Professional Documents
Culture Documents
P (/pen) P (/pen)
S S1 Red pens
A S0
PPF
P1 B
P1 q1 B
P0 C
P0
q0 A
D1
D0 D1
q0 q1 Q1 Q0
Q/t (pens/year) Q/t (pens/year)
Q1 Q0
A An increase in demand for red B and since producers now Green pens
pens (D0 to D1) increases quantity reallocate scarce resources from
supplied green pens to red pens, supply
of green pens decreases from S0 C Assuming only two goods, red
and green pens, the reallocation of
to S1. resources from green pens to red
pens can be illustrated using a PPF.
Figure 7.2a) to c) illustrates how the flexibility of competitive markets leads to market
dynamism where prices change ultimately in accordance with the forces of supply
and demand. Assume two goods, for example red and green pens, and optimum efficiency
(Pareto optimum see next chapter) in an economy. Recall the basic issue of scarcity and
endless wants and how markets solve the basic economic problem via the signalling function of
prices.
Point A in figure a) illustrates an increase in demand for red pens which drives up the
price and signals suppliers (incentive function of price) to increase the quantity
supplied of red pens (q0 to q1).
Point B, figure b) and c): Since the economy is operating at optimum efficiency (point
A, figure c)), suppliers must reallocate resources from green pens to red pens, points A
to B in the PPF, figure c).
As resources used in the manufacturing of green pens become more scarce, the supply
for green pens decreases from S0 to S1 (figure b)). The increase in the price of green
pens (P0 to P1) signals consumers to decrease their consumption (rationing function of
price) of green pens quantity demanded for green pens decreases from Q0 to Q1.
Fig. 9.4 Demand for DVDs values of PED along a linear demand curve
A PED = (infinite)
10
Price (/DVD)
PED = 6.33
11 PED = 6.33
PED = 21
10 9
1 2
9
Point value of PED
PED = 3.4
8
PED = 2.14 B PED = 1 (unitary)
7
PED = 1.44
6
PED = 1
5 PED = 0.69
4 PED = 0.47
3
C PED = 0 (zero)
PED = 0.29
2 PED = 0.16
1 PED = 0.05
0 0 1 2 3 4 5 6 7 8 9 10 11
Quantity (1,000s)/week
o Pareto optimum
The concept of societal efficiency in an economy was pioneered by the Italian/French
social-economist Wifredo Pareto (1848 1923) and is often explained using a PPF for
supporting illustration. For once, I shant be different. Societal efficiency is said to be
maximised when the economy is operating on the PPF; anything else would mean that
resources are not being used to the utmost. The PPF in figure 8.4 shows an economy
where output is divided into goods for IB teachers1 (such as TOK books and
comfortable shoes) and IB students (Nintendo games and m
P ($)
Infinite price elasticity; PED =
11
Elastic portion of demand curve; PED > 1
Q/t
5.5 11
Determinants of PED
Thereareanynumberoffactorsthatwillhaveaninfluenceonthepriceelasticityofdemand,
allofwhichdealdirectlyorindirectlywiththestrengthofconsumerspreferencesandtheir
abilitytofind/acceptothergoodsinstead.Onerealisesintuitivelythattheelasticityofdemand
formedicineswilldifferfromthatofluxurycruisesintheCaribbean.Thedeterminantsofprice
elasticityofdemandcanbeoutlinedinthreeheadings;
1. Theavailability/closenessofsubstitutes;
2. Thetimespaninvolved;and
3. Theproportionofincomespentonthegood.
1
There are so many things Id love to put herebut my editor wont let me. Feel free to write to me with
suggestions!
Fig. 9.8 Total revenue (TR) along a demand curve
P ($) TR; $3 x 1 = $3
4
TR; $2 x 2 = $4
3
2 TR; $1 x 3 =$3
1
0 Q/t
0 1 2 3 4
Fig. 9.9 Total revenue for Linas Lemonade Emporium
Price ($/litre)
Remember, the
portion of the
10 demand curve above This is the point of unitary PED. Any
unit PED is the movement towards this point will
9
elastic portion. increase TR. Setting price/output at this
8 point maximises TR.
7
6
Remember, the
5 portion of the
demand curve below
4 unit PED is the
3 inelastic portion.
1
D
0 Q (litres per day)
0 1 2 3 4 5 6 7 8 9 10
21
16
TR
a) Cigars b) Almonds
P ($/cigar)
S+tax P ($/hg) S+tax
S0
S0
1.6
1,11
Tax = $1 per 1 Dalmonds
cigar
1
0.6 Tax = $1 per hg
0,11
Dcigars
68 100 50 100
Q/t (millions cigars/month) Q/t (millions hgs/month)
Note: We will re-do the issue of indirect taxation (e.g. expenditure tax) in Chapter 13.
Closelyrelatedtotheissueofthetimeinvolvedinincreasingquantitysuppliedwithinagiven
period,istheability(andcost!)incurredbyproducersinswitchingfromtheproductionofone
goodtoanother.Aproducersubstituteisagoodwhichsupplierscanswitchtoasanalternative
nottobeconfusedwithconsumersubstitutes.Theeaseordifficultyanygivensupplier
experiencesinmovingproductiveresourcesfromonegoodtoanotherwillbeamajorfactorin
determiningsupplyelasticity.Acommonclassroomexampleiswhiteboardpensandpermanent
markersbeingverycloseproducersubstitutes.Switchingfromwhiteboardpenstopermanent
markers2wouldinvolveverylittleinthewayoftoolreadjustment,machinemodifications,new
materialandknowledgeandsoforth.Supplywouldbeveryelastic.Switchingfromcompact
carstomidsizedcarsisalsofairlysupplyelastic.
Manyprimarygoodssuchasironore,teakwoodandagriculturalgoodswillbehighlyinelastic,
astheabilitytoswitchtosuchgoodsintheshortrunisverylimited.Thebasicpremisehereis
thatoncesuppliershavealargeamountofresourcessunkinacertainsector,thereapplicability
oftheseresourcesisthekeytoincreasingsupplyofothergoods.Justconsidercommodities
suchasironandcopper;ifyouhaveacoppermineanddemandforironincreasesitsgoingto
beabitdifficulttoswitchproductiontoiron.Imean,youhaveacoppermine
2
Afavouriteclassroomprankknowntoallmypeople,incidentally.
Price (/jacket)
Market for jackets
210 Consumer surplus
200
A
190 P ()
B F
180
C G S S
170
D H
160
E I
150 P
V IX
140
IV VIII
130 D
III VII D
120 Q/t
II VI Q
110
I
100
Supplier surplus
90 I
0 1 2 3 4 5 6 7
Quantity (100s jackets/week)
Remaining Sum of the net
consumer surplus losses of
consumer
surplus and
A + B: loss of A: govt tax B: net loss of
P (/pen) Tax per pen supplier surplus
consumer revenue paid consumer
= deadweight
surplus due to by consumers surplus
loss
tax
S
P1
B A A
P0 A B B
C D D D
C C
P*
<definition>
Deadweight loss: A deadweight loss is an efficiency loss to society since societal
surplus is decreased without a corresponding gain for another actor in society. It is the
net loss of consumer surplus and supplier surplus.
<end def>
Definition: Ad valorem tax
An ad valorem tax (value added tax) is based on the base value (price) of a good sold, and as it
is a percentage the amount of tax per unit will increase as the base value increases.
a) Cigarettes b) Oranges
P (/pack) P (/kg)
S+tax
S+tax
S0 S0
140
120
Tax = 50 per
100 Tax = 50 per 100 kg
90 pack
Doranges
70
Dpetrol
80 100 60 100
Q/t (millions packs/month) Q/t (millions kg/month)
Governments tax goods to either gain government tax revenue or decrease consumption of the good.
Expenditure taxes are indirect taxes. Consumers pay to firms which then pass on the tax to
government. This increases firms costs and thus decreases supply.
A specific tax or unit tax is an expenditure tax on goods based on a unit sold or consumed such as
2 per bottle of wine or pack of cigarettes.
An ad valorem tax is a percentage added on to the base value or price of the good.
HL extensions
The more price inelastic demand is the higher the incidence of tax is on the consumer and the
greater is the overall incidence of tax (government revenue).
<Def>
Definition: Subsidy
A subsidy is a money gift/grant from government which acts as a) an incentive to producers to
produce more; and b) lowers the (marginal) costs of production. Both of these forces serve to
increase supply.
<End def>
The main reasons for subsidies are:
Increasing employment increased output in firms can create demand for labour and
unemployment falls (infrastructure projects such as bridges and dams)
Protecting a way of life and culture traditional way of life in farming/rural areas can
be upheld (farming subsidies in the EU)
Redistribution of income disadvantaged industries receiving subsidies can retain
wage levels for employees (mining industries in the UK in the 1980s)
Meet international competition and improve the trade balance as subsidies lower the
costs of production, domestic industries become more price competitive which can
increase exports and/or decrease imports (oil industry subsidies in the US)
Improve production potential and products subsidies to firms and universities serve
to increase research and development (R&D) spending which can increase productivity
and spur innovation (alternative energy in Spain and Denmark)
Provide more goods which are societally beneficial goods which have positive
effects not only on the consumer but other groups (third parties) are said to be under-
consumed without a subsidy (milk and dental care in Sweden)
105
S+subsidy
100 Subsidy/unit
Total incidence of the
= 10
95 subsidy, e.g. govt. cost
of the subsidy: 10 x
60,000 tonnes =
600,000
D
50 60
Q/t (1,000s tonnes/year)
Actual costs of subsidies: I once asked a lady at the milk section in a grocery store in
Sweden if she thought milk was expensive and to my amazement she said Not as
expensive as it would be without the subsidy! She had her mind screwed on right
just look at figure 14.1 and calculate the actual cost per tonne of wheat! Yes, the entire
subsidy from government comes from tax money. Milk buyers are paying for this
subsidy indirectly
o Inefficiency costs arise since the decision to take my tax money and give it to
wheat/milk producers is made by the government. It would be far more
efficient to let the price mechanism allocate resources.
o All of the subsidies will entail administrative costs.
o The heaviest costs are of course the opportunity costs of the subsidies. Most
of us in the developed world could think of a number of better things to do
with the money than to give it to farmers.
