Unit 7- Absolute and Comparative Advantage

Absolute Advantage

• Individual- exists when a person can produce more of a certain good/service than someone else in the same amount of time or resources
• National- exists when a country can produce more a good/service than another country can in the same time period or using the same amount of resources

Comparative Advantage

• A person or a nation has a comparative advantage when it can produce the product at a lower domestic opportunity cost than can a trading partner.

         Examples of output problems

1.      meat produced in a day

2.      video games produced in a year

         Example of input problem

1.      hours to make a video game 

Specialization and trade

• Gains from trade are based on comparative advantage
• Country should import whichever product they do not have the advantage in producing

Unit 7- Balance of Payments

Balance of payments

•  Measures of money inflows and outflows between the united states and the rest of the world (ROW).
• Inflows are referred to as credits
• Outflows are referred to as debits

• The balance of payment is divided into three accounts:

1. Current account

2. Capital/financial account

3. Official reserves account

•  Double entry book keeping- Every transaction in the balance of payments is recorded twice

Current account

•  Balance of trade or Net exports

      -  Exports of goods/services- import of goods/services.

      -  Exports create a credit to the balance of payments.

      -  Imports create a debit to the balance of payments.

•  Net foreign income

      -   Income earned by the U.S. owned foreign assets

      -   Interest payments on U.S. owned foreign assets

      -   Net transfers are usually unilateral

      -    Foreign aid- a debit to the current account.

      

Capital Account

•  balance of capital ownership
• Includes the purchase of both real and financial assets
•  Direct investment in the United States is a credit to the capital account
• Direct investment by United States firms/individuals in a foreign country are a debit to the capital account- Ford factory in China
• Purchase of foreign financial assets represents a Debit to the capital account- Franco buys stock in Saudi Aramco
• Purchase of domestic financial assets by foreigners represents a credit to the capital account.

               

 Relationship between current and capital account

•  The current account and the capital account should zero each other out
•  if the current account has a negative balance (deficit) then the capital account should then have a positive balance (surplus).

 Official reserves

•  foreign currency holdings of the U.S. FED
• balance of payments surplus- the fed accumulates foreign currency and debits the balance of payments
•  When there is a balance of payments deficit- the fed depletes its reserves of foreign currency and credits the balance of payments. 
• The U.S. is passive in its use of official reserves. It does not seek to manipulate the dollar exchange rate
• China is active in its use of official reserves. It actively buys and sells dollars in order to maintain a steady exchange rate with the U.S.

Formulas

1. Balance of trade- Good exports + goods imports

2. Balance on goods and services- 

Goods exports + service exports + goods imports + service imports

3. Current Account-  Balance on goods and services + net investment + net transfers

4. Capital account- Foreign purchases + domestic purchases

Unit 4- Money Supply

Calculating Money Supply

• When a customer deposits cash or withdraws cash from their deposit account it has no effect on money supply it only changes: the composition of money, excess reserves, and required reserves
• When the fed buys or sells bonds, the money goes to ER

• Required Reserve = Amount of deposit x required reserve ratio
• Excess Reserves = Actual Reserves - Required Reserves
• Maximum amount a single bank can loan = the bank's ER
• Money multiplier = 1 / reserve ratio
• Total Change in Loans = ER x money multiplier
• Total Change in the money supply = (ER x money multiplier) + securities bought by FED

Unit 4- Tools of Monetary Policy

Reserve Requirement

• Only a small percent of your bank deposits is in the safe; the rest of your money has been loaned out; this is called "Fractional Reserve Banking". 
• FED sets the amount that banks must hold. 
• The reserve ratio is the % of deposits that banks must hold in reserve and not loan out.
• When the FED increases the money supply, it increases the amount of money held in bank deposits.
• Recession- Decrease the Reserve Ratio;  Money supply increases, interest rates decrease, Aggregate Demand increases
• Inflation- Increase the Reserve Ratio; Money supply decreases, interest rates increase, Aggregate Demand decreases

