1

Problem Explanation

Week 1

Voluntary exchange

Real-Nominal Principle

Determinants of Demand

Demand Function

Demand Curve

Income Effect

Substitution Effect

Giffen Goods

Bandwagon Effect

Snob Effect

Veblen Effect

Supply

Determinants of Supply

Market Supply

Supply Curve

Shift of D Curve

Shift of S Curve

Voluntary exchange > both better offOne will not agree, until gain something off it

People ≠ interested in nominal valuesBut real values, i.e. 5000 (nominal) = 2,500 (real), incl. taxes

Prices of the good in question (Px), Prices of related goods (Pr), Expectations of Price Changes (Pe),Consumer Incomes (Yc),Consumer Tastes and preferences (Tc),Advertising (A),Others (government policy, demographics, etc)

QDx = f (Px, Pr, Pe, Yc, Tc, A, etc.)

Quantity demanded in relation to the Price

Falling price, causes people to feel richer = people buy more

Other goods are consumed, prices fall, Q increases

Rise in their prices make people buy more(rice and noodles in China, gasoline, parfum e.g.)

Increasing D, others buy the commodity as well

Decreasing D, others buy the commodity as well

Increasing D, cause increasing Price (luxury cars, e.g.)

Quantities a Firm is willing to supply

Prices of the Good in Question (Px)Prices of Inputs (Pf)Availability of Inputs (Sf)Technology (T)Environment (W)Government Policy (G)

QSx = f (Px, Pf, Sf, T, W, G)

Quantity Supplied in relation to the Price of the Commodity(higher P, higher Y; lower P, lower Y)

To the Right: Increasing D, Increasing Y (Px constant)To the Left: Decreasing D, Decreasing D (Px constant)

Down: Increasing S, Decreasing PxUp: Decreasing S, Increasing Px

2

Equilibrium (D+S)Market Price in Competitive Markets

Law of Demand

Law of Supply

Willingness to pay

Consumer Surplus

Total Consumer Surplus

Willingness to accept

Producer Surplus

Producer Surplus

Total Surplus

Market Equilibrium

The Invisible Hand

Elasticity

(1) Point Elasticity

(2) Arc Elasticity

(3) Calculus Approach

Intersection of D and S Curve

Upward Shift in D, shortage, increasing P(new market Equilibrium)

Upward Shift in S, surplus, decreasing P(new market Equilibrium)

Max. amount you’re willed to pay

Difference between your willingness and the price(willed: 10€, paid: 5€, consumer surplus: 5€)Measured by the area below Equilibrium, above P

Sum of consumer surpluses in the market

Min. amount willing to pay = marginal cost of production

Difference between Price received and marginal cost(cost: 10€, charges: 20€, producer surplus: 15€)Measured by the area above Equilibrium, below P

Sum of surpluses earned by all producers

Consumer + Producer Surplus

Highest possible Surplus, therefore Efficient

Most efficient market Equilibrium, in case of:(1) No external Benefits (pollution)(2) No external Costs (free riders)(3) Perfect Information (statistics)(4) Perfect Competition

Measures the degree of sensitivity of quantity demanded,or quantity supplied to changes in any determinant

Measures the percentage change in the dependent variableCaused by the percentage change in the independent variable(determinant), holding the values of other variables constant:

Measures E at a specific point on the Curve

Calculates the Average E between points on the Curve

(summary measure of all points)

Uses differential Calculus (derivatives) in measuring EMeasures E by visual Inspection

3

(4) Geometric or GraphicalApproach

Elasticity CoefficientE = 1E > 1E < 1E > 0E < 0E = 0

More Elastic

Less Elastic

Total Revenue(Total Sales)

Elasticity CoefficientE > 1E < 1E = 1

Week 2

Governmental Intervention

Price Ceiling

Price Floor

Consumer Choice

Consumer Equilibrium

Producer Choice

Producer Equilibrium

Law of dim. MU

Price/Supply/Output ElasticityUnitary ElasticElastic (Luxury)Inelastic (Necessity)

