Comparative and Absolute Advantage

Absolute Advantage 

• Who can produce more with the same resources
• Who can produce most output with less resources
• Example: Produce 100 computers vs 20 computers (Abs Advantage: 100)

Comparative Advantage 

• Who can produce with the lowest opportunity cost

Productivity

Output

Examples:

• Ton/Acre
• Miles/Gal
• Word/Min
• Apples/Tree
• Computers Produced/Hour

Input

Examples:

• Number of Hours to do a job
• Number of Gallons of Paint to Paint a house
• Number of Acres to feed a horse

Foreign Exchange Market

Foreign Exchange Market: 

• Buying and selling of currency

Appreciation: 

• "Strong dollar"
• the dollar buys more currency and results in less expensive imports and more expensive exports
• Lead to a trade deficit, imports will increase because they are cheaper

Depreciation: 

• "Weak dollar"
• The dollar buys less of another currency and results in more expensive imports and less expensive exports
• Leads to a trade surplus, cheap exports and currency is weak

Balance of Trade

Current Account:

• Balance of trade/Net exports = (Exports-Imports)
• Exports= Credit/Asset
• Import= Debit/Liability

Net Foreign Import/Net Investment

• Income earned by the U.S owned foreign assets and Income paid to foreign held import assets

Capital/Financial Account

• The balance of capital ownership that includes the purchase of real and financial assets
• Direct Investment in the U.S. is a credit to the capital account 
• Direct Investment by U.S forms/individuals in a foreign country are debits to the capital account 
• Purchase of foreign financial assets represents a debit to the capital account 
• Purchase of domestic financial assets by foreigners represents a credit to the capital account 
• Current and capital account should zero each other out

Official Reserves

• Foreign currency holding of the U.S. balance of payments
• Official reserves should zero out balance of payments

Balance of Trade:
Good Export + Goods Imports

Balance on Goods and Services:
(goods exports + service exports) + (good imports + service imports)

Balance on Current Account:
Net Exports/Balance of Goods and Services + Net Investment + Transfers

Capital Account:
Foreign Purchase of U.S Assets + US Purchase of Foreign Assets

Account Balance:
Current + Capital

Official Reserves - Account Balance = 0

Current accounts: foreign purchase of markets + U.S. purchase of markets

Cost Push and Demand Pull Inflation

Short Run Aggregate Supply:

• Period in which wages and other input prices remains fixed as price level increase or decrease

Long Run Aggregate Supply:

• Period of time in which wages have become fully responsive to change in price level

Effects over short-run:

• In short run, price level changes allow for companies to exceed normal outputs and hire more workers because profits are increase while wages remain constant.
• In the long run, wages will adjust to the price level and previous output levels will adjust accordingly.

Equilibrium in the Extended Model:

• The extended model means the inclusion of both the short run and long run AS curves.
• The long run AS curve is representative with a vertical line.

Demand pull inflation in the AS model

• Demand-pull: prices increase based on the increase in AD
• In Short run, demand pull will drive up prices and increase production.
• In long run, increase in AD will eventually return to previous level. 

Cost Push and the Extended Model

• cost-push arises from factors that will increase per unit cost such as increase in the price of a key resource. 
• Short run shifts left. What is important is that in this case, it is the cause of price level increase, not the effect. 

Dilemma for the Government

• In an effort to fight cost-push. The government can react in two different ways.
• Action such as spending by the government could begin an inflationary spiral.

The Long-Run Phillips Curve

• Natural rate of unemployment is held constant.
• Because the Long Run Phillips curve exists at the natural rate of unemployment (UN) Structural changes in the economy that UN will also cause the Long-Run Phillips Curve to shift.
• Increase in UN will shift Long-Run Phillips Curve right.
• Decrease in UN will shift Long-Run Phillips Curve left.

Short Run Phillips Curve:

• Trade of between inflation and unemployment.

Long Run Phillips Curve:

• NO trade of between inflation and unemployment in the long run.
• Occurs at natural rate of unemployment.
• Represented by vertical line.
• Long Run Phillips Curve will shift if the LRAS shifts.

Natural rate of unemployment is equal to frictional +structural + seasonal unemployment.

Maj LRPC assumption is that more worker benefits create higher natural rates and fewer worker benefits creates lower natural rates.

Supply Shock

• Rapid and significant increase in resource cost, which causes SRAS curve to shift.
• Most likely shift to left and SRPC will shift right.

Misery Index

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

Reaganomics/Supply Side Economics

• Show change in AS not in AD, which determines the level of inflation, unemployment notes and economy growth.

