that firms plan to produce# while
C
1
is the amount of consumption goods that households plan to bu. %hen these are equal# (HBEthe
resources devoted to the production of new capital goods are equal to the savings rate of households.
"he propensit of households to save# rather than spend# their mone will have long term
implications for economic growth.
1owever# C
.
and C
1
are not alwas equal. .irms might produce more consumption goods than
households plan to bu# in which case goods will be left unsold. Retailers will place smaller orders#
and manufacturers will reduce production. "a!ing all firms together# this results in a reduced G;).
Bince firms are producing less goods# the will require less resources# resulting in a reduction of
G;(. "his will result in lower income for households and will cause C
1
to fall even lower. A
recession will occur. G;( and G;) will continue to fall until inventories fall below desired levels# at
which point the process will reverse. 1owever# the recession will have been a period of wasted
productivit# where actual output fell below potential output# unemploment was in evidence# and
societ was less well off than it could have been.
Fn the other hand# if households want to bu more than firms are producing# retailers will
e'perience shrin!ing inventories as goods are sold faster to meet demand. "he will increase the si&e
of their orders and manufacturers will increase production. More resources will be required# resulting
in higher household income# which in turn results in even more demand. G;) and G;( will rise and
a Jboom/ will result. "he increase in G;) and G;( will be constrained onl b potential output. As
this point is reached# demand continues to rise despite an inabilit to increase suppl to match#
.2
resulting in higher prices# which cause households to bu less goods. Frders will decrease and the
Jbusiness cce/ will be repeated.
6ggregate 'emand
G;) is purchased b four groups. "he sume of the e'penditure of the four groups is !nown as
aggregate demand. "he four groups are:
Consumers @householdsA
.irms
Government
(nternational @foreign households# firms and governmentsA
"his is represented b the equation: G H C I ( I G I K L M# where:
- G H aggregate demand# a!a G;)# G;(# G;*
- C H consumption e'penditure
- ( H investment e'penditure
- K H production of e'port goods
- M H e'penditure on import goods
Go"ernment Policy
*ach component of aggregate demand can be affected b governmental policies. (f potential output
in the short term is fi'ed# government policies that affect aggregate demand can affect the
unemploment rate and the inflation rate. 1owever# man of the polic tools available to the
government act with a time lag# and as a result is it quite difficult to !eep aggregate demand
constantl at the desired level. "he desired level @potential outputA is itself constantl changing
@usuall increasingA. 1ouseholds and firms have minds of their own# and ma not behave as
predictedEthe household savings rate and firms/ investment rates can var widel. .inall# there are
li!el to be e'ogenous shoc!s to the econom# li!e natural disasters# sudden changes in import
prices# currenc crises# etc.
"here are two main categories of government economic polic. .iscal polic involves control of
government e'penditure and ta'ation. Monetar polic involves control over the suppl of mone
and hence interest rates.
.3
(f the level of demand in an econom equals potential output @>A# then no 3gap4 e'ists. 1owever#
most of the time the two will not be equal. %hen aggregate demand is lower than potential output#
unemploment over and above the 3full emploment rate of unemploment4 will e'ist and resources
will be wasted.
%hen aggregate demand is greater than potential output# it is impossible to increase production and
therefore prices will rise# resulting in an 3inflationar gap.4 *ventuall# as prices rise# marginal
buers will drop out and demand will decrease to a new full emploment equilibrium at a higher
price level.
(n order to avoid either inflation or unemploment# the government must attempt to equate aggregate
demand with potential output# ie force demand towards the value <,. "his is the onl level of
demand at which >HG. "his simple model shows no inflationar pressure at full emploment.
Buppose the government is successful in one ear in equating >HG. 1owever# investment has ta!en
place# so ne't ear potential output will be >
,
N >. (f aggregate demand remains at G# an
output/emploment gap will e'ist. (n order to maintain full emploment the government will need to
estimate >
,
and move to a new level of aggregate demand G
,
such that G
,
H>
,
. "he government must
continue to estimate potential output and# through fiscal and monetar polic# control aggregate
demand in subsequent periods so that G
-
H>
-
# G
0
H>
0
# etc. ;eedless to sa# this is quite a difficult
problem.
Under normal economic conditions where > is increasing from ear to ear# the government will
have to increase G to match. "here are three was of increasing G:
.7
A
g
g
r
e
g
a
t
e

D
e
m
a
n
d
GNP and Employment
D1
D2
D3
Y1
E1
Y2=Q
E2
Output /
Employment
Gap
Inflationary
Gap
Government e'penditure
Reduction in ta'ation
(ncrease in mone suppl
(f the government increases e'penditure# G is immediatel increased b the amount of the
e'penditure because government demand is part of aggregate demand. 1owever# for the firms
producing the goods and services and the households who own resources used b the firms# income
will increase. Bome of this new income will be spent on additional goods and services. "here is
therefore a multiplier effect where G H !G. (n order to increase aggregate demand from G
+
to
G
,
# the government can simpl increase its e'penditures b @G
,
=G
+
A/!.
Bimilarl# cutting ta'es will increase G b some multiple of the amount of the ta' cut. "he fact of the
ta' cut does not in itself constitute an increase in demand# because the mone is not spent on goods
as it is in the case of a government e'penditure increase. 1owever# the multiplier effect still comes
into pla as households and firms spend some portion of the increased income provided b the lower
ta' rate.
