HE9091: Principles of Economics

Lecture 1: Introduction to Economics

1.1 Scarcity and Cost-Benefit Principles
1.2 Opportunity Cost and Incentive Principle
1.3 Demand and Supply
1.4 Market Equilibrium and Price Control
1.5 Shifts in Demand and Supply
1.6 Efficiency and Equilibrium Principles

Lecture 2: Elasticity and Consumer Behaviour

2.1 Price Elasticity of Demand (Use midpoint formula unless otherwise stated)
2.2 Income Elasticity of Demand
2.3 Cross-Price Elasticity of Demand
2.4 Price Elasticity of Supply
2.5 Total Utility and Marginal Utility
2.6 The Rational Spending Rule
2.7 Demand and Consumer Surplus
2.8 Supply and Producer Surplus

Lecture 3: Perfect Competition, Production and Efficiency

3.1 Perfectly Competitive Markets
3.2 Production and Cost
3.3 Profit and Loss in the Short Run
3.4 Market Equilibrium and Efficiency
3.5 Taxes and Efficiency
3.6 Long Run Adjustment in Perfect Competition

Lecture 4: Imperfect Competition and Game Theory

4.1 Sources of Market Power
4.2 Profit Maximization for Monopolist
4.3 Price Discrimination
4.4 Game Theory and Strategic Decisions
4.5 Prisoner’s Dilemma
4.6 Decision Tree
Lecture 5: Externalities, Property Rights and Economics of Information
5.1 External Costs and Benefits
5.2 The Coase Theorem
5.3 Property Rights and the Tragedy of the Commons
5.4 Optimal Amount of Information
5.5 Asymmetric Information
5.6 Adverse Selection and Moral Hazard

Lecture 6: Economics of Public Policy

6.1 Economics of Health Care Delivery
6.2 Environmental Regulation
6.3 Public Policy in Pollution Control
6.4 Public Good and Private Good
6.5 Optimal Quantity of Public Good
6.6 Additional Functions of Government and Sources of Inefficiency
HE9091: Principles of Economics
Lecture 1: Introduction to Economics
1.1 Scarcity and Cost-Benefit Principles
a) Scarcity Principle: People have unlimited wants and limited resources. Having more of
one good means having less of another. (No Free-Lunch Principle)
b) Cost-Benefit Principle: A rational individual takes action if and only if the extra benefits
are at least as great as an extra cost.
c) Economic surplus = Total benefit - Total cost

1.2 Opportunity Cost and Incentive Principle

a) Opportunity cost: the value of what must be forgone in order to undertake an activity.
i) Implicit cost
ii) Total cost includes opportunity cost
b) Sunk cost: Costs that are beyond recovery when a decision is made
c) Marginal cost/benefit: Increase in total cost/benefit from one additional unit of an
activity
d) Average cost/benefit: Total cost/benefit divided by total cost/benefit
e) Normative Economics: Judgements
f) Positive Economics: Facts

1.3 Demand and Supply

a) Law of Demand: Consumers buy less of a product as the price of the product rices. Price
and quantity demanded are inversely related.
b) Buyer’s reservation price: Highest price an individual is willing to pay for a good.
c) Substitution effect: Buyers switch to substitute when price goes up
d) Income effect: Buyers’ overall purchasing power goes down when price goes up
e) Law of supply: Producers supply more of a product as the price of the product increases.
Price and quantity supplied are positively related.
f) Low-Hanging Fruit Principle: In the process of increasing the production of any good,
one first employs those resources with the lowest opportunity cost and only once these
are exhausted turns to resources with higher costs.
g) Seller’s reservation price: Lowest price the seller would be willing to sell for

1.4 Market Equilibrium and Price Control

a) Market Equilibrium: Occurs when all buyers and sellers are satisfied with their
respective quantities at the market price. (Quantity demanded = Quantity supplied)
b) Incentive Principle: Actions are more likely to be taken if their benefits rise. Actions are
less likely to be taken if their costs rise
i) Surplus: Each supplier has an incentive to decrease the price in order to sell more
 ii) Shortage: Each supplier has an incentive to increase the price in order to sell
more
c) Price Ceilings: Maximum allowable price set by law
i) Below equilibrium
ii) Results in shortage
d) Movement along the Demand Curve: A change in quantity demanded results from a
change in the price of a good.
e) Movement along the Supply Curve: A change in quantity supplied results from a
change in the price of a good.

1.5 Shifts in Demand and Supply

a) Shifts in Demand
i) Price of complementary goods
ii) Price of substitute goods
iii) Income (normal vs inferior goods)
iv) Taste and preferences
v) Number of buyers in the market
vi) Expectations about the future

b) Shifts in Supply
i) Change in price of input
ii) Change in technology
iii) Weather
iv) Number of sellers in the market
v) Expectation of future price changes
*Price changes never cause a shift in demand or supply*

1.6 Efficiency and Equilibrium Principles

a) Efficiency and Equilibrium: MSB = MSC
i) Markets communicate information effectively: Value buyers place on the product
and opportunity cost of producing the product
ii) Markets maximise the difference between private benefits and costs
iii) Market outcomes are the best provided that: The market is in equilibrium AND no
external costs or benefits are shared with the public
b) No Cash on the Table: When surplus is maximised. No opportunity to gain from
additional sales or purchases
 c) Buyer’s surplus: Buyer’s reservation price minus market price
d) Seller’s surplus: Market price minus seller’s reservation price
e) Total surplus:
i) Buyer’s surplus + seller’s surplus
ii) Buyer’s reservation price - seller’s reservation price

f) Efficiency Principle: Equilibrium price and quantity are efficient if:

i) Sellers pay all costs of production
ii) Buyers receive all the benefits of their purchase
g) Socially optimal quantity: Maximises total surplus for the economy
from producing and selling a good. (MC = MB)
h) Equilibrium Principle: Market in equilibrium leaves no unexploited opportunities for
individuals