•   Inflation: a general rise in the price level
•   Deflation: A general rise in the price level
•   Disinflation: a decrease in inflation rate over time
•   Stagflation: unemployment and inflation increasing at the same time

Supply side economists:

• Support policies that promote GDP growth by arguing that high marginal tax votes along with the current system of transfer payments: Unemployment compensation welfare programs provide disincentive to work, invest, innovate and undertake entrepreneurial ventures. 

Low marginal tax rates:

• induce more work, thus AS increase.
• also makes leisure more expensive and work more attractive. 

Incentives to save and invest:

1. High marginal tax rates reduce the rewards for saving and investment.
2. Consumption might increase, but investments depend upon saving.
3.  Lower marginal tax rates encourage savings and investing.

Laffer Curve:

• Theoretical relationship between tax rates and government revenue.
• As tax rates increase from (0) tax revenues increase from 0 to some max level and then declines.

Criticism of Laffer Curve:

• Research suggests that the impact of the tax rates on incentives tow work, save, and invest are small.
• Tax cuts increase demand, which can fuel inflation and demand may exceed supply.
• Where the economy is actually located on the curve is difficult to determine.

Money

Uses of Money:

1. Medium of Exchange

• Barter and trade

2. Unit of Account

• Economic worth
• "is this the right value"

3. Store Value

• "is this dollar really a dollar"
• is the money at home that is stores the same value as the one in the bank?
• NO because the money in the bank draws interest 

Types of Money

1. Commodity 

• Item, product, material
• Gold and silver 

2. Representative money

• ex: IOU's
• basically worthless

3. Fiat Money

• It is money because the government says so

Characteristics of Money

1. Durability

• wrinkled but still in same composition
• however if washed, it's faded

2. Portability

• shoes, wallet, ground
• Travels everywhere

3. Divisibility

• Can be broken up in multiple units

4. Uniformity
5. Scarcity
6. Acceptability

• Taken everywhere
• Wherever you go, the rate is the same

Money Supply

M1 Money:

• Cash, coins, currency, traveler's checks (ques), demand or check-able deposits (checks, savings account)
• 75%
• the largest component of M1 money is checking deposits

M2 Money: 

• M1 money + savings account

M3 Money: 

• M2 + Money market accounts + CD's

Money Market Account:

• CD's: Certificate of Deposit = money saved, grows interest
• gives lowest rates because they don't want to give you interest
• Liquidity: easy to convert to cash
• M2 and M3 are easy to convert to cash
• M1 isn't easy because it's checks 

Balance Sheet

• it summarizes the financial position of a bank at a certain time 
• Liabilities = Assets
• ER + RR = DD
• Liabilities = what you owe
• Assets = what you own

Liabilities

• Net worth or Owner's Equity
• DD (demand deposits - checkable deposits)

Assets

• RR (required reserves)
• ER (excess reserves)
• Property
• Securities or Bonds (investments)
• Loans

Fractional Reserves Banking System

• the bank holds a fraction of the deposits back as a reserve in the bank
• that's how they earn money
• vault cash
• loan out your money saved

Money Market

• It is the market where the Fed and the users of money interact thus determining the nominal interest rate.

Money Demand (MD or DM)

• Comes from households, firms, the government, and the foreign sector.

Money Supply 

• Determined ONLY by the federal reserve.
• Vertical because it is independent of the interest rate

Types of Money Demand

1. Transaction Demand

• Demand for the dollar as a medium of exchange

2. Asset Demand

• Demand for money as a store of value 
• It is dependent upon the interest rate

3. Total Money Demand

• It is downward sloping because at high interest rates
• People are less inclined to hold money and more inclined to hold stocks and bonds. 

Monetary Policy

Contractionary Policy:

• MS will shift to the left
• Interest rate increases
• reserve ratio - increases
• discount rate - increases
• OMO - sell bonds (less cash) MS decreases

Expansionary Policy:

• MS will shift to the right
• Interest rate decreases 
• reserve ratio - decreases
• discount rate - decreases
• OMO - buy bonds (more cash) MS increases

• Loanable Funds: it is the market where buyers and savers meet to exchange funds at the real interest rate. 
• Both the demand and supply of loanable funds comes from households, firms, government, and the foreign sector 

Tools that the Fed Use:

1. Discount Rate:

• FDIC member banks and other eligible institutions may borrow short term loans directly from the Fed.
• "LAST RESORT"

2. Reserve Requirement 

• The fed sets the reserve requirement ratio (RRR)
• Banks keeps the reserve requirement $ amount in a vault

3. Open Market Operations (OMO)

• ONLY TOOLS/OPTIONS ARE TO BUY OR SELL BONDS
• The feds can buy or sell bonds from the public or the banks
• If the feds sell bonds the feds gets the cash and removes it from money supply
• On the flip side- if the fed buys bonds, the nation gets 

4. Federal Fund Rate (unofficial)

• FDIC member banks loan each other money overnight.
• Borrowing from your friend 

5. Prime Rate

• The interest rate that banks charge our most credit-worthy customers.

