• Economics focuses on all the choices people make as well as the personal and social consequences of these choices
  

1. SCARCITY
   

• Scarcity occurs because our limited resources and time can only yield limited production and income but people’s wants are virtually unlimited.
  
  • Scarcity necessitates trade-off
    
  • Scarcity forces us to choose
    
• Economics is the study of how people, individually and collectively allocate their limited resources to try to satisfy their unlimited wants.
  
• A Good is any item or service that adds to human happiness.
  
  • Commodities are tangible goods that can be bought and sold
    
  • Desirable things that are not scarce are Free Goods.
    
  • For a specific individual, the possession of a specific unit of a given good has
    
    • Value in use
      
    • Value in exchange
      

     

• PRODUCTION AND RESOURCES
  
  • Production entails using technology to apply energy to materials in ways that make the materials more valuable, or that otherwise help satisfy human wants
    
  • Productive Resources = Factors of Production = Input
    
  • Technology consists of the “recipes” available for use in combining and reshaping resources in production process
    
    • How resources can be combined productively clearly depends on technology
      
    • Technology determines whether some materials are even seen as resources
      
    • Knowledge and technology are closely intertwined
      
  • Four broad categories of resources
    
    • Labor
      
      • The physical and mental talents that people can make available for production
        
      • Typically measured by time available for work during the a period
        
      • All payments per period for labor services are called Wages.
        
    • Land
      
      • Includes all natural resources
        
      • Payments per period for the use of land are called Rent.
        
    • Capital
      
      • Investments that make natural resources more productive are capital, which includes all produced resources. i.e., building, machinery, roads
        
      • The production of new capital is Investment.
        
      • Some capital wears out each year; this decline in value is Depreciation.
        
      • Net Investment = Total Investment – Depreciation
        
        • Total Investment each year is gross investment
          
      • Development of a rich economic infrastructure is a key for growth and development.
        
      • On-the-job training or acquisition of a college degree as investment in Human Capital.
        
      • Paper assets like currency or stocks and bonds are Financial Capital, which ultimately permits the purchase and use of finished goods or resources, including Economic Capital.
        
        • Financial Capital – A deed to a house
          
        • Economic Capital – The house itself
          
      • Payments for both physical and financial capital are called Interest.
        
    • Entrepreneurship
      
      • Entrepreneurs provide specialized human resources; they combine labor, land, and capital to produce goods while incurring risk in their quest for profit.
        
      • Profit = Sales Revenue – Wages – Rent – Interest
        
      • Loss is negative profit.
        

       

• UNLIMITED HUMAN WANTS
  
  • Constraints on resources and time are only one of two important dimensions of scarcity. The other dimension of scarcity stems from our unlimited wants
    
  • Rational Self-Interest
    
    • Adam Smith assumed that people act purposefully to maximize their satisfactions, given their limited time, information, resources, and budgets
      
    • The economist’s characterization of Homo sapiens as Homo economicus views all human behavior as rationally self-interested
      
    • The economist’s notion that people act rationally merely implies that people try to act in ways consistent with their own objectives, even if their goals seem absurd to most outsiders
      
    • The assumption of self-interest need not imply total selfishness
      
    • Personal values powerfully influence our perceptions of costs and benefits
      

       

• SOME BASIC CHOICES
  
  • Scarcity forces every society to make choices in trying to resolve three basic economic questions
    
    • What economic goods will be produced?
      
      • Current resources and technology limits a society to choosing one combination from the innumerable mixes of goods that could feasibly be produced in a given period
        
      • How to produce?
        
    • How will resources be used in production?
      
      • Most goods can be produced with many different mixes of resources
        

       

    • Who will get to consume economic goods?
      
      • Who will get
        
        • Income and wealth
          
        • Specific goods
          
  • How society answers these basic questions ultimately determines our economic structure and level of prosperity
    

   

• OPPORTUNITY COSTS
  
  • Opportunity Cost (Economic Cost) is the value of the best alternative surrendered when a choice is made
    
    • Choosing any scarce thing forecloses other options; such lost options are economic costs
      

     

• MONETARY (ABSOLUTE) PRICES
  
  • Opportunity costs may be only loosely related to monetary (absolute) prices
    
    • Absolute Prices are prices in terms of some monetary unit
      
  • Opportunity cost as measured by relative prices shape most decisions
    
    • Relative Prices are the prices of goods or resources in terms of each other, and are computed by dividing their absolute prices by one another
      
      • Absolute prices bear little on rational decisions until we convert them to relative prices
        
      • Relative prices guide decision; changes in absolute prices ultimately affect most decisions only to the extent that relative prices are distorted
        
    • Relative prices compress immense amounts of information about buyer’s desires and seller’s costs
      
    • Relative prices signal opportunities for pleasure and prospects of pain
      
      • Sellers view relatively high prices for goods (relative to their production costs) as incentives that stimulate production, while low prices are disincentives that push resources into alternative types of production
        
    • Relatively higher prices for goods or resources signal greater relative scarcity and discourage lower-valued uses of goods
      

     

• ECONOMIC EFFICIENCY
  
  • Economic Efficiency is achieved when we produce the combination of outputs with the highest attainable total value, given our limited resources
    
  • Economic Efficiency, broadly considered, means that it is impossible for anyone to gain unless someone else loose.
    
  • Allocative Efficiency requires the patterns of national output to mirror what people want and are willing and able to buy
    
  • Productive (Technical) Efficiency requires minimizing opportunity cost for a given value of output
    
  • Distributive Efficiency requires that specific goods be used by the people who value them relatively the most
    
    • The question of “Who?” is divisible into issues of (a) the distribution of income and wealth, and (b) the distribution of goods
      

1. ECONOMIC ANALYSIS
   

    

• COMMON SENSE AND THEORY
  
  • Steps in any scientific theory
    
    • Identify the problem
      
    • Preliminary thinking and relative data collection
      
    • Develop theory and refine it
      
    • Collect more data and (Re)test model
      
  • New theory that passes this test gradually replaces older theory and becomes part of our common sense
    
  • Occam’s Razor is the idea that the simplest workable theories are also the most useful and the best.
    
  • A good theory or model as simple as possible predicts how the real world works. Common sense evolves as exceptions to old theories compel acceptance of better theories, if they seem reliable after extensive testing.
    

• POSITIVE VS. NORMATIVE ECONOMICS
  
  • Positive Economics address “what is” and predicts observable and testable tendencies in economic relationships
    
    • Positive economics cannot determine whether any goal is good or bad.
      
  • Normative Economics depends on value judgments and addresses what “should be.”
    
    • Normative issues frequently turn on questions of equity and provoke debate among economists and the public alike.
      

• MACROECONOMICS AND MICROECONOMICS
  
  • Macroeconomics focuses on aggregate variable relevant for an entire national economy, or even the world economy
    
    • Macroeconomic policy addresses the total effects of changing taxes and government spending, or growth in the money supply
      
    • Economic security closely related to achieving commonly agreed-upon normative goals of macro policy
      
      • High employment
        
      • Price-level stability
        
      • Economic growth
        
  • Microeconomics is the study of individuals decision-making, resource allocation, and how relative prices, output, and the distribution of income are determined
    
    • Three major goals of dominate micro policy
      
      • Efficiency
        
      • Equity
        
      • Freedom
        
    • All goals involve trade-offs
      
  • Our ability to achieve macro goals depends on micro policy, and vice versa
    

CHAPTER 2. SCARITY IN A WORLD IN TRANSITION

1. CIRCULAR FLOWS OF INCOME

• Markets pivot on the decisions of households and business, which together are called the Private Sector.
  
• Government, the Public Sector
  
• Circular Flow Model – how income and resources flow between households and business firms
  

• HOUSEHOLDS
  
  • Households are centers for consumption and ultimately own all wealth, including resources that they make available to businesses or government in exchange for income
    
  • Labor is the principal assets of most households
    

• FIRMS
  
  • A Business Firm is a privately owned and operated center for production
    
  • Firms prompt households to provide specific resources with incentives in the forms of wage rates paid for specific labor skills, rental rates for land, or rates of return on capital
    

• GOVERNMENT
  
  • Taxes are the primary sources of government revenue
    
  • A critical point in the circular flow model is that firms nor government are not the final owners of resources or product, because all firms are ultimately owned by people in households
    

2. SPECIALIZATION AND TRADE

• Both living above bare subsistence and economic efficiency require
  
  • Production entailing a division of labor
    
  • Specialization and exchange according to comparative advantage
    

• DIVISION OF LABOR
  
  • The Division of Labor entails dividing the work required to product a given good or accomplish a particular task
    
  • Gains from the division of labor arise because
    
    • Teamwork fosters productivity
      
    • People develop expertise in particular jobs
      

• COMPARATIVE ADVANTAGE
  
  • The Law of Comparative Advantage: Mutually beneficial exchange is possible whenever relative production costs differ prior to trade
    
  • Absolute advantages do not translate into comparative advantages. In other words, even if one has absolute advantages over the other, both parties still can gain if they trade.
    
    • i.e., A lawyer who can type faster than the secretary is better off hiring a secretary for $10/hr while she can make $100/hr.
      
  • Comparative advantage is molded by
    
    • Climate and locate
      
    • Institutional and cultural factors
      
    • Government policies
      
    • The skills and education of the populace
      
    • The vigor of internal competition and size of domestic market
      
    • The commitment of domestic entrepreneurs to innovate new technologies and cultivate global markets
      

3. PRODUCTION POSSIBILITIES

• PRODUCTION POSSIBILITIES FRONTIERS (PPF)
  
  • A Production Possibilities Frontier depicts the maximum combinations of goods a society can produce in a given period
    
  • The three critical assumptions of PPF model
    
    • The amounts of resources are fixed, but can allocated among different types of production
      
    • Technology, which includes such things as the state of knowledge about production and the qualities of resources, is assumed constant
      
    • All scarce resources are fully and efficiently employed.
      

• DIMINISHING RETURNS
  
  • The Law of Diminishing Returns: As any activity is extended, it eventually become increasingly difficult to pursue the activity further.
    
  • The Principle of Increasing Costs: Repeatedly increasing output by some set proportion ultimately requires more than proportional increases in resources and, thus, higher costs
    

4. ECONOMIC GROWTH

• Economic growth occurs when
  
  • Production possibilities frontiers shift outwards, so that more of all goods can be produced, or when
    
  • The value in exchange of a national output increases for purpose of international trade
    
  • Economic Growth entails increases in the value of a nation’s productive capacity.
    
  • Growth is driven by
    
    • Technological advances
      
    • Increases in the availability of resources or improvements in their quality
      
    • Increased values for the goods in which a country specializes
      

• TECHNOLOGICAL ADVANCES
  
  • Growth occurs when entrepreneurs implement technologies allowing amounts of resources to produce more output
    
  • Technological advances in any active industry expand production possibilities for all other industries since resources would be freed from that industry to produce other goods
    
  • The innovation of new technologies is a key for economic growth-and for successful entrepreneurship
    

• EXPANDING THE RESOURCE BASE
  
  • Natural Resources: Land
    
    • Finding better uses for existing natural resources effectively increases the quality of the land available
      
    • Wiser land-use policies are also possible ways to boost the productivity of existing land, effectively increasing land resources and fostering growth
      
  • Labor
    
    • Growth of the labor forces and economic growth can be fostered through
      
      • Increases in the number of workers
        
      • Improvements in their productivity
        
      • More support for education or on-the-job training program
        
      • Provision of daycare for the children of people who cannot to work due to lack of affordable and reasonably convenient daycare
        
  • Capital: Saving and Investment
    
    • Consuming less than we produce is Saving, which allows resources to be channeled into productive Investment.
      
    • Rapid investment boosts production possibilities in two ways
      
      • First, more capital is available
        
      • Second, new capital embodies more advanced technology than that embodies in older buildings and machinery
        
    • However, productive capacity is eroded if depreciation exceeds investment
      
    • Growth in an efficient economy is stimulated by rapid investment, which requires more saving
      
    • Economic growth is stimulated if saving is channeled into productive investments
      

• GROWTH AND INTERNATIONAL TRADE
  
  • Specialization and exchange accordingly to comparative advantage allows any society’s consumption to exceed its PPF in isolation
    
  • The more relative production costs differ among trading countries, the greater will be the gains from trade
    

5. ALLOCATIVE MECHANISMS

• THE MARKET SYSTEM
  
  • Markets enable buyers and sellers to transact business so that people can share in the gains through specialization and exchange according to comparative advantage
    
  • Common characteristics of the market system
    
    • Buyers who demand goods or the resources that produce them if prices are acceptable
      
    • Suppliers who make products or resources available if the price is right
      

• BRUTE FORCE
  
  • Brute Force is a way to decide who gets what and can be viewed as a fine system.
    
  • Brute force also wastes resources
    

• QUEUING
  
  • Queuing: lining up or first-come, first-served systems
    
  • If queuing were the dominant allocation mechanism, so much time would be spent in lines that little production would occur
    

   

• RANDOM SELECTION    
  

• TRADITION
  
  • Resources and human talent are wasted when tradition alone rules
    
  • Some efficient traditions are often reinforced by laws and government regulations
    

• GOVERNMENT
  
  • Among the criteria government leaders might use to distribute production are equal share and need
    
    • Equal Shares
      
      • What is equal or fair to each individual?
        