Lecture 2: Elasticity and Consumer Behaviour

2.1 Price Elasticity of Demand
a) Price elasticity of demand:
i) Percentage change in quantity demanded from a 1% change in price
ii) Measure of responsiveness of quantity demanded to change in price

b) Calculating PED:
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑
i) 𝑃𝐸𝐷 =

TE Ia
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒
∆𝑄/𝑄
ii) 𝑃𝐸𝐷 = ∆𝑃/𝑃
𝑃 1
iii) 𝑃𝐸𝐷 = 𝑄
× 𝑠𝑙𝑜𝑝𝑒 (Price elasticity is different at each point)
iv) Revenue maximised when PED = 1
 c) Determinants of Price Elasticity of Demand:
i) Substitution options: More options, more elastic
ii) Budget share: Large share, more elastic
iii) Time: Long time to adjust, more elastic
d) Total Expenditure: Total Revenue = P x Q
i) When Price increases, total expenditure can increase, decrease or remain the
same, depending on elasticity

e) Midpoint Formula for Elasticity of Demand

I
∆𝑄/[(𝑄𝑎+𝑄𝑏)]/2 ∆𝑄/[(𝑄𝑎+𝑄𝑏)]
i) ϵ = ∆𝑃/[𝑃𝑎+𝑃𝑏)]/2
= ∆𝑃/[𝑃𝑎+𝑃𝑏)]
ii) Use by default unless otherwise stated

I
2.2 Income Elasticity of Demand
a) Income Elasticity of Demand: percentage change in quantity demanded from a 1%
change in income
i) Normal good: (+ve)
ii) Inferior good: (-ve)
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑
b) 𝑌𝐸𝐷 = 𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑖𝑛𝑐𝑜𝑚𝑒

2.3 Cross-Price Elasticity of Demand

a) Cross-Price Elasticity of Demand: percentage change in quantity demanded of good A
from a 1% change in price of good B
i) Complements: (-ve)
ii) Substitutes: (+ve)
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑 𝑜𝑓 𝐴
b) 𝑋𝐸𝐷 = 𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝐵
2.4 Price Elasticity of Supply
a) Price Elasticity of Supply: percentage change in quantity supplied from a 1% change in
price
b) Calculating PES:
∆𝑄/𝑄
i) 𝑃𝐸𝑆 = ∆𝑃/𝑃
𝑃 1
ii) 𝑃𝐸𝑆 = 𝑄
× 𝑠𝑙𝑜𝑝𝑒
c) Supply curve with positive intercept: PES decreases as Q increases
d) Supply curve with 0 intercept: PES = 1
e) Determinants of PES:
i) Input Flexibility: adaptable inputs, more elastic
ii) Mobility of inputs: resources able to move where needed, more elastic
iii) Produce substitute inputs: Alternative inputs easy to find, more elastic
iv) Time: Long run, more elastic

2.5 Total Utility and Marginal Utility

a) Utility: Satisfaction people derived from consumption
i) Marginal Utility: additional utility from consuming one more unit
b) Law of Diminishing Marginal Utility: Additional utility gained from consuming an
additional unit of a good tends to decrease as consumption increases beyond some point
c) Budget Allocation: Maximise utility when the marginal utility per dollar spent is the
same for all goods
d) No Money Left On the Table Principle: Take a dollar away from the good with low
marginal utility and spend it on the good with high marginal utility until marginal utility
per dollar begin to equalise.

2.6 The Rational Spending Rule

a) Rational Spending Rule: Spending should be allocated across goods so that the marginal
utility per dollar is the same for each good
i) MUa / Pa = MUb / Pb
b) Substitution effect: When the price of a good goes up, substitutes for that good are
relatively more attractive
c) Income effect: Changes in price affect the buyers’ purchasing power. Acts like a change
in income.
2.7 Demand and Consumer Surplus
a) Welfare of society: Economic surplus = Consumer surplus + Producer surplus
b) Individual and Market Demand Curve: Market demand is the horizontal sum of
individual demand curves

c) Consumer surplus: difference between buyer’s reservation price and market price
i) Area under demand curve and above market price

2.8 Supply and Producer Surplus

a) Individual and Market Supply curve:

b) Producer surplus: Difference between the market price and seller’s reservation price
i) Area above the supply curve and below the market price
Lecture 3: Perfect Competition, Production and Efficiency
3.1 Perfectly Competitive Markets
a) Perfectly Competitive Markets:
i) Products:
1) identical goods offered by many sellers
2) No loyalty to suppliers
ii) Many buyers and sellers:
1) Each has small market share
2) Price takers (No buyer or seller can influence price)
iii) Mobile Resources
1) Inputs move to their highest value use
2) Firms enter and leave industries
iv) Informed Buyers and Sellers: Perfect information
1) Buyers know market prices
2) Sellers know all opportunities and technologies

3.2 Production and Cost

a) Factor of production: input used in the production of a good or service
i) Capital
ii) Entrepreneurship
iii) Land
iv) Labour
b) Short run: At least one of the firm’s factors of production is fixed
i) Variable factors of production can be changed in the short run
ii) Fixed factors of production cannot be changed in the short run
c) Long run: period of time in which all inputs are variable
d) Law of diminishing Returns: When some factors of production are fixed, the marginal
product of the variable factor will eventually decline
i) At low levels of production, LDR may not hold: Gains from specialisation
ii) Diminishing returns eventually sets in and is often caused by congestion:
1) Only so many people can fit into the office
2) Only one worker can use the machine at a time
e) Cost Concepts:
i) Fixed cost: sum of all payments for fixed inputs
ii) Variable cost: sum of all payments for variable inputs
iii) Total cost: sum of all payments for all inputs
iv) Marginal cost: change in total cost divided by change in output
3.3 Profit and Loss in the Short Run
a) Profit = total revenue - total cost
b) Profit-maximizing: MC = MR

c) Shutdown Condition: P x Q < VC or P < AVC

d) Accounting Profit: Total revenue - Explicit cost
i) Explicit cost: payments firms make to purchase resources and products from other
firms
e) Economic Profit (aka excess profits): Total revenue - implicit cost - explicit cost
i) Implicit cost: opportunity costs of the resources supplied by the firm’s owners
f) Normal Profit: Normal profit occurs when Economic profit = 0

