CFA 2018 level 1 economics

Topics in Demand And Supply Analysis

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LOS a

Elasticities of demand
Price elasticity

Sensitivity of quantity demanded to change in price

Income elasticity

Sensitivity of quantity demanded to change in income

Cross price elasticity

Sensitivity of quantity demanded to change in price of
related goods (compliment or substitute)

Price
elasticity
Pe =

Cross price
elasticity

Income
elasticity

% ∆ in Qd
% ∆ in P

Ie =

% ∆ in Qd
% ∆ in I

Pe =

% ∆ in Qd
% ∆ in Py

Pe > 1 = Demand is elastic

Ie = +ve: Good is a normal good

Pe = +ve: Good is substitute

Pe < 1 = Demand is inelastic

Ie = −ve: Good is an inferior good

Pe = −ve: Good is complement

Price

e

High Pe

re

Pe is close to 1

Low Pe

Quantity

LOS b & c

nT

Demand curve

Substitution and income effects
Substitution effect

Income effect

Normal good (P È 10%)

Ç Qd 10%

Ç Qd 10%

Inferior but not Giffen good (P È 10%)

Ç Qd 10%

È Qd 5%

Inferior and Giffen good (P È 10%)

Ç Qd 10%

È Qd 15%

Fi

Particulars

Every Giffen good is an inferior good but every inferior good is not a Giffen good
For Giffen goods, income effect is more dominant than substitution effect
Veblen Good - Higher price makes goods more desirable
Eg. Louis Vuitton bag
May have a positively sloped demand curve


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LOS d

Diminishing marginal returns
Marginal returns refer to the additional output produced by using one more
unit of labor or capital while keeping the other constant
Total output

Marginal
product
decreasing

Marginal
product
negative

Marginal
product
increasing
Inputs beyond this quantity are said to
produce diminishing marginal returns

Quantity
of labor

LOS e

Breakeven and shutdown points of production
Perfect
competition

Monopolistic
competition

e

Monopoly

re

Imperfect
competition

Breakeven quantity TR = TC

In short run shutdown if,
P < AVC

In short run shutdown if,
TR < TVC, P < AVC

In long run shutdown if,
P < ATC

In long run shutdown if,
TR < TC, P < ATC

nT

Breakeven quantity P = ATC, TR = TC

Fi

ª
ª
ª
ª
ª

P = Price
ATC = Average total cost
TR = Total revenue
TC = Total cost
AVC = Average variable cost

Cost
Marginal
cost curve
ATC curve
AVC curve

AFC curve

Quantity

Oligopoly


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LOS f

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Economies and diseconomies of scale
Quantity VC per unit

TVC

TFC

TC

MC

1

10

10

100

110

-

2

9

18

100

118

8

3

8

24

100

124

6

4

7

28

100

128

4

5

8

40

100

140

12

6

9

54

100

154

14

7

10

70

100

170

16

Economies of scale

Diseconomies of scale

Price

Short run
ATC curves

e

Long run
ATC curve

Diseconomies of scale

re

Economies of scale

nT

Constant returns
to scale

Fi

Long run ATC curve shows minimum ATC for each level of output
assuming that scale of the firm can be adjusted

Quantity


The Firm And Market Structures

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LOS a

Characteristics of different markets

Characteristics

Perfect
competition

Monopolistic
competition

Oligopoly

Monopoly

No. of sellers

Many

Many

Few

One

Product
differentiation

Homogeneous

Differentiated

Homogeneous

Unique

Barriers to entry

Very low

Low

High

Very high

Pricing power of
firm

None

Some

Some or
considerable

Considerable

Non price
competition

None

Advertising +
Product
differentiation

Advertising +
Product
differentiation

Advertising

LOS b

Perfect
competition

Monopoly

re

Monopolistic
competition

e

Relationships between P, MR, MC, economic
profit and Pe under different market structures

Oligopoly

In equilibrium,

In equilibrium,

P = MR = MC =ATC
Pe - Perfectly elastic

P > MR = MC
Pe > 1

nT

In equilibrium,

Economic profit = 0

LOS c

Economic profit = 0

In equilibrium,

P > MR = MC
Pe > 1

Economic profit +ve in long run

P > MR = MC
Pe > 1
Economic profit +ve in long run

Profits may be zero

Firm’s supply function (Perfect competition)