- (Normal) = Substitute- (Inferior) = Complement- Unrelated

Substitutes, Multiple Uses, Large Outlays, Luxuries

Complements, Limited Uses, Small Outlays, Necessities

TR = P * QMR = Slope of TR Equation(change in TR, when one more unit is sold)TR = max when MR = 0

Elastic (P increases, TR falls; P decreases, TR rises)Inelastic (P increases, TR rises; P decreases, TR falls)unitary(P increases, TR max; P decreases, TR max)

Price Controls, Taxes, Controlling QuantityCauses Deadweight Losses

Price below the Equilibrium Price (shortage)

Price above the Equilibrium Price (surplus)

Maximize satisfaction (combination of goods)X and Y goods that yield the same level of utility

Indifference CurveMarginal Rate of Substitution of Y for XMUX / MUY

Tangency budget line and indifference Curve (highest possible)

Maximize Profits (combination of goods)Two inputs > specific level of output

Isoquant CurveMarginal Rate of Substitution of L for K in producingMPL/MPK

Tangency isocost line and isoquant curve (highest possible)

Extra Utility you get for a certain commodity diminishesas extra units are obtained, and increases attractivenessof other commodities

Extra productivity or addition to output obtained by a firm

4

Law of dim. MR

Factors of Production

Marginal Product

Average Product

Output Elasticity

Optimal Hiring Rule

Increasing Returns

Constant Returns

Decreasing Returns

Oppurtuntiy Cost

Profit

Variable Costs (TVC)

Fixed Costs (TFC)

Total Costs (TC)

Average Fixed Costs (AFC)

Average Variable Costs (AVC)

Average Total Costs (ATC)

Elasticity of Total Cost (EC)

Diseconomics of Scale

by using an extra unit of variable input (L, K) diminisheswhen combined with fixed quantities of another input (R)

Fixed Inputs: cannot change (land, buildings, factory)Variable Inputs: directly related to Y (labor hours, machines)

Change in total product per unit change in the variable inputMPL = dTP / dL or MPk = dTP / dK

Total product divided by the quantity used of variable inputAPL = TP / L or APK = TP / K

EL = MPL / APL

EK = MPK / APK

MRP = MRCMRP = Marginal Revenue Product of the variable Input(+1 worker = +1 sale)MRC = Marginal Resource Cost of the variable Input(+1 worker = increase in total costs)

Y increases greater then increase in Inputs (inc. slope)

Y increases in same proportion as Inputs (const. slope)

Y increases in a smaller proportion as Inputs (dec. slope)

You sacrifice A, to get B (Slide 75)

Total Revenue – Total CostAccounting Profits = TR - Explicit CostEconomic Profits= TR - Explicit - Implicit Cost

Costs that are a function of Output

Costs that do not vary directly with Output (e.g. Rents)

TC = TFC + TVC

AFC = TFC / Q

AVC = TVC / Q

ATC = TC / Q = AFC + AVC

Measures the percent change in TC, resulting from a 1% change in Output QEC = (dTC / dQ)/TC / Q = MC / ATC

When Firm increases its outputs, long-run average cost of production increases, two reasons:a, coordination problems and b, increasing input costs

Marginal Product of L Change in Output, from one additional unit of L

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Marginal Revenue Productof Labor (MRP)

Output Effect

Input-substitution-effect

Why Wages differ

Lorenz Curve

Gini coefficient

WEEK 3

Structure-

Conduct-

Performance-

Matrix

Perfect Competition (S.4)

Contribution Margin

Extra revenue generated from additional unit of LMRP = marginal product x price of output

Change in Quantity of Labor demandedresulting from a change in Y

Change in Quantity of Labor demandedResulting from an increasing price of L, relative to the price of other Inputs

Few people with required SkillsHigh Training CostsUndesirable Working ConditionsArtificial barriers to entry (e.g. Doctors, licensing)Racial DiscriminationLearning Effect (learning skills, college graduates)Signaling Effect (information about skills, college graduates)

Represents Income distributionCumulative distributive Function of a probability distributionPercentage of Households: X-AxisPercentage of Income: Y-AxisTherefore, measures social inequality

Area between the line of perfect equality and theobserved Lorenz Curve, percentage change between boththe higher the coefficient, the more unequal the distribution is