Profit

Accounting Profit Implicit Cost Economic Profit

Example 1:
Ali’s decision: continue farming or quit?
- Quit farming and earn $11,000 per year working retail
- Explicit farm costs are $10,000
- Total Revenue is $22,000
Ali should stick with farming because:
- Accounting Profit = Total Revenue - Explicit cost
Accounting Profit = $22,000 - $10,000
= $12,000
- Implicit cost = Opportunity cost
= $11,000
- Economic Profit = Accounting Profit - Implicit cost
Economic Profit = $12,000 - $11,000
= $1000
He should stick with farming because his economic profit is positive.

Example 2:
Ali’s decision: continue farming or quit?
- Quit farming and earn $11,000 per year working retail
- Explicit farm costs are $10,000
- Total revenue is $20,000
Ali should not stick with farming because:
- Implicit cost = Opportunity cost
Implicit cost = $11,000
- Economic profit = Total revenue - implicit cost - explicit cost
Economic profit = $20,000 - $11,000 - $10,000
= -$1000
He should not stick with farming because his economic profit is negative.

g) Invisible Hand Theory: actions of independent, self-interested buyers and sellers will
often result in the most efficient allocation of resources
h) Two functions of Price:
i) Rationing function: price distributes scarce goods to consumers who value them
most highly
ii) Allocative function: price directs resources away from overcrowded markets that
are undeserved
3.4 Market Equilibrium and Efficiency
a) Market Equilibrium: leaves no opportunities for individuals to gain
i) Markets work best when:
1) Buyers’ marginal benefits = sellers’ marginal cost
2) Society’s marginal benefits = society’s marginal costs
b) Market Equilibrium in Perfect Competition:
i) In the long run, all perfectly competitive firms use the same cost savings
techniques, new firms enter the market
ii) Market supply increases, equilibrium price decreases, profit decreases until zero
profit in the long run
iii) Perfectly competitive firm is both productive efficient (produce at lowest ATC)
and allocative efficient (P=MC)
c) Economic efficiency: exists when no change could be made to benefit one party without
harming the other (equilibrium price and quantity)

3.5 Price control and Efficiency

a) Price ceilings: Maximum allowable price specified by the law
b) Price subsidies: Meant to assist low-income consumers, government funding of
“essential” goods and services
c) Surplus lost to a Price Ceiling: Shortages, increases non-market costs
i) Waiting in line (only rich get the goods)
ii) Side payments/Black market
d) Alternative better policy: Subsidy
i) Leads to overproduction
ii) Waste of resources and inefficiency
 e) Subsidy results in less efficiency:
i) - Imported bread costs $2 (perfectly elastic supply)
- Government subsidise bread
- Government imports bread for $2, sells for $1
- Consumer surplus increase from $4mil to $9mil
(increase in surplus = $5mil)
ii) - Government loses $1 on every loaf of bread
- Imports 6 million loaves for $2 per loaf
- Government losses = $6mil
iii) - Net benefit of subsidy program:
- Gain in Consumer surplus - government losses
- $5mil - $6mil = -$1mil
f) Effects of Tax:
i) Leads to underproduction
ii) Cash on the Table and inefficiency
iii) Output stops where marginal benefit still exceeds marginal cost

3.6 Long Run Adjustment in Perfect Competition

a) Perfect Competition:
i) Short run: firm may earn profit, break even or incur loss
ii) Long run: firm break even due to free entry and exit
Lecture 4: Imperfect Competition and Game Theory
4.1 Sources of Market Power
a) Imperfect competition: Price setters (Have some ability to set their own prices)
i) Long run economic profits possible
ii) Reduce economic surplus (inefficient)
b) Types of imperfect competition:
i) Monopoly: Only one seller, no close substitutes
ii) Monopolistic competition: Many firms producing slightly differentiated products
that are close substitutes
iii) Oligopoly: Small number of large firms producing products that are identical or
close substitutes
c) Market Power: firm’s ability to raise its price without losing all its sales
d) 5 Sources of Market Power:
i) Exclusive control over inputs
ii) Patents and copyrights
iii) Government licence or franchise
iv) Economies of scale
v) Network Economies: value of product increases as number of users increases
e) Returns to scale: Percentage change in output from a given percentage change in ALL
inputs
i) Constant returns to scale: doubling all inputs doubles output
ii) Increasing returns to scale/Economies of scale:
1) output increases by a greater percentage than the increase in input
2) Average costs decrease as output increases
3) Natural monopoly: monopoly that results from economies of scale
iii) Decreasing returns to scale: Doubling all inputs less than doubles output
f) EOS and Start-up Cost: A good whose production has large start-up cost and low
variable cost is subject to EOS (ATC declines sharply as output increases)
i) Average Total Cost = (Fixed cost/Quantity) + (Marginal cost)
ii) Average total cost decreases as output increases
 g) Fixed Cost and Marginal Cost: Firms that have high fixed cost and low marginal cost
may have tendency to become a monopolist
i) High fixed cost: Creates barriers to entry and need high output to average out the
cost
ii) Low marginal cost: As output increases, average total cost decreases over a large
range of output
iii) As a result, firm becomes more efficient as production increases → Monopolise
the market

