Transcript Lecture Notes: Econ 202 - Faculty Personal Homepage

Chapter 25
Output And Prices
in the Short-Run
What Happens to the equilibrium national
income when the price level changes ?
• There is a negative relationship between the
price level and the Aggregate Expenditure .
• A change in the price level have an effect on
consumption , C and on net exports which
in turn affect Aggregate Expenditure.
I. Change in Consumption, C
• An increase in domestic price level , lower
the real value of wealth or income which in
turn decrease consumption and the decrease
the Aggregate Expenditure , so AE function
shift downward .
• So as P rises , real W falls , C decreases,and
AE Function shift downward .
• A fall in the price level has the opposite
effect .
II. Change in Net Exports ( X- M)
• When domestic price level rises, then
domestic goods become more expensive
relative to foreign goods. Therefore,
• Domestic consumers will buy less of
domestic goods and more of foreign goods,
so imports will rise .
• Foreign countries will reduce their purchases of
our domestic goods so Exports will decrease
and as a result Net Exports ( X- M ) will fall .
Change in Equilibrium National Income
• Change in the price level change both
Consumption and Net export .
• A rise in the price level will decrease both C
and ( X-M ) so AE function shift down and
Y will decrease .
• A fall in the price level has the opposite
effect so as P falls , Y will rise .
The Aggregate Demand
• The negative relationship between the price
level and National income is called
Aggregate Demand , AD .
• AD curve is negatively slopped which
means that :
• As Price level decrease, Income will rise
and as price level rises , Income will falls .
• The change in price level , P, causes a
movement along the AD curve .
Equilibrium National Income and
The Price Level
• So far, we have discussed how equilibrium
National Income is determined using only
the Aggregate Demand , AD .
• To complete the picture, we need to add the
Aggregate Supply to show the final market
equilibrium .
The Aggregate Supply Curve
• Shows the relationship between the quantity
supplied by all firms and the price level .
• Short-run Aggregate Supply, SRAS curve:
relates the price level to quantity supplied
by all firms with the assumption that prices
of all factors of production remain constant.
• Long-run aggregate supplied curve, LRAS:
relates the price level to quantity supplied
by all firms after the economy has fully
adjusted to the change in the price level .
Short-Run Aggregate Supply
• The SRAS curve shows a positive
relationship between the price level and the
total output produced by all firms in the
economy.
• A change in the price level causes a
movement along the SRAS curve from
one point to another .
Shift in SRAS Curve or
Aggregate Supply Shock
• There are two reasons for SRAS
curve to shift :
• 1. Change in prices of inputs or
cost of production .
• 2. Increase in productivity .
I. Change in Prices of Inputs
• If prices of inputs rise .. Cost of
production will rise .. profit will decrease,
therefore, for the same output to be
produced , an increase in the price level is
required , otherwise the firms will cut
production and that shift the SRAS curve
to the left .
• If prices of inputs fall … it will have the
opposite effect . (shift SRAS to the right )
II. Increase in Productivity
• If labor productivity rises .. Unit cost of
production will fall as long as the wage rate
does not rise sufficiently to offset the
productivity rise . This will shift the SRAS
curve to the right .
• If labor productivity falls it will have the
opposite effect which means it will shift
the SRAS curve to the left .
Macroeconomic Equilibrium
• The intersection between the AD and SRAS
curves give us the macroeconomic
equilibrium of national income and the
price level .
• Any shift in either the AD or SRAS curves
leads to change in the equilibrium value of
the national income and the price level .
Aggregate Demand Shock
• An increase in AD … shift the AD curve
to the right , and this increase both the
equilibrium national income and the
price level . This increase in AD is called
Expansionary Demand Shock.
• A fall in AD … shift AD curve to the left,
and this decrease both equilibrium
national income and the price level . This
is called Contractionary Demand Shock
Aggregate Supply Shock
• An increase in aggregate supply will shift
the SRAS curve to the right or downward
and this will lead to an increase in the
equilibrium national income , but to a
decrease in equilibrium price level .
• A decrease in aggregate supply will shift
the SRAS curve to the left or upward,
and this decreases equilibrium national
income , but increases the price level .
Stagflation
• An increase in the price level is called
Inflation .
• A decrease in output is called Stagnation.
• The combination of inflation and
• stagnation is called Stagflation
The Multiplier when the price level is
held constant { Simple multiplier }
• The simple multiplier measures the
horizontal shift in AD curve in response
to the change in autonomous expenditure.
• If the price level is held constant, it
means that firms are willing to supply all
output demanded at the existing
price.This leads to horizontal SRAS
curve called “ Keynesian SRAS curve “ .
Keynesian SRAS Curve
• Keynesian SRAS curve is horizontal .
• Based on the Keynesian SRAS curve ,
firms will supply whatever they can sell
at their existing price as long as they are
operating below the normal capacity .
• Therefore, based on the Keynesian SRAS
curve, real national income is demand
determined .
What happens in the case in which
SRAS curve slope upward ?
• In this case, a rise in national income
caused by an increase in AD will be
associated with a rise in the price level .
• The multiplier effect when the price level
is allowed to vary would be smaller than
the simple multiplier .