Description of key features of the market (buyers, sellers)

Description of the behavior of firms (pricing)= Competition among firm

Description of the welfare effects (use of resources)= deadweight-losses?

determines the behavior of firms = determines the various aspects of market performance

no single Firm can influence prices (large number of firms)perfect information: buyers/sellers = same Informationhomogenous products (standardized)mobility of sourcesmarket operates (buyers/sellers are price takes)short-run profit, long-run: break-even (see also S. 5)Firms produce, Price = LAC (lowest possible price for consumer)Long-Run: resources are efficiently utilized, no idle capacityTo Maximize profits: Produce when MR = MCBreak-Even Point: TR = TC

How much of fixed costs is being recovered when a product

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Average Contribution

Break-Even Point (S. 22)

Operation of Firms

Short-Run Curve

Short-Run Equilibrium

Long-Run Equilibrium

Long-Run SupplyAC increases

Constant-Cost-Industry

Symptoms of Market Failure

Imperfect Markets (S. 41)

Monopoly (S. 42)

sells at a certain price:TCM = TR – TVC

Difference between the selling price of the product and the unit variable costACM = P – AVC

Profit = Area below TR and TC, after intersection of TR and TCmaximizing profits:reducing fixed costsreducing the average variable cotsraising the price

TR > variable costs (firms operate)TR < variable costs (firms shut-down) = MC = AVC

Relationship between market price and the quantity supplied(by all firms in the short-run)

Quantity Supplied = Quantity DemandedMaximization of Profits, given the market price

both short-run conditions are met, plus,each firm earns zero economic profit(no incentive for other firms to leave the market, or to enter)

Increasing Input Price (limited amounts drive up competition)Less Productive Inputs

AC of production = constant horizontal long-run supply curve

Microeconomic Level Existence of imperfect markets presence of externalities asymmetric information provision of public goods

Macroeconomic Level Income inequalities Existence of unemployment and business cycles

Perfect Competition = IDEAL Imperfect Competition Monopoly Oligopoly Duopoly Monopolistic Competition

Single Seller, product has no close substitutesbarriers to entry, control over market resources, patentsPrice > MR (earns extraordinary profits)produces where MR = MCTherefore, can increase profits and cause price discriminationproduces less, charges higher prices (misallocation of R)Negatively sloping Demand Curve

7

Monopolist’s Output

Deadweight Losses (S. 49)

Price DiscriminationSlides 55 – 57

Natural Monopoly

Price Controlsof Monopolies

Antitrust Policy

to sell more, lower prices: MR < PMR curve is below the Demand CurveExtraordinary profits, because of AC Curve (above MR)Governmental intervention (taxing profits), or lower price

Quantity Supplied = Intersection of MR and MCProfits = Intersection of AC and MC up to Demand (S. 43)

Q satisfies marginal principle, MR = MCDemand Curve determines the price associated with QProfit per Unit sold = P – ACTotal Profit = Profit per Unit * Number of sold Units

A measure of the inefficiency from monopoly;equal to the decrease in the market surplus

Charging different Prices for different GroupsOpportunity for Price Discrimination, when

Firm got market Power Different Consumer Groups Resale is not possible

Idea: Reduce Deadweight Loss arising from monopolyand recapture loss in Consumer SurplusConsumer’s Loss causes increasing Producer’s benefitExamples: airline tickets (discounts), discount coupons, etc.

A market in which large economies of scale ensure thatonly a single large firm can surviveGovernment can intervene by regulating the priceA monopoly can sometimes be better for efficiency reasons

Output Level: MR = MC

A Second Firm won’t enter the market, becauseits demand curve will always lie below the Long-Run AC

Price Controls, Antitrust Laws Breaking Up Monopolies Blocking Mergers Regulating business practices Deregulation and privatization

e.g. AC Pricing Policy:D Curve intersects the long-run AC Curve(=governmental intervention, new prices)

To break up dominant firms, prevent some corporate mergers,and regulate business practices that reduce competition

1, e.g. break up one firm into several smaller firmsTrust = arrangement under which the owners of several firmstransfer their decision-making powers to small group of trustees

