Transcript Chapter 2

GSIAS – North American Economy
Economics 101
Lesson Overview
Microeconomics
• Supply/Demand/Equilibrium

Govt. Policies Effect (Drugs/Min. Wage/Taxes)
• Economic Models

Perfect Competition / Monopolies
Macroeconomics
• GDP

Circular Flow Model
• Economic Growth and Production
• Interest Rates and Inflation
• Open Economy Macroeconomics
2-2
Macro vs. Micro Economics
Microeconomics is the study of how individual
households and firms make decisions and how
they interact with one another in markets.

Prices and selection of products
Macroeconomics is the study of the economy as a
whole. Its goal is to explain the economic
changes that affect many households, firms, and
markets at once.



Inflation
Unemployment
Economic Growth
Demand
• The quantity demanded of any good is
the amount of the good that buyers are
willing and able to purchase.
• Law of demand: the claim that the
quantity demanded of a good falls when
the price of the good rises, other things
equal
THE MARKET FORCES OF SUPPLY AND DEMAND
4
The Market Demand Curve for Lattes
P
Qd
(Market)
$0.00
24
$5.00
1.00
21
$4.00
2.00
18
3.00
15
4.00
12
5.00
9
6.00
6
P
$6.00
$3.00
$2.00
$1.00
Q
$0.00
0
5
10
15
THE MARKET FORCES OF SUPPLY AND DEMAND
20
25
5
Demand Curve Shifters
• The demand curve shows how price affects
quantity demanded, other things being equal.
• These “other things” are non-price determinants
of demand (i.e., things that determine buyers’
demand for a good, other than the good’s price).
• Changes in them shift the D curve…
$6.00
P
$5.00
$4.00
$3.00
$2.00
$1.00
$0.00
THE MARKET FORCES OF SUPPLY AND DEMAND
0
5
10
15
20
25
30
Q
6
Summary: Variables That Influence Buyers
Variable
A change in this variable…
Price
…causes a movement
along the D curve
# of buyers
…shifts the D curve
Income
…shifts the D curve
Price of
related goods
…shifts the D curve
Tastes
…shifts the D curve
Expectations
…shifts the D curve
THE MARKET FORCES OF SUPPLY AND DEMAND
7
ACTIVE LEARNING
1
Demand Curve
Draw a demand curve for music downloads. What
happens to it in each of
the following scenarios? Why?
A. The price of iPods
falls
B. The price of music
downloads falls
C. The price of CDs falls
8
Supply
• The quantity supplied of any good is
the amount that sellers are willing and
able to sell.
• Law of supply: the claim that the
quantity supplied of a good rises when
the price of the good rises, other things
equal
THE MARKET FORCES OF SUPPLY AND DEMAND
9
The Market Supply Curve
P
QS
(Market)
$0.00
0
1.00
5
2.00
10
$4.00
3.00
15
$3.00
4.00
20
$2.00
5.00
25
6.00
30
P
$6.00
$5.00
$1.00
Q
$0.00
0
5
10 15
THE MARKET FORCES OF SUPPLY AND DEMAND
20 25 30
35
10
Supply Curve Shifters
• The supply curve shows how price affects
quantity supplied, other things being equal.
• These “other things” are non-price
determinants of supply.
• Changes in them shift the S curve…
$6.00
P
$5.00
$4.00
$3.00
$2.00
$1.00
$0.00
0
THE MARKET FORCES OF SUPPLY AND DEMAND
5
10
15
20
25
30
35
Q
11
Summary: Variables that Influence Sellers
Variable
A change in this variable…
Price
…causes a movement
along the S curve
Input Prices
…shifts the S curve
Technology
…shifts the S curve
# of Sellers
…shifts the S curve
Expectations
…shifts the S curve
THE MARKET FORCES OF SUPPLY AND DEMAND
12
ACTIVE LEARNING
2
Supply Curve
Draw a supply curve for tax
return preparation software.
What happens to it in each
of the following scenarios?
A. Retailers cut the price of
the software.
B. A technological advance
allows the software to be
produced at lower cost.
C. Professional tax return preparers raise the price
of the services they provide.
13
Supply and Demand Together
P
$6.00
S
D
$5.00
$4.00
$3.00
Equilibrium:
P has reached
the level where
quantity supplied
equals
quantity demanded
$2.00
$1.00
Q
$0.00
0
5
10 15 20 25 30 35
THE MARKET FORCES OF SUPPLY AND DEMAND
14
Surplus (a.k.a. excess supply):
when quantity supplied is greater than
quantity demanded
P
$6.00
D
Surplus
S
$5.00
Example:
If P = $5,
then
QD = 9 lattes
$4.00
and
QS = 25 lattes
$3.00
$2.00
resulting in a
surplus of 16 lattes
$1.00
Q
$0.00
0
5
10 15 20 25 30 35
THE MARKET FORCES OF SUPPLY AND DEMAND
15
Surplus (a.k.a. excess supply):
when quantity supplied is greater than
quantity demanded
P
$6.00
D
Surplus
$5.00
S
Facing a surplus,
sellers try to increase sales
by cutting price.
This causes
QD to rise and QS to fall…
$4.00
$3.00
…which reduces the
surplus.
$2.00
$1.00
Q
$0.00
0
5
10 15 20 25 30 35
THE MARKET FORCES OF SUPPLY AND DEMAND
16
Surplus (a.k.a. excess supply):
when quantity supplied is greater than
quantity demanded
P
$6.00
D
Surplus
$5.00
S
Facing a surplus,
sellers try to increase sales
by cutting price.
This causes
QD to rise and QS to fall.
$4.00
$3.00
Prices continue to fall until
market reaches
equilibrium.
$2.00
$1.00
Q
$0.00
0
5
10 15 20 25 30 35
THE MARKET FORCES OF SUPPLY AND DEMAND
17
EXAMPLE 2:
A Shift in Supply
EVENT: New technology
P
reduces cost of
producing hybrid cars.
S1
S2
STEP 1:
S curve shifts
because
P1
STEP 2: event affects
cost of production.
P2
S shifts right
D
curve event
does not
shift,
because
reduces
STEP 3: production
because
cost,
The shift causes
price
technology
is
not
of
makes productionone
more
to fall
the
factorsatthat
profitable
anyaffect
given
and quantity to rise.
demand.
price.
THE MARKET FORCES OF SUPPLY AND DEMAND
D1
Q1 Q2
Q
18
EXAMPLE 3:
A Shift in Both Supply
and Demand
EVENTS:
price of gas rises AND
new technology reduces
production costs
STEP 1:
Both curves shift.
STEP 2:
P
S1
S2
P2
P1
Both shift to the right.
STEP 3:
Q rises, but effect
on P is ambiguous:
If demand increases more than
supply, P rises.
THE MARKET FORCES OF SUPPLY AND DEMAND
D1
Q1
Q2
D2
Q
19
EXAMPLE 3:
A Shift in Both Supply
and Demand
EVENTS:
price of gas rises AND
new technology reduces
production costs
STEP 3, cont.
But if supply
increases more
than demand,
P falls.
P
S1
P1
P2
D1
Q1
THE MARKET FORCES OF SUPPLY AND DEMAND
S2
Q2
D2
Q
20
APPLICATION: Does Drug Interdiction Increase
or Decrease Drug-Related Crime?
• One side effect of illegal drug use is crime:
Users often turn to crime to finance their habit.
• We examine two policies designed to reduce
illegal drug use and see what effects they have
on drug-related crime.
• For simplicity, we assume the total dollar value
of drug-related crime equals total expenditure
on drugs.
• Demand for illegal drugs is inelastic, due to
addiction issues.
ELASTICITY AND ITS APPLICATION
21
Policy 1: Interdiction
Interdiction
reduces the
supply of
drugs.
Since demand
for drugs is
inelastic,
P rises proportionally more
than Q falls.
Price of
Drugs
S1
P2
initial value
of drugrelated
crime
P1
Result: an increase in
total spending on drugs, and
in drug-related crime
ELASTICITY AND ITS APPLICATION
new value of drugrelated crime
S2
D1
Q2 Q1
Quantity
of Drugs
22
Policy 2: Education
Education
reduces the
demand for
drugs.
Price of
Drugs
new value of drugrelated crime
D2
D1
S
P and Q fall.
Result:
A decrease in
total spending on
drugs, and in
drug-related
crime.
ELASTICITY AND ITS APPLICATION
initial value
of drugrelated
crime
P1
P2
Q2 Q1
Quantity
of Drugs
23
The Minimum Wage
Min wage laws
do not affect
highly skilled
workers.
They do affect
teen workers.
Studies:
A 10% increase
in the min wage
raises teen
unemployment
by 1-3%.
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
W
unemployment S
Min.
wage
$5
$4
D
400
550
L
24
CASE STUDY: Who Pays the Luxury Tax?
• 1990: Congress adopted a luxury tax on
yachts, private airplanes, furs, expensive
cars, etc.
• Goal of the tax: raise revenue from
those
who could most easily afford to pay –
wealthy consumers.
• But who really pays this tax?
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
25
CASE STUDY: Who Pays the Luxury Tax?
Demand is
price-elastic.
The market for yachts
P
Buyers’ share of
tax burden
S
PB
In the short run,
supply is inelastic.
Tax
Sellers’ share of
tax burden
PS
D
Q
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
Hence,
companies
that build
yachts pay
most of
the tax.
26
DWL and the Size of the Tax
Initially, the tax is T
per unit.
Doubling the tax
causes the DWL to
more than double.
P
new
DWL
S
T
2T
initial
DWL
Q2
APPLICATION: THE COSTS OF TAXATION
Q1
D
Q
27
Revenue and the Size of the Tax
The Laffer curve
shows the
relationship
between
the size of the tax
and tax revenue.
Tax
revenue
The Laffer curve
Tax size
APPLICATION: THE COSTS OF TAXATION
28
THE MEASUREMENT OF GROSS
DOMESTIC PRODUCT
• Gross domestic product (GDP) is a
measure of the income and
expenditures of an economy.
• GDP is the total market value of all
final goods and services produced
within a country in a given period of
time.
The Circular-Flow Diagram
• The Circular-Flow Diagram: a visual model of
the economy, shows how dollars flow through
markets among households and firms
• Two types of “actors”:

households

firms
• Two markets:

the market for goods and services

the market for “factors of production”
THINKING LIKE AN ECONOMIST
30
FIGURE 1: The Circular-Flow Diagram
Households:
 Own the factors of production,
sell/rent them to firms for income
 Buy and consume goods & services
Firms
Households
Firms:
 Buy/hire factors of production,
use them to produce goods and
services
 Sell goods & services
THINKING LIKE AN ECONOMIST
31
FIGURE 1: The Circular-Flow Diagram
Revenue
G&S
sold
Markets for
Goods &
Services
Firms
Factors of
production
Wages, rent,
profit
THINKING LIKE AN ECONOMIST
Spending
G&S
bought
Households
Markets for
Factors of
Production
Labor, land,
capital
Income
32
THE COMPONENTS OF GDP
GDP (Y) is the sum of the following:

Consumption (C)

Investment (I)

Government Purchases (G)

Net Exports (NX)
Y = C + I + G + NX
Productivity
• Recall one of the Ten Principles from Chap. 1:
A country’s standard of living depends
on its ability to produce g&s.
• This ability depends on
productivity, the average quantity of g&s
produced per unit of labor input.
• Based on:
-Physical Capital
-Human Capital
-Natural Resources
-Technical Knowledge
34
THE MARKET FOR LOANABLE
FUNDS
• Financial markets coordinate the
economy’s saving and investment in the
market for loanable funds.
• The market for loanable funds is the
market in which those who want to save
supply funds and those who want to
borrow to invest demand funds.
Supply and Demand for Loanable
Funds
• Loanable funds refers to all income that
people have chosen to save and lend out,
rather than use for their own consumption.
• The supply of loanable funds comes from
people who have extra income they want to
save and lend out.
• The demand for loanable funds comes from
households and firms that wish to borrow to
make investments.
Supply and Demand for Loanable
Funds
• Interest rate
 the
price of the loan
 the
amount that borrowers pay for loans
and the amount that lenders receive on
their saving
 in
the market for loanable funds, the real
interest rate
Supply and Demand for Loanable
Funds
• Financial markets work much like other
markets in the economy.
• The equilibrium of the supply and
demand for loanable funds determines
the real interest rate.
Figure 2 An Increase in the Supply of
Loanable Funds
Interest
Rate
Supply, S1
S2
1. Tax incentives for
saving increase the
supply of loanable
funds . . .
5%
4%
2. . . . which
reduces the
equilibrium
interest rat e . . .
Demand
0
$1,200
$1,600
3. . . . and raises the equilibrium
quantity of loanable funds.
Loanable Funds
(in billions of dollars)
THE FEDERAL RESERVE SYSTEM
• The Federal Reserve (Fed) serves as
the nation’s central bank.
 Three
Primary Functions of the Fed
• Regulates banks to ensure they follow federal
laws intended to promote safe and sound
banking practices.
• Acts as a banker’s bank, making loans to banks
and as a lender of last resort.
• Conducts monetary policy by controlling the
money supply.
The Federal Open Market Committee
• Open-Market Operations
 To
increase the money supply, the Fed
buys government bonds from the public.
 To
decrease the money supply, the Fed
sells government bonds to the public.
BANKS AND THE MONEY SUPPLY
• Banks can
influence the
quantity of demand
deposits in the
economy and the
money supply.
Money Creation with FractionalReserve Banking
• When a bank makes a loan from its reserves,
the money supply increases.
• The money supply is affected by the amount
deposited in banks and the amount that banks
loan.



