Course Lecture Notes for Cumulative Final Exam (Combined weeks 1-10)

WEEK ONE

Instructor Lecture: Nature of EconomicsContent Author: Dr. Basma Bekdache

This week we begin our introduction to the exciting world of economics. By the end of this semester, you will be able to read the daily economic news and understand what it means, how it impacts you, and how to analyze it using the economic way of thinking. You may even be able to make a prediction using one or more of the economic models that you will learn in this course!

The first thing we have to do before we study a new subject matter is to introduce its language so that we are all on the same page. The language of economics includes several terms that you may also encounter in other disciplines, and some that will be unique to economics. In this lecture, we will discuss and define a number of concepts, which will be used throughout the semester and that are central to the study of economics. First and foremost let's define what economics is all about.

What is Economics?

Economics can be defined as the study of how we allocate scarce (or limited) resources to satisfy unlimited wants. It is the study of how people make choices.

Resources are things that we use to make goods and services that people want. Examples of resources are:

Time MaterialsLabor hours

Land Capital Oil

Etc.

Why do people have to make choices?

That's right, we have to make choices because resources are limited or scarce. Think of the resource time. What kind of choices do you have to make everyday to satisfy your wants given your limited time?

In making choices people respond to incentives, which are the rewards we receive when we choose to engage in particular activities.

Macroeconomics and Microeconomics

We can think of economics as consisting of two major branches: Macroeconomics and Microeconomics.

Macroeconomics (macro for short) is the study of the economy as a whole or economic aggregate. Can you think of examples of topics that fall under the subject of macroeconomics?

Correct. The unemployment rate, inflation, interest rates, the government budget deficit or surplus, and GDP (Gross Domestic Product) are all examples of topics that we study in macroeconomics.

Microeconomics (micro for short) is the study of specific markets, individuals, and firms in the economy. A few examples of microeconomic topics are:

What determines the demand and supply for cars or pizza? How does an individual decide how much time to spend working or taking

vacation? How does a business decide how much to produce?

We will see later as the semester progresses that often times, we need to blend Micro and Macro analyses in order to answer some questions about the economy. For example, to understand what determines the amount of jobs available in the economy, or unemployment, we use a demand and supply model of the labor market along with an aggregate demand and aggregate supply model of the aggregate economy's level of production.

WEEK ONE

Instructor Lecture: How Do We Study Economics?Content Author: Dr. Basma Bekdache

Economics is often described as an empirical science. This is because we use economic models and test them using the scientific method. However, since people's behaviors determine outcomes in the economy, economics cannot be analyzed as an exact science (such as physics or chemistry), therefore, we tend to describe economics as a mix of science and art.

We have already used the term economic model. What is a model?

A model is a simplified representation of a reality.

Can you think of examples of models that you encounter in your daily life, not necessarily related to economics?

I can think of these models: a map is a model of roads, a clock is a model of time, and a small car prototype is a model of actual size car, etc.

Notice that in some cases (e.g., clock time, map) the model does not resemble the reality. In economics, our models will take a variety of forms that don't resemble the reality. They can be graphs (see lecture on graphs), tables, equations, and prose that describe relationships among economic variables.

A variable is something that can change over time. We will refer to many of the economic terms we use this semester as economic variables since their values may

change from period to period. For example prices, income or the interest rate you pay on your credit card are all examples of variables. An example of an economic model from macro is the relationship between household spending and income. An example from micro is the relationship between the price of a good and the quantity demanded and supplied for that good.

Each model is usually based on a set of assumptions. Assumptions are things that we take to be true for the purpose of the model we are building. For example, let's say we are trying to model the relationship between price and the quantity that people want to purchase of a good or service. We might say that when the price of pizza decreases, people will want to buy more pizzas. This statement is based on the assumption that peoples' preference for pizza has not changed, and that their incomes are staying the same. In other words, when we modeled the demand for pizza, we had to make the assumption that income and tastes were held constant. This is referred to as the ceteris parebus assumption, or "other things held constant".

Why do we use models?Since the economy and its various sectors are complicated, we use models to organize thoughts and narrow problems down so they are manageable and easy to understand. Models are used to analyze past situations, and understand relationships among variables. Models are also used to forecast or predict future values of economic variables.

When we are using models for forecasting, we often assume that economic agents are rational. Rational economic agents use all available information to update their models before they make predictions. A rational economic forecast does not repeat the same forecasting errors, as these should be taken into account in updating the model. Bounded rationality is an alternative assumption that states that people are not fully, but nearly rational since it is impossible for people to examine every choice available and know all information applicable to models.

Economists often have theories about how economic variables are related. Theories are statements or ideas about how things should be. However, since economics is an empirical science, theories are not taken to be true unless the models are empirically tested and supported by real-life data. Models and the corresponding theories are useful only to the extent that they are representative of actual data on economic variables. Empirical economics is the application of statistical methods to the testing of economic models.

Finally, in talking about economics we distinguish between positive and normative statements. A positive statement is one that describes "what is" and is a pure description of the events or situation that are being studied. A normative statement is

one that introduces individuals' opinions or judgments about the situation. It is "what ought to be" rather than "what is." As you may have guessed, economics as a science is consistent with using positive statements to explain and describe economic models.

Please continue to the next section of the chapter by clicking on the next item in this week's packet.

WEEK ONE

Course Lecture 1-1: Production Possibilities Curve (Frontier) LectureContent Author: Dr. David Dieterle

"The World of Trade-offs"

This section is very important to an understanding of how "trade-offs" in economics work in the real world. As the Production Possibilities Curve (PPC) suggests, it is a graphical illustration of the trade-offs that occur, and the choices made in the production of goods and services. A PPC helps us see what is being given up (opportunity costs) as the trade-off in the production between two different goods or services. The PPC represents the resource allocation for all the combinations of outputs between two goods or services.

There are several assumptions that are crucial to the interpretation of A PPC. As an essential understanding of this important theoretical concept is important, let's keep in mind a few basic assumptions.

All resources are fully employed. We take a static look-meaning we are looking at an economy in "a specific

moment in time"-a snapshot look. o The quantities of inputs (factors of production) are fixed for that moment in

time. o Technology does not change.

It is important to keep these assumptions front and center as we look at a PPC. These assumptions provide the basis for the PPC current ("static") state. In a moment we will see what happens when one, or several, of the assumptions change. But first, we need to take a look at how we can use the PPC to determine whether an economy is being efficient or inefficient with the allocation of its resources in the output determinations for two goods.

The figure below provides a good example of the locations of three points relative to a PPC. What story does each one of those points tell us about the resource allocation of this two good economy? Well, let's take a look----

Point A: On the curve

full production, full use of resources

Point B: Inside the curve

inefficient and incomplete use of

resources

Point C: Outside the curve

impossible to achieve

An economy fully utilizing all of its resources in an efficient manner will be producing the two

An economy falling short of full utilization of the resources for producing the two goods will be reflected

To say an economy is at a point OUTSIDE the PPC (Point C) is bit tricky. It is because an economy cannot

goods at a point ON the PPC (Point A). While the market will determine the relative combination between the two goods, by producing on the curve, all of the resources available to the economy for the production of the two goods is being fully utilized.

at a point INSIDE the PPC (Point B). This less than full utilization could be for several reasons associated with our assumptions: poor economy, costs associated with the fixed quantity of inputs, and less than fully employed resources including technology. Whatever the reason, an economy producing the two goods inside the curve has a significant problem with under utilized capacity of inputs.

function outside the PPC, therefore Point C is impossible. Here is where I like the term "frontier." If you think about the term frontier, it means the far reaches of ability. (i.e., frontier of space, frontier of the ocean, historically our western frontiers) It gives us that vision of being on the edge of possibility - economically being a "Production Possibilities Frontier."

Economic Growth and PPC

Finishing up with a description of a production point OUTSIDE the Curve (Point C), leads us to a natural extension question. If Point C is impossible, given current set of assumptions, is it possible to ever attain Point C?

And to that the answer is an emphatic YES.

As Miller states, "Over time it is possible to have more of everything." PPC can also be used to exhibit the economic growth of an economy through the changing of the assumptions; time becomes dynamic, technology changes, more resources employed, or additional inputs efficiently added and used in the production of the two goods. The figure below provides a good illustration of how a PPC can show the economic growth of an economy.

So how does an economy decide which goods or services it will produce, and in what combinations will the inputs be used?

Comparative and Absolute Advantage

This leads us to the concepts of absolute and comparative advantage. While we are going to hold off on a more elaborate discussion of these for later in the course, let's explore for the moment at least their definitions, and how they relate to our current discussion of the PPC. In a common sense sort of way, absolute advantage plainly is, "I can do something better than you" - period. Economically speaking, it just means I can produce more outputs with the same inputs, or produce the same outputs with fewer inputs.

With comparative advantage the rubber meets the road. With comparative advantage you might hear, "I can do something with fewer opportunity costs than others." (i.e., comparatively) Comparative advantage focuses on the more efficient allocation of inputs relative to the opportunity costs associated with how others allocate comparable inputs. By focusing on our comparative advantages, for example, reducing our opportunity costs, an economy becomes more efficient.

These concepts become especially applicable when discussing trade and the global economy. That is why we will be returning to them when we discuss global trade and globalization.

Specialization, Division of Labor, and Interdependence

The final concepts I want to present in this chapter are: specialization, division of labor, and interdependence. These three concepts are very much related to each other. For an economy to implement division of labor principles, the workers involved in the economy will specialize in the production of a specific good or service. This specialization by each worker means we are now interdependent with the other workers to obtain all the goods and services we choose to possess or implement.

Please watch the following 3 minute presentation.

WEEK ONE

Instructor Lecture: More on Opportunity CostContent Author: Dr. Basma Bekdache

In this lecture we revisit the concepts of scarcity and opportunity cost and learn how to compute opportunity cost in various scenarios. We will also discuss the law of increasing cost, which explains the shape of the Production Possibilities Curve (PPC). Finally, we will use the PPC to illustrate the choices a society makes today regarding its production of consumer and capital goods and discuss its implications on future economic growth.

Recall from the previous lectures, that resources, also called Factors of Production are things that we use to produce goods and services that the society wants. Factors of production generally fall into one of the following categories (more on this subject in week 7):

Labor:

The human resource. Usually, the number of hours worked for production.

Capital:

The amount of physical capital-plants, machines, equipment to be used in production

Human capital:

The level of education and training of the labor input.

Technology:

The society's level combined of knowledge.

Since resources are scarce, there is an opportunity cost associated with using our resources. Do you recall what we mean by scarcity?

Right, scarcity is the fact that resources are limited and are insufficient to produce everything to satisfy the unlimited wants of society.

Since resources are scarce, when we choose to use a resource to produce good X, we are giving up the option to use the same resource for the production of another good Y. The value of good Y that could have been produced is the opportunity cost of the choice we made to produce good X. In general, we can say that:

Opportunity cost is the highest valued, next best available alternative that must be given up to obtain something or satisfy a want.

Let's consider a couple of examples. Suppose it takes you one hour to cut your grass. In the same hour you can cook one meal and do a load of laundry. What is the opportunity cost of cutting your grass?

Correct, the opportunity cost of cutting your grass is one meal and one load of laundry because that is what you give up if you decide to spend your time cutting grass.

Suppose that your hourly wage is $20/hour. You have a choice to pursue a college degree but classes are only offered during the day when you can be working. If the class takes up two hours a day, what is your the opportunity cost (per day) of making the choice to take the class, everything else held constant?

You got it. The opportunity cost of taking the class is $40.

Think about how your answer would change if you can take classes after work. What would be the opportunity cost of taking the class then?

The concept of opportunity cost is very important to economic analysis. You will see as the semester progresses that it applies to almost everything we study, from the decision of an individuals of how much to decision to consumer or save to a firm's decision of how much to spend on capital good s to be used for production. We will discuss more applications later, but for now let's review the PPC.

Law of Increasing Opportunity Cost

Let's return to the example of digital cameras and pocket PCs that you considered in the last lecture to illustrate the PPC. In panel (a ) we can see the production possibilities that are plotted in panel (b). The fact that the PPC is downward sloping shows that there is a tradeoff or opportunity cost which occurs due to scarcity. If we want to produce more pocket PC's (as in moving from combination B to C) we have to give up some production of digital cameras.

(Reprinted from Roger LeRoy Miller, Economics Today, 14th edition)

Specifically, looking at the table or the graph, what is the opportunity cost of producing the first 10 pocket PCs (going from 0 to 10)? What about the next 10 PCs (going from 10 to 20), and the next 10 etc? What is happening to the opportunity cost of producing pocket PCs as we produce more and more pocket PC's?

The opportunity cost of the first 10 PC's is 2 digital cameras (50-48); the next 10 is 3 digital cameras (48-45); the next 10 is 5 digital cameras (45-40) etc. The opportunity cost of producing more and more PCs, as measured by how many digital cameras we have to give up producing, is increasing as we produce more and more PCs. This is called the Law of increasing costs.

The law of increasing costs refers to the fact that the more we produce of a good, the opportunity cost of that good generally increases. It is the reason why the PPC is bowed out (decreasing slope) as illustrated in the graph below.

(Reprinted from Roger Le Roy Miller, Economics Today, 14th edition)

Why does this happen?Using the goods in this example, as we produce more and more PC's, we have to use to resources that were specialized in producing digital cameras and adapt them to the production of PC's. This raise the opportunity cost of producing PC's. If resources are easily adaptable to the production of any good, then the PPC will be less bowed out. The more specialized the resources, the more bowed out the PPC (reflecting greater increase in opportunity costs).

WEEK ONE

Instructor Lecture: More on Saving and Economic GrowthContent Author: Dr. Basma Bekdache

This section illustrates the role of saving in economic growth. Consider the PPC for an example where the society has to choose to produce from one of two categories of goods: consumer goods and capital goods. Consumer goods are goods produced for personal satisfaction while capital goods are goods that are used to produce other goods.

If a society produces more capital goods today, it will have more capital available for production in the future, which implies it can produce more of everything in the future. We called this economic growth and it is shown as a shift to the right in the PPC.

We can see that if we choose to consume less today (or save) as in point C (and compared to points A or point B), we can achieve greater economic growth since by choosing more capital goods today, the capital stock will increase, allowing us to produce more in the future.

WEEK ONE

Instructor Lecture: More on Comparative Advantage and SpecializationContent Author: Dr. Basma Bekdache

Earlier in this week, we defined comparative advantage as being the ability to produce a good or a service at lower opportunity cost. Let's see if we can apply this concept to decide how one should spend their resources. Let's consider a simple example.

Suppose...

Who has the comparative advantage in the production of chairs?

To answer this question, we have to calculate and compare the opportunity cost of producing a chair for both Bob and Ted individually.

To produce one chair, Bob has to give up the production a quarter of a table, which is what Ted can produce in 1 hour if he does not make the chair. For Ted, making one chair means giving up making two-thirds of a table. Who has the comparative advantage in making chairs?

Suppose that Bob can make either four chairs or one table in an hour and Ted can make either three chairs or two tables in an hour.

Who has the comparative advantage in the production of chairs?Correct. Since Bob has the lower opportunity cost (2/3 > 1/4), he has the comparative advantage in making chairs.

Using similar reasoning we can show that Ted has the comparative advantage in producing tables.

So why do we care about who has the comparative advantage?

We do because we can show that if someone (or nations) specialize in the production of the good in which they have a comparative advantage, total production will be greater which benefits everyone.

Using the same example, let's compare the total number of chairs and tables produced in one hour if Bob and Ted specialize (i.e. they produce only the good in which they have a comparative advantage) to the total production when Bob and Ted split their time between the production of chairs and tables (e.g. if they do not specialize). Let's assume they each spend a half hour on each good.

In the case of specialization:

TOTAL PRODUCTION IS: 4 chairs, 2 tables.In one hour Bob produces 4 chairs and Ted produces 2 tables.

In the case of no specialization:

In a half hour, Bob can produce 2 chairs.In the second half hour, Bob can produce ½ table.

In a half hour, Ted can produce 1.5 chairs.In the second half hour Ted can produce 1 table.

TOTAL PRODUCTION IS: 3.5 chairs and 1.5 tables.

This is less than the production that can be attained if they specialize which is 4 chair and 2 tables.

The concept of comparative advantage is applicable to trade between nations. When nations specialize in their comparative advantage and trade with the rest of the world, economic output increases leading to a higher average standard of living.

WEEK ONE

Course Lecture 1-2: Consumer ChoiceContent Author: Dr. David Dieterle

There are four critical concepts you will need to become familiar with for future discussions:

1. Utility 2. Marginal analysis 3. Diminishing marginal utility 4. The difference between total and marginal

While "utility" is the term used in economics to define a consumer’s satisfaction, to measure this utility it is important to understand the difference between what economist’s mean by the term, "marginal", and "marginal analysis".

When economists study human behavior, they are most concerned with what happens to the utility, or production (producer side which we will discuss later), when one more unit is consumed (or produced). Therefore, the economists view of human action is to study the results of adding one more unit; marginal analysis. Economists are always interested in what happens "at the margin" (adding one more unit). Marginal utility can be calculated by dividing the change in total utility by the change in number of units consumed. The key to understanding marginal analysis is that we are studying behavior or production changes with the addition of ONE ADDITIONAL UNIT. Contrary to "normal" thinking, total utility is irrelevant in marginal analysis. We will look at the relationship between marginal and average later on.

The last major concept of this chapter is diminishing marginal utility (DMU). Take your time with this concept. DMU is the idea that as utility increases with the continued consumption of a good, a point will be reached when the utility of the additional unit will be less then the one before it. For most of us, a good example of this is eating pizza. The first piece of pizza goes down well, tastes great, and satisfies completely. So we have another. Again, complete total satisfaction. So we have a third. Now, suddenly, we eat it a little slower, the taste not have the zip it did with the first two, and our satisfaction level is less. It can be said the third piece was where we reached DMU; the total climbs, but we have reached maximum satisfaction. Even if

we go on and eat three more pieces, for a total of six!

Conclude your initial introduction to marginal analysis and DMU with a review of DMU and the diamond-water paradox of Adam Smith.

WEEK ONE

Course Lecture 1-3: Interpreting GraphsContent Author: Dr. Linda Wiechowski

Please watch and listen to the following 7 minute VoiceOver PowerPoint for a discussion of graphs. You will learn how to plot points on a graph, how to calculate the slope of a line, as well as create a formula for the line.

For a printable version of this powerpoint, click Here.

You have two examples that you can work through. Both of the examples show you step-by-step how to solve for the equation of a line.

Four more practice problems are shown that you can try. Only the answer is given for these problems. You will need to work through the problems using the same steps as the previous sample problems.

WEEK TWO

Course Lecture 2-1: Demand and Supply Content Author: Dr. David Dieterle

This week you are going to learn about the key concepts that make up microeconomics; supply, demand, price, and elasticity. Don't fall behind. These concepts are so vital to your overall understanding of economics role in our life and a thorough understanding here is critical to your future success in this course.

The title of this lecture is arguably the most popular phrase in all of Economics. The media, political pundits, and just about anyone who wants to make one think they understand the world of economics can quote this phrase and make people think they know what they are talking about regarding almost any economics topic or issue.

Yet, if we surveyed 100 people asking them to define "supply and demand," the great majority of them would get it wrong.

Why?Most of them would have received their definition from the media, who get it wrong 95% (if not more) of the time.

We are going to spend our time "getting it right." At the conclusion of this lecture, you will have the "right" definition and understanding of both supply and demand. And you will understand why most everyone gets it wrong.

Before we dive into supply and demand as concepts, let's review (for at least most of you I presume) the notion of a "market."

A market is anytime there is a voluntary interaction between a buyer and a seller. Think back to the last 24 or 48 hours - have you bought something; anything? You, as the buyer, made your purchase from the seller. So just remember when it comes to identifying a "market." if someone is buying from someone who is selling, you have a market of voluntary exchange.

You now understand a market is the abstract concept economists use to present the "environment" to discuss and analyze how producers and consumers (buyers and sellers) interact with each other. A "marketplace" is defined by the laws of supply and demand.

The Laws of Demand and Supply

The Law of Demand focuses on the relationship between price and the quantity demanded of a good or service by a consumer.

There are a couple of characteristics of the consumer that are important for you to understand:

1. A consumer must be willing to purchase the good or service at each price 2. A consumer must be able to purchase the good or service at each price

You might be quite "willing" to purchase a Rolls Royce Pierce Arrow automobile (most of us would!). However, you are probably not "able" (And if you are, call me immediately!). In the reverse, you might be quite "able" to purchase a Yugo, but have a good understanding of quality and are not "willing" to do so. As we move along in this chapter and the course, it is important to remember that markets are made up of consumers (demand) and producers (supply) who are both "willing" and "able" participants.