    • Need
      
      • Difficult for anyone to judge someone else’s needs
        
      • Distribution by need causes special-interest groups to devote resources to lobbing to make decision-makers aware of their special needs
        
    • Misallocation
      
      • Government decision making is often crude relative to the fine-tuning made possible through individual choice
        
        • In consumption, when people have differing preferences
          
        • In production, when policies specified centrally are not attuned to local conditions
          

6. ECONOMIC SYSTEMS IN TRANSITION

• Every society attempts to cope with scarcity in certain basic ways
  
  • Use of money to convey information about relative prices
    
  • Specialization according to comparative advantages
    
  • Division of labor
    
• How and when different Allocative mechanisms are used determines how efficiently a society produces and delivers goods to its members
  
• Economic systems are conventionally classified by who makes decision and who owns which resources
  
• FOUNDATIONS OF CAPITALISM
  
  • Hallmarks of pure capitalism are private property and decentralized, laissez-faire policies by government
    
  • Private Property Rights
    
    • Fee-Simple Property Rights, the broadest of private property rights, include rights to
      
      • Use a good as you choose as long as no one else’s rights are violated
        
      • Trade or give these rights to others people
        
      • Deny use of the goods to others
        
    • The Labor Theory of Value asserts that human labor is the source of all value
      
    • The Natural Rights theory suggests a need for more practical foundations for property rights.
      
    • Laws govern the ways we use both our own and our neighbors’ property. Government in a capitalist society establishes who owns what and how ownership rights can be transferred
      
    • Socialism holds that most nonhuman resources should be owned by the state, acting as a trustee for all the people in society, and not by private individuals
      
  • Laissez-Faire Policies
    
    • A laissez-faire government only specifies property rights and enforces contracts
      
    • Decision-making is private and decentralized
      
    • Capitalism allows people maximum freedom because it requires only minimal government
      

• CENTRAL PLANNING IN A COMMAND ECONOMY
  
  • Communism replaces the decentralized decisions of a market systems with central planning
    
    • Under Marxist communism, Central Planning(centralized decision-making) accompanies socialist resources ownership in a command economy
      

• ECONOMY SYSTEMS AS INFORMATION PROCESSORS
  
  • One way to retain power is to monopolize information, so secrecy is common under all forms of totalitarianism
    
  • Political freedom and decentralized markets expedite flows of information and technological advances
    

• ARE ECONOMIC SYSTEMS COVERGING?
  
  • The efficiency of capitalism depends on how well it meets consumer wants, given the resources available
    
  • Market allocations of goods and resources are a key element of capitalism
    

CHAPTER 3. DEMAND AND SUPPLY

• Marginalism: The idea that most decision entail weighing the relative costs and benefits of small changes in behavior
  

1. THINKING AT THE MARGIN

• Adjusting rational decisions to changes in relative costs and benefits tends to be a Marginal or Incremental Process
  
• Economists often refer to a marginal unit of something as its Extra or Last Unit, which is often misinterpreted as a specific unit.
  
• Decisions about buying or selling are based on opportunity costs, which ultimately depend on the relative marginal benefits and costs of goods
  

2. DEMAND

• Demand is the quantity of a specific good that people are willing and able to buy during a specific period, given the choices available
  
• The market prices of goods and the amounts consumers purchases are negatively related
  
• Purchasing patterns depend on two sets of relative prices
  
  • Market Prices are the prices charged for goods whether we buy them or not
    
  • Demand Prices reflect the relative values an individual subjectively places on having a bit more or less of a good
    

   

• THE LAW OF DEMAND
  
  • Two reasons for the purchases of a good rise when its price falls
    
    • Substitution Effect
      
      • People find substitutes for goods that become relatively more costly and wider uses for goods that become cheaper
        
      • The Law of Demand: All else being equal, consumers buy more of a good during a given period the lower its relative price, and vice versa
        
      • The Principle of Diminishing Marginal Utility(Satisfactions): The more your have of any good relative to other goods, the less you desire and are willing to pay for additional units of that good
        
    • Income Effect
      
      • The purchasing power of a given money income increases, so you can buy more of the good while maintaining or even increasing your other purchases
        
  • Note that all influences on consumption of a good other than its own price are assumed constant in deriving the law of demand
    

• INDIVIDUALS’ DEMAND CURVES
  
  • The law of demand’s negative relationship between the price of any good and the quantity consumed yields a negatively sloped demand curve
    
  • A Demand Curve depicts the maximum quantities of a good that give individuals are willing and able to purchase at various prices during a given period, all else assumed equal
    
  • Demand curves reflect subjectively determined marginal benefits of goods
    

• MARKET DEMAND CURVES
  
  • A Market Demand Curve is the horizontal summation of the individual demand curves of all potential buyers of a good
    

• OTHER INFLUENCES ON DEMAND
  
  • A good’s relative price is joined by six other broad determinants of the amounts consumer purchase
    
    • Tastes and preference
      
      • Preferences mirror our perceptions of the desirability of goods and our individual idiosyncrasies
        
    • Income and its distribution
      
      • Demands for higher quality goods tends to rise if income grows
        
      • Goods for which demand is positively related to income are Normal Goods (luxuries)
        
      • When a poor family’s income rises, its demands fall for such Inferior Goods
        
      • With all else being equal, it follows that income redistribution alters the structure of demand
        
        • Transferring income from rich to the poor causes declines in demands for both inferior goods and luxuries
          
        • Rising inequality stimulates demands for both
          
        • However, that one family’s inferior good can be another’s luxury good
          
    • Prices of related good
      
      • A good’s own price is important, but prices of related product also influence demand.
        
      • Most goods are at least weak substitutes for one another
        
      • Substitutes are the goods increasingly purchased in place of the item in questions when its price rises or vice versa
        
      • Complementary Goods generate more consumer satisfaction if consumed together. Increases in the price of a good tend to reduce demands for its complements, and vise versa.
        
    • Numbers and ages of buyers
      
      • Population growth expands the numbers of potential buyers and, therefore, the market demands for most goods
        
    • Expectations about future prices, income, and availability
      
      • Consumers who expect shortages or price hikes in the near future may rush to buy storable products now, thus booting current demands
        
      • Expectations of higher income often tempt people to splurge
        
      • Expectations about government actions also affect buying patterns
        

       

    • Government taxes, subsidies, and regulations
      
      • Regulation and taxes or subsidies also influence demand
        
  • Demand grows when
    
    • Preferences change so that people are more inclined to buy a good
      
    • Consumer incomes rise in the case of a normal good
      
    • The price of a substitute good rises or the price of a complement falls
      
    • The population of consumers expands
      
    • Consumers expect higher prices or incomes or anticipate shortages of the goods
      
    • Favorable regulation is adopted, taxes are cut, or government subsidies the good
      

• CHANGES IN DEMAND
  
  • If a determinants of demand other than a good’s own price changes, there is a Change in Demand and a shift in the demand curve
    

• CHANGES IN QUANTITY DEMANDED VS. CHANGES IN DEMAND
  
  • Changes in Quantity Demanded
    
    • Follow changes in the price of the good
      
    • Movements along a demand curve
      
  • Changes in Demand
    
    • Reflect changes in influences on purchase other than a good’s own price
      
    • Involve shifts of demand curves
      

3. SUPPLY

• Supply refers to the quantity of a specific good that sellers will provide under alternative conditions during a given period
  

• THE LAW OF SUPPLY
  
  • The Law of Supply: All else being equal, higher prices induce greater production and offers to sell more output during a given period, and vise versa
    
  • The law of supply generates positively sloped supply curves
    
  • A Supply Curve shows the maximum amounts of a good that firms are willing to furnish at various prices during a given period
    
  • The positive slopes of supply curves reflect eventual increases in costs per extra unit when output grows because
    
    • Ultimately encounter diminishing returns
      
    • May be forced to pay current works overtimes wages for extra hours
      
    • Successfully attract more labor or other resources only by paying more for them
      
  • A Supply Price is the minimum price that will induce a seller to increase production beyond its current level
    
  • Market Supply Curves entail horizontally summing all firms’ supply curves.
    

   

4. OTHER INFLUENCES ON SUPPLY

• An increase in the supply of a good means that more is available at each price; the supply price required for each output level falls.
  
• On the other hand, decreases in supply raise supply prices
  
• Expectations of price hikes that immediately raised the opportunity of oil, and thus reduced the supply of oil, and thus reduced the supply of gasoline
  
  • Gasoline sold today is not available for sale at a later date at a potentially higher price
    
• A supply curve reflects the positive relationship between price and quantity supplied per period, holding constant
  
  • Technology
    
    • Included such influences on production costs as the state of knowledge, the quantities of resources, the legal environments, and such natural phenomena as physical laws and weather
      
    • Costs fall and supply grows when technology advances
      
  • Resource Costs
    
    • Supply declines when resource costs rise
      
  • Prices of Other Producible Goods
    
    • Changes in the prices of other potential outputs can shift the supply of the current good
      
    • On the other hand, when goods are byproducts, an increase in the price of one joint product yields an increase in the supply of the other even if the price of the other good falls
      
  • Expectations
    
    • Durable Goods (Storable Goods) provide benefits across time
      
    • Non Durable Goods (Perishable Goods) can become worthless unless consumed soon after production
      
    • The longer term effect of expectations of rising prices is that supplies of durable goods grow when
      
      • Swollen inventories are sold and
        
      • New investments become productive
        
  • The Number of Sellers in the Market
    
  • Taxes, Subsidies, and Government Regulations
    

• CHANGES IN QUANTITY SUPPLIED VS. CHANGES IN SUPPLY
  
  • A Change in Supply occurs only when the supply curve shift
    
  • A Change in the Quantity Supplied is caused by a change in the price of the good in question.
    

5. MARKET EQUILIBRIUM

• Supply and demand jointly determine prices and quantities so that market achieve equilibrium
  
• In an Equilibrium, any pressures for change must be offset by opposing forces
  
• Market Equilibrium occurs at the price-quantity combination where the quantities demanded and supplied are equal
  
• The amounts buyers will purchase at the Equilibrium Price exactly equal the amounts producers are willing to sell
  
• A Surplus is the excess of the quantity supplied over quantity demanded when the price is above equilibrium
  
• A Shortage is the excess of quantity demanded over quantity supplied when the price is below equilibrium
  
• Equilibrium is not instantaneous
  
• How rapidly markets adjust to changed circumstances depends on
  
  • The quality of information and how widely and quickly the relevant information is disseminated
    
  • Market structure-the vigor or lack of competition
    

• SUPPLIES AND DEMANDS ARE INDEPENDENT
  
  • Supplies and demands are normally independent of each other, at least in the short run
    
    • i.e., Supply curves can be constructed for mud pies even if there is no demand for them
      

CHAPTER 4. MARKETS AND EQUILIBRIUM

1. THE SEARCH FOR EQUILIBRIUM

• CHANGES IN SUPPLY
  
  • When demand is constant
    
    • Expanding supplies push down prices and increase the quantities sold
      
    • Decreases in supply exert upward pressures on prices and decrease the quantities traded in the market
      

• CHANGES IN DEMAND
  
  • When supply is constant
    
    • Expanding demand exerts upward pressure on both prices and quantities
      
    • Decreases in demand exerts downward pressures on both prices and quantities
      

• SHIFTS IN SUPPLY AND DEMAND
  
  • When both demand and supply grow, quantity increases but price changes are unknowable without more information
    
  • If demand rises while supply falls, the price rises, but we cannot predict quantity changes without more information
    
  • Declines in demand and increases in supply cause prices to fall, but predicting quantity changes requires more data
    

2. TRANSACTION COSTS

• Transaction Costs are the costs associated with
  
  • Gathering information about prices and availability
    
  • Mobility, or transporting goods, resources, information costs, time, risk or potential buyers between markets
    
• Transaction costs create opportunity cost wedges between the various market prices for the same good
  
• Seller would always sell at the highest possible price if transaction costs were zero, while buyers would only pay the lowest possible price
  
• Paying a higher monetary price is often efficient if acquiring the good at a lower monetary price entails high transaction costs
  
• The speed of equilibrium is negatively related to the costs of mobility and information
  

• INTERMEDIARIES
  
  • Intermediaries specialize in reducing uncertainness and cutting the transaction costs of conveying goods from original producers to the final users, often transforming the good to make it more compatible with ultimate users’ demands
    
  • Intermediaries help minimize transactions costs
    
  • Retail stores and wholesalers are examples of operations that cut transaction costs
    
  • One important way in which intermediaries reduce transaction costs is by absorbing risk
    
  • Arbitrage is the process of buying at a lower price in one market and selling at a higher price in another, where the arbitrageur knows both prices and the price differential exceeds transaction costs
    
  • Speculators derive income by buying something at a low price and storing it in the hope of selling it later at a higher price
    

3. MARKETS AND PUBLIC POLICY

• PRICE CONTROLS    
  
  • A Price Ceiling is a maximum legal price
    
    • A price ceiling set above the equilibrium market-clearing price is usually as irrelevant as a la limiting joggers to 65 mph
      
    • Price ceilings below equilibrium create shortages and drive up opportunity costs which unnecessarily exceed free-market prices
      
  • A Black Market is an illegal market where price controls are ignored
    
  • A Price Floor is a minimum legal price
    
    • Price floors set below equilibrium tend to be as irrelevant as laws requiring pilots to fly above sea level
      
    • Price floors exceeding equilibrium create artificial surpluses and raise costs. Production costs of the surplus goods exceed their values to consumers
      
    • Most common in labor market and agriculture
      
    • Inefficiency is a major problem
      

• MINIMUM WAGES AND UNEMPLOYMENT    
  
  • Wage floors create surpluses of workers and unemployment just as surely as price floors for goods cause surpluses of goods.
    