4.2 Profit Maximization for Monopolist

a) Monopolist: maximises profits and applies the Cost-Benefit Principles (like all other
firms)
i) Increase output if MB > MC
ii) Decrease output if MB<MC
b) Marginal Benefit = Marginal revenue: Change in total revenue from a one-unit change
in output
i) Marginal Revenue is less than price for monopolist

c) Profit maximisation: MC = MR
i) When MC > MR, decrease output
ii) When MC < MR, increase output
d) Monopoly Profit:
i) Profit = Total revenue - total cost
ii) Profit = (P x Q) - (ATC x Q) = (P - ATC) x Q
iii) If P > ATC, then firm earns profit
 e) The Invisible Hand Fails:
i) Given a demand curve: P = 15 - 2Q,
ii) Marginal revenue curve: MP = 15 - 4Q
iii) Marginal cost is a line with zero intercept and a slope of 1 MC = Q

4.3 Price Discrimination and Monopolies

a) Price Discrimination: charging different buyers different prices for essentially the same
good or services
i) Conditions:
1) Separate the groups
2) No reselling of the product possible
b) Forms of Price Discriminations:
i) Hurdle method: discounts for identifiable groups (e.g. students, senior citizens)
ii) Perfect discrimination: negotiate separate deals with each customer
c) Monopoly and Public Policy:
i) Monopoly tends to create deadweight loss and reduce total economic surplus
ii) Policy options:
1) Government ownership and operation
2) Regulation
3) Competitive bids for natural monopoly services
4) Break up monopolist
d) Monopolies:
i) State-Owned Natural Monopoly
1) MC is always less than average cost
2) Fund losses from tax revenues
3) Fixed monthly fee plus usage fee
4) Limited incentives to innovate and cut costs
5) Commonly used for water, Post Office, and power
ii) Regulated Monopolies
 1) Cost-plus regulation: government sets the price that a firm can charge by
looking at the firm’s explicit cost plus a markup for implicit cost
2) Disadvantages:
(a) High administrative costs
(b) Reduced incentives for cost-saving innovations
(c) Price is greater than marginal cost
3) E.g. Electricity, telephone and cable
iii) Exclusive Contracting for Natural Monopoly
1) Government awards contract to low bidder for natural monopoly services
(Firm that is confident in producing at lowest cost)
2) Could achieve marginal cost pricing IF government pays the resulting
losses
3) E.g. Garbage collection, fire protection, road construction, Department of
Defence
iv) Break Up Monopoly
1) Two objections to monopolies:
(a) Restrict output, decrease total surplus
(b) Raise price, earn economic profits and exploit consumers
2) Policy:
(a) Break up monopolist to introduce competition
(b) May undermine economies of scale if there is natural monopoly
and discourage innovation
e) Anti-Trust Laws: Enhances competition attempt to limit deadweight loss
i) Limitations of limiting monopoly:
1) Discourages innovation (e.g. patents encourages innovation)
2) Reduces economies of scale that minimise ATC
3) Reduced increased benefits from network economies

4.4 Game Theory and Strategic Decisions

a) Basic elements of a game:
i) The players
ii) The available strategies, actions, or decisions
iii) The payoff to each player for each possible action
b) Dominant strategy: One that yields a higher payoff no matter what the other player does
c) Dominated strategy: Any strategy available to a player who has a dominant strategy
d) Payoff matrix: Table that describes the payoffs in a game for each possible combination
of strategies
Example 1: Payoff is symmetric
- Dominant strategy is raising advertising spending
- Both companies will be worse off
Thai Airways Options

Singapore Airlines
Raise Spending No Raise
Options

Singapore: $5,500 Singapore: $8,000

Raise Spending
Thai: $5,500 Thai: $2,000

Singapore: $2,000 Singapore: $6,000

No Raise
Thai: $8,000 Thai: $6,000

e) Nash's equilibrium: any combination of strategies in which each player’s strategy is her
or his best choice, given the other player’s strategies
i) Equilibrium occurs when each player follows his dominant strategy, if it exists
ii) Equilibrium does not require a dominant strategy

Example 2: Different payoffs; non-symmetric

- Thailand raises spending
- Singapore anticipates Thailand’s action; does not raise

4.5 Prisoner’s Dilemma

a) Prisoner’s Dilemma: Game in which each player has a dominant strategy, and when
each plays it, the resulting payoffs are smaller than if each had played a dominated
strategy.
Example 3
- Both confess and are worse off

I
b) Cartel: Coalition of firms that agree to restrict output to increase economic profit
i) Restrict total output: allocate quotas to each player
ii) The agreement is not legally enforceable

Example 4: Cartel
- If one firm lowers price, they capture the entire market
- Dominant strategy for each firm is to lower price to $0.90
- Cartel agreements are unstable
Mountain Spring's Options

Aquapure's
Charge $1 Charge $0.90
Options

Aquapure: $500 Aquapure: $0

Charge $1
Mtn Spring: $500 Mtn Spring: $990

Aquapure: $990 Aquapure: $495

Charge
$0.90 Mtn Spring: $0 Mtn Spring: $495

c) Repeated Prisoner’s Dilemma: Sample players repeatedly face the same prisoner’s
dilemma
d) Tit-for-tat strategy: says that my move in this round is whatever your move was in the
last round
i) If you defect, I defect
ii) Rarely observed in the market because it breaks down with more than two players
or potential players
4.6 Decision Tree
a) Decision tree/Game tree: describes the possible moves in a game in sequence
i) More useful way of representing payoffs when timing matters

Example 5: Simultaneous Decision

- Two Nash Equilibrium outcomes: Bottom left and Top right
- Profits are higher when each company offers a different type of smartphone
Sony Xperia Options

Samsung
Quad Core No Quad Core
Galaxy Options
Samsung: $60 M Samsung: $80 M
Quad Core
Sony: $60 M Sony: $70 M
Samsung: $70 M Samsung: $50 M
No Quad Core
Sony: $80 M Sony: $50 M