Now back to this relationship idea . . .

The Laws of Demand and Supply are laws that describe the relationship between the price of a good and service, and the quantity that will be demanded or supplied. These can both be best understood if you think about them intuitively and remembering one of the core principles of economics, "people respond to incentives in predictable ways."

First, let's look at demand and supply intuitively.

As a consumer, what is your reaction when a good or service you often purchase rises in price? At first, you may not do anything. But if the price rise continues, at some price you will stop buying it. You begin to search out alternatives. Well, that's the Law of Demand. As the price of a good of service goes up, consumers will buy less of it. The relationship between price and quantity demanded is INVERSE. As one goes up, the other goes down . . . and vice versa. Intuitively, does that make sense? You exhibited this relationship with the Chocolate Chip Cookie Survey.

Regarding Supply, just the opposite applies. As a producer, if the price of the good or service you provide goes up, your incentive and intuition tells you to do

what? That's right, produce more it. The Law of Supply states the relationship between price and quantity supplied is a direct relationship.

Both of these relationship ideas should become clearer to you as we explore these graphically as demand and supply schedules and curves.

Demand SchedulesLet's return to the Cookie Survey for a moment. Last week you completed a survey based on your willingness and ability to purchase chocolate chip cookies. As you and each of your classmates completed the survey and the results were tabulated, in the aggregate all of you began to illustrate a picture on your total willingness to purchase the cookies at the various prices. This "story" was reflected in the chart. If you want, go back and take a look at the chocolate chip cookie "story" the class created. What you created was a Demand Schedule. It is similar to the one illustrated below:

Demand CurvesDemand curves, by extension, are demand schedules in graph form. If we use Quantity(Q) for the vertical axis, and Price(P) for the horizontal axis, then a demand curve becomes nothing more than the "picture" of the demand schedule "story". Our story is now a picture:

Supply Schedules and Supply CurvesWhat we just discussed about the demand schedule and demand curve applies for the supply schedule and supply curve but for one major exception; we have to apply the Law of Supply which changes the relationship between quantity supplied and price. Remember, the Law of Supply states a DIRECT relationship between quantity and price. So a supply schedule "story" would look something like the supply schedule below:

The Supply Curve, consequently, will be upward to the right reflecting the story that as prices increase, a producer is willing and able to produce more of the good or service. The Supply Schedule below reflects this direct relationship:

One additional point needs to be emphasized here. If you look at the definitions they both have a very important phrase, "other things being equal". The only relationship being considered is the relationship between price and quantity-nothing else. This is important because it will help us distinguish between changes along the curve (change in quantity demanded) and the creation of a new curve (change in demand).

NOTE: We will cover shifts in demand and supply further in the lecture.

There are two more key issues we need to address: shifts in demand (supply) curves versus quantity demanded (supplied).

When a curve (demand or supply) shifts, it is because something has created an entire change in overall preferences for the good or service in question. The "story" has changed. It is now more than a change in price. Let me repeat that. It is now more than a change in price.

By now you should realize a demand (supply) curve, (the picture), represents a set of prices and quantities that one is able and willing to purchase (produce) at every price on the curve, other things being equal.

But what happens when "other things" are not equal, and the "other things" change? That's our next task.

Determinants of Demand

When the "other things" change, the story and picture regarding our relationship between quantity demanded and price changes. Before we go there, let's take a look at what are some of these "other things" that could change the demand picture. What are the determinants of demand?

IncomeAs one's income changes, the willingness and ability to purchase a good or service also changes. Are there items you buy more or less of now than at a different time in your life? I suspect we all have a few of those. Well, one of the reasons for our change in consumer behavior could be our income level. While economists call this the "income effect", if the change in income is significant as an economy, it will change the demand "picture" of a good or service.

Tastes and preferencesIt may be a news article has announced research that drinking wine will add 40 years to your life! What do you suppose will happen to the demand for wine? Or the reverse, the research announces wine will deduct 40 years from your life. Again, what do you suppose will happen to the demand for wine? As a society we are a pretty fickle lot when it comes to the latest fads in food, clothing, toys and gadgets, and most goods. These tastes and preference fads change the demand "picture" for goods and services.

Prices of substitutes and complement goods and servicesIf the price of coffee suddenly quadrupled, many of us may switch to tea, thus increasing the demand for tea. Coffee and tea are considered by many to be substitute goods. The price of the substitute (coffee) changes the demand of the good (tea). Having grown up on peanut butter and jelly sandwiches, if the price of jelly quadrupled, my mom may have resorted to bologna sandwiches (Yuck!!). If many moms did the same, the demand for the good, peanut butter, would change because of a price change in a complement good, jelly.

Expectations of buyersGoing back to the wine research, if as a result of the good news buyers now have expectations of living longer because of drinking wine, demand for wine will definitely change. Buyers' expectations (whether founded or not) will change the demand story and picture of a good or service.

Number of buyersFinally, a change in the number of buyers for a good or service will change the demand story and picture. We are seeing this today in the demand for health care of senior citizens as the baby boomer generation reaches senior status. Since I "are one," I am also anticipating an increase in the supply and quality of that health care! But that's another story. . .

Determinants of Supply

Some of the "other things" that would change the supply story and picture include determinants that influence the production of/and providing of goods and services.

Costs of InputsThe costs of the inputs (land, labor, capital) is one of the key determinants of supply. As costs of the inputs decline, for example, production costs decline, it allows the producer to produce more at each price. The opposite is also true decreasing supply when the costs of the inputs increase.

Changes in technologyAs technology changes, a producers willingness and ability to provide goods and services changes. Technology has been the number one change in the manufacturers ability to provide goods and services to the marketplace.

Taxes and subsidiesGovernment tax policies or incentives through subsidies certainly change a producers willingness and ability to provide goods and services to the marketplace. This would also include a country's protectionist policies like tariffs, which are taxes on imported goods.

Price expectationsLike consumers, if producers expect a change in the price for the good or service they provide, their willingness and ability to provide the marketplace will change.

Number of companies in an industryAs the number of companies increases, or decreases, the competitive environment changes. This change can also impact a producers willingness and ability to provide goods and services to the marketplace.

IMPORTANT MESSAGE FROM THE SPONSOR!Changes Along a Curve (changes in quantity demanded) vs. a New Curve (changes in demand)

To best understand changes along the curve we have to understand two characteristics: one, the demand schedule ("story") has not changed, and two, since the story hasn't changed, the "picture" hasn't changed. All that has changed is the price (P) which by extension changes the quantity demanded (Qd) as you will see below.

Now that we have identified the "other things" that can influence the demand of a good or service, these determinants change the demand schedule (story) and by extension the demand curve (picture). A changed schedule means that the consumer has changed their willingness and ability to purchase the good or service at all prices. When the schedule changes the curve changes, i.e. we now have a new demand curve as shown below.

Please view the following 6 minute presentation.


Likewise, just as with demand, if these "other things" change the story, the picture changes and we have new supply curves, as shown below.

Normal goods vs. Inferior Goods

One more distinction we should make before moving on. When one talks about the law of demand and the relationship between price (P) and quantity demanded (Qd), one is also making an assumption on the type of good or service. When income increases, and the change in demand obeys the law of demand, we identify that good or service as a normal good. So if income rises, and this change creates a normal movement of the new demand curve, we are dealing with a normal good. Most goods and services are normal goods obeying the law of demand.

Now let's change the response of an increase in income. If one's income increases, yet the demand response is in the direction opposite the law of demand, then we say the good is an inferior good. That is to say as our income changes, the demand for that good or service actually goes in the opposite direction. The good graphs below reflect the response of an inferior good.

I warned you this is an extremely important section. It is one of the most important we will cover during our tour of microeconomics. But we are almost through it . . . two more topics.

WEEK TWO

Course Lecture 2-2: Putting Demand and Supply TogetherContent Author: Dr. David Dieterle

The key point to get across here is that when one "crosses the curves" a very exciting, enlightening occurrence happens; we suddenly are provided crucial information on the market place interactions between buyers and sellers. This information helps both parties make decisions regarding their participation in the market place.

That information is in the form of a price. Not just any price, but a price at which buyers and sellers will be able to buy all they are willing and able to purchase, and producers will sell all they are willing and able to produce; a market equilibrium price or market clearing price. At the market clearing price there will be no shortages and no surpluses. Economic life is beautiful and everything is right with the world!

However, as you can see from the graph above, if the price is not at market clearing price, there will be a consequence. If the price of a good or service is ABOVE market clearing price too much will be produced and a surplus will occur.

If the price of a good or service is BELOW market clearing price more will be demanded for purchase then will be produced and a shortage will result.

Finally, be sure you understand the significance and difference between the three "states" of a market:

1. Market clearing or equilibrium price; Qd = Qs 2. Surplus; Qd < Qs 3. Shortage; Qd > Qs

WEEK TWO

Course Lecture 2-3: Demand and Supply AnalysisContent Author: Dr. David Dieterle

There are several key elements you will need to be sure to familiarize yourself with regarding the concepts of demand and supply.

Microeconomics is made up of many "signals" in the marketplace. The key signal is the price system. The price system provides both the consumer and producer significant information for them to determine what action to take in the marketplace that will best serve their self-interest. Also here, jump over to the section on rationing function of prices.

The price system evolves around and is totally dependent on the idea of voluntary exchange. Voluntary exchange is the action between individuals where both feel they will be better off after the exchange. We began practicing voluntary exchange as young children, trading with our siblings or friends everything from dolls to cards to even bikes - which I had to give back! For me, it was baseball cards. When I opened up my bubble gum pack and found Mickey Mantle inside, it was like winning the lottery. Yet, it wasn't too long after that I found myself trading Mickey for my favorite Cincinnati Red, Ted Kluzewski. I was convinced I was better off with Ted than Mickey - and now you know your instructor is a very old man.

Every one of us has a story of voluntary exchange. Voluntary exchange makes the economic world go round, as we will see later in the course. It is voluntary exchange and the decisions of consumers and producers that create changes in our willingness and ability to buy or produce goods and services.

Finally, government controlled price controls in the form of price ceilings and price floors distort markets creating shortages and surpluses respectively. Both actions restrict the marketplace.

Price ceilings create shortagesPrice ceilings restrict the supply of goods because they don't permit prices to reach equilibrium. Rent controls for example. While certainly well intentioned, they create

disincentives for landlords and property owners to maintain their property or for others to buy property and add to the rental housing market.

Price floors create surplusesPrice floors subsidize over production of a good or service, resulting in a surplus. Agricultural price floors create over production of food stuffs. Minimum wage is a price floor on what employers can pay their employees, regardless of the market conditions at the time.

WEEK TWO

Instructor Lecture: Shortages and Surpluses: Application and AnalysisContent Author: Dr. Basma Bekdache

In previous lectures you learned about the three potential states of a market: Equilibrium, shortage, and surplus. Let's consider some situations and practice determining the state of the market from the graphs. We can then discuss adjustment to equilibrium when the price is allowed to change and the situations that arise when the price is not allowed to change to clear the market as in the case of price floors and price ceilings.

Consider the market for gasoline shown in the figure below:

What is the equilibrium price and quantity in this market?

Quantity demanded equals quantity supplied at 30 million gallons per day and a price of $2 per gallon. Recall that $2 is also called the market clearing price.

What is the state of the market if the price was $4? What about 1$?

At a price of $4, there is a surplus (or excess supply). The amount of the surplus is equal to 50-10 = 40 millions of gallons per day. At a price of $1, there is a shortage or excess demand. The amount of the shortage is equal to 40-20 = 20 million gallons per day.

Assuming no price controls, how do you think the market adjusts if the price is too high and there is a surplus? Or when the price is too low and there is a shortage?

Your intuition is right. When there is a surplus, the price will decrease as firms there is an excess of goods at the high price. This will continue until the excess supply is eliminated and the market price is reaches the equilibrium price. Similarly, in a shortage, the price is bid up" by the excess demand. The price will stop increasing when the quantity demand and supplied are again equal at the market clearing price.

What happens when the price market is not allowed to change to clear the market (or equate quantity supplied and quantity demanded? Let's revisit the price controls defined in the previous lecture. As you can see in the graph below, when the government imposes a price ceiling to keep the price low, it is set below the equilibrium price, since the equilibrium price is believed to be too high.

What do you think happens in this situation?

There is shortage. Since the shortage cannot be eliminated with the price increasing, usually a black (or illegal) market will develop to satisfy the excess demand.

Below we can see a typical example of price floor, the minimum wage. A price floor is regulation that is meant to keep the price above equilibrium, when the equilibrium is believed to be too low.

At the wage, Wm, there is an excess supply of labor (the surplus is QS - Qd), which is equivalent to unemployment since not everyone available for work is working at that wage. The impact of the minimum wage is to reduce employment in that market from Qe

to Qd

WEEK TWO

Course Lecture 2-4: Demand and Supply Elasticity Content Author: Dr. David Dieterle

You are about to enter the world of truly exciting economics. No, that is not an oxymoron! You will understand why demand and supply curves look differently - why some are flat, others almost vertical. You will understand what that means to our economic decisions as consumers and producers. Probably most of all, you will see this "economic stuff" really does have relevance in the real world.

Elasticity is the concept that reveals the responsiveness of changes in quantity demanded to changes in price. An important mathematical point is to remember the change is measured as a percent change in quantity demanded divided by a percent change in price as noted in the equations below.

Price elasticity of demand really provides explanations on why many economic actions are either valid or not valid. Why does government like to tax gas, cigarettes, and alcohol? Why can't some retailers just raise prices any time they wish?

When a good's elasticity is elastic, like a rubber band, as prices change the consumers' responsiveness is greater than the change in price. Conversely, if a good's elasticity is inelastic, like a wall, as prices change the consumers' responsiveness is smaller than the change in price. This distinction will be made clearer in the following discussions. Hopefully, this will give you a mental picture of what to look for as we now discuss consumers behavior when prices of goods and services change.

Price elasticity of demand identifies the percentage change in Quantity Demanded to percentage change in Price. Couple of key points:

1. Focus is on percentage change, not absolute changes. 2. Mathematically, the ratio will always be negative. Don't be concerned.

Remember these three scales:

Ratio < 1 INELASTIC Elasticity of Demand - % change of Qd is less than % change of price

= 1 UNITARY ELASTIC Elasticity of Demand - % change of Qd is equal to % change of price

> 1 ELASTIC Elasticity of Demand - % change of Qd is greater than % change of price

Price Elasticity of Demand

A measure of the sensitivity of quantity demanded to changes in price. The percentage change in quantity demanded divided by the percentage change in price (absolute value)

(The following formulas and graphs provided by Dr. Linda Wiechowski)

The formula for the price elasticity of demand is:

Price Elasticity of Demand: Examples

Price Elasticity Ranges

The price elasticity of demand results in a value that falls within one of five ranges:

Elasticity and Total Revenues

The final aspect for price elasticity of demand is another way in which to measure the relationship between price and Qd is to look at price increases and what it does to Total Revenue (TR). The following is a helpful guide:

If p increases (decreases), and TR increases (decreases), price elasticity of demand is inelastic.If p increases (decreases), and TR remains the same, price elasticity of demand is unitary.If p increases (decreases), and TR decreases (increases), price elasticity of demand is elastic.

Please see the following information about the relationships between the types of price elasticity and total revenue. This panel shows the table of data:

Determinants of the Price Elasticity of Demand

Just as there are determinants that changed demand and supply, there are also several determinants that can change the price elasticity from elastic to inelastic, or vice versa.

Existence of substitutes - The more substitutes available, the larger the elasticity of demand. While gasoline may have few substitutes, producing a small elasticity, chocolate bars can have many leading to a much larger elasticity.

Percentage of budget - The larger percentage of one's budget, the larger elasticity of demand. As prices change of those items absorbing more of our budget, we are more inclined to search out substitute goods.

Time - The more time one has for adjusting to price changes, the larger the elasticity of demand.

Elasticity of Supply

Elasticity of supply measures the responsiveness of quantity supplied (Qs) to changes in price (P). Again like elasticity of demand, it is measured as a percentage change in quantity supplied (Qs) divided by the price (P).

WEEK THREE

Course Lecture 3-1: Public Spending and Public ChoiceContent Author: Dr. David Dieterle

This week you are going to discuss reasons and purposes for government's role in the economy. Yes, we live and operate in an economic system where individual choice and decisions by both producers and consumers reign as key methods of choice making in the market place. Yet, there are times when we need a third party, for example the government, to help provide goods and services (mostly services) we deem especially important as a society to be available to all citizens. How and why society makes those decisions is what we will explore in Chapter 5.

In Chapter 5 we are going to look at why government sometimes needs to get involved in the economy. There are times when the market leaves us with consequences we do not like, does not provide a good or service to the quantity we as a society would like, or does not provide the good or service due to costs or other reasons. Economists refer to these situations as market failures even though many economists grimace at the use of that term.

One area in which a market failure can occur is when a market action has a consequence whose cost is actually borne by a third party. These third party costs are called externalities. Externalities can be both positive and negative, or both dependent on the recipient. The key point to understand with an externality is that the economic activity has a benefit or cost to a third party independent of the market transaction.

Let me illustrate externality that can be both positive and negative with a story.

When I was a young boy growing up in Kettering, Ohio, our back yard was the neighborhood baseball field. I also lived in a neighborhood with close neighbors, one being a very nice elderly couple, Mr. and Mrs. Peters.

One summer the local utility company came through and put up new utility poles and hung large lights for nighttime security. One of these poles was on the fence line between the Peters' yard and our yard. While the light certainly achieved its purpose of providing security for the neighborhood, the Peters had another view. The new light was shining directly into the Peters' bedroom, a situation not conducive to good sleep. This was definitely a negative externality. Yet, for a group of neighborhood ten year olds it was exactly what we wanted- night baseball!! For us, it was definitely a positive externality.

In both situations the new light provided an externality to a third party. In one instance, it was positive, in another negative.

Why does government get involved with externalities in the first place? Often, externalities become a problem because the externality influences non-property, such as air with air pollution. Since no one owns the air, there is no property right allotted to an owner. A property owner has certain rights relative to use, exchange, and condition. If you are a property owner you expect to have certain rights as to what you can do with your property. These rights will often negate the true costs associated with an externality action. A key role of government in an economy is providing a legal system to protect and enforce an owner's property rights. You expect government to uphold those rights for you in your actions and dealings with others, consistently and regardless of whom the action is for or against. This consistency is the rule of law for a society. Well, if those rights are not present because there is no owner, then the Government intervenes to serve as a "referee" between the party creating the externality and the party affected by their actions.

How does government correct externalities?

Generally we think of government getting involved in the correcting of negative externalities such as all forms of pollution. As we know, people respond to incentives and disincentives. Government actions can create either incentives or disincentives to correct externality situations. It is sort of deciding whether to use the carrot or the stick as an incentive for an action to happen, or a disincentive for an action not to happen.

So what does the government do?

When it comes to negative externalities, government has mainly two sticks, special taxes or regulation. Regarding pollution, government can charge taxes for over polluting, or charge a tax to allow pollution. Or, they may place regulations to either prevent polluting, force reduced polluting, or create an environment or market for pollution. Regardless, remember from earlier discussions all choices have consequences that lie in the future. It is important for governments to identify future consequences before implementing taxes or regulations.

What about positive externalities?

Sometimes, government wants to encourage positive externalities. They may accomplish this by producing and/or financing the production of the good or service providing the positive externality as they do with higher education, subsidizing (negative tax) the good or service such as subsidies for public education, or could establish regulations creating incentives for the positive externality to occur, such as vaccinations for school age children.

Another function of government, often as a result of externalities, is to provide certain goods and services. These are called public goods. Public goods are, as their name suggest, for consumption and use by the general public and can be consumed by many individuals simultaneously. This is in contrast to goods that are consumed or used by only one individual at a time, generally the individual who paid for the good or service. These are private goods.

So how do we distinguish between public goods and private goods?

Public goods satisfy two conditions or characteristics. One, as stated previously, a public good can be used by many people at the same time without interfering with each other's utility of the good. This can called shared consumptionm. Two, a public good or service is one in which consumers cannot be excluded from its use, regardless of such things as where they live, where they are from, or if they paid taxes to support the good or service. This is called the exclusion principle. This exclusion principle creates what economists like to call the free rider problem. We will take up the free rider problem a bit later.