2, to block mergers that would reduce competition and lead to higher prices (merger = one or two firms combine operations)3, Tie-in-Sales (buyers are forced two buy a second product)

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Monopolistic Competition(brand markets)

Short-Run

Long-Run

Monopolistically Com-petitive Market

Effects of Market Entry

Entry-Stops:Long-Run Equilibrium

Monopolistic vs.Perfect Competition (A)(S. 85)

Monopolistic vs.Perfect Competition (B)(S. 86)

WEEK 4

3, Predatory Pricing (firm decrease price to drive out rivals)= both will practices will be supervised by government

Many firms selling a differentiated productease of entryblend of competition and monopoly (brand loyalty)availability of close substitutes limits monopoly powerfirms engage in non-price competition (Advertising) toraise market shareclustering of pricesfirms misallocate resources but to lesser degree (sincedemand is elastic)more variety of consumers, but advertising and productdifferentiation may be excessive and wasteful

Negatively sloped Demand Curve (more elastic due toavailable substitutes)Maximization of Profits at MR = MC but P > AVC

Firms are attracted, because of short-run profitsor leave, faced with losses until D Curve of remainingfirm is tangent to AC and firms break even (P=AC) (S. 76)

Each firm produces a slightly different product(narrowly defined monopoly)Products sold by different firms are close substitutes(keen competition between firms for consumers)

Decreasing Profits, due to market price drops quantity produced decreases firm’s AC of production increases

Firms enter the market until such point that prices areequal to AC (break even). Thereafter, firms will neitherenter nor exit the Industry (S. 83)

Perfectly competitive market, firm-specific D Curveis horizontal at the market price, and MR equals Price.Equilibrium: Price = MC = ACThe Equilibrium occurs at the minimum of the AC Curve

Monopolistically competitive market, firm-specific D Curveis negatively sloped and MR < Price.Equilibrium: MR = MC and Price = AC

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Oligopoly

Cournot Duopoly (S. 5)

Bertrand Duopoly (S. 6)

Edgeworth Duopoly (S. 7)

Sweezy Oligopoly (S. 8)

Oligopolistic Behavior

Game Theory (S. 11)

Few sellersProducts may be homogeneous or differentiatedEntry Barriers exist (Cartels, established firms lower prices)Firms are mutually interdependentFirms engage in non-price competition (Advertising)Firms collude on what prices to charge orhow to divide the market to prevent new entrantsPrices tend to be rigidFirms misallocate resources and can earn profits in thelong-run because of restricted entryExcessive Advertising and differentiation, spend on R&D

Involves Uncertainty about Reaction of the Competitor

Two firms react to each other’s output changes untilboth reach an equilibrium positionReaction continue until both firms have equal output

Two firms react to each other’s output changes untilboth reach an equilibrium positionBoth firms set prices, assuming the other firm’s priceis independent of its own choice of outputIf both firms set equal Prices > MC, outbalanced market sharebut, if one lowers, it gains the whole marketBoth are therefore tempted to lower pricesFirm won’t P < MC, otherwise lossIntersection of both, P = MC

Firms act as a monopolist, Profit Maximization MR = PCharacterized by price undercuttingsPrice undercutting continues until both reach Max. Output

Kinked Demand CurveD Curve is bent at the prevailing market Price (kink)price increase: other firms won’t change their prices(quantity will decrease by large amount, elastic)price decrease: other firms will also decrease their prices(quantity will increase by small amount, inelastic)

Responses to Uncertainty

Cartel Pricing1, Cartel = group which coordinates pricing decisions(often charging the same price for a particular good)2, Arrangement under which the two firms act as one(coordination their pricing decisions = price fixing)

Study strategic behavior of oligopolists, study of decision-making in strategic situationsBasic Elements

Players (Parties) Strategies (Possible Actions) Payoffs (Each receives for following a strategy)

dominant strategy = yields a higher payoff, no matter what

10

Duopolists’ Dilemma

Guaranteed Price Matching

Overcoming the Dilemma(S. 26)

Price Leadership

Limit Pricing

How to measure MarketPower?