  • Minimum wage laws deprive some unemployed workers of job opportunities and can cause them to give up hope
    

• THE WAR ON DRUGS
  

4. THE MARKET IN OPERATION

• WHAT?    
  
  • Our exploration of the price system has relied on two critical assumptions
    
    • Individuals are self-interested and try to maximize their personal satisfaction through the goods they consume
      
    • Firms try to maximize profits when they sell goods to consumers willing to pay for them
      
  • The market system answers the What? Question by producing the things people demand
    

• HOW?    
  
  • A firm’s ability to exploit consumers is limited
    
    • Competition keeps prices from straying much above costs for long
      
    • Suppliers try to be efficient
      
  • Competition ensures that priced is approximately equal to the opportunity cost incurred in production
    
  • Competitive markets answer the How? Questions by shifting resources into goods where production costs are relatively the lowest
    

• FOR WHOM?    
  
  • Consumers who hold dollar votes and are willing to pay market prices purchase and consume goods
    
  • The market offers some major compensating advantages
    
    • Decisions are decentralized
      
      • No government agency dictates what everyone must buy or produce
        
    • Markets tend to be efficient
      
      • Consumers usually pay prices for good that roughly reflect the minimal costs of producing these goods
        
    • Although markets may not provide perfect stability, the forces that drive markets toward equilibrium tend to yield more stability than most other mechanisms
      

5. GOVERNMENT IN A MARKET ECONOMY

• Widely accepted economic goals for government in a market economy are
  
  • To provide a stable legal environment for business activity
    
    • In a market economy, government establishes rules about legal relationships between parties, sets standards for money and weights and measures and engages in other activities intended to promote the public welfare
      
  • To promote and maintain competitive markets
    
    • Market Power (Monopoly Power) exists whenever individual firms significantly influence the supply and price of a good and may be present even if several firms share a market
      
    • The basic approach to controlling monopoly power in US has been through antitrust laws and regulation
      
  • To allocate resources to meet public wants efficiently
    
    • Because no individual willingly bears the costs of adequately accommodating everyone’s desires for pollution or National defense, price signals emitted by consumers are distorted and firms cannot privately market these goods profitably
      
    • Externalities occur when some benefits or costs of an activity spill over to parties not directly involved in the activity
      
    • Private decisions result in underproduction and overpricing of goods that generate positive externalities because the value to society exceeds the demand price individuals willing to pay when they are uncompensated for external benefits
      
    • Public Goods are both
      
      • Nonrival because numerous people can consume the same unit of such a good simultaneously and
        
      • Nonexclusive because denying access to such goods is prohibitively expensive
        
      • Public goods cannot be privately and profitably marketed to efficiently service our collective demands for them
        
  • To facilitate equity through redistributions of income
    
    • Through welfare and disaster relief
      
  • To ensure full employment, a stable price level. Economic security, and a growing standard of living
    
    • Market systems may lack strong natural mechanisms that consistently yield full employments without inflation
      
    • The major tools government uses to try to achieve macroeconomic goals includes
      
      • Variations in taxes
        
      • Government spending
        
      • The supply of money
        
  • International policies also have macroeconomic ramifications
    

6. THE SCOPE OF GOVERNMENT

• Federal Level
  
  • Expenditures tend to focus on activities with national implication
    
  • Almost 60% of revenues come from taxes on individual or corp. incomes
    
  • Additional 30% is from Social Security taxes
    
• Local and State Level
  
  • Expenditures is directly at services that affect people in more limited geographical areas
    
  • 2/3 of revenues are from
    
    • Grants from the federal government
      
    • Property taxes
      
    • Sales taxes
      
• Taxes can be related to income in three basic ways
  
  • Progressive
    
    • Higher income, higher taxes
      
  • Proportional
    
    • Taxes collected at a fixed percentage of income regardless of income level
      
  • Regressive
    
    • The percentage of income paid as taxes declines as income rises
      
    • i.e., Social Security Tax: only 15% upto $60,000
      
• Market tend to be inefficient when
  
  • Firms exercise market power or
    
  • Property rights are uncertain or unenforceable
    
  • At the macroeconomic level, persistent high employment, erratic swings of the price level, and unbalanced or sluggish growth may also signal inefficiency.
    

CHAPTER 5. FOUNDATIONS OF MACROECONOMICS

• The central goals of macroeconomics are
  
  • High employment
    
  • Price level stability (keeping inflation in check)
    
  • Economic growth
    

1. BUSINESS CYCLES

• Periods of economic expansion and contraction alternate over a Business Cycles
  
• A typical business cycle
  
  • Peak (Boom)
    
  • Recession (Contraction)
    
  • Depression (Trough)
    
  • Recovery (Expansion)
    

• TURNING POINTS IN BUSINESS CYCLES    
  
  • Turning Points
    are unofficial until the next peak or trough is passed
    
    • Troughs of the cycle occur when most measures of business activity indicate low point
      
    • Peaks are dated when most data point to cyclic highs
      

• SPECIAL ASPECTS OF BUSINESS CYCLE    
  
  • Social losses from recession
    
    • Waves of crime, illness, and breakdowns of family structures
      
      • Marriage and divorce are both positively related to economic swings
        
    • Trigger epidemics of stress-related disease
      
    • Suicide
      

2. BUSINESS CYCLE THEORIES

• EXTERNAL SHOCK THOERIES
  
  • External Shocks are economic disturbances that originate outside an economy
    
    • i.e., Wars, weather, oil
      
  • The Sunspot Theory is an exotic external shot theory developed by W. Staney Jevons in 1875
    
    • Sunspot: nuclear storms on the sun’s surface affect weather and, hence, agriculture
      

• POPULATION DYNAMICS THOERIES
  
  • Population Dynamics approach, which concludes that bare subsistence is all that people can ultimately expect. A theory from biology illustrates why these early forecasts were pessimistic
    

   

  • Population S-curve
    
    • Birth rates depend primarily on maternal health. Favorable events trigger population explosions because birth rates rise while death rates fall
      

• MARXIAN CAPITALISTIC CRISES
  
  • Marx condemned markets as permitting the rich and powerful to exploit workers
    
  • Marxists view business cycles as driven by increasing concentrations of wealth in the hands of capitalists
    

• LONG WAVES AND INNOVATION
  
  • Joseph Schumpeter proposed a long-wave theory of business cycles in which development is fueled when entrepreneurs initiate such innovations as
    
    • Discoveries of raw materials
      
    • New goods or new quality in familiar products
      
    • Technological advances
      
    • The opening of new markets
      
    • Major reorganizations of industries
      
  • Major innovations generates Spinoffs, which are related inventions, mimicries of an original innovation, or the births of new industries
    
  • Economic growth peaks by the time society fully adapts to a major innovations; saturated markets cannot absorb further supply increases or emulation of the new technology
    
  • The next long-wave process is sparked by a new wave of innovation and minor innovations might explain shorter cycles
    
  • Institutional features in a society as essential for innovation and economic vitality identified by Schumpeter
    
    • Entrepreneurs must have broad discretion about how to operate
      
    • Well-developed financial markets must channel credit to entrepreneurs, allowing investment in new capital and R&D even before they actually contribute anything to national income
      

• PYSCHOLOGICAL THOERIES
  
  • Psychological theories of cycles focus on how human herd instincts make prolonged optimism or pessimism contagious
    

• CLASSICAL MACROECONOMIC THEORY
  
  • Most modern economists now focus on two general theories that compete in explaining broad cyclic activity
    
    • Classical theory
      
      • Classical Macroeconomic Theory stress coping with scarcity from the supply side as the key to macroeconomic vitality and supports
        
        • Market solutions to problems and
          
        • Laissez-fairs (minimal) government policies
          
      • Classical economics relies heavily on the self-correcting power of automatic market adjustments (Smith’s “invisible hand”) to cure macroeconomic instability including excessive unemployment
        
      • Economists inspired by classical reasoning would rely primarily on market forces, with changes in government policies being used only as a last resort to cure an economy in tumult
        
    • Keynesian theory
      
      • Keynesian Theory views inadequate demand as the cause of cyclic downturns and recommends actively adjusting government policies to combat instability
        
      • Economists who follow in the footsteps of Keynes tend to advocate activist government policies, with reliance on market forces
        

3. AGGREGATE DEMAND AND AGGREGATE SUPPLY

• Demand and supply analysis describes not only movements in the prices and quantities of individual goods, but also trends in such broad macroeconomic aggregates as national income and the price level
  
• Aggregate Demand and Aggregate Supply curves are useful in tracing business cycles and describing the broad effects of change in macroeconomic policies
  

   

4. AGGREGATE DEMAND CURVES

• Aggregate Demand for national output is underpinned by the purchases of four groups of ultimate buyers
  
  • Consumers
    
  • Investors
    
  • Government
    
  • Foreigners
    
• Their spending plans are interdependent, and are combined in an Aggregate Demand curve
  
  • The amount of national output each group buys depends, in part, one the price level
    
• An Aggregate Demand Curve depicts a negative relationship between the price level and purchases of national output
  
• The Aggregate Demand curve is negatively sloped because
  
  • The Wealth Effect
    
    • Higher average prices reduce the amount of domestic production sold along an Aggregate Demand curve
      
  • The Foreign-Sector Substitute Effect
    
    • Higher US prices cause domestic consumers to buy more imports and fewer US goods
      
    • A higher price level shrinks investment in US because both foreign and US firms would find it relatively more profitable to invest abroad
      
    • Trends toward imports and foreign investments reinforce the wealth effect in making Aggregate Demand curves negatively sloped
      
  • The Interest Rate Effect
    
    • The amount of borrowing required to finance a major purchase rises if the price level rises
      
    • A higher price level increases the demand for loanable funds and, consequently, increases the interest rate, which is the cost of credit
      

   

5. SHIFTS OF AGGREGATE DEMAND CURVES

• Changes in national income and the price level reflect movements along the Aggregate Demand curve; they do not cause it to shift
  
• Aggregate Demand curve shift when planned spending changes for consumption (C), investment (I), government (G), or net export to foreigners (X-M, or exports minus imports)
  

   

• CONSUMER SPENDING (C)
  
  • Consumer living standards and buying habits helps shape consumption spending, which represents about 2/3 of Aggregate Demand
    
  • Planned Consumed is also influenced by
    
    • Disposable income
      
      • Disposable income is the amount available to spend after subtracting federal and state taxes and then adding any transfer payment
        
        • Transfer payments : such as income received, but not earned, as unemployment compensation or Social Security
          
      • On balance, these adjustments shrink aggregate disposable income to less than national income
        
      • Keynesian theory emphasizes disposable income as the driving force behind consumer spending
        
      • Changing relationship between national income and disposable income alter consumers’ spending plans and shift Aggregate Demand
        
    • Wealth or expected income
      
      • Expected higher income after graduation makes the accountant over philosophy the more probable buyer
        
      • Wealthy people or those who expect higher incomes typically spend more than poorer people with identical current incomes
        
      • When expectations change, the Aggregate Demand curve shifts
        
    • Average size and ages of households
      
      • Societies full of young or large families consume proportionally more from a given current income than societies composed of older or smaller families
        
    • Stocks of consumer goods on hand and household balance sheets
      
      • Shrinking debt stimulated consumption
        
    • Consumer expectations about future price, incomes, and availability of goods
      
      • Consumer debt usually climbs when buyers stockpile goods to guard against inflations, but shaky confidence may reduce use of credit
        

• INVESTMENT (I)
  
  • Economic investment enhances future consumption
    
  • Three basic investment categories
    
    • New building and all other construction
      
    • New equipments
      
    • Inventory accumulation
      
  • All investment is cyclically sensitive, but inventories are especially volatile
    
    • Unexpected inventory changes signal firms to adjust their hiring of resources and their orders to suppliers
      
  • Planned investment spending depends powerfully on expected rates of returns
    
    • A Rate of Return is the annual percentage earned from an investment after all costs are considered
      
    • Rates of return, the level of investment, and Aggregate Demand are positively related to the net revenue expected from investment across time
      
      • Investors prefer more income to less and lower costs to higher while current income to delayed income and try to postpone cost whenever possible
        
    • Another major influence on rates of return and investment is risk
      
    • Investment is stimulated when technological advances are innovated. Innovations yielding high rates of return tend to arrive erratically and in waves
      
  • Costs of investment
    
    • Expected returns rise when capital prices fall and shrink when construction or machinery costs rise
      
    • Interest is the major cost of investment
      
      • Investors’ opportunity costs rise when interest rates rise
        
    • Taxes on investment income are another consideration
      

• GOVERNMENT (G)
  
  • Expectation about government policies also affect investment and government affects Aggregate Demand most directly through its spending and its tax policies
    
  • Government purchases
    
    • Government purchases both consumption and investment types and they directly increase Aggregate Demand
      
    • Some government outlays, however, do not entail direct spending such as cash transfer payments in terms of SS or unemployment compensations
      
  • Tax rate
    
    • Higher tax rates generally decrease Aggregate Demand
      
  • Money
    
    • When people have more money they tend to spend it
      
    • A larger money supply, all else being equal, allows a greater supply of loanable funds, so interest rates will be lower
      
    • Lower interest rates stimulate borrowing and spending by both consumers and investors
      

• THE FOREIGN SECTOR (X-M)
  
  • Exports (X)
    
    • Exports reflect foreign demands for US goods. Thus, they increase Aggregate Demand
      
  • Import (M)
    
    • Import augment Aggregate Supply but may reduce Aggregate Demand for domestic production because imports sometimes replace purchases of domestic output
      