Dowering ta'es and increasing e'penditures are both e'amples of fiscal polic. "he monetar polic
solution to low aggregate demand is to increase the mone suppl faster than the growth in the
demand for mone. "his will cause the price of moneEthe interest rate# REto fall. :orrowers
@both households and firmsA ta!e the cost of borrowing into account when considering ta!ing out a
loan. "hus a decrease in R normall results in an increase in borrowing and a resulting increase in G
as the borrowed mone is spent on goods and services. Again# the initial round of e'penditure will
trigger a multiplier effect as the increased income to firms and households results in additional
rounds of e'penditure and new income.
"he process of controlling demand through mone suppl is comple'. "he policma!er must first
estimate both current > and G and the e'pected change in > for which G should be ad$usted. "his
will give the change in G to be desired. "hen# the si&e of the multiplier must be estimated# which will
give the amount of the initial increase in e'penditure that will result in the desired overall increase in
G. "hen# the sensitivit of consumers and businesses to interest rate changes must be estimated# to
determine the change in R that will result in the desired new e'penditures. .inall# the current rate of
increase of demand for mone must be estimated# which will lead to an estimate of the rate of
increase of mone suppl that will result in the desired interest rate. (f an significant changes occur
while the process is under wa# the estimates ma be wrong and the process ma have to be re=
started.
.;
Ff course# a combination of fiscal and monetar polic can be used. "a' cuts and increased
government e'penditure cannot be maintained forever? eventuall problems with high government
debt will surface. Monetar polic depends on consumers/ and business managers/ e'pectations and
attitudes# which change frequentl. And while the goal of closing the inflationar or emploment
gaps is universall desirable# other social values outside the realm of economics will also contribute
to decisions on government polic. Macroeconomic goals generall accepted as desirable are:
Dow inflation rate
Dow unemploment rate
:alanced government budget
"rade balance
Btable currenc in international e'change mar!ets
.>
Money and its theorys using Tariffs and 1uotas
"he models so far have not included the concept of mone. "his is unsatisfactor because mone
clearl plas a part in economics. A complete macroeconomics theor must be capable of e'plaining
the historical behavior of the price level. (n addition# mone ma have an importance beond the
simple measure of prices# because monetar factors ma influence 3real4 values such as output#
income and emploment.
Mone is anthing which is generall acceptable for the settlement of debts. Mone does not have to
be created b a central authorit. (n prison# cigarettes can become mone simpl because the are an
acceptable medium of e'change. (n man economies the most important source of mone is
commercial ban! deposits. :an! deposits are mone because the are generall acceptable for the
settlement of debts# rather than through an legal or Jofficial/ authorit. JDegal tender/ is mone
which has been legall protected such that the refusal to accept it for the settlement of a debt is
illegal. *ven though ban! deposits are not legal tender# man people find a chec! drawn on a ban!
deposit account acceptable as a form of mone.
There are three forms of money:
Coins
;otes
:an! deposits
Money has three functions:
6 medium of exchange: %ithout mone# goods and services could onl be traded through
bartering# which is wasteful and difficult# particularl in a highl speciali&ed modern econom.
Mone is used as a universall acceptable barter substitute. "o be useful for this purpose# mone
must posess the following characteristics:
- it must be widel acceptable?
- it must have a high value to weight ratio?
- it must be divisible to settle debts of differing values?
- it must be difficult to reproduce# counterfeit or debase in value.
6 unit of account or measure of "alue: Mone provides a standard b which the value of an
good or service can be measured. (f a car costs O,2#777 and a hamburger costs O,# then a car is
worth# and can be e'changed for# +,#277 hamburgers.
.?
A store of wealth: A household @or firmA can sell its factor services or goods for mone# and then
!eep the mone until it has decided what to do with it. Almost ever household and firm holds some
amount of mone. "o act as a satisfactor store of wealth# the value of mone must be reasonabl
stable over time.
5anking
Friginall# mone e'isted in the form of coins made of precious metals. :an!notes represented a
promise to provide precious metals on request. After a transaction involving ban!notes# there would
eventuall be a reconciliation where precious metals changed hands. "his is called Jcloa!room
ban!ing./ Fver time# the ban!notes themselves too! on acceptabilit as a form of mone in their own
right. "he recipient of a ban!note would simpl e'change it for other goods# never requiring
conversion to the actual precious metals underling its value. As a result# ban!s found the could
issue ban!notes in e'cess of their holdings of precious metals and still maintain convertibilit. "hus#
the ban!s became manufacturers of mone# practicing Jfractional=reserve ban!ing./
An fractional reserve ban!ing sstem depends on its abilit to maintain confidence and
convertibilit. "he power of ban!s to issue ban!notes in e'cess of their deposits was sometimes
abused# and when confidence wea!ened# this could result in an inabilit to maintain convertibilitE
and the collapse of the ban!. "o avoid this outcome# ban!s became regulated b the government.
*ventuall the right to create ban!notes was vested in a state=controlled central ban!# and the
commercial ban!s turned to deposit ban!ing. "he commercial ban!s are still able to create mone#
not b issuing ban!notes# but b creating deposit accounts in e'cess of their cash reserves. "he ban!s
have to be able to convert deposit accounts to cash on demand# but b long e'perience have found
that if cash reserves meet or e'ceed some ratio of total deposits# this is sufficient to maintain
convertibilit under all normal situations. "his is not a foolproof sstem? ban!s can still go bro!e.
:ut since ban!s can create deposit balances larger than the cash balance the hold# the are still
manufacturers of mone.