Deposits into a bank are recorded as both assets
and liabilities.
The fraction of total deposits that a bank has to
keep as reserves is called the reserve ratio.
Loans become an asset to the bank.
Money Creation with FractionalReserve Banking
• When one bank loans money, that
money is generally deposited into
another bank.
• This creates more deposits and more
reserves to be lent out.
• When a bank makes a loan from its
reserves, the money supply increases.
THE CLASSICAL THEORY OF
INFLATION
• Inflation is an increase in the overall
level of prices.
• Hyperinflation is an extraordinarily high
rate of inflation.
The Level of Prices and the Value of
Money
• The quantity theory of money is used to
explain the long-run determinants of the
price level and the inflation rate.
• Inflation is an economy-wide
phenomenon that concerns the value of
the economy’s medium of exchange.
• When the overall price level rises, the
value of money falls.
Money Supply, Money Demand, and
Monetary Equilibrium
• The money supply is a policy variable that is
controlled by the federal govt.
• Through instruments such as open-market
operations, the govt. directly controls the
quantity of money supplied.
• Money demand has several determinants,
including interest rates and the average level
of prices in the economy.
Money Supply, Money Demand, and
Monetary Equilibrium
• People hold money because it is the
medium of exchange.
 The
amount of money people choose to
hold depends on the prices of goods and
services.
• In the long run, the overall level of prices
adjusts to the level at which the demand
for money equals the supply.
Figure 2 An Increase in the Money
Supply
Value of
Money, 1 /P
(High)
MS1
MS2
1
1
1. An increase
in the money
supply . . .
3
2. . . . decreases
the value of
mone y . . .
Price
Level, P
/4
12
/
1.33
A
2
B
14
/
(Low)
3. . . . and
increases
the price
level.
4
Money
demand
(High)
(Low)
0
M1
M2
Quantity of
Money
Open-Economy Macroeconomics:
Basic Concepts
• An open economy interacts with other
countries in two ways.
 It
buys and sells goods and services in
world product markets.
 It
buys and sells capital assets in world
financial markets.
The Flow of Goods: Exports, Imports,
Net Exports
• Net exports (NX) are the value of a
nation’s exports minus the value of its
imports.
• Net exports are also called the trade
balance.
The Flow of Goods: Exports, Imports,
Net Exports
• Factors That Affect Net Exports
 The
tastes of consumers for domestic and
foreign goods.
 The
 The
prices of goods at home and abroad.
exchange rates at which people can
use domestic currency to buy foreign
currencies.
The Flow of Goods: Exports, Imports,
Net Exports
• Factors That Affect Net Exports
 The
incomes of consumers at home and
abroad.
 The
costs of transporting goods from
country to country.
 The
policies of the government toward
international trade.
The Flow of Financial Resources: Net
Capital Outflow
• Net capital outflow refers to the
purchase of foreign assets by domestic
residents minus the purchase of
domestic assets by foreigners.
• A U.S. resident buys stock in the Toyota
corporation and a Mexican buys stock in
the Ford Motor corporation.
The Flow of Financial Resources: Net
Capital Outflow
• When a U.S. resident buys stock in
Telmex, the Mexican phone company,
the purchase raises U.S. net capital
outflow.
• When a Japanese residents buys a
bond issued by the U.S. government,
the purchase reduces the U.S. net
capital outflow.
The Flow of Financial Resources: Net
Capital Outflow