Equity3: I also asked a French ex-wifes family at their dinner table one time what
do you think about me, the Swede, paying tax money so you French can enjoy cheap
cheese?4 Looooong silence and thenno answer. The fact is that Sweden is one of
the largest net contributors to the EU and thus the Common Agricultural Policy (CAP)
and France is one of the largest net beneficiaries. Even if I had been in Sweden I would
have asked the question of a Swedish farmer why are farmers considered so
valuablewhy not cobblers or thatchers The basic question here is on what
grounds government not the consumer! decides who gets subsidies.
Developing countries: I hate to run this in to the ground but heres another one. At a
dinner party here in Mexico I asked my hosts (who are still my friends!) so, how do
you feel about US subsidies on cotton, corn and pork? My ears are still burning from
the reply, which was along the lines of how US producers were dumping5 agricultural
products on Mexico and destroying domestic markets due to the fall in prices. (Like a
good economist, I looked it up. See the table below.) There are numerous examples of
how subsidies in high income countries create surpluses of agricultural produce which,
when dumped on LDCs causes not only loss of LDC export income but also the
destruction of domestic LDC markets. In Chapter 15 I shall return to the issue of how
rich world intervention on agricultural markets destroys livelihoods in poor countries.
3
Equity means fairness in distribution of societal resources.
4
Yes, I actually did this. Nothing like a little light chit-chat to make a dinner pleasant. Dessert
waschilled, shall we say.
5
This has a very specific definition in economics. It is the selling of goods on foreign markets
at below the cost of production at home.
Summary and revision (need a cool pic here.maybe a pic of someone doing push-ups!)
1. A subsidy is a gift or grant of money to firms which lowers (marginal) costs of production and
serves as an incentive for firms to increase output.
Governments subsidise industries in order to create employment, preserve a way of life/culture, create equity
in society, improve the home economys international competitiveness, facilitate R&D, and increase
consumption of goods considered to be beneficial to society.
D
Q0 Q1 Q/t ()
Subsidy = 2 Subsidy = 2
P (/tonne) per tonne P (/tonne) per tonne
Cost to govt (= total
S0 incidence of subsidy) S0
5 5 5
S+ subsidy S+ subsidy
4 4 4
3 3 3
D D
6 10 6 10
Q/t (1,000s tonnes /month) Q/t (1,000s tonnes /month)
1. Externalities
a. Negprod (pollution)
b. Negcons (de-merit goods and bads)
c. Poscons (merit goods [def; high pos extsand good for user
in LR], public goods [def; non-excl and non-rivalrous)
d. Posprod (stoopid)
2. Imperfect competition (use mons as ex)
3. Info asymmetry (used cars, health/fire insurance)
4. Common access resources (tragedy of the commons today the sea!)
P($/unit) MSC
MPC
MPC MSC; extent of the negative
externality in production
Psoc opt
P0 Welfare loss in producing Qsoc opt to Q0
more units of plastic each unit has a
higher MSC than MSB
MSB (= MPB)
Qsoc opt Q0 Q/t (units/month)
MPC + tax
MPC0
Psoc opt
Expenditure tax per unit
P1
P0 Extent of negative
externality without tax
MSB (= MPB)
Q/t
Qsoc opt Q Q
1 0
P($)
Government subsidies or government provision
MSC0 (= MPC) increase supply from MSC to MSC+subsidy, bringing
total output to Q1 and closer to the societally optimal
MSC1 output of Qsoc opt.
Psoc opt Government incentives such as paying families for
every day their children are sent to school will increase
demand for education, shown by the shift from MPB0
P0
MSB to MPB1 again, output is closer to the societally
optimal level of Qsoc opt.
MPB1
MPB0
Q0 Q1 Qsoc opt Q/t (school hours/year)
Extent of positive
externality
Potential welfare
gain
1) Consumersignorethebenefitstoothers:Theinabilitytoseehowpersonal
consumptionspillsoverandbenefitsothersocietalmembersisperhapsoneofthe
largestobstaclesinpeopleconsumingthesociallyoptimalquantity.Theexistenceof
positiveexternalitiesinitselfmeansthatthegoodwouldbeunderconsumedand
thereforeunderprovided.
2) Consumersignoretheirownfuture
benefits:Anotherexplanationforunder
consumptioncanbefoundinwhateconomistscalltimeinconsistentbehaviour.
Thisariseswhenthebenefitstotheuser/consumerarefarinthefuturewhilethecosts
areimmediate.Insuchsituations,peoplearenotinclinedtogivethebenefitsenough
weightinweighingthecostsandbenefits.Givinguppresentenjoymentinorderto
learnFrenchwouldincreasepossiblefuturebenefitsintravelandemployment
possibilitiesbuthowmanywouldactuallythinkalongtheselines?! 6
Oneofmyfavouriteexamplesoftimeinconsistentbehaviourwaspointedoutbyoneofmy
6
students.InthemovieBridgetJonessDiarytheresthescenewhereshewrites;Monday
28thofApril.Gymvisits,zero.Numberofgymvisitssofarthisyear;1.Costofgym
membershipperyear;370.
Summary and revision (need a cool pic here.maybe a pic of someone doing push-ups!)
Positive externalities in production are when the marginal private costs are higher then the marginal
social costs (MPC > MSC). In terms of resource allocation, the good is underprovided. Fire breaks
protecting individual properties is an example of a good with positive externalities in production.
Positive externalities in consumption exist when an individuals consumption of a good has positive
effects on non-users/consumers. Thus the marginal social benefits are greater than the marginal
private benefits (MSB > MPB) and the good is under-consumed. Health care, education and pension
schemes are examples of goods with positive externalities in consumption.
Merit goods are goods which have benefits to the user in the future and also positive spillover effects
in consumption.
Since merit goods are under-consumed in terms of societal optimum (e.g. where MSC = MSB),
government policies aim to increase demand and or increase supply of merit goods:
Increasing demand: positive advertising campaigns for bicycles, incentives for households in
developing countries to send children to school, and information to households about recycling are
all possible government measures.
Increasing supply: government or the municipality can supply the good at break-even price or even
at a loss, subsidise the good, and offer various forms of incentives for firms to provide more of the
goods.
Figure19.1classiceconomicdivisionofgoods
7
But theres no way Im not going to tell the following little story! My friend Toni lives in a gated
community e.g. an area behind gates where you have to show ID to get in. After some heated discussion
in the community about who was paying for the streetlights or not, the community leaders assigned
streetlights! Anyone who didnt pay their bill found themselves on a very dark street. Another favourite
example in economics bites the dust
Definition: Public goods
A public good is distinguished by high positive externalities but also non-rivalry (my use does
not diminish your use) and non-excludability (non-payers cannot be excluded once provided)
in provision. It is very difficult to charge individual users and is thus often provided by public
monies.
Free rider problem means that it is possible to consume a good or resource without paying
for it. This is a problem common to public goods and thus precludes provision by a free
market.
Examples of public goods are police force, lighthouses, air traffic control, street lights,
fireworks displays, military defence, earthquake or tornado warning systems and flood
banks
The solution to market failure in the case of public goods is to provide the goods via
taxpayers money.
Theory of the firm
8888
Recallthatprofitistheresultofsubtractingtotalcostsfromtotalrevenue,whichintheunitcost
picturecorrespondstosubtractingaveragecostsfromaveragerevenue.Figure2.3.24shows
threepossibilities:
Normalprofit:WhenthemarketpriceequalstheACofthePCMfirm,thefirmwill
breakeven,i.e.itwillenjoynormalprofits.Thisisshowninthediagramtothefarleft
above,astheMR=MCpointcoincideswithaveragecosts.AsAR=ACthereisa
normalprofit.
Abnormal/supernormalprofit:Themiddlediagramillustratesasituationwherethe
marketprice(andthustheMR,ARcurve)isabovetheaveragecost.Thefirmsets
outputatQmaxandearnsanabnormalprofit,shownbytheredarea.
Loss:Finally,whenthepriceisbelowanypointontheACcurve,thefirmwilloperate
ataloss,asprofitmaxoutput(Qmaxwhichisthesameasthelossminimisinglevel
ofoutput;Qlossmininthediagram)resultsinanARbelowAC.Thelossisshownbythe
darkgreyareainthefarrightdiagram8.
8
Students often ask why the firm continues to set output at MC = MR even when average costs are
higher than the price. The answer is that this point is also the loss minimising point of output, i.e. the
firm would make an even greater loss by setting output at any other level than the MC = MR point.
Fig. 2.3.30 Short run loss in a perfectly competitive market firm
P AR, MR, D P
D
Q/t Q/t
Q-max Qmkt
The perfectly competitive market model is based on five main assumptions; 1) a large
number of firms; 2) the firms are producing homogenous goods; 3) the individual firm is a
short run profit maximiser; 4) there is perfect knowledge and information; 5) there are no
barriers to entry.
The assumptions result in each individual firm on the perfectly competitive market being a
price taker. Thus; P = AR = MR = Dfirm (Price is murder).
The profit maximising level of output is where MC = MR. The firms supply curve is the
marginal cost curve since any change in the market prices will move the profitmax point of
output along the upward sloping portion of the MC curve.
In the short run, the PCM firm can be making an abnormal profit (AR > AC); a normal profit
(AR = AC); loss (AR < AC).
In the long run the PCM firm will make a normal profit. Abnormal profits will attract market
entry and the price will fallwhile losses will cause market exit and the market price will rise.
Hence, in the long run, the PCM firm will be operating where P = MC = AR = AC min = AR.
The break-even price for a firm is the quantity at which P (AR) = AC.