Generall spea!ing# the greater the liquidit of an asset# the less profitable it is. :an!s therefore do
not want to !eep their assets in liquid forms such as cash. 1owever# in order to satisf their
customers/ demands for cash# at least some of the ban!/s assets must be in cash or short=term liquid
forms. "he ban! will have to choose a cash ratio that is believed to be sufficient to meet demands for
cash# and act to maintain cash reserves at the level this ratio indicates.
/A
As an e'ample# consider a monopol commercial ban!# with a desired cash ratio of +7C. .or
simplicit# assume that members of the public wish to hold a constant amount of cash# and will
immediatel deposit all cash the receive above this amount? in other words# the public/s marginal
propensit to hold cash is &ero.
Fn the first da# the ban! opens its doors and a member of the public deposits O+77. "he ban!/s
balance sheet will read:
Assets Diabilities
Cash O+77 <eposit O+77
"he ban!/s cash ratio is now +77C# which is well above its desired ratio of +7C. "he ban! will
therefore act to bring the cash ratio bac! to its desired level. (n order to do so# it must create deposits
activel. (t can do this in two was: Ma!ing loans to customers# and purchasing securities. %hen the
ban! ma!es a loan# it issues a chec! drawn on itself @but no cashA in e'change for a promise to pa
bac! the loan amount plus interest. Bimilarl# when the ban! purchases securities it pas for them
with a chec! drawn on itself and e'pects to receive dividends or coupon paments as a result.
:ecause the ban! is a monopol and the public/s marginal propensit to hold cash is &ero# the
deposit creation process cannot reduce the ban!/s cash reserves? there is no lea!age of cash bac! to
the public because an cash that gets out to the public is immediatel returned to the ban!. (n
addition# if the ban! issues a chec! drawn on itself as pament for loans or securities# this chec! will
immediatel be returned to the ban! to credit the account of the household or firm to whom the loan
was made or from whom the securities were purchased. (f we assume that on da two the ban!
returns to its desired cash ratio b purchasing OP77 in bonds and issuing O-77 in loans# the new
balance sheet will be:
Assets Diabilities
Cash O+77 <eposit O+777
:onds OP77
Doans O-77
"his is an equilibrium position because the cash ratio is +7C as desired b the ban!. "he change in
deposits required for an given change in cash holdings is given b: <HdC# where d is the credit
multiplier# which is simpl the reciprocal of the cash ratio. (n this case# if the cash ratio is +7C# the
credit multiplier is +7. %hatever change occurs to the ban!/s cash holdings must be multiplied b +7
to determine the change that will occur in the ban!/s total deposits.
/.
"he initial assumptions of a monopol ban! and &ero cash lea!age are somewhat unrealistic. "he
monopol assumption is not reall necessar: (f man ban!s e'ist# the process of deposit creation
becomes more complicated# but the result is the same. .rom the individual ban!/s perspective# an
deposit creation must reduce its cash reserves. %hen a ban! issues loans and purchases securities
through chec!s drawn on itself# some of these chec!s will be deposited at other ban!s. "his will
result in a cash drain to the ban! creating the deposits. As cash reserves decrease and deposits
increase# the ban! will reach an equilibrium position where the cash ratio equals the desired value#
but it will do so more quic!l and with less total deposits on the boo!s than the monopol ban!.
1owever# even though there is a lea!age of cash from the individual ban!# the total amount of cash
held b the ban!ing sstem as a whole has not changed. Fther ban!s/ cash reserves have increased
b the same amount b which the first ban!/s reserves have decreased. "hese other ban!s# if the
were in equilibrium to begin with and if the desire the same cash ratio as the first ban!# will now
desire to issue loans and bu securities to restore their own cash ratios. .or the ban!ing sstem as a
whole# the change in deposits will still equal the change in cash reserves times the credit multiplier.
Removing the assumption of &ero marginal propensit to hold cash# however# does change the
situation somewhat. (f this is greater than &ero# then an increase in deposits will result in some
additional cash staing with the public# resulting in a Jlea!age/ from ban! cash reserves. (n this
event# the ban!s will not be able to increase deposits b the full credit multiplier? the amount b
which deposits will increase for an given increase in cash reserves will be d@+=M)1CA. "he abilit
of ban!s to create deposits is therefore limited b two factors: "he public/s propensit to hold cash#
and the ban!s/ propensit to !eep cash for liquidit purposes as represented b the desired cash ratio.
All modern economies have a central ban!# responsible for controlling the commercial ban!s in such
a wa as to support the monetar polic of the econom. "he central ban! conducts its business b
acting as a ban!er/s ban!# or lender of last resort# and also as the government/s ban! and the manager
of public debt. "he central ban! attempts to influence the level of economic activit through
regulating the suppl of mone and the availabilit and cost of credit. (n most countries# the central
ban! has man instruments of control# including a monopol over the creation of ban! notes# the
abilit to dictate the minimum cash ratio which must be observed b the commercial ban!s#
regulator authorit over consumer credit# and ultimatel the abilit to issue direct instructions to the
commercial ban!s and other financial institutions.
"he most important instrument of control available to the central ban! is the buing and selling of
government bonds in the open mar!et. (f the central ban! bus bonds# it pas for them with a chec!
drawn on itself and paable to the seller# sa a private citi&en. "he seller will then deposit the chec!
with the commercial ban! where the hold an account# which will then present the chec! for
//
pament b the central ban!. "his pament will increase the cash reserves of the commercial ban!#
which will then increase its deposits b a credit multiplier factor to bring its cash ratio bac! to the
desired level. Fn the other hand# if the central ban! sells bonds# it e'pects pament in the form of a
chec! drawn on a commercial ban!. (t will present this chec! for pament# resulting in a transfer
from the commercial ban! bac! to the central ban!# reducing the cash reserves of the commercial
ban! and therefore requiring a multiplied reduction in deposits to restore liquidit.