    • National income influences US imports
      
    • US exports depend primarily on economic conditions abroad
      
    • Net Export (X-M) are usually only a negligible percentage of Aggregate Spending (10% of national income of US)
      

6. AGGREGATE SUPPLY

• The Aggregate Supply Curve reflects a positive relationship between the price level and the real quantity of national output
  
  • The positive slopes of Aggregate Supply curves mirror those of market supplies
    

• SLOPES OF THE AGGREGATE SUPPLY CURVE
  
  • The general law of diminishing returns partially accounts for the upward slope of supply curves for individual firms and for market supply curves
    
    • Additional production eventually becomes ever more costly as output levels grow
      
    • Then, firms may require higher prices to justify expanding their output
      
    • Moreover, higher prices embody greater incentives for firms to produce more output because profit opportunities are enhanced
      
    • A similar logic applies for the economy as a whole
      
  • Capacity and Price-Cost Dynamics
    
    • Prices adjust more rapidly than production costs; costs are relative more “sticky.” When the price level rises, delayed hikes in costs yield profit incentives to expand production
      
      • The prices a firm can charge in a growing economy tend to rise faster than its resource costs
        
      • However, prices tend to fall faster than costs when business activity slows down
        
    • Production costs per unit are much slower to adjust to changes in Aggregate Demand than are the prices of output. This is the major reason why a society’s Aggregate Supply is positively sloped in the short run
      
  • National Output and the Work Force
    
    • As the economy approaches its capacity, additional output becomes increasingly costly, pushing prices up sharply
      
    • Rising employment and output levels generate pressure for hikes in wages and prices, while falling employment and output create pressure for wage and price cuts
      

• SHIFTS IN AGGREGATE SUPPLY
  
  • Aggregate Supply is determined by how technology is used to combine the available quantities and qualities of labor, land, capital, and entrepreneurship, ultimately determining productive capacity and costs
    
  • Major determinants in addition to prices are
    
    • Resources costs
      
      • As resource cost climb, Aggregate Supply falls and vice versa
        
      • Labor supplies depend on how individuals balance income from work against their enjoyment of leisure
        
      • Higher wages due to power of unions and organized labor
        
      • Rightward shifts occur when new resources are discovered and push prices down
        
      • Some costs may rise artificially if economic power becomes more concentrated
        
      • Aggregate Supply grows if competition intensifies because
        
        • External firms’ quests for share of monopolists’ profits
          
        • Vigorous antitrust actions
          
        • The invasion of a market by imports
          
    • Production technology
      
      • Technological advances shift Aggregate Supply curves rightward
        
    • Expectations
      
      • Changing expectations about inflation or future prosperity acutely affect Aggregate Supply
        
    • Taxes or subsidies or regulations on producers
      
      • Work versus leisure choices are influenced by taxes and social welfare policies
        
      • Higher taxes make earning additional income worth less
        
      • Abolishing burdensome regulations shifts Aggregate Supply rightward
        
      • Efficient regulations expand Aggregate Supply
        
      • Government may also enhance Aggregate Supply through
        
        • Direct funding of R&D that advance technology
          
        • Subsidies or tax incentives that stimulate private R&D
          
        • Patent or copyright protection
          
    • The prices of other producible goods
      
    • The number of producers in the market
      

7. MACROECONOMIC EQUILIBRIUM

• Aggregate Demand and Aggregate Supply meet to yield a unique short-run equilibrium for aggregate levels of prices and outputs
  
• Once explanation for recession or depression is a drop in Aggregate Demand
  
• Real growth accompanies by mild inflation conform to expansion of Aggregate Demand relative to Aggregate Supply
  
• Changes in Aggregate Supply can lead to growth or stagflation
  
  • If Aggregate Supply shrinks, rising price accompany declines in output and more unemployment, a condition known as Stagflation
    

   

8. THE AMERICAN BUSINESS CYCLE

• THE PROSPEROUS 1920S
  
  • Prosperity was sparked by
    
    • Rapid growth of technology, labor productivity, and productive capacity
      
    • The popularity of such new and important goods as telephone, radio, and auto
      
    • The electrification of homes and industries
      
    • A wave of optimism lasting until 1929
      

• THE GREAT DEPRESSION OF THE 1930S
  
  • Real disposable income fell more than 26% between 1929 and 1933, while unemployment rates mounted from 3.2% to nearly 25%
    
  • The 6% to 8% annual drop in average prices between 1929 and 1933 but did not help the unemployed
    
  • Recessions and depressions are almost uniformly periods when Aggregate Demand has plummeted
    

• WARE AND ITS AFTERMATH IN THE 1940S
  
  • Massive defense spending during WW II snapped the economy out of the depression in the early 1040s
    

• THE SLUGGISH 1950S
  
  • John F. Kennedy was the first major US politician to propose tax cuts to stimulate Aggregate Demand when the economy was not in deep depression
    

• THE BOOMING 1960S
  
  • The general law of diminishing returns partially accounts for the upward slope of
    

• STAGFLATION IN THE 1970S
  
  • Declines in Aggregate Supply relative to Aggregate Demand may account for economic stagnation
    

• THE ERRATIC 1980S
  
  • The US national debt, which had tripled in the 1970s, tripled again between 1980 and 1990
    
  • The international competitiveness of the US economy became a paramount issue when goods from Pacific Rim countries and the European Community began flooding world markets, dislodging US products from markets they had once dominated
    

• MUDDLING THROUGH IN THE 1990S
  
  • Hugh deficits in the federal budget and the US balances of trade and payments persisted into the mid-1990s
    
  • In US, movements were launched to reinvent government and to reform the health-care system, which had grown from about 5% of national income in the 1950s to absorb roughly 14% of income by 1994
    

CHAPTER 6. EMPLOYEMENT AND UNEMPLOYEMENT

1. LABOR MARKETS IN THE TWENTY-FIRST CENTURY

• CHANGES IN THE SUPPLY OF LABOR
  
  • The Labor Force (LF) consists of all employed (E) or unemployed (U) civilians over age 16 plus members of the Armed Forced stationed in the US
    
    • LF = E + U
      
  • A Labor Force Participation Rate (LFPR) is the proportion in the labor force from a specific group. For the total labor force,
    
    • The LFPR = LF / Population of the specific group
      
  • The Employment to Population Ratio is the total employment (E) relative to that population (Pop) or E / Pop
    
  • The Unemployment Rate is the number unemployed as a percentage of the labor force or U / LF
    
  • The labor-force participation rates have been grown by
    
    • Women
      
    • Immigration
      
  • Two demographic trends have profound affected labor supplies
    
    • The growth in the number of two-income households
      
    • The number of households headed by women
      

• CHANGES IN THE DEMAND FOR LABOR
  
  • Broad changes to the supply side of our national labor market have been matched by dramatic changes in demands for labor.
    
    • The demand for labor ultimately derives from consumer demands for goods and depend on workers’ productivity
      
  • Ongoing changes in product markets profoundly affect labor productivity
    
    • Globalization has intensified competition in many industries
      
      • The drive for cost-efficiency means that skilled labor commands premium wages
        
      • Less-skilled Americans increasingly must compete with lower-cost foreign labor
        
      • International trade tends to equalize the wages of domestic workers with those of comparably skilled foreign workers
        
        • Free international trade erodes the incomes of less-skilled Americans while boosting wages for low-skilled foreign workers
          
        • Skilled Americans gain by producing for foreign markets and by buying imported goods at lower prices
          
      • Competing successfully in the global economy requires flexibility
        
    • For several decades US employment has been shifting from commodity production to the provision of services
      
    • Government policies about labor markets have altered employer-employee relationships
      
      • Increased cost of hiring, retaining, firing, and laying off workers
        
      • Growing numbers of workers are lumped together as the contingency work force
        
        • The Contingency Work Force consists of part-time and temporary employee plus business service providers plus the self-employed
          

2. THE CONCEPT OF UNEMPLOYMENT

• CHANGES IN THE SUPPLY OF LABOR
  
  • Conceptually, Unemployment occurs when people are able to work and would willingly accept the prevailing wage paid to someone with their skills, but either cannot find or have not yet secured suitable employment
    
  • Although markets for most good remedy surpluses rapidly through price cuts, similar remedies do not seem to work as quickly in labor markets when there are gluts of workers
    
    • Wages are seldom perfectly flexible; they tend to be downwardly sticky, which prolongs unemployment
      

• VOLUNTARY VS. INVOLUNTARY UNEMPLOYMENT
  
  • Voluntary Unemployment occurs when people could find work quickly, but choose to search for what they view as better jobs in terms of pay or working conditions
    
  • Involuntary Employment occurs when people lack jobs, but they are willing , able, and even eager to work at wages commensurate with their skills
    

• STICKY WAGES
  
  • Sticky Wages and Prices occurs when wages or prices fail to instantaneously adjust to clear a market at the point where the quantities demanded and supplied are equal
    
  • Barriers to wage cut
    
    • Psychological aversion to accept wage cut
      
    • Minimum wage laws
      
    • Individual workers cannot negotiate their own wages with unionized employers
      
    • Seniority rule
      
    • Employee moral
      
  • However, even if wages are sticky in the short run, they ultimately fall if business is depressed for a sufficient period
    

3. MEASURING UNEMPLOYMENT

• CHANGES IN THE SUPPLY OF LABOR
  
  • The major source of US unemployment statistics is a monthly Dept. of Labor surveys of about 60,000 households
    

   

  • Employed Persons include
    
    • Anyone who worked for pay any time during the week that included the 12^th day of the month or without pay for 15 hours or more in a family-operated firm and
      
    • Those temporarily absent from regular jobs because of illness, vacation, strike, or similar reason, Armed Forced personnel stationed in the US are also counted as employed
      
  • Unemployed Persons are those who did not work during the survey week but were available for work, except for temporary illness, and who looked for jobs within the preceding four weeks, Persons who did not look for work because they were on layoff or waiting to start new jobs within the next 30 days are also counted as unemployed
    

• LIMITATIONS OF UNEMPLOYMENT STATISTICS
  
  • Failure to include discouraged workers and the part-time unemployed in unemployment statistics biases official unemployed statistics downward
    
    • Discouraged Workers are so pessimistic about their prospects that they do not look for jobs. Although they would like to work
      
      • The discouraged worker syndrome is probably most pronounced during recession, when job openings are perceived as few and far between
        
    • All part-time employees are considered employed
      
  • Dishonest nonworkers bias unemployment data upwards
    
    • Dishonest Nonworkers claim to be available for work so they can draw unemployment benefits even though they do not intend to work
      

4. SOURCES OF UNEMPLOYMENT

• FRICTINAL UNEMPLOYMENT
  
  • Frictional Unemployment arises from transaction costs incurred in matching workers with jobs (i.e., job relocation)
    
    • Many economists refer to frictional unemployment as Search Unemployment
      
      • Search process can be viewed as investments in information
        
      • Unemployment rate naturally rise as the average duration of search increases
        
    • The existence of frictional unemployment implies that a target of zero unemployment would be neither reasonable nor desirable
      
      • Zero unemployment would freeze all workers in their current jobs, no matter how unsatisfactory
        
      • Firms would be stuck with their currents workers, no mater how bad the mismatch
        

• SEASONAL UNEMPLOYMENT
  
  • Seasonal Unemployment varies systematically over the year
    

   

• STRUCTURAL UNEMPLOYMENT
  
  • Structural Unemployment occurs when a worker’s skills fail to match the requirements of virtually any job opening
    
  • Reasons why people who are structurally unemployed usually jobless for long periods
    
    • Structural change displaces some workers
      
    • Firms may find it unprofitable to hire and train certain workers (high school dropouts or exconvicts) if expected training costs outweight benefits to the firms
      

• CYCLICAL UNEMPLOYMENT
  
  • Cyclical Unemployment coincides with downturns in business cycle
    
    • Marginal firms are especially vulnerable to recessions
      
    • Historically, cyclical unemployment bore most heavily on manufacturing and construction workers
      

• INDUCED UNEMPLOYMENT
  
  • Induced Unemployment is a consequence of government policies that create “wedges” so that wages are not at their equilibrium values
    
    • Minimum-Wage Laws
      
      • Overprice the labor of unskilled and inexperienced workers and limit job opportunities
        
    • Unemployment Compensation
      
      • Provides incentives for people who sincerely desire work to turn down some job offers in hopes that they will find the perfect position if they keep looking
        
      • Payment of unemployment compensation in the US is usually limited to 26 weeks
        
      • Higher relative rates of unemployment compensation make it easier for unemployed people to cling to unrealistic expectations and to remain out of work longer
        
      • It biases official unemployment statistics upward because cheaters who don’t truly want to work are counted as jobless
        

• ACCOUNTING FOR JOBLESSNESS
  
  • Different government programs broadly aimed at different types of unemployment
    
    • State employment offices match job applicants with vacancies to reduce transaction cost the boost frictional and seasonal unemployment
      
    • Government retraining programs are intended to provide marketable skills to the structurally unemployed, and firms that hire the hard-core unemployed receive tax subsidies
      
    • Occasional reforms to unemployment compensation systems are aimed at reducing induced unemployment
      
    • Policymakers attempt to reduce cyclical unemployment by trying to dampen the frequency, intensity, and duration of economic downturns
      

5. COSTS OF UNEMPLOYMENT

• LOSSES OF AGGREGATE INCOME
  
  • The Lost-Income Costs of unemployment consist of the value of the output the unemployed could have produced
    

• SOCIAL COSTS OF AGGREGATE INCOME
  
  • The social and psychic costs of unemployment may outweigh all the financial losses
    
    • The self-confidence of workers who view their jobs as central to their lives may be crushed by extended unemployment
      
    • Joblessness wreaks havoc with family structures
      

6. BENEFITS FROM UNEMPLOYMENT

• ALLOCATIVE BENEFITS
  
  • Frictional unemployment yields Allocative benefits by matching workers and jobs
    
    • Finding a new job tends to be easier if you are not working fulltime
      
    • Pools of idle labor allow firms to screen more potential employees than if unemployment were zero
      
  • Lower transaction costs enhance economic efficiency
    
  • Unemployment also prompts some workers to return to school or to acquire skills through on-the-job apprenticeships
    

• DISCIPLINARY BENEFITS
  
  • Some economists view possible layoffs as curbs to undue demands for wages and fringe benefits
    
  • Threats of unemployment are also powerful work incentives for people who respond better to sticks than to carrots
    
  • Due to the higher costs of unemployment in general than its benefits includes the emphasis policymakers devote to curing it
    

CHAPTER 7. INFLATION

1. THE CONCEPT OF INFLATION

• Inflation occurs when the average level of prices rises; the average price level falls during Deflation
  
  • Price increase for a single good may not be inflationary.
    