1, Lerner Index(S. 35)

2, Herfindahl Index(S. 36)

Concentration Ratios

the other player choosesdominated strategy = leads to a lower payoff than analternative choice, regardless of what the other chooses

Although both firms would be better off if they chose thehigh price, each firm chooses the low price (SS. 16 – 17)

occurs because the two firms are unable to coordinatetheir pricing decisions and act as one (s.a. Prisoner’s dilemma)

Strategy where a firm guarantees it will match a lower priceby a competitorEliminates the duopolists’ dilemma and makes cartel profitsand pricing possible, even without a formal cartel

Leads to higher priceBUT, guarantees that consumers will pay the high price

1, duopoly pricing strategy2, grim-trigger strategyi.e. firm responds to underpricing by choosing a price so lowthat each firm makes zero economic profit3, tit-for-tat strategyi.e. one firm chooses whatever price the other firm chosein the preceding period

One Oligopolist = Price Leadersets a price, while expecting that other firms will match the Pricebut, signals may be misinterpreted1, change in market conditions, just match the price, butprice fixing continues2, under pricing, price war may be triggered, result:destroying the price-fixing agreement

Picking a price which is lower than normal monopoly Price

1, Lerner Index2, Herfindahl Index

Indicator of monopoly Power, defined as:L = (P – MC) / PPerfect Competition: P = MC (value of zero)P > MC, Index varies between 0 and 1The closer to 1, the greater the degree of Monopoly

Index measures industrial market concentrationindividual market share of each firm in fractional terms is squaredthe H-index is given by the sum of the squared terms:H = Σ si

2 (si = market share of the firm)

H-Index takes into account the number of firms,and their size differencesN-equal-sized firms = 1/N, Monopoly = 1, tend to one when fewfirms and/or greater degree of inequality in market sharesMeasure Industry Concentration, degree of market control

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Exercises:Slides 42 – 45

Monopsony (S. 47)

Monopoly vs. Monopsony(S. 50)

WEEK 5

Macroeconomic Goals

Macro- Instruments (S. 3)

Circular Flows of IncomeSlides 4 – 9

Dual Gap Analysis

Real Sector Indicators

National Accounts

Ratio = Proportion of total Output produced by the firms,focusing on the largest firms (≠ HHI, focus on entire industry)

e.g. ratio over 90% of industry’s output produced by the fouror the eight largest firms, indicates oligopolistic marketstructures, significant market control (S. 38)

One single buyer of a producte.g. government marketing board buys all Y of Farmers

Positively sloped market supply of laborto hire more workers, pay higher wages(Marginal Labor Costs > Wage)

Hire more workers:Marginal Benefit of Labor = Marginal Labor Cost

Monopoly: single seller of output high price of output small quantity of output monopolist uses market power to increase P

Monopsony: single buyer of input low price of input small quantity of input monopsonist uses market power to decrease wages, or other input prices

achieve sustainable economic growth (GDP/GNP) contain inflation to moderate levels provide employment / reduce unemployment attain external balance distribute fruits of growth equitably

Monetary Policy (money supply, interest rates, etc.)Fiscal Policy (taxation, expenditures, etc.)External Policy (exchange rate, debt management)

Financial Sector Gap: S – IGovernment Sector Gap: T – GExternal Sector Gap: X – M(S – I) + (T – G) = (X – M)

GDP / GNP (nominal, real, per capita)Price Indicators (CPI, PPI, WPI, RPI, GDP deflator)Employment (Labor force, employment rate, unemployment)Business Cycle Indicators (leading, co-incident, lagging)

1, Gross Domestic Product (GDP)

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GDP

Real GDP

Nominal GDP

How to measureNational Income

Private Investment

Net Exports

= final output produced in a given country2, Gross National Product (GNP)= final output produced by nationals of a country, includingthose who are abroard; GDP + income from abroad = GNP3, Net National Product (NNP)4, Gross National Income (GNI)5, Net National Income (NNI)= GNP less depreciation6, Disposable Income (DI)7, National Income= NNP less indirect taxes

Total market value of all the final goods and services producedwithin an economy in a given yeartotal market value = Q * P

only newly produced goods are included in GDP

Takes into account Price changesmeasure of total output does not increase just because pricesincrease, uses prices as of a base year, prices are thereforekept constant, i.e. only Q changes

current prices to measure GDPPrices can increase due to higher costs of Production