• Variables that Influence Net Capital
Outflow
 The
real interest rates being paid on foreign
assets.
 The
real interest rates being paid on
domestic assets.
 The
perceived economic and political risks
of holding assets abroad.
 The
government policies that affect foreign
ownership of domestic assets.
The Equality of Net Exports and Net
Capital Outflow
• For an economy as a whole, NX and
NCO must balance each other so that:
NCO = NX
• Why?
When a nation is running a trade surplus (NX>0), it is
selling more goods/services to foreigners than it is buying.
What is it doing with the foreign currency received? Must be
buying foreign assets. Capital is flowing out of the country
(NCO>0).
When a nation is running a trade deficit (NX<0), it is
buying more goods and services from foreigners than it is
selling. How is it financing the purchase? It must be selling
assets abroad. Capital is flowing into the country (NCO<0).
Saving, Investment, and Their
Relationship to the International
Flows
• National saving (S) equals Y – C – G so:
S = I + NX
• or
Saving
=
S
=
Domestic + Net Capital
Investment
Outflow
I
+
NCO
THE PRICES FOR INTERNATIONAL TRANSACTIONS:
REAL AND NOMINAL EXCHANGE RATES
• International transactions are influenced
by international prices.
• The two most important international
prices are the nominal exchange rate
and the real exchange rate.
Nominal Exchange Rates
• The nominal exchange rate is the rate at
which a person can trade the currency
of one country for the currency of
another.
Real Exchange Rates
• The real exchange rate is the rate at
which a person can trade the goods and
services of one country for the goods
and services of another.
Figure 1 The Market for Loanable
Funds
Real
Interest
Rate
Supply of loanable funds
(from national saving)
Equilibrium
real interest
rate
Demand for loanable
funds (for domestic
investment and net
capital outflow)
Equilibrium
quantity
Quantity of
Loanable Funds
Figure 3 How Net Capital Outflow
Depends on the Interest Rate
Real
Interest
Rate
Net capital outflow
is negative.
0
Net capital outflow
is positive.
Net Capital
Outflow
The Market for Foreign-Currency
Exchange
Real
Exchange
Rate
Supply of dollars
(from net capital outflow)
Equilibrium
real exchange
rate
Demand for dollars
(for net exports)
Why does demand slope
downward? Why is the Equil.
Qty vertical?
Equilibrium
quantity
Quantity of Dollars Exchanged
into Foreign Currency
The Effects of Government Budget Deficit
1. A budget deficit reduces
the supply of loanable funds . . .
(a) The Market for Loanable Funds
Real
Interest
Rate
r2
r
2. . . . which
increases
the real
interest
rate . . .
S
(b) Net Capital Outflow
Real
Interest
Rate
S
B
r2
A
r
3. . . . which in
turn reduces
net capital
outflow.
Demand
NCO
Quantity of
Loanable Funds
Net Capital
Outflow
Real
Exchange
Rate
E2
5. . . . which
causes the
real exchange
rate to
appreciate.
E1
S
S
4. The decrease
in net capital
outflow reduces
the supply of dollars
to be exchanged
into foreign
currency . . .
Demand
Quantity of
Dollars
(c) The Market for Foreign-Currency Exchange
The Effects of an Import Quota
(a) The Market for Loanable Funds
Real
Interest
Rate
(b) Net Capital Outflow
Real
Interest
Rate
Supply
r
r
3. Net exports,
however, remain
the same.
Demand
NCO
Quantity of
Loanable Funds
Net Capital
Outflow
Real
Exchange
Rate
E2
2. . . . and
causes the
real exchange
rate to
appreciate.
Supply
1. An import
quota increases
the demand for
dollars . . .
E
D
D
Quantity of
Dollars
(c) The Market for Foreign-Currency Exchange