Suppose Sony Moves First

b) Threats, Promises and Commitments:

i) Credible threat: threat to take an action that is in the threatener’s best interest to
carry out
ii) Credible promise: promise to take an action that is in the promiser’s best interest
to carry out
iii) Commitment problem: arises from an inability to make credible threats or
promises
1) A commitment device changes incentives to make threats or promises
credible
Lecture 5: Externalities, Property Rights and Economics of Information
5.1 External Costs and Benefits
a) Externality: Name given to an external cost or external benefit of an activity
i) External cost: Cost incurred by someone who is not involved in the pursuit of the
activity
ii) External benefit: Benefit gained by someone who is not involved in the pursuit of
the activity
b) Resource allocation
i) Externalities reduce economic efficiency
ii) With externalities, private market outcomes do not achieve the largest possible
economic surplus → Cash is left on the table and leads to Market Failure
iii) Need to rectify externalities for the market to be efficient

5.2 The Coase Theorem

a) Coase Theorem: If people can negotiate the right to perform activities that cause
externalities, they can always arrive at efficient solutions to problems caused by
externalities
i) Negotiations must be costless
ii) Adjustment to the externality is usually done by the party with the lowest cost
b) Laws Can Change the Outcome:
i) Suppose the law makes polluters liable for the cost of cleaning up their pollution
1) Polluters need to compensate non-polluters and get lower incomes
2) Non-polluters get higher incomes after compensation
c) Legal Remedies for Externalities: When negotiation is not costless, laws may be used
to correct for externalities
i) Burden of the law can be placed on those who have the lowest cost
d) Taxes or Subsidies to remove Externalities:
5.3 Property Rights and the Tragedy of the Commons
a) Tragedy of Commons: tendency for a resource that has no price to be used until its
marginal benefit is zero.
i) Use of property will increase until MB = 0

Example 1:
Suppose 5 villagers spend $100 for either a steer or a government bond that pays 13%

- The fourth is indifferent between the two assets, and hence buys a steer
- Fifth buys a bond
- Total revenue for the 5 villagers: 5 x $113 = $565
- Total net income = $65
They could have done better

- Net income from one bond after one year is $13

- Buy a steer only if its marginal benefit is at least $13
Better choice:
- First villager buys a steer and all others buy bonds
- Total net income is 26 + 4(13) = $78

5.4 Optimal Amount of Information

a) Imperfect information: Information can only be obtained with a cost via research or
middleman
b) Optimal Amount of Information: MC =MB
i) MB starts high, then falls rapidly (Low-Hanging Fruit Principle)
ii) Marginal cost starts low, then increases
c) Free-rider problem: Exists when non-payers cannot be excluded
from consuming a good
i) Interferes with incentives
 ii) Market quantity is below social optimum
d) Rational Search Guideline: Additional search time is more likely to be worthwhile for
expensive items than cheap ones
e) Gamble Inherent in Search: Additional search has costs that are certain but benefits that
are uncertain
i) Each outcome has a probability to occur
ii) Expected value = sum of possible outcome x respective probabilities
iii) Fair gamble: Expected value = 0
iv) Better-than-fair gamble: Expected value = +ve
f) Risk Preferences:
i) Risk-neutral: accept any gamble that is fair or better-than fair
ii) Risk-averse: refuse any fair gamble
iii) Risk-seeking: accept any gamble that is less than fair

Example 1: Gamble in the Search of house

- Apartment type A: $400, 80% availability
- Apartment type B: $360, 20% availability
- Cost per visit: $6
- Risk-neutral

Two outcomes of the gamble:

1) Apartment type A: net benefit = -$6 with 80% probability
2) Apartment type B: net benefit = $34 with 20% probability
Expected value of gamble is: ($34)(0.20) + (-$6)(0.80) = $2
Hence, gamble is more than fair, accept gamble and keep searching

5.5 Asymmetric Information

a) Asymmetric information: occurs when either the buyer or seller is better informed about
the goods in the market
i) Party with additional information may use to gain at the expense of the other party
b) The Lemons Model: Asymmetric information tends to reduce the average quality of
goods for sale
i) People who have below average cars (lemons) are more likely to want to sell them
1) Buyers know that below average cars are likely to be on the market and
lower their reservation price
ii) Good quality cars (jewels) are withdrawn from the market
1) Average quality decreases further and reservation prices decreases again
5.6 Adverse Selection and Moral Hazard
a) Adverse selection: occurs because insurance tends to be purchased more by those who
are more costly for companies to insure
i) Insurance is most valuable to those with many claims
ii) Adverse selection increases insurance premiums → reduces attractiveness to
insurance to low-risk customers
iii) Rates increase and drive out good customers
b) Moral Hazard: tendency of people to spend less effort protecting insured goods
i) People take more risk with insured goods or activities
ii) Deductibles give policyholders an incentive to be more cautious
c) Co-payment to reduce moral hazard:
i) Suppose a car owner has a $1000 deductible policy
ii) The owner pays the first $1000 of each claim → strong incentive to avoid
accidents
iii) Claims less than $1000 are not reported, insurance premiums go down

Lecture 6: Economics of Public Policy

6.1 Economics of Health Care Delivery
a) Economies of Health Care: Health care spending tend to grow faster than income as
economy develops
i) Improved quality of tests, procedures, and drugs etc.
ii) Third-party payment system: insurance
b) Health Care Delivery: Perform a service only if benefit > cost
i) However, benefits are complicated to measure:
1) Usual measure is willingness to pay
2) Some patients are unable to pay for basic services
3) Society assumes some responsibility via government-provision insurance
4) Confused by third-party payment system
c) Full Insurance Coverage
i) Creates waste
ii) Amount of waste depends on the price elasticity of demand for medical services
Example 1:
Alternative Coverage Scheme to remove lost in surplus:

d) Types of coverage:
i) First-dollar coverage: pays all expenses for the insured’s health care
ii) $1000 deductible: pays all expenses after the patient has paid $1000 (more
efficient)
e) Asymmetric information in Health Care: Doctors have more information than the
patients and tend to recommend additional prescriptions and tests to patients to earn
more.
i) Doctors that provide health services for a fixed annual fee → reduced incentives
to prescribe expensive tests
f) Adverse Selection in Health Care: Only people who are likely to incur high medical
cost are keen to purchase insurance
i) Insurance premiums are raised and a downward spiral ensues, resulting in
unaffordable health care
ii) Private insurance companies are reluctant to issue individual policies to people
with serious health issues
g) Health Insurance Market:
i) Employer-provided insurance/Group insurance: Lower risk
ii) 3 Main National Health Insurance provision :
1) Non-discrimination to pre-existing conditions
2) Include all individuals
 3) Subsidies to low-income families

