Specialization 

• Individuals and countries can be made better off if they will produce in what they have a comparative advantage and then trade with others for whatever else they want/need.

Absolute Advantage

• The producer that can produce the most output OR requires the least amount of inputs (resources).

Comparative Advantage 

• The producer with the lowest opportunity cost.
• Countries should trade if they have a relatively low opportunity cost.

Input vs Output

• Output Problem: Presents the data as products produced given a set of resources. 

• Ex: Number of pens produced

• Input Problem: Presents the data as a number of resources needed to produce a fixed amount of output. 

• Ex: Number of labor hours to produce 1 bushel
• When identifying absolute advantage, input problems change the scenario from who can produce the most to two can produce a given product with the least amount of resources. 

Foreign Exchange

• The buying and selling of currency 
• Visiting Europe and exchanging dollars for Euros
• Any transaction that occurs in the Balance of Payments necessities foreign exchange
• The exchange rate (e) is determined in the foreign currency markets ---> (price of currency)

Changes in Exchange Rates

• Exchange rates are a function of the supply and demand for currency
• Increase in supply of currency = decrease in exchange rate of currency
• Increase in demand of currency = increase in exchange rate of currency

Appreciation and Depreciation

• Appreciation: When the exchange rate of currency increases
• Depreciation: When the exchange rate of that currency decreases

Exchange Rate Determinants

• Consumer Tastes
• Relative Income
• Relative Price Level

 

Balance of Payments

• Measure of money inflows and outflows between the United States and the Rest of the World (ROW)
• Inflows=Credit
• Outflow=Debit
• Divided into Three Accounts
• Current Account
• Capital/Financial Account
• Official Reserves Account 

Current Account

• Balance of Trade (Net Exports)
• Exports of goods and services/Imports of Goods and Services 
• Exports become credit to balance of payments
• Imputed become debit to balance of payments
• Net Foreign Income
• Income earned by US owned foreign assets- Income paid to foreign held to US assets
• Net Transfers 
• Foreign Aid ---> A debit to the current account 
• Ex: Mexican migrant workers send $ to family in Mexico

Capital/Financial Account

• The balance of capital ownership 
• Includes the purchase of both real and financial assets
• Direct investment in US is credit to capital account
• Ex: Toyota factory in San Antonio
• Direct investment by US firms/individuals in a foreign country and debits to the capital account 
• Ex: Intel factory in Costa Rica
• Purchase of foreign financial assets represents a debit to the capital account
• Ex: Warren buys stock in Petrochina
• Purchase of domestic financial assets by foreigners represents a credit to the capital account 
• Ex: The United Arab Emrite Sovereign wealth fund purchases a large stake in NASDQ

Official Reserves 

• The foreign currency holdings of the United States Federal Reserve System
• When there is a 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 Official Reserves zero out the balance of payments 

Laffer Curve

Manipulating AS by enacting policies to stimulate incentives to work, save, and invest

• Tax cuts to increase disposable income
• Hard to enact policy because disincentive, people take advantage of welfare

Laffer Curve: Displays theoretical relationships between tax cuts and government revenue.

• Criticisms of the Laffer Curve
• Empirical evidence suggests that the impact of tax rates on incentives to work, save, and invest, are small
• Tax cuts can also increase demand which can fuel inflation
• Where the economy is actually located on the curve is difficult to determine

The Different "tions" of Economic

Inflation: When price levels increase

Deflation: When price levels decrease

Disinflation: The rate of inflation decreases

Hyperinflation: Monetary inflation occurring at a high rate 

Short-Run Phillips Curve & Stagflation

If inflation persists, and the expected rate of inflation rises, then the entire SRPC moves upwards

Stagflation: Simultaneous rise in inflation and unemployment

Supply Shocks (Adverse Supply Shocks): Rapid and significant increase in resource cost, which causes the SRAS to shift

• Depreciation of a Dollar
• Oil Embargo
• Rapid increase in price of gas

• If inflation expectations drop due to new technology, then SRPC will move downward

LRPC: Natural Rate of Unemployment= Frictional, Seasonal, and Structural Unemployment

Missing Index

• A combination of inflation and unemployment in any given year. 
• Single digit misery is good

The Phillips Curve

In the Short Run

• The Phillips Curve represents a trade-off between inflation and unemployment.
• Inverse Relationship
• Inflation Up, Unemployment Down
• Each point on the Phillips Curve corresponds to a different level of output. 