The sum of the individual MC curves for firms on the perfectly competitive market is the
market supply curve. MCindividual = Smkt
Using factors of production in order to create the highest possible output per unit of input is the measure
of efficiency productive efficiency. In other words, when goods are produced at the lowest possible
cost per unit there is optimal allocative efficiency. This is where Q = ACmin. The issue of efficiency is
basically Firms are doing things right!
The question of whether consumers are then willing and able to buy the amount of goods produced is
also a measure of efficiency allocative efficiency. When firms are producing goods in the correct
quantity as defined by market demand then there is no excess in supply or demand and firms are
allocating factors of production allocatively efficiently. This is when output is set where P = MC. The
issue of efficiency is basically Firms are doing the right things!
Assumptions of the oligopoly model
Anoligopolyhassomekeydefiningcharacteristics,namelythatthemarketisdominatedbya
fewlargefirmsandthatpotentialentrantsfacehighbarrierstoentrythelatterbeingakey
differencetothemonopolisticallycompetitivemarket.Furthermore,productscanbeboth
homogeneousanddifferentiatedforexamplebothcement(homogeneous)andbreakfast
cereals(differentiated)areoligopolisticmarkets.Withtheseoutliningassumptionsinplacethe
oligopolisticmarkettakesonanumberofratheruniquefeatureswhichsubsequentlydefinethe
market.
The kink in the demand curve means that the MR curve will be
discontinuous broken.
P, costs ($)
The dotted extensions of the curves are only to show how each
MR curve will cut halfway on the Q-axis. (Dont include
Elastic these in your own diagrams!)
demand
Inelastic demand (note that since only the inelastic portion of the
PEQ D-curve is used, MR will be negative)
D, AR
MR
Q/t
QEQ D, AR
MR
P, costs ($)
MC0 The broken MR curve enables a range of
possible MC = MR points. The diagram shows
MC1 that marginal costs can change without the
QEQ oligopolist having to change output in order to
MC2 stay at the profitmax level of output.
D, AR
Q/t
QEQ
MR
Fig. 2.3.51 Normal profit and loss in monopoly
Outside the syllabus: Note that the finer the demand segment, the more
consumer surplus is captured by the firm. Remaining consumer surplus is
shown by the increasingly saw-toothed blue triangles in the diagrams.
P($)
4 AC
1
MR D, AR
0
0 10 20 30 40 Q/t (1,000s /week)
Summary and revision
Price discrimination occurs when firms with market power set different prices for the same good according to
different price elasticities of demand amongst consumers.
Firms price discriminate for several reasons. The obvious reason is that since average costs do not change the
can increase profit by selling some of the units at higher prices. Other reasons include market capture by a
firm wishing to expand and/or attain economies of scale; earn goodwill by setting prices lower for
disadvantaged groups; public monopolies might price discriminate in order to increase output to a more
societally beneficial level; a loss-making monopoly can use price discrimination to recoup some/all of the loss.
There are many ways for a price discriminating firm to segment the market into groups. The more
commonly used segmentation variables are age, sex, time, income and geographical location.
The necessary preconditions for successful price discrimination are: 1) There must be distinctly identifiable
groups with different PED values; 2) The seller must have a degree of market power; 3) The seller must be
able to limit arbitrage e.g. groups getting the good at a low price selling to groups prepared to pay a higher
prices.
When sellers divide the market into ever smaller segments, profit for the seller rises and consumer surplus
decreases.
Possible advantages for firms of price discrimination are increased profits, possibility of increasing market
share and then attaining economies of scale, and societal goodwill.
Possible advantages for consumers include lower prices for some groups, improved products if firms use
increased profits for R&D, and in the case of a loss-making monopoly getting the good produced at all.
Possible disadvantage for firms is that separating the market increases administration costs.
The potential disadvantages to consumers would be that some consumers end up paying a higher price (and
they will not necessarily be the poorest groups), the loss of consumer surplus, and increased abnormal profits
might help finance predatory pricing.
A publicly owned monopoly can increase societal welfare via price discrimination by setting the price at a loss
making level (MC pricing) and then recouping some/all of the losses by charging certain groups more for the
good/service.
Macro
Intro to macro; main macro goals
1Growthdefinedastheincreaseingrossnationalproduct(GDP)orgrossnational
product/grossnationalincome(GNP/GNI)andmeasuredinmoneytermsandadjusted
forinflation
2Pricestabilitydefinedasastableincrementalincreaseinthepricelevel(inflation)
andmeasuredbytheconsumerpriceindex(CPI9)andtheGDPdeflator.10
3Lowlevelsofunemploymentdefinedasthenumberofpeople,outofthetotal
availableworkforce,whodonothavejobsandgivenasapercentagevalue
4Externalequilibriumdefinedasstablea)exchangeratesandb)curraccbalance
betweenimportsandexports(thisisthefocusofSection4)
Inadditiontotheabovefourmainstreamgoals,economistsincreasinglybringup
issuestobefoundwithinthefollowingcaptions:
5Environmentalconcernsoftendefinedaseconomicgrowthincompliancewith
nondepletingandnondegenerativeresourceuseandmeasuredusingvarious
environmentalindicatorsofpollutionovertime
6Distributionofincomedefinedashowwellincomeisspreadbetweentherichest
andpoorestsectionsofthepopulation
7Productivityoffactorsdefinedastheoutputperunitofinput(factorsof
production)andoftenmeasuredbylabourproductivityindicesandcapitaluseper
moneyvalueofoutput
Tradeoffs:1and2;2and3;1and5;1and6;(1and4a;1and4b)
Alltheabovearesubjecttoavarietyofgovernmentpoliciesaimedatachievingthe
goalsortargets.Theproblemisthatitisimpossibletoachieveallofthegoalsatonce.
Infact,virtuallyeverymacroeconomicgoalwillconflictwithatleastoneothergoal.A
simpleillustrationiswhenaneconomyexperiencesincreasedoutput(goal1above)
thisoftenleadstoinflation(makinggoal2moredifficult)andpossiblyan
environmentalburden(conflictingwithgoal5).AsweshallseeinChapters57and59,
theseconflictinggoalswillcreatenumeroustradeoffsforgovernmentswhichinturn
addstoanalreadyheatedtheoreticalandpoliticaldebate.
9
TheCPIisalsoknownastheretailpriceindex(RPI).
10
Thereareanumberofotherindicesdesignedtocalculateunderlyingorcoreinflation.
Moreonthislater.
(Type 4 Medium heading) 2. Expenditure method of accounting
Thebasicaccountingpremisehereisthatallexpenditureflowsfromeconomicagents
(households,firms,government,andforeigners)constitutetotalexpenditureandthusincome.
Basically,thismethodofaccountinglooksattotalspendingduringaperiodoftimeanddivides
thespendersupintogroupsinordertofollowtheflowsandseewhoisspendingonwhat.Total
expenditureinaneconomybecomesthesumofconsumptionexpenditure(C),investment
expenditure(I),governmentexpenditure(G),exportexpenditure(X)minustheimport
expenditure(M).WhileyouskimthroughIrishexpenditureinFigure3.1.4,trytofigureout
whywesubtractimportsfromGDP.
F
F GrossdomesticproductinIreland2001expendituremethodofaccounting
Expendituretype Amount(millionsof)
Householdconsumption(C) 55,202
Totalprivateexpenditureoncapital(plusphysical
27,461
changeinstocks)(I)
Governmentexpenditure(G) 15,413
Exports(X) 112,938
Imports(M) 95,702
lesstaxesonexpenditure 14,572
plussubsidies 2,697
statisticaldiscrepancy 569
GDPatfactorcost 102,869
Consumptionmeasurestheamountofpersonalmoneyspentongoodsandservices
duringtheyear.Consumptionisoftendividedintodurables(cars,refrigeratorsetc.),
nondurables(beerandDonegaltweed)andservices(suchascarrepairs,hotelstays
andbanking).
Investmentisfirmsexpenditureoncapitalgoodssuchasmachines,equipmentand
factories,oftenreferredtoasfixedcapitalformation.11
11
The total figure on investment also includes changes in stocks, circulating capital, since any
unsold goods produced in the time period are part of inventory and still represent output even
though they have not been sold. Unsold and unfinished goods are accounted as expenditure by
the firm. Say a firm produces 100,000 worth of Widgets but sells only 90,000 worth. If we
Governmentsbuildroads,hiremoreteachersandbuyfighteraircraftfromdomestic
firmsthisissimplyyourtaxmoneybuyinggoodsandservices;government
spending.Sinceitisfareasiertoaccountforthemarketpriceofajetfighterthan
100,000schoolhours,manyservicesareestimatedatthecostofprovisionratherthan
marketprices.
IfanIrishcompanysells1millionworthofknitwearbutdomesticexpenditurefor
thisgoodisonly900,000,thentherewouldbeadiscrepancybetweenthevalueof
expenditureandoutput,i.e.EO.Thisexplainswhyexportexpenditure
foreignersspendingonIrishgoodsisadded,sinceweareestimatingthetotal
expenditureongoodsproducedinthecountry.
Inadherencewiththis,anyexpenditurebyIrishonnondomesticgoodsmustbe
deducted.Thisimportexpendituredoesnotrepresentanydomesticoutputand
representsaflowofmoneyoutofthesystem.Oftenoneseesthetermnetexports
used,whichistheproductofexportrevenueminusimportexpenditure.
WenowarriveatGDPatmarketprices,whichmustbeadjustedfortwosystematic
inconsistencies;taxesandsubsidies.Sincewearemeasuringexpenditure,mostgoods
willincludeaproportionofindirect(expenditure)taxes,suchasvalueaddedtaxes
(VAT)andexciseduties.Sincethesetaxesdonothaveanycorrespondingoutputthey
mustbesubtracted.Subsidiesskewthefiguresintheoppositemanner,sincethevalue
ofsubsidieslowersthefinalmarketpricebelowtheactualfactorcost.Therefore
subsidiesmustbeaddedon.