"hese open mar!et operations also affect the cost of borrowing. (f the central ban! acts to e'pand the
mone suppl b buing bonds# commercial ban!s will desire to ma!e more loans. Bince the suppl
of loans is now greater# and assuming the demand curve has not changed# the Jprice/ of loansEthe
interest rateEwill decrease. Conversel# if the central ban! restricts the mone suppl b selling
bonds# commercial ban!s will cut down on the number of loans the want to ma!e# thus raising
interest rates. Monetar polic can therefore affect aggregate demand and therefore the level of
output# income and e'penditure. %hen interest rates fall @riseA# investment e'penditure increases
@decreasesA and therefore aggregate demand increases @decreasesA b some multiplier. "he process is
as follows:
+. "he government desires to conduct an e'pansionar @restrictiveA monetar polic# so the central
ban! bus @sellsA government bonds on the open mar!etEor perhaps simpl changes the cash ratio
required of commercial ban!s.
,. "he increase @decreaseA in cash reserves of the commercial ban!s will have a magnified effect on
deposits# through the credit multiplier. "hus the mone suppl will increase @decreaseA b a multiple
of the change in cash reserves.
-. "he increase @decreaseA in the mone suppl will reduce @raiseA the cost of borrowing. (nterest
rates will fall @riseA as a result.
0. "he change in interest rates will cause a movement along firms/ marginal efficienc of
investment schedules. "his movement will lower @raiseA the standard to which business investments
are compared. .irms will therefore ta!e on more @lessA investments.
2. "hrough the multiplier process# the increase @decreaseA in investment e'penditure will lead to a
magnified increase @decreaseA in national income# output and e'penditure.
Theories of Money
"he quantit theor of mone postulates a direct and immediate lin! between the mone suppl and
aggregate demand# b assuming that households and firms onl hold mone for the purpose of
financing their transactions. An increase in the mone suppl will result in a situation where
/0
households and businesses have more mone than the wish to hold in transactions balances and
the will spend the e'cess# thus resulting in an increase in aggregade demand. Restriction of the
mone suppl will result in a situation where households and businesses have less mone than the
wish to hold# so the will reduce e'penditures in order to increase their mone balance# thus
reducing aggregate demand.
"he Qenesian theor# on the other hand# suggests that the changes in the demand for and suppl of
mone are reflected immediatel onl in the mar!et for securities. Qenesian theor holds that if
households and businesses have e'cess mone the will invest it in securities# and if the have too
little mone the will sell some of their held securities. Changes in mone suppl will not be
reflected immediatel in aggregate demand# although the effect on the securities mar!et will have an
indirect effect on aggregate demand through the interest rate.
(n some circumstances# monetar polic ma be unable to raise aggregate demand# even indirectl.
(f# in business managers/ opinions# investment opportunities are poor# perhaps because the level of
economic activit is low and general business e'pectations are pessimistic# then an e'pansionar
monetar polic ma be ineffective. Commercial ban!s ma have difficult persuading businesses to
ta!e on new loans# and businesses managers ma decide not to invest in new ventures even though
their e'pected return is higher than the prevailing interest rate. (n these circumstances# the demand to
hold mone ma be strong# so e'pansion of the mone suppl winds up largel in idle mone
balances# rather than being spent on the purchase of bonds. Bince the securities mar!et is unaffected#
the interest rate will not change? so even the indirect effect on aggregate demand is neutrali&ed.
/2
The 1uantity Theory of Money
"he naRve form of the quantit theor proposes a direct relationship between changes in the mone
suppl and changes in the general price level. "his can be stated as MSH)" where M is the quantit
of mone in circulation @the mone supplA# S is the velocit of circulationEthe average number of
times each unit of mone is spent per period# ) is the general level of prices# and " is the total
number of transactions in the period. MS is referred to as the monetar side of the equation and )"
is referred to as the commodit side. Fn the monetar side# the amount of mone in circulation times
the number of circulations per period must equal the total value of all transactions in the period. Fn
the commodit side# the average price of all goods times the number of transactions per period must
also equal the total value of all transactions in the period. "he two sides are thus b definition equal.
;aRve quantit theor supposes that the velocit of circulation is comparativel stable over time#
depending on habit# institutional arrangements# the manner in which wages are paid# etc. and could
therefore be regarded as constant in the short run. "he number of transactions would ver directl
with the level of real income: "HG. ;o multiplier constant is needed because the units of price level
are unspecified. Bo# MSH)G. .urthermore# naRve monetarists believe that mar!et forces will alwas
force G equal to the full emploment level# b which view G can also be considered constant in the
short term. Bo# with constant S and constant G# MH). "hus the conclusion of the naRve quantit
theor is that changes in the mone suppl affect onl the price level and nothing else. As a result#
monetar polic cannot have an effect on real output or income.