1, production approachmeasuring value added in all firms and industriesGDP by industrial originthree major groupings: agriculture, industry and servicesvalue added = additional value at each stage of productionfinal products are counted; ≠ intermediate inputs2, income approachmeasuring value added contributed by economic factorsadding up all rewards for factor incomes:

wages (labor income) profits and dividends (firm’s income) interest income (on savings) rent (landlord’s income)

3, expenditure approachmeasuring all components of aggregate demandadding up all demand in the economy, consisting of

private consumption private investments government spending net exports (exports less imports)

Spending on new plants and equipmentNewly produced HousingAdditions to Inventories during the current year

New investment expenditures = gross investmentNet Investment = Gross Investment – Depreciation

Total Exports – Total Imports

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Trade Deficit

Trade Surplus

GDP Equation

Personal disposableIncome

Fluctuations in GDP(S. 34)

Inflation Rate

CPI(S. 39)

Costs of Inflation

How to measureUnemployment

Labor Force

Cyclical Unemployment

Frictional Unemployment

Structural Unemployment

Seasonal Unemployment

Income-Expenditure-Model

Consumption Function

Import > Export

Import < Export

YGDP = C + I + G + NXGDP = Consumption + Investment + Government Purchases+ Net Exports

Income of household after paying income taxes

1, Peakoutput starts to decline: recession starts2, Troughoutput starts to increase: recession begins to end3, Expansionrecovery period4, Recessionsix consecutive months of declining real GDP

dP/P (percentage rate of change of a price index)

Measures changes in a fixed basket of goods

CPI in year K = (cost of basket in year K)/(in base year) * 100

Creates Winners and LosersIndividuals and Institutions will change behavior+50%/month: Hyperinflation (s.a. Scooter – Hyper Hyper)

unemployment rate = unemployed / labor force

Employed + Unemployed

accompanies fluctuations in real GDP

occurs because it takes time to find a job / hire workers

occurs when jobs are eliminated and new jobs are created

harvest season, winter season, etc.

Developed by J. M. KeynesHigher Expenditures = generate higher levels of income

Equilibrium Output = y* = C + I = planned expenditures

Keynesian Cross (S. 64)

Output > Demand (glut), production would fallOutput < Demand (shortage), production would rise

Relationship between Consumption spending and

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Savings Function

The Multiplier(S. 73)

Government Spendingand Taxation

Fiscal Multipliers

Automatic Stabilizers

the level of Income

C = Ca + byCa = autonomous consumption, does not depend on incomeby = Marginal Propensity to Consume (MPC)i.e. the fraction of additional income that is spent

Increase/decrease in Ca shits the entire function up/down increase in consumer wealth, increasing Ca

increase in consumer confidence, increasing Ca

Increase/decrease in MPC increases/decreases the slope

Equilibrium Output:C + I intersect 45° line, at that level of output,y* = desired spending equals output

Relationship between level of saving and Level of IncomeIncome is either spent (C) or saved (S)

Therefore, Marginal Propensity to Save = 1 – MPC1 = MPC + MPS

Equilibrium Output = I = SLevel of Savings ≠ fixed, depends on GDP

Fraction to save determined by MPS

When Investment increases by ΔI from I0 to I1, Equilibrium output increases by ΔY from Y0 to Y1

The Result: ΔY > ΔI

Government Spending and Level of Taxationaffect the level of GDP in the Short-Run (influence on D)

Keynesian Fiscal Policy:Taxes and spending to influence the level of GDP

Planned expenditures including government = C + I + G

multiplier for government spending:

or the Consumption Function with Taxes is:

Disposable income is: y- T

Tax Multiplier:

or

Automatic Stabilizers are taxes and transfer payments thatstabilize GDP without requiring policy-makers to take explicit

15

Aggregate Demand(S. 87)

Equilibrium Output

Multiplier forInvestment

actions: when income is high, G collects more taxes, and pays

out less transfer payments, decreasing consumer spending when output is los, G collects less taxes, and pay

out more in transfer payments, increasing consumer spending

AD Curve shows the combination of prices and Equilibrium Output

Prices Fall > Expenditures Increase > Y increases (S. 87)G increases > Expenditures Increase > Y increases (S. 88)Increasing G Spending shifts the AD Curve Up