After,onceagain,adjustingforstatisticalerrorswearriveatGDPatfactorcost,whichisthe
samevalueasintheincomemethodusedearlier.Thesetwomethodsshowtheflipsidesofthe
coin,asincomeinaneconomymustequalexpenditure,whichinoneofthemostcommon
formulaicexpressionsis;Y=C+I+G+XM.Wenowfinishwiththemethodusedto
calculatethephysicaloutputinmoneyterms.
Inflation
Definition; Deflation
When the average price level, determined by the CPI or the GDP deflator, falls consistently
during a time period, there is deflation, or negative inflation.
Definition; Disinflation
When there is a fall in the rate of inflation, say from 5% to 4%, one speaks of disinflation.
Rory,
baskets!
20 pints of Guinness: 30 20 pints of Guinness: 32 20 pints of Guinness: 33
10 kgs of mutton: 35 10 kgs of mutton: 36 10 kgs of mutton: 39
10 cans of crab pat: 40 10 cans of crab pat: 41 10 cans of crab pat: 42
100 kgs potatoes: 20 100 kgs potatoes: 19 100 kgs potatoes: 18
. . .
. . .
. . .
and 1,000 other and the same 1,000 and the same 1,000
consumer goods goods as before goods as before
__________________ __________________ __________________
Total cost of basket in Dec Total cost of basket in Dec Total cost of basket in Dec
1995 = 200,000 1996 = 203,200 2001 = 238,000
CPI (t0) = 200,000 x 100 CPI (t1) = 203,200 x 100 CPI (t6) = 238,000 x 100
200,000 200,000 200,000
Terms:
Deflation: decrease in the Plev(e.g. negative infl or CPI goes from 123 to 122)
Summary and revision
Inflation is a general and consistent rise in the average price level as measured by the CPI
or the GDP deflator.
Deflation is a general and consistent fall in average prices as measured by the CPI or the
GDP deflator.
Deflation can be benign (caused by an increase in AS whereby the price level falls but GDP
increases) or malign (a decrease in AD causes both deflation and negative growth).
The consumer price index (CPI) is an index which shows the price of a basket of goods at
the base period (year) and over consecutive periods (years). The difference in the CPI is
inflation.
Core inflation is the CPI with highly volatile goods removed these are usually oil/energy
and food/agricultural goods. When the most volatile goods are removed, the index has a
better predictive value for future inflation.
The producer price index (PPI) is a measurement of the change of prices in inputs used by
firms. Raw materials, goods in process and finished wholesale goods are price indexed and
computed. It is posited though highly uncertain in many cases that the PPI will precede
the CPI and thus act as good lead indicator of future inflationary movements.
GDP + property income from abroad property income paid abroad = GNPor
GDPnom
114.7
GDPreal
89,3
58.1
56.9
89.3
52.6 56.9
52.6
Year
1995 1996 2001 1995 1996 2001
Nominal GDP: year 1995 = 52,641 bn 1996 = 58,080 bn; 2001 = 114,744 bn.
Real GDP: year 1995 = 52,641 bn; 1996 = 56,891 bn; 2001 = 89,320 bn
1. Compositionofoutput:PerhapsthemaincriticismofGDPasameasureofwelfareis
thathoweveraccuratethefiguresareforoutput,thefinalGDPfiguredoesnotshow
whatisbeingproducedwerebacktoagunsorbutterproblem.TheSovietUnionof
the1930sputgreateffortintocompetingwiththewestintermsofoutputandgrowthin
ordertoshowthesuperiorityofthecentrallyplannedsystem.Goingbyofficialoutput
figurestheUSSRwontherace,butwhatthefiguresdonotshowisthattheSovietsput
themajorityofresourcesintoproducingcapitalgoodsandneverreallygotaroundto
providingforthewantsandneedsofitscitizensintermsofconsumergoods.Acountry
withdoubledigitgrowthratesandemptyshelvesissomethingofananomalybutquite
possible,whichisalsooftenthecaseintimesofmajorconflictswhenarmaments
accountforeconomicgrowthwhichinnowayrepresentsanincreaseinthestandardof
living.
2. Compositionofexpenditure:Inaveinsimilartotheabove,nationalincomefiguresare
oftenskewedbythesimplefactthatdifferentcountrieswillhavedifferentexpenditure
patterns.ThecoldandicyNordiccountriesspendasizableproportionoftheirincomeon
heatinghomesandofficesbutthisdoesntmeanahigherstandardoflivingthanin
temperateclimate.ComparingFinlandsGDPfigureswithBermudascouldgettricky
indeed.
3. Distributionofincome:Allpercapitanationalincomefiguresareaveragesand
thereforeneglecthowincomeisdistributedamongstcitizens.Thethirdrichestcountry
intheworld,theUSA,hadapercapitaGDPofUSD35,200in2000whilethesecond
richest,Norway,hadUSD37,200.12Yetthehighest10%ofallincomeearnersin
Americaaccountedfor30.5%ofnationalincomeandatthesametimethecountryhad
some30millionpeoplelivingbelowtheofficialpovertyline.13InNorway,ontheother
hand,21.8%ofincomewenttotherichest10%therebyaccountingforonethirdless
thantheUSAsrichestupperdeciles.
4. Unaccountedforactivity:Statisticalinaccuracieswillbeenhancedbythefactthata
portionofeconomicactivitywillbehidden;parallelmarketsforgoodsandlabourare
notableexamplesofatypeofsystematicerrorsincerealoutputisconsistentlyunder
reported.ThelargeelementofbarterandnonmoneyeconomicactivityinLDCswill
leadtoconsistentunderreportingofrealoutputfigures.Moredevelopedcountrieswill
alsohavealargesectionofunreportedactivity,butinthiscaseprimarilyduetotax
avoidanceandevasionoflabourlaws.
Note: large parallel markets can seriously underestimate economic activity. For example,
unreported national income on a global basis amounts to almost 31% of the worlds
GDP.14 The range is from 9% of GDP in the US to over 70% in Bolivia and Georgia.
Indonesia is estimated by the OECD to have a parallel market of close to 80% of all
economic activity. Such figures seriously undermine the validity of national income
accounting figures.
5. Exchangeratesdistortions:SincethecomparisonofdifferentcountriesGDPmustbe
putintosomeformofcommonlanguage,asinglecurrencyisused,oftentheUSD.In
doingthis,themarketexchangeratesfordifferentcurrenciesareusedwiththe
unfortunatesideeffectofgrosslyunderestimatingaverageincomesoflowcostcountries
whenpurchasingpoweristakenintoaccount.Seepurchasingpowerparity(PPP)below.
6. Externalitiesandenvironmentaldamage:GDPfiguresdonotshowsoilerosion,air
pollution,landdegradation,deforestation,depletednaturalreservesofresourcesorthe
oftenmonumentaldisruptionstovaluesandtraditionsasaresultoflargescaleeconomic
growthinarelativelybriefperiodoftime.
Inspiteoftheheavycriticismleviedabove,GDPpercapitaadjustedforpurchasingpower(see
below)isstillthebestsingleindicatorofdevelopmentavailable.Thereisrelativelyclear
positivecorrelationbetweenmoststandardoflivingindicatorsandeconomicgrowththe
problembeingthatitisverydifficulttoseewhichcomesfirst,i.e.thereisacausalityproblem.
12
NationalAccountsofOECDcountries,Mainaggregates,Volume1,updatedversionfrom
2003
13
PovertyintheUnitedStates,USCensusBureau2000,page3
14
Schneider, Buehn, Montenegro, Shadow economies all over the world: New estimates for
162 countries from 1999 to 2007, World Bank Discussion Paper at
http://www.econ.jku.at/members/Schneider/files/publications/LatestResearch2010/ShadEcWorl
d10_2010.pdf
Summary and revision
GDP is accounted for via three methods; the output method (sum of value-added in an
economy); the income method (sum of wages, rents, interest and profits); and the expenditure
method (sum of consumption expenditure, investment, government spending, and net exports).
Domestic means produced within a countrys borders.. and disregards who owns the
factors. National looks instead at who owns the factors regardless of where production
takes place
Real GDP (or GDP at constant base year values) is nominal GDP adjusted for inflation. To
calculate real GDP, divide nominal GDP by the GDP deflator (a broad price index) and then
multiply by 100. (Rory, could you put the formula here please?)
Per capita GDP or GNP is calculated by dividing GDP or GNP by the population.
National income figures are used to compare the overall success of an economy with others
and to provide statistical material for governments to base future decisions on.
Simple demand shows the ability and willingness of consumers to buy a single good. The sum
of total demand, the aggregate, shows the demand for all goods and services in an economy.
Our AS-AD model uses the overall price level instead of price and total output adjusted for
inflation real GDP instead of quantity.
The AD shows the correlation between the overall price level (GDP deflator) and the demand
for consumption, investment, government and net export expenditure.
Shifts in AD
Expectations
inflationexpectationsCAD..or..inflationexpectationsCAD
perceivedwealthS&CADorperceivedwealthS&C
AD
expectedincomeCADorexpectedincomeCAD
Householddebt:During2007theimpendingeconomiccrisisbecameincreasingly
evidenttoeverybodyexceptbanks,financialadvisers,fundmanagers,government
officials,centralbankers,households,journalistshm,OK,maybeitwasntthat
evident.15Inanycase,Americanhouseholdsdebtreachedtheastronomicallevelof
closeto140%ofgrossdisposableincome(incomeaftertax)during2007whilethe
overheatingUSeconomydroveupinterestrates.Theresultwasanaveragehousehold
interestpaymentof12to14%ofdisposableincome.Naturallythishadaseriously
dampeningeffectonhouseholdconsumption;duringthefirstquarterof2008,
consumptionexpenditureinhouseholdsfellby1.0%andatotalof10%overthefull
year.16
15
Possibly the most famous predictor of the impending crisis was Dr Nouriel Roubini (aka Dr
Doom) of New York University who warned about the impending US housing bubble and
economic effects as early as September 2006. See www.economicpredictions.org/who-
predicted-the-financial-crisis.htm
16
See the US BEA at www.bea.gov, Table 2.3.1
Fiscalpolicy:Governmentscanusefiscalpolicese.g.changingvarioustaxratesoraltering
governmentspendingtoinfluenceaggregatedemand.Forexample,anincreaseinincome
taxeslowersthehouseholdsdisposableincomewhichinturnlowersconsumptionand
aggregatedemand.Increasedexpendituretaxes,e.g.VAT,havethesameeffectduetothe
decreaseinrealincome.