Cost

Fi

Marginal
cost curve

Cost

Short run
market supply
curve

ATC curve
AVC curve

D = MR

Quantity
In the short run, MC curve is above AVC curve
In the long run, supply curve MC is above ATC curve
There is no well defined supply curve for other markets

Quantity


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Price
Marginal
cost curve
Demand
curve

P1

MR = P ×

)1 − P1 )
e

Marginal
revenue curve

Quantity

Q1

Under monopolistic competition, oligopoly and monopoly, equilibrium
quantity is determined by the intersection of MC and MR

LOS d

Optimal price and output for firms
Firms maximize profits by producing the quantity where MC = MR
In perfect competition P = MR
In monopolistic competition and monopoly, price is the intersection of
demand curve and profit maximizing quantity of output

Factors affecting long-run equilibrium under each market structure

e

LOS e

An increase in demand will increase economic profits in the short run under all market structures

re

+ve economic profits result in entry of firms into the industry (except oligopoly and monopoly)

−ve economic profits result in exit of firms

nT

When firms enter an industry, market supply increases, which causes decrease in market price
and an increase in equilibrium quantity

Pricing strategies in oligopoly
1

Kinked demand curve

Price

More elastic

Fi

Kink

Less elastic

Quantity
Increase in a firm’s product price will not be followed by its competitors, but a decrease in price will
Kink is the price above which the demand is elastic and below which the demand is inelastic


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2

Cournot model

Considers a duopoly i.e. two firms with identical and constant marginal cost of production
Price Perfect
competition

Monopoly

Monopoly

Perfect
competition

Quantity -

3

Nash equilibrium

Nash equilibrium is reached when the choices of all firms are such that there
is no other choice that makes any firm better off. Eg. prisoner’s dilemma

Choices:
High price
Low price

A - High price: 300

B - Low price: 500

B - Low price: 1300

A - Low price: 1400

A - High price: 1000

4

B - High price: 700

re

B - High price: 100

e

Firms - A & B

A - Low price: 500

Dominant firm model

One firm has significantly large market share because of its greater scale and lower cost
structure (Dominant firm)
Market price is determined by the dominant firm and other firms take this price as given

nT

Firm’s decisions are interdependent

If there is a price war, then dominant firm’s market share Ç

If there is no price war, then over time dominant firm’s market share È

Fi

Natural monopoly - Single firm supplying the entire market demand for the product

LOS f

Pricing strategies

Firms under any market maximize profits by producing the quantity where MC = MR
In perfect competition P = MR = AR =MC = ATC

In monopolistic competition, oligopoly and monopoly, price is the intersection of
demand curve and profit maximizing quantity of output
Pricing strategies under oligopoly - Kinked demand curve, Cournot model, Nash
equilibrium, dominant firm model


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LOS g

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N-firm concentration
ratio

HerfindahlHirschman Index

Eg. N = 4
Add up the market share of 4 largest
companies in the industry

Eg. N = 4
Add up the square of market shares of
4 largest companies in the industry
It captures the merger effect

Limitations :
ΠDoes not comment on pricing power
 Does not capture the merger effect

Limitations :
ΠDoes not comment on pricing power

Both the ratios are used to measure the degree of monopoly or market power of a firm
None of the ratios consider barriers to entry

LOS h

Identifying the market structure in which firm operates

ΠExamine no. of firms in the industry, check if products are homogeneous or differentiated,
see barriers to entry/exit and check if there is any non price competition

Fi

nT

re

e

 Compare these with the characteristics that define each market structure


Aggregate Output, Prices And Economic Growth

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LOS a

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GDP using expenditure and income approach
ª Gross domestic product (GDP) is the total market value of final goods and
services produced within a country during a certain time period
ª It is most widely used measure of the size of a nation’s economy
ª It includes only purchases of newly produced goods and services
ª Sale or resale of goods produced in previous periods is excluded
ª Goods and services provided by government are included in GDP (valued at cost)
ª Value of owner-occupied housing is also included in GDP (value is estimated)
Expenditure approach -

Total amount spent on goods and services produced
during the period
Calculated as;
Consumption (C) + Investment (I) + Government
expenditure (G) + [Exports − Imports] (X − M)
Total income earned by households and companies
during the period

e

Income approach -

re

Calculated as;
Consumption (C) + Savings (S) + Taxes (T)