6.2 Environmental Regulation

a) Ways to reduce pollution:
i) Regulation (set maximum pollution limits and giving out permits)
1) Advantages of Auctioning permits:
(a) Utilises low-cost permit control → Permit fees can offset with
other taxes
(b) Predictable operating and investing environment
(c) Government can set target pollution

ii) Tax smoke at a rate of $T per ton (firms will reduce pollution as long as the cost
of reduction is less than $T)
1) However, it is difficult to determine optimal tax rate (MC = MB)
(a) Set the tac too low and get too little reduction
(b) Set the tax too high and get too much reduction

Regulation Taxing

6.3 Public Health and Safety

a) Workplace Safety:
i) Safety standards: Safety incurs cost and employers would not employ the optimal
amount of safety without regulation
ii) Safety is a consideration in the competition for labour (If an employer offers too
little safety, he loses worker to firms with optimal safety precautions)
b) Public Health: Optimal policies to prevent illness should equate the marginal social
benefit with the marginal social cost
 i) Market forces result in too few vaccinations
ii) Laws requires compulsory vaccinations
6.4 Public Good and Private Good
a) Public Good: Pure public goods are provided by government
i) Non-rivalrous: consumption by one person does not diminish its availability to
others (e.g. National defence and public lectures)
1) Non-payee get to consume the product → cost of production are difficult
to recover directly
2) Free-rider problem
ii) Non-excludable: difficult or costly to exclude non-payers from consuming (e.g.
Over-the-air broadcasts and Fireworks displays)
1) Same product can be made available to many customers
2) MC = 0
3) Optimal quantity is P = MC
iii) Hence, charging positive price reduces total surplus
b) 4 Types of goods:

Types of Goods Non-rivalrous Non-excludable Rivalrous Excludable

Public

Private

Collective

Common

6.5 Optimal Quantity of Public Good

a) Cost of a public good: Sum of explicit and implicit costs incurred to produce it
b) Benefits of a public good: Benefit of an additional unit of public good is the sum of
reservation price someone would pay for it
(Compared to private good: Benefit of an additional private good is the highest price
someone would pay for it)
c) Paying for Public Good: Not everyone benefits equally from a public good or service
i) Taxing people in proportion to their willingness to pay is equitable but impractical
ii) Possible solutions:
1) Government provision of Public Goods
(a) Advantages:
(i) Low cost to collect additional revenue
(ii) No negotiations over distributions of costs
(b) Disadvantages: One size fits all problem
 (i) Some paid for goods they don't want
(ii) Some don’t get goods they paid would pay for
2) Head tax: Tax that collects the same amount from every taxpayer
(However, head tax is regressive as it takes up a larger proportion of
income from the poor, and hence will be voted against)
3) Proportional Tax on Income: requires all taxpayers to pay the same
proportion of their incomes in taxes
iii) Higher income groups tends to consume more public goods (Parks, community
libraries) than lower income groups
iv) Progressive taxes take a larger share of higher incomes as tax and thus, support a
better outcome for all groups than head tax which is regressive
d) Public Good Market Demand: Vertical Summation

e) Optimal Quantity of Parkland

f) Private Provision of Public Goods: Alternative ways to raise revenues

i) Funding by donation
ii) Exclude non-payers (with the help of technology)
iii) Sale of by-products (Advertising on TV, Internet)
 g) Funding by Advertising (both cause inefficiencies)
i) Advertisers choose programs
ii) Pay-per-view
1) MC = 0, audience is 20mil
2) Fee = $10, audience is 10mil
3) Lost in surplus = $50mil
4) More elastic demand, greater loss
in surplus

6.6 Additional Functions of Government and Sources of Inefficiency

a) Roles of government
i) Regulate activities that generate externalities
ii) Define and enforce property rights
b) Rent seeking: Firms compete for a single contract, spend potential profits on bid
preparation and lobbying
i) Socially unproductive efforts to gain a price
ii) Government projects have large gains for a few small costs for many → Potential
winners have large benefits, but potential losers have less at stake and spread
across many small losers
c) Tax considerations: Government spending generally exceeds tax revenues and results in
budget deficit → Crowding out effect
i) Crowding out: reduction in private investment caused by increased in interest
rates from government borrowing
ii) If a market works efficiently, adding taxes creates inefficiency
Example:
1) Initial equilibrium is $20,000 and 6mil cars
2) $2000 tax shifts supply up
3) New equilibrium at $22,000 and 4mil cars
4) Total surplus decreases
However, economic loss of a tax may be offset by the surplus
created from the public good or service. → Taxes on externalities
increase economic efficiency
Lecture 7: Gross Domestic Product (GDP) and Inflation
7.1 Gross Domestic Product (GDP)
7.2 The Expenditure Method
7.3 Nominal and Real GDP
7.4 Real GDP and Economic Well-Being
7.4 The Consumer Price Index
7.5 Adjusting for Inflation
7.6 Costs of Inflation