TCADorTCAD
Monetarypolicy:ThisisamacropolicytoolinthehandsoftheCentralBank(ornational
bank)andinvolvesadjustinginterestrates(r)orchangingthesupplyofmoney.Tight
monetarypolicy,hereanincreaseininterestrates(r),hasatwofoldeffect;
1)Theopportunitycostofconsumptionrisessincethereismoreinterestforegonebykeeping
moneyinthebank;and
2)Thecostofservicingloans(theinterestpayments)increases.
Thecompoundedeffectofanincreaseininterestrateswillbethatsaving(S)increasesand
borrowingdecreases.Bothleadtoadecreaseininvestment(I)andconsumption(C)theseare
componentsofaggregatedemandintheeconomy.Conversely,loosemonetarypolicyof
loweringinterestrateswillhaveastimulatoryeffectonaggregatedemand.
rS&I&CADorrS&I&CAD
Investment and AD
Profitandrevenueexpectations:Firmsrelyagreatdealonexpectedexpenditureinthe
economyfortheirplannedinvestment.Whenfirmsexpectfutureprofitstorisetheywill
bemorewillingtoinvestinthepresent.Accordingly,newtechnologywhichmightserve
toincreaseproductivityandquicklyregaininvestmentcostswilladdtofirms
willingnesstoinvest.Thiswasoneofthereasonsforthemassiveincreasein
InformationTechnologyspendingintheUSduringthelatterpartofthe1990s.
profitexpectationsIADorprofitexpectationsIAD
Policy expectations: All the main actors on the macro scene will adjust their behaviour when
possible changes in government policies appear on the horizon. For example, the mere rumour
of proposed interest rates hikes can cause a change in expenditure patterns when firms and
households advance investment and consumption in order to avoid higher loan burdens in the
future. An expectation of higher profit and income taxes will induce firms and households to cut
back on expenditure in anticipation of falling net profits and incomes.
Govt spending
GADorGAD
Net exports
Exchangerates:Ifthevalueofthedomesticcurrencyfallsthenimportswillbemore
expensivefordomestichouseholds/firmsjustasexportgoodswillbecomecheaperfor
foreignhouseholds/firms.AssumethattheArgentinepeso(ARS)isatanexchangerate
ofUSD0.23foroneARS(orUSD1=ARS4.33)andthatakgofbeefcosts$US10in
AmericaandARS43.3inArgentina.Thepriceintermsoftheexchangerateisthe
sameinbothcountries;ARS43.34/4.33=$US10.
NowpositthattheArgentineanpesodepreciates(falls)toARS1=$US0.20(e.g.thattheUSD
appreciatesto$US1=ARS5.00):
o The Americans experience that Argentinean beef has fallen in price and now
need only $US 8.67 (ARS 43.34 x 0.20) to buy the 43.3 pesos necessary to
buy a kg of Argentinean beef that still costs ARS43.3 since we are assuming
ceteris paribus.
o The Argentines, conversely, will see how the price of American beef has risen
to ARS 50.0 per kg. Ceteris paribus, one can expect Argentinas exports of
beef to increase and the imports of American beef to decrease. Both variables
are forces in increasing aggregate demand. (Note that this is a shift in
aggregate demand not a movement along! It is the price of the foreign
currency that has changed not the domestic price levels.)
exchangerateX&MADorexchangerateX&M
AD
tradepartnersYXADortradepartnersYXAD
tradepartnerspricelevelX&MADortradepartnersprice
levelX&MAD
Summary and revision (need a cool pic here.maybe a pic of someone doing push-
ups!)
Any change in the economy affecting one of these components will shift the AD curve.
Export revenue and import expenditure is affected by exchange rates, trade partners
income, trade barriers, relative prices and relative inflation.
Price
level SRAS will shift primarily due to
changes in the price of factors
SRAS and legislation on taxes and
2 SRAS labour.
P2
0
SRAS
P0
1
P1
AD0
Y2 Y0 Y1 GDPreal/t
Summary and revision (need a cool pic here.maybe a pic of someone doing push-
ups!)
Aggregate supply is the planned output of goods and services in an economy during a
period of time. The short run aggregate supply curve is shows positive correlation between
the price level and planned output.
A key assumption of the SRAS curve is that factor prices and factor availability are
considered constant. Any change in these variables will shift the SRAS curve.
Shifts in short run aggregate supply are primarily caused by the price, availability,
efficiency and quantity of factors of production. Short run aggregate supply shifts due to:
changes in factor prices (wages, raw material, capital)
changes in factor efficiency (new technology, production methods)
taxation (profit taxes, labour taxes, environmental taxes)
government regulations (overtime regulation, subsidies)
external shocks (natural disasters, weather)
SRAS
SRAS
(new-
P0 P0 classical)
AD AD
AD
Y0 L e n g t h o f
Deflationary A
c y c l e E
gap
Time
t0 t1 t2 t3 t4
Inflationary
gap
Keynessview:
Marketsareinherently(=essentially)unstableanddonotnecessarilyclear.Itisquite
possibleforlabourmarketstorenderhighlevelsofunemploymenteveninthelong
run.Keynesharshlycriticisednewclassicalthinkingforfallacyofcomposition;
simplybecauseindividualmarketsmightcleardoesnotmeanthatthisholdstruefor
theaggregate.Loweringwagesmightwellincreasethedemandforandamountof
labourersinoneindustrybutnotinallindustries.
Wagesaredownwardsticky,i.e.labourers/unionsaremostunwillingtoacceptcuts
inwagerates.Thisaddstolabourmarketdisequilibriumbykeepingwagesabove
marketclearinglevel.Realwagessimplydonotfallenoughtocompletelyclearthe
marketandrestorefullemployment.(ReviseminimumpriceinSection2.1.)
Sincelabourmarketsareimperfect,noninterventionistpoliciesdonothelp
unemploymentandinfactmayservetokeepunemploymentrateshighoverlong
periodsoftime.
ThetraditionalKeynesianaggregatesupplycurve,AS,showsthreepossiblerangesofoutput:
Horizontalportion:Thedepressionrangeofmassunemployment(uptoY0)follows
thecourseofthepreviousaggregatesupplycurve,whereoutputincreaseswithoutan
increaseinthepricelevel.ThehorizontalportionoftheinvertedLshapedcurve
showsthatincomecanincreasetoY0withoutariseinthepricelevel.Thisisbasedon:
o Keynesspremiseofdownwardstickinessoflabour.Sincelabourers/unions
areunwillingtoacceptlowerwages(thisisthedownwardstickinessof
labourpricespart17)duringaperiodofdemanddeficiencyandresulting
unemployment,asituationofhighunemploymentmaypersistinthelongrun.
o Duetotheabundanceexcesssupplyoflabourandotherfactorsatlow
incomelevels,labourerswillbehighlyreluctanttobidupwagesevenas
outputincreases.ImaginethatoutputincreasesfromanyoutputleveluptoY1
withtheensuingincreaseindemandforlabour.Bothnewlyhiredand
existingworkerswouldnotbeinapositiontobidupwagessincethereare
thousandswaitinginlinefortheirjobs.Thusitispossibletoincreaseoutput
withoutcreatingupwardpressureonwagesandfinalprices,resultingina
horizontalaggregatesupplycurve.
Tradeoffportion:AtY0theeconomyismovingclosertothefullemploymentlevelof
outputandfirmsarerespondingtohigherfinalpricesfortheirgoodsandservices.This
middlerangeportraysthecorrelationbetweenahigherpricelevelandincreasingreal
output(explainedearlier)leadingtheaggregatesupplycurvetobeupwardsloping.
Thisrange,Y0toYFE,illustratestwoimportantpoints.
o Thefirstisthataggregatesupplywillincreaseonlywhenfirmsareableto
enjoyhigherfinalpricesfortheiroutputandthuscoveradditionalcosts
arisingfrombottlenecksinsupply.
o Thisportionhighlightsoneofthemostimportantpolicydebatesin
economics;theapparenttradeoffbetweenunemploymentandinflation.
RecallthatoneofthekeyconclusionsofKeynesiantheoryisthatmarketsare
imperfectandthusgovernmentinterventionisnecessaryinordertocreate
labourmarketclearingandthusfullemployment.Themiddlerangeofthe
aggregatesupplycurveindicatesthatgovernmentswillfaceamacroeconomic
opportunitycostissue;increasedgovernmentspending(whichstimulatesAD)
mightresultinlowerunemploymentatthecostofahigherpricelevel,i.e.
inflation.Thistradeoffbetweeninflationandunemploymentisacentral
subjectofChapter54,thePhillipscurve.
Verticalportion:TheverticalrangeofASatYFEandbeyondisthesameasthe
physicallimitillustratedearlier(Figure3.3.2SRAS)wherefirmssimplycannot
increaseoutputwhatevertheincentivesoffinalprices.Thecompletepriceinelasticity
ofsupplybeyondpointYFEillustratestheeffectofevermorescarcefactorsof
productionandthusincreasingoutputconstraints.Thisisthefullemploymentlevelof
output,YFE.Firmswillnotbeabletohireadditionallabourandnoincreaseinoutput
ispossible;theaggregatesupplycurveisvertical.Anyincreaseinaggregatedemand
willbepurelyinflationary.
F Keynesianaggregatesupply
17
Ioftenexplaindownwardstickybyreferringtogoodandbadwines.Itseasytogetusedto
goodwinesandmostdifficulttomovebackdownonthequalitylistonceoneisusedtothe
goodstuff.Acquiredtasteisthusdownwardsticky.
Price level
(index) AS Beyond YFE firms are unable to
increase output no matter what the
P2 price level is the AS curve becomes
vertical.
P1
P0
GDPreal/t
Y0 YFE
Depression and mass When the economy nears the full employment level of output,
unemployment at low YFE, higher costs will induce firms to raise prices the AS
levels of income. As curve slopes upwards. (For full explanation, see the Phillips
labour will have difficulties Curve, Chapter 54.)
in bidding up wages and
firms will have excess
(unused) capacity, costs
in firms do not rise when
output increases.
Price level
(index)
AS At the full employment level of
output, any increase in aggregate
demand is purely inflationary.
P3
AD3
P2
At low levels of income it is possible
AD2 for aggregate demand to increase
P1 without causing inflationary pressure.
AD0 AD1
Y0 Y1 GDPreal/t
YFE
Monetarist view of AS
1. The starting point for the monetarist school was that People are not fooled by
having more money. In other words, as income increases when moving along
the short run aggregate supply curve people would realise that the higher price
level would hollow out their unchanged wages. Labourers in the
monetarist/new classical view thus do not suffer from money illusion but are
well aware of the negative effects of a higher price level on real wages.
2. This view (new-classical from now on) therefore strongly disagreed with the
Keynesian assumption that wage rates would remain unchanged in the long run.
Wages are market-based and therefore highly flexible - workers inflationary
expectations (see Section 3.5) would force them to use their bargaining power
to bid up wages when the price level increased in order to retain their purchasing
power.
3. Since higher wages eat up the distance between the final price firms get for
their goods and the costs of producing them, the short run aggregate supply
curve will shift to the left when wage levels in the economy are bid up. (This is
no different from saying that an increase in factor prices decreases supply, i.e.
aggregate supply.) Thus there will be a separate short run aggregate supply
curve for every wage and factor price rate.
SRAS
When the economy is operating below
P
potential output, there will be
additional unemployment. In the long
run, factor prices will adjust, real wages
will fall, and both factor and goods
AD markets will clear. The economy will
again be operating at long run (general)
equilibrium, YFE.
YFE GDPreal/t
BtoC:TheshortruneffectisaninflationarygapatpointB.Inlinewithderiveddemand
effectsonfactors,thiswillresultineverscarcerfactorsofproductione.g.capital,raw
materialandlabourandtheincreaseinthepricelevelfromP0toP1willleadtoahollowing
outofwagesforworkers.Factorpriceswillultimatelybeforcedupwardsasfirmsbidon
availablefactorsandworkerswilldemandhigherwagestomakeupforlostrealpurchasing
power;shortrunaggregatesupplywilldecreaseinthelongrun,shownbytheshiftfromSRAS0
toSRAS1.Theeconomyhasreturnedtothefullemploymentlevelofoutput,YFE,butata
higherpricelevel,P2.ThisispointCinthediagram.
TheABCseriesinfigure46.5onceagainshowstheimportanceofthelongrunaggregate
supplyinthenewclassicalASADmodel.Anypointofshortrunequilibriumbeloworabove
thelongrunpotentialshownbytheLRAScurveinthemodelwillultimatelybecorrected
asfactormarketsclear.
AfallinADpointCtoDtoA:Ibrieflyillustratethenewclassicalviewofthelongrunby
assumingthattheeconomyisinitiallyinequilibriumatpointC,andthataggregatedemand
insteadhasdecreased,shiftingaggregatedemandfromAD1toAD0movingtheeconomyto
pointDandaresultingdeflationarygap.Asfirmslowerpricesinaccordancewithfalling
demand,thegapbetween(falling)finaloutputpricesandwagepricesnarrows,thisinfact
meanshigherrelativelabourpricesforfirms.Firmsrespondbydemandinglesslabourandas
thelabourmarketresponds,labourpricesfallwhichenablesfirmstoincreaseoutputand
increaseshortrunaggregatesupply.ThisincreasestheshortrunaggregatesupplyfromSRAS1
toSRAS0bringingtheeconomybacktogenerallongrunequilibriumatpointA.
Figure51.2Equilibriuminthelabourmarket
a: Supply and demand for labour b: Full employment on labour market
PL (real PL (real
wage rate) wage rate)
ASL TLF
ASL TLF
U0 U1 U2 NRU
W* W*
ADL ADL
FE U* QL/t FE U* QL/t
Equilibrium
unemployment
There will always be a degree of unemployment even when the labour market has
cleared. Equilibrium unemployment is therefore the same as the natural rate of
unemployment (NRU) shown as the difference between FEU*.
Heresaclue;cyclical/demanddeficientunemploymentisalsoknownasKeynesian
unemployment!RecallthatKeynesianeconomicsviewsmarketsasimperfectlyfunctioningin
general,andthatlabourmarketsspecificallysufferfromdownwardstickiness.Theconceptof
cyclicalunemployment,inaccordancewithKeynesianassumptions,meansthatrealwageswill
notfallintheshortrunandthemarketwillbeindisequilibrium.Inotherwords,sincelabourers
willbehighlyunlikelytoacceptlowerwages(andfirmswillalsobereluctanttolowerthem)
therealwageratewillremainatW*andcreateanexcesssupplyoflabouratthegoingwage
rate.Whilethelabourmarketmightultimatelyclear,theproportionofpeoplenotaccepting
jobsatlowerratesmightlastforsometime,withunemploymentratesabovethemarket
clearinglevelofW1.Keynesianeconomicslooksuponmarketsasinherently
unstable/imperfectwhichexplainsthepropensitytowardsgovernmentintervention.
Figure51.3Disequilibriumunemploymentcyclicalordemanddeficientunemployment
I: Aggregate supply and II: with the total labour
demand for labour force
Cyclical
addition to
PL (real PL (real
unemployment
wage ASL wage
ASL TLF
rate) rate)
NRU
W* W* Natural rate
of
W1 W1 unemployme
ADL0 ADL nt0
ADL1
QL/t ADL
U0 U1 FE U0 U1 FE U*1 QL/t
Accordingtonewclassicalviews,whentherealwagerateisabovemarketequilibriumwage,
W*infigure51.6,therewillbemorelabourerswillingtoacceptjobsthanthereisdemand
fromfirms.Morelabourersarewillingtoacceptajob(e.g.thereisamovementalongtheASL
curve)atW0butthereislessdemandfromfirms,shownbythequantitydemandedforlabourat
U0.Thereisnowmorelabourwillingtotakejobsthanthereareoffersofjobs.Accordingtothe
newclassicalview,disequilibriumunemployment(e.g.unemploymentabovethenaturalrate)
existsbecauselabourmarketforceshavenotbeenabletoclearthemarketbyloweringthereal
wageratesufficiently.ThewagerateofW0isabovethemarketclearingrateofW*,creating
realwageunemploymentofU0U2.TotalunemploymentisthusU0U1,abovewhatwouldbe
thelevelofunemploymentifthelabourmarketclearedatawagerateofW*thenaturalrate
ofunemploymentofFEU*.
Howistherealwageratesetatabovemarketclearinglevel(W*infigure51.6)andwhycanit
remainthere?Thenewclassicalviewgivesthreemainreasons:
1. Onemainreasonisthatthegovernmentmighthaveinstigatedminimumwage
legislationwhichsetsthepriceoflabourhigherthanthelabourmarketwould.
2. Anothercommonargumentisthatsocialwelfarestatesmighthave
social/unemploymentbenefitswhichwoulddecreasethepropensityofpeopleinthe
labourforcetoacceptwagesbelowacertainrate.Highunemploymentbenefitsmean
thattheopportunitycostofremainingunemployedisrelativelylowlabourerslack
incentivestotakejobsatthegoingrealwagerate.
3. Tradeunionpowermightservethesamepurpose;bysuccessfulbargainingofwages,
wagesarebidupaboveequilibriumlevel.(Notethattheconceptofdownwardsticky
wagesisrelevantheretoo.)
Allinall,thesethreefactorsareconsideredtobuildinmarketimperfectionsandhinderthe
labourmarketfromclearing.Theresultofthesestructuralimpediments(=hindrances)isa
higherlevelofunemploymentthanthefullemploymentlevel.
Figure51.6Disequilibriumunemploymentrealwageunemployment
PL (real
wage rate)
ASL TLF
W0
NR
W*
U
AD
L
U0 FE U2 QL/
U* U1 t
Figures 3.4.2 I, II and II; Demand management, business cycle and aggregate demand
Peak
Potential real GDP
Trough
t0 Time
t1
II: Contractionary policies III: Expansionary policies
and
Price AD
level and level
Price AD
LRAS LRAS
AD1
AD0 SRAS
SRAS
P0
P1
P1
P0
AD0
AD1
YFE Y1 Y0 GDPreal/t Y0 Y1 YFE GDPreal/t
Marcia: I cant shade the blue in AD1,Y1 and P1 or the dotted lines its
either one blue or another. Can you?
1. Labour:Supplysideeconomicsinlabourmarketscentreonincreasinglabourmobility
bothintermsofgeographylocation,industryandtimebetweenjobsbyincreasing
theincentivesoffirmstohireandlabourerstoacceptjobs.Thebasicidealistoincrease
thesupplyandoverallqualityoflabourwhilecreatingmechanismsforwellfunctioning
labourmarkets.Thefollowingpointsareoftenputforward:
Changelabourlawsandmakeiteasierforfirmstohireandfire,reducingsearchcosts
andrisksforfirmswhiledecreasingbetweenjobtimeforlabourers.
Educationandretrainingschemeswillincreasethequalityoflaboure.g.labour
capitalandincreasethespeedbywhichredundantlabourcanbereallocated.Such
schemescanbeencouragedbygivingtaxbreakstofirmswhichimplementthem.
Reducing/abolishingregionalsupportschemesinordertohighlightdifferencesin
regionalunemploymentlevelsandthusencouragepeopletomovetonewjobsinother
regions.
Cuttingbackonsocialwelfare/unemploymentbenefitsinordertoencouragepeopleto
acceptjobsbyincreasingtheopportunitycostsofunemployment.
Reducingunionpowersay,bymakingsympathystrikesillegalandmaking
collectivebargainingharderinordertoreducewagestickiness.
Abolishminimumwagestoallowmarketforcestosetwages.
Decreasemarginaltaxratesonincomeasanincentiveforlabourerstoworkmore;and
decreaselabourtaxesinordertodecreaselabourcostsforfirms.
2. Capital:Byincreasingboththequalityandquantityofcapital,supplysideeconomics
aimstoincreasethelongrunaggregatesupply:
Taxbreaks/deductionstofirmsfor(re)investmentwillstimulateinvestment
expenditure.
Lowertaxesondividends(ashareofcompanyprofitspaidtoshareholders)can
increaseinvestmentfundingforfirmssincemorepeoplewillbewillingtobuyshares.
Lowerprofit(corporate)taxesencouragefurtherinvestmentbyfirms.
3. Competition:Finally,supplysideeconomistspointtotheimportanceofcompetitionin
aneconomyasanoverridingelementinincreasinglongrunaggregatesupply:
Privatisationofgovernmentrunbusinessesandderegulationofmarketsarestaple
supplysidemeasuresinincreasingcompetitiveforcesinaneconomy.
Deregulation.
GrantsubsidiesortaxreductionsforfirmsfundingR&Dcentres.
Encourageentrepreneurshipbygrantingtaxholidaysandcreatingbeneficialfunding
schemesforstartups,e.g.newfirms.
Tradeliberalisationreducingtariffs(=importtariffs)andotherbarrierstofreetrade
andfreecapitalflows(easierforeigninvestment)arepoliciesoftenputforwardby
supplysiders.
Themainthemeinsupplypoliciesisthatmarketforcesarefarbetteratcreatingoutputinthe
longrunthangovernmentinterventionintheformofdemandmanagement.Sustainablelong
runincreasesinGDPcanonlybeincreased,accordingtothisneoclassicallyorientatedview,
byincreasinglongrunaggregatesupply.Allowingfirmstomakeaprofitundercompetitive
forcesandcreatingconditionsforfactormarketstoclearwillshiftthelongrunaggregate
supplycurveandthereforedecreasethenaturalrateofunemployment.
Macrogoals:Byadjustingmonetaryandfiscalpolicies,itispossibletoinfluencethe
levelofeconomicactivityandthereforeoutput,unemployment,inflationandthetrade
balance.Inotherwords,demandmanagementgivespoliticianstoolstoachievethe
macroeconomicgoalsofsociety.
Stability:Builtinfiscalstabilisersautomaticstabilisershelpevenouttheeconomic
cyclesandcreatestabilityandpredictabilityintheeconomy,whileeveningoutsome
oftheexcesses/surplusesinproductivecapacityovertime.
Governmentgoals:Discretionaryfiscalpoliciesinturnallowgovernmentstosteerthe
economyinlinewithbothconsensusviewsofeconomicgoalsandideological
underpinningsandidealsofsocial/economicwelfare.Fullemploymentincreases
livingstandardswhiletaxrates,unemploymentbenefitsandgovernmentspendingall
helpinimprovingsocialwelfaresystemsandredistributingincomesintheeconomy.
NotethattheconceptssuchasfairnessandequalityareNOTentirelynormative.
Thereareinfactagoodmanysoundeconomicargumentsunderliningsocial
redistributionbywayoftaxesandtransferpayments,inthatagreatmanyeconomic
andsocialcostsshowstrongpositivecorrelationtoincreasedinequalityofincomeand
wealth;crime,alcoholismanddrugabusearenotableexamples.Thisisasubjectof
Section3.6.
TheKeynesianmultiplier:Keynesianeconomicsalsostressestheelementofself
perpetuationisstimulatingaggregatedemandviafiscalpolicyduringrecessionary
periods;themultipliereffect(HL,seebelow).TheeffectisbuiltintotheKeynesian
modelandshowshowthenetfinaleffectofincreasedgovernmentspendingorlower
taxesisincreasedoversuccessiveroundsintheeconomy.Forexample,if
governmentspendingincreasesby10billionsaytobuildroadsandother
infrastructurethenjobswillbecreatedandunemploymentwillfall.Itdoesntstop
there;manyofthosewhohavebeenunemployedforsometimewillhavepentup
consumptiondemands,sotheywillspendmostoftheirwages.Thisspendingwillin
turncreatemoredemand,whichcreatesmorejobs,whichlowersunemployment
etc.Thus,accordingtoKeynesians,amajorbenefitofdemandsideeconomicsisthat
thereisaleverageeffectofusingfiscalstimulation,sincethefinalincreasein
nationalincomeisgreaterthaninitialbudgetcosts;Yfinal>Ginitial(orYfinal>
Tinitial).Theincreaseinnationalincomewillultimatelypadgovernmenttaxcoffers
andhelptomakeupforpossibledeficitspendingdoneinthefirstplace.
Inflationrosetohithertounseenlevelsandbudgetdeficitsgrewsincegovernment
spendingduringrecessionaryperiodswasevermoreseldommadeupforduring
booms.
Thisincreasedgovernmentindebtednessledtomostdebilitatingexchangerate
problems(seeSection4.6).Increasinglyopeneconomiesmeantthatgovernment
spendingand/orlowertaxeswouldnothavethesamemultiplicativeeffectonthe
domesticeconomy,asanincreasedproportionofdisposableincomegainsflowedout
ofthecountrytobuyimports.
Thesemainweaknessesinusingdemandmanagementtocontroltheeconomyaregivenbelow
underthreeheadings;
1. Tradeoffproblems;
2. Timelagsandexacerbationofthecycle;and
3. Neoclassicaleconomistscritiqueofdemandmanagement.
Fivepossiblemacroeconomictradeoffsemergefromthediscussionabove:
A. Growthpricestability
B. Unemploymentpricestability
C. Unemploymentbalancedbudget
D. Growthtradebalance
E. Domesticmonetarypolicy(interestrate)freedomstable(orfixed)exchange
rate
Finally,afewwordsonthealluringanderroneousconclusionthateconomistsofdemand
sidecutareagainstallformsofsupplysidepolicies.Infact,oneoftheareasofconsensusin
economicpolicytodayisthatsupplysidepoliciesindeedincreaselongrunaggregatesupply.
However,itisinthechoiceofsupplysidepoliciesthatdisagreementisstilltobefound.Neo
classicaleconomistsfavourpoliciesbasedonfreemarketsandincentives,suchaslowertaxes
andprivatisation.Keynesianeconomistsprefersupplysidepoliciesofinterventionisttype,
suchasgovernmentfundingofworkerrecruitment/educationandretrainingcentres.
Costpushinflation
19
Nobel Laureate in economics, 2008
20
1993articlebyKrugman,publishedat;
http://www.pkarchive.org/economy/ConservativeMirage.html
I: Supply-side shock II: Cost-push III: Cost-push
Price inflation
Price spiral
Price LRAS
level LRAS level LRAS SRAS level SRAS4
2 H
D
P3 P7 G SRAS3
SRAS1 SRAS1 P6
P2 F SRAS2
SRAS0 SRAS0 P
B C 5
P1 P1 P4 E
B P3 AD3
P0 A P0 A
D AD2
AD1
AD0 AD0 AD1
Y1 YFE GDPreal/ YFE GDPreal/ YFE GDPreal/
t t t
Govt.
M S T Total increase in Y:
Round 1: 50 bn.
Round 1: 50 bn.
Round 2 + 30 bn.
C = 30 bn Round 2: 30bn. = 80 bn.
Households Firms
Round 3 + 18 bn.
C = 18 bn Round 3: 18bn. = 98 bn.
Round n + ? .
C...n Round n.. ?
Final increase = ?
Round 3: 18 bn.
interest
Thisproportionofincreasedconsumptionintheexampleis0.6(i.e.60%ofanyincreasein
householdincomegoestoconsumption),whichisthemarginalpropensitytoconsume.Inthe
firstroundinfigure47.1,theincreasein(Y)of50billioningovernmentspendingresultedin
anincreaseinconsumption(C)of30billion.
C 30 billion
MPC= ---
Y---- = --50
---------billion
------------ = 0.6
S M T
MPS= -Y
------- MPM= --Y
------ MPT= -Y
------
Letusassumethatoutofthe50billionincreaseinincome,householdssave2.5billion(5%
or0.05),use7.5billion(15%or0.15)forimportsandhavetopay10billionintax(20%).
2.5 7.5 10
MPS = -50
--------- MPM = --50 ------- MPT = 50
---------
MPL = 0.05+ 0.15+ 0.2 MPL = 0.4
MPL = S + M + T 20 billion= 0.4
----------------Y
--------------------- -50
-----------
----------
billion
21
YoudontneedtobeWernervonBrauntorealisethatthesumofthemarginalpropensityto
consumeandthemarginalpropensitytoleakmustalwaysequalone.Thismakesperfectsense,
sinceanyincreaseinhouseholdincomewilleitherbeusedfordomesticconsumptionor
savings/taxes/imports.Thus;MPC+MPL=1,and1MPC=MPL.
Section 3 trade
Why trade?
1. Factor endowment Nicaragua has weatherSweden has forests
2. Increase in div of labourspecialisationeff
3. Variety and choice
4. Peace dividend
5. EOS
6. Transfer of knowledge and technology
7. Consuming outside PPF theory of comp adv CPF arises!
THEORY OF COMPARATIVE ADVANTAGE
If Mexico has a lower opportunity cost (in terms of foregone production of agricultural goods)
in the production of 1 unit of textiles, then Mexico has a comparative advantage in the
production of textiles.
4 PPF D
3.2
PPF
2
C
P1 Sworld P1 Sworld
D D D
Q0 Q QS1 Q0 QD1 Q QS1 QS2 QD QD1 Q
2
(tonnes (tonnes (tonnes /
/year) Imports /year) Imports year)
A+B+C+D; loss of
consumer surplus (HL)
P
Sdomestic A A; gain of domestic
(/kg) supplier surplus (HL)
B; efficiency loss I =
B Green loss to society
F; remaining revenue
of foreign suppliers
(200,000)
QUOTAS
Wenowturntootherformsoftradebarriers,i.e.nontariffbarriers.Acommonmethodto
protectthedomesticeconomyisbysettingactualquantitativelimitsontheamountofimports,
aquota.