Discount Rate

• Interest rate that the FED charges commercial banks
• To increase money supply, FED should decrease the discount rate
• To decrease money supply, FED should increase the discount rate

Open Market Operations

• The FED buys/sells government bonds 
• most important and widely used tool monetary policy.
• To increase money supply, FED buys bonds.
• To decrease money supply, FED sells bonds

Unit 4- Banks and the FED

Function of Banks

• A bank is a financial intermediary- uses liquid assets to finance the investments of borrowers.
• Fractional Reserve Banking- depository institutions hold liquid assets less than the amount of deposits; can take the form of currency in bank vaults or bank reserves deposits held at the Federal Reserve

• T-Account (Balance Sheet)- statements of assets and liabilities
• Asset (Amounts owned)- items to which a bank holds legal claim; the use of funds by fiancial intemediares
• Liabilities(Amounts owed)- the legal claims against a bank; the source of funds for financial intermediaries

Function of the FED

• issues paper currency
• sets reserve requirements and holds reserves of the bank
• lends money to bank and charges interest
• check clearing service for banks
• acts as a personal bank for government
• supervises member banks
• controls money supply

Reserve Requirement

• FED requires bank to always have some money readily available to meet consumers' demand for cash, this amount is set by the FED is the required reserve ratio
• the required reserve ratio is the percentage of demand deposits that must not be loaned out
• required reserve ratio usually = 10%

Unit 4- Demand of Money and Money Market

• Demand of Money has an inverse relationship between nominal interest rates and the quantity of money demanded

Financial Sector

• Financial Asset- something an individual owns
• Financial Liabilities- something an individual owes
• Interest Rate- cost of borrowing money
• Stock- financial assets that convey ownership in a company 
• Bonds- Money paid to the government with a promise to pay back with interest.

Unit 4- Time Value of Money

Time Value of Money

• Is a dollar today worth more than a dollar tomorrow? Yes
• Why? Opportunity cost and inflation, this it the reason for charging and paying interest

Symbols and Notations

• v = future value of $
• p = present value of $ 
•  r = real interest rate (nominal interest rate - inflation rate) 
• n = # of years
• k = # of times interest is credited throughout the year

Forms

• Simple Interest Form- v = (1+r)^n x p
• Compound Interest Form- v= (1+ (r/k))^(nk) x p

Unit 4- Introduction to Money

Uses of Money

• Medium of exchange- used to barter/trade
• Unit of Account- establishis economic worth in an  exchange process
• Store of Value- money holds its value over a period of time while products may not

Types of Money

• Commodity Money- gets it value from the type of material its made from
• Representative Money- paper money that is backed by something tangible (gold standard)
• Fiat Money- money backed by the word of the government

Characteristics of Money

• Portable, durable, uniform, scarce, acceptable, divisible

Money Supply

• M1 Money-currency(cash and coins), checkable deposits/demand deposits (checking accounts), traveler's checks; M1 is most liquid money, makes up 75% of money. Liquid money is easy to convert to cash
• M2 Money- consists of M1 money and saving accounts and deposits held by banks outside of US. M2 is not as liquid as M1 money
• M3 Money- consists of M2 money and certificate of deposits (CD's); any money that is withdrawn must be paid with interest

Monetary Policy Video

Unit 4- Monetary Policy

Types and Functions of Money

• 3 types of money: Commodity, Representative, and Fiat
• Commodity- a good that has other purposes serves as money; not usually divisible or durable
• Representative- currency being used represents a specific quantity of a precious metal; for example: the gold standard of the old U.S.
• Fiat- money is not backed by a precious metal; it is legal tender that must be accepted for transactions and is backed by the word of the government

• Functions of money- Medium of exchange, Store of Value, and Unit of Account
• Medium of Exchange- trade money for a desired good or service
• Store of Value- putting money in a bank and expecting it to retain value
• Unit of Account- equating price to worth(value and quality)