"he naRve quantit theor can be modified to ield the Jmodern/ quantit theor# which suggests that
changes in the suppl of mone can affect real income and output# with the magnitude of the effect
varing inversel with how close the econom is to full emploment. (f substantial unemploment
e'ists# G is well below >. Under these circumstances# if the suppl of mone increases then
households and businesses will spend the e'cess above the amount the wish to hold for transactions
purposes. "he additional demand created would lead to an increase in income and output @GA and
therefore emploment. As the econom approaches full emploment# however# further increases in
the mone suppl will begin to affect the price level more than the level of income. .inall# when
full emploment is reached# increasing the mone suppl can onl affect the price level since
emploment can no longer increase. "he modern quantit theor therefore attempts to show that so
long as unemploment e'ists# changes in the mone suppl will have a direct effect on aggregate
demand# with the magnitude of the effect depending on the si&e of the gap between current
emploment and full emploment.
/3
The Ceynesian Theory of Money
%here the quantit theor treats mone e'clusivel as a medium of e'change# the Qenesian
theor stresses that mone serves other functions as well. "here are three tpes of demand for mone
balances:
"he transactions demand# which arises from the fact that people need mone to finance current
transactions. 1ouseholds and firms hold mone balances to bridge the gap between the reciept of
income and its e'penditure. "he amount of mone held for such purposes will be closel related to
the level of national income. 1owever# it is also li!el to be influenced b the rate of interest. (f the
rate of interest is high# there will be a strong motive to avoid holding mone and instead hold interest
bearing assets.
"he precautionar demand# which consists of mone to be held to meet the sudden arrival of
unforseen circumstances. Again# the main factor li!el to influence this amount is the level of
income# though again high interest rates will tend to push mone out of this categor.
"he speculative demand# which emphasi&es the use of mone as a store of wealth rather than a
medium of e'change. 1olding mone has an opportunit cost: "he income or utilit foregone on the
investments or goods the mone could have bought. "herefore it would seem that households and
firms ought immediatel to invest or spend all mone above that required for transactional and
precautionar needs. 1owever# in the presence of uncertaint# individuals or firms will sometimes
believe that the returns available in the future might be sufficientl better than the returns available
toda that it is worth waiting.
"he speculative demand bears further analsis. %hile there will be speculation on all goods and
services whose price can change with time# the speculative demand is particularl interesting in the
mar!et for government bonds. (f households and firms believe the price of bonds will fall in the near
future# the will be li!el to sell their current holdings of bonds and to defer purchasing new bonds
until the price drop has ta!en place. "hese actions increase the suppl and reduce the demand for
bonds on the open mar!et# which will have the effect of lowering their price. Under this situation# the
speculative demand for mone will be high as households and firms will wish to hold mone in
anticipation of the price drop. Conversel# if households and firms e'pect bond prices to rise# then
the will defer selling bonds now and# if the have mone available# will tend to want to bu bonds.
"his will decrease the suppl and increase the demand for bonds# driving prices up? and the
speculative demand for mone will be low# because speculative monies will tend to be invested in
bonds.
/7
"he price of government bonds and the interest rate are inversel and tightl related. Buppose that an
individual is considering the purchase of a government bond which pas O+7 per annum. "he bond
will not be worth buing unless it returns at least the current rate of interest. (f the current rate of
interest is +7C# then the bond is worth buing onl if it costs O+77 or less. (f the current rate of
interest is +2C# then the bond is onl worth buing at OPP.P6 because this is the amount over which
O+7/ear represents a +2C return. (n a competitive mar!et# sellers will not be willing to sell at less
than the Jgoing rate/ so bond prices will be ver closel pegged to the price at which the provide a
return equal to the currentl prevailing rate of interest. @Fr: "he interest rate is the return on
government bonds? the more ou have to pa for them# the less return ou/re getting.A
%e have established that the speculative demand for mone varies based on the e'pected changes in
bond prices. (f bond prices are e'pected to fall# the demand will be high# and vice versa. Bince bond
prices var inversel with the interest rate# if the interest rate is e'pected to rise# the speculative
demand for mone will be high# and vice versa. (t is reasonable to suppose that when the interest rate
is quite low# most people will e'pect it to rise? and when it is quite high# most people will e'pect it to
fall. "herefore# the speculative demand for mone varies inversel with the currentl prevailing
interest rate. (f the interest rate is low# then the e'pectation will be that it will rise# which means that
bond prices will fall# which means people would rather hold onto their mone so the can bu the
cheap bonds later# so the speculative demand for mone will be high? and vice versa through the
whole process.
Considering all three tpes of demand for mone# it follows that the overall demand for mone
balances will var directl with the level of income and inversel with the rate of interest. 1igher
@lowerA G means more @lessA mone held in transactional and precautionar balances. 1igher @lowerA
interest rates mean more @lessA incentive to reduce mone balances so as to ta!e advantage of
investment returns# and also more @lessA incentive to purchase government bonds with mone
otherwise held in speculative balances. .or a given G# the relationship between the demand for
mone and the rate of interest is called the Jliquidit preference schedule/ which loo!s li!e this:
Demand for oney

2
!
a
t
e

o
f

I
n
t
e
r
e
"
t

#
!
$

%&P

1
!
2
!
1
D
/;
"he point on the demand curve that intersects with the @verticalA mone suppl curve will determine
the equilibrium rate of interest. M
"I)
represents the amount of mone held for transactional and
precautionar purposes# which for our purposes is assumed to var onl with G. Bince G is held
constant here# M
"I)
is a vertical line: At all rates of interest# the same amount of mone is held. "he
speculative demand for mone is a function of the rate of interest# reflected in the sloped portion of
the demand curve. 1owever# once a sufficientl low interest rate is reached# the curve becomes
hori&ontal. "his reflects the observation that at ver low interest rates# households and firms are
simpl not interested in buing an more bonds. .or one thing# the interest rate is so low that
everone is convinced it should rise soon# so nobod will want to invest in current# low=ield bonds.