A+B+C+D; loss of
consumer surplus (HL)
P
Sdomestic A A; gain of domestic
(/kg) supplier surplus (HL)
B; efficiency loss I =
B Green loss to society
F; part of original
revenue of foreign
suppliers (200,000)
SUBSIDIES
Anyactionbygovernmentwhichlowerstheratioofdomesticpricestoimportprices(inother
wordsraisestherelativepriceofimportsorlowerstherelativepriceofdomesticgoods)will
serveasabarriertotrade.Therefore,whendomesticproducersreceivedirectpaymentsfor
productionorindirectproductionincentivessuchastaxbreaksorlowinterestloans,theeffect
isthatofasubsidy.Asubsidylowerstheproductioncosts(HL:marginalcosts)fordomestic
producersandenablesthemtobemorecompetitivewithforeignproducers.
F TheeffectsofasubsidyoncottonTshirts
Total cost of subsidy to
government; $600,000 ($2
x 300,000) per year (HL)
P ($/shirt)
Sdo S+subsidy
m
12 Subsidy/uni
t = $2 (HL)
10 Sworld
D
200 300 400 Q/t (1,000s
shirts/year
Decrease in )
Imports after
imports subsidy
ThesupplycurveforEUROsisupwardsloping(diagramIinfigure4.6.2)sinceahigherprice
fortheEUROceterisparibuswouldenableEuropeancitizenstobuymoreAmericangoods,
andindoingsomoreEUROswouldbeavailableontheUSmarket.Thedemandcurveis
downwardslopingtoindicatethatAmericanswillbuymoreEUROswhentheygetmore
EUROsandthusgoodsfortheirUSdollars.
F IandII;TheexchangeratesfortheEUROandtheUSdollar
P of in USD P USD in
Initial S$0
S equilibrium:
1 = 1.28 USD S$1
1.30 and thus
0.78
1USD = 0.78
1.28 0.77
New
D1 equilibrium:
D0 1 = 1.30 USD D$
and thus
Q Q 1USD = 0.77
Q Q
Q Q$ (millions/day)
0 1 0 1
(millions/day)
DiagramIinfigure4.6.2aboveshowshowaninitialequilibriumintheexchangerateforthe
EUROissetatUSD1.28.ThisgivesanexchangeratefortheUSdollarof0.82,shownin
diagramII.SaythatthereisincreasedAmericandemandforEuropeangoodsoranincreasein
AmericantouriststoEurope:
EURO:thedemandforEUROswillincreasefromD0toD1indiagramI,andthe
exchangerateforEUROswillrise(appreciateseefurtheron)fromUSD1.28to
USD1.30.
USD:AsmoredollarswouldflowintoforeignexchangeofficestobuytheEURO,the
supplyofUSdollarswouldincrease.ThisisshownindiagramII,wherethesupplyof
USdollarsincreasesfromS0toS$1,andtheexchangeratefortheUSdollarfalls
(depreciates)from0.78to0.77.ThenewexchangeratefortheUSDisnaturallythe
inverseofthepriceoftheEURO(1/1.30).
PleasenotethatIusetwodiagramssimplytoillustratethepriceofoneintermsoftheother,
andtheshiftsindemandandsupplyforacurrencyintwomarketstheEUROmarketandthe
USdollarmarket.Intheremainderofthischapter,Iwillillustrateusingonecurrencyatatime.
P of $US P of $US
(TWI) (TWI)
SUSD2
SUSD SUSD0
104 SUSD1
104
100
100
96
96 DUSD1
DUSD0
DUSD2 DUSD
Q2 Q0 Q1 Q$ (millions/day) Q Q Q Q$ (millions/day)
2 0 1
Increase in demand for the US dollar: Increase in supply of the US dollar:
US exports of goods/services US imports of goods/services
in foreign investment in US in US foreign investment abroad
in US interest rates in foreign interest rates
in US inflation rate in foreign inflation rate
speculative buying of US dollar speculative selling of US dollar
US central bank buys dollars (= decrease US central bank sells dollars (= increase
in foreign reserves) in foreign reserves)
Inordertomaintainthefixedexchangerate,theBankofEnglandwouldusetheforeign
reservestobuyandsellthepoundonadaytodaybasis:
Keepingthepounddown:DiagramIshowshowthelongrungoalofanexchangerate
ofUSD2.8tothepoundiskeptatpointA,atS0andD0.Thepoundwasallowedto
fluctuatewithinanarrowbandof2UScentsupordownwhichthepoundhadto
remainwithin.Anincreaseddemandforthepound,D0,whichthreatenedtoputthe
exchangerateabovetheceiling,USD2.84atpointC,wouldbemetbyintervention
sellingofthepoundbytheBankofEngland.22Thiswouldincreasethesupplyof
poundsontheforeignexchangemarket,S0toS1,andbringtheexchangerateforthe
poundbackdownwithintheupperlimitofthebandatpointDUSD2.82perpound.
Keepingthepoundup:Inthesameway,whentheexchangerateforthepoundfell
belowthelowerlimit,saytopointCatUSD2.76perpound,S2andD0in
diagramII,theBankofEnglandwouldinterveneandbuypoundsusingforeign
currencies(e.g.USdollars)fromtheforeignreserves.Thisincreasedthedemandfor
thepound,D0toD1bringingtheexchangeratebackuptothelowerlimitof
USD2.78perpoundatpointD.Inessence,theEnglishcentralbankusedUSdollars
tobuybackitsowncurrency.23
F FixedexchangeratetheBrettonWoodssystem
22
Ineffect,theBankofEnglandbuysupUSdollarswiththepound.
23
Perhapsthishelpsclarifytheconfusingissueofhowaminusvalueintheforeignreservesin
capitalaccount(Section4.5)meansthatinfacttheforeignreserveshaveincreased.When
theBankofEnglandbuysforeigncurrency,poundsflowoutofEngland(minusvalueinthe
capitalaccount)andnowtheBankofEnglandhasincreaseditsholdingofforeigncurrencies.
I: Keeping the pound down II: Keeping the pound up
P of in USD
D2 Outside the band!
D1 When the exchange rate falls below
S2 2.78 the Bank of England will have
D0 C S0 to buy up Q1Q3 pounds (D0
2.84
B shifts right to D1) on the foreign
2.82
D Ceiling
exchange market to keep the pound
A P of in within the band.
2.80 LR target $US
2.78 Floor
D0 S0 S1 S2
Q 2.82 D1 Ceiling
Q0 Q1 Q2 Q3
(millions A
/day) 2.80 LR target
When the exchange rate rises
above 2.82 the Bank of England 2.78 D Floor
will have to sell Q1Q3 pounds (S0 B
2.76
shifts right to S1) on the foreign C
exchange market to keep the pound Q (millions
within the band. Q0 Q
1
Q2 Q3 /day)
Outside the band!
Negativeeffectsofovervaluedcurrency:
Thecurrentaccountinthebalanceofpaymentscanbeadverselyaffectedifthestrong
currencyleadstoincreasedimportexpenditureand/ordecreasedexportrevenue.There
hasbeenclearcorrelationbetweenastrongerdollarandtheUScurrentaccountdeficit.
Astronglyexportorientatedcountry,forexampleChina,wouldfeartheeffectsofa
higherexchangerateongrowthandunemployment.Theofficialfiguresshowthat
exportsaccountfor37%ofGDPandonecanwellimaginetheeffectsondomestic
growthandunemploymentduetoastrongcurrency.24
Domesticfirmswhichhavelargeforeigninvestmentswillseethatprofitsdeclinewhen
theyarerepatriated.
Negativeeffectsofundervaluedcurrency:
Anundervaluedcurrencywillhavethefollowingeffects:Importersandfirmsreliant
onimportedfactorsofproductionwillseecostsrise;householdswillcutbackon
importedgoodsandforeigntravel;andgovernmentswithahighproportionofforeign
debtwillseehowdebtservicingbecomesdearer.
Acountrywithaloworundervaluedexchangeratewillinalllikelihood
experienceinflation.Therearetwocontributingcauses:
o Astrongexportingnationwillexperiencerisingaggregatedemandand
demandpullinflation.
o Anationwithahighvolumeof(HL:relativelypriceinelastic)imported
factorsofproductionwillseeincreasedexpenditureonimportedfactors.This
willdecreaseaggregatesupplyandthuscontributetocostpushinflation.
24
The official figure of 37% of GDP should be taken with scepticism. There are some serious
studies showing that the official figures are seriously inflated and the real value lies closer to
10%. See for example
Basic answer: Due to charsof PCM.of no BTEand perf kn/infoand
homog good, any abn profit will attract new firms (mkt entry) leading to an
increase in S lower mkt price and since the PCM firm is a P-taker, the fall in
price results in a LR situation where AR = AC.
Def; PCM and abn , 2p
Assumptions of PCM, 2p
Diagr showing mkt and firm, clear that MC = MR in both t0 and t1, 3p
Expl of how perf kn/info and low/no BTE cause mkt entry when firms
see abn , 2p
Clearly linking to points in diags (e.g. profitmax and profit) in SR and
LR, 2p
Basic answer: Having one firm (mon)is usually considered less desirable
because of higher prices and lower Q consumed, which CSand leads to a
DW loss and sub-opt all/prod eff yet; there are situations such as nat mons
and large EoS where society gains from mon.
Def/assume; monone firmunique goodhigh BTEimperf
kn/infopossible LR , 2p
Diag series showing DW lossetc, 3p PLUS expl of issues herein e.g.
profit LReffDW loss mon is indeed less desireable!, 3p
Eval, up to 5p each (expl plus diags):
o Eos
o Nat mon
o AC-pricing in public utilities
o Existence of high neg exts