Money Market Graphs

• Vertical Axis- interest rate(i)
• Horizontal Axis- Quantity of Money
• The demand for money is sloping down because when the interest rate is high, the quantity of money demanded is low
• The supply of money is vertical because it does not vary based on the interest rate, instead it is set by the Fed
• When demand increases, there is upward pressure on interest rates
• The Fed can increase money supply to bring interest rates back down

Fed's Tools of Monetary Policy

• There are two types of monetary policies: Expansionary(easy money) and Contractionary(tight money)
• The Fed can control the Reserve Requirement(RR) which is the percentage of the bank's total deposits that they must hang on to
• If the Fed wants to increase money supply, then they can lower the RR because the money that has been in RR becomes excess reserves which is the money that can be loaned out
• The Fed can control the discount rate which is the interest rate at which banks can borrow money from the Fed
• If the Fed wants to increase money supply, then they can lower the discount rate which encourages banks to borrow more money
• Most common tool of the Fed is buying and selling government bonds/securities
• If the Fed wants to increase money supply, then it buys bonds/securities

Loanable Funds Market

• Loanable funds is the money that is in the banking system that is available for people to borrow
• Vertical Axis- Interest rate(i)
• Horizontal Axis- quantity of loanable funds (Qlf)
• The demand for loanable funds is downward sloping because when the interest rate is higher then people want to borrow less
• The supply of loanable funds is upward sloping - it comes from the amount of money people have in banks (dependent on savings); the more money people save then the more money the bank has available for loans
• If people have incentives to save less, then the supply of loanable funds shifts to the left
• If the government is running a deficit: demand for money shifts right, interest rates increase, and the demand for loanable funds increases

Money Creation and Multiple Deposit Expansion

• Banks create money by making loans
• The money multiplier (1/RR) is used to determine the total amount of money created on a loan; the formula is: amount deposited x money multiplier
• Multiple Deposit Expansion- all the potential loans that are possible if a person deposits a set amount of money
• Depositing a set amount of money doesn't mean it is guaranteed to make the maximum amount of money because it is assuming that the banks have no excess reserves
• If there are excess reserves, it decreases the total increase of money

Relating Money Mkt, Loanable Funds Mkt, and AD-AS

• Money Market- the vertical axis is interest rate and the horizontal axis is the quantity of money. The demand for money is downward sloping while the supply of money is vertical because it is controlled by the Fed.
• Loanable Funds Market- the vertical axis is interest rate and the horizontal axis the quantity of loanable funds. The demand for loanable funds is downward sloping while the supply of loanable funds is upward sloping.
• AD-AS- the vertical axis is price level and the horizontal axis is the GDP. AD is downward sloping while AS is upward sloping.
• In Deficit spending: In the money market the demand for money increases and interest rate increases, in the loanable funds market the demand for loanable funds also increases along with the interest rate or the supply of loanable funds decreases, in AD-AS the AD increases along with the price level and GDP
• MV = PQ ; an increase in interest rate also increases price level

Fiscal Policy

• Changes in the expenditures or tax revenues of the federal government

Tools of Fiscal Policy

• Taxes- Government can increase or decrease taxes
• Spending- Government can increase or decrease spending

Budgets

• Balanced budget- Revenues = Expenditures
• Budget deficit- Revenues < Expenditures
• Budget surplus- Revenues > Expenditures
• Government debt- Sum of all deficits - sum of all surpluses
• Government borrows from: individuals, corporations, financial institutions, and foreign governments whenever it is is in a deficit

Fiscal Policies

• Discretionary- requires government action
• Automatic- takes effect without action from the government
• Contractionary- response to inflation, decrease government spending and increase taxes
• Expansionary- response to recession, increase in government spending and decrease in taxes

Automatic Stabilizers

• policies and programs that are designed to offset shifts in the economy that do not require government action
• Examples: welfare checks and social security

Tax Systems

• Progressive Tax System- average tax rate (Tax Revenue/ GDP) rises with GDP
• Proportional Tax System- average tax rate remains constant as even as GDP changes
• Regressive Tax System- average tax rate falls with GDP