How can we tell if a good or service is a public or private good?

Good question, glad you asked.

Instructions: Below is a chart that will help us differentiate between a public good and a private good. Build the chart by dragging and dropping each of the goods listed on the outer edges of the chart to their respective quadrants based on the vertical and horizontal labels displayed.

Now that you have had a minute to review the chart, let's take a look at each of the cells.

In the top left cell are goods and services that exclude individuals and there is not shared consumption. If you don't pay for it, you don't get it! The goods and services that fit into this cell are definitely private goods.

Let's jump down to the lower right cell where individuals are not excluded and shared consumption exists. So, regardless of what you did, who you are, or where you are from, you share in the consumption of this good or service and we all share it together! Ah, togetherness!! This is clearly a cell for all public goods.

The two cells with the question marks, "?", are the fun ones. Let's explore each of these, starting with the upper right cell. In this cell we have both shared consumption yet one can be excluded-Hmmmm?? How does that work? What is a good or service where many of us can participate or consume at the same time, yet can also be excluded for some reason, like not paying the fee or price? Answers might be restaurants, golf courses, theaters, parks, libraries, schools to name just a few. Now, can you think of restaurants that are private and ones that are public? What golf courses? Parks? Libraries? Schools? If you think about it, all these "categories" of goods and services have both public and private entities. Regarding our discussion, this cell actually contains both public and private goods and services.

What about the other question mark cell in the lower left? The goods and services that fit into this cell do not exclude one from use, yet can only be consumed by one individual at a time. Defining goods and services in this group can get a bit muddled. What good or service is consumed by only one person, but cannot be excluded? What about a drinking fountain? How about a Porta-John? Or a public restroom for that matter? Hey, let's not get carried away with the shared consumption thing!! Seriously, as you can see this group of goods and services is a bit tricky.

Back to the public goods for a moment. By definition and extension all public goods have one thing in common, the free rider problem. So before we leave this topic of public goods, it is important to briefly introduce a concept applicable to all of us. Yes, we have all been free riders no matter how much you have paid in taxes. First, let us set the record straight; being a free rider is not a bad thing. Being a free loader, yes that's a problem! But a free rider is anyone who has used a public service and not been party of paying the costs for the production and/or operation of the good or service. At some time in our life we have all taken advantage of a public good or service when the cost of the good or service was paid for by others. Now I know you are reading this thinking-"Prof, you're wrong; not me, I have never done that!" So let me ask you this. Have you ever driven on a road in another state in which you live? Or have you ever enjoyed a city or county park in a city or county where you don't live? The challenge for any government at any level that offers public goods or services is how to reduce the free rider problem.

The free rider problem can take on a very different perspective when we extend this concept to national and international issues pertaining to national defense, international cooperation, and international alliances. But we will save that discussion for later...

WEEK THREE

Instructor Lecture: ExternalitiesContent Author: Dr. Basma Bekdache

In this lecture we review market failures and illustrate the impact of government intervention on the market equilibrium price and quantity.

Let's check to see if you recall what we mean by a market failure. So - What is a market failure?

A market failure is a situation where the market equilibrium quantity is either too much or too little as compared to what would be optimal for society.

Market failures generally arise when there are positive or negative externalities. An externality occurs when a third party (someone not involved in the activity) is affected by someone's action.

A typical example of a negative externality is the pollution that results from a firm or an industry's production process. Consider the following example of a steel mill depicted in the demand and supply graph below. The supply curve for steel is given by S1 and the demand curve is D, so that the equilibrium quantity exchanged is 110 million tons of steel and the price is $500 per ton (point E).

Assume that currently the government does not regulate pollution and that this steel mill's production emits spoke (pollution) which causes diseases and dirties the environment for the people living in that area. This is an example of a negative externality. Therefore, it is desirable that less steel is produced in order to reduce the

negative effects of this production process. Here we say that the market over allocates resources to the production of steel when the negative externality is not taken into account (as shown in the market equilibrium at point E). If the negative externality is taken into account, for example by imposing environmental regulations on the steel mill, then the supply curve for steel would shift to the left (S2) to reflect the increase in cost due to complying with regulations. This would take the market equilibrium to E1 thus reducing the amount of steel produced and reducing the pollution.

The example above shows that in this case, there is a role for the government to help the market achieve the optimal outcome. By forcing the polluting firms to bear some of the cost of the negative externality, the market ends up producing less of the good that is causing the negative consequences on the third parties.

Using similar reasoning, let's work through an example of the opposite situation from the one discussed above. Suppose we would like to see more resources allocated to the production of a good or service because it has positive consequences on society. Consider the graph below, which shows the market for inoculations (or flu shots as an example). The demand for shots is given by D1 and the supply by S. The market equilibrium at point E (150 million inoculations per year) is considered to be insufficient, so that we say, the market under allocates resources to the production of this good. Why do you think the activity of taking shots is considered to have a positive externality?

Right, the more people take flu shots, the less people get the flu which should result in everyone being healthier-which should ultimately lower the cot of healthcare and minimize the number of lost work days.

The optimal scenario is for the number of shots taken to increase. What can the government do to increase the number of inoculations?

One way is to raise the demand for inoculations, taking the demand curve to D2, say to 200 million per year as shown in equilibrium E2. Another way is to raise demand is to subsidize the cost of shots made available through employers, thus encouraging more people to get them since they are free. Another way is to educate the public on the benefits of taking inoculations thus raising awareness and potentially raising demand.

Can you think of other examples of positive or negative externalities?

WEEK THREE

Course Lecture 3-2: Rents, Profits, and the Financial Environment of BusinessContent Author: Dr. David Dieterle

Over the next several weeks we are going to explore an area of microeconomics known as the theory of the firm. We are going look at how economists use a different prism to view the business environment and business structures as compared to a business person and/or an accountant. At the conclusion, you will have a much better understanding of the "microeconomics" side of the economics world.

Economic Rent

Economic rent takes on several forms, economic rent of land or economic rent of labor. First, let's make sure you are comfortable with the definition. "Economic rent" is the value of the land or labor above its opportunity cost (i.e., its next best alternative).

Let's look at two examples of how, "Economic rent allocates resources to their highest-valued use."

Land example - The Empire State Building

Real estate in mid-town Manhattan in New York City has been considered some of the most valuable real estate in the world. Yet, it is only land, just like central Iowa farmland or upper Michigan forests. If as good economists we want to allocate our resources most efficiently, i.e., their highest valued use, we want to minimize the opportunity cost

of their use. This is where economic rent comes in. What would be the next best alternative for use of the land that the Empire State Building sits upon? Maybe a smaller office building, or retail, or maybe even farmland would occupy the real estate. Whichever its opportunity cost use, would it have the same value? Of course not. Any value above its opportunity cost value is considered economic rent.

You can see from the graph below, at any point in time supply (S) of land is perfectly inelastic. As a result, as the demand for the land increases so does the economic rent for the land (D1 to D2) which raises the land's price (P1 to P2).

Source: Miller, Roger; Economics Today, 14th Edition

Labor example - Ben Wallace

For those of you not familiar with Ben, "Big Ben" was a professional basketball player with the Detroit Pistons. He left the Pistons for the Chicago Bulls, and since landed in Cleveland. He has been an all-star and was named best defensive player for several years. He is very good, and he makes a lot of money as a professional athlete. As an economist, I am more interested in what his next best alternative for a profession might be. For example, his opportunity cost of playing professional basketball. Without knowing Ben, or his personal situation, I can still say with a very high degree of confidence if he was not playing professional basketball, his next best alternative would not be valuing him at the millions of dollars he currently receives as a professional basketball player. As a result, what he receives above the value of his next best alternative profession is Ben's economic rent.

Like "Big Ben", most "superstars" whether in sports, films, or entertainment such as the "Stars" in the chart below are receiving economic rent for their current earnings. What is your economic rent?


Profits of a Firm

"The Profits of a Firm" is a very important concept for you to become very familiar and comfortable with. It also may be a little difficult, especially for those of you who have accounting backgrounds, and for those of you who have business backgrounds and careers. There is a very significant difference between how an economist views the idea of "profit" to that of a business person (with accounting), which you will see.

Accountants' view of a business operation is very concrete, and direct. They identify the costs of production, the expenses of a business. These are called explicit costs, as they are paid costs and accurately known. Then they identify the business's revenue through the selling of the good or service. Subtracting the costs from the revenue, an accountant will provide the business owner a picture of the business health of the business.

An accountant's view of profits:

Accounting profit = total revenue - explicit costs (expenses paid)

However, an economist takes a different view of

profits. While an economist also takes into account the revenue and expenses of the business, they have one more item in their bag of numbers. Remembering economics is about trade-offs and opportunity costs, the economist also wants to know what the business owner could have earned had they not allocated their available resources to the production of the business's good or service, but say invested the "expenses" in a money market account. Isn't that lost savings a cost to the business owner? Absolutely it is, and the economist wants to count it as a cost of doing business. These are the implicit costs of doing business. Implicit costs are the opportunity costs of the productive resources used in the creation of the good or service of the business. As a result, the economist formula for profit has an additional cost, implicit costs, as shown below:

An economist's view of profits:

Economic profits = total revenue- (explicit costs + implicit costs)

Economic profits are much harder to achieve. They are also much more descriptive in illustrating the efficient allocation of resources for the business owner.

Course Lecture 4-1: The Firm: Cost and Output DeterminationContent Author: Dr. David Dieterle

Economic Pairs

If you remember in week one you were introduced to several - what I described as economic pairs. Well, there are several more of these "pairs" as we explore microeconomics and the theory of the firm. By taking a few moments at the beginning, we will have a head start on the important concepts of this lecture.

This lecture is chock full of the critically important concepts the micro-economist uses in assisting companies to be more effective and efficient. At the conclusion of this lecture, you will have a better understanding of how an economist can help businesses be more efficient and maximize their profits in the allocation of the factors of production they own and use to produce goods and/or services for their business.

Let's begin with a quick introduction to several economic pairs:

Variable vs. fixed

Variable input

An input whose quantity used in the production process is determined by the quantity of goods and/services produced.

Fixed input An input whose quantity used in the production process is not a set amount in the production process regardless of how many

goods and/or services are produced.

Average vs. marginal

Average The total divided by the quantity.

MarginalThe difference in the total when one more unit is added.

Before we attack the average product, marginal product relationship let's take a moment and do a short exercise to prove a point:

Please add up the following numbers:30, 24, 33, 36, 45, 35, 30, 35, 44, and 33

1. What is your answer? Have it -- good!2. How many numbers did you add? What is the average?

Now, add 32.

1. What is the new total? What is the new average?2. What is the marginal quantity in this new set of numbers?

If you answered 32 as the marginal quantity, you are correct.

Now, add 40.

What is the new total? What is the new average?What is the marginal quantity in this new set of numbers?

Again, if you answered 40 as marginal quantity, you are correct.

Remember: Marginal value is the value of the LAST unit added.

Can you see the relationship between the marginal number and the average?

When we add one more number (marginal), in what direction does the average go?

Inputs vs. outputs

Inputs The capital (K) and labor (L) factors of

production used by a business to produce goods and/or services.

Outputs (Q) The goods and/services produced.


A second important relationship is an understanding of the relationship between inputs and outputs. This relationship is how a business defines its productivity. It is how we define productivity at the macroeconomic level as well which we will cover later in the course. Be absolutely sure you understand the definition of production.

Increasing productivity, using the input/output relationship, is defined as a resulting increase in output using additional inputs or in a more efficient manner. Another way of increasing productivity is by maintaining output level with a decreasing level of inputs.

This relationship leads to what many consider the defining definition of economics; diminishing marginal product (returns).

Course Lecture 4-2: Diminishing Marginal ProductContent Author: Dr. David Dieterle

Before we define diminished marginal product, it's important to remember that marginal product is the change in total product that occurs when a variable input is increased and all other inputs are held constant.

Now we can go ahead and define Diminishing Marginal Product (DMP). DMP is an understanding that at some point, as equal additional units of input are added, the increase in marginal output will decrease. This decrease will continue, lowering average product until marginal product becomes negative and total product actually decreases. The charts below exemplify this relationship between marginal, average, and total product.

Source: Miller, Roger, Economics Today, 14th Edition

Remember, you have actually already been introduced to this notion through diminishing marginal utility. That is, the idea that as utility increases with the continued consumption of a good, a point will be reached when the utility of the additional unit will be less than the one before it. DMP is exactly the same concept, only now we are using it in the production process. Another way of looking at it is that DMU was measuring the consumer's satisfaction with goods and services from the Product Market; DMR is measuring the producer's use of the factors of production from the Resource Market.

As we look at DMP, remember a couple of cues:

1. The point of DMP is not the same as a decrease in Total Product (TP). If you look at the charts above, DMP (panel c) is reached at two units of labor. Yet, if you scan up to panel b Total Product continues to rise. That's because DMP, even though descending, it is still positive which means additional labor will continue to add to the Total Product.

2. So if DMP is not where TP declines, where does it decline? Let's turn the question, where does MP go negative? At about 7.5 units of labor, MP goes negative signifying that TP will now decrease.

Understanding these cues and the MP - TP relationship hinges on your understanding of the marginal-average, and marginal- total relationships discussed earlier. If you are not comfortable here yet, I strongly suggest you return to the earlier section; Average vs. Marginal.

Instructor Lecture: More on Marginal Product and Marginal CostContent Author: Basma Bekdache

Earlier this week you learned how to define production and marginal product. You also learned about the law of diminishing marginal product (also referred to as diminishing marginal returns). What happens to marginal product has important implications on the cost structure of the firm, which is a key determinant of its production level. In this lecture, we'll review and calculate marginal product, explain why it's diminishing and explain its relationship to marginal cost.

Do you recall the general definition of the marginal product of an input?

The marginal product of an input is defined as the change in total production (output) per unit increase in the input (equal to change output/change in input). If the input in question is labor, we can say that the marginal product of labor (MP) is the extra (or marginal) units of output we get when we you add an extra unit of labor.

Before we get to an example, let's remember that our analysis assumes that the firm is operating in the short-run. How do we define the short-run?

The short-run is a time period where at least one input is fixed (or cannot be changed). The input that is usually assumed to be fixed in the short-run is the capital stock, such as plant size. In the long-run, all inputs to the production process can change.

Suppose that the production function of snowboards is as described in the following table:

Quantity of Labor(workers per

week)

Total production of

snowboards(per week)

1 22

2 52

3 81

4 100

5 115

6 126

What is the marginal product of the 1st unit of labor? How about the 2nd, 3rd, 4th, etc? When does diminishing marginal product set in?

The marginal product of:

The 1st unit of labor is 22 snowboards, The 2nd is 30 snowboards (= 52-22), The 3rd is 29 (=81-52), The 4th is 19 (=100-81), The 5thth is 15m, and The 6th is 11 snowboards.

Diminishing product starts after the 2nd unit of labor.

Why does diminishing marginal product occur? That is, why is it that every extra unit of labor gives us less and less additional output?

Diminishing marginal product occurs because the other inputs, specifically, capital is fixed since the firm is operating in the short-run. In this example, with a given plant size (and a given set of tools and machines to be used for production), adding more workers will yield less and less additional output since the additional labor has to share the existing machines and tools.

Therefore, we know that diminishing marginal product occurs in the short-run when some of the other inputs are fixed. In the long-run, if we add labor and expand plant size (and get more machines and tools) at the same time, diminishing returns does not occur as quickly, especially if technology is improving as well, allowing the Labor input to be more productive at using the capital.

So why should marginal product be important to the firm? To answer this question we need to explain the relationship between marginal product and marginal cost. We will see next week that marginal cost is a key determinant of the production level of the firm.

Relationship between Marginal Product and Marginal cost:

Consider the definition of Marginal Cost (MC) that you learned in the previous lecture:

In the short-run, the labor input is the only variable input. Assuming (with no loss of generality) that the cost of labor is the same for all units of labor, meaning hiring the 1st unit of labor costs the same as the second and 3rd etc. and is equal to the wage, $W.

We can see that the change in total cost (numerator in MC formula) is the same as the wage rate W. That is, when we add an extra unit of labor on the margin, we are adding $W to total cost. What about the change in output (the denominator in the formula for MC)? What is the change in output that results from adding that extra unit of labor?

The extra unit of labor is adding its marginal product! So the change in output is equal to the MP of that extra unit of labor.

Given this, MC can be rewritten as:

As we can see from the MC formula in (2), as the marginal product of labor increases, the marginal cost of labor decreases, given W!

Intuitively, given the wage that the firm pays an additional worker, the more this extra worker produces (the higher his/her marginal product), the lower this extra worker is effectively costing the firm, (i.e., its marginal cost decreases, which is what we are seeing in the relationship above.

Let's have a look at the table below to work through a numerical example of this relationship:

Columns 1 and 2 show the production function while column 4 shows the

marginal product of labor.

Suppose that each unit of labor costs $W = $1,000. We can calculate the marginal cost using the relationship in (2) and get the results shown in column 6.

For example, for the 5th unit of labor MP = 50 internet accounts serviced (290-240), given W = $1,000, MC = 1,000/50 = 20. Similarly for the 6th unit, MC = 1,000/40 = 25.00. Since we have diminishing marginal product, the MC of the 6th unit of labor is greater than that of the 5th unit.

Therefore, MC will rise when MP starts to diminish! We can see this in the graphs below as well. Note that MP and MC are almost like mirror images of each other. MC declines when MP is rising. MC starts to increase when MP declines or at the point where diminishing marginal product sets in, which is after the 3rd unit in this example.

What's the implication of this relationship on a firm's cost structure?

A firm can reduce it's marginal cost if the marginal product of its labor increases! Can you think of ways to increase marginal product of labor?

Course Lecture 4-3: Short-Run Costs to the FirmContent Author: Dr. David Dieterle

In some ways, and at the chagrin of some educators, one way to begin to remember and ultimately understand the use and application of these formulas is to first, memorize them; second, see their relationship to each other, and third, see their relationship to the production process.

First, let's take a look at the popular short-run cost curves:


Second, spending time with the definitions.

Before we move on and look at the curves as curves, let us take a moment and make sure we have an understanding, mathematically speaking, and we are comfortable with each of these:

In the beginning we differentiated between variable costs and fixed costs, remember? So our first equation for Total Costs should make very logical sense:

TC = TFC + TVC

Now as we move on to the average cost curves, beginning with average total cost (ATC). For all the average costs curves, just remember how we arrive at an average. We have been doing it since fourth grade!

Divide the total (T--) by the quantity (Q)

The results for each of the totals then are logical extensions of fourth grade math:

ATC=TC/Q AVC=TVC/Q AFC=TFC/Q

Remembering our definition of marginal, identifying marginal cost (MC) becomes an extension of the definition, or the change in total cost by adding one more unit (change Q).

MC = change in TC/change in Q

Now that we have seen the mathematical look to these cost curves what do they look like as curves?



Third, let's spend a minute taking a look at the production curves. While studying the cost curves, pay special attention to the graphing of these cost curves in the figure above. While you may not be asked to directly recreate these cost curves, you will be responsible for their relationship to each other. Then again, maybe you will.

Notice the relationship between marginal cost (MC) and average total cost (ATC). As MC is decreasing, notice ATC decreasing as well to between 3 and 4 units. As the MC begins its climb upward, what is ATC doing? Hint: Go to the discussion earlier about the marginal-average relationship.

As MC intersects ATC, how does the MC-ATC relationship change again?

Finally, as MC>ATC, the ATC begins to increase.

Another relationship exemplified in the figure above is the Total Cost (TC), Total Fixed Cost (TFC), and Total Variable Cost (AVC). If you add the AFC and AVC curves, you can determine Total Cost (TC) curve. Also, if you observe the three curves, you will also notice the cost between 0 and AFC is equal to the amount between the AVC and TC

Instructor Lecture: Long-Run Cost CurvesContent Author: Dr. Basma Bekdache

The previous lectures focused on the cost structure of the firm in the short-run. Let's consider some issues that apply when we extend the analysis to the long-run. Do you recall how we define the long-run?

The long-run is a time period when all inputs (or factors of production) can change.

The plant size (or the amount of physical capital) was fixed in the short-run. When we vary the plant size, we can envision the long-run average total cost curve of the firm as consisting of the minimum points of the various short-run average total cost curves that apply for different plant sizes. We can see this is the graphs below:

In the example shown above, SAC1 represents the Short-run Average total cost curve if the firm is operating under plant size 1. If the firm expands to plant size 2, the short-run average total cost is SAC2 and so on. Panel (b) shows the long run average total cost curve as the locus of points representing the minimum unit cost of producing any given rate of output, given current technology and resource prices.