The Long Run Phillips Curve

• Occurs at the natural rate of unemployment
• Represented by a vertical line
• No trade-off between inflation and unemployment
• Economy produces at the full employment output level
• The LRPC will only shift if the LRAS curve shifts
• Increases in unemployment LRPC ---->
• Decreases in unemployment LRPC <---
• Structural changes in the economy that affect unemployment will also cause the LRPC to shift 

Monetary Policy Assignment

Loanable Funds Market

• The private sector supply and demand of loans 
• This market brings together those who want to lend money (savers) and those who want to borrow (firms with investment spending projects) 
• This market shows the effect on REAL INTEREST RATE 
• Demand- Inverse relationship between real interest rate and quantity loans demanded 
• Supply - Direct relationship between real interest rate and quantity loans supplied 
• This in NOT the same as the money market (supply is not vertical)
• Prime Rate -Intrest rate that banks charge their most credit worth customers 

Tools of Monetary Policy

• Reserve Requirement 
• Fractional reserve systems 
• The Fed sets the amount that the banks must hold 
• The reserve requirement (reserve ratio) is the percent of deposits that banks must hold in reserve ( the percent they can not loan out) 
• Using Reserve Requirement 
• Recession, what should the FED do to the reserve requirement 
• Decrease the reserve ration 
• 1. Banks hold less money and have more excess reserves 
• Banks create more money by loaning out excess 
• Money supply increases, interest rates fall, AD goes up
• Opposite during Inflation Times 
• Open Market Operation
• When the FED buys or sells government bonds (secretes)
• This is the most important and widely used monetary policy 
• If FED buys bonds- it takes bonds out of the economy and replaces them with money; MS increases
• If the FED sells bonds- it takes money and gives the security to the investors; MS decrease 
• Discount Rate
• There are many different interest rates, but they tend to all rise and fall together 
• The Discount Rate is the interest rate that the fED charges commercial banks for short-term loans 
• Federal Funds Rate 
• The Federal Funds rate is the interest rate that banks charge one another for overnight loans 

Money Creation

• A single bank can create money by the amount of its excess reserves 
• The banking system as a whole can create money by a multiple of the excess receivers 

• MM x ER= Expansion of money 

• Money Multiplier = 1/rr

New vs Existing $ 

• If the initial deposit in a bank comes from the FED or bank purchase of bond or other money out of circulation (buried treasure), the deposits immediately increases the money supply 
• The deposit then leads to further expansion of the money supply through the money creation process 
• Total change in MS if initial deposit is new $= Deposit + $ created by banking system 
• If a deposit in the bank is existing $ (already counted in M1), deposition the amount does NOT change the MS immediately because it is already counted
• Existing currency deposited into a checking account changes only the composition of the money supply from coins/paper $ to checking account deposit 
• Total change in the MS if deposits is existing $ = banking system c

Fractional Reserve System

Fractional Reserve System
The process in which banks hold a small portion of their deposits in reserves and they loan out the excess.
Demand Deposits
Created through the Fractional Reserve System
Required Reserves
Cash that banks keep on hand
Total Reserves (TR) or Actual Reserves (AR)
*Required Reserves (RR) + Excess Reserves (ER)

Money Market

• Demand for money has an inverse relationship between nominal interest rates and the quantity of money demanded 
• When the interest rate increases, the quantity demanded of money falls because individuals would prefer to have interest earring instead of borrowed liabilities
• When interest rates decrease, the money quantity demanded increase. There is no incentive to convert cash into interest earning assets 
• Money demand is downward sloping 
• Money Demand Shifters 
• Change inn price levels 
• Change in income 
• Changes in taxation that affects investment 
• Increasing the Money Supply 
• If the FED increase the money supply, a temporary surplus of money will occurs at 5% interest. 