   

2. PRICE INDEX NUMBERS

• An Index is a series of numbers that summarize what has happened over time to prices (inflation or deflation), productivity, labor markets, construction, or some aggregation of other items
  
  • Index = (Value of Variable in Current Period) / (Value of Variable in Base Period) X
    

    100
    

  • Index numbers are easier ways to interpret change than trying to digest that original numbers
    
  • Most indices are seasonally adjusted to make data more comparable over time
    
• Three principal indices used to measure inflation
  
  • The Consumer Price Index (CPI)
    
  • The Producer Price Index (PPI)
    
  • The Gross Domestic Product Deflator (GDP Deflator)
    

• MEASURING CONSUMER PRICES (CPI)
  
  • The Consumer Price Index (CPI) is a statistical measures of changes across time in the prices of a basket of typical goods purchases by typical consumers
    
    • The CPI estimates purchasing power by tracking the costs of a sample market basket that consists of over 650 products and service3s
      
    • To update the CPI, each month the Bureau of Labor Statistics (BLS) samples prices of items in this representative market basket in nearly 100 different major markets
      
    • The BLS also conduct annual surveys of the prices paid and spending patterns of thousands of households in over 1,000 marketing areas to calculate weights for the CPI’s components. The components of the CPI are weighted to reflect relative importance
      
    • The base period is changed every few years because spending patterns change, which requires updating weights for various goods
      

• HOW THE CPI IS USED
  
  • CPI is used to estimate changes in the purchase power of money and as an escalator (cost-of-living adjustment) in some contracts calling for future payments
    
  • Moving from Nominal to Real Values
    
    • Nominal or Monetary Values are the dollar amounts received or paid today
      
      • Nominal values lose comparability over time unless adjusted for inflation or deflation
        
    • Real Values are nominal values adjusted for changes in the price level
      
    • Yreal = Ycurrent / (CPI / 100)
      
      • Yreal = The purchasing power of real income
        
      • Ycurrent = The purchasing power of current income
        
    • Deflation is the process of ensuring the comparability of nominal values by adjusting them for inflation
      
      • Real Value = Nominal Value in Dollars / (Price Level / 100)
        
    • The CPI may either overstate or understate the amount of inflation experienced by any given individual
      
      • Inflation is especially harmful if the prices of goods you like rise faster than inflation, but you could actually gain during inflation if prices drop for the goods you buy most
        
      • Inflation also affects people less to the extent that they easily substitute goods for which nominal prices changes at different rates
        
  • CPI as an Income or Payment Escalator
    
  • CPI as an Economic Indicator
    

• PROBLEMS WITH THE CPI
  
  • Estimating changes in consumer prices poses conceptual problems for the BLS
    
  • How can the BLS adjust the CPI to accurately reflect changes in?
    
    • Consumption patterns
      
      • Inflation tends to overstated because consumers purchase more goods whose prices rise more slowly and cut back on items where prices rise most rapidly
        
    • The availability for new products
      
      • The BLS now conducts annual Consumer Expenditure Surveys in attempts to keep pace with changing consumption patters
        
    • New qualities in older goods
      
      • The CPI overstates inflation if the BLS ignores the fact that price hikes sometime merely reflect quality improvements
        
      • Direct measures of the value of quality changes are impossible, so the BLS uses an indirect methods; it estimates the costs of quality changes
        
    • The prices of major assets such as homes, which some family bought earlier at lower prices, while others must pay higher current prices to buy now
      

• OTHER PRICE INDICES
  
  • Producer Price Index (PPI)
    
    • The Producer Price Index covers nonretail markets, averaging price changes for over 2,800 primary products and intermediate goods
      
    • Most prices summarized by PPI are the wholesale selling prices of representative producers
      
    • The prices used for imported products are the prices paid by the original importer
      
    • PPI often signals the direction consumer prices will take
      
  • The GDP Deflator
    
    • The GDP Deflator is used to deflate the nominal value of our GDP
      
      • GDP is the total market value of all goods produced in an economy in a year
        
    • The GDP deflator is largely based on other price indices
      
      • Each component of consumer spending is adjusted using appropriate data from CPI
        
      • Business spending for capital equipment or raw materials is deflated with appropriate parts of the PPI
        

3. TYPES OF INFLATION

• Inflation can be classified by how rapidly average prices rise, by whether people expect, or distinction pinpoint its causes
  
• CREEPING OR GALLOPIN INFLATION VS. HYPERINFLATION
  
  • Creeping Inflation occurs when average prices rise at fairly low rates
    
  • Galloping Inflation occurs if average prices rise at double-digit annual rates
    
  • Hyperinflation occurs when average prices rise more than 50% per month
    
    • During hyperinflation
      
      • Transaction costs skyrocket
        
      • Barter takes over and goods and resources are traded directly for other goods or resources, without money as an economic lubricant
        

       

• ANTICIPATED VS. UNEXPECTED INFLATION
  
  • Categorized by how accurately people anticipate changes in the price level
    
  • Unexpected changes in average prices do far more harm than anticipated ones
    
  • The rate of inflation may be less harmful than its volatility
    
  • Hedging is one way people try to buffer against expected losses of purchasing power
    
    • Attempt to avoid possible losses from foreseeable possibilities are Hedges
      

     

• DEMAND-SIDE INFLATION
  
  • We can use the Aggregate Demand-Aggregate Supply model to help identify different sources and types of inflation
    
    • When a given prices rises, then
      
      • Demand increased
        
      • Supply decreased
        
      • Some combination of both
        
  • Demand-Pull (Demand-Side) Inflation occurs when average prices rise because Aggregate Demand grows excessively relative to Aggregate Supply
    

• SUPPLY-SIDE INFLATION
  
  • Supply-Side Inflation results when Aggregate Supply shrinks (i.e, because of rising resource prices or technological reversal), causing the price level to rise and aggregate output to fall
    
  • Cost-Push Theory of Inflation
    
    • Rising labor costs are passed forward to consumers as pushed-up prices
      
    • Rising oil prices or increases in the prices of imported goods or raw materials pass forwarded to consumers as pushed-up prices
      

• Administered-Price Inflation
  
  • Firms with market power may be reluctant to raise prices because they fear adverse publicity, antitrust actions, or similar threats to their dominance in a market
    
  • However, they use hikes in wages or other resource costs as excuses to raise prices, generally by more than their higher costs would justify
    

   

• MIXED THEORIES OF INFLATION
  
  • Composition-Shift Inflation Theory
    
    • It is assumption that prices are rise more easily than they fall at least in the short run
      
    • As sales shrink, firms reduce output and lay off workers rather than reducing prices
      
  • Expectational Inflation
    
    • We create our own future realities by what we anticipate
      
      • Producers who expect inflation build inventories by boosting output while cutting back on current sales
        
      • Buyers expect inflation, they will try to accumulate their own inventories of durable goods
        
      • At the end inflationary expectations quickly cause price hikes because this reduces supplies (by producers) and increase demands (by consumers)
        
    • Aggregate Demand grows excessively if the money supply grows faster than real output
      

4. INFLATION’S COSTS AND BENEFITS

• REAL-INCOME COSTS OF INFLATION
  
  • Inflation increases transaction costs and reduces real income by
    
    • Making the information about market conditions summarized in monetary prices less certain
      
    • Unnecessarily shifting resources into the repricing of goods
      
  • Inflated Transaction Cost
    
    • Transaction costs increase because perceptions about prices and purchasing power turn out to be mistaken far more frequently during inflationary periods than when average prices are stable
      
    • Also because resources that could have been used productively elsewhere are used to reprice goods (Menu Costs of Inflation)
      
  • Distortion Costs
    
    • Distortion costs emerge from feelings of uncertainty among savers and investors
      
    • Inefficiencies in decision making caused by inflation are termed Distortion Costs
      
    • Funds that would normally flow into new capital may be diverted into real estate or inventories, so that growth and technological advances sputter well below the levels needed fro a healthy economy
      

• SOCIAL COSTS OF INFLATION
  
  • Inflation is roughly what mathematicians call a Zero Sum Game
    
  • Income redistributions from inflation are a major source of inflation’s social costs
    
    • Even though losses to some are offset by gains to others, the process seems capricious and erodes the trust we have in each other
      
    • The prices of physical assets such as land and housing often rise even more rapidly than the rate of inflation
      

• BENEFITS OF INFLATION
  
  • A little inflationary pressure may ease needed changes in relative prices. This is especially true if price reductions are resisted more vigorously than price increase
    
  • Inflation’s effects on capital accumulation and economic growth may also be positive at times
    
  • Inflation may ease expanding government spending relative to private spending
    

• THE DISCOMFORT INDEX
  
  • The economic Discomfort Index equals the inflation rate plus the overall unemployment rate
    
    • Index intended to summarize the general state of the economy
      

CHAPTER 8. MEASURING ECONOMICS PERFORMANCE AND GRWOTH

1. GROSS DOMESTIC PRODUCT (GDP)

• Gross Domestic Product (GDP) is the total market value of goods and services produced within a country during some period, usually one year
  
  • Incomes of all foreign individuals who work in the US and all profits from the US operations of foreign-owned corps. are included in US GDP
    
  • GDP = C + I + G + (X – M)
    
    • C     = Consumer spending
      
    • I     = Business investment
      
    • G     = Government spending
      
    • X – M = Net export
      

• GDP AS AND ECONOMIC INDICATOR
  
  • Official estimates of GDP are reported in nominal dollar amounts
    
    • Thus, these data series must be deflated (divided by [GDP deflator/100]) to make them truly comparable across time
      
      • This yields estimated of real GP that indicate the effectiveness of government policies
        
  • Forecasts of GDP help government decision-makers time corrective policies
    

• GDP AND ECONOMIC WELL-BEING
  
  • Real GDP provides a crude gauge of national well-being
    
    • Income and employment are tied to aggregate output, so individual incomes and spending tend to swing with macroeconomic activity
      
    • Dividing real GDP by population yields a rough measure of the average well-being of individuals.
      
    • Per capital real GDP indicates how well-off average Americans are now relative to earlier times or to typical people in other countries and helps us compare growth rates among countries
      

2. MEASURING GDP

• GDP is measured in two basic ways
  
  • The expenditure approach
    
  • The income approach
    

• THE EXPENDITURE APPROACH
  
  • Measuring GDP by the expenditure approach leads us to the final buyers of all US output
    

• Aggregate Expenditures are the sum of
  
  • Consumer Spending (C)
    
    • Household outlays include spending on non-durable goods, durable goods, and services
      
    • Person Consumption Expenditures are the value of all commodities and services that household and individuals buy
      
  • Business Investments (I)
    
    • Economic Investment refers to acquisition of new physical capital
      
    • Investment does not refer to flows of money or documents that we term financial investment
      
      • The purely financial transactions such as purchases of new stocks and bonds are not economic investment
        
    • Business spending for new capitals is called Gross Private Domestic Investment (GPDI)
      
    • Foreign investments by American firms not included
      
    • Investment by foreign companies in US is part of US GPDI
      
    • The major components of investment spending are
      
      • All new construction, including housing
        
      • All final purchases of new equipments
        
      • Changes in business inventories
        
        • Raw materials
          
        • WIP
          
        • Finished goods
          
  • Government Purchases (G)
    
    • The most important resource government buys is its employee’s labor
      
    • All government goods enter the GDP accounts at the prices government pays for them
      
      • For GDP accounting purposes, government is assumed to add nothing to the value of the labor and other resources it uses
        
    • Government purchases do not include transfer payments (i.e., SS payments)
      
  • Net Spending by Foreigners (X-M)
    
    • Net exports are defined by as export (X) minus imports (M)
      
      • Exports are goods manufactured domestically and bought by foreigners
        
      • Imports are goods produced in foreign countries and consumed or invested in the US
        

• THE INCOME APPROACH
  
  • All spending ultimately translates into income. Thus, national output calculated by the expenditure approach must equal National Income
    
    • National Income (NI) is computed by summing all payments to resources owners-wages, rents, interest, and profits
      
  • However, due to the limitations of accounting data cause NI to be measured as the sum of five slightly different categories
    

   

  • Wages and Salaries
    
    • The category covers both money wages and fringe benefits
      
  • Noncorporate Proprietors’ Income
    
    • Proprietors’ incomes are received by sole proprietors, partnerships, certain professional association, and unincorporated farms
      