Fnce this point has been reached# further increases in the mone suppl will simpl find their wa to
idle balances and further reductions in the interest rate will not occur.
"he Qenesian theor of mone# unli!e the quntit theor# suggests that changes in the mone
suppl do not lead directl to changes in aggregate demand. (nstead# monetar polic affects interest
rates# thus indirectl influencing those components of aggregate demand which are sensitive to
interest rates. ;ote that we can conclude from this that the graph above is inadequate to e'plain the
final equilibrium interest rate. "he graph above is for a fi'ed value of G. :ut a change in interest
rates @at least along the sloped portion of the curveA will result in a change in G. Bo the initial
equilibrium shown b the graph above cannot be the final value. "his will be anal&ed in detail later.
(t is also highl noteworth that Qenesian theor suggests that monetar polic will be ineffective
in dealing with a deep recession. %hen the rate of interest is so low that the liquidit schedule is
operating on the hori&ontal portion of the curve# the government can e'pand the mone suppl until
it turns purple and no further reductions in interest rateEand therefore no further effect on aggregate
demandEwill be forthcoming. Qenes suggested that in a deep recession# with substantial spare
capacit and pessimistic business e'pectations# e'tremel low interest rates would be necessar to
stimulate investment# but these rates might be below the minimum to which monetar polic can
force the rate. "his is the famous JQenesian liquidit trap./
/>
6d"antages and 'isad"antages of Tariffs D 1uotas
6d"antages&

"here are two basic was to provide protection to domestic import=competing industries? a tariff or a
quota. "he choice between one and the other is li!el to depend on several different concerns.
Fne concern is the revenue effects. A tariff has an immediate advantage for governments in that it
will automaticall generate tariff revenue @assuming the tariff is not prohibitiveA. >uotas ma or ma
not generate revenue depending on how the quota is administered. (f a quota is administered b
selling quota tic!ets @i.e.# import rightsA then a quota will generate government revenue# however# if
the quota is administered on a first=come# first= served basis# or if quota tic!ets are given awa# then
no revenue is collected.
Administrative costs of tariffs and quotas are also li!el to differ. "ariff collection involves product
identification# collection and processing of fees. >uota administration will also involve product
identification and some method of !eeping trac!# or counting# the product as it enters the countr in
multiple ports of entr. (t ma also involve some method of auctioning or disbursing quota tic!ets. (t
is not obvious which of these two procedures would be less costl# although# if ( had to guess# (
would lean towards tariff collection.
)erhaps the most important distinction between the two policies# however# is the protective effect the
polic has on the import=competing industries. (n one sense# quotas are more protective of the
domestic industr because the limit the e'tent of import competition to a fi'ed ma'imum quantit.
"he quota provides an upper bound to the foreign competition the domestic industries will face. (n
contrast# tariffs simpl raise the price# but do not limit the degree of competition or trade volume to
an particular level.
.or this reason# current %"F member countries agreed in the Urugua round to phase out the use of
quotas# used primaril in agriculture industries. (nstead countries will appl tariffs that are equivalent
in their mar!et effects to the original quotas. "his ad$ustment is referred to as tariffication. (n this
wa# future rounds of trade liberali&ation negotiations will be able to use fair reciprocal concessions
to bring these tariffs down further.
/?
'isad"antage&
1uota Impacts and 'isad"antages:
>uotas are usuall emploed to protect infant industries and !eep mar!et entr costs low for
domestic producers. Fften the quotas last long after the industr has matured. Fther uses for quotas
are to protect strategic industries such as defense and agriculture. (n mar!et environments where
imports are on the rise# quotas are more protective than tariffs. %hen one countr uses quotas# its
trading partners do the same and cite the same reasons. "he end result is less e'porting opportunit
for all producers and higher prices for all consumers. >uotas are also cumbersome for the countr
using them. "he require a lot of paperwor! indicating e'act amounts of products for each countr
facing a quota. (t is also difficult to measure the precise degree of protection quotas offer.
Tariff Impacts and 'isad"antages:
"ariffs raise the price of imports. "his impacts consumers in the countr appling the tariff in the
form of costlier imports. %hen trading partners retaliate with their own tariffs# it raises the cost of
doing business for e'porting industries. Bome analsts believe that tariffs cause a decrease in product
qualit. :usinesses loo! for was to cut production costs to account for tariffs. "ariffs are more
transparent and easier to administer than quotas. "his ma!es it easier for trading partners to negotiate
them down or eliminate them.
Other Problems -ith Tariffs and 1uotas:
1igh tariffs and quotas can result in trade wars between nations. "he *uropean Union and China
were involved in a trade dispute over te'tiles that delaed an agreement that e'pired in ,772. "he
United BtatesT high tariffs on auto parts are said to be a stic!ing point in a number of trade agreement
negotiations. "hese disagreements hurt the incomes of each countr involved in the disputes. "rade
onl wor!s when countries import and e'port.