Consumption and Savings

Consumption

Disposable Income (DI)

• the net income or the income after taxes
• DI= Gross Income - taxes
• Households can either consume or save disposable income

Consumption

Household spending

The ability to consume is constrained by - the amount of disposable income and the propensity to save   

Savings

• Household are not spending
• The ability to save is constrained by the amount of disposable income and the propensity to consume

Average Propensity to Consume (APC) and Average Propensity to Save (APS)

• APC + APS = 1
• 1 - APC = APS
• 1 - APS = APC
• APC > 1 .: Dissaving
• APS .: Dissaving

Marginal Propensity to Consume (MPC) and Marginal Propensity to Save (MPS)

• Marginal propensity to consume - ΔC/ CD 
• % of every extra dollar earned that is spent

• Marginal Propensity to save - ΔS/ ΔDI
• % of every extra dollar earned that is saved

• MPC + MPS = 1
• 1 - MPC = MPS
• 1 - MPS = MPC

Spending Multiplier

• An initial change in spending (C, IG, G, XN) causes a larger change in Aggregate Spending, or Aggregate Demand
• Multiplier = Δ AD / Δ C,I,G,or X
• Multiplier = 1 / (1-MPC) or 1/MPS
• Multipliers are positive when there is an increase in spending and negative when there is a decrease

Tax Multiplier

• When the government taxes, the multiplier works inverse
• Tax Multiplier = -MPC / (1-MPC) or -MPC / MPS
• If there is a tax-cut, then the multiplier is positive

Schools of Economics

Classical

• Modern Followers: Adam Smith, John B. Say ,David Ricardo, and Alfred Marshal
• Say's Law: supply creates its own demand, production = income = spending, under spending us unlikely, whatever output produced will be demanded
• Savings (leakage) equals investment (injections)
• prices and wages are flexible downward
• supply curve is vertical
• Aggregate supply determines output and employment
• Unemployment rarely exists due to wage/price flexibility
• Aggregate demand determines price level and is usually stable
• Basic Equation: MV = PQ
• Role of Government: monetary rule, maintain money
• Laissez faire is best
• Economy is self regulating
• Inflation is caused by too much money
• The short run is actually short

Keynesian

• Modern followers: J.M. Keynes
• Say's Law: depressions refute Say's law, demand creates own supply, under spending persists
• Savings does not equal investments; different motivations
• Prices and wages are inflexible downward ; known as Ratchet Effect
• Supply curve is horizontal
• Aggregate demand determines output and employment
• Unemployment usually exists
• Aggregate demand changes due to determinants and is usually unstable
• Basic Equation: C + Ig + G + Xn = GDP
• Role of government: fiscal policy is tax and spend, believe in active government, economy is not self regulating
• Inflation caused by too much demand
• Short run is actually long

Investment Demand and Interest Rates

Investment Demand

• Investment- money spend or expenditures on: new plants, physical capital, new technology, new homes, and inventories (goods sold by producers)
• Shape of the ID curve is downward sloping because, when interest rates are high, fewer investments are profitable; when investment rates are low, more investments are profitable

Shifts in Investment Demand

• Costs of production

  -Lower costs shift ID right
 - Higher costs shift ID left

• Business taxes

-Lower business taxes shift ID right
-Higher business taxes shift ID left

• Technological change

-New technology shift ID right
-Lack technology change shifts ID left

• Stock of Capital

-economy is low on capital, then ID shifts right
-economy has plenty of capital, then ID shifts left

• Expectations

-Positive expectations shift ID right

-Negative expectations shift ID left

Interest Rates

Expected Rates of Return

•  businesses make investment decisions with cost/benefit analysis
•  businesses determine the benefits of investment with the expected rate of return
•  business count the cost with the interest cost
• business determine the amount of Investment they undertake?                                       - Compare expected rate of return to interest cost                                                         - If expected return > interest cost, then investment should be made                             - If expected return < interest cost, then don't invest

Real Interest Rate (r%) vs Nominal Interest Rate (i%)

• Nominal is the observable rate of interest
• Real subtracts out inflation (π%) and is only known ex post facto (after the fact)
• real interest rate (r%) formula: r% = i% - π%

Aggregate Demand and Aggregate Supply

Aggregate Demand

• demand by consumers, businesses, government, and foreign countries
• relationship between price level and real GDP output is indirect

Reasons Why AD is Downward Sloping

1. Real - Balance Effect- higher price levels reduce the purchasing power of money

• decreases the quantity of expenditures
• Lower price levels increase purchasing power and increase expenditures.