The Importance of the Shape of SRAS
curve
• Over the horizontal range of SRAS curve any
change in AD will change the equilibrium
national income only.
• Over the Intermediate range of SRAS : any
change in AD will change both the equilibrium
price level and income .
• Over the steep range of the SRAS curve: any
change in AD will cause large change in
equilibrium price level ,but small change in
equilibrium national income .
The Effect of Demand Shock when
the SRAS curve is Vertical
• When the SRAS curve is vertical,
then any change in AD will change
the price level only , and no change
in equilibrium national income.
• The multiplier in this case is zero .
Chapter 26
Output and Prices in the
Long Run
Potential VS. Actual National Income
• Potential National Income, or Y*: Is the
total output that can be produced when all
production resources are being used at their
normal rate of utilization . Therefore, the
potential National income represent what
should be produced by the economy.
• Actual National Income , or Y: Is the output
actually produced given by the intersection
between AD and SRAS curves .
The Output Gap
• Is the difference between the potential
and actual output .
• Output Gap = Y* - Y
• When Y* > Y we have Recessionary gap
• When Y* < Y we have an Inflationary
gap
Factor Prices and Output gap
• Recessionary gap ( Y* > Y ) causes
downward pressure on wages to fall .
• Inflationary gap ( Y* < Y ) causes
upward pressure on wages to rise .
• When Y = Y* , so the GDP gap = 0 , there
is neither downward nor upward
pressure on wages to go up or down .
Long-Run Consequences of AD Shock
1.Expansionary AD Shock: increase in AD
-A rise in AD .. Shift AD curve to the right.
- This open an inflationary gap (Y > Y*)
- The inflationary gap put pressure on wages to
rise .. Increase cost of production .. Which
shift SRAS curve to the left . This process will
continue until the inflationary gap is
eliminated.
- This process is called “Self-Adjustment
mechanism .
2. Contractionary AD shock
• Assume the economy is initially operating
at full employment . Then ,
• A fall in AD shift the AD curve to the left
and open a recessionary gap .
• This gap , put pressure on wages to fall,so
cost of production will fall . This
encourage more production, so SRAS
curve shift to the right until the gap is
eliminated . This process is called
( Self-Adjustment mechanism )
Long-Run Equilibrium
• The intersection between AD and LRAS
curves give us the equilibrium P and Y in
the long-run
• Any shift in AD or LRAS curves will
change the equilibrium value of P and Y .
• Any change (shift) in AD in long-run will
change the price level only .
• Any change in LRAS will change both
price level and national income , P and Y
Basic Theory of Fiscal
Stabilization
• Fiscal Policy: is the use of government
expenditure ( G) and/or government
revenue ( T ) to stabilize the economy at
full-employment . Fiscal policy can be
divided into two cases :
• 1. Expansionary Fiscal Policy .
• 2. Contractionary Fiscal Policy .
1. Expansionary Fiscal Policy
• A fall in T and/or a rise in G will shift AE
function upward and shift AD curve to
the right , and this will increase the
national income or GDP .
• Therefore, if the government would like
to increase National income or GDP it
should use the expansionary fiscal policy.
2. Contractionary Fiscal Policy
• A rise in Taxes and /or fall in government
expenditure will decrease AE , and shift
AE function downward and shift AD
curve to the left , and this will decrease
the equilibrium national income or GDP.
• Therefore, if the government would like
to decrease GDP , it should use the
contractionary fiscal policy .
How a Recessionary gap can be
eliminated ?
• 1. SRAS curve shift to the right as a
result of decrease in prices of input and
the cost of production ( self-adjustment
mechanism process ) .
• 2. AD curve shift to the right as a result
of a rise in G /and or a fall in T which will
restore full employment at Y* , but at a
higher price level .
Advantages VS Disadvantages
of Fiscal Policy
• Advantage: The use of fiscal
policy will shorten the period of
recession .
• Disadvantage: the use of fiscal
policy may cause the economy to
overshoot its potential output .
How an Inflationary gap can be
eliminated ?
• 1. SRAS curve may shift to the left as a
result of an increase in prices of factors of
production (self-adjustment mechanism )
.
• 2. AD curve shift to the left as a result of
fall in G and/or a rise in T
(contractionary fiscal policy ) .
Built in Stabilizers
• These policies specify that government
spending or tax changes will take place
automatically in response to upturn and
downturn in economic activities .
• Example of automatic measures are :
• 1. Unemployment compensation .
• 2.various welfare programs .
• 3. Progressive income tax .
The effect of Fiscal Policy that
is not revesed
• If the economy overshoot its potential
level of output, it is possible to stabilize
the economy at full employment if the
fiscal policy can be quickly reversed.
• But, if the fiscal policy can not be
reversed quickly , then the output gap
will exist for longer period, and
eventually will be closed through the selfadjustment mechanism .
Chapter 27
The Nature of Money and
Monetary Institutions
Definition of Money
• Economists define money as :
• Anything that is generally accepted in
payment for goods or services or in the
repayment of debts .
• Barter economy is defined as:
an economy where one good is being
exchanged directly for another good.
Wealth and Money
• Wealth is all assets (including money)
that are owned by an individual such as
Bonds , Stocks , Land, Furniture, Cars,
Houses , etc.
• Money is just one asset of the total wealth
of the individual .
• Wealth is much broader concept than
money .
Income VS. Money
• Income is f Flow of earning per
period of time .
• Money is a stock i.e. certain
amount of at a given point in
time .
Functions of Money
• 1. Act as a medium of exchange .
• 2. Act as a unit of account .
• 3. Act as store of value .
1. Money act as a medium of exchange
• This means that money is used to
pay for goods and services .
• This act promotes economic
efficiency by reducing transaction
cost .
• It eliminates much of the time spent
in exchanging goods and services in
the Batter economy .
Barter Economy
• Exchanging one good for another good
• In this economy, the transaction cost is
very high .
• In this economy people have to satisfy
“ Double Coincidence of wants “
2. Money act as a unit of account
• We measure the value of goods and services
in terms of money .
• In money economy , the number of prices
needed equal to the number of goods and
services to be exchanged .
• In barter economy, the number of prices
needed equal to n ( n-1 )
2
where n = number of goods to exchanged
3. Money act as a store of value
• Money is a store of purchasing power
over time .
• You can sell what you have for money,
and then store your money until you have
the time and desire to buy .
• Money is not the only asset that has this
function , but it is the most liquid asset .
• Money losses value during inflation
period .
Money Supply
• Is the total stock of money in the
economy at any moment in time .
• There are different definitions for the
money supply . These definitions vary in
terms of what deposits are included .
Definitions of Money Supply
• 1. Narrow definition of money supply or
M1
• Broader definition of money supply or
M2 and M3
Narrow definition of money supply
• M1 = currency in + deposits that can be
circulation
used as a medium of
exchange
• Therefore :
• M1 = C + DD + NOW D + ATS D + any
checkable deposits .
• NOW D = Negotiable Order of Withdrawal
• ATS D = Automatic Transfer Service
Broader Definition of Money
Supply or M2 and M3
• M2 = M1 + SD + Small TD
• M3 = M2 + Large denomination of TD
• Where :
SD = Saving deposits
TD = Time deposits
Near Money & Money substitutes
• Near Money:
Are assets that satisfy the store of value
function and can be converted into a
medium of exchange, but they are not
themselves a medium of exchange .
Example:
Treasury Bills that mature in 30 days
Money Substitutes
• Are things that serve as temporary
medium of exchange, but are not a store
of value .
• Example:
• Credit card such as Visa or Master Card
Inter-Bank Activities
• 1. Banks often share loans . This is called
“pool Loans “ .
• 2. The bank credit card are operated by
large groups of banks .
• The most important form of inter-bank
cooperation is Check-Clearing &
collection . Clearing House is the place
where inter-bank debts are settled. This
function is performed by the central bank
Banking System
• 1. The Center Bank
• 2. The financial Institutions such as
commercial banks .
The Central Bank: It is the government
owned and operated institution that serve
to control the banking system ,and it is
the sole money issuing authority .
Basic Functions of Central Bank
• 1. Act as banker of commercial banks .
• 2. Act as banker of the government .
• 3. Act as controller of the nation’s money
supply .
• 4. Act as regulator of money market .
1. Banker of Commercial Bank
• Accept deposits of commercial banks .
• Transfer money from one account to
another account on demand .
• Act as a lender of last resort to
commercial banks when they have urgent
need for cash by providing temporary
short-term loans .
2. Banker to the Government
• The government deposits the fund in the
central bank .
• The government write checks against its
account in the central bank .
• The central bank sells government bonds
or securities for the government .
3. Controller of Money supply
• The central bank can use the
monetary policy [ changing
the money supply] to close the
GDP gap and stabilize the
economy at its full
employment level or Y* .
4. Regulator of Money Market
• The central bank assume responsibility
for supporting the financial system in the
country .
• Help to moderate the rapid swing in the
interest rate to prevent serious disruption
by wide scale panic and bank failure.
• Act as lender of last resort to the
commercial banks .
Financial Intermediaries
• They are privately owned institutions that
serve the general public.
• They are called intermediaries because they
stand between Savers and borrowers .
• We will focus on the commercial banks,
although the same analysis applies to other
intermediaries as well .
Commercial Banks
• Modern commercial banking system are of
two main types :
• 1.one has small # of banks , but each bank
• with a large # of branch offices .Example
the banking system of UK and Canada.
• 2. The other type consists of a large # of
independent banks .Example, the banking
system of U.S.A .
Reserves of Commercial Banks
• Commercial banks needs to keep only
fractional reserves against their deposits
during the normal times .
• IN abnormal times, the commercial banks
can borrow reserves from the central bank
to meet any abnormal situation .
Required VS. Actual Reserves
• Required Reserves is the reserves required
by the central bank and it is calculated as a
percentage of the total deposits .
• Excess Reserves is the reserves above the
required reserves .
• Actual Reserves is the sum of required
reserves plus excess reserves .
Money Creation by the
Banking System
• Assume that banks can invest in only one
asset ( Loans ) .
• Assume that there is only one kind of
deposit ( Demand Deposit ) .
• Assume the required reserve ratio is fixed
for all banks at 20% .
• Assume no excess reserves , so banks keep
only the required reserves .
• Assume no cash drain from the system .
Creation of Deposits Money
• Having all the previous assumptions in
mind , assume that National Commercial
bank ( NCB ) has the following Balance
sheet ( in thousands ) :
Assets
Liabilities & Equity
Cash & other SR 200 Deposits SR 1000
Reserves
Capital
100
Loans
900
_____
SR 1100
SR 1100
Now Assume a foreigner , who just arrived in the
country opened an account with NCB and
deposited SR 100,000 ( New deposit) , so the
balance sheet after the deposit will be :
Assets
Liabilities & Equity
Cash and other Reserves SR 300
Loans
900
______
SR 1200
Deposits
Capital
SR 1100
100
________
SR 1200
Since Actual reserves
= SR 300,000
Since Required reserves = SR 220,000 therefore this
bank has Excess Reserves = SR 80,000
Now the NCB will use the excess reserves of SR 80,000 to
make new loans , so the balance sheet after making the
loan will be as follows :
Assets
Cash & other Reserves SR 220
Loans
980
_______
SR 1200
Liabilities & Equity
Deposits SR 1100
Capital
100
_______
SR 1200
Now the new loan ( SR 80,000) made by the NCB either
will be re-deposited in the same bank or it will be
deposited in another bank ( second-generation bank)
where 20% will be added to the required reserves and
the remaining balance will be given as a loan .
The sequence of loans and deposits after a single initial
deposit of SR 100,000 in NCB is as follows :
Bank
New
deposits
New
Additional
loans
reserves
1st generation bank SR 100
SR 80
2nd generation bank
80
64
3rd generation bank
64
51.2
4th generation bank
51.2
40.96
5th generation bank
40.96
32.77
0
0
Total for banking
SR 500
SR 400
system
SR 20
16
12.8
10.24
8.19
0
SR 100
Creation of Deposits ( assuming 10 percent reserve
requirement and a $ 100 increase in reserves )
Bank
Increase in
Increase in
Increase in
Deposits ($)
Loans ( $ ) Reserves($)
_________________________________________________
First National
0.00
100.00
0.00
A
100.00
90.00
10.00
B
90.00
81.00
9.00
C
81.00
72.90
8.10
D
72.90
65.61
7.29
.
.
.
.
.
.
.
.
Total for all banks 1000.00
1000.00
100.00
Excess Reserves and Cash Drain
• If we relax the two assumptions related to
excess reserves and cash drain, what
happens to the change in deposit and the
change in loans for the banking system ?
• If banks do not choose to use their excess
reserves to expand their loans, then there
would be no expansion of loans and change
in deposit will equal to change in reserves.
Excess reserves & Cash drain
Continue
• But, if banks decided to hold part of its
excess reserves and use the remaining
reserves to make new loans , then the
multiplier will be smaller, and in turn, the
change in loans and deposits for the banking
system will be smaller as well .
Example
•
•
•
•
•
•
Assume the following :
Change in reserves = SR 100,000
Required reserve ratio = 20%
Excess reserve ratio = 5%
Cash drain ratio = 15%
Find the change in deposits and change in
loans for the banking system ?
The answer
• Change in Deposits =
1
. 100,000
in banking system
.20 + .05+.15
= SR 250,0000
Change in Loans = 250,000 ( 1-.20-.05-.15)
In banking system = 250,000 ( 0.60 )
= SR 150,000
Chapter 28
Money, Output , and
Prices
Chapter 28
• In this chapter , we will focus on
• How money affect the economy ?
• The interaction between money supply and
money demand .
• How household divide their total wealth
between money & interest earning bonds.
Present Value and Interest
Rates
• Present value of an asset is the value now
of the future payments that the asset
offers .
• The present value depends on the interest
rate , because we use the interest rate to
discount the future payments .
Example
•
•
•
•
•
Given the following data :
Par value or face value of a bond = $ 1000
Coupon rate of interest = 10 %
Maturity = 5 years
Required : What is the present value of
this bond a. If market interest rate is
10% ?
b. If the market interest rate is
20% ?
If Market interest rate is 10%
• PV =[ R1 + R2 + ….. + Rn ] + F
•
1
2
n
n
•
(1+i ) (1+i ) ….. (1+i ) (1+i)
• PV = [100 + 100 + …. + 100 ] + 1000
1
2
5
5
•
(1.10) (1.10) …… ( 1.10) (1.10)
• PV = $ 999.96 = $ 1000
If market interest rate is 20%
• PV = [ 100 + 100 + … + 100 ] + 1000
•
1
2
5
5
•
(1.2 )
( 1.2)
( 1.2 ) ( 1.2 )
• PV = $ 701 Therefore ,
• The higher the market interest rate, the
lower is the present value of a bond .
Supply and Demand for Money
• Supply of Money: is the total stock of
money in the economy at any moment in
time . The money supply is controlled by
the central bank .
• Demand for Money: is the amount of
wealth that every one in the economy wish
to hold in the form of money balances .
Motives for holding Money
• 1. Transactions Motive
• 2. Precautionary Motive
• 3. Speculative Motive
1. Transactions Motive
• People need money to pay for goods and
services . And firms need money to pay for
factors of productions .
• Money held to finance such flows are called
“ Transactions balances “ .
• What determines the size of the
transactions balances ?
• The size of transactions balances is
positively related to the value of transaction
Transactions Motive
d
• M = f (T)
• T = f (Y)
• Therefore d
•
M =f (Y)
2. The Precautionary Motive
• Precautionary balances provide protection
against uncertainty about timing of cash
flows . Therefore, the greater such balances,
the greater is the protection against running
out of money.
• Precautionary balances provide protection
for the unexpected events such as sickness
or car accidence etc.
• Precautionary motive causes the demand for
money to vary positively income .
3. The Speculative Motive
• Firms and Households hold some money
against uncertainty resulting from the
fluctuation in the prices of other financial
assets .
• Money balances held for the above purpose
is called “ Speculative balances “ .
• Speculative motive implies that demand for
money vary positively with wealth, but it
vary negatively with interest rate .
Monetary Equilibrium &
Aggregate Demand
• Monetary equilibrium occurs at the point
where demand for money equals the supply
of money . Therefore, at monetary
equilibrium we have :
•
d
s
•
M
= M
The Transmission Mechanism
• This is the process by which changes in the
demand for money or change in supply of
money affect the aggregate demand .
• The Transmission Mechanism operates
through three stages or links. These are :
• 1.Link between monetary equilibrium & interest rate .
• 2.Link between interest rate and investment .
• 3.Link between investment and aggregate demand .
I. Link between Monetary
equilibrium and Interest Rate
• Any change in either the Demand for
money or the Supply of money will
change the interest rate . Example:
• An increase in Demand for money will
increase the market interest rate .
• An increase in Supply of Money will
lower the market interest rate .
II. Link between Interest Rate
and Investment Expenditure
• Other things being equal, a
fall in interest
rate decreases the cost of borrowing and that
encourage more borrowing to finance more
investments. Therefore, there is a negative
relationship between interest rate and
investment expenditure.
• This relationship is called “ Marginal
Efficiency of Investment or MEI .
III. Link between Investment
and Aggregate Demand
• An increase in money supply decreases
interest rate, which encourage more
investment and hence increase AE and
that shift the AE function upward and
shift AD curve to the right and that
increases national income or the
aggregate demand ( Y ) .
Strength of Monetary Forces
• By how much will a given change in money
supply causes national income to change ?
• Here, we need to distinguish between two
cases :
• 1. Long-run effect on national income .
• 2. Short-run effect on national income .
Long-run Effect on National
Income
• An increase in money supply shifts the
• AD curve to the right, but that has no
effect on the level of national income (Y) in
the long-run, because in the long-run the
LRAS curve is vertical . Therefore,
• In the long-run, any change in AD will
change the price level only .
Short-run effect on National
Income
• Change in AD depends on :
• 1. How much interest rate will fall in
response to a given increase in money
supply ?
• 2. How much investment expenditure will
change in response to a change in the
interest rate ?
1. The change in interest rate in
response to a change in money supply
• The flatter the demand for money function
( the more sensitive the demand for money
to interest rate) the less that interest rate will
fall as a result of an increase in money
supply.
2. The change in investment in
response to a change in interest rate
• The more interest-sensitive is the
investment function ( the flatter the
investment function ) , the more it will
increase in response to a given fall in
interest rate . Therefore,
• The size of the shift in AD in response to
change in money supply depends on the
shape of demand for money function and
the marginal efficiency of investment .
Effective Monetary Policy
• The steeper the demand for money function
or ( the less interest-sensitive the demand
for money function ) , because that leads to
greater effect on the market interest rate .
• And the flatter ( or more interest-sensitive)
is the Marginal Efficiency of Investment ,
MEI , because that will cause greater effect
on investment level .
Chapter 29
Monetary Policy
Control of the Money Supply
• There are four ways in which the central
bank affect the money supply . These are
• 1. Open market operations .
• 2. Reserve required ratio .
• 3. Discount rate .
• 4. Selective credit control .
1. Open Market Operations
• The Process of buying and selling
government bonds in the financial
market is called “ Open market
operations “. This process can be divided
into to cases :
• A. Open Market Purchase .
• B. Open Market Sale .
Open Market Purchase
• Central bank buy government bonds
from firms and/or households .
• The central bank pay for these bonds
with check.
• The seller deposits the check in its own
bank account .
• The commercial bank present the check
to the central bank for payment .
• Central bank make a book entry .
The effect of purchasing bonds
by the central bank
• 1. Create excess reserves at commercial
banks .
• 2. This enable the commercial banks to
create more loans .
• 3. The increase in loans will create more
deposits by the banking system , and that
will increase the money supply.
Open Market Sale
• The central bank sells government bonds
and receive a check drawn on commercial
bank .The value of the check will be
deducted from the deposit at that bank.
• This decrease the reserves available to
commercial banks which will decrease the
loans made by commercial banks.
• This decrease the deposit created by banks
which in turn decrease the money supply .
2. Reserve Requirement
• An increase in the required reserve ratio
forces the banks with no excess reserves
to decrease its loans, which in turn,
decreases the deposits and that will
decrease the money supply .
• Example:
3. Discount Rate
• This is the interest rate charged by the
central bank on loans borrowed by the
commercial banks .
• A fall in discount rate may encourage
more borrowing by commercial banks
and that increases the reserves of the
banks , which in turn, increases loans and
deposits in the banking system and that
finally will increase the money supply.
Net Un-borrowed Reserves or
Free Reserves
• It is the Total reserves minus both the
required reserves as well as the borrowed
reserves . Therefore :
• Free
= Total
–
reserves
reserves
Example:
Required – Borrowed
reserves
reserves
Example
• Given the following Balance Sheet for NBC
find the Free Reserves or Net Un-borrowed
Reserves. Assume r = 20% .
• Cash & other reserves = SR 20,000
• Loans = SR 23,000 ; Deposits = SR 40,000
• Borrowed Reserves = SR 2,500
• Capital = SR 500 Therefore,
• Free Reserves = 20,000 – 8000 - 2500
•
= SR 9500
4. Selective Credit Control
• Margin Requirement:
• It is the fraction of the price of stock that
must be put in cash by the purchaser and
the balance can be borrowed from the
brokerage firm .
• If the C.B would like to increase the
money supply , it will reduce the margin
requirement and the opposite is also true.
Instruments & Objectives of
Monetary Policy
• TheT central bank conduct the monetary
policy to influence the real national income
and the price level .
• The ultimate objective of the central bank
( Y , P ) are called “ Policy Variables “
Policy Instruments
• To achieve its objective, the central bank
uses certain variables or tools . These
variables are called Policy Instruments.
• Variables that are neither policy
variables nor policy instruments, but play
a key role in the execution of monetary
policy are called Intermediate Targets.
Intermediate Targets
• There are two Intermediate targets available
for the central bank . These are :
• 1. Money supply 2. Interest rate
• The central bank can not control both of
these targets independently if the demand
function is unstable . Therefore, the
central bank need to choose to control
either the money supply or the interest
rate.
Case 1 : controlling Money Supply
• If the central bank chooses
money supply as the
intermediate target, then it
must accept the fluctuation in
the interest rate .
Case 2 : controlling the interest rate
• If the central bank would like
to control interest rate , then
it must accept the fluctuation
in the money supply .
Chapter 30
Inflation
Definition
• Inflation is defined as :
• “ The General Increase in the
price level “ .
Causes of Inflation
• 1. Shift in AD curve to the right. This is
called “ Demand Shock Inflation “ or
Demand –Side Inflation or Just Demand
Inflation.
• 2. Shift in SRAS curve to the left. This is
called “ Supply Shock Inflation “ or SupplySide Inflation or Cost- Push Inflation .
Demand Shock
• 1. Isolated Demand Shock: Shift in AD
curve to the right without monetary
validation ( which means with money
supply held constant .
• 2. Sustained Demand Shock: shift in AD
curve to the right accompanied by a
monetary validation . This will lead to
sustained inflation .
Supply Shock
• 1. Isolated Supply Shock: Once and for
all increase in the cost of production .
• 2. Repeated Supply Shock
Isolated Supply Shock
• A. If No Monetary Validation:
• An Isolated supply shock without
monetary validation will have a period of
inflation followed by a period of deflation
• B. Supply Shock inflation with monetary
Validation: This cause the initial increase
in the price level to be followed by
further increase in the price level .
Repeated Supply Shock
• This means continuous shift in SRAS
curve to the left resulting from
continuous rise in wage or price of raw
materials . Here also we need to
distinguish between two cases :
• A. IF No Monetary Validation .
• B. If there is a monetary validation.
Chapter 33
Economic Growth
Definition
• Economic Growth is defined as the long-run
increase in per capita real output of a
society .
• Real per capita output = Total real GDP
• Or real per capita GDP
Population
• The growth in real per capita GDP means
that the average standard of living is higher.
The Nature of Economic Growth
• There are 3 ways of increasing the GDP :
• 1. Policies that increase Aggregate Demand.
• 2. Policies that reduce structural or
frictional unemployment which can increase
the employed labor force and thus increase
potential output.
• 3. Over the long-run, the main cause of
rising national income is economic growth
Economic Growth - Continue
• Growth is much more powerful method of
raising the living standards than the removal
of a recessionary gap or structural
unemployment .
• A small differences in growth rate make big
differences in the level of potential national
income over few decades .
Example
• If two countries ( A and B ) start with the
same level of income or GDP say $100
million . And if country A grows at 3% per
year while country B grows at 2% per year
than A’s income will be twice B’s income
in 72 years as shown in the next table :
Economic Growth
Year
0
growth rate of growth rate of
2%
3%
$ 100
$ 100
10
122
135
30
181
244
70
400
796
72
416
845
Example 2
Year
Growth rate of 1%
Growth rate of
2%
$ 100
0
$ 100
10
111
122
30
135
181
35
142
200
70
201
400
Benefit of Growth
• Over the Long-term economic growth is the
primary engine for raising general standards
• Economic growth reduces income
inequalities without actually having to
lower anyone’s income.
• Economic growth may change the whole
society’s consumption patterns.
Cost of Growth
• Growth requires heavy investment of
resources in capital goods as well as in
activities such as education.
• Growth which promises more goods
tomorrow, is achieved by consuming fewer
goods today. Therefore, for the economy as
a whole this sacrifice of current
consumption is the primary cost of growth.
Inputs, Technological Progress and
Economic Growth
• To increase average income, a country has
to increase its output.
• The country’s output depends on its
resources or inputs and on the techniques it
employs for transforming inputs into output.
• The relationship between inputs and outputs
is called “ Production Function “ .
Factors of Production
•
•
•
•
1. Land or Natural Resources .
2. Labor
3. Capital
Countries can not achieve rapid and
sustained economic growth by increasing
their stock of natural resources .
• But, countries can and do experience
fluctuations in income as a result of
fluctuations in the prices of their natural
resources .
Economic Growth
• At the time at which prices of inputs are
rising quickly that bring temporary income
growth .
• But to achieve long-term sustained income
growth, countries have to look beyond their
natural resources .
• sustained increase in labor input . A country
can produce more output if its population of
workers grows .
Capital Growth
• Population growth on its own does not lead
to higher per capita output.
• The input that is most responsible for rapid
and sustained economic growth is the
capital .
• There are two broad types of capital :
1. Physical capital .
2. Human capital .
Physical Capital
• Includes such things as
highways, railways,
dams, tractors, factories,
trucks , cars , and
buildings .
Human Capital
• Is the accumulated knowledge and skills of
the working population that enable them to
increase their output .
• As individuals accumulate more capital
their income grow .
• As nations accumulate more capital per
worker, labor productivity and output per
capita grow .
Technological Change
• Although rich countries have much more
capital than the poor countries, that is not
the only difference between them .
• Typically, rich countries uses more
productive technologies than do poor
countries. AS a result, even if both countries
have the same per capita capital, the rich
countries produce more output than the poor
Determinant of Growth of Total
Output
•
•
•
•
1. Growth in the Labor Force
2. Growth in Human capital
3.Growth in Physical capital
4. Technological improvement
1. Growth in the Labor Force
• This may be caused by growth
in the population or increase
in the fraction of the
population that chooses to
participate in the labor force .
2. Growth in Human Capital
• This is the increase in skills
that workers have either
through formal education or
on-the-job experience .
3. Growth in Physical Capital
• Such as factories, machines,
transportation, and
communications facilities.
These are increase only
through process of investment
4. Technological Improvement
• This may be brought about by
innovation that introduces
new product, new ways of
producing existing product
and new forms of business
organization .
Note
• Chapter 33 up to page 728
Chapter 35
Gain From International
Trade
In this chapter we will discuss :
•
•
•
•
•
•
•
Sources of the gain from trade .
Absolute advantage from trade.
Comparative advantage of trade.
Opportunity cost .
Gain from trade with variable cost .
Sources of comparative advantage .
The Terms of trade .
Sources of the Gain from Trade
• Without Trade: , each person would have
to be self-sufficient , i.e. each would have
to produce all goods and services that he
or she consumed.
• Trade among individuals allows people to
specialize in activities they can do well
and to buy from others the goods and
services they can not easily produce .
This same basic principle also applies to
nations
• With trade , each nation is able to
concentrate on producing goods and
services that it produce efficiently while
trading to obtain goods and services that
it does not produce efficiently .
• The gain from trade is clear when there is
an absolute advantage .
Absolute Advantage
• Is the ability to produce a good with
fewer inputs or to produce more output
with the same quantity of inputs .
• One country is said to have an absolute
advantage over another in production o x
when an equal quantity of resources can
produce more X in the first country than
in the second country .
Comparative Advantage
• Is the ability to produce a good or a service at
a lower opportunity cost than other producers
.
• If countries ( Nations ) specialize in their
areas of comparative advantage then the
world output will increase . To see this let us
compare two cases :
• 1. When there is no trade (no specialization )
• 2. When there is trade ( after specialization )
Example
•
•
•
•
•
•
•
•
1. Assume we have two countries ( U.S.A & France)
2. Assume Labor is the only factor of production .
3. You are given the following table :
Comparative cost of production
Product
U.S.A (worker/day) France(worker/day)
1 unit of X
1
1
1 unit of Y
1
2
4. Assume that the workforce in each country consist of
200 workers divided equally in production of X and Y .
The Answer
• From the table, we see that the U.S.A is just
as good at producing X as France .
• But, U.S.A has absolute advantage in
producing Y .
• Now, looking at the comparative cost of
production expressed in worker per unit , we
see that :
The Answer - Continue
U.S.A.
France
• Relative price
of X to Y
1/1=1
1/2=½
• Relative price
of Y to X
1 /1 = 1
2/1=2
Since , in France the opportunity cost of producing X
is lower than in U.S.A , So France has a comparative
cost of producing X, so France will specialize in the
production of X.
Case # 1 : World output before trade or
No Specialization
•
U.S. A.
Product
workers
X
Y
100
100
output
100
100
France
World
workers
output
output
100
100
100
50
200
150
Case # 2 : World output with trade
( after specialization )
U.S. A
France
World
Product
X
Y
Workers output
-200
-200
workers output
200
--
200
--
output
200
200
You see that world production has increased from
( 200 X and 150 Y ) to ( 200 X and 200 Y ) after
specialization without any increase in the resources.
Therefore, world output is greater when countries
specialize in producing the goods in which they have
a comparative advantage and then engage in trade.
Example: Gains from specialization with
Absolute Advantage
• Amount of wheat and cloth that can be produced
with 1 unit of resources in U.S.A. and England.
•
Wheat (bushels)
Cloth (yards)
• U.S.A.
10
6
• England
5
10
• Therefore, U.S.A. has absolute advantage in
producing wheat, and England has absolute
advantage in producing cloth .
Gain from specialization with Absolute
Advantage
•
•
•
•
•
•
•
If U.S.A specialized in wheat and England in cloth :
Wheat (bushels)
Cloth (yards )
U.S.A.
20
0
England
0
20
_______
________
20
20
We see that total world production of both wheat
and cloth increases when each country produces
more of the good in which it has absolute advantage.
Changes resulting from the transfer of 1 unit of
U.S. resources into wheat and 1 unit of English
resources into cloth
•
Wheat ( bushels)
Cloth (Yards)
• U.S.A.
+ 10
-6
• England
- 5
+ 10
•
________
________
•
+5
+4
• Therefore, specialization of each country in the
product in which it has absolute advantage will
increase total production of both commodities .
Gain from specialization with comparative
advantage
• Amount of wheat and cloth that can be produced
with 1 unit of resources in U.S.A and England :
•
Wheat (bushels)
Cloth ( Yards )
• U.S.A.
100
60
• England
5
10
• Here , U.S.A has absolute advantage in both goods.
• So, it seems that U.S.A has nothing to gain by
trading with England, But by looking at the
comparative advantage , we see that is wrong .
Gain from specialization with comparative
advantage
• U.S.A can produce 20 times as much as wheat as
England ( 100/5 = 20 ) by using same quantity of
resources .
• But, it can produce only 6 times as much cloth
( 60/10 = 6 ) as England .
• Therefore, U.S.A. said to have comparative
advantage in the production of wheat , and a
comparative disadvantage in production of cloth.
While England has the opposite case .
Changes resulting from the transfer of onetenth of 1 unit of U.S. resources into wheat and
1 unit of English resources into cloth
•
Wheat (bushels)
Cloth ( yards )
• U.S.A.
+ 10
- 6
• England
- 5
+ 10
•
_______
________
• world
+5
+4
• Therefore, when there is comparative advantage,
specialization make it possible to produce more of
both commodities .
Conclusion
• The gain from specialization depends on the
pattern of comparative not on absolute
advantage . Therefore,
• If there is comparative advantage , then there
are gains from trade .
• If there is No comparative advantage, then
there are no gains from trade.
• Therefore, absolute advantage without
comparative advantage does not lead to gains
from trade.
The Opportunity Cost
• The Opportunity cost is defined as :
The best alternative given up . Example:
Given the following Table below , find the
opportunity cost of producing each unit
of wheat and cloth ?
Wheat (bushels)
Cloth( Yards )
U.S.A.
10
6
England
5
10
The Opportunity cost of wheat & cloth
U.S.A
England
Cloth
6/10 = 0.6 yard
10/5 = 2 yards
Wheat
10/6 = 1.67 bushels
5/10 = 0.5 bushels
Therefore, U.S.A. has lower opportunity cost of
producing wheat 0.6 yard relative to 2 yards .
While, England has lower opportunity cost in
producing cloth 0.5 bushels relative to 1.67
Conclusion
• The gain from trade arises from differing
opportunity costs in the two countries .
• The country which has lower opportunity cost
will have a comparative advantage over the other
country in the production of the product.
• The opportunity costs depends on the relative
cost of producing two products not on the
absolute cost .
• When opportunity costs are the same in all
countries, there is no gain from specialization .
The Terms of Trade
• The terms of trade refer to the ratio of the prices
of goods exported to the prices of those imported
•
Terms of trade = index of export prices X100
index of import prices
A rise in the price of exported goods, with the
price of imports unchanged, indicates a rise in
the term of trade, so it will take fewer exports to
buy the same quantity of imports .
Example
•
•
•
•
Assume the following :
Export price index = 100
Import price index = 100
The Term of Trade = 100 X 100 = 100
100
Which means that a unit of export will buy
one unit of import .
Example - Continue
• Now, if export price index rises from 100 to 120
while import price index remain constant at 100
• Then Term of trade = 120 X 100 = 120
100
Which means that a unit of exports will buy 20 %
more imports than at the old term .
Therefore, a rise in the term of trade is referred to
as “favorable change in the country’s term of
trade “ . A fall in the term is unfavorable change
Example 2
•
•
•
•
•
Assume the following :
Index of export prices rises from 100 to 120
Index of import prices rises from 100 to 110
Therefore :
The old Term of Trade = 100 X 100 = 100
100
The new term of trade = 120 X 100 = 109
110
Example - Continue
• This means that with the new terms of trade
a unit of exports will buy 9% more imports
than at the old terms .
• Therefore, a favorable change in the term of
trade ( a rise in export prices relative to
import prices ) means that a country can
acquire more imports per unit of exports
and vice versa .