Lecture 8: Unemployment and Economic Growth

8.1 Demand and Supply in Labour Market
8.2 Measuring Unemployment
8.3 Types of Unemployment
8.4 Impediments to Full Employment
8.5 Economic Growth and Labour productivity
8.6 Determinants of Average Labour Productivity
8.7 Policies to Promote Economic Growth

Lecture 9: Capital Formation, Financial Markets and Money Supply

9.1 Saving, Wealth and National Saving
9.2 Investment and Capital Formation
9.3 Demand and Supply of Saving
9.4 Bonds and Stocks
9.5 Commercial Banks and Money Creation
9.6 Central Bank and Money Supply
9.7 Money Demand and Money Supply

Lecture 10: Aggregate Expenditure and Stabilization Policy

10.1 Recession and Expansion
10.2 Potential Output and Output Gap
10.3 The Keynesian Model
10.4 Aggregate Expenditure and Multiplier
10.5 Short Run Equilibrium Output
10.6 Fiscal Policy
10.7 Monetary Policy
Lecture 11: Aggregate Demand, Aggregate Supply and Macroeconomic Policy
11.1 The Aggregate Demand Curve
11.2 The Aggregate Supply Curve
11.3 Aggregate Demand-Aggregate Supply Analysis
11.4 Anti-Inflationary Monetary Policy
11.5 Response to Aggregate Demand Shock
11.6 Response to Aggregate Supply Shock

Lecture 12: Exchange Rate, International Trade and Capital Flow

12.1 Exchange Rate Determination
12.2 Flexible and Fixed Exchange Rates
12.3 Nominal and Real Exchange Rates
12.4 Purchasing Power Parity Theory
12.5 Trade Balance and Net Capital Inflows
12.6 International Capital Flows
Lecture 7: Gross Domestic Product (GDP) and Inflation
7.1 Gross Domestic Product (GDP)
a) Gross domestic product: The market value of final goods and services produced in a
country in a given period of time
b) Types of goods and services:
i) Final goods:
1) End products of production
2) Included in GDP
ii) Intermediate goods:
1) Used up in production of final goods
2) Not included in GDP to avoid double counting
iii) Capital goods:
1) Long-lived goods used in the production of other goods and services
2) Houses, apartments, motels, Machines used in production, Delivery
vehicles and taxis
c) Value Added: Market value of the product - cost of inputs purchased from other firms

7.2 The Expenditure Method

a) Users of final goods:
i) Households
ii) Firms
iii) Government
iv) Foreigners
b) 3 GDP Approaches :
i) Production:
1) Market value of final goods and services(Market value = Amount spent)
ii) Expenditure
1) Total spending for final goods - value of imports
iii) Income
1) Labour income + Capital Income
c) Consumption expenditure: spending by households for goods and services
d) Investment: spending by firms on final goods and services
i) Business fixed investment (Economic Investment): purchases of new capital
1) Plant
2) Property
3) Equipment
ii) Residential investment: construction of new homes and apartment buildings
iii) Inventory investment: Change in unsold goods to the company’s inventory
1) Goods that are produced but not yet sold
iv) Financial investment: Purchases of bonds, stocks, and other financial assets
 1) Purchase generally transfers ownership of a portion of the firm’s existing
capital stock
2) Not included in calculation of GDP
e) Government purchases: Final goods and services bought by central, state, and local
governments
i) Excludes transfer payments
f) Net exports: Exports - Imports
i) Exports are goods and services produced domestically and sold abroad
ii) Exports reduce the amount available to the domestic economy
iii) Imports are purchases in domestic economy of goods and services produced
abroad
iv) Import needs to be excluded from the calculation
g) GDP Expenditure Equation: Y = C + I + G + NX
i) Y = GDP/ output
ii) C = Consumption Expenditure
iii) I = Investment
iv) G = Government purchases
v) NX = Net Exports
h) Income Approach to GDP: GDP = labour income + capital income
i) When a good is sold, its proceeds are distributed to workers or business owners
ii) Labour income: wages, salaries, benefits, and incomes of self-employed
iii) Capital income: pays for physical capitals and tangibles
1) Profits for business owners
2) Rent for land
3) Interest for bondholders

7.3 Nominal and Real GDP

a) Real GDP: values of output in the current year using the prices from the base year
b) Nominal GDP: values of output in the current year using prices from the current year

7.4 Real GDP and Economic Well-Being

a) Real GDP is flawed to measure Well-being:
i) Values only market transactions: Other illegal transactions, volunteer work, and
household production is omitted
(Non-market activities are important in poor countries as there are more
self-sufficient households and bartered goods and services)
ii) Maximising GDP does not necessarily maximise national well-being: GDP does
not account for intangibles people value, such as crime rates, traffic congestion,
open space, sense of community and leisure
 iii)Maximising GDP could be at the expense of poor environmental quality:
Producing more output requires more factories, and extraction of mineral
resources → Contributes to degrading of environmental quality such as pollution
iv) GDP does not capture the effects of income inequality: Income distribution can be
very unequal, although the GDP value is very high
b) GDP as Welfare Measure: GDP per capita is positively associated with several
measures of well-being:
i) Material standard of living: more goods and services
ii) Health and life expectancy
iii) Education (higher enrolment rates)

7.4 The Consumer Price Index

a) Consumer Price Index: Measure of the cost of living during a particular period. It
measures:
i) Cost of a standard basket of goods and services in a given year
same but
ii) quantity
Relative to the cost of the same basket of goods and services in the base year
iii) CPI for base year is always 1 different
Base year for CPI normally changes every 5 years prices
b) Price Index: measures the average price of a given class of goods and services relative to
the price of the same goods and services in a base year

7.5 Adjusting for Inflation

a) Rate of inflation: Annual percentage change in the price level
b) Nominal quantity: measured in terms of its current dollar value
c) Real quantity: measured in physical terms (quantities of goods and services)
i) Deflating a nominal quantity converts it to a real quantity: Nominal quantity/
price index = Real quantity