The Federal Reserve Bank

Nickname: The FED

The Central Bank 

Job: The promote economic growth  and maximum employment 

Stocks & Bonds

• Bonds are loans
• Stocks you own 
• Bonds: are loans, or IOUs, that represent debt that the government or a corporation must repay to an investor. The bondholder has no ownership of the company 

Bonds 

• First: if a corporation issues and then sell a bond its a 
• Liability for the corporation 
• Asset for the buyers 
• If that corporation issues a 10k bond with a 10 yr. term and a 5% interest………..
• Nominal interest rate at the time of issue = 5%
• Increases if the nominal interest rate falls to 3%
• Decreases if the nominal interest rate rises to 8%

Stocks 

• Stockowners can earn a profit in two ways
• Dividends, which are portions of a corporation’s profits, are paid out to stockholders 
• the higher the corporation profit, the higher the dividends 
• A capital gain is earned when a stockholder sells stock for more than he or she paid for it 
• A stockholder that sells stock at a lower price that the purchase price suffers a capital loss

Money

The Barter System: Goods and services are traded directly. There is no money exchanged.
Money
Anything that is generally accepted in payment for goods and services.
*Not wealth or income
Wealth: the total collection of assets that store value.
Income: A flow of earnings per unit of time.
Money can be used as:
1. Medium of Exchange
*Buy goods and services
2. Unit of Account
*Measuring the value of goods and services
3. Store of Value

3 Types of Money:
1. Representative Money: Money that represents something of value
Ex: IOU's

2. Commodity Money: Something that performs the function of money and has alternative uses
Ex: Salt, Gold, Silver, Cigarettes

3. Fiat Money: Money because the government says so
Ex: Paper Money, Coins

Six Characteristics of Money:
1. Durability
2. Portability
3. Visibility
4. Uniformity
5. Limited Supply
6. Accessibility

3 Types  of Money Supply:
•Liquidity: Ease with which an asset can be accessed and converted into cash (liquidized)
•M1 (High Liquidity): Coins, currency, and checkable deposits (Checks; Personal and corporate checking accounts which are the largest component of M1)
*Demand Deposit or Money Supply
•M2 (Medium Liquidity): M1 plus saving deposits (money market accounts), time deposits (CD's=Certificates of Deposit), and Mutual funds below $100k
•M3 (Low Liquidity): M2 plus time deposits above $100k

Automatic or Built-In Stabilizers

·      Anything that increases the government’s budget deficit during a recession and increases its budget surplus during inflation without requiring explicit action by policymakers

·      Transfer Payments 

• Welfare Checks
• Food Stamps
• Unemployment Checks
• Corporate Dividends
• Social Security 
• Veteran's Benefits 

Fiscal Policy

How does the government stabilizes the economy?
Fixed Policy: actions by Congress to stabilize the economy or

Fiscal Policy

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

•   Two tools of fiscal policy

Taxes: government can increase or decrease taxes

Spending: government can increase or decrease spending

·      Fiscal policy is enacted to promote our nation’s economic goals: full employment, price stability, and economic growth

Deficits, Surpluses, and Debt

·   Balanced budget

•  Revenues = Expenditures

·  Budget deficit

•  Revenues < Expenditures

·      Budget surplus

•  Revenues > Expenditures

·      Government Debt

•  Sum of all deficits – Sum of all surpluses

·      Government must borrow money when it runs on a budget deficit

•   Government borrows money from
•   Individuals
• Corporations
•  Financial Institutions
• Foreign Entities or foreign government

Fiscal Policy Two Options

·      Discretionary Fiscal Policy (action)

•  Expansionary fiscal policy- think deficit
•  Contractionary fiscal policy- think surplus

·      Non-Discretionary Fiscal Policy (no action)

Three Types of Taxes

·      Progressive Taxes: takes a larger percent of income from high income groups (takes more from rich people)

•  Ex: current federal income tax system

·      Proportional Taxes (flat rate): takes the same percent of income from all income groups

•  Ex: 20% flat income tax on all income groups

·      Regressive Taxes: takes a larger percentage from low income groups (takes more from poor people)

• Ex: sales tax; any consumption taxes

·      Contractionary Fiscal Policy (The BRAKE): laws that reduce inflation, decrease GDP (close a inflationary gap)

•   Decrease government spending
•  Tax increases
•  Combination of the two

·      Expansionary Fiscal Policy (The GAS): laws that reduce unemployment and increase GDP (close a recession gap)