LOS b

Expenditure approach

nT

Sum of value
added

GDP is calculated by adding
the value created at each
stage of production

Fi

LOS c

Value of final
output

GDP is calculated using only
the final value of good and
services

Nominal GDP

Real GDP

Output - Current year

Output - Current year

Prices - Current year

Prices - Base year

GDP deflator -

Nominal GDP
× 100
Real GDP

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LOS d

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National income - Compensation to employees
+ Corporate and govt. profits before tax
+ Non corporate business income
+ Rent
+ Interest
+ (Indirect taxes − Subsidies)

Personal income - National income
+ Transfer payments by govt.
− Corporate and indirect taxes
− Undistributed corporate profits

Personal disposable income - Personal income
− Personal taxes

GDP under income approach can also be calculated as :
National
income

+

Capital consumption
+
allowance

Adjustment for difference
between GDP under
income and expenditure
approach

LOS e

re

e

Depreciation of
physical capital

Statistical
discrepancy

Fundamental relationship among C, S, T, I, G and (X − M)
Total income must equal total expenditures
GDP under income approach = GDP under expenditure approach
C + S + T = C + I + G + (X − M)

nT

S = I + (G − T) + (X − M)

Fiscal
deficit

Trade
surplus

Fi

(G − T) = (S − I) + (M − X)

Fiscal deficit must be financed by
some combination of trade deficit or
excess of savings over investment


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LOS f

IS and LM curves
IS - Investment and Savings
LM - Liquidity and Money supply

Real interest
rate (r)

Real interest
rate (r)

Real
income

Real
income

Π+ve relation
r and (S − I)

Assumption Real money
supply is
constant

 −ve relation
y and (S − I)

e

Therefore,
−ve relation b/w
r and y

Ÿ y Ç = Precautionary & transaction demand Ç
Ÿ Demand for money Ç = Cost of money Ç

re

(S − I) = (G − T) + (X − M)
y Ç Fiscal deficit & Trade surplus È = (S −I) È

Ÿ rÇ=yÇ

Aggregate demand curve

LM1

Fi

IS

Real money supply ‘Constant’
P Ç = MS/P È

Price

LM2

nT

Real interest
rate (r)

Output
(y)

If MS/P È then, LM curve
shifts to the left (increases
real interest rate)
IS curve - −ve relation (r & y)
LM curve - +ve relation (r & y)
Output
(y)

Aggregate demand curve −ve relation (p & y)

ª Marginal propensity to save (MPS) - Proportion of additional income that is saved

ª Marginal propensity to consume (MPC) - Proportion of additional income spent on consumption
ª MPS + MPC = 100%


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LOS g

Aggregate supply curve
Price
LRAS

SRAS

VSRAS

Potential GDP
è VSRAS - Firms adjust output without changing price. VSRAS curve is perfectly elastic
è SRAS - When prices increase, input costs (such as wages) do not increase as they
are fixed in the short run
è LRAS - All input prices are variable in the long run. LRAS curve is perfectly inelastic
and it shows the level of potential GDP
è Price level has no long run effect on aggregate supply

LOS h

e

Causes of movements along and shifts in aggregate
demand and supply curves
Price

P2
P1

Q1

Output

nT

Q2

re

Price

Output

Movement along the curve

Shift in curve

Reasons :
Change in price (all other
factors keeping constant)

Reasons

Fi

Aggregate demand curve

ª

ª
ª
ª
ª
ª
ª
ª

Increase in consumers’
wealth
Optimistic business
expectations
High future income
expectation by consumer
High capacity utilization
Expansionary monetary
policy
Expansionary fiscal policy

Home currency
depreciation
Global economic growth

Aggregate supply curve

ª
ª
ª
ª
ª
ª

Increase in productivity
Increase in supply and
quality of labor
Increase in supply of
natural resources
Increase in the stock of
physical capital
Technology improvement
Currency appreciation


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LOS i, j & k
Short-run effects of changes in aggregate demand and supply

Type of change

Real GDP

Unemployment

Price level

Ç Aggregate demand

Ç

È

Ç

È Aggregate demand

È

Ç

È

Ç Aggregate supply

Ç

È

È

È Aggregate supply

È

Ç

Ç

Price

Price

Price

P1
P0

P0

P0

P1

P1

Output

Price

P1
P0

Output

Q0 Q1

Q1 Q0

Output

Q1 Q0

Q1 Q0

Recessionary gap Potential GDP > Real GDP

e

Inflationary gap Real GDP > Potential GDP

Stagflation High inflation combined with slow economic growth

LOS l

Short-run effects of shifts in both aggregate demand and supply
Aggregate
demand

Aggregate
supply

Real GDP

Price level

Ç

Ç

Ç

Ç Or È

È

È

Ç Or È

Ç

È

Ç Or È

Ç

È

Ç

Ç Or È

È

nT

È

Sources of
economic growth

Fi

LOS m

re

and high level of unemployment

ª
ª
ª
ª
ª

Labor supply
Human capital

Physical capital stock
Technology
Natural resources

Sustainability of
economic growth

ª Rate of increase in
the labor force
ª Rate of increase in
labor productivity

Output


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LOS n & o

Production function

Describes relationship between output and labor, capital and total factor productivity
Total factor productivity (TFP) - It is a multiplier that quantifies the amount of output
growth that cannot be explained by the increases in labor and capital. Increase in total
factor productivity can be attributed to advances in technology
∆Y = TFP +

α × ∆K + (1 − α) × ∆L

Residual income
that explains
the effect of
technology
Growth
in GDP

Growth of
capital

Share of growth
explained by the
capital

Growth of labor

Growth in per capita potential GDP

Growth in technology
+ WL (Growth in labor)
+ WC (Growth in capital)

Growth in technology
+ WC (Growth in capital)

e

Growth in potential GDP

Fi

nT

re

Above model is on neoclassical economics


Understanding Business Cycles

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LOS a

Business cycle and its phases
Real GDP
Trend
Cycle
gh

ak

Pe

ou

Tr

Expan
sion

Contraction

Time
ª Expansion - Increase in output, employment, consumer spending, business investment and inflation
ª Contraction - Decrease in output, employment, consumer spending, business investment and inflation
ª Peak - Inventory/sales ratio is highest

e

ª Trough - Inventory/sales ratio is lowest
ª Business cycles recur but not at regular intervals

re

ª Beginning of expansion/contraction - 2 consecutive quarters of growth/decline in real GDP

LOS b Fluctuations in sector as economy moves through the business cycle
ª Firms are slow in laying off employees in early contraction period
ª Firms are slow in hiring employees in early expansion period

nT

ª Housing activity decreases if home prices rise faster than income
ª Firms use their physical capital more intensively during expansion and
less intensively during contraction
ª Imports increase during expansion

ª Exports increase during contraction

Fi

LOS c

Theories of the business cycle
Classical economics
GDP Ç

Economy
neutral stay

Subsistence
Wages Ç

Wages È

Population
explosion
Supply
Ç
(labor)


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Neoclassical school

Economists believe that shifts in ADC and ASC are
caused by changes in technology
They also believe business cycles are temporary

Keynesian school
Economists believe that shifts in aggregate demand are due to changes in
expectations
Keynesian economists believe that wages are downward sloping
Policy prescription - Increase aggregate demand directly, through
monetary policy or fiscal policy

New Keynesian school
Adds the assertion that inputs as well as wages are sticky

Monetarist school
Business cycles are caused by inappropriate decisions by the monetary authorities

e

They suggest, the central bank should follow a policy of steady and predictable
increases in money supply

re

Austrian school

They believe that business cycles are caused by government intervention

New classical school

These economists introduced real business cycle theory (RBC)

nT

RBC emphasizes the effect of real economic variables such as change in technology
and external shocks
RBC holds that policymakers should not intervene in business cycles

LOS d

Types of unemployment

Fi

Frictional

Time taken by employees
to find the jobs that fit
them

Structural

Cyclical

Caused by long-run
changes in the economy

Caused by changes in
general level of economic
activity

Workers lack requisite
skills

+ve in contraction & −ve
in expansion


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Labor force = Workers employed + workers unemployed
Unemployment rate =

Workers unemployed
Labor force

Underemployed worker - Worker employed at a low paying job despite being qualified
Labor force

Activity ratio/Labor force participation ratio =

Working age population

Discouraged worker - Workers who are not actively seeking work. They are not
considered as a part of unemployed workers and therefore not a part of labor force

LOS e

Inflation, hyperinflation, disinflation and deflation
10%

13.36%

110

20%

Inflation -

100

Disinflation -

100

110

117

124

Deflation -

100

90

80

70

10%

125
6.36%

150
5.98%

ª Hyperinflation - Inflation that accelerates out of control

e

ª To consider a situation of rising prices as inflation, the prices of almost all goods should rise
ª Inflation erodes the purchasing power of currency
ª Inflation favors borrowers at the expense of lenders

Construction of indices used to measure inflation

re

LOS f

Consumer price index (CPI) -

Cost of basket at current prices
Cost of basket at base prices

x 100

ª Weights assigned to each good and service in CPI basket can differ significantly across
countries and regions

nT

ª Headline inflation - Price indexes for all goods

ª Core inflation - Price indexes that exclude food and energy (because their prices are volatile)

Inflation measures

Laspeyres price index

Fi

LOS g

Paasche price index

Quantity Base year

Quantity Current year

Price Base year

Price Base year

LPI :

P1 × Q 0
× 100
P0 × Q 0

PPI :
P1 × Q 1
× 100
P0 × Q 1

Fisher price index

It is geometric
mean of a LPI
and PPI

Hedonic pricing is used to measure the upward bias present


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LOS h

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Cost-push inflation

Demand-pull inflation
Caused by increase in
aggregate demand

Aka wage pushed inflation

Increases price level and
temporarily increase real GDP
above nominal GDP

Caused by decrease in
aggregate supply
Initially decreases GDP

LOS i

Central bank can try to bring
economy back to potential GDP

Economic indicators
Leading

Coincident

Lagging

Manufacturers’ new orders for
consumer goods and materials
Inventory-sales ratio

Real personal income

Building permits

Index of industrial production

10-year T-bonds less federal
funds

Manufacturing and trade sales

Fi

nT

Consumer expectations

Labor cost per output

Average prime lending rate

re

S&P 500 equity price index

e

Manufacturers’ new orders for
non-defense capital goods exaircraft

Change in consumer price
index
Average duration of
unemployment

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LOS a

Monetary And Fiscal Policy

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Monetary policy

Fiscal policy
Undertaken by government
Budget surplus = (T − G) > 0

Undertaken by country’s central
bank

Budget deficit = (G − T) < 0

Expansionary (accommodative) When the central bank increases
the quantity of money and credit

Can also be used as a tool for
redistribution of income and
wealth

Contractionary (restrictive) When the central bank reduces
the quantity of money and credit

LOS b

Functions and definitions of money

ª Money - Generally accepted medium of exchange

e

ª Primary functions Ÿ Serves as a medium of exchange
Ÿ Serves as a unit of account
Ÿ Provides store of value
ª Narrow money = Currency and coins in circulation + Balances in checkable bank deposits
ª Broad money = Narrow money + Amount available in liquid assets

LOS c

re

Fractional reserve banking system

Total amount of money created -

New deposit
Reserve ratio

Money multiplier -

1
Reserve ratio

Quantity theory of money

nT

Money supply × Velocity

Quantity of money

=

Price × Real Output

Total spending

Money neutrality - Money Supply « ¢ Price «

Velocity - Average number of times a unit of currency changes hands

Fi

Monetarists believe that money is not neutral in the short run

LOS d

Demand for money

ª Transaction demand - Money held to meet the need for undertaking transactions
GDP « ¢ Transaction demand «
ª Precautionary demand - Money held for unforeseen future needs

GDP « ¢ Precautionary demand «
ª

Speculative demand - Money that is available to take advantage of investment opportunities in future
Opportunity cost » ¢ Speculative demand «


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Supply of money
Nominal
interest rate

Nominal
interest rate
Money
supply

Excess of
supply

Excess of
demand

r1
r2
r3

Money
demand

Quantity

Quantity
Money
supply

Supply of money is determined by central bank and is independent of interest rate
Therefore MS is always perfectly inelastic

LOS e

Fischer effect
@ 10% p.a.

Inflation

True saving 3

re

Consumption cost 107

110

e

100

Real rate of
return

Nominal risk-free rate = Real risk-free rate + Expected inflation

nT

Nominal risk-free rate = Real risk-free rate + Expected inflation + Risk premium
Investors require risk premium for expected inflation

LOS f

Roles and objectives of central banks

Objectives

è Sole supplier of currency
è Banker to the government and other
banks
è Regulator and supervisor of payments
system
è Lender of last resort
è Holder of gold and foreign exchange
reserves
è Conductor of monetary policy

è Primary objective - Control inflation
è Stability in exchange rates with
foreign currencies

è Full employment
è Sustainable positive economic growth
è Moderate long-term interest rates

Fi

Roles


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LOS g

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Costs of expected and unexpected inflation
When inflation is higher than expected, borrowers gain at the expense of lenders
Unexpected inflation can increase the magnitude and frequency of business cycle

LOS h

Tools used to implement monetary policy
ª

Policy rate/discount rate/refinancing rate/2-week repo rate
ª Reserve requirements
ª Open market operations

Expansionary policy

Contractionary policy

» Policy rate
» Reserve ratio
Buying securities

« Policy rate
« Reserve ratio
Selling securities

LOS i

Monetary transmission mechanism
Monetary policy

Asset prices

Market interest rates

(fall as discount rate for
future CFs increase)

Growth expectations
(decrease)

nT

re

(increase)

e

(increase in official interest rate)

Domestic demand
(reduces)

Exchange
(appreciate)
(foreign investors might
want to invest)

Net external demand
(decreases)
(Exports decrease,
Imports increase)

Inflation rate

Fi

(decreases)

LOS j

Independence

Qualities of effective central bank
Central bank is free from political interference

Operational independence - Central bank is allowed to
independently determine the policy rate
Target independence - Central bank sets the target inflation level

Credibility
Transparency

Central bank follows through on its stated policy intentions
Central bank discloses the state of economic environment by
issuing inflation reports


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LOS k

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Effects of changes in monetary policy

LOS m

Expansionary

» Economic growth

« Economic growth

« Market interest rates

» Market interest rates

» Inflation

« Inflation

« Domestic currency

» Domestic currency

« Imports

» Imports

» Exports

« Exports

Interest rate targeting

Exchange rate targeting

Most widely used method for making
monetary policy decisions

Greater volatility of money supply to
maintain stable foreign exchange rate

Increasing money supply when specific
interest rates rise above the target band

and decreasing money supply when rates
fall below the target band

Developing countries target a foreign
exchange rate between their currency and
another (often the U.S. dollar), rather than
targeting inflation

e

LOS l

Contractionary

Determining whether a monetary policy is expansionary or contractionary

re

ª Neutral interest rate - It is the rate of interest that neither spurs nor slows the economy
ª Neutral interest rate = Real trend rate of growth + long run expected inflation
ª Expansionary policy - Policy rate < Neutral interest rate
ª Contractionary policy - Policy rate > Neutral interest rate

!
!

Monetary policy changes may affect inflation expectations to such an extent that long-term
interest rates move opposite to short-term interest rates
Individuals may be willing to hold greater cash balances without a change in short-term rates
(liquidity trap)

Banks may be unwilling to lend greater amounts, even when they have increased excess reserves
Short-term rates cannot be reduced below zero
Developing economies face unique challenges in utilizing monetary policy due to undeveloped
financial markets, rapid financial innovation, and lack of credibility of monetary authority

Fi

!
!
!

Limitations of monetary policy

nT

LOS n

LOS o

Roles and objectives of fiscal policy

Roles

Objectives

è Determining taxation policies and
government spending to meet
macroeconomic goals

Influencing the level of economic

activity
è Redistributing wealth or income
è Allocating resources among industries
è


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LOS k

Fiscal policy tools

Spending tools

Revenue tools

Transfer payments, current
spending (goods and services
used by government), and
capital spending (investment
projects)

Direct taxes (levied on income
or wealth)

Fiscal multiplier -

Indirect taxes (levied on goods

and services)

1
1 − MPC (1 − t)

If tax rate « then, fiscal multiplier »
If MPC « then, fiscal multiplier «

LOS q

Arguments about size of fiscal deficit
Arguments against

Arguments for

Debt may be financed by domestic citizens

Fiscal deficits may prompt needed tax
reform

re

Fiscal deficits may not be financed by the
market when debt levels are high

e

Higher future taxes lead to disincentives to
work

Deficits for capital spending can boost
productive capacity of the economy

nT

Crowding-out effect as government
borrowing increases interest rates and
decreases private sector investment

Defecits aid in increasing GDP and
unemployment
Ricardian equivalence may prevail

When the economy is operating below full
employment, deficits do not crowd out
private investment

Recardian equivalence - Taxpayers increase savings in order to offset the
expected cost of higher future taxes

Implementation of fiscal policy and difficulties of implementation
ª Delays in realizing the effects of fiscal policy changes limit their usefulness

Fi

LOS r

ª Causes of delay;
Ÿ Recognition lag
Ÿ Action lag

Ÿ Impact lag
ª Additional macroeconomic issues;
Ÿ Misreading economic statistics
Ÿ Crowding-out effect
Ÿ Supply shortages
Ÿ Limits to deficits
Ÿ Multiple targets


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LOS s

© 2017 FinTree Education Pvt. Ltd.

Determining whether a fiscal policy is expansionary or contractionary
» in surplus - Expansionary
« in surplus - Contractionary
» in deficit - Contractionary
« in deficit - Expansionary

LOS t

Interaction of monetary and fiscal policy
Fiscal policy

Interest rate

Output

Private sector
spending

Public sector
spending

Contractionary

Contractionary

«

»

»

»

Expansionary

Expansionary

»

«

«

«

Contractionary

Expansionary

«

«

»

«

Expansionary

Contractionary

»

Varies

«

»

Fi

nT

re

e

Monetary policy


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International Trade And Capital Flows

LOS a

LOS b

Gross domestic
product (GDP)

Gross national
product (GNP)

Total market value of goods
and services produced within
a country during a certain
time period

Total market value of goods
and services produced by
labor and capital of a country
(can be within the country or

outside the country)

Benefits and costs of international trade
Costs

Benefits
One country can specialize in
the production of one good and
benefit from economies
of scale

Costs of trade are primarily
borne by those in domestic
industries that compete with
imported goods

There is more product variety,
more competition, and more
efficient allocation of resources

e

Unemployment increases,
income inequality

Benefits of trade > Costs of trade for economy as a whole

Comparative advantage and absolute advantage

re

LOS c

Absolute advantage -

Comparative advantage -

Lower cost in terms of resources
Opportunity cost in terms of other goods

Country B

Food

4

8

Drink

6

7

nT

Country A

Opportunity cost of good x - Quantity of ‘X’ should be in the denominator

Fi

Opportunity cost of food for Country A =

Opportunity cost of food for Country B =

6
4
7
8

= 1.5

= 0.875

Since opportunity cost of Country B is lower, it has comparative advantage in producing food
Country B has absolute advantage in producing both food and drink because it is able to
produce more than Country A
Country B should produce (and export) food and Country A should produce (export) drink


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Ricardian
model

LOS d

Heckscher–Ohlin
model
Two factors of production - labor
and capital

Only one factor of production labor

Comparative advantage Differences in relative amounts of
each factor

Comparative advantage Differences in labor productivity

Country that has more capital will
specialize in capital intensive good
and trade for less capital intensive
good

Heckscher-Ohlin model
ª This model says price of scarce factor of production in each country will increase
ª The good that country exports will rise in price
ª The good that country imports will fall in price

LOS e

Types of trade and capital restrictions
Arguments that have support for capital restriction

e

Infant industry Protection from foreign competition is given to new industries

re

National security It is in the best interest of a country to protect producers of
goods crucial to it’s national defense so that those goods are
available domestically in the event of conflict

Arguments that have little support for capital restriction
Protecting domestic jobs Some jobs are lost, some jobs are created and prices for
domestic consumers will be less without import restrictions

nT

Protecting domestic industries Firms often use political influence to get protection from
foreign competition to the detriment of consumers, who pay
higher prices

Types of trade restrictions

Tariffs

Quotas

Taxes on imported good
Ç in domestic price
È in quantity imported

If domestic government collects the full value
of import license, result is same as for a tariff

If domestic government does not charge for the
import licenses, there would be gain to
importers, this is referred to as quota rent

Fi

Domestic producers gain

Restriction on quantity of goods to be imported

Foreign exporters lose

VER
Voluntary export restraint
Agreement by a govt to
voluntarily unit the quantity
of good to be exported
No capture of quota rents
Protects domestic consumers
in importing country

Export subsidy
Payment by government to its exporters

Generally export subsidies will benefit the producer (exporter)
Generally it will result in increase of price and reduction of consumer surplus in the exporting country
In a small country, price will increase by the amount of subsidy to equal world price + subsidy
For a large country, world price decreases and some benefits from subsidy accrue to foreign
customers while foreign producers are negatively affected