    • However, given the limitations of accounting data, proprietors’ income is considered as “profit,” only for purpose of GDP accounting
      
  • Corporate Profits Before Taxes
    
    • Corporations use their accounting profit in three ways
      
      • Corporate income tax
        
      • Dividends paid to stockholders from after-tax income
        
      • Undistributed corporate profits for remaining profits kept in the firm as working capital or to finance either internal expansion or external acquisitions
        
  • Rental Income
    
    • Accounting rents are usually derived the leasing of real property and from renting any assets (i.e., videotapes or U-Haul trailers)
      
  • Interest
    
    • NI accounting conventions treat interest paid to holders of government bonds as a transfer payment and exclude it from the interest component of NI
      

3. RECONCILING GDP AND NI

• Two major adjustments required to reconcile GDP and NI
  
  • Subtract depreciation from GDP to compute Net Domestic Product (NDP)
    
    • Gross Private Domestic Investment (GPDI) overstates growth of the nation’s stock of capital because some capital wears out each year
      
    • Accountants refer to the decline in value of capital because of wear and tear or obsolescence as Depreciation
      
    • Subtracting depreciation from GDPI yields Net Private Domestic Investment, an estimate of annual growth in a nation’s capital
      
    • Net Domestic Product (NDP) is the net value of an economy’s annual output after adjusting for depreciation
      
  • Subtract indirect business taxes from Net Domestic Product to compute NI
    
    • The funds paid for goods and the funds firms receive are not equal due to sales and excise taxes known as Indirect Business Taxes collected
      

• THE VALUE-ADDED APPROACH
  
  • NI is calculated primarily as a double check on GDP figures
    
  • To avoid double counting sales figures, NI accounts use the value-added techniques
    
    • A firm’s Value Added is computed by subtracting from its sales revenues any purchases of intermediate goods from other firms
      

4. MOVING FROM GDP TO DISPOSALBE PERSONAL INCOME

• FROM NI TO PERSONAL INCOME (PI)
  
  • Personal Income (PI) is the money income received by households before they pay their personal taxes
    
  • PI = NI – Corp. profits with inventory adjustments – Corp. contributions for SS – Net interest + Government transfer payments + Personal interest income + Dividends + Business transfer payments
    
  • NI = GDP – Depreciation – Indirect Business Taxes
    

• FROM PI TO DISPOSALBE PERSONAL INCOME (DPI)
  
  • Disposable Personal Income (DPI) is income households can choose to consume or save after subtracting income taxes from personal income
    
  • DPI = PI – Person Income Taxes
    

5. LIMITATIONS OF GDP ACCOUNTING

• Limitations that fall into four broad categories
  
  • Inaccuracy
    
  • Incompleteness
    
  • Misclassification
    
  • Ambiguity
    

   

• INACCURACY
  
  • Underreporting of income
    
  • Most accounts are reported to the exact dollar
    

• INCOMPLETENESS: NONMARKET TRANSACTIONS
  
  • Not all productive activity is marketed
    
    • Values of homemakers’ services are not included
      
    • Cash or barter transactions not included
      

• MISCLASSIFICATION
  

• AMBIGUIRY: GOVERNMENT OUTPUT
  
  • The government seldom directly charges prices for its services to final users, so the value of government output is somewhat ambiguous
    

• AMBIGUIRY: INTERNATIONAL COMPARISONS
  
  • The Exchange Rate Approach
    
    • International exchange rates for currencies often fail to reflect the relative costs of living in different countries
      
      • An Exchange Rate is the relative price of one currency in terms of another
        
      • The Law of One Price assumes that transaction costs are zero and concludes that only one price can exist at any given moment for identical items
        
  • The Purchasing Power Parity (PPP) Approach
    
    • The Purchasing Power Parity (PPP) approach adjusts exchanges rate conversions for differences in costs of living before comparing GDPs between countries
      

• GDP AND SOCIAL WELFARE
  
  • The GDP accounting system fails to deduct for negative aspects of economic growth, particularly environmental degradation
    
  • The Measure of Economic Welfare (MEW) deducts items that do not contribute to economic welfare and adds beneficial items not new counted in GDP
    
    • Major items deducted from GDP
      
      • Spending that does not add a better life
        
        • i.e., Commuting costs and national defense
          
      • Losses associated with pollution, urban congestion
        
    • Major items added to GDP
      
      • More inclusive estimates for unmarketed output
        
        • i.e., do-it-yourself projects
          
      • The value of increased leisure
        

CHAPTER 9. CLASSICAL MACROECONOMICS AND KEYNESIAN AGGREGATE EXPENDITURE

• Classical and Keynesian theories are at the core of the major alternative approaches to modern macroeconomics.
  
  • Classical economics
    
    • Focuses on how automatic adjustments in microeconomic markets ensure macroeconomic stability in the long run, pinpointing increases to Aggregate Supply as the key to resolving problems posed by scarcity
      
    • Its conclusions tend to support laissez-faire government policies.
      
  • Keynesian economic theory
    
    • Suggests that shocks to Aggregate Demand may destabilize an economy for prolonged periods, concluding that simulative government policies are appropriate cures for excessive unemployment
      

1. CLASSICAL THEORY

• Classic Economics conclude that, without government interventions, Aggregate Supplies and Aggregate Demands adjust naturally to offset pressures for long-term unemployment or substantial economic inefficiency
  
  • Classical macroeconomics predicts that any negative effects of business cycles will be overcome by market forces automatically
    
  • Classical economics suggests that a market economy with flexible prices, wages, and interest rates automatically moves toward full employment and economic health
    

   

• SAY’S LAW
  
  • Say’s Law asserts that “Supply creates its own demand.”
    
  • Say acknowledged the possibility of sporadic gluts of some goods but, reasoning that surpluses in any market must be offset by shortages in others, concluded that economy-wide gluts for most goods cannot occur. Surpluses or shortages in specific markets are remedied because surpluses drive down prices and production in the long run, while both rise to cure shortages.
    
  • The Challenge of Underconsumption
    
    • Critics of Say’s Law point out that people seldom spend all they earn, so saving might result in inadequate Aggregate Demand
      
      • The classical rebuttal is that, in a pure market economy, all consumer saving is invested by business
        
    • Early classical reasoning asserted that people save only to facilitate higher future consumption
      
      • The rate of saving is positively related to the interest rate
        
        • Lower interest rates stimulate more rapid investment
          
      • Saving is positively related to interest rates while investment is negatively related to interest rates
        

• FLEXIBLE WAGES, PRICES, AND INTEREST RATES
  
  • Flexible Interest Rates tend to equalize the amounts of saving and investment
    
  • Classical economists went a step farther, arguing that flexible wages and prices ensure full employment even if interest rate adjustments in capital markets fail to do so
    
    • If saving exceeds investment, then Aggregate Supply exceeds Aggregate Demand.
      
    • If people are saving more, they are thus consuming less, and this deficiency of demand presses prices down when unwanted inventories accumulate, resulting in layoffs and creating temporary surpluses in labor markets.
      
    • As wages and prices fall, the quantities of goods and labor demanded will rise, restoring the economy to full employment
      
    • On the other hand, any excess of Aggregate Demand over Aggregate Supply would cause the thermostat of price adjustments to generate wage hikes and price increases
      
  • Classical economists use intuition and logic to conclude that involuntary unemployment is impossible and joblessness is not a social problem; it is an individual choice
    
  • Classical Theory and The Price Level
    
    • Say’s Law, coupled with flexible interest rates, prices, and wages would, according to classical theory, keep workers fully employed. Essentially, classical reasoning views that Aggregate Supply curves as vertical at full employment
      
    • Classical economics depends on Say’s Law and flexible interest rates, prices, and wages to ensure full employment
      
    • Classical analysis teaches that the price level is directly related to Aggregate Demand, which in turn depends strictly on the money supply.
      
    • Thus, classical reasoning supports a stable money supply as the key to price-level stability, precluding significant inflation or deflation.
      

• THE GREAT DEPRESSION: CLASSICAL THEORY AT BAY
  
  • Classical macroeconomics stressed the stability of a market system and had as its central goals
    
    • Expansion of Aggregate Supply-our productive capacity
      
    • Limiting growth of Aggregate Demand to muzzle inflation
      
  • According to Say’s Law, supply creates its won demand, so classical theory predicts that rampant unemployment will be rare, and certainly cannot persist
    
  • The paradox for classical theory presented by the Great Depression set the stage for development of a theory to explain involuntary unemployment
    
  • Keynesian theory concludes that “demand creates its own supply.”
    
    • The Keynesian focus yields a mode of depression
      
    • Keynesian analysis indicates that high unemployment may plague a market economy in a short-run equilibrium that may persist for so long that the long run becomes almost irrelevant
      
    • The widespread acceptance of Keynes’s model in more prosperous times stems from its appealing policy prescriptions to remedy a depression: lower taxes and increased government spending
      

     

2. THE KEYNESIAN FOCUS ON AGGREGATE DEMAND

• Keynes’s major concern was ensuring that Aggregate Demand is adequate for full employment of all resources
  
  • Keynes’s perception that Aggregate Supply is effectively horizontal in a depression let him focus on Aggregate Expenditures while ignoring changes in the price level
    

• KEYNESIAN AGGREGATE EXPENDITURES
  
  • Aggregate Expenditures (AE) or Aggregate Spending is the total value of annual spending on domestic production. An Aggregate Expenditure Curve is the relationship between total spending and national income
    
  • Components of Aggregate Spending
    
    • AE = C + I + G + (X-M)
      
      • C     : Spending for consumer goods
        
      • I     : Capital investment by private firms
        
      • G     : Government spending
        
      • X-M: Net exports
        
        • X: Export
          
        • M: Import
          

3. CONSUMPTION AND SAVING

• The most important factor determining total consumer spending is household’s current income
  
• Consumption and Saving Schedules
  
  • Saving is unconsumed income, or the change in total wealth over some period
    
  • Wealth is the stock of saving accumulated during past saving periods
    
  • Dissaving occurs when people spend more on consumption than their income. It is financed by borrowing, or by spending past savings
    

   

• AUTONOMOUS AND INDUCED CONSUMPTION AND SAVING
  
  • Autonomous Consumption (C_a) is consumer spending unrelated to income
    
    • People must consume something to live even if they have zero income
      
    • Autonomous consumption accounts for most of consumption behavior only at very low levels of disposable income
      
  • Induced Consumption occurs only because people have income to spend
    
    • The bulk of consumption in a prosperous economy is induced
      

• MARGINAL PROPENSITIES TO CONSUME AND SAVE
  
  • The Marginal Propensity to Consume (mpc) is the relative change in consumption induced by a small change in disposable income
    
    • mpc = Change in planned consumption (∆C) / Change in disposable income (∆Y_d)
      
  • The Marginal Propensity to Save (mps) is the relative change in saving induced by a small change in disposable income
    
    • mps = Change in planned saving (∆S) / Change in disposable income (∆Y_d)
      
    • mps = 1- mpc
      

   

• OTHER DETERMINANTS OF CONSUMPTION
  
  • Five other types of variables that largely determine autonomous consumption
    
    • Wealth and expectations about future income
      
    • Customary standards of living
      
    • Household sizes and age structures
      
    • Household balance sheets and stocks of consumer goods
      
    • Consumer expectations about the prices and availability of products
      
  • Consumption spending accounts for about two-thirds of Aggregate Expenditures.
    

4. INVESTMENT

• Investment is relatively the least stable. According to Keynesian theory, the volatility of investment may be the root cause of most business cycles
  

• TYPES OF INVE
  
  • Economic investment can be classified into three basic groups
    
    • New construction
      
    • New machinery and equipment
      
    • Inventory accumulation
      

• EXPECTED RETURNS FROM INVESTMENTS
  
  • The Rate of Return is the annual percentage of earnings from an investment after all opportunity costs or, more analytically, the annual percentage by which assets will grow if the profits from an investment are continually reinvested
    
  • Factors that influence expected returns from investment before delving into some intricacies of the costs of investment
    
    • Expectations About the Business Environment
      
      • Confidence about future demand is necessary before firms make investments to produce more output
        
      • Expected changes in government policies may either encourage or squelch investment
        
    • Technological Innovations
      
    • Stocks of Capital Relative to Total Productions (GDP)
      
      • Strong investment incentives emerge when near-peak business activity presses against capital capacity
        
      • On the other hand, purchases of new capital fall when economic activity slips, idling substantial amounts of capital
        

       

       

5. THE EQUILIBRIUM RATE OF INVESTMENT

• DIMINISHING RETURNS TO INVESTMENT
  
  • Investment, like other economic activities, is subject to the law of diminishing returns
    
  • For a given mood among investors, the greater the level of economic investment, the lower the expected rate of return on additional investment. Typical rates of return are negatively related to the level of investment in part because the most profitable investments are the first undertaken.
    

• COSTS OF INVESTMENT
  
  • Investment decisions depend in part, on costs for new capital
    
  • Taxes and Subsidies
    
    • Taxes on investment income are another cost consideration.
      
      • Higher corp. income taxes lower the rate of return curve.
        
      • Investment tax credits or government funding of research and development may boost demands for investment
        
  • Interest Rates
    
    • When interest rates rise, investors’ opportunity costs rise
      
    • Interest rates (i) and rates of return (r) are both expressed as annual percentages
      
      • Changes in interest rates involve movements along rate of return curves, while other types of changes shift these curves
        
      • Investment occurs as long as the expected rate of return is at least as great as the interest rate
        
    • The expected rate of return schedule rises (shifts to the right) when GDP grows and investors become optimistic or when capital prices decline.
      