Output = planned expenditures = C + IOutput = C + I

Consumption Function

For a new Level of Investment I0, we have

For a new level of Investment I1, we have

Substituting for the levels of Output, we have

Because (I1 – I0) is the Change in Investment, we can write:

16

Government Spendingand Taxes(S. 94)

Summary

WEEK 6

Government Spending and Taxes:

Government Expenditure: 1 / MPSTax Multiplier: -MPC / MPSBalanced Budget: 1With Trade: 1 / (1 – MPC + MPM)With Tax and Trade: 1 / (1 – MPC (1 – t) + MPM)

MPC = Marginal Propensity to ConsumeMPS = Marginal Propensity to SaveMPM = Marginal Propensity to Importt = Tax Rate

17

Phillips Curve

Stagflation

Friedman

Rational Expectations

Natural Rate ofUnemployment

Velocity of Money

Quantity Theory ofMoney

Money as a veil

Money is desired as

Negative Relationship btw. wages and unemployment(wages were indicators of Inflation)Increasing Money Supply leads to decreasing Unemployment,but increasing Inflation

Stagnation (Recession) combined with Inflationtrade-off between unemployment and Inflation (Phillips) isno longer observed

Demand-Pull Inflation:Shifting D Curve: Unemployment dec., Inflation inc.

Cost-Push InflationShifting S Curve: Unemployment inc., Inflation inc.

Introduced the idea of adaptive Inflation expectations

Expectations Philips Curve:Relationship between Unemployment and Expectations,when taking into account expectations of Inflation

Unemployment varies with unanticipated Inflation

When economy experiences a boomUnemployment is below natural rate, Inflation is higher than expected

When economy experiences a recessionUnemployment is above natural rate, Inflation is lower than expected

People look at all variable information in making judgmentspolicy = ineffective, people will outguess governmentPeople will realize trend in policies and incorporate this intheir expectations

Public forecasts the future correctly, on average

Rate of Unemployment can shift demographics, composition of workforce institutional changes state of the economy changes in growth of labor productivity

velocity of money = nominal GDP / money supply

M * V = P * YIncrease in Money Supply leads to an increase in Prices

Money has a neutral effect on physical or real quantitiesof output

temporary abode of purchasing power and store of wealth

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a commodity

Money Neutrality

Money Dichotomy

Fisher’s Equation

Hyperinflation

Price stability accordingto Friedman

Keynes vs. Friedman

Fiscal Policy

Expansionary andContractionary Policies

FriedmanContributions (S. 38)

Government Spending

WEEK 7

Change in Supply of Money will not change Y in the long-run

Distinction between nominal and real values;money is a veil in the long- and the short-run

M * V = P * T(V, T = constant, change in M will increase P)

Arises when Government allows money supply to grow inorder to finance the gap between government spendingand revenues – the budget deficit

Governments could use a mix of borrowing funds from thepublic and printing money to cover the deficit

Government is forced to print new moneyto stop Hyperinflation, eliminate G deficit = stop printing

Rate of growth of money supply equal to long-run rate ofeconomic growth = price stabilityMV = GDP

Slide 40Monetarism vs. Fiscal

Allocation (provision of goods and services) Distribution (altering distribution of income) Stabilization (address problems of unemployment) Regulation (legal framework)

Expansionary: increase ADContractionary: decrease AD

Lags: Inside (Problem – Implementation) versus Outside Lags (Policy – Impact)

Monetary: Inside Lag (Short) Immediate Implementation of BanksOutside Lag (Long) 1-3 years for interest rates or moneysupply to have an impact on inflation

Fiscal:Inside Lag (long) Government takes time to enact tax measuresOutside Lag (Short) Taxes are raised, immediate impact

general public services defense education health social security and welfare debt servicing, economic services

19

Spiderpig, Spiderpig,does whatever a Spiderpig does…

Can he swing from a web? No, he can’t, he’s a pig.Look Out! Here is a Spiderpig!