In panel (a), what do you notice is happening to the SAC curves as the firm's plant size increases?Think about this before clicking here for the answer.

In panel (a), the SAC curves are decreasing as the firm expands production capacity. When a firm can achieve lower average total costs when it expands its size, we call it Economies of Scale.

In panel (b), we can see that the Long-run Average cost curve is U shaped. What does this mean? Up to a certain output level, average total costs decrease as the firm expands plant size. Then its average costs stay about the same and after a certain output level (at SAC5 in this example), average costs tend to increase with a bigger plant size. We can think of three separate portions of this curve and define them as follows:

1. Economies of scale refers to decreases in long-run average total costs resulting from increases in output panel (a) below.

2. Constant returns to scale shown in panel (b) below is a situation where average costs do not change with the size of the output.

3. Diseconomies of scale refers to increases in long-run average total costs resulting from increases in output (panel c).

What can explain economies of scale or diseconomies of scale?

Economies of scale can result from many factors. In most cases, large fixed costs, such as those associated with a big car factory, are spread out over more units of output which decreases the average unit costs. Operational efficiencies and specialization also contribute to economies of scale. Bulk buying and spreading overhead are additional factors as well as financial considerations factors that sometimes enable large firms to obtain better financing and thus reduce their average costs of production. Diseconomies of scale start to occur when firms get too large to the point where they become inefficient. The firm can reach a certain size where coordination and communication problems start to limit the efficiency of management, thus increasing its average costs of production.

A related measure to long-run average costs is the minimum efficient scale.Minimum Efficient Scale (MES) is the lowest possible output for which the firm reaches its lowest long-run average total cost.

Given this definition, what is the MES in the example shown in the graph above?

The MES in this example is 10 units of output. This the smallest output this firm can produce to achieve its minimum long-run average total cost.

Economists use MES as a measure of how competitive a market can become. If the output that it takes to reach minimum long-run average costs is small, then given total market size, there is room for many firms to enter and produce in this type of market. If MES is large then only a few companies will be able to exist in the same market, given the total market size. Therefore, MES can be used as a measure to predict the likely market structure of a particular market.

Course Lecture 5-1: Perfect CompetitionContent Author: Dr. David Dieterle

Businesses come in all shapes and sizes. They compete in the marketplace every day against businesses similar in how they conduct business on a daily basis. This week you will be introduced to the characteristics of four market structures in which businesses compete: perfect competition, monopolistic competition, oligopoly, and monopoly. In economics, we call this the theory of the firm. You will see how and why some businesses operate the same, how and why some businesses operate differently, and why their knowledge of these similarities and differences can help them compete in the marketplace.

Let's ask ourselves a few questions about each industry structure:

1. What are the characteristics of each market structure? 2. How is demand determined? 3. How are profits maximized? 4. What signals do profits provide producers?

We can view each market characteristics by asking a few key questions:

Answering these questions provides us enough information to classify every company into a market structure and gain a better understanding of the "why" they conduct business the way they do. Let's set the stage to compare the four market structures by looking at the most "pure" market structure; perfectly competitive market structure.

The Perfectly Competitive Market Structure

Of the four structures, perfect competition creates the most "pure" structure since no one buyer or seller can have an effect on the market price. The characteristics of a perfectly competitive market structure include:

Large number of sellers and large number of buyers. Product sold is homogenous. A homogenous product is one that is exactly the

same, regardless of who makes it, sells it, or buys it. Each product is a perfect substitute for another. Agricultural product such as wheat is considered homogenous.

Both buyers (consumers) and sellers (producers) have access to the same information.

There are no barriers to entry. Both producers and consumers can enter and exit the industry with relative ease. The factors of production used can be transferred to another industry quite easily.

Producers are price takers. As price takers, the producers have no ability to set price but must take the price established by the market.

At the end of the lecture we will take a look at each of these characteristics and how they differ (or are similar) for each of the four market structures. But for now, let's keep our focus on the perfectly competitive firm.

How is Demand Determined?

The demand curve for a firm in a perfectly competitive industry is a horizontal line. Of course the obvious question is "why?"

If we look at the graphs below we see Panel (a) representing the industry and Panel (b) the Individual Firm within the industry. The industry demand curve looks very much like what we studied earlier on supply and demand, markets and prices. Yet when broken down to the individual firms of the market, the demand curve becomes a horizontal line and tells a very different story. This story can be explained by returning to the characteristics of the market structure: many buyers and sellers, full information, homogeneous product, no barriers to entry. With all these characteristics at play, the individual firm has absolutely no influence on the market price of the product (i.e., a price taker). Consequently, the firm has only one price it can charge. In our example, the price for pen drives is $5. As a result, the firm has a demand curve that is horizontal representing only the one price it can charge. Any other price cannot be charged because the demand curve represents a market of consumers who are willing and able (sound familiar?) to only purchase pen drives at $5.

The Demand Curve for a Producer of Flash Memory Pen Drives

(Source: Economics Today, Miller, 14th Edition)

So if the firm can only charge $5, how can it make a profit? Ah, the next big question...

How are profits maximized in each of the market structures?

For every firm, total revenue (TR) is the price per unit times quantity sold (TR=PQ). Yet, there is one point at which profits can be maximized by a firm. Look at the graph below:

Profit Maximization, Panel (b)


Profit Maximization, Panel (c)


Think about what we just viewed. For our purposes, let's momentarily pay special attention to the bottom Panel (c). First, look at the demand curve (d). With a horizontal demand curve, at the margin adding one more unit (margin) the price does not change. As a result the marginal revenue (MR) is the same as price (P) which is the demand curve (D). In essence, in a perfectly competitive industry P, MR, and D are equal, and therefore interchangeable. If you know one, you know the other.

Regarding marginal cost (MC) and the MC curve, you were introduced to this curve in previous lectures. Now imagine as if you are standing on your head looking at it! What other curve does it replicate? (Hint: Think about our pizza eating.). If you return to the lecture on diminishing marginal returns you will find some interesting similarities between DMR and the MC curve. Cool!!

There is a second way to look at the MC curve. On the MC curve, diminishing marginal returns sets in at 3 units. Beyond 3 units, the MC curve is moving upward - yet, MC < AVC and below MR. We are definitely making short run profits at the margin; MC < MR! So let's continue producing additional units (Q). Are we still making profits (i.e., is MC < MR)? Keeping our focus on panel (c) above, what interesting things happen beyond point E?

YES, beyond point E MC is now more than MR! We are no longer making a profit, but now experiencing a loss. Since we do not want to suffer losses we can then determine we are best at Point E where MC=MR. We have, in economics jargon, obtained the point of profit maximization!

Profits are maximized at the point at which marginal cost (MC) is equal to marginal revenue (MR). This is true for every firm of every industry.

Another interesting "point" about our MC curve. If you remember the marginal-average relationship we discussed earlier, when MC > AVC something interesting happens. The point where MC > AVC the curve becomes a firm's short run supply curve (s). Look at the figure below and you will see what I mean.

The Individual Firm's Short-Run Supply Curve


Before we move on, remember as we stated earlier, MC = MR is the profit maximizing point for every firm in every industry. Profit maximizing will always occur where MR = MC. It just may not be quite as obvious in the other market structures of monopolistic competition, oligopoly, and monopoly.

Pretty cool stuff, huh? Notice as we move through the course, the concepts and topics discussed in earlier lectures are beginning to come together and bring our economic world to life! And ... we are just getting started!

Short Run Profits

Profits come in several sizes. There are normal profits, economic profits, and of course no profits. Each provides firms information and signals on how a specific market is postured for growth, decline, or stability. Now it is time to see how these signals are exhibited. We will wrap up this lecture by looking at how businesses can use the information and respond to certain business climates.

Measuring Total Profits


The above graph gives us our first look at Total Profits. Notice that MC = MR (profits are maximized) is below average revenue (AR). Remembering our marginal- average relationship, with a horizontal d curve, MR = AR. Observe it is above average total cost (ATC= TC/Q). That means for every unit sold, where MC = MR, AR > ATC.

In this scenario the profits are considered economic profits because they exceed the normal profits. Normal profits are "built in" to the explicit costs of doing business. Economic profits, however, return not only explicit costs, but implicit costs as well. When economic profits are present, it is a signal to others firms that entry to the market is a good thing and profits can be earned.

The other side of the business coin is the graph below where AR < ATC at MC=MR.

Minimization of Short-Run Losses


When at MC = MR and P < ATC, the firm will experience short run losses as shown in the graph. This information becomes signals for businesses to not allocate resources to the market, or exit the market.

When a firm is in this situation, does it continue to operate or shut down? Does it exit the industry or hang in there? The answer is a definite MAYBE. Seriously, the rule for continuing to operate or shut down has a contingent "IF" attached.

In the short run, if price (P) exceeds average variable costs (AVC) per unit, stay open. Obviously a business cannot stay open in the long run if it continues losing money. But, if a firm can cover its variable costs, it might survive.

Why cover variable costs instead of fix costs? Good question - glad you asked.

Remember our definitions of the two costs. A firm will have to cover fix costs (FC) whether it produces 0 units or a million. Variable costs (VC), on the other hand, are per unit of production sensitive. So if VC costs can be covered, it is reasonable to continue producing. In the long run, eventually FC will become VC. Then the decision-making process begins again.

The graph below shows the break even price where MC = ATC = AR = P = d; i.e. all the economic stars are in alignment. Remember, a "normal profit" (return on investment) is built into the cost structure of a firm. So if the firm achieves this break even point, a normal return on investment will be realized. This is the point of zero economic profits.

Short-Run Shut Down and Break-Even Prices

(Source: Economics Today, Miller, 14th Edition

Instructor Lecture: More on Perfect Competition - The Firm's Short-Run Supply CurveContent Author: Dr. Basma Bekdache

In this lecture we're going to derive a firm's supply curve using the information we learned in the previous lecture. Let's begin with a quick review of the most important points that were made in the previous lecture.

First: Since firms in a perfectly competitive market are faced with a perfectly elastic (horizontal) demand curve, marginal revenue is equal to the output price (MR=P). Recall that price equals average revenue (P=AR) for all types of firms, but only for perfect competition can we say that MR=P.

Second: To maximize total profits, firms must choose output such as MR = MC. For the perfectly competitive firm this implies that profit maximization occurs at P = MC (since MR= P). Firms break even if price is equal to average total cost at the profit maximizing output level (P = MC = ATC). Finally, firms can be incurring economic losses and still operate in the short-run if price is greater than average variable cost (P > AVC). Firms should shut down (stop producing) in the short-run if output price is less than average variable cost (P < AVC). The graph below, which appeared in the previous lecture, shows the break-even and shut down prices of the perfectly competitive firm.

As we can see in the figure above, when demand is at d1 (price = 4.5) the firm is breaking even. We can see this since P = ATC at the profit maximizing output (E1). When demand falls to d2, the profit maximizing (loss minimizing) output becomes point E2 (quantity produced falls from 7 to 5 and the firm is now making a loss since P < ATC).

Short-run Supply Curve

In week 2 we learned that a supply curve shows a positive relationship between the quantity supplied and the price of output. Now that we know how a perfectly competitive firm decides how much to produce, we can see how the supply curve is derived from the MC curve. When the firm is faced with a given price, it produces the amount that is consistent with P=MC. As P changes, the quantity produced changes along the MC curve. Therefore, the MC curve represents the supply curve of the firm, since it gives us the quantity supplied for various prices. The firm stops producing when the output price drops below the minimum AVC, therefore only the portion of MC above AVC represents the supply curve of the firm. This is shown in the graphs below for one firm and for the industry as a whole in panel (c):

Source: Miller, Economics Today, 14th Edition

Understanding that the supply curve of a business is their marginal cost curve sheds light on the reasoning behind the determinants of supply we learned about in week 2. Recall we stated that an increase in the cost of inputs such as the wage rate would shift the supply curve to the left. Can you explain why this happens using the MC curve?

If the wage paid by the firm increases their MC increases. Therefore, the MC curve shifts up and to the left. Since the supply curve is the same as MC, the supply curve would shift left, consistent with a decrease in supply.

We can also see how an increase in productivity leads to an increase supply as we said in week 2. An increase in productivity raises marginal product. An increase in MP decreases MC (see lecture from week 4 on the relationship between MP and MC). When MC decreases, the MC curve shifts down and to the right. This shifts the firm's supply curve to the right consistent with an increase in supply.

Instructor Lecture: More on Perfect Competition - Industry in the Long-runContent Author: Dr. Basma Bekdache

We are now ready to discuss what happens to the perfectly competitive industry in the long-run. Recall that one of the features of a perfectly competitive structure is that there are no barriers to entry (i.e., firms can enter and exit the industry at very little cost). Also recall that the firm can be in either one of three situations:

1. Making economic profits, 2. Breaking even, or 3. Incurring economic losses.

This is summarized in the graph below:

Firms in the same industry are all faced with the same price (remember they are price takers), but they don't necessarily have the same cost structure. But suppose many firms in this market have the average cost curve AC3 so that they are making economic profits. What do you think will happen in this industry?

In this industry, new businesses will be attracted to this industry since there are economic profits.

Profits and losses act as signals for resources to enter an industry or to leave an industry. When we have economic profits, it signals resources to enter the market. Similarly, economic losses signal resources to exit the market. At break-even, resources will not enter or exit the market. Let's suppose we are in a constant cost industry (an industry whose total output can be increased without an increase in long-run per-unit costs). As firms enter an industry with economic profits, the supply curve in that industry will shift to the right (since the number of sellers increased). This drives the industry equilibrium price down, everything else held constant. As each firm is faced with a lower price (the horizontal demand curve shifts down), their economic profits decrease and are eventually down to zero as more firms continue to enter the industry. Conversely, as firms exit an industry that is incurring persistent economic losses, the industry supply curve shifts to the left (because the number of sellers decreased). This drives the

industry equilibrium price up, everything else held constant. This means that the firms that remain receive a higher price and eventually reverse their economic losses. This adjustment process continuously takes place, leading to a competitive long-run equilibrium where firms make zero economic profits. The firm's long-run situation is shown in the graph below, where the price is exactly equal to average short-run and long-run cost and the firm is making zero economic profit, which is equal to the normal rate of return.

Marginal Cost Pricing

A final point to make about perfect competition (in the short-run and long-run) is perhaps one of the most important. Firms in competitive markets are always producing at a point where the output price is equal to marginal cost (recall that profit maximization occurs at MR=MC and since P=MR for perfectly competitive firms, P=MC as well). The fact that P=MC is referred to as Marginal cost pricing. Marginal Cost Pricing refers to a system of pricing in which the price charged is equal to the opportunity cost to society of producing one more unit of the good or service in question. The opportunity cost to society of using a particular resource for production is its marginal cost. This result is important since it indicates that resources are being used most efficiently since the price of the output exactly reflects the cost of the resource. Therefore, competitive markets are considered to be the most efficient for resource allocation.

Course Lecture 6-1: The Data of Macroeconomics - UnemploymentContent Author: Dr. Basma Bekdache

In this lecture we begin our study of the Macreconomy! We first introduced the difference between micro and macroeconomics at the beginning of the semester. Do you recall the definition of Macroeconomics?

Macroeconomics is the study of the behavior of the economy as a whole.

Given that you have been exposed to several microeconomic models at this point in the semester (i.e., demand and supply, the profit maximizing model of the firms, etc.), you probably feel quite comfortable with using models and variables to analyze economic problems and answer economic questions. Recall that an economic model is:

Click on the option that best completes this sentence.

Before we can begin modeling the economy as a whole, we have to spend some time defining and measuring the most important macroeconomic variables. Therefore, the next couple of lectures will be quite descriptive, as we will learn how to measure the variables that tell us how the whole economy is performing. These measures are commonly referred to as Macroeconomic Aggregates. Once we are done with this, then we can start developing the aggregate demand/aggregate supply model which will help us analyze the economy and answer a number of interesting policy questions.

Examples of such questions are:

1. What happens when the government lowers taxes, or increases government spending?

2. Why does the Fed sometimes raise or lower interest rates?

3. Should policy be used to try to influence the economy?

So how do we decide how the economy as a whole is performing? From your own experience and reading the daily news, you probably have heard of a few terms that are always mentioned about the economy.

The most commonly mentioned measures are: GDP (Gross Domestic Product), Inflation, and Unemployment! If this was your answer, you are right!

We are interested in learning how much the economy produced in a given year, what happened to the general price level in a given month or year, and finally, we are interested in the proportion of people who are looking for a job and are not working.

Does that mean that these are the only variables we study about the economy? You probably guessed no. There are many other important variables that we can study. However, the aforementioned three variables are indicators that can flag problems and tell us whether we need to explore more variables. It’s similar to when you go visit your doctor for your annual check up. They take your temperature, blood pressure, and a few others things. If one of these measures turn up abnormal, then they investigate further. Perhaps the economic variable that people can relate to the most is unemployment. Let’s start with that and learn how to calculate and interpret the Unemployment Rate (UR).

The unemployment rate is defined as the proportion of the labor force that is unemployed. The labor force is the part of the population that is eligible to work and is looking for a job. More specifically:

Source: Reprinted from Roger LeRoy Miller, Economics Today, 14th edition.

The labor force is defined as individuals 16 or older who are either currently working or are actively looking for a job.

According to these figures for 2007, the UR was 4.8 percent. That is, 4.8 percent of the people who were eligible to work and were actively looking for work but are not working. Let’s see if we can look at the UR with more recent figures. We can visit the Web site of the Bureau of Labor Statistics (BLS) to view the current statistics on unemployment.

This week’s packet also contains a link to a presentation that will help you to navigate the BLS Web site.

We can see on the top left under Latest numbers that the UR for December 2008 is 7.2%! Obviously larger than the 4.8% we got for 2007. We will learn soon that a major type of unemployment (called cyclical) occurs when the economy is in a downturn and firms are laying off workers because they are producing less. How does that compare to other years for the U.S? We can take a look back over the last Century by going to a time series graph for the UR.

Course Lecture 6-2: The Data of Macroeconomics: InflationContent Author: Dr. Basma Bekdache

You probably already know something about inflation from your own experience! When you start paying more for gasoline or food and/or other items that you regularly purchase, you notice a difference in how much you can afford to buy with your current income. If this happens then you are experiencing a decrease in your "purchasing power" due to inflation. The opposite can also occur. If overall prices go down (deflation), then you can buy more goods and services with the same income, which is an increase in your purchasing power. Based on this, how do you think we define inflation and deflation?

Inflation is defined as a sustained increase in the general or overall price level. Deflation is a decrease in the overall price level.

Before we learn how to calculate inflation figures, let's pause for a moment on the definition above. The key word in this definition is overall or general price level (we can also say the average price level). If the price of one or two items we buy increases that does not necessarily mean that there is economy-wide inflation. Recall that Macroeconomics deals with aggregates or totals. Here too we have to define an aggregate price level that represents almost all of the goods in the economy. Let's denote this price level by P. Then we see that P is rising, so then we can say that there is inflation. You're probably wondering how we can define one number that represents all of the prices in the economy. For that, economists turn to prices indices. There are several price indices that we can use to calculate inflation:

1. The Consumer Price Index (CPI) 2. The Gross Domestic Product (GDP) deflator 3. The Producer Price Index (PPI) 4. The Personal Consumption Expenditures (PCE) Index

The most commonly used indices are the first two listed above. A little bit later we will learn how to compute the CPI, an index which is based on a representative bundle of goods and service.

For now, let's assume we have the price index, denoted by P, and let's learn how we can use this index to calculate an inflation rate. The inflation rate is given by the percentage change in the price index from one period to another - say from one year to another).

The Bureau of Labor Statistics computes (among many other statistics) the CPI and inflation for our whole economy as well as various regions and cities. Let's check the BLS Web site for some data on the CPI and use it to illustrate how we can compute inflation using a price index.

Navigating the BLS Web site, we can find the CPI for 2000 and 2001 to be 172.2 and 177.1 respectively. To calculate the inflation rate let's apply the percentage change formula we discussed earlier in the lecture. Do you recall how to calculate a percentage change in a variable? Take a moment to try to calculate this for yourself.

That's right. The percentage change in a variable, X, is given by the [(new value - old value)/old value ] * 100) or [(X2 -X1)/X1]*100)

Do you think an inflation rate of 2.8% is high or low for the U.S economy? Also, how do you think inflation moves with the state of the economy? For example, when should we see it increase or decrease? To try to answer these questions, let's have a look at historical data for inflation in the U.S.

http://www.bls.gov/

We can see that, generally, inflation tends to increase when economic activity is increasing and vice versa.

There are however, a few periods of time where the economy is in a downturn, and we still experience inflation. We will see later in our model that this occurs when we have a decrease in aggregate supply or what we call a supply shock. On the other hand, when aggregate demand is increasing leaving to more economic activity, inflation tends to increase as well. We will call that a demand shock.

We can go back to the BLS Web site and check the latest data on inflation:

What is happening to overall prices according to the latest data?Why do you think prices are now (increasing or decreasing)?

In December 2008 the economy experienced deflation. The price of oil, and food fell leading to a drop in the general price level. This is consistent with the weakening demand conditions that are occurring now due to the credit tightening and drop in consumer confidence.

http://www.bls.gov/

We still have not discussed why rising inflation is a problem for the economy. In fact, one of the two main goals of the Federal Reserve, the nation's central bank-a lot more on this later, is to maintain price stability! Why is price stability so important?

High and unstable prices can generate uncertainly in the economy, which can lead to erratic economic behavior and creates inefficiencies. In addition, inflation leads to high interest rates and redistributes the income in the economy between creditors and debtors.

We will show how this occurs shortly. But first, let's turn our attention back to calculating inflation and return to the subject of the price index!

How to calculate the Price Index

The formula for the price index is given by:

Let's focus on the CPI. The basic idea is to track the dollar value (or dollar price) of a typical market basket of goods and services relative to a reference point in time we call a base year. The choice of the base year is not important as long as it is not a year where prices are not unusually high or low. In the example we consider next, the market basket consists of two goods, for simplicity sake. In reality, the BLS defines the market basket using hundreds of goods and services that a typical average consumer might purchase.

Course Lecture 6-3: The Data of Macroeconomics: Business FluctuationsContent Author: Dr. Basma Bekdache

By now, you know how to compute and interpret the unemployment and inflation rates. You also know a little bit about how these two economic indicators move when economic activity is changing. In the next lecture we will also learn details on how we measure the output (income) or production level of the economy and its growth rate, using real Gross Domestic Product (GDP). Before we dive into the details of National Income Accounting, let's sketch a picture of how economic activity, as measured by real GDP, might look over time and then ask ourselves what we expect to see happen to unemployment and inflation over that period of time.

Real Gross Domestic Product: Level and Growth Rate

Reprinted from the Federal Reserve Bank of San Francisco Educational Resources Web site

Looking at the blue line in the chart above, what do you notice is happening to the production level of the economy over the last 40 years or so? What do you notice if instead you zoom in only a few years, say from 1975 to 1980 or 1990 to 1992?

And to that the answer is an emphatic YES.The economy's production level is trending up over a long period of time. However, it fluctuates around the trend in different years. For example, in 1975, real GDP decreased and again in 1990 and 1991, whereas it increased in 1978 and 1992.

Next week we will study the determinants of the long-term upward trend in GDP or the long-term economic growth trend. Focusing on the economic fluctuations for now, economists often speak of these fluctuations occurring in cyclical fashion sometimes termed the business cycle. We can envision economic activity changing as in the chart below:

Source: Economics Today, Roger Miller, 14th edition

As you can see, when real GDP is increasing above the trend, we say the economy is an expansion phase, whereas real GDP decreasing and falling below the trend is termed a contraction (or recession - a lot more to say about that later).

The model we will develop in the next two lectures will enable to analyze and understand the factors that lead the economy through these fluctuations. Economists have found over the years that it is very difficult to predict exactly when the economy will transition from one phase of the cycle to another. Obviously, everyone would be interested in avoiding a recession since it causes unemployment and implies loss of income and a lower standard of living. Later on we will discuss the role of government and Federal Reserve policy in trying to predict and influence the business cycle to minimize fluctuations.

Course Lecture 6-4: Gross Domestic Product: Definition and MeasurementContent Author: Dr. Basma Bekdache

We've been talking about Gross Domestic Product (GDP), for a quite a while now, as being a measure of the economy's output or production level. In this lecture we learn how to compute and interpret GDP and real GDP figures. We also learn about what GDP does not tell us about the economy. We will have a look at the definition shortly. But first, let's ask ourselves this question:

Why is the economy's output or production level a measure of how well it's performing? In other words why do we care about the output of the economy?

If you thought the economy's total production level is tied to the total income in the economy, you are right!

When an individual or a business in the economy produces a good or service it creates income to the inputs (or factors of production) that were involved in the creation of this good or service. Therefore, an increase in aggregate output is the same as an increase in aggregate income and vice versa.

As an example:

When I purchase a cup of coffee at Starbucks for $3.00, the value of the production of this cup of coffee is $3.00, and this amount is also income to the owner of the Starbucks store. Part of it goes to wages to the workers there, another part to the cost of materials, rent, etc.

So the value of the output is also the value of the income to the inputs that helped produce the coffee cup.

Economists often represent this relationship between aggregate income and aggregate output using the following circular flow diagram:

Source: Economics Today, Roger Miller, 14th edition

Gross Domestic Product (GDP) is defined as the total market (dollar) value of all final goods and services produced in a given period (year or quarter) within the nations' domestic borders.

Important things to note about this definition:

Market value:

We need to use the dollar value (instead of quantities) as a weight to add up all the different goods in the economy. Can you imagine how hard it would be to express total production in terms of quantities instead?

As an example, you would have to

say: this year the economy produced 1,000 bushels of corn, 10,000 cars, 500 computers etc. We can't really add things up if they are not the same units! Therefore, we use a common denominator, their market (dollar) value. When all items are expressed in dollars they can be summed up into one number representing the value of total production in the economy.

Final goods:

These are goods that require no further processing and are ready to be consumed, such as a car or a loaf of bread. Intermediate goods on the other hand go back in the production process. Examples are wheat used in bread production, steel used in cars, tires on a car etc.

Why do we only include final goods?

If we count both, intermediate goods causes us to overstate production as we end up double counting some items. So if we count the value of the tire and then also the value of the car which includes the tire, we would be double counting the tire!

In a given year: GDP is a flow not a stock measure. Do you recall the difference between a stock and a flow?

A flow variable is one that is defined over a specified period of time, such as a year or a quarter. A stock variable accumulates over time and is measured at a specific point in time. For example, your savings per year or per month is a flow whereas the level of your wealth at the end of the year (or month) is a stock.

Now let's turn to how we calculate GDP. There are two main methods for computing GDP:

1. The expenditure approach. 2. The income approach.

In the expenditure approach, GDP is found by adding up the value of all the spending that takes place in the economy. We can think of the whole economy as consisting of the following sectors (or economic agents) and their corresponding spending:

1. HouseholdsTotal spending by households on durable and non durable goods is called Consumption (denoted by C)

2. FirmsTotal spending by businesses on plants, equipment, machinery and inventories is called Investment (denoted by I)

3. GovernmentTotal state and federal spending by the government, excluding transfers, is called Government spending (denoted by G)

4. The Rest of the World

Goods produced here and sold overseas are called Exports (EX). Good we buy from the rest of the world are called Imports (IM).

In net, total spending on good produced here by foreigners is called:

We can summarize the expenditure approach using the following relationship:

Notice that IM or Imports are being subtracted out of the GDP calculation? Why are we subtracting imports?

Imports are goods that were not produced in the domestic economy. Therefore, they should not be included in our production level. They are subtracted because they are already included in other spending the components C, I and G!

The economy's national income accounts are kept at the Bureau if Economic Analysis (BEA). Let's visit the BEA Web site to check the latest figures on the spending components and compute GDP using the expenditure approach

Let's go to the Bureau of Economic Analysis (BEA (http://www.bea.gov), and follow the appropriate links to find real GDP tables.

Or link directly to the National Income and Product Accounts Table:

Let's apply this to 2006 data from the BEA. In billions of dollars, the spending components values are:

C = 8,029, I = 1,912.5, G = 1,917.2, X = - 615.7What is GDP?

GDP = C + I + G + X = 8,029 + 1912.5 + 1917.2 - 615.7 = 11, 243 billion

We will revisit these figures again shortly to learn about the shares of each of the spending component in GDP. But first, let's learn about the income approach.

Recall the circular flow concept described above. Each dollar that is spent in the economy represents a dollar of income to one or more of the factors of production. In the Income approach, the value of GDP is computed by adding the total income of all the factors of production. Specifically: we add wages (income to labor), interest (income to capital), Rent (income to land) and Profits (income to entrepreneurs). The following table shows a calculation of GDP using the Income and expenditure approaches:

http://www.bea.gov/national/nipaweb/TableView.asp?SelectedTable=6&FirstYear=2007&LastYear=2008&Freq=Qtr

http://www.bea.gov/

Given these figures, which spending category do you think represents the largest portion of GDP?

Consumption is the largest portion of GDP. Let's have a look at a times series graph of the GDP components to see how the spending shares change over time

We have learned how to measure the economy's output using the GDP measure obtained from the expenditure and income approaches. What are some items that may not reflected in the GDP measure?

GDP does not reflect any home production that takes place in the economy. For example if I cut my own grass, this production does not enter the GDP

calculation. But If I hire a company to cut my grass, then it is reflected in GDP. Illegal activity is also excluded from GDP.

GDP does not (and should not) include any financial transactions or transfers. That is because a transfer of wealth does not involve new production. For example, if a stock is bought or sold, it does not enter GDP since this transaction does not produce a new good or service.

Finally, GDP is not a measure of the well being of an economy since it does not reflect the quality of life of people living in that society.

Course Lecture 6-5: Nominal and Real GDP Content Author: Dr. Basma Bekdache

We first learned about the distinction between nominal and real values in our discussion on inflation and interest rates. Do you recall what is a real value?

That's right! A variable is in expressed in real terms if it is adjusted for price changes or inflation.

When we calculate GDP as described before using the expenditure or income approach, we are computing nominal GDP since we use the current market value of goods and services which is determined by current year price.

So why do we need to adjust for inflation?

Nominal GDP can overstate the production level of the economy.

Looking at GDP from year to year, we are interested in whether the economy's production level and income grew in real terms. Since nominal GDP figures are obtained using current year prices, nominal GDP from year to year can increase even if the quantities produced did not increase but only their market value or prices rose. Therefore, if there is inflation, nominal GDP overstates the growth rate of the economy. In order to avoid misrepresenting the growth rate of the economy due to changes in prices, economists base their growth rate calculations on real GDP, which is nominal GDP adjusted for inflation.

Real GDP is found by computing the dollar value of current year production using base year prices. Recall that the base year is a reference year where we hold the price level constant. Real GDP can also be computed using the GDP deflator as follows:

Real GDP - [Nominal GDP / GDP Deflator] * 100

Per Capita Real GDP

To adjust for population growth over time we compute Real GDP per capita or Real GDP per person as follows:

Per capita real GDP = Real GDP/ Population

This measure also allows for comparison of standard of living over different countries with different populations.

WEEK SEVEN

Course Lecture 7-1: Economic GrowthContent Author: Dr. Basma Bekdache

Earlier in the semester, we discussed the production possibilities frontier as a model that represents the economy's tradeoffs and output choices given its existing resources, at a point in time. Using the PPC, we showed how a society can expand its production possibilities (i.e. produce more of everything) if it increases one or more of its factors of production. For example, if the economy has more capital (i.e., machines, equipment, and factories), its PPC shifts to the right, indicating that the economy's potential has grown.

Do you recall what we call an increase in the economy's potential output?

We called this Economic Growth.

In this lecture, we revisit the concept of economic growth and focus on its determinants. Understanding what determines an economy's potential production level will set the stage for the next lecture where we show the Long-run Aggregate Supply Curve (LRAS). The LRAS is a key component of the Aggregate Demand /Aggregate supply model which we will continue to build throughout this week's lecture. The LRAS will represent the level of output, which the economy can reach if it's fully utilizing its resources. It can be thought of as a goal for where the economy should be. After we are finished building the entire model, we will use it to analyze why and how the economy may produce at above or below that level in the short run. We will also analyze the consequences of each situation on the economy and whether and how, if any, policy can be used to steer the economy to its potential level.

Before we describe the factors that lead to economic growth, let's revisit the data on output that we learned about in last week's lecture. Recall that to allow for population changes over long periods of time, we look at a variable that is derived from Real GDP, the measure of the economy's output. Do you recall this variable?

That's right. It's real GDP Per Capita or real GDP/Population.

Let's have a look at a time series graph for data on Real GDP per capita for the U.S economy:

Looking at this graph, how would you describe the trend in Real GDP per capita?

We can see that output per person trends upwards over the whole period, but it also fluctuates up and down and around the trend over various years.

In this lecture, we focus on the long-term upward trend in per capita Real GDP. We will shift our focus to short term fluctuations in Real GDP (or the business cycle) next week. We can be more specific and compute the growth rate in per capita Real GDP from year to year. The average growth rate for the U.S for the period 1990-2007 is about 3%.

What do you think accounts for this average positive growth rate? To answer this question, we have to ask ourselves what factors determine how much an economy is capable of producing at a point in time. What do you think an economy needs to produce?

You probably thought of the human resource or Labor, and the physical resources, or Capital.

Other important factors of production (or resources) are the level of education (or human capital), natural resources (or Land), and Entrepreneurship (the ability to

create and manage businesses). How much an economy has of all of these resources determines its long term ability to produce.

As an example, what do you think would happen to the economy's growth rate if business spending on plants and equipment increases (i.e., using last week's definition - if Investment (I) increases)?

The economy's growth rate should expand! Business Investment leads to an increase in the physical resources or capital of the economy which enables it to produce more of everything.

In a similar reasoning, an increase in any of the aforementioned resources helps the economy grow more over time and vice versa. Any permanent decrease in one or more of the factors of production can hinder economic growth.

There is one last very important determinant of growth that we did not discuss yet. Can you guess what it is? I'll give you a hint: This important determinant of growth is the result of research and development, new ideas, and innovations. It represents society's pool of knowledge!

Yes, it's technology! One of the most important factors of production, technology cannot be measured directly. Instead we observe its effects on production levels and quality of products. Technological improvements enable us to produce the same level of output more efficiently (or cheaper). Equivalently, we can say, technology enables us to produce more with the same amount of the other inputs. (i.e., labor, capital etc.).

This leads us to another concept intimately related to technology and economic growth: Productivity! What is productivity? At some point or another, we've all used this term in our daily lives. What does it mean when we say that we are being more productive at a certain activity?

Labor Productivity is measured as output per hour of work. We say we are more productive if we can produce more with the same resources.

For example, if I could cut my grass in 2 hours and now I can cut my grass and trim the bushes in 2 hours, then I can say I became more productive at yard work. This is because I can accomplish (or produce) more with the same resource, which is 2 hours of my time.

What do you think could have helped me become more productive at doing yard work? Click on each of the options below to see if and how that effort could have helped.

1.

Buying a new faster mower.

Yes, technology raises productivity.

2.

Buying an electric trimmer.

Yes, an increase in physical capital raises labor productivity.

3.

Learning new

Yes, an increase in human capital helps too!

techniques for doing yard work.

4.

I decided to work harder.

No, I should have been working as hard as I could from the beginning since I have my self-interest incentive to cut my cost, which is my time!

Productivity is important to economic growth. An increase in productivity leads to lower costs of production or more efficiency, which in the long-run enables the economy to produce more.

To continue please click on the next link in the navigation bar on the left.

WEEK SEVEN

Course Lecture 7-2: Long-Run Aggregate SupplyContent Author: Dr. Basma Bekdache

We are now finally ready to start our model of the macro economy! In this lecture we work on the Long-Run Aggregate Supply curve (LRAS) piece of the model. Next lecture, we develop Aggregate Demand, and then we put them together! As we are building the model, the material is quite theoretical at times. But bear with it and before you know it, you'll be able to put on your economist hat to analyze real life economic scenarios and make predictions using this model. Recall that one reason we use models is to simplify a complicated reality (such as the economy) and visualize it in order to understand it, analyze it, and make predictions.

The two macroeconomic variables that the model will explain are Real GDP (output) and inflation (as derived from changes in the price index). Since unemployment is inversely related to output, we can also make predictions on unemployment indirectly through our predictions on output. Given this, the graphical depiction of the model will have Real GDP on the horizontal axis and the price level on the vertical axis. Let's start with some definitions:

Aggregate Supply: the total of all planned production for the economy.

Long-run: A period of time where all inputs are variable and prices are flexible.

Long-run Aggregate Supply (LRAS) - A vertical line that represents the level of Real GDP when the economy is fully utilizing its resources and producing at potential (full employment output, which is equivalent to being on the frontier of the PPC), as shown in the graph below:

According to panel (b) in the graph above, what is the level of potential GDP?

In this example, potential Real GDP is 12 trillion. We can see this since the LRAS is placed at that level on the horizontal axis.

Since the economy is at full employment output (potential) at 12 trillion, what is the unemployment rate at this level of production? Hint: Recall definitions of unemployment from last week's lecture.

Since at potential output (where LRAS is placed), there is no cyclical unemployment, the unemployment rate will be equal to the Natural Rate of Unemployment.

Why is the LRAS a vertical line in the model graph? To answer this, it helps to ask yourself, is the level of real GDP at potential (or full employment) related to the price level?

The answer to his question is No! The price level does not determine how much the economy can produce at potential.

As we learned in the previous lecture, potential real GDP is determined by the factors of production (or the amount of resources-also called endowments) in the economy.

Given this, let's work on an exercise to see if you recall these factors and how they affect the economy's potential. In addition, let's also show how a change in a factor of production affects the placement of the LRAS in our model.

To continue please click on the next link in the navigation bar on the left.

WEEK SEVEN

Course Lecture 7-3: Aggregate DemandContent Author: Dr. Basma Bekdache

We have already represented the production side of the economy in the long-run using the LRAS curve. Now let's represent the demand side of the economy, starting with this definition:

Aggregate Demand: the total of all planned expenditures in the economy.

Aggregate Demand Curve (AD): a line showing the relationship between total expenditures and the aggregate price level (or GDP deflator).

We already know a great deal about the total expenditures of the entire economy from last week's lecture. Hint: Review section on expenditure approach to computing GDP.

Do you recall what makes up aggregate spending or total expenditures in the economy?

You remembered! Total expenditures are the sum of household spending or Consumption (C), Business spending or Investment (I), Government Spending (G), and foreigners' spending or Net Exports (X).

Clarification Note:Last week, in the expenditure approach to measuring GDP, we showed how to compute GDP as the sum of all expenditures in the economy. Here we just defined Aggregate Demand to be equal total planned expenditures, and in the previous lecture we defined Aggregate supply to be total planned production. Is there any inconsistency in these

definitions? Actually, no. When we are computing output using the GDP measure, we assume that we are observing the economy in a short-run equilibrium where Aggregate demand is equal to aggregate supply. Therefore we can compute total production / output as equaling total spending. In the model we have here, we start by discussing the demand and supply (production) sides of the economy separately and then show how we reach the short-run and long-run equilibriums.

To draw the Aggregate Demand curve in our model, we need to determine how these components relate to the price level. That is, we need to understand what happens to either one or more of C, I, G or X when the aggregate price level changes, all other things held constant.

When the price level rises, the total spending in the economy falls and when the price level falls, total spending rises, that is the AD curve is downward sloping as shown below:

Source: Roger Le Roy Miller, Economics Today, 14th edition

Does this make sense? Why do you think total spending would decrease if the price level increases and total spending would increase if the price level decreases?

I am guessing you thought of at least one reason, which is that an increase in the price level decreases the real value of our money balances which makes us feel less wealthy and leads us to want to spend less on goods and services. This is called the real-balance or wealth effect.

In addition to the real-balance effect, there are two other channels through which we can find an inverse (or negative) relationship between total expenditures and the price level. These are:

1. The interest rate effect:As we learned in last week's lecture, nominal interest rates are directly related to inflation. When prices increase, interest rates tend to increase which in turn discourage spending by consumers and businesses, thereby reducing total spending.

2. The open economy:When domestic prices rise relative to those in the rest of the world, everything else held constant, our goods and services become more expensive to foreigners, which reduces out exports. At the same time, we buy more from foreigners since their goods are cheaper, which increases our imports. The decrease in export (Ex) and the rise in imports (IM) reduces exports (X), which reduces total spending.