      • Investor pessimism or higher capital prices shrink expected rates of return and investment.
        
      • Interest rate changes induce movements along a rate of return curve: for a given expected rate of return, higher interest rates discourage investment, but falling interest rates foster investment and economic growth
        
    • The real world volatility of investment is probably attributable to changes both in expectations and in interest rates
      

• INVESTMENT AND AGGREGATE EXPENDITURES
  
  • Investment is affected by the level of National Income because the state of the economy significantly shapes investors’ expectation.
    
  • Business profits are bolstered by economic growth, which gives corp. greater opportunities to retain earnings for investment purposes
    
  • Autonomous Investment (I_a) is investment that is assumed independent of income in simple Keynesian models
    
    • Optimism joined with low interest rates creates high levels of autonomous investment
      
    • Pessimism or high interest rates cause autonomous investment to be very low.
      
  • Keynesians believe that during severe economic downturns pessimism may so overwhelm even very low interest rates that investment will be trivial
    

6. GOVERNMENT PURCHASES

• Autonomous Government Purchases (G_a) are government purchases of goods and resources assumed to be independent of income in simple Keynesian models
  

7. THE FOREIGN SECTOR

• The Keynesian convention is to look only at the net effect of the foreign sector on Aggregate Expenditures, so AE = C + I + G + (X – M)
  
• The net effect of international trade on US Aggregate Expenditure is relatively small
  
• Autonomous Net Export (X_a – M_a) are the difference between exports and imports that are treated as independent of income in simple Keynesian models
  
• International trade augments both the purchasing power of National Income and the value of US domestic output through
  
  • Specialization according to comparative advantage
    
  • Dissemination of new technology
    
  • Competition to
    
    • Improve quality
      
    • Reduce prices
      
    • Cut production costs
      
  • Provision of certain goods that otherwise might not be available
    

8. AGGREGATE EXPENDITURES

• The Keynesian convention is to look only at the net effect of the foreign sector on Aggregate Expenditures, so AE = C + I + G + (X – M) = C_a + (mpc x Y) +I_a + G_a + (X_a – M_aP)
  
  • mpc x Y = Induced Spending
    
  • Y = Income
    
• Most modern economists now recognize that
  
  • The overall health of any economy depends on both Aggregate Supplier (the classical perspective) and Aggregate Demand (the Keynesian emphasis)
    
  • Macroeconomic adjustments entail both changes in wages and price (classical) and quantity adjustments (Keynesian) whereby output and employment vary
    
  • Consumption and saving are influenced by both interest rates (classical) and income (Keynesian)
    
  • The structure of incentives embedded in relative wages and prices affects macroeconomic performance (classical theory and modern Keynesian structural macroeconomics)
    

CHAPTER 10. MACROECONOMIC EQUILIBRIUM

1. AGGREGATE EXPENDITURES AND EQUILIBRIUM

• Employment rises if National Income grows
  
• Aggregate Expenditures and National Output interact to yield a macroequilibrium
  

• NATIONAL OUTPUT
  
  • Consider the National Output schedule as reflecting a Keynesian Aggregate Supply curve because firms willingly produce whatever is demanded
    
    • “Demand creates its own supply” in Keynesian analysis
      

• AGGREGATE EXPEDITURES
  
  • Basic Keynesian models of closed, private economies simplify analysis by ignoring government and the foreign sector, so Aggregate Expenditures is the sum of only planned consumptions and planned investment
    

• KEYNESIAN EQUILIBRIUM
  
  • Keynesian Equilibrium is achieved when Aggregate Output and Income precisely equals planned Aggregate Expenditures
    
  • Disequilibrium
    occurs whenever plans for Aggregate Expenditures differ from Aggregate Output and Income
    
  • What happens if National Output exceeds planned AE?
    
    • Inventories of unsold goods increase
      
    • Cutting back production and employee layoffs by firms
      
    • Output drops
      
  • What happens if planned AE exceeds National Output?
    
    • Inventories of goods reduce
      
    • Expanding employment and output by firms
      
    • Income increases
      

     

• PRICE VS. QUALITY ADJUSTMENTS
  
  • Price rises in individual markets if quantity demanded exceeds quantity supplied; if quantity supplied exceeds quantity demanded, price falls
    
  • Why price adjustments are absent in Keynesian depression models?
    
    • The reason is that Keynesians assume that quantity adjustments predominate in situations of excess capacity and high unemployment; the Aggregate Supply curve is treated as horizontal
      
  • The classical Aggregate Supply curve is vertical, and the classical model relies on price-level adjustments to buffer against shocks to Aggregate Demand
    

2. A KEYNESIAN SAVING = INVESTMENT EQUILIBIRUM

• Actual and planned saving and investment are all equals (S = I) in a Macroequilibrium in a private economy without government or foreign trade
  
• Households’ saving plans and firms’ investment plans must both be realized for equilibrium to occur, regardless of whether the model used to Keynesian or classical
  

• PLANNED SAVING AND INVESTMENT
  
  • Withdrawals occur when income is not spent on domestic output
    
    • In addition to saving, withdrawals include taxes and imports
      
  • Autonomous spending (regardless of source) represents an Injection into the Keynesian spending stream.
    
  • Excess saving causes unwanted inventories to pile up; output exceeds sales because withdrawals create excess supplies of most goods
    

• BALANCING PLANNED AND ACTUAL SAVING AND INVESTMENT
  
  • When households’ plans to save and firms’ plans to invest are both realized, sales precisely sustain equilibrium output with no net pressure for growth or stagnation
    

3. THE MULTIPLIER EFFECT

• The Multiplier Effect occurs when one person’s spending becomes someone else’s income, and some of the second person’s income is subsequently spent, becoming the income of a third person, and so on.
  
• The Autonomous Spending Multiplier is the total change in income generated, divided by the change in autonomous spending that triggered the spending -> income -> spending sequence
  
  • When investment is the source of new autonomous spending, this autonomous spending multiplier equals the ratio ∆Y / ∆I = 1 / mps = 1 / (1 – mpc)
    
  • The multiplier is the reciprocal of the mps
    
• Real-World Multipliers
  
  • The historical mps is about 7%, suggesting a multiplier of between 14 and 15
    
  • The linkages between spending rounds are much looser in the real world than in this model
    
  • The full multiplier effect is felt only after all spending rounds have been completed
    
    • Realistically, only the first few rounds of spending occur in the same year as any new injection
      
    • Statistical estimates of the value of the autonomous spending multiplier place its maximum real value at around 2, even during the Great Depression
      

• THE PARADOX OF THRIFT
  
  • Keynesian theory suggests that attempts to save more may cause income to fall so much that actual saving shrinks, a problem known as the Paradox of Thrift
    
  • The paradox of thrift suggests that increased desired to save may shrink actual saving and investment, with income and consumption also falling, leaving people with lower standards of living
    
• THE INVESTMENT ACCELERATOR
  
  • An Investment Accelerator exerts pressure for accelerated income growth when rising consumption and income stimulate new capital investment
    
  • Aggregate Expenditure is both multiplied by induced consumption and accelerated by induced investment. Thus, a change in autonomous spending may increase income by even more than the multiplier effect along
    

4. EQUILIBRIUM BELOW POTENTIAL GDP

• POTENTIAL GDP
  
  • Potential GDP (Full-Employment GDP) is an estimate of what the economy could produce at high rates of utilization of our available resources, especially full employment of labor
    
    • Potential GDP is not an absolute limit on productive capacity in the same way a production possibilities frontier is
      
    • For example, potential GDP might be exceeded through slavery, or if people who would normally choose not to work took temporary jobs to support a national defense effort.
      
    • Ideally, potential GDP reflects only activities that are informed and voluntary
      

• THE GDP GAP
  
  • The GDP Gap is the difference between potential and actual GDP
    

• THE RECESSIONARY GAP
  
  • The Recessionary Gap measures the amount by which autonomous spending falls short of that needed to bring equilibrium income to full employment
    
  • The recessionary gap is defined by any shortfall in autonomous spending, not by the amount by which equilibrium income falls short of full-employment income
    
  • GDP Gap = Recessionary Gap x Multiplier
    
    • Any shortfall in equilibrium income is a GDP gap and equals the recessionary gap times the autonomous spending multiplier
      

• THE INFLATIONARY GAP
  
  • An Inflationary Gap is the amount by which autonomous spending exceeds that needed to achieve full-employment equilibrium
    

5. AGGREGATE DEMAND AND AGGREGATE EXPENDITURES

• Positive relationships between Aggregate Expenditure curve (AE) and Aggregate Demand curve (AD)
  

• PRICE LEVELS AND AGGREGATE EXPEDITURES
  
  • When the price level changes, the amount of domestic output demanded changes, but the Aggregate Demand curve itself does not shift
    
  • How do changes in the price level affect Keynesian Aggregate Expenditure curves?
    
    • Price Levels and Autonomous Spending
      
    • Deriving Aggregate Demand from Aggregate Expenditure Curves
      

• SHIFTS IN AGGREGATE DEMAND CURVES
  
  • Changes in the price level will shift the Aggregate Expenditure curve, but spending can change for other reasons, including changes in consumer confidence or in the business climate
    
  • If the price level is stable, changes in autonomous spending shift the Aggregate Demand curve horizontally by the amount of autonomous spending times the multiplier
    

• PRICE LEVELS AND AGGREGATE EXPEDITURES
  
  • When the price level changes, the amount of domestic output demanded changes, but the Aggregate Demand curve itself does not shift
    

CHAPTER 11. FISCAL POLICY

• Keynesians traditionally viewed fiscal policy as a tool to fine-tune Aggregate Expenditures and protect people from turbulent swings in their well-being
  
• Fiscal Policy entails the use of government spending and tax policies to stimulate or contract macroeconomic activity
  
• One offshoot of new classical macroeconomics, Supply-Side Economics
  
  • Supply-siders argued that high tax rates discourage productive effort so much that reducing tax rates would increase Aggregate Supply, National Income, and tax revenue
    

1. FISCAL POLICY: THE DEMAND SIDE

• The federal government operates a Balanced Budget when its tax revenues equal its outlays of funds, a Budget Deficit when its outlays exceed revenues, and a Budget Surplus if tax revenues exceed outlays
  
• Changes in taxes and government outlays fall into two categories: discretionary and automatic
  
  • Discretionary Fiscal Policy involves deliberate legislative changes in government outlays or taxes to adjust Aggregate Demand and stabilize the economy
    

• DISCRETIONARY SPENDING AND EQUILIBRIUM
  
  • The effect of government purchases can be described in a manner parallel to the planned saving = planned investment approach
    
  • Saving and taxes are both withdrawals, while investment and government purchases are both injection. Planned injections must equal planned withdrawal at equilibrium
    

• TAXES AND EQUILIBRIUM
  
  • The Autonomous Tax Multiplier ins the proportional change in income causes by a given change in autonomous taxes and is written as ∆Y / ∆T_a
    
    • Taxes, like saving, are withdrawals that pull down spending and income. Thus, the autonomous tax multiplier is a negative number
      
  • Consumer decisions about spending depend on disposable income (Y_d) instead of Aggregate Income (Y) because households along ultimately bear all tax burdens
    
  • The Tax Multiplier
    
    • One minus the autonomous spending multiplier equals the tax multiplier
      
      • 1 – (1 / mps) = ∆Y / ∆T_a
        
    • The tax hike may be viewed by taxpayers as a cut in disposable income National Income is not affected initially. Only after the drop in disposable income lowers consumer spending would output be reduced if all else were constant. Thus, government purchases affect Aggregate Expenditure but new taxes do not
      

• The Balanced-Budget Multiplier
  
  • The Balanced-Budget Multiplier indicates that identical increases in autonomous spending and in autonomous taxes will yield an identical increase in equilibrium income, so it always equals 1
    
  • Equal increases (or decreases) in government spending and taxes will raise (or lower) equilibrium National Income by an identical amount
    
  • Keynesians traditionally prescribe to cure specific economic ills
    
    • Inflationary pressures can be relieved through tax hikes, cuts in government outlays, or a mix of both
      
    • Tax increases or cuts in government spending drive federal budgets toward surplus or reduce deficits
      
    • If excessive unemployment is the major problem, then tax cuts or increased government outlays temporarily move the budget into a deficit (or reduce a surplus) and expand output, employment, and income
      

2. AUTOMATIC STABILIZERS

• Keynesians view budget deficits as the right medicine to cure a recession and surpluses as remedies for inflation.
  
  • Most politicians enjoy granting the tax cuts and new spending projects Keynesians prescribe for recession
    
  • However, raising taxes and slashing budgets to fight inflation are poison for incumbents when reelection time rolls around
    
  • New laws to create surpluses during business expansions that might erupt into inflation are not always necessary
    
  • Certain features of our tax system and some government spending programs automatically push budgets toward surpluses during booms of the business cycle and into deficit during cyclical downturns.
    
  • Automatic Stabilizers are tax structures and government spending programs that cause budget deficits to grow automatically during recessions or surpluses to grow when expansion is rapid
    
    • Automatic stabilizers are sometimes called nondiscretionary fiscal policy because no overt government action is required
      

     

• AUTOMATIC TAX ADJUSTMENTS
  
  • Personal and corporate income tax revenues are both closely tied to income
    
    • When prosperity boots National Income, federal revenues from progressive corporate and personal income taxes rise more than proportionally.
      