Example 1: Family income in 2013 and 2018

Can a family buy more with $40,000 in income in 2013 or with $44,000 in 2017?
- 2013 is the base year for CPI

- $40,000 in 2013 has greater purchasing power

 d) Real wages: wage paid to the worker measured in terms of purchasing power
i) Calculated by dividing the nominal wage by the CPI for that period
e) Indexing: increases a nominal quantity each period by the percentage increase in a
specified price index
i) Prevents purchasing power of the nominal quantity from being eroded by inflation
ii) Indexing automatically adjusts certain values, such as Social Security payments,
by the amount of inflation
iii) E.g. If prices increase 3% in a given year, the Social Security receive 3% more
iv) Indexing is sometimes included in labour contract
f) CPI and Inflation: CPI tends to overstate inflation by 1 to 2 percentage points a year
i) Unnecessarily increases government spending
ii) Underestimates increase in standard of living
g) Quality Adjustment Bias: CPI measures price changes but not quality changes
i) Adjusting for quality is difficult
1) Large number of goods
2) Subjective differences
ii) Incorporating new goods is difficult
1) No base year price for this year’s new goods
h) Substitution Biases: CPI uses a fixed basket of goods and services
i) When the price of a good increases, consumers buy less and substitute other
goods
ii) Failing to account for substitution overstates inflation

7.6 Costs of Inflation

a) Price Level: measure of the overall level of prices at a particular point in time
i) Measured by a price index such as CPI
b) Relative price: Relative price of a specific good is a comparison of its price to the prices
of other goods and services
c) Noisy Prices: Inflation creates static in communication where buyers and sellers can’t
easily tell whether
i) The relative price of a good is increasing OR
ii) Inflation is increasing the price of this good and all others
d) Indexing Avoids Distortions: Index Income taxes to avoid bracket creep
i) Bracket creep: occurs when a household is moved into a higher tax bracket due to
increases in nominal but not real income
e) Inflation and interest rate: Real interest rate = Nominal - inflation
i) Real interest rate: annual percentage increase in the purchasing power of financial
assets
ii) Nominal interest rate: annual percentage increase in the dollar value of an asset
f) Fisher effect: tendency for nominal interest rates to be high when inflation is high
Lecture 8: Unemployment and Economic Growth
8.1 Demand and Supply in Labour Market
a) The Labour Market: Supply and demand curve used to find the price of labour (real
wages) and the quantity (employment)
i) Labour market is in input market
ii) Demand for labour is a derived demand
b) Demand for Labour depends on:
i) Productivity of workers (higher productivity, higher demand)
ii) Price of worker’s output
c) Diminishing returns to labour:
i) Assumes non-labour inputs are held constant
ii) Adding one worker increases output but by less than the previous worker added
d) Value of marginal Product (VMP):
i) Extra revenue that an added worker generates
e) Demand Curve for Labour: Hire an extra worker if and only if the VMP exceeds the
wage paid
i) If wage is $60,000, BCC will hire 3 workers
ii) The lower the wage, the more workers employed
f) Shifting Demand for Labour: Demand shifts when VMP of workers changes
i) Price of company’s output
1) An increase in market demand
ii) Productivity of workers
1) Greater quantity of non-labour inputs
2) Organizational change
3) Training and education
g) Individual Labour Supply
i) Reservation wage: lowest wage a worker would accept for a given job
1) Opportunity cost of working is your leisure activity
2) Work compensates you for lost leisure
3) If working conditions are unpleasant or dangerous, a premium would be
included in the wage
h) Aggregate Labour Supply: Macroeconomic determinants of labour supply
i) Size of working age population
1) Domestic birth rate
2) Immigration and emigration
3) Ages when people enter and retire from the workforce
ii) Share of working-age population willing to work
 i) Shifts in Labour Supply: Caused by any change in the number of workers willing to
work at each wage
i) Increase in working age population
ii) Increase in share of working age population willing to work (Women’s
participation in the labour force has increased in the last 5o years
j) Effect of Globalisation:
i) Expansion of many markets to worldwide supply:
1) Increasing ease of goods and services crossing national borders
ii) Worker mobility: movement of workers between jobs, firms, and industries
1) Market incentives move workers out of textile and into software
2) Transition aid by government can assist workers to make software
iii) Benefit: Increased in specialisation and efficiency
1) Countries specialising in producing goods which they can produce
efficiently
iv) Disadvantage:
1) Domestic goods are no longer competitive (Some domestic sectors shrink)
2) Wage inequality increase → Low-skill industries face international
competition → Political resistance to free trade grows
k) Effect on Technological Change:
i) Source of increasing wage inequality
1) Technological change may favour higher-skilled or better educated
workers
2) Some innovation renders old skills less valuable
3) Skill-biased technological change affects the marginal products of higher
skilled workers differently from those of lower-skilled workers
(a) Recent changes favour higher skilled workers
(b) Automobile production lines increasingly use robots

8.2 Measuring Unemployment

a) Working age population: Consists of Employed, Unemployed, and Out of labour force
i) Unemployed: People who are willing to work, able to work and had spent some
time searching for job yet still unable to find one
ii) Labour force = employed + unemployed
iii) Unemployment rate = (unemployed/labour force) x 100%
iv) Participation rate = (labour force/ working age population) x 100%
 b) Costs of Unemployment:
i) Economic costs
1) Lost wages and production
2) Decreased taxes and increased transfers
ii) Psychological costs
1) Individual self-esteem
2) Family stress of decreased income and increased uncertainty
iii) Social cost
1) Potential increases in crimes and social problems
c) Duration of Unemployment: Costs of unemployment are directly related to the length of
time a person has been unemployed
i) Short-term unemployed have low cost
1) Find a permanent job after searching a few weeks
2) May find a better fitting job that match the ability of the workers which is
beneficial
ii) Long-term unