Semester 1 Flashcards
1
Q
What to do when
MC < MB
A
Do more
2
Q
What to do when
MC > MB
A
Do less
3
Q
The circular flow of income
A
- firms and households
- goods market
-real flows : goods and services
-money flows : consumer expenditure - factor markets
-real flows : services of labour and other factors
-money flows : wages and other incomes
4
Q
The command economy (state/gov controls all resources)
AD vs DIS
A
AD:
high investment, high growth
stable growth
social goals pursued
low unemployment
DIS:
problems of gathering information
expensive to administer
inappropriate incentives
shortages and surpluses
5
Q
Free market (based on demand and supply decisions, such as shortages/surplus, price equilibrium, responses to changes in demand and supply.)
AD vs DIS
A
AD:
transmits information between buyers and sellers
no need for costly bureaucracy
incentives to be efficient
competitive markets responsive to consumers
DIS:
competition may be limited: problem of market power
inequality
problem of poor and/or asymmetric information
may respond poorly to serious shocks, such as a pandemic
the environment and other social goals may be ignored
may encourage greed and selfishness
6
Q
Mixed economy
A
(has some gov intervention such as taxes, subsidies, benefits, direct provision, direct control, legislation )
7
Q
Economics as a social science
A
difficulties in conducting controlled experiments in many parts of the subject
problems of predicting human behaviour
behavioural economics
8
Q
Economics and policy
A
Positive (fact, factual, prediction, forecasting, can be tested) and normative (opinion, nonfactual)
the role of the economist in policy making
9
Q
The law of demand
A
The quantity of a good demanded per period of time will fall as price rises and will rise as price falls, other things being equal (ceteris paribus).
the income effect
- The effect of a change in price on quantity demanded arising from the consumer becoming better or worse off as a result of the price change.
the substitution effect
- The effect of a change in price on quantity demanded arising from the consumer switching to or from alternative (substitute) products.
10
Q
The demand curve assumptions
A
other things remain equal (ceteris paribus)
a given time period
11
Q
determinants of demand
A
tastes
number and price of substitute goods
number and price of complementary goods
Income (normal and inferior goods)
distribution of income
expectations
12
Q
Movements along and shifts in the demand curve
A
change in price
- movement along D curve (change in quantity demanded)
change in any other determinant of demand
- shift in D curve (change in demand)
- increase in demand= rightward shift
- decrease in demand= leftward shift
13
Q
Possible causes of a rise in demand
A
- Tastes shift towards this product
- Rise in price of substitute goods
- Fall in price of complementary goods
- Rise in income
- Expectations of a rise in price
14
Q
shift vs movement in demand
A
A shift in the demand curve is referred to as a change in demand. (new line due to on-price factors)
A movement along the demand curve as a result of a change in price is referred to as a change in the quantity demanded. (change in the quantity demanded due to price variation)
15
Q
simple demand functions calculation
A
Qd = a – bP
This equation says that the quantity demanded (Qd) will fall as the price of the good (P) rises.
16
Q
complex demand functions calc
A
Qd = a – bP + cY + dPs – ePc
- This equation also says that the quantity demanded (Qd) will fall as the price of the good (P) rises.
- But it also adds that the Qd will rise as the level of consumer incomes (Y ) rises, will rise as the price of a particular substitute (Ps) rises and will fall as the price of a particular complement (Pc)
rises.
17
Q
why?
As price rises, firms supply more
A
- it is worth incurring the extra unit costs
- firms switch from less profitable goods
- in the long run, new firms will be encouraged to enter the market
18
Q
determinants of supply
A
costs of production
profitability of alternative products (substitutes in supply)
profitability of goods in joint supply
nature and other random shocks
expectations of producers
19
Q
Fall in supply of potatoes: example
A
The cost of producing potatoes rises.
The profitability of alternative crops (e.g. carrots) rises.
A poor potato harvest.
Farmers may find producing other crops more enjoyable.
Farmers expect the price of potatoes to rise (short-run supply falls).