Expansionary Monetary Policy/Easy Money (Recession)

• Buy bonds (Big Bucks)
• RR down
• DR down
• FFR down
• i down
• Ig, Increases
• AD up
• MS up
• $ Depreciates

Contractionary Monetary Policy/Tight Money (Inflation)

• Sell bonds
• RR up
• DR up
• FFR up
• interest, Increases
• Ig, Decreases
• AD, Shifts Down
• MS, Shifts Left
• $ Appreciates

Money Creation Process

• (Assume 10% reserve requirement)

Fiscal Policy

Classical 

• Competition is good
• In the long-run, the economy will balance at or near full employment
• Invisible Hand - no government intervention 
• Trickle Down Effect - help rich first, then everybody else

Keynesian 

• Competition is flawed
• In the long-run, we are all dead
• The economy is not always at or near full-employment 

Fiscal Policy 

• Changes in the expenditures or tax revenues of the federal government 
• 2 Tools of Fiscal Policy:
• Taxes - Government can increase or decrease
• Spending - Government can increase or decrease
• Enacted to promote our nation's economic goals: full employment, price stability, economic growth
• If Taxes Increase, Spending Increases; vice versa

Deficits, Surpluses, Debts

• Balanced Budget
• Revenue = Expenditures
• Budget Deficit
• Revenue < Expenditures
• Budget Surplus
• Revenues > Expeditures
• Government Debt:
• (Sum of all deficits - Sum of all surpluses)

• Government must borrow money when it runs a budget deficit
• Government borrows from
• Individuals
• Corporations
• Financial Institutions
• Foreign Entities or Foreign Governments 

Fiscal Policy Two Options

• Discretionary Fiscal Policy (action) 
• Expansionary fiscal policy - think deficit
• Contractionary fiscal policy - think surplus
• Non-Discretionary Fiscal Policy (no action)

Discretionary and Automatic Fiscal Policies

Discretionary:

• Increasing or decreasing government spending and/or taxes in order to return the economy to full employment
• Policy involves makers doing fiscal policy in response to an economic problem

Automatic: 

• Unemployment compensation and marginal tax rates are examples of automatic policies that help mitigate the effects of recession and inflation
• Automatic fiscal policy takes place without policy makers having to respond to current economic problems

Contractionary and Expansionary Fiscal Policy

• Contractionary Fiscal Policy - policy designed to decrease aggregate demand
• Strategy for controlling inflation

• Expansionary Fiscal Policy - policy designed to increase aggregate demand
• Strategy for increasing GDP, combating a recession, and reducing unemployment

Expansionary Fiscal Policy

• Recession is countered with expansionary policy
• increase government spending (G ↑)
• decrease taxes (T↓)

Contractionary Fiscal Policy 

• Inflation is countered with contractionary fiscal policy
• Decrease in government spending (G↓)
• Increase taxes (T↑)

Automatic or Built-In Stabilizers

• Anything that occurs without government regulation
• Anything that increases the government's budget deficit during a recession and increases its budget surplus during an inflation without requiring explicit action by policy makers

Automatic Stabilizers

1. Transfer payments 
2. Welfare checks
3. Food stamps
4. Unemployment checks
5. Corporate dividends
6. Social security
7. Veterans benefits 

Progressive Tax System:

• Average tax rate (tax revenue/GDP rises with GDP)

Proportional Tax System: 

• Average tax rate remains constant as GDP changes

Regressive Tax System:

• Average tax rate falls with GDP

Consumption and Savings

Disposable Income ( DI ):

• Income after taxes or net income

2 Choices:

• With disposable income, households can either:
• Consume (Spend)
• Save (Not Spend)

Consumption:

• Household spending
• The ability to consume is constrained by:
• the amount of disposable income 
• the propensity to save
• Do households consume if DI = 0?
• autonomous consumption
• dissavings

Savings: 

• Household NOT spending
• The ability to save is constrained by:
• the amount of disposable income
• the propensity to consume
• Households do not save if DI = 0 

MPC & MPS 

Marginal Propensity to Consume (MPC)

• MPC = ⧍C/⧍DI
• % of every extra dollar earned that is spent

Marginal Propensity to Save (MPS)

• MPS = ⧍S/⧍DI
• % of every extra dollar earned that is saved

Multiplier are (+) when there is an increase in spending; (-) when there is a decrease

Calculating the Tax Multiplier

• When the government taxes, the multiplier works in reverse 
• Money leaving circular flow 

Tax Multiplier (Negative)

• - MPC / 1 - MPC
• - MPC / MPS

If there is a tax cut, then the multiplier is positive, more money in circular flow