      • Corporate profits is the most sensitive of all incomes to swings in economic activity
        
        • A 10% decline in National Income might totally wipe out corporate profit, while 10% growth may cause aggregate profit to double or even triple
          
        • Tax revenue from corporate income is highly cyclical
          
      • Progressive personal income tax rates are the main reason why tax collections rise or fall proportionally faster than income.
        
        • This process acts as an automatic stabilizer during inflationary episodes because as income rises, tax collections rise even faster, accelerating withdrawals from the economy and dampening inflationary growth of nominal income
          

• AUTOMATIC CHANGES IN GOVERNMENT OUTLAYS
  
  • Transfer, unemployment, and social security payments rise during recession, thus, helping stabilize consumption, and ultimately Aggregate Expenditure
    
  • Although inadequate to completely offset strong pressures for a recession, automatic stabilizers do slow abrupt changes in the economy, giving policymakers more time to formulate discretionary policy
    
  • Fiscal Drag may hinder the natural growth of GDP because rising income boosts tax revenue and may shrink outlays for transfer programs
    
    • When potential income is growing rapidly, our built-in stabilizers may retard actual economic growth, a problem Keynesians refer to as fiscal drag
      

3. CYCLICAL VS. STRUCTURAL DEFICITS

• Imbalance in the federal budget may be more a symptom of economic distress than a result of discretionary policy
  
• Federal deficits or surpluses are affected by the level of GDP as well as by discretionary fiscal policy, so that appropriateness of fiscal policy is not obvious solely form the evidence of actual deficits or surpluses
  
  • A Structural Deficit (or Surplus) is an estimate of the budget deficit (or surplus) that tax and spending structures would yield if the economy achieved its potential
    
    • During a recession, estimating the structural deficit entails adding to the actual deficit extra tax revenues that would be collected if full employment were achieved and deducting the outlays on unemployment benefits and other transfer payments caused by cyclical unemployment
      
  • A Cyclical Deficit occurs when falling income during a recession shrinks tax revenues while increasing transfer payments, Prosperity, on the other hand, could yield a Cyclical Surplus
    
    • Transfer payment can be treated as negative taxes which decline in importance as National Income rises
      
• An excessive structural surplus can create a cyclical deficit
  
• The actual deficit is determined by the fiscal mix of the federal budget and the state of the economy. Expansionary fiscal policy creates structural deficits, and recession triggers cyclical deficits
  

4. CLASSICAL ECONOMICS AND FISCAL POLICY

• Classical theory tends to support policies that are relatively laissez-faire
  
  • High tax rates are alleged to
    
    • Inspire widespread tax evasion and tax avoidance
      
    • Intensify lobbying for tax loopholes
      
    • Smother productivity
      

• DOES TAXATION HAVE A NATURAL LIMIT?
  
  • The Laffer Curve: Very low tax rates might be raised to yield higher tax revenue, but raising tax rates excessively eventually drives tax revenues down when taxpayers decide either
    
    • That the extra effort necessary to generate extra taxable income is not worth it or
      
    • That cheating the tax system is okay
      
  • Marginal Tax Rates are the percentage taxes on small amounts of extra income
    

• TAX REVENUE AND PROGRESSIVE MARGINAL TAX RATES
  
  • Many economists in the classical camp argue that sharply progressive tax rates
    
    • Cannot accomplish the goal of flattening the distribution of income
      
    • Diminish and distort productive activity
      
  • Progressive Tax is one for which higher marginal tax rates fall on higher incomes
    
  • More evidence that increased progressivity may be counterproductive
    
  • Critics of progressivity echo Schumpeter’s law, which suggests that people ultimately find ways to beat any tax system intended to collect more than about 27% of their income
    

• GOVERNMENT PURCHAES AND TRANSFERS: NEW CLASSICAL VIEW
  
  • Keynesians view government purchases as direct source of Aggregate Expenditures and transfer payments as quickly translated by recipients into new consumer spending.
    
    • Keynesians have traditionally focused on cures for short-run problems and stressed activist fiscal policy as a tool to adjust Aggregate Demand
      
  • On the other hand, advocates of the new classical economics sense that this focus on demand is shortsighted and worry about the incentive effects of government programs because
    
    • There is less incentive to sacrifice our time by working and less net gain from investing if the government guarantees us a reasonably comfortable life by providing many necessities
      
    • Transfer programs are viewed as problems for two reasons
      
      • Incentives to work and invest are reduced for those who work and invest and who then pay taxes that government channels to others
        
      • Those who received transfer payments also suffer disincentives against work or saving
        
  • New classical economics would redirect fiscal policymakers to
    
    • Set nonintrusive economic policies that permit markets to make long-run adjustments
      
    • Limit tax rates and government outlays because of disincentives that dampen Aggregate Supply.
      

CHAPTER 12. MONEY AND BANKING

1. BARTER: EXCHANGE WITHOUT MONEY

• Barter occurs when people directly exchange their goods for someone else’s goods
  
  • Barter systems fail to generate efficient amounts of information about potentially beneficial agreements
    
  • Transactions are infrequent because information is extremely costly
    
• Your Wealth is the difference between the value of your assets and the value of your liabilities
  

2. FUNCTIONS OF MONEY

• Money is
  
  • A medium of exchange
    
  • A measure of value or unit of account
    
  • A store of value
    
  • A standard of deferred payment
    

• MEDIUM OF EXCHANGE
  
  • Money performs as a Medium of Exchange when it is used to execute transactions
    

• MEASURE OF VALUE
  
  • Money serves as a Measure of Value or Standard Unit of Account when used as a common denominator to rank the relative prices of goods
    
    • Use of money as a standard unit of account reduces the information needed to make sound market decisions
      

• STORE OF VALUE
  
  • Money performs as a Store of Value when people hold it as an asset because it is relatively less risky or because they view the transaction costs of conversion into other assets as too high
    

• STANDARD OF DEFERRED PAYMENT
  
  • Money performs as a Standard of Deferred Payment by allowing intertemporal contracts
    

   

• LIQUIDITY AND MONEY
  
  • Liquidity is negatively related to the transaction costs incurred in the purchase or sale of an asset
    
    • Time required to sell, certainly about price, and the quality of information are crucial aspects of asset liquidity, which hinges on transaction costs
      
    • One way to rank an asset’s liquidity is to estimate the percentage you would lose if you had to sell it immediately
      

3. TYPES OF MONEY

• Money can be classified as either commodity money or fiat money
  
  • Commodity Money is valuable apart from what it will buy (i.e., gold)
    
  • Fiat Money has value only because of its use as money (i.e., $100 bill)
    

• COMMODITY MONIES
  
  • Characteristics necessary for use of any commodity as money over a long period are
    
    • Acceptability
      
    • Durability
      
    • Divisibility
      
    • Homogeneity
      
    • Portability
      
    • Relative stability of supply
      
    • Optimal scarcity
      
      • Optimal Scarcity means that nay commodity used as money cannot be too common, nor can be counterfeited easily.
        
  • The profit government makes when it coins or prints currencies whose face values exceed their commodity values is know as Seigniorage
    

• FIAT MONEY
  
  • Paper money and coins are collectively called Currency
    
  • Fiat can be interpreted as “because we command.”
    
  • Major advantages of fiat money are
    
    • Its supply can be controlled fairly precisely by government
      
    • It is much less costly to produce than commodity money, making its use relatively efficient
      
    • If monetary policymakers do a good job, fiat money has all the qualities required of a good commodity money
      
  • The major disadvantage of fiat money is that if irresponsible monetary policymakers run the printing presses too fast, they wreak havoc on the financial system and the economy in general
    

4. THE SUPPLY OF MONEY

• NARROWLY DEFINED MONEY (M1)
  
  • M1 = Currency + Demand deposits in financial institutions
    
    • Demand Deposits are funds in checking accounts in commercial bank, savings and loans, or credit unions
      
  • Currency is the most easily identified component of the money supply because it may be used
    
    • For virtually all transactions
      
    • To price goods and services
      
    • As an asset
      

• NEAR-MONEY (M2, M3, and L)
  
  • The economists who use broader definitions of the money supply than M1 believe that people’s spending levels are more predictably by monetary data if we include the liquid assets that are highly interchangeable with currency and demand deposits
    
  • M2 = M1 + Small time deposits
    
  • M3 = M2 + Institutional money market mutual funds + large time deposits
    
  • L = M3 + Liquid such asset as short-term government bonds and commercial paper
    

5. BANKS AND THE CREATION OF MONEY

• US currency is printed by the Federal Reserve Systems (bills) and minted by the Treasury (coins)
  
• Demand deposits (checking accounts) are the largest component of our money supply
  
  • Currency is little more than convenience money, less than 30% of Mi
    

   

• THE ORIGIN OF FRACTIONAL RESERVE BANKING
  
  • Beginning of checking accounts-the receipts issued by the goldsmiths were primitive demand deposits
    
  • The goldsmiths began lending some of the gold on deposit to borrowers who would pay interests
    
    • Just like depositors, most borrowers preferred receipts to the actual gold
      

• DEMAND DEPOSIT EXPANSION
  
  • Bankers keep Reserves on hand to meet withdrawals by depositors (or legal requirement)
    
    • Reserves equal 20% of deposits
      
  • Fractional Reserve Banking legally permits financial institutions to hold less than 100% of their deposits as currency in their vaults
    

• THE POTENTIAL MONEY MULTIPLIER (m_p)
  
  • The Potential Money Multiplier (m_p = 1 / rr) indicates the total demand deposits that can be generated from a new deposit of $1 in a banking system that is “fully loaned up,” if people keep all their currency in the bank (no one keeps any cash on hand)    
    
    • rr = The reserve ratio or percentage of demand deposit (DD) held as reserves
      
    • potential money multiplier is 5
      

• THE ACTUAL MONEY MULTIPLIER (m_a)
  
  • The Actual Money Multiplier (ma) expresses the relationship between the money supply and currency in circulation or in bank vaults
    
    • m_a = MS / MB
      
      • MS = The money supply
        
      • MB = The currency that legally can serve as reserves in banks
        

        = Known as the Monetary Base or High-Powered Money which is the base on which the money multiplier operates in the money creation process
        

        • The Monetary Base equals currency in the hand of the nonbanking public plus all bank reserves
          
  • The actual money multiplier (m_a) could be as high as 1 / (rr + xr)
    
    • xr = Excess reserves
      
    • However, people keep some money as cash, and firms hold some currency
      
    • The historical average real money multiplier is at 2.6
      

• THE MONEY DESTRUCTION PROCESS
  
  • Banks lend to, and borrow from each other through private banking network called the Federal Funds Market
    
    • These interbank lending mechanisms normally enable banks that have inadequate reserves to replenish their reserves and honor all their demand deposit liabilities
      
  • The “runs” on banks and financial panics that resulted finally caused the Congress to establish a “banker’s bank” Federal Reserve System
    

6. FINANCIAL INSTITUTIONS

• Major types of financial institutions include credit unions and savings and loan associations
  
  • Important economic roles performed by financial institutions include
    
    • Channeling funds from savers to investors
      
    • Providing secure places for savers to keep their deposits
      
    • Facilitating flows and payments of funds
      

• FINANCIAL INTERMEDIATION
  
  • Channeling savings to investors is the single most important macroeconomic function of our financial system
    
  • Financial Intermediation occurs when financial institutions make the savings of households whose incomes exceed their spending available to investors, or to other households that wish to spend more on consumer goods than their incomes allow
    

• THE DIVERSITY OF FINANCIAL INSTITUTIONS
  
  • Commercial Banks
    
    • Commercial banks provide more services to their depositors than simple maintenance of checking and savings accounts
      
  • Thrift Institutions
    
    • Saving and loan association, mutual savings banks, and credit unions are called Thrift Institutions
      
    • The major difference between thrift institutions and commercial banks used to be that commercial banks offered checking accounts while thrift institutions could not
      
    • Most of the loans made by savings and loan associations and mutual savings banks are used to finance housing
      
  • Insurance Companies
    
    • Risk Aversion occurs when people are willing to pay a premium to avoid risk
      
    • Insurance Companies can sell us a guarantee against risk for a fee that is large enough to cover their claims and operating costs and still permit a profit
      
  • Securities Markets
    
    • Brokers who buy and sell financial securities also provide financial intermediation
      
    • Securities include paper assets such as stock and bond
      
      • A Bond is simply an IOU issued by a corporation or government agency that pays interest to the lender
        
      • A Share of Stock is a claim to partial ownership of a corporation
        

CHAPTER 13. CENTRAL BANKING: THE FEDERAL RESERVE SYSTEM

• The Central Bank of a country
  
  • Controls the volumes of money in circulations
    
  • Performs the government’s banking functions
    
  • Regulates banks and other financial institutions
    
  • Serves as a “banker’s bank”-holding deposits from commercial banks and making loans to them as needed
    

1. THE PURPOSES OF FINANCIAL REGULATIONS

• Major goals for a central bank include
  
  • Protection of depositors’ savings
    
  • Macroeconomic stability
    
  • Promotion of efficiency
    

2. THE FEDERAL RESERVE SYSTEMS

• The Fed’s objectives are
  
  • To act as a “lender of last resort”
    
    • This means the Fed lends money to inherently sound banks so they can survive bank runs when financial panics drive armies of depositors to demand withdrawals
      
  • Fed processes checks drawn on one bank and deposited elsewhere
    
  • The Fed’s key role is to conduct monetary policy
    
• Fed’s Board of Governors
  
  • There are seven members
    
  • Appointed to staggered 14-year terms because Congress feared the central bank might become highly politicized
    
  • Each president and Congress has limited power over the Fed because they appoint only one new member of the Board of Governors every other year