•  Increase government spending
•   Decrease taxes on consumers

Classical and Keynesian Economics

Classical:

• Trickle Down Theory 
• Help the rich first then everyone else
• In the long run, the economy will balance @ full employment output
• The Invisible Hand

Keynesian 

• AD is the key, not AS
• In the long run, we are dead
• Leaks cause recessions

Reasons why prices tend to be "sticky" or inflexible in a downward direction

1. Menu Cost
2. Wage Contracts
3. Minimum Wage
4. Fear of Price Wars
5. Morale, Effort-Productivity 

Loanable Funds Market

• Ig: Gross Private Domestic Investment
• r: interest rate
• Sm: supply of money

Multiplier

The Spending Multiplier Effect: An initial change in spending (C, Ig, G, Xn) causes a larger change in aggregate spending or aggregate demand

Multiplier = Change in AD / Change in Spending (C, Ig, G, Xn)

• Why: expenditures and income flow continuously which sends off a spending increase in the economy

Spending Multiplier = 1 /1-MPC or 1 /MPS

Increase in Spending = +

Decrease in Spending = - 

Tax Multiplier: When government taxes, multiplier works in reverse

• Why: Now money is leaving the circular flow

Tax Multiplier = -MPC / 1 - MPC or -MPC / MPS

• Tax Cut = +
• Now more money in the circular flow

Consumption and Saving

Disposable Income: Income after taxes or net income

DI= Gross Income - Taxes

• With disposable income, households can either:
• Consume (Spend Money on goods and services)
• Save (Not spend money on goods and services)

Consumption

• Household Spending
• The ability to consume is controlled by:
•  The amount of disposable income
• The propensity to save
• Do households consume if DI=0?
• Autonomous Consumption
• Dissaving

Saving

• Household NOT spending
• The ability to save is constrained by:
• The amount of disposable income
• The propensity to consume
• Do households save if DI=0?
• No

APC and APS

APC= Average Propensity to Consume

APS= Average Propensity to Save

APC + APS = 1

1 - APC = APS

1 - APS = APC

-APS = Dissaving

APC > 1 = Dissaving

MPS and MPS

MPC= Marginal Propensity to Consume

Change in C / Change in DI

• % every extra dollar earned that is spent

MPS= Marginal Propensity to Save

Change in S / Change in DI

• % of every extra dollar earned is saved

MPC + MPS = 1

1 - MPC = MPS

1 - MPS = MPC

Determinants of Consumption and Saving

• Wealth
• Expectations
• Household Debt
• Taxes

AS/AD Model

• The equilibrium of AS and AD determines current output (GDPr) and the price level (PL)
• Full Employment: Exists where SRAS and LRAS intersects
• Inflationary Gap: Output is high and employment is less than NRU
• Recessionary Gap: Output low and unemployment is more than NRU

Aggregate Supply

Aggregate Supply: The level of real GDP that firms will produce at each price level

• Long-Run: Period of time where input prices are completely flexible and adjust to changes in the price level
• The level of real GDP supplied is independent to the price level
• Short-Run: Period of time where input prices are sticky and do not adjust to changes in the price level
• The level of real GDP supplied is directly related to the price level

Long-Run Aggregate Supply (LRAS)

• Marks the level of full employment in the economy (analogous to PPC)

Short-Run Aggregate Supply (SRAS)

• Input prices are sticky and do not adjust to changes in the price level
• Level of real GDP supplied is directly related to the price level
• Upward Sloping
• Increase ---->
• Decrease <----

Per-Unit Production Cost

Total Input Cost/Total Output Cost

Determinants of SRAS

1. Input Prices

• Domestic resource prices 
• Wages (75% of all business costs)
• Cost of Capital
• Raw Materials (Commodity Prices)
• Foreign Resource Prices
• Stronger $= lower foreign price
• Weaker $= higher foreign price
• Market Power 
• Monopolies/Cartels that control resources
• Control price

2. Productivity

3. Legal Institutional Government 

• Taxes and subsidies
• Taxes ($ to government) on business increase pre unit of production cost= SRAS <----
• Subsidies ($ to government) to business reduce per unit production cost= SRAS ---->
• Government Regulation
• Creates a cost of compliance= SRAS <----
• Deregulation reduces compliance cost= SRAS ---->