Now that we know why the AD curve slopes downward, we are ready to discuss shifts in the AD curve. Do you recall what it means when a curve shifts to the right or to the left? In this particular case for AD, what can we tell is happening if we see the curve shift to the right as shown below?

When the AD curve shifts to the right, we say AD increased. This means at any value for the aggregate price level, total spending increased. Recall that this is different from a movement along the curve which indicates that total spending is changing due to a change in the price level.


When AD shifts to the left (as shown below), we say AD decreased. This means that total spending decreased at any price level.


The factors that cause AD to increase (or decrease) are called non-price determinants of AD. Non-price determinants of AD are economic variables or events that influence any of the spending components. The following table summarizes a number of these determinants:


To understand how each of the changes listed above affect AD, let's have a closer look at each of the rows in the table and determine which of the spending components are affected in each case. Let's work together on some of these changes using the following presentation (before you watch , try to predict which of C, I , G or X are affected in each case). When you are done, you can check your thinking by working on the remaining items in the table using similar reasoning.

Please watch the following 6-minute presentation.

WEEK SEVEN

Course Lecture 7-4: Long-Run Equilibrium and the Price LevelContent Author: Dr. Basma Bekdache

By now, you should be familiar with the determinants of long-run aggregate supply (LRAS) and the determinants of aggregate demand (AD), our representation of the production and spending sides of the economy as a whole, in the long-run. We are now ready to put them together to discuss long-run equilibrium. You first used the concept of equilibrium at the beginning of the semester, in week 2's micro demand and supply model. Do you recall how we defined equilibrium?

Equilibrium is a state of no change or a state of balance. In the market for a particular good or service, equilibrium price and quantity are those that occur when quantity demanded equals quantity supplied, such that there is no need for the price to adjust. If quantity demanded is not equal to quantity supplied, we have a disequilibrium (either a surplus or shortage) and the price of the good adjusts to eliminate the shortage or surplus.

For the economy as a whole, long-run equilibrium occurs at the price level where AD intersects LRAS as shown below:


According to the figure above, what is the equilibrium price level in this economy?

Given potential real GDP of 12 trillion and the level of aggregate demand (AD curve), the equilibrium price level is 120. This is the price level at which total aggregate spending equals total long-run planned production.

How does the economy end up at this equilibrium price level of 120?

Let's consider alternative price levels and explain the adjustment to equilibrium.

If the GDP deflator or the price index was at 140, then AD would be too low as compared to total planned production.

AD = 11 trillion, potential output = 12 trillion.

In this situation of excess supply, the excess capacity in the economy eventually drives prices down towards the equilibrium. Remember that prices are completely

flexible in the long-run!

Similarly, if the GDP deflator was equal to 100, AD is too high as compared to potential output.

AD= 13 trillion, supply is 12 trillion

The excess demand in the economy puts upward pressure on prices and takes the price level towards its equilibrium level of 120.

Note that since the economy's output in the long-run is determined by the factors of production or the endowments that determine potential output, AD does not play a role in determining how much the economy produces in the long run. AD does however determine the price level! We will see next week that AD plays a very important role in determining the economic fluctuations around potential real GDP or the economy's production level in the short-run.

Inflation and Deflation in the Long-Run

At this point, we should be able to use our model to explain trends in prices and output. Looking at the equilibrium graph above, what can cause an increase in the equilibrium price level (or inflation)?

That's right. There are two situations that can result in inflation:

1. A decrease in LRAS, and 2. An increase in AD, as shown in panels (a) and (b) below.


What about deflation? When does that occur? One situation that can result in the price level decreasing over time is if we have economic growth (LRAS shifting right) without matching increases in AD as follows:


Can you think of another scenario where we can also experience deflation?

That's right if LRAS is stable and AD decreases, that can also cause deflation. Draw the graph to show yourself that this situation leads to a lower equilibrium price level.

Applying the Model to U.S Data

Let's apply our model to explaining observations or trends in real GDP and prices in our economy. In last week's lecture, we examined time series data on inflation and real GDP (i.e., we examined inflation and real GDP individually over time). The following chart plots U.S. data on the price index and real GDP for the period 1970 to 2007 using the model graph set up, with the GDP deflator measured on the vertical axis and real GDP measured on the horizontal axis. This allows us to see the relationship between the price level and real GDP as it evolves over time. You can envision each of these data points as an equilibrium point in our model or the intersection of AD and LRAS.


Looking at this graph, how do you see the price level and real GDP changing together over time? How can we explain this trend using our long-run model?

Let's listen to the following 5-minute presentation to practice using the model to answer these questions.

WEEK EIGHT

Course Lecture 8-1: Short-Run Aggregate Supply and the Short Run EquilibriumContent Author: Basma Bekdache

Last week we developed the long-run model of the economy. The long-run model allows us to explain and analyze the long-term trend in Real GDP and inflation. Although it is very important to understand factors that lead to long-term economic growth and contribute to long-term price stability, it is equally important to understand economic fluctuations around the trend. In fact, most of us can only relate to short-run changes into the economy, as that is what affects our daily livelihood. Specifically, we are all interested in learning what can cause downturns in economic activity or recessions. This is important to us as recessions are coupled with layoffs and unemployment. We also want to find out if and how government or central bank policy can alleviate or reverse recessions. Alternatively, if economic activity is really strong, we can face inflation, which has its detrimental effects on the economy in the short run as well. In this situation, central bank policy may be used to slow down the inflationary effects by raising interest rates to reduce aggregate demand. This week we develop the short-run version of our model of the economy, which is the tool we use to analyze economic fluctuations and economic policy.

Note that this model is the same as the long-run model with the exception of aggregate supply. This is because in the long-run, aggregate supply is determined by the availability of endowments or factors of production (which determine potential or full employment GDP). In the short-run the behavior of firms in the economy determines aggregate supply.

Let's start by stating what we mean by the words short-run. Perhaps it helps to revisit the definition of the long-run, do you recall what defines the long-run?

Yes, the long-run is a period of time where all inputs are variable and all prices are flexible or can change.

Given this, what would you say defines the short-run?

Right again! The short run is a period of time where some inputs are fixed and some prices are inflexible or fixed.

So what does it mean for some inputs to be fixed?

Example:

Suppose a small business is facing more demand for its product and it determines that it needs to expand its production to meet the growing demand. In the short-run, the business can hire more labor (variable input) to increase production but it needs time to buy a new plant or expand its physical space. In the short-run, the capital (plant or physical capacity) is a fixed input.

Given that firms face constraints on production capabilities in the short-run, how do they vary their production levels (real GDP) in response to changes in the price level? In other words, what is the shape of the aggregate supply curve for the whole economy in the short run? Recall that in our model, the price level is on the vertical axis and real GDP appears on the horizontal axis.

If you guessed that the short-run aggregate supply curve (SRAS) is upward sloping, reflecting that firms would produce more in response to higher prices, you were at least partially right! Why aren't you completely right? Because as we will soon see, the slope of the SRAS changes depending on where the economy's output is relative to its potential.

The following graph shows the widely accepted modern Keynesian SRAS with a positive slope, placed relative to the LRAS or potential real GDP. As we will see a little later, there are other versions of the SRAS that can result when we change our assumptions about price flexibility in the economy. The modern Keynesian SRAS is consistent with empirical data reflecting the behavior of firms in the economy.

There are two important things to note about the graph above:

1. The intersection of AD and SRAS represents the equilibrium of the economy in the short-run. In this example, the economy is producing at potential since AD intersects LRAS as well. Recall that LRAS represents real GDP at full employment or potential.

2. The slope of the SRAS is flatter at levels of real GDP that are below potential (to the left of LRAS) and gets steeper as the economy's output surpasses potential output (to the right of LRAS).

Why do you think the SRAS gets steeper as the economy produces more and more? Keep in mind that when the SRAS is flat, a change in AD leads to a bigger change in Real GDP than a change in price. When the SRAS is steeper, a change in AD leads to a bigger change in the price level than the change in Real GDP.

You're on the right track. When real GDP is below potential, firms have excess capacity. At that time, when faced with higher demand, a business responds by meeting the extra demand and raising production without raising prices too much. On the other hand, when real GDP is above potential, firms are over utilizing their resources (hiring extra labor, overworking their equipment). In this situation, an increase in demand will lead to higher prices ad firms need to compensate for the higher costs they incur to increase production when they are operating over capacity.

Recessionary gap and Inflationary gap

In the situation depicted in the graph above, the economy's short-run equilibrium is such that the economy is also on its long-run growth path or at full employment. We can see this because the short -run equilibrium (intersection of SRAS and AD) is the same as the long-run equilibrium (intersection of AD and LRAS). We already know from previous weeks' lectures that real GDP fluctuates around its trend (recall the idea of the business cycle?). For now, let's assume Aggregate Supply is stable and that there are changes in AD (we will discuss shifts in Aggregate Supply in the next couple of lectures).

In the following presentation, we will look at graphs depicting two other possible short-run equilibria for the economy that would result when there are changes in AD, creating economic fluctuations.


WEEK EIGHT

Course Lecture 8-2: Classical and Keynesian ModelsContent Author: Basma Bekdache

The modern Keynesian SRAS discussed in the previous lecture has not always been a common way for economists to depict the supply side of the economy in macroeconomic models. In this lecture we will present two other points of view about how the economy might operate in the short-run: the Classical and Keynesian models. As you will see soon, these two models have completely different assumptions about prices and yield completely different policy implications for the economy in the short-run. In that sense, they represent extreme cases. As you may have guessed given the name of the SRAS from the previous lecture, modern Keynesian, the commonly used upward sloping SRAS has more in common with the Keynesian model. After we're done with this lecture you will be able to understand why this is the case and why most (but not all) economists tend to view the modern SRAS as the one that is the closest to reality.

The Classical Model:

The most important assumption in the classical model is that all prices in the economy are completely flexible in the short-run as they are in the long-run. This assumption leads to the result that all markets always clear since the price is able to adjust to eliminate any disequilibrium immediately. Take as an example the labor market, where the wage rate is the price of labor. If there is a change in demand that prompts firms to reduce production and lay off workers, the unemployment rate will tend to increase.

Under the classical model, the unemployment will not persist since the wage rate (an input price) is completely flexible and will decrease as firms hire less labor. The lower wage rate will then prompt firms to produce more again and the economy will return to its potential. The same thing can occur for other prices in the economy (price of materials, interest paid on a loan etc.). If there is lower demand for an input, its price will decrease and the economy will return to its initial production level due to the lower input prices. Similarly, if there is an increase in demand for an input (say labor), then its price will increase (wage will increase) again bringing the economy back to its potential level.

The following graph depicts the economy in the classical model:

Following the reasoning we gave above, if AD increases from AD1 to AD2, real GDP increases above its potential (point A). This raises the wage rate and other input prices, which decreases output back to its initial level due to the higher input prices (the economy returns to E1). Conversely, if AD decreases from AD1 to AD3, real GDP falls below potential (point B), higher unemployment lowers wages and other input prices, taking the economy back to E1.

The following schematic summarizes the basic adjustment mechanism underlying the classical model in the case of a decrease in AD.


Therefore, in the classical model, since the SRAS and LRAS are the same (vertical and placed at potential GDP), what do you think happens if there are changes in aggregate demand?

That's right, given a vertical aggregate supply, AD cannot influence the level of real GDP in the short run. Any changes in AD will only cause a change in inflation. If AD increases, the price level rises (inflation) and if AD decreases, the price level decreases (deflation). This has the implication that policy should not be used to manage real GDP in the short-run as it would be ineffective!

The Keynesian Model:

In this model, the central assumption is that wages and other inputs prices are almost completely fixed or inflexible (or sticky) in the short-run, leading to a horizontal SRAS as shown below:

As you can see, this is the exact opposite of the assumption in the classical model. The assumption that prices are "sticky" in the Keynesian model was based on data observation from the 1930's and 1940's where the price level was not changing in response to a period of high unemployment (or lower aggregate demand). If prices are completely fixed as shown by the horizontal Keynesian SRAS above, what will happen in this model if there are changes in aggregate demand?

Click here for the answer.

Back the Modern Keynesian SRAS:

For the history of the U.S. data, we know that there are periods of inflation and low unemployment, and periods of high unemployment and low inflation. The classical model does not allow for any unemployment (since it is assumed that wages adjust immediately to eliminate the excess supply of labor) or for real GDP to go below potential. The Keynesian model (with horizontal SRAS) does not allow for any inflation to occur even in periods of high AD. Given this analysis, these models are considered to be extreme cases which are not representative of the whole period of data for the U.S and most other countries. The modern Keynesian model detailed in the previous lecture (graph shown again below) allows for some price stickiness by showing the SRAS to be flat or nearly horizontal when the economy is below potential and letting prices becoming more flexible (or adjust upwards and downwards faster) as the economy gets closer to its potential. Therefore, we will use the modern Keynesian model in our future analysis of economic policy which we will cover over the next couple of weeks.


WEEK EIGHT

Course Lecture 8-3: Shifts in Aggregate SupplyContent Author: Basma Bekdache

In the previous lectures we learned how to use our model to depict economic fluctuations (changes in real GDP away from potential) that result in recessions or expansions. The situations we have considered were due to changes in Aggregate Demand, which can happen if any of the spending components change.

Can you recall from last week's lecture a factor that increases (or decreases) AD?

Yes, a decrease in taxes can raise AD (shift right). Also, an increase in consumer confidence can raise AD. Revisit last week's lecture to remind yourself of some other events that can happen to increase or decrease AD.

Changes in aggregate supply can also cause economic fluctuations and changes in inflation. We learned last week about what can cause a shift in long-run aggregate supply (LRAS), but what about shifts in short-run aggregate supply (SRAS)?

Before we talk about the consequences of shifts in supply, let's review how the graphs change when there is a shift in supply and consider what can happen in the economy to cause such shifts. We will also see that some of the factors that may cause a change in SRAS also cause a change in LRAS.

The following table summarizes changes that cause an increase or decrease in supply. An increase in SRAS in shown as a shift to the right in the SRAS, whereas a decrease in shown as a shift to the left in SRAS. The graphs below the table show how we depict the changes in SRAS only and changes in both SRAS and LRAS.



To understand how each of the changes listed above affect Aggregate Supply, let's have a closer look at each of the rows in the table and determine why SRAS changes and whether the change also affects LRAS. Let's consider some of these events in the following presentation. After you are done watching, you can work by yourself on the remaining items in the table to check your understanding.



Consequences of changes in short-run aggregate supply

As we saw earlier in the presentation, SRAS can decrease due to a variety of events which raise firms' costs of production, leading to lower aggregate supply (SRAS shifts left). We can see this situation and how it affects the short-run equilibrium in the figure below:


Initially the economy is at the equilibrium E1. When aggregate supply decreases the short-run equilibrium shifts to E2. How is the equilibrium E2 different from E1?

Yes, the price level increased (from 120 to 125) causing inflation, and real GDP decreased, causing a recession.

Since the inflation was caused by a decrease in aggregate supply, it is termed cost-push inflation (recall that demand pull inflation occurs when the price level rises due to an increase in aggregate demand).

Economists sometimes use the term stagflation to refer to the situation when real GDP decreases along with inflation. This is a term that combines the words stagnation (since real GDP is decreasing) with inflation (since the price level is rising). This is also referred to as a negative (or adverse) supply shock. This is because there was a change in aggregate supply that adversely affects the economy. As we will see next week when we discuss economic policy, stagflation is a very difficult situation for the economy since it is difficult to correct using policy. Just to preview the weeks ahead, you can see from the graph above that if policy makers try to raise AD to increase GDP back to potential and reduce unemployment, they will cause even higher inflation.

What do you think happens to real GDP and prices in the short-run when we have a positive (or good) aggregate supply shock or an increase in supply?

That's right, an increase in aggregate supply leads to lower prices (deflation) and raises real GDP as shown in the figure below:


WEEK NINE

Course Lecture 9-1: Aggregate ExpendituresContent Author: Basma Bekdache

This week we begin our section on economic policy. In the next lecture, we will define government policy (Fiscal policy) and explain its impact on the economy using the macroeconomic model (Aggregate Demand /Aggregate supply), which we developed over the last 2 weeks. Next week we focus on defining and explaining the role of the Federal Reserve (Monetary policy) and using the model to analyze its policy effects on the economy.

We have already touched on the subject of economic policy when we discussed factors that shift aggregate demand. Do you recall some policy changes we previously discussed as determinants of aggregate expenditures and aggregate demand?

If you thought of taxes, interest rates or the money supply, you remembered correctly! We previously mentioned that lower taxes encourage households to spend more (consumption increases), which leads to an increase in aggregate demand. We also talked about lower interest rates (or an increase in the money supply) achieving the same effect on Investment as well. To refresh your memory on this material, you can return to lecture 7-3 in week 7.

Although we have an idea of how policy affects aggregate demand and real GDP, we are now ready to dig deeper into this subject and consider the question of how much is real GDP changing when taxes or the interest rate are changed? In answering this question, we will explain the transmission mechanism of policy in the economy and how different macroeconomic variables interact to achieve the full effect on GDP and unemployment.

Let's begin by revisiting each of the spending components that make up aggregate expenditures.

Consumption (C), Investment (I), Government Expenditures (G), and Net Exports (X).

We will refer to an expenditure that does not vary with the level of real GDP or real income as autonomous, that is as independent of the level of real income. As we will see in the next lecture, the amount of government spending (G) is determined by the

government budget as set by congress and the administration. It does not systematically depend on the level of income in the economy. Therefore, we will take G as given and consider it to be an autonomous variable. This means that G will increase or decrease when we are analyzing a scenario where the government decided to raise or lower their spending, but it will not automatically change when real GDP changes.

Similarly Net Exports (X), or (Exports - Imports), is also an autonomous variable. This is because Exports depend on foreign real GDP (foreign real income) not our real GDP. We will also for now make the simplifying assumption that Imports do not vary with the level of real income. Therefore, changes in X will affect our real GDP but X will not automatically change when real GDP changes.

Investment

How about Investment? Recall from week 6 that this variable represents business spending on plants and equipment, machines and inventories to be used for production. Can you think of some factors that influence the decisions of businesses of how much to spend on Investment projects?

Yes, future sales or expected future real GDP is one of the important variables to consider. Firms will spend to increase their capacity (Investment increases) when they expect economic activity to increase and the demand for their product or service to increase.

Other economic variables that influence the level of business investment (I) are:

The interest rate:Firms either borrow or use retained earning (cash leftover) to finance projects. In either case, the interest rate represents the cost of Investment. If the firm borrows, an increase (decrease) in the interest rate raises (lowers) the cost of the project. If the firm uses internal funds, an increase (decrease) in the interest rate implies that the opportunity cost of using the funds

elsewhere has increased (decreased). Given this, how would you describe the relationship between Investment and the interest rate?

Correct. When the interest rate increases (decreases), Investment projects are more (less) expensive and Investment decreases (increases).

So far, we've discussed two determinants of Investment, the interest rate and expectations of future real GDP. Investment is not systematically affected by current real GDP as firms usually plan Investment projects in advance as part of their strategic or long-term planning. Therefore, Investment is also autonomous, since it does not respond to on current changes in real GDP or real Income. Another important determinant of Investment is firms' existing capacity utilization rate. The capacity utilization rate is to the proportion of existing physical capital that is currently being used for production. Why do you think this is an important variable?

Right. If firms have excess capacity or too much slack, then Investment will not increase when the interest rate is lower since businesses already have the ability to increase production without adding to their capital stock. Similarly if firms are running low on capacity, they might increase Investment even when interest rates are not too low.

Therefore, when we state that Investment is inversely related to the interest rate, we have to remember that this is true only when we hold everything else constant.

Consumption

The last, and perhaps the most important, of the expenditures to discuss is household spending or Consumption. This spending category is important because it makes up a large portion of real GDP (recall from week 6 that C is about 2/3 of real GDP). In

addition, we will see shortly that Consumption is a variable that does depend on current real GDP (or real income). This dependency will be a key factor determining the multiplier effect that results from a change in any of the autonomous spending categories. What are some factors that determine the level of household spending?

Yes, definitely, current after tax or disposable income! This is the most important determinant of Consumption, simply because current disposable income is what we have available for spending or saving. On the aggregate, disposable income is measured using real GDP minus taxes.

Intuitively, we expect that when disposable income increases, consumption increases, and vice versa. That is, spending by households is positively related to real GDP or real Income. Let's be more specific about this relationship. Suppose that your after-tax income increases by $100. By how much do you think your consumption would increase?

Yes, the answer will vary for different individuals. If someone was liquidity constrained, then they might spend all of the extra income. Another individual may decide to spend a portion and save the rest.

On the aggregate (for the whole economy), we find that on average, when disposable income increases by $100, consumptions increases by less than $100. If we express this per dollar, then we can say for every dollar increase in aggregate income, consumption increases by less than $1. The fraction by which consumption increases for every dollar increase in disposable income is called the Marginal Propensity to Consume (MPC). The MPC is defined as:

In the example we gave above, suppose when income increases by $100, consumption increases by $90, what is the MPC?

The MPC is $90/$100 = 0.9. That is, when income increases by $1, spending increases by 90 cents.

What happens to the rest of the $100? That's right, it is saved. So in this example, 10 cents out of every extra dollar of income is saved.

We will come back to the MPC shortly in the next section in our discussion of the multiplier. Let's review other factors that also influence the level of household spending. The following are non-income determinants of consumption:

Wealth:Accumulated savings and various assets that we own are all part of our wealth (house, cars, retirement accounts, etc). Consumption and wealth are positively related. If the value of our assets increases, we feel wealthier, and we could spend more.

Expectations about future income:Households tend to act to even out their consumption patterns over time. If we anticipate an increase in income, we may increase consumption today based on the expected increase in future income. Similarly, if future income is expected to decrease, consumption could decrease today to save for the future.

Interest rates:The interest rate represents the opportunity cost of consuming today. Every dollar that we spend today on goods and services can be saved, earning the market interest rate. Given this, an increase in the interest rate should discourage consumption and a decrease in the interest rate should make it easier to spend. In addition, if we borrow to consume, then the interest rate is part of the direct cost of spending. This also contributes to the negative relationship between the interest rate and consumption.

WEEK NINE

Course Lecture 9-2: The Multiplier Effect

Content Author: Basma Bekdache

Suppose that Government spending increase by 100 billion. We know that this should raise real GDP since this is an increase in aggregate demand leading to an increase production or real GDP Recall that when aggregate demand increases, firms notice a decrease in their planned inventories which signals that they should increase production to meet the increased demand. Do you think the increase in real GDP will be more or less than the 100 billion rise in G?

Correct! Real GDP will increase by more than 100. This is due to the multiplier process, which occurs since consumption responds to changes in real GDP.

Why does real GDP increase by more than the change in G? Let's think of this process for a one dollar increase in G.

When G increases by $1, this raises real income by $1 Think of this as the first round of the process. The increase in real income by $1 raises consumption by the amount of the MPC.

If the MPC is 0.9, this means people spend 90 cents out of every extra dollar of income. When consumption increases by 90 cents, this raises real GDP and real income by another 90 cents, bringing the total to $1+$0.9 = $1.90. This is the second round of the process.

The 90 cents increase in income leads to an increase in Consumption of (0.9 x 90) cents or 81 cents. This is the third round of the process. Now real GDP has increased by ($1+ $0.9+ $0.81 = $2.71).

This process continues until the $1 increase in G turns into a $10 increase in real GDP, or the $100 billion increase in G turns into a $1 trillion increase in real GDP.

We know this because the process described above leads to the following expression for the multiplier:

The following table shows another example of the multiplier process for a case where Investment (I) increases 100 billion and the MPC is 0.8.

(Reprinted from Roger LeRoy Miller, Economics Today, 14th Edition)

What is the multiplier in the example shown in the table?

Right! The multiplier is: (1/1-MPC) = 1/(1-0.8) = 5, which is also equal to500/100 = 5. This means real GDP increases by $5 for every dollar increase in I.

What do you think happens to the multiplier if the MPC increases?

Yes, the multiplier increases as the MPC increases. If we spend more out of every extra dollar earned MPC increases. A given increase in any of the autonomous expenditures (I, G, or C) will flow through the economy faster and generate a bigger impact on real GDP and real income.


WEEK NINE

Course Lecture 9-3: Fiscal Policy

Content Author: Dr. Basma Bekdache

So far we have learned how the various sectors of the economy interact to influence the level of production (income) and inflation. In this lecture, we discuss Fiscal policy and its potential impact on output, unemployment, and inflation. Let’s begin with a general description of economic policy.

There are two types of economic policy:

1. Fiscal Policy

Policy that is conducted by the administration and congress (the government) and consists of changes in taxes (T) and/or government spending (G).

2. Monetary Policy

Policy that is conducted by the Central Bank (the Federal Reserve or the Fed) and consists of changes in the money supply and interest rates.

Fiscal and Monetary policies are implemented by separate policy makers (note that the Federal reserve is independent from the government – more on this next week). Depending on the circumstances, sometimes we have a mix of fiscal and monetary policies, and other times only one type of policy is used at a time. In either case, the goals of economic policy are the same and are usually stated to be:

Promoting economic growth (low unemployment), and Maintaining price stability.

We will see a little later that these goals can conflict at times and create dilemmas for policy makers.

Discretionary Fiscal Policy refers to the discretionary changes in government expenditures and/or taxes in order to achieve the national economic goals. Notice we added the word discretionary in this definition. What does it mean to say that the policy is discretionary?

That’s right. Discretionary policy is policy that is made at the discretion or choice of the policy maker and generally is decided upon based on the circumstances. This is in contrast to a rule that the policy maker has to follow.

Let’s take a look at how Fiscal policy affects the economy. Using the Aggregate Demand/Aggregate supply model from last week, how do you think a change in taxes affects real GDP, unemployment and inflation, everything else held constant? This should be review of concepts we learned over the last two weeks but now placed in the context of policy making.

Good job. If the government lowers taxes (T decreases), Consumption increases leading to an increase in AD. This raises real GDP and the price level (leading to inflation). Unemployment decreases since firms hire more as production increases. Similarly, higher taxes decrease consumption and AD causing real GDP and the price level to decrease (leading to deflation). Unemployment rises since firms lay off workers as output decreases.

Now let’s ask the same question but assume the government wants change spending (G) instead of changing taxes.

Correct again. If the government increases spending (G increases), AD increases. This raises real GDP and the price level (leading to inflation). Unemployment decreases since firms hire more as output increases. Conversely, a decrease in government spending lowers AD, causing real GDP and the price level to decline (leading to deflation). Unemployment rises since firms lay off workers as output decreases.

These results are summarized in the two graphs below:

When economic policy (in this case fiscal) is used to stimulate the economy, resulting in an increase in real GDP, we refer to it as Expansionary policy. When policy is aimed at reducing real GDP, it is called Contractionary Policy.

Given what we just reviewed about how fiscal policy affects the economy, let’s consider two different scenarios about the economy. Let’s first identify the state of the economy, and then let’s put our policy hats on and pretend we‘re the government and make policy recommendations aimed at keeping output at the full employment level.

WEEK NINE

Course Lecture 9-4: Crowding OutContent Author: Basma Bekdache

In the previous lecture, we showed how the government can influence the level of real GDP or income in the economy by changing taxes and/or changing government spending. Particularly, the government could lower taxes or raise government spending to increase aggregate demand when the economy is in a recession in order to steer the economy back to full employment. Does this mean that it is always desirable for the government to increase spending (or lower taxes) in a recession to stimulate the economy? You might be tempted to say yes since it is obviously optimal for the economy to be at full employment, but the question is whether Fiscal policy (instead of monetary policy as an alternative) is always a good policy choice. The answer is No! Do you know why?

You’re on the right track. Stimulating the economy with Fiscal policy is not always desirable since lowering taxes and/or raising government spending raises the government budget deficit. This can have negative consequences on the economy.

The government budget is defined as the difference between government spending (G) and government revenues or net taxes (T). We will spend more time on this subject in the next lecture, but for now, let’s just think about this by making an analogy to an individual’s budget.

Let’s take me as an example. If I spend less on goods and services than my after tax income, then I have leftover income or savings. If my spending exceeds my income, then I have to come up with the difference—either by borrowing or by using previous period savings (or wealth). For the government, if G is less than T, the government has a budget surplus (akin to the leftover income), and if G exceeds T, we say the government has a budget deficit (akin to my spending more than my income). As we will see in the next lecture, for most of the recent history of the U.S. economy, the government has experienced budget deficits. Given this, any time the government increases spending or lowers taxes, government borrowing increases to finance the new deficits. The accumulation of government borrowing is also called the public debt.

The government borrows by issuing securities (Treasury bonds, notes etc.—more on this later), which individuals and firms with excess funds or savings can purchase to earn interest. An increase in government borrowing increases the demand for these

loanable funds, which everything else held constant raises the interest rate. As we know from week 7, an increase in the interest rate causes Investment (business spending on plants and equipment) and Consumption to decrease. Therefore, we say that the increase in government spending crowds out private spending.

The Crowding out effect refers to the fact that an increase in government spending leads to a decrease in Investment and Consumption due to higher interest rates that result from more government borrowing.

The following chart summarizes the process that leads to the crowding out effect:


The decrease in private spending offsets some of the increase in Aggregate Demand due to the increase in G. This can be seen in the graph below by the AD shifting back to the left due to the crowding out effect.

(Reprinted from Roger LeRoy Miller, Economics Today, 14th edition)

Crowding out is undesirable since the positive impact of increased government spending is partially offset by less private spending as shown in the figure above. However, most economists are concerned about crowding out not only due to its short-term offset on Aggregate Demand but mainly due to its impact on Investment Spending. Can you think of why it is particularly important for Investment not to decrease due to crowding out? (You may need to revisit week’s 6-8 lectures to refresh your memory on the special role of Investment in aggregate expenditures). You reviewed well! Investment is a special spending component since it is through business spending on plants and equipment that the capital stock is maintained and increased. The capital stock is a key determinant of long-term economic growth. Therefore, a decrease in Investment could hinder the economy’s growth potential and could lead to a decrease in potential GDP (LRAS shifts left).

We will see next week when we study monetary policy that the Federal Reserve can accommodate Fiscal policy by raising the money supply and trying to keep the interest rate from rising due to increased government borrowing. This policy mix is sometimes optimal when it is necessary for Government spending to increase to stimulate the economy.

WEEK NINE

Course Lecture 9-5: Policy Lags Content Author: Basma Bekdache

So far, we’ve talked about how Fiscal policy affects the economy and about when the government should conduct expansionary or contractionary policies. In this lecture we discuss the timing of policy in light of the existence of time lags. The discussion of time lags leads us to the debate about whether policy should be used to try to manage the economy, especially in the presence of automatic stabilizers. This debate applies to monetary policy as well. Let’s start with policy lags and end with explaining the concept of automatic stabilizers.

There are three types of time lags associated with economic policy:

Recognition lag:Refers to the time it takes to gather information about the current state of the economy.

As we learned in week 6, economists look to several economic variables to measure the economy’s performance. Economic data is gathered with some delay. For example, GDP is available on a quarterly basis, unemployment and some jobs indicators on a monthly basis. To shorten the recognition lag policy makers look for leading indicators to predict changes in the economy’s cycles. Leading indicators are events that have been found to occur before changes in business activity. For example, decreases in real GDP are often preceded by decreases in the money supply and increases in weekly unemployment insurance claims. Nevertheless, there is a time lag between when the state of the economy changes, and when that change is revealed in the data.

Action lag:Refers to the time between recognizing there is a problem in the economy and taking policy action.

The action lag is quite long for Fiscal policy since legislation is required for any changes in government spending or taxes to be put into effect. Monetary policy on the other hand has a

very short action time lag. As we will see next week, the Fed’s interest rate setting body, the Federal Open Market Committee (FOMC), decides on interest rates in a two-day meeting, and the policy is put into effect immediately after the meeting.

Effect lag:The time from when policy is implemented and when it affects the economy.

This effect or impact lag can be quite long depending on the response of the various sectors of the economy to the policy. Take for example the policy of lowering taxes to reverse a recessionary gap. Depending on the type of tax cut (temporary or permanent) and how consumers react, they may or may not choose to spend part or all of the increase in their after tax income. If the tax cut is spent, economic activity increases faster than if household spending is unresponsive to the policy. Similarly with monetary policy, lower interest can take up to two years to generate their full impact on GDP. This is because GDP will start to increase when consumers and businesses spend more in response to the lower interest rates. Whether, when and how much consumption and Investment react to lower interest rates and how fast that

flows through the economy (recall the multiplier process from earlier this week) depends on may other variables which are highly uncertain from the point of view of policy makers.

Now that we’ve learned about the various time lags associated with Fiscal policy, how do you think this affects its effectiveness in reaching the policy’s economic goals?

Click on the option that best completes this sentence.

Correct! Since policy lags are long and variable, they make it more difficult for Fiscal policy to fine-tune the economy. For example, expansionary policy may not produce the desired results until the economy is already experiencing inflation.

This discussion leads us to a point of view that suggests that it is best not try to manage the economy’s output. The argument rests on the idea that the presence of time lags makes it hard to predict when policies will achieve their intended results, which at times can lead to even greater fluctuations in output. Proponents of this argument will point to the existence of automatic stabilizers as alternatives to actively managing the economy through discretionary changes in government spending and taxes.

Automatic (or built-in) stabilizers refer to the changes in government spending and taxation that occur automatically without deliberate action of Congress. These are the tax system, unemployment compensation and welfare spending.

Since we have a progressive tax system where the amount of taxes we pay and the tax rate both depend on the level of income, tax revenues increase when the economy is expanding (as real GDP and income increase) and tax revenues decrease when the economy experiences a recession (as real GDP and income decrease). At the same time, government spending on unemployment compensation and welfare payments increase during recessions (as real GDP decreases) and decrease during expansions. These changes combined lead to an “automatic” relationship between the government budget and economic activity. The budget deficit (G - T) increases during recessions and decreases during expansion. Since a surplus is the opposite of a deficit (defined as T - G), we can say that if an economy had a surplus, the surplus would decrease during a recession and increase during expansions. The following chart illustrates this relationship:

(Reprinted from Roger Le Roy Miller, Economics today, 14th edition)As we can see from the figure above, tax revenues are positively related to real GDP while unemployment compensation and transfer payments are negatively related to real GDP. The figure and the discussion above explain the automatic or built in relationship between the government budget and real GDP. Recall that we referred to these as “automatic stabilizers.” So how is this relationship between GDP and the budget stabilizing, or how does it minimize the fluctuations in real GDP?

Right. Changes that occur automatically in G and T tend to pull real GDP in the opposite direction taking it back to full employment. Let’s think about how this works.

When the economy is in a recession, G increases (because unemployment compensation and welfare increase) and taxes decrease (because real GDP decreased). These two changes cause an increase in aggregate demand (or at least reverse the decrease in aggregate demand), which partially reverses the decrease in real GDP. Similarly, when the economy is expanding, G decreases and T increase. This causes a decrease in aggregate demand and reverses some of the increase in real GDP. Therefore, automatic changes in G and T tend to stabilize the fluctuations in real GDP.

WEEK NINE

The Deficit and the Debt

We've briefly talked about the government budget in the previous lecture as part of our discussion on crowding out. In this lecture, we examine the government budget in more detail and relate it to the public debt. We also look at historical data for the deficit and the debt.

The government budget is defined as the difference between government spending and taxes. The budget can be in one of three possible situations:

Take the following hypothetical example. If in 2003 government spending (G) was $600 billion and tax revenues (T) were $700 billion, how would you describe the government

budget for 2003? How would your answer change if the government increases spending by $150 billion for 2004, but tax revenues remain the same?

Correct! For 2003 the government has a budget surplus of $100 billion, given by T-G = 700-600 = $100 billion. In 2004, G = $750 billion (600+150 = $750 billion). There is now a budget deficit = G-T = 750-700 = $50 billion.

Now that you are comfortable calculating the government budget deficit (or surplus), do you think the deficit is a flow or stock measure? (You may need to revisit week 6 lectures to remind yourself of the definition of a flow.)

Good job. It is a flow measure. That is, it is defined over a specific period of time, usually a year. A stock measure is one that accumulates over time and is measured as of a specific point in time.

Therefore, when we say, as in the example above, that the deficit for 2004 is $50 billion, this figure represents the government budget for the year 2004 only. No other period is reflected in this figure. This distinction between flow and stock measures is relevant here because people often confuse the deficit with the public debt, which is a stock measure. Let's define the public debt and explain the difference.

The government issues securities or bonds in order to finance the deficit. They are debt instruments called Treasury securities, named as such since the Treasury department issues them on behalf of the government. They consist of Treasury Bonds, Notes and Bills, depending on the securities maturity or due date. The public debt is defined as the total value of all outstanding government securities.

The public debt is a stock variable that is related to the deficit in a specific way. Whenever the government budget is in deficit, the public debt increases since more debt is issued to finance the deficit in that year. Therefore, the debt generally increases. The public debt can only decrease if the government budget is in surplus and the surplus is used to pay off the existing debt.

Now that we know the difference between the deficit and the debt, let's have a look at the historical data for the U.S economy in the following presentation.



In the preceding presentation, we examined historical data on the government budget and public debt, as of 2007. Let's update these data.

According to the Congressional Budget Office (CBO), the following figures apply for 2008:

Government spending = $2,983 billion, Tax revenues = $2,524 billion. What was the government budget deficit for 2008?

The deficit for 2008 is equal to G – T = $2,983 - $2,524 = $459 billion, which is 3.2% of GDP.

As of 2008, the public debt is equal to 5,803 billion, which is about 40% of GDP.

For the most recent information and additional details on the U.S. government budget, you can visit the following links:

CBO Web site: http://www.cbo.gov/ White House Office of Management and Budget:

http://www.whitehouse.gov/omb/budget/

WEEK TEN

Course Lecture 10-1: Definition of MoneyContent Author: Dr. Basma Bekdache

This week we discuss money, the Fed, and monetary policy! Money is a word we often use in our daily lives. We hear people say, "I need more money... " or "...if I make more money..." We are accustomed to using the word money to refer to our income, which is what we earn in return for our work. On the aggregate (for the whole economy), income and money are intimately related and have a predictable relationship. However, they are not the same thing. So let's begin this week by defining money, explaining how it's different from income and learning how to measure the quantity of money in circulation.

Money Defined

What would you say if someone asked you to explain what money is? I am guessing you would start to describe what you can do with money. For example, "Money is what I use to pay for goods and service," or "Money is how prices are quoted in the economy." Our money is called the U.S. dollar, which is also the name of our currency. In other countries, currencies have different names, such as the Mexican peso or the Canadian dollar.

Functions of Money

Notice that to define money, we had to think of its functions (or what it can do for us). These are necessary for an item, something to be called money, and can be summarized as follows:

Medium of exchange: Money is anything that is accepted as a means of payment for goods or services. The U.S. dollar is paper or fiat money. Fiat money does not have intrinsic value, or value in and of itself. Commodity money such as gold has intrinsic value since it can be used to make jewelry or other things. Over time paper money replaced barter and commodity money since it facilitates exchange and is the most efficient form of payment. Barter is a situation where goods are exchanged for other goods. This requires what economists refer to as the double coincidence of wants. That is, I can only trade with someone that has what I want, and I happen to have what they want! Therefore, barter is obviously inefficient and limits trade and specialization. Why does the system of fiat money work - that is, why do people accept the U.S. dollar as a means of payment?

I accept the U.S. dollar as payment since I know everyone else in the economy accepts it as well! Everyone accepts it since it is the legal tender and is backed by the full faith of the U.S. government.

Unit of Accounting:

Money is used to express prices in the economy. When I see a price tag on a car of $25,000, money is serving its function as a unit of account. It serves as a common denominator of the price system in the economy.

Store of Value:

Money allows us to transfer value or wealth into the future. This means that money that is not spent today can be spent in the future since it will still be accepted as a means of payment. Let's be careful here not to misinterpret what we mean by "holding value." We do not mean that purchasing power will stay the same since that will depend on inflation. If prices are rising fast (there is high inflation), then the purchasing power of the dollar will decrease.

Standard of Deferred Payment:

Another essential property of money is that we can use it to pay back debts maturing in the future. This property of money is similar to the store of value function because if money does not retain its value, people in the economy will not accept it for future payments of debt.

Money and Income

To understand the difference between income and money, let's consider a simple example where our class represents the whole economy. To make it easy let's start with zero income and one unit of money or $1. You can assume that one person in the class inherited the $1 and other stuff. Suppose this classmate asks you to help them copy notes in return for a one dollar. What is the amount of money (or the money supply) in this fictional economy? What is the income in this economy?

Yes, money is $1 and income is $1.

Now assume that you buy a notebook from a classmate for $1. Now what is the amount of money in the economy? What is the total income in the economy?

Right, the quantity if money is still $1, but total income is $2!

As we can see, money and income are not exactly the same but they are intimately related. If the amount of transactions (exchanges) in the economy increases, then the amount of money in circulation has to increase to support the added transactions. Otherwise, as we will see later the interest rate will increase if money supply is too low. Alternatively, an increase in the amount of money available can raise the amount of transactions in the economy and hence raises income. We will see in the next few lectures that the Federal Reserve (Fed), as part of monetary policy, often adjusts the money supply in order to align aggregate demand with full employment output.

Liquidity

In our discussion of money, we will often refer to the word liquidity. What do we mean when we say an asset is liquid? Another definition is needed for this question. What is an asset?

An asset is something we own that has value. This is the opposite of a liability, which is something we owe that has value.

Liquidity is how easily (or quickly) we can turn an asset into cash without much loss of value.

Note that the most important part of this definition is the last piece of the definition which is, "without much loss of value." Obviously any asset can be turned into cash if the owner is willing to take any price offered to them even if that does not reflect the asset's value. A liquid asset is one that can be easily converted into cash without loss of value.

We can think of liquidity as a spectrum with various assets ranging from highly liquid to highly illiquid. How do you think money fits in this spectrum of liquidity?

That's right. Money is the most liquid asset.

The following chart gives examples of various assets in relation to degree of liquidity.


WEEK TEN

Course Lecture 10-2: Measurement of MoneyContent Author: Dr. Basma Bekdache

How we measure money?

The central bank of the U.S. or The Federal Reserve (Fed) measures the money supply for our economy. They define two monetary aggregates (or money stock measures), M1 and M2, with M1 being the narrow definition of money, consisting of the most liquid forms of money. M2 is defined as a broader monetary aggregate, adding savings and other types of accounts to M1. Specifically,

Checkable deposits (also called demand deposits) are basically checking account balances. Traveler's checks issued by depository institutions (commercial banks, credit unions etc.) are already included in demand deposits, therefore only traveler's checks not issued by banks are added to M1. The composition of M1 for 2007 is shown in the pie chart below.


The following definitions apply.

Savings Deposits are interest-earning funds that can be withdrawn at any time without payment of a penalty.

Money Market Deposit Accounts (MMDAs) are accounts issued by banks yielding a market rate of interest with a minimum balance requirement, a limit on transactions, and having no minimum maturity.

Time Deposit is a deposit in a financial institution that requires notice of intent to withdraw or must be left for an agreed period. Early withdrawal may result in a penalty.

Certificate of Deposit (CD) is a time deposit with fixed maturity.

Money Market Mutual Funds are funds obtained from the public that investment companies hold in common. Funds are used to acquire short-maturity credit instruments such as CDs and U.S. government securities.

As you can see from these definitions, M2 adds to M1 assets that are almost money called Near monies, are highly liquid, and are easily converted to cash.

The composition of M2 for 2007 is shown in the pie chart below:


The Fed tracks the money stock measures and studies their relationship with economic activity and spending. The broad money definition of M2 is found to be more stable over long periods of time and correlates better with overall economic activity.

Let's test our understanding of M1 and M2 and see why it is a more stable aggregate than M1. ATM's were introduced in the late 1960's and became widely used in the early 1970's. What do you think happened to M1 and M2 balances as a result of the introduction of ATM's?

Correct. M1 balances decreased as a result of ATM's. Since ATM's made it more convenient to transfer funds from savings and other interest earning accounts, less cash and checking account balances were held in favor of interest earning type accounts or near monies. Therefore, M1 declined. M2 stayed about the same. Remember that M2 includes M1. The funds that shifted from M1 to accounts in M2 left M2 unchanged (since the M1 portion of M2 decreased by the same amount as the increase in the near monies portion of M2.

For the most recent information and additional details on the money stock measures, you can visit the following link:

Federal Reserve Board web site-Statistical Releases: http://www.federalreserve.gov/releases/h6/current/h6.htm

WEEK TEN

Course Lecture 10-3: Federal Reserve SystemContent Author: Dr. Basma Bekdache

In this lecture we discuss the Federal Reserve System (Fed for short), which is the Central bank of the U.S. A central bank is usually an official institution that has a primary function of regulating the banking system and performing banking functions for their nation's governments. In the U.S. and other major industrialized countries, the central bank is independent from the government and has a key role to conduct monetary policy in a manner consistent with the nation's economic goals. We will discuss what it means for the Fed to be independent shortly. Let's first learn about its organizational structure.

The Fed was created on December 23, 1913 by an Act of Congress, The Federal Reserve Act. The system consists of the following 3 important parts:

Board of Governors (BOG) has seven members that are appointed by the President and confirmed by the Senate. Each member serves a 14-year term. One of the members is designated by the president and confirmed by the Senate to serve as the Chairman of the Board for a four year term. Do you know who the current chairman of the BOG of the Fed is?

That's right, you've heard about him in the news, Dr. Ben Bernanke is the current chairman of the Fed's BOG. He has been in this position since February of 2006.

Reserve Banks (12 District banks) are the operating arms carrying the day to day operations of the Federal Reserve System. There are 12 District banks and 25 branches that serve the whole nation.

The chart below shows the various districts and the areas they serve.


Which District bank serves the Detroit area?

Correct! The Federal Reserve Bank of Chicago serves our area. There is also a Detroit branch in downtown Detroit.

Federal Open Market Committee (FOMC) consists of the seven members of the BOG and five district bank presidents. The FOMC is the most important part of the Fed, as it is responsible for formulating monetary policy in order to achieve the stated economic goals of promoting economic growth and price stability. It controls a key interest rate, the Federal funds Rate, by manipulating the amount of Reserves that banks hold with the Fed.

Functions of the Fed

The Federal Reserve System as a whole has many important functions. The Fed:

Supplies the economy with fiduciary currency Provides a payment-clearing system Holds depository institutions' reserves

Acts as the government's fiscal agent Supervises depository institutions Acts as a "lender of last resort" Regulates the money supply

The following chart summarizes the organizational structure of the Fed and lists the functions of each of its organizational parts.


There are several terms that are in the chart above that we need to define: the discount rate, reserves, and reserve requirements. We will defer defining these until the next lecture since they are part of the discussion on the Fed's Monetary policy tools.

Central bank Independence

At the beginning of this lecture we mentioned that the Fed is independent from the government. But the Fed was created by an Act of Congress and thus is bound by the Articles of the Federal Reserve Act of 1913. It is accountable to the government accordingly. So what do we mean when we say it's independent within this structure?

The Fed is independent in that its policy decisions are not directly affected by anyone in the government (congress and the administration). It is not officially part of

the government and is not paid by the government- Fed pays its employees from interest earned on loans and Treasury securities. The fed policy making body, the FOMC, does not check with anyone in Congress or the administration before making decisions on interest rates. The founders of the Fed intended it to be structured this way so that it is not directly part of the political process. Do you know why it may be good for the economy if the central bank is not part of the government?

By focusing on the goal of low inflation without political pressure, independent central banks can help avoid a political business cycle. This is a situation where the economy gets into an inflationary equilibrium due to the incumbents stimulating the economy in times of elections. Studies show that countries with independent central bank have lower average inflation rates than those whose central banks are part of the government.

Central bank independence does not imply that the Fed and the government do not work together to achieve common economic goals. In fact they are doing this now, coordinating Fiscal and Monetary policies in order to stimulate the economy out of a recession.

For more information on the organizational structure of the Fed, you can visit the following link:

Federal Reserve Web site - About the Fed: http://www.federalreserve.gov/aboutthefed/default.htm


WEEK TEN

Course Lecture 10-4: Monetary Policy ToolsContent Author: Dr. Basma Beckdache

As we learned in the previous lecture, one of the main functions of the Fed is to regulate the money supply. We also learned how to measure the money supply using the monetary aggregates M1 and M2. There are still several unanswered interesting questions:

First, how does the Fed influence the money supply? Second, how do changes in the money supply (or interest rates) influence the

state of the economy? Finally, we always hear in the news about the Fed changing interest rates, not

the money supply. What is the relationship between interest rates and the money supply?

We will answer the first question in this lecture. In the next two lectures, we will explain the impact of monetary policy on the economy and explore the relationship between the money stock and interest rates using a model of the money market.

The Fed traditionally uses three primary tools to conduct monetary policy:

1. Reserve Requirements:The Fed sets the reserve requirements for all depository institutions. A depository institution is one that accepts funds in the form of deposits and lends them out to borrowers, such as commercial banks, credit unions, and savings banks. Reserves are deposits held at Federal Reserve banks and vault cash. Depository institutions are

operating in a fractional reserves system, where a fraction of the deposits made by savers are loaned out.

There are two types of reserves:

a. Required reserves: The parts of deposits that are required to be held in reserves (i.e., the portion of deposits that cannot be loaned out). The reserve requirement ratio (RR) set by the Fed is the percentage of deposits that have to be kept on reserve. As an example, suppose RR is 10% (or .10) and Bank ANC has $150,000 in deposits. What is the bank's required reserves?

In this case, required reserves = $15,000. Since the bank has to hold 10% of its deposits on reserves, we find required reserves as follows:

b. Excess reserves: If the bank chooses to hold more than the required reserves, that is if their actual (or legal) reserves exceed required reserves, we say the bank has excess reserves, consistent with the following definitions:

Legal reserves = Actual amount of reserves being held by the bank.Excess reserves = Legal (or actual) Reserves - Required Reserves.

When the banks have no excess reserves, we say they are "loaned up".

Continuing with the example of Bank ANC. Suppose the bank's legal reserves are equal to $25,000. How can we describe Bank ANC's reserves situation?

Bank ANC has excess reserves in the amount of $10,000. This is found using the following:

Recall that the money supply aggregates M1 and M2 are mainly deposits and cash. Therefore, when deposits increase, the money supply increases and vice versa. For simplicity, let's assume for now that when banks make loans, those loans ultimately get deposited back in the banking system, creating more deposits. If some of the loans are not deposited in the system (i.e., people keep their cash at home instead), a process called currency drain, the amount of deposits would not rise as much when loans are

made leading to a smaller increase in the money supply. Given this, how can the Fed use reserve requirements to increase the money supply?

Think about this question and then click on the button of your choice.

In summary, an increase (decrease) in the required reserve ratio makes it more (less) expensive for banks to meet reserve requirements thus reduces (expanding) bank lending. Although changing reserve requirements is one of the tools available to the Fed to control the money supply, it is not often used to conduct monetary policy. The reserve requirements ratio for large institutions was lowered from 12 to 10 percent in 1992 and has not changed since. Why do you think the Fed does not often change the required reserves ratio?

Correct. Depository institutions channel funds from savers to borrowers by making loans based on their deposits. If the reserve requirement ratio was not stable and predictable, it would be very difficult for banks to plan their loans and conduct business.

Because of this, the Fed focuses on other tools to conduct monetary policy. As we will see soon, the Fed does seek to change the amount of reserves to alter the money supply but not by changing the reserve requirement ratio.

For more information on reserve requirements, you can visit the following section of the Federal Reserve Web site:

http://www.federalreserve.gov/monetarypolicy/reservereq.htm

2. The Discount Rate:The discount rate is the interest rate charged to depository institutions on loans that they receive from the Fed - made through the discount window at their regional Federal Reserve bank. The discount rate is generally set slightly above the usual level of another short-term market interest rate, the Fed funds rate. The rate varies depending on whether the borrowing institution qualifies under the primary, secondary or seasonal credit programs (see Federal Reserve Web site link to discount rate programs below for more details). Loans made through the discount widow, are generally made overnight for the purpose of managing reserve requirements. Other short-term loans are also sometimes extended under the secondary program to meet depository institutions other short-term liquidity needs. Generally, banks and other depository institutions prefer to borrow from other banks when they are short on reserves. When banks borrow from each other they pay the Federal Funds rate - more

on this in a minute. This preference appears to stem from a perception that since the Fed is a "lender of last resort," banks should only go to the discount window when they have already exhausted other channels.

How can the Fed use the discount rate to influence the money supply? What do you think the Fed should do to the discount rate if the aim was to lower the money supply - say because the economy is overheating and they are trying to reduce aggregate demand?

Think about this question and then click on the button of your choice.

Correct! Raising the discount rate reduces the ability of banks to make loans which lowers the amount of deposits and the money supply.

The discount rate as of March 2009 is 0.5% and 1.0% for the primary and secondary credit programs respectively.

For more information on the discount window programs and current rates, you can visit the following section of the Federal Reserve Web site: http://www.federalreserve.gov/monetarypolicy/discountrate.htm

3. Open Market Operations:Open Market Operations (or OMOs for short) are the principal tool used by the Fed for implementing monetary policy. OMOs refer to the buying and selling of Treasury Securities and other government agency securities in the open market. The objective of OMOs is specified by the policy directive of the Federal Open Market Committee (FOMC) in terms of a target level for the Federal funds rate or the quantity of reserves. The Federal Funds rate (Fed funds rate for short) is the interest rate paid by banks to borrow funds kept at the Federal Reserve (reserves) from other banks overnight. The Fed funds rate is basically the price of reserves. Banks that have excess reserves charge this rate when they lend to banks that are short on reserves.

The Federal Funds rate is a key interest rate in the economy since it represents a base interest rate for all lending institutions. If the Fed funds rate increases, all other interest rates in the economy tend to increase as depository institutions pass on the higher cost of funds to their customers. Given this, the Fed targets this key interest rate to influence aggregate demand. If the Fed wants to raise the money supply and stimulate economic activity, they act to lower the Fed funds rate. Conversely, if the Fed is trying to reduce aggregate demand to contain inflation, they act to increase the

Fed funds rate and increase the cost of funds causing the money supply to decrease.

Let's talk about how OMOs or the buying and selling of securities influence the Fed funds rate.

Recall that the Federal funds rate is the rate charged by banks to other banks for borrowing reserves. If we think of the market for reserves in terms of the demand and supply model from week 2, we can see how an increase in the supply of reserves would decrease the Fed funds rate and vice versa. That is, if there are more (less) reserves in the banking system the price of borrowing reserves, which is the Fed funds rate would decrease (increase).

Open Market Purchase:When the Fed acts to lower the Fed funds rate they buy Treasury securities from depository institutions (basically giving cash to the banks and taking away treasury securities. This raises the level of reserves (since banks now have cash that can be loaned out that they did not have prior to the Fed's purchase of securities) and lowers the Fed funds rate.

Open Market Sale: When the Fed acts to raise the Fed funds rate they sell securities to the banks. This lowers the amount of reserves, as banks exchange their cash for securities. This lowers the amount of reserves (akin to a decrease in the supply of reserves) and puts upward pressure on the Fed funds rate.

As of December 2008, the Fed funds target has been set at 0 -.25%, which is historically extremely low.

For more details and current information on the Fed's open market operations, you can visit the following link: http://www.federalreserve.gov/fomc/fundsrate.htm


WEEK TEN

Course Lecture 10-5: The Money MarketContent Author: Dr. Basma Bekdache

In the previous lecture, we learned how the Fed influences the money supply using reserve requirements, the discount rate, and open market operations (the Fed funds rate). To gain a better understanding of how the actions of the Fed influence other market interest rates, we make use of a simple model of the money market. Let's start building the model by defining money demand and deriving the demand for money curve. We will then interact this with money supply and derive the equilibrium interest rate.

The Demand for Money

What do we mean by "the demand for money?" We surely don't mean wanting more money! If we group assets into two main categories: interest earning and non-interest earning, and use the M1 definition of money, we can see that money is the non-interest earning asset. Without much loss of generality, we can call the interest earning asset "bonds." The demand for money refers to the willingness to hold part of our income (or wealth) in the non-interest earning asset, money. Given that bonds earn interest and money doesn't, what motivates people to hold money as an asset, other things held constant?

Right. We need the liquidity of money to conduct many transactions. Therefore, one of the main motives for holding money is the transactions demand for money. We can summarize the motives for holding money as follows:

Transactions demand:Refers to holding money as a medium of exchange to conduct transactions. The amount of money (or money balances) that people hold for this purpose varies directly with the level of income and economic activity. When aggregate income increases in the economy, the number of transactions tends to increase leading to a higher demand for money and vice versa.

Precautionary demand:Refers to holding money to meet unplanned expenditures and

emergencies. The greater the uncertainty about income and expenditures the greater the money balances that people will hold for this purpose.

Asset Demand:Sometimes we hold money simply as an asset that holds value over time. We might also hold it for speculative reasons, to have the liquidity to purchase other assets (stocks, bonds, real estate) that we speculate will increase or decrease in price depending on market conditions. Speculating refers to making predictions on changes in the price of certain assets and acting on that prediction.

How should the demand for money be related to the interest rate? That is, given their income, what should happen to the amount of money that people hold as the interest rate increases or decreases?

Hint: Think of the opportunity cost of holding money.

The interest rate represents the opportunity cost of holding the non-interest earning asset money. It is what we give up when choose money over bonds. Therefore, the demand for money is negatively related to the interest rate that can be earned on the other type of assets.

In the money market graph, with the quantity of money on the horizontal axis, and the interest rate on the vertical axis (representing the price of money), the demand for money curve has a negative slope as shown in the graph below.

(Roger Le Roy Miller, Economic Today, 14th edition)

Equilibrium in the money market:

Recall that money supply is the actual amount of money in circulation or M1. We know from the previous lectures that the money supply can be increased or decreased if the Fed uses any of the three monetary policy tools. However, the money supply itself is not dependent on the market interest rate. Since money supply is a constant with respect to the interest rate, it is a vertical line in the money market model graph, as shown below.


The money market is in equilibrium at the interest rate r1, where the quantity of money demanded is equal to money supply. Let's reason through how the market reaches the equilibrium interest rate r1.

At any interest rate greater than r1, money supply (or the actual amount of money being held-shown by the red curve) is greater than money demand (the amount that people are willing to hold at that interest rate - shown by the blue curve). In that situation we have an excess supply of money. That is people are holding more money than they would like at that interest rate. To reduce money balances, they buy bonds (or interest earning assets). This raises the amount of loanable funds in the market and lowers the interest rate, towards r1.

Conversely, at any interest rate less than r1, money supply is less than money demand. We have an excess demand for money or people would like to hold more money at that interest rate. To increase money balances, they sell bonds. This lowers the amount of loanable funds in the market and raises the interest rate, towards r1.

Given the adjustment mechanism we just described above, what do you think the Fed should do if they want to lower the equilibrium market interest rate?

The fed should increase money supply. This creates an excess supply of money, which drives down the market interest rate. This is illustrated in the money market graph below.


To increase interest rates, the Fed can decrease the money supply to cause an excess demand for money pulling the interest rate to a higher equilibrium. Can you illustrate this situation with your own sketch of the money market graph? Please take a moment to sketch this out.

In choosing how to express their policy targets, the Fed focuses on a target interest level that is deemed consistent with the ultimate economic goals. The money market graph is useful in illustrating the fact that when the Fed chooses a target level for the interest rate, they cannot control the money supply at the same time, as shown in the graph below:



WEEK TEN

Course Lecture 10-6: Effects of Monetary Policy on the EconomyContent Author: Dr. Basma Bekdache

So far, we spent quite some time discussing the Fed, monetary policy tools, and the money market. The interest rate and the money supply are intermediate goals that the Fed sets in order to reach the ultimate goals of their policy. Do you recall what the ultimate goals of economic policy are?

As discussed in previous lectures, the goals of monetary policy are economic growth and price stability.

So how does the Fed go about achieving these goals?

The Fed can influence Aggregate Demand (AD) through the interest rate. Specifically, the transmission mechanism for monetary policy can be summarized in the following schematic.

(Reprinted from Roger LeRoy Miller, Economic Today, 14th edition.)

As shown in the graphs below, expansionary monetary policy is aimed at increasing AD in order to increase real GDP and reduce unemployment. Conversely, contractionary monetary policy is aimed at decreasing AD in order to reduce economic activity to prevent inflation. Recall from prior weeks that when AD increases real GDP increases, but prices increase as well causing inflation. Since price stability is a goal that can conflict with economic growth (if the economy is already at potential), the Fed sometimes undertakes a contractionary policy to promote price stability.

Similar to what we did last week with Fiscal policy, let's consider two different scenarios about the economy. Then, let's pretend we're in an FOMC meeting and make policy recommendations aimed at keeping output at the full employment level.

Course Lecture Notes for Cumulative Final Exam (Combined weeks 1-10)

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