0A
Income and Employment
(f we !now the equilibrium level of national income @GA and potential income @>A# then we also
!now the unemploment rate. (f >HG# then the unemploment rate is the full emploment rate of
unemploment? i.e. unemploment is confined to structural# frictional and seasonal unemplment
and no demand deficient unemploment e'ists. (f GU> then demand deficient unemploment e'ists
proportional to the si&e of the deflationar gap @>=GA. (f GN> then over=full emploment and an
inflationar gap e'ists. "he question is# how is the price level @and hence the rate of inflationA
determined9
Qenesians believe that monetar factors are critical in determining equilibrium income/output and
equilibrium interest rates# but do not ascribe a central role to monetar factors in determining the
price level. "he Qenesian school postulates the )hillips Curve# which graphs the unemploment
rate against the inflation rate:
'nemployment rate
1(2)
I
n
f
l
a
t
i
o
n

!
a
t
e
*(2) +) 12)
3(2)
,)
1-)
P.illip" /ur0e
"he )hillips Curve provides the missing lin! in the Qenesian structure since it purports to show a
fi'ed relationship between the unemploment rate and the interest rate# although there is a lag
e'pected between changes in one value and changes in the other. Given G and ># the unemploment
rate can be determined? given the unemploment rate# the inflation rate can be determined. "he
)hillips Curve presents policma!ers with a difficult trade=off between inflation and unemploment.
(n the e'ample shown# at the full emploment rate of unemploment @sa +.2CA# inflation is
0.
unacceptabl high. (f &ero inflation is desired# unemploment will be unacceptabl high.
)olicma!ers must choose the most palatable combination of inflation and emploment.
Monetarists# on the other hand# do not believe in the )hillips Curve. Monetarists believe that the
suppl and demand of mone is of prime importance in determining the price level. Milton .riedman
is a monetarist and a long=time opponent of the Qenesian school. %e shall now investigate the two
schools.
0/
Causes and Effects of Inflation
(n the post=%%(( period all ma$or economies have e'perienced inflation# although the rate of
inflation has varied widel both between nations and between time periods for a given nation. "he
persistence of inflation and the tendenc for the rate of inflation to rise for substantial periods has
resulted in a situation where great weight is given to the prevention of inflation# even at the e'pense
of allowing a high rate of unemploment. (nflation is undesirable for two main reasons:
(nflation impairs the efficienc of the price mechanism and raises transaction costs because
mone becomes less reliable as a standard of value. (n the presence of inflation it is difficult to !now
if a price increase on a given good represents an increase in the general price level# or an increase in
the price of that good relative to other goods. (n order to answer this question# it would be necessar
to collect information on the current prices of man other goods. Bimilarl# the seller will have
difficult determining the relevant prices of factor inputs# substitute goods# etc.
Unanticipated inflation redistributes income and resources in a largel capricious manner.
(nflation penali&es those with incomes that are fi'ed in mone terms# and favors those whose mone
income reacts quic!l to changes in the price level. "he former group includes most pensioners#
students# and man salar earners# while the latter group includes most wage and profit earners.
%here household incomes include transfer paments from the government# it is possible to inde'
paments to !eep pace with inflation# but the more successfull this is done# the greater the
inflationar bias in the econom. Unanticipated inflation also favors borrowers and penali&es
lenders# because if the loan amount and interest paments are fi'ed in mone terms# inflation results
in the lender receiving less real value than e'pectedEif the inflation continues# lenders will respond
b charging higher interest rates to compensate. .inall# if ta' brac!ets are assigned based on
noninde'ed mone values# inflation can shift the boundar real income between ta' brac!ets# which
can result in a ma$or unplanned reallocation of income from households to the government. (nde'ing
ta'es will prevent this outcome# but again# the more successfull ta'es are inde'ed# the greater the
inflationar bias in the econom.
A continued higher rate of domestic inflation than that which prevails in other nations will
increase imports# reduce e'ports# and create problems for continued stable currenc e'change rates.
(n the presence of unanticipated inflation# the above effects are often capricious and unintended.
Continued inflation will lead to an ad$ustment in behavior patterns which can mitigate the effects#
but inflation can never be full anticipated. .ull anticipation would require not onl full information
on the aggregate rate of inflation# but also requires that ever economic agent have information on
all the relative price movements which affect their decisions.
00
Up to %%(( most industriali&ed nations e'perienced periods of inflation ccling with periods of
stable or falling prices. Fccasional e'amples of high# sustained inflation can be found as a result of
things li!e the Bpanish gold discoveries of the fifteenth centur and the German hper=inflation of
+5,-# but these were isolated events with an easil identifiable cause. "he sustained and near=
continuous inflation e'perienced b all ma$or economies subsequent to %%(( has no historical
precedent. "he emergence of persistent# widespread inflation has led to a ma$or re=e'amination of
the theor of price determination. At the most basic level the proposed theories can be classified into
Jdemand=pull/ and Jcost=push/ models.
"he demand=pull model# favored b Qenes# sees price increases as a consequence of e'cess demand
for goods and services which e'ceed the capacit output of the econom. As real output cannot
increase significantl beond capacit output# e'cess demand Jpulls up/ the prices of final goods and
services. At the same time# as firms bid up the prices of factors of producion# mone incomes rise.
"his approach has some problems. (t cannot e'plain monetar factors which are clearl observed to
be capable of causing inflation @eg# the Bpanish gold discoveriesA# nor does it deal with the
possibilit that monetar factors could be used to combat inflation. (t also regards wage and salar
earners as passivel reacting to changes in the price level b bargaining up their incomes. 1owever#
in the +527s and +5P7s# more centrali&ed wage and salar bargaining became a feature of the ma$or
economies# and as a result a new school of thin!ing developed which elevated labor mar!ets to a
primar# causative role in the determination of the price level.