Potato farmers may leave the industry.
20
Q
movements vs shifts in supply
A
change in price
- movement along S curve (change in quantity supplied)
change in any other determinant of supply
- shift in S curve (change in supply)
increase in supply = rightward shift
decrease in supply = leftward shift
21
Q
Possible causes of a rise in supply
A
- Fall in costs of production
- Reduced profitability of alternative
products that could be supplied - Increased profitability of goods in
joint supply - Benign shocks
- Expectations of a fall in price
22
Q
simple supply functions calc
A
Qs = a + bP
estimated supply equations
problems of estimating supply equations
23
Q
What happens to the equilibrium price when there is a change in demand or supply?
A
The equilibrium price will remain unchanged only so long as the demand and supply curves remain unchanged. If either of the curves shifts, a new equilibrium will be formed.
A change in demand: if one of the determinants of demand changes (other than price), so the whole demand curve will shift.
This will lead to a movement along the supply curve to the new intersection point
24
Q
effects of shifts in the demand curve
A
movement along the supply curve and the new demand curve
25
effects of shifts in the supply curve
movement along demand curve and new supply curve
26
What are the determinants of demand (other than price)?
tastes
number and price of substitute goods
number and price of complementary goods
income
distribution of income
expectations
27
What are the determinants of supply (other than price)?
costs of production
profitability of alternative products (substitutes in supply)
profitability of goods in joint supply
nature and other random shocks
expectations of producers
28
elasticity
the responsiveness of demand and supply
29
Price elasticity of demand
the responsiveness of demand to a change in price
%change in demand / % change in price
30
elastic
Elastic (│PD │>1) : where a change in price causes a proportionately larger change in the quantity demanded.
31
inelastic
Inelastic (│PD │<1) : where a change in price causes a proportionately smaller change in the quantity demanded.
32
unit elastic
Unit elastic (│PD │ = 1) : where price and quantity demanded change by the same proportion.
33
Determinants of price elasticity of demand
number and closeness of substitute goods
the proportion of income spent on the good
time
34
Price elasticity of demand and consumer expenditure (PxQ)
effects of a price change on expenditure: elastic demand
effects of a price change on expenditure: inelastic demand
special cases
- totally inelastic demand: PeD = 0
- infinitely elastic demand: PeD = infinity
- unit elastic demand: PeD = –1
applications to price decisions
different elasticises along a demand curve
35
the elasticity of a straight-line demand ‘curve’ (constant dQ/dP)
(∆Q/ ∆P) x (P/Q) = (1/slope) x (P1/Q1)
36
supply function is linear:
(1/slope) x (P1/Q1)
37
income elasticity of demand
&change in QD/ %change in income
or change in QD/QD / change in incomes/income
38
determinants of incomes elasticity of demand
Normal goods : YeD > 0
- necessities: 0< YeD <1
- luxury goods: YeD >1
Inferior goods: YeD < 0
39
Cross-price elasticity of demand
QD good a/QD good a ÷ P good b/P good b
%change in QD of good A / %change in price of good B
40
Minimum price (a price floor) (surplus)
Justifications:
* to protect producers’ incomes
* to create a surplus
* to deter the consumption of a particular good
Effects: the government can use various methods to deal with the surpluses associated with minimum prices.
* buy and store goods, destroy it or sell abroad
* quotas on the quantity produced
* demand could be raised by advertising
41
What are the main drawbacks of minimum prices as a control measure
Firms with surpluses on their hands may try to evade the price control and cut their prices.
Firms may feel less need to find more efficient methods of production and to cut their costs if their profits are being protected by the high price.
The high price may discourage firms from producing alternative goods which they could produce more efficiently or which are in higher demand, but which nevertheless have a lower (free-market) price.
42
Maximum price (a price ceiling) (shortage)
justification: fairness, but might lead to further problems with allocation. In this case the goods will be allocated based on:
* “First-come, first-served” basis (lead to long queues)
* Random ballot (ensures a fair chance for all. Some may receive it or unfair if they don’t receive it)
* Favoured customers (regulars or those with special connections; lead to unfair distribution and favoritism)
* A measure of merit (ensure that those most deserving receive the goods)
* A rule or regulation (for who can access the goods, such as income levels or family size)
* Rationing (each person or household is allowed a fixed amount of the goods)
43
Solutions to max prices
- Direct government production
- Subsidies or tax relief to firms
- Provide more alternative goods
- Income control
44
indirect tax ( tax on the expenditure of good)
what is specific tax and ad valorem
* Specific tax: an indirect tax of a fixed sum per unit sold.
- Example: tax per litre of petrol
* Ad valorem tax: an indirect tax of a certain percentage of
the price of the good.
- Example: VAT
45
What is the effect of a tax being levied on a good in terms of the supply curve?
When a tax is levied on a good, this has the effect of shifting the supply curve upwards by the amount of the tax.
In the case of a specific tax, it will be a parallel shift, since the amount of the tax is the same at all prices.
In the case of an ad valorem tax, the curve will swing upwards. As price rises, so the gap between the original and new supply curves will widen, since a given percentage tax will be a larger absolute amount the higher the price.
46
The incidence of taxation different elasticises
The producers’ share
greater, the less elastic the supply and the more elastic the demand
The consumers’ share
greater, the less elastic the demand and the more elastic the supply
47
What is the impact on the UK economy of fewer people
smoking? Is raising tobacco taxes beneficial?
- Spending on smoking-related health care
- Wider costs to society (smoking breaks, unemployment, loss of potential lifetime earnings)
48
Three problems with raising tobacco taxes:
- Smuggling and tobacco-related crime
- Disproportionate income on different members of society
- Demand for tobacco is getting more elastic
49
Rational Consumer
A person who attempts to get the best value for money from their purchases, given a limited income. In other words, attempts to maximise one’s individual satisfaction for the income earned.
People buy goods and services because they get satisfaction from them. Economists call this satisfaction “utility”.
We will assume that a person’s utility can be measured. We use imaginary measure called utils, where a util is one unit of satisfaction.
50
Total Utility
Total Utility (TU) – the total satisfaction a person gains from all
those units of a commodity consumed within a given time
period.
Example: if Lucy drinks 10 cups of tea a day, her daily total
utility from tea is the satisfaction derived from those 10 caps.
51
Marginal Utility (MU)
Marginal Utility (MU) – the additional satisfaction gained from consuming one extra unit within a given period of time a person gains from all those units of a commodity consumed within a given time period.
Example: The marginal utility that Lucy gains from her 3rd cup.
52
principle of diminishing marginal utility.
The more of a commodity you consume, the greater will be your total utility.
However, as you become more satisfied, each extra unit that you consume will probably give you less additional utility than previous units.
In other words, your marginal utility falls (the marginal utility curve is downward-sloped), the more you consume. This is known as the principle of diminishing marginal utility.
53
Are there any goods or services where consumers do not experience diminishing marginal utility?
Virtually none, if the time period is short enough. If, however, we are referring to a long time period, such as a year, then initially as more of an item is consumed people may start ‘getting more of a taste for it’ and thus experience increasing marginal utility. But even with such items, eventually, as consumption increases, diminishing marginal utility will be experienced.
54
Explain the relationship between the Total Utility (TU) curve and the Marginal Utility (MU) curve, including how the marginal utility is calculated and what happens to the TU curve when marginal utility reaches zero.
The MU curve slopes downwards.
The TU curve starts at the origin.
The TU curve reaches a peak when marginal utility is zero.
Marginal utility is the slope of the line joining two adjacent quantities on the curve. For example, the marginal utility of the third packet of crisps is the slope of the line joining points a and b.
The slope of such a line is given by the formula
55
Marginal consumer surplus (MCS)
is the difference between what you are willing to pay for one more unit of a good and what you are actually charged
56
Total consumer surplus (TCS)
is the sum of all the marginal consumer surpluses that you have obtained from all the units of a good you have consumed
57
What determines when a consumer stops purchasing additional units of a good?
- People will go on purchasing additional units as long as they gain additional consumer surplus: MU > P.
- But as more is purchased, so they will experience diminishing marginal utility and at some point: MU = P, so no further consumer surplus can be gained.
- At that point, they will stop purchasing additional units, because optimum level of consumption has been reached.
58
Limitations of the one-commodity version
A change in the consumption of one good will affect the
marginal utility of substitute and complementary goods.
Deriving a demand curve from a marginal utility curve measured
in money assumes that money itself has a constant marginal
utility.
If people have a rise in income, they will consume more, the
marginal utility of the goods that they consume will diminish.
Thus an extra £1 of consumption will bring less satisfaction than
previously. So, the marginal utility of money diminishes as
income rises.
59
The equi-marginal principle:
a consumer will get the highest utility from a given level of income when the ratio of the marginal utilities is equal to the ratio of the prices.
60
approachThe limitations of the marginal utility approach
Utility cannot be measured in any absolute sense. We cannot really say, therefore, by how much the marginal utility of one good exceeds another.
An alternative approach is to use indifference analysis. This does not involve measuring the amount of utility a person gains, but merely ranking various combinations of goods in order of preference. It assumes that consumers can decide whether they prefer one combination of goods to another.
61
Indifference analysis involves
Indifference analysis involves the use of indifference curves and budget lines.
An indifference curve shows all the various combinations of two goods that give an equal amount of satisfaction or utility to a
consumer.
An indifference curve is often (although not always) is bowed in towards the origin.
Indifference curves cannot cross.
62
Marginal Rate of Substitution
The amount of one good (Y) that a consumer is prepared to give up in order to obtain one extra unit of another good (X)
Ignoring the negative sign, the slope of the indifference curves at a point is equal to the MRS.
As we move down the indifference curve, the MRS diminishes as the slope of the curve gets less.
63
The budget line
The budget line shows what combinations of two goods you are able to buy, given (a) your income available to spend on them and (b) their prices.
64
The optimum consumption point
The optimum consumption point is where the budget line touches (is ‘tangential to’) the highest possible indifference curve.
65
Indifference analysis: limitations
In practice, it is virtually impossible to derive indifference curves
Consumers may not behave ‘rationally’
Indifference curves are based on the satisfaction that consumers believe they will gain from a good. This belief may well be influenced by advertising.
Certain goods are purchased only now and again.
66
The law of diminishing returns
When increasing amounts of a variable factor are used with a given amount of a fixed factor, there will come a point when each extra unit of the variable factor will produce less extra output than the previous unit.
67
The short-run production function:
total physical product (TPP)
- TPP= f (land, workers)
average physical product (APP)
- APP = TPP/QV
marginal physical product (MPP)
- MPP = changeTPP/changeQV
68
Short run costs - Measuring costs of production: opportunity costs
- explicit costs (Direct, out-of-pocket payments for expenses needed to run a business. e.g. wages, rent, utilities)
- implicit costs (Costs that do not involve a direct payment of money to a third party)
- Fixed costs: Total costs that do not vary with the amount of output produced
- Variable costs: Total costs that do vary with the amount of output produced
- Total costs
total fixed cost (TFC)
total variable cost (TVC)
total cost (TC = TFC + TVC)
69
short run costs
Marginal cost
marginal cost (MC) and the law of diminishing returns
the relationship between the marginal and total cost curves
Average cost
average fixed cost (AFC)
average variable cost (AVC)
average (total) cost (AC)
relationship between AC and MC
70
Average and Marginal Costs
-AFC
-AVC
-AC
AFC: This falls continuously as output rises.
AVC: The shape of the AVC curve depends on the shape of the APP curve. As the average product of workers rises, the average labour cost per unit of output (the AVC) falls: as APP falls, AVC must rise.
AC: This curve is the sum of the AFC and AVC curves. Note that as AFC fall less, the gap between AVC and AC narrows.
Note: When marginal cost (MC) is below the average cost (AC), then AC falling.
When MC is above the average cost (AC), AC start increasing.
- When the marginal cost (MC) of producing an additional unit of output is less than the average total cost (AC), the new unit is relatively cheaper to produce than the
average of all units produced so far.
- When the marginal cost is greater than the average total cost, the new unit is more expensive to produce than the average of all units produced.
71
Long run theory of production - economics of sale
specialisation and division of labour
indivisibilities
container principle
greater efficiency of large machines
by-products
multi-stage production
organisational and administrative economies
financial economies
economies of scope
72
Diseconomies of scale
managerial complexity
alienation
industrial relations problems
disruption if part of complex production chains fail
73
Optimum combination of factors
1. Simple two-factor case
2.Multi factor case
1. if MPPa/Pa > MPPb/Pb costs can be produced by using more factor a and less factor b
costs minimised where:
MPPa/Pa = MPPb/Pb
2. costs minimised where:
MPPa/Pa = MPPb/Pb ... = MPPn/Pn
(the equi-marginal principle)
74
Isoquant-isocost analysis
Isoquants
their shape
diminishing marginal rate of substitution
isoquants and returns to scale
isoquants and marginal returns
Isocosts
slope and position of the isocost
shifts in the isocost
Least-cost combination of factors for a given output
point of tangency
comparison with marginal productivity approach
Highest output for a given cost of production
75
Long-run costs
Long-run average costs (average cost of producing a unit of output over a long period of time, when all inputs are variable):
shape of the LRAC curve
assumptions behind the curve
-At each level of output, the cost of production is fixed. Factor prices might be different at different levels of output.
-Technological advancements and changes in factor quality occur in the very long run.
-Firms always choose the least-cost combination of factors to produce a given level of output.
76
long run costs
Long-run average costs
shape of the LRAC curve
assumptions behind the curve
Long-run marginal costs
Relationship between long- and short-run AC
the envelope curve
Long-run cost curves in practice
the evidence
minimum efficient plant size
Derivation of long-run costs from an isoquant map
derivation of long-run costs
the expansion path
77
total revenue
- Total revenue is the firm’s total earnings per period of time from the sale of a particular amount of output (Q).
- TR=Price per Unit × Quantity Sold= P×Q
78
Average revenue
- Average revenue is the amount the firm earns per unit sold.
- AR=TR/Q
79
Marginal revenue
- Marginal revenue is the extra total revenue gained by selling one more unit (per time period).
- MR=ΔTR/ΔQ
80
profit maximised where
profit maximised where MR = MC
81
loss minimising:
still produce where MR = MC (if at all levels of output AC is above the AR curve)
82
when is the short-run shut-down point
P = AVC
Will shut down if cannot cover variable costs
83
Long run shut down point
long-run shut-down point (the AR curve is touched the LRAC curve):
P = LRAC
84
Classifying markets by degree of competition
number of firms
freedom of entry to industry
nature of product
nature of demand curve
85
The four market structures
perfect competition
monopoly
monopolistic competition
oligopoly
86
features of perfect competition
-many firms
-freedom of entry
-homogenous (undifferentiated) product
-horizontal curve
-price taker
short run equilibrium:
-P=MC
-possible supernormal profits
-possible short-run loss
-Short run supply curve of firm SRMC > AVC
-Short run industry supply curve, horizontal aggregate
Long run equilibrium:
-all supernormal profits competed away
-the firm’s long-run supply curve, LRMC > AC
-the long-run industry supply curve,
increasing/constant/decreasing cost industry
Incompatibility of economies of scale with perfect competition
e.g. agriculture
87
Ad of perfect comp
P = MC
production at minimum AC
only normal profits in long run
responsive to consumer wishes: consumer sovereignty
competition efficiency
no point in advertising
88
Dis of perfect comp
insufficient profits for investment
lack of product variety
lack of competition over product design and specification
89
Monopolistic competition
-many firms
-freedom of entry
-differentiated products
-downward sloping but elastic curve
Equilibrium
-Short run: supernormal profits MR=AC AR>AC
-Long run: MR=MC, AR=AC
-under-utilisation of capacity in long run
e.g. restaurants
90
Limitations of the monopolistic comp model
imperfect information
difficulty in identifying industry demand curve
entry may not be totally free
Indivisibilities assets of a firm that competitors cannot perfectly
duplicate
importance of non-price competition
The public interest
comparison with perfect competition
comparison with monopoly
91
oligopoly
-few firms
-some barriers to entry
-can be differentiated or undifferentiated
-downward sloping inelastic curve
-independence of firms
e.g. petrol
92
Factors favouring collusion (oligopoly)
few firms, open with each other
similar production methods; similar products
significant entry barriers
stable market
collusion is legal
93
collusive collusion
equilibrium of the industry
allocating and enforcing quotas
94
Tacit collusion
Tacit collusion
price leadership
dominant firm
barometric
rules of thumb
The breakdown of collusion
95
Non-collusive oligopoly: assumptions about rivals’ behaviour
Three well-known models
Cournot
Bertand
kinked demand curve
96
The Cournot model of duopoly
firms choose a quantity without knowing rivals’ production plans
production has long lead times/inflexible
market price adjusts instantly
homogenous goods
residual demand after rival has chosen quantity
MR curve and profit-maximising price and output for firm A
downward-sloping reaction functions for each firm
- best response to all potential outputs
-Cournot equilibrium
97
The Bertrand model of duopoly
firms choose prices without knowing prices set by other firms
prices set in advance – cannot easily be changed
firms can adjust output instantly – no capacity constraints
homogenous good
equilibrium: price cutting until all supernormal profits are competed
away
Bertrand paradox
Impact of changing assumptions
98
kinked demand curve
kinked demand curve theory provides a framework for understanding the pricing behavior of firms in oligopolistic markets
Upward-sloping portion: if a firm raise prices from above the market price, their competitors will not follow, leading to a loss of market share.
Downward-sloping portion: If a firm lowers its price below the market price, its rivals are likely to follow suit in order to maintain their market share. This means that the firm will not gain many new customers, and its total revenue may not increase significantly.
99
monopoly
-one firm
-restricted barriers to entry
-unique product
-highly inelastic curve
- MR below AR
-price control
Equilibrium price and output
-MC =MR
-price given by demand (AR) curve
e.g. microsoft, railway line
100
Reasons for barriers to entry
economies of scale
- natural monopoly
absolute cost advantages
- control over key inputs, superior technology, more efficient production methods, economies of scope
switching costs
- searching
- contractual / learning / uncertainty / compatibility/ network externalities
product differentiation and brand loyalty
legal restrictions
mergers and takeovers
aggressive tactics (price war, different offers, massive advertising)
101
Dis of monopoly
high prices / low output: short run
high prices / low output: long run
lack of incentive to innovate
X-inefficiency
102
Ad of monopoly
economies of scale
profits can be used for R&D and investment
potential for high profits encourages innovation
competition for corporate control
103
Classifying markets by degree of competition
number of firms
freedom of entry to industry
nature of product
nature of demand curve
104
Concentration ratios
simple number of firms does not indicate how concentrated a market is
concentration ratios give an indication of the degree of competition
the percentage market share of the largest so many firms
3-firm, 5-firm, 15-firm etc. concentration ratios
the ratio often depends on how quickly economies of scale are exhausted
also depends on barriers to entry
105
contestable markets
Importance of potential competition
-low entry costs
- low exit costs
Perfectly contestable markets
Hit-and-run competition
Importance of the theory of contestable markets
Contestable markets and the public interest
- similarities with perfect competition
- similarities with pure monopoly
106
lecture 6
107
The quantity theory of moneyThe quantity theory of money
the quantity equation: MV = PY
the stability of V
the stability of Y
108
Interest-rate transmission mechanism
stage 1: money – interest rate link
stage 2: interest rate – investment link
stage 3: multiplier effect
109
Limitations of the interest rate transmission mechanism
Possible problems with stage 1: money → interest rate link
elastic demand for money
unstable demand for money
Possible problems with stage 2: interest rate → investment link
inelastic investment demand
unstable investment demand
Need to consider balance sheets
precautionary effects
cash-flow effects
how interest-rate elastic is aggregate demand?
effects of financialisation and growth of balance sheets
110
The exchange-rate transmission mechanism
The stages :
money supply → interest rate link
interest rate → exchange rate link
exchange rate → import and export link
the strength of the effect
the variability of the effect
111
Portfolio balance
the theory of portfolio balance – a mechanism stressed by monetarists
explaining portfolio balance theory
Keynesian critique
112
Monetary growth in the UK
excess nominal money balances as an indicator of short-term activity and
price movements
growth rate of money holdings of sub-sectors
113
The stability of the velocity of circulation
short-run variability of V
it depends on whether money supply is directly controlled
e.g. the use of quantitative easing in response to the aftermath of the financial
crisis and the Covid-19 pandemic
long-run stability of V
114
Monetary effects of changes in aggregate demand
effect on interest rates
effect on national income
115
Crowding out
the analysis of crowding out
the extent of crowding out
responsiveness of demand for money to an interest rate change
responsiveness of investment to an interest rate change
analysis under Keynesian and monetarist assumptions
debate about crowding out in the early 2010s
116
Money supply: exogenous or endogenous?
Extreme monetarist and Keynesian views
Keynesians: total endogenous (affected by aggregate demand)
Monetarists: total exogenous (crowding out takes place)
Need to reduce endogenous element if government adopts control of money supply as basis of monetary policy
Difficulties in controlling money supply directly (control interest rates →demand for money)
Quantitative easing and the economic impact of injections of liquidity
in response to financial crisis and Covid-19 pandemic
117
The goods and money markets
Interaction of both markets
Contemporary analysis applies the IS/MP model
equilibrium in goods market
interest rates are key tool of monetary policy in many countries
inflation rate targeting
118
The IS curve
Real interest rate, national income and equilibrium in the goods market
Deriving the IS curve
Elasticity of the IS curve
A) More responsive I and S → larger effects on national income→ elastic IS
B) The size of the multiplier (1/mpw): ↑multiplier⥤↑elastic IS
Keynesians: inelastic IS →interest rates do not affect goods market much
Monetariss: elastic IS →interest rates significantly affect saving & investment
Shifts in the IS curve
Change in interest rates will cause movements along the IS curve.
Change in another determinant of investment/saving moves the whole curve.
119
The MP curve
National income and the real interest rate chosen by monetary authorities
Deriving the MP curve (LM now is called MP curve)
Inflation targeting by central banks (short-term response)
Price expectations inertia: inflation expectations are constant/anchored
↑r if ↑π // ↓r if ↓π
Elasticity of the MP curve
Below potential Y: ↑π little effect on π/r→elastic MP (flat curve)
Above/To potential Y: ↑π →C.B ↑r→inelastic MP (steep curve)
Shifts in the MP curve
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MP curve shifts
* Change in target rate of inflation: MP shifts downwards
* Inflationary shock: MP shifts upwards
* Changes in C.B. policy: change of shape → ↑target Y (steep curve)
* Change in national income Y: shift to the right
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Equilibrium in the model
The central bank will reduce the interest rate to Re to achieve the target rate of inflation at Ye (a move along the MP curve from b to a)
122
Full effects of changes in the goods and money markets
- effects of shifts in the IS curve
- effects of shifts in the MP curve
- shifts in both curves
- effects of shifts in either or both curves
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Credit cycles and the goods market
(Evidence of credit cycles)
Evidence of credit cycles
Financial accelerator
interest-rate differentials
- Saving & borrowing rate differentials
availability of credit (pro-cyclical flows)
interaction of multiplier and the financial accelerator
- Accelerator: ↑ mpcd
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Financial instability hypothesis
stages of credit accumulation
financial tranquillity, financial fragility and financial bust
irrational exuberance (euphoria→confidence→↑exp.returns on assets)
Minsky moment:
economic shock after irrational exuberance→ pessimism
balance-sheet recession: agents ↑saving & ↓debt →AD shock
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IS/LM analysis
The goods and money markets
The IS curve
movements along versus shifts of the IS curve
The LM curve
deriving the LM curve
elasticity of the LM curve
shifts in the LM curve
Equilibrium in the model
126
effects of changes in the goods market of the ISLM
- a rise in injections
127
effects of changes in the money market of the ISLM
- a rise in money supply
128
effects of changes in both markets of the ISLM
- A rise in both Injections and the money supply
129
lecture 7
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The aggregate demand curve
AD = C + I + G + X – M
income and substitution effects
income effect: + P ➔ -W/P ➔ -C ➔ -D➔ -Y
income effect:
* international substitution effect (↑Imports // ↓Exports)
* Inter-temporal substitution effect (↑ r→ ↑ S→ future bias)
* real balance effect (↓S value)
131
Aggregate demand and aggregate supply
(shape vs shift)
SHAPE:
The bigger the income and substitution effects,
the more elastic will the curve be.
SHIFTS:
The AD curve can shift inwards (to the right) or outwards (to the left), in exactly the same way as the demand curve for an individual good.
To shift, there should be a change in one of its components (C+I+G+(X-I))
Why the AD curve slopes downwards
* international substitution effect (+ P ➔ +M & -X)
* Inter-temporal substitution effect
* real balance effect
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Diminishing returns: (AS)
Fixed K and other factors (inputs) ➔ -
Mp ➔ ➔ + Mc [sticky inputs]
Growing shortages of certain variable factors: + Production ➔ increasingly + difficult to find
inputs (skilled labour, raw materials).
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changes in costs on the AS curve
* general inflation
* wage rates
* exchange rates
* technology
* changes in price expectations
134
Equilibrium
shifts in the AD curve
shifts in the SRAS curve
effect depends on the elasticity of the other curve
elasticity of the SRAS curve
+elastic SRAS→↑ΔY if ↑P
135
demand pull inflation
continuous shifts of the AD curve
subsequent effects
136
cost push inflation
supply shocks
continuous shifts of the SRAS curve
subsequent effects
137
Unemployment and the labour market
aggregate demand and supply of labour:
ADL: Amount of working positions offered given the wage rate
ASL: Amount of workers willing to accept such positions give the wage rate
- Inelastic: LFP usually does not change
significantly
equilibrium in the model
disequilibrium unemployment (shown above graph)
equilibrium unemployment
138
Disequilibrium unemployment
real-wage (classical) unemployment
demand-deficient (cyclical) unemployment
unemployment arising from a growth in the labour supply
139
employment types
frictional (search) unemployment
problem of imperfect information
structural unemployment: skills and geography
changing pattern of demand
regional unemployment
technological unemployment
seasonal unemployment
140
Classical model of labour markets. HP:
* flexible real wage rates
* no money illusion
* natural levels of employment and income (or output)
implications for shape of LRAS
temporary deviations of output from its natural level
141
Keynesian model of labour markets
wage and price rigidity
effective demand for labour
negative and positive output gaps
142
Controversy 1: Flexibility of prices and wages
the right: flexible prices and wages
the left: price and wage rigidities
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Controversy 2: Flexibility of aggregate supply
How responsive is national output (i.e. aggregate supply), and
hence also employment, to a change in aggregate demand?
Suppose AD shifts from AD1 to AD2:
Effect on P and Y (and employment)… depends on AS curve’s shape
the right… AS determined independently of aggregate demand
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Slide 62
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