      2. Interest - Rate Effect- When the price level increases, lenders need to charge higher interest rates to get a return on their loans.

• Higher interest rates discourage business investment and consumption

     3. Foreign Trade Effect- When U.S price level rises, foreign buyers purchase fewer U.S goods and Americans buy more foreign goods.

• Exports fall and imports rise causing real GDP demanded to fall

Shifts of AD

• components of GDP (Consumption, Domestic Investment, Government Spending, and Net Exports) shift AD

Consumption

1. Consumer wealth

• More wealth = more spending (AD shifts right)
• Less wealth = less spending (AD shifts left)

2. Consumer expectations

• Positive expectations = more spending (AD shifts right)
• Negative Expectations = less spending (AD shifts left)

3.Household Indebtedness

• Less debt = more spending (AD shifts right)
• More debt = less spending (AD shifts left)

Domestic Investment

1. Real interest rate

• Lower real interest rate = more investment (AD shift right)
• Higher real interest rate = less investment (AD shifts left)

2. Expected Returns

• Higher expected returns = more investment (AD shift right)
• Lower expected returns = less investment (AD shift left)
• Expected returns are influenced by: Expectations of future profitability, Technology, Degree of excess capacity, Business taxes

Government Spending

• More government spending (AD shift right)
•  Less government spending (AD shift left)

Net Exports

1. Exchange Rates

• Strong USD = more imports and fewer exports (AD shifts to left)
• Weak USD = fewer imports and more exports (AD shifts to right)

2. Relative Income

• Strong foreign economy = more exports (AD shifts to right)
• Weak foreign economy = less exports (AD shifts to left)

Aggregate Supply

• level of real GDP that firms will produce at each price level

Long run AS

• Period of time where input prices are completely flexible and adjust to changes in the Price level
• In the long-run, the level of Real GDP supplied is independent of the price level
• Long-run Aggregate Supply or LRAS marks the level of full employment output
• LRAS is vertical at the economy's level of full employment.

Short run AS

• Period of time where input prices are sticky and do not adjust to changes in the price level.
• In the short run, the level of real GDP is directly related to the price level
• Because input prices are sticky in the short-run, SRAS is upward sloping

Shifts in SRAS

• An increase in SRAS is a shift to the right.
• A decrease in SRAS is a shift to the left
• Per unit cost of production = Total input cost / Total output

Input Prices

• Domestic Resource Prices

          - Wages (75% of all business costs)

          - Cost of Capital

          - Raw materials (commodity prices)

• Foreign Resource Prices

          - Strong USD = lower foreign resource prices

          - Weak USD = higher foreign resource prices

• Market Power

          - Monopolies and cartels that control resources control the price of those resources

          -Increase in Resource Prices = SRAS left

          -Decrease in Resource Prices = SRAS right

Productivity - Total output / Total inputs

• More productivity- lower unit production cost = SRAS right
• Lower productivity-higher unit production cost = SRAS left

Legal-Institutional Environment

• Taxes (money to government) on business increase per unit production cost = SRAS left
• Subsidies (money from government) to business reduce per unit production cost = SRAS right

Government Regulation

•          Government regulation creates a cost of compliance = SRAS left
•          Deregulation reduces compliance costs = SRAS right

Circular Flow Model, GDP, Inflation, and Unemployment

Circular Flow

• Circular flow represents transactions within an economy, looking in a broad sense
• The goods and services flow clockwise in a circular flow model

 Economic Factors

• Households- person or group of people that share their income
• Government: can refer to local or national
• Firm- an organization that produces goods & services for sale

Markets

• Resource/Factor Market- households sell resources and firms buy them
• Product Market- firms produce goods and services, and households buy them

Gross Domestic Product

• market value of all final goods and services produced within a nation within a given year

Not Included in GDP

• Intermediate goods- goods that require further processing before they are ready for final use
• Used/Secondhand goods- trying to avoid double counting
• Purely financial transactions- stocks and bonds
• Unreported business activity- unreported tips; underground market
• Non-market activities-anything you do for yourself; volunteering
• Transfer payments- public such as social security or private transfer payments such as scholarships

Included in GDP

• C- personal consumption expenditures- wages, etc.
• Ig-Gross private domestic investments- new factory equipment, factory equipment maintenance, construction of housing, unsold inventory of products built in a year
• G- government spending
• Xn- net exports- (exports-imports)

Formulas

• Expenditure approach- C + Ig + G + Xn
• Income Approach- W(wages) + R(rent) + I(interest) + P(profits)
• Nominal GDP- Price of current year x quantity of current year
• Real GDP- Price of base year x quantity of current year 

• Net Domestic Product(NDP) - GDP- depreciation
• Net national product(NNP)- GNP- depreciation
• GNP- GDP + Foreign factor payment

• Budget surplus/deficit- government purchases- government taxes and fees collection + government transfer payments
• Trade Surplus/deficit- Exports- imports
• National income- GDP- indirect business taxes-depreciation-net foreign factor payment 
• Disposable income- national income-personal household taxes + government transfer payments

Inflation

• general increase in prices and fall in the purchasing value of money

GDP Deflator

• price index- used to adjust from nominal to real
• (nominal GDP/ real GDP) x 100
• in base year, the GDP deflator will always equal 100
• for years after the base year, GDP deflator is greater than 100
• for years before the base year, GDP deflator is less than 100

Consumer Price Index (CPI)

• most commonly used measurement for inflation
• measures the cost of a market basket of goods for a typical urban American family
• (cost of market basket of goods in given year/ cost of market basket of goods in base year) x 100

Inflation

• [(price index in year 2 - price index in year 1) / price index in year 1] x 100

Interest Rate

• Nominal Interest Rate- percentage increase in money the borrower must pay the lender for a loan; not adjusted for inflation; Expected interest rate + inflation premium
• Real Interest Rate- percent increase in purchasing power the borrower must pay the lender for a loan; adjusted for inflation; nominal interest rate- inflation

• Hurt by inflation- savers, those on a fixed income, creditors and debtors
• Helped by inflation- debtors
• Cost of living adjustment(COLA)- automatic wage increase when inflation occurs

Unemployment

• failure to use available resources, particularly labor to produce desired goods and services
• Underemployment- not using resources effectively

Labor Force

• above 16 years old of age
• able/ willing to work
• employed and unemployed
• Not in labor force- military, students, retired, disabled, home makers, mental institutions, people in prison, those not looking for a job

Unemployment Rate

• [ # of employed / ( # of employed + # of unemployed)] x 100
• full employment/ natural rate of employment- 4-5 percent

Types of Unemployment

• Frictional- searching for a job, temporarily unemployed or in between jobs; have transferable skills; better opportunity; HS and college graduates
• Structural- changes in structure of the labor force, which makes some skills and jobs obsolete; does not have transferable skills
• Seasonal- depends on the time of year and nature of the job, school bus drivers, life guards, etc.
• Cyclical- results from economic downturn such as a recession, as demand for goods fall, demand for labor falls as well, and workers are laid off

• Frictional + Structural = NRU
• Full employment- no cyclical unemployment

• GDP Gap- amount by which actual GDP falls short of potential GDP
• Okun's Law- for every 1% in which actual unemployment rate exceeds NRU, a GDP gap of about 2% exists
• Rule of 70- amount of years to double income= 70/ growth rate