"his new# Jcost=push/ model sees price increases as a consequence of bargains struc! in the factor
@primaril laborA mar!ets# which raise the production costs of emploers# who then pass on higher
costs in the form of higher prices. Most cost=push models incorporate the following elements:
- )rices and costs are Jadministered/ rather than responsive to the mar!et forces of demand and
suppl. %ith the e'ception of a few trul competitive mar!ets @agricultural commodities# for
e'ampleA# most mar!ets for final products have some strong anti=competitive elements# meaning that
one or a small number of producers have an influential role in setting prices.
- Bimilarl# labor mar!ets are Jadministered/ in that wages and salaries are largel determined b
bargains struc! between emploers and trade unions# rather than b mar!et forces.
- .inal product prices are also Jadministered/ on the basis that firms set prices on a cost=plus basis#
with prices reflecting the full cost of production plus some mar!=up for profit. As a result# if costs
rise# firms will attempt to pass on the higher costs to consumers# in the form of higher pricesEso the
whole econom is essentiall on a cost=plus basis.
- "he purpose of trade unions is to bargain better pa for their members.
02
- Dabor represents the single largest factor mar!et# b a wide margin.
Under such a sstem# bargaining over mone wages and salaries is considered the primar Jmotor/ of
inflation. "rade unions continuall attempt to bargain for better wages and salaries. Bometimes# the
are successful. %hen this happens# the factor costs of labor @the largest cost of productionA increase#
so firms pass this increase on to consumers in the form of higher prices. "he increase in prices will
erode the real value of the mone increase in wages# which ma then lead to further demands for
wage increases. JCost=push/ inflation originates with higher wage costs which then push up prices.
Cost=push inflation is li!el to occur in economies where wages and salaries are not fle'ible
downwards# a feature of most modern economies. (t has long been recogni&ed that wor!ers# trade
unions# etc.# will particularl resist an cut in mone wages. "hat being so# firms# faced with lower
demand for their products# ma be reluctant to lower prices# because the Jstic!iness/ of wages would
mean that the price cuts would mainl be at the e'pense of profits. (nstead# the firms will lower
output and therefore emploment.
%here deficient demand ma not cause prices to fall# e'cess demand will be reflected in higher
wages and prices. (n other words# the reaction of wages and prices is asmmetrical. (f this is so# then
a change in the distribution of demand# even given the same aggregate demand# could cause prices to
rise. (nflation does not occur as a result of e'cess aggregate demand# but rather as the result of e'cess
demand in particular mar!ets and the failure of prices to fall in particular demand=deficient mar!ets.
(n addition# price increases in particular mar!ets are li!el to trigger Jspill=over/ or Jlin!age/ effects
in other mar!ets. .or e'ampe# if wage agreements are interlin!ed so that trade unions negotiate
similar wage increases for everone the represent# then Jbidding up/ of wages in one sector will
encourage wor!ers in other sectors to demand raises as well.
Cost=push inflation can onl occur in the presence of a permissive monetar polic which allows the
continued e'pansion of the mone suppl. 1igher wages which result in higher prices must raise the
mone value of output# unless offset b an accompaning reduction in output and emploment. (f the
mone suppl is fi'ed# it would be necessar for the velocit of circulation of mone to rise to
generate the higher level of monetar demand consistent with the higher mone value of output. "o
sustain a continuing inflation# the velocit of circulation of mone would have to increase
continuousl. As the velocit of circulation is heavil influenced b institutional arrangements and
e'isting habits# it is unli!el to be able to change quic!l enough to sustain much inflation.
(n short# if faced with an increase in mone wages# the monetar authorities can either hold the
mone suppl constant or allow it to increase but at a rate lower than the rate of increase of mone
03
wages# with the result of a fall in output and emploment but stable prices# or the can allow the
mone suppl to increase to allow a sufficient level of monetar demand to sustain the same output
at higher prices.
"here are two additional possible sources for cost=push inflation: (mports and e'pectations. (mported
inflation occurs when trade or other factors cause the prices of imported goods to rise# particularl
when demand for those goods is relativel price inelastic? not onl do consumers pa mor directl
for the imported goods# but because imported factor inputs are now more e'pensive# inflation will
accelerate through the entire econom# as in the +567s oil crisis. *'pectations=based inflation is a
relativel recent concept. *conomic models generall treat e'pectations one of three was:
*'pectations are static L people alwas e'pect the current situation to continue?
*'pectations are adaptive L people/s e'pectations change over time to ad$ust to the situation?
*'pectations are rational L people base their e'pectations on the same information as is available
to polic ma!ers.
"he favorite e'ample of rational e'pectations is the stoc! mar!et. (f ou read in the newspaper that
(:M is going to have a good ear# there is no point rushing to bu the stoc! as a result# because
everone else has alread read the newspaper article and mar!et trading has alread ad$usted the
price of (:M stoc! to account for the news. ;or is there an point ta!ing advice from our
stoc!bro!er# as anthing the stoc!bro!er !nows is alread accounted for b the mar!et prices of
stoc!s. "he onl information which has not alread been accounted for in the stoc! prices is insider
information# but trading based on insider information is illegal. "he theor incorporating rational
e'pectations is called the *fficient Mar!et 1pothesis. *'pectations affect the inflation rate to the
e'tent that firms and individuals do business in the e'pectation of future benefits or costs. (f ou
agree to purchase goods for future deliver# ou must agree on a price toda. "he price which ou
are willing to pa will depend on our e'pectations of the future value of the goods to be delivered#
which depends on our e'pectations regarding inflation. (f ou have agreed to a deal at some
specified price and date in the future# ou have in effect established a part of what the price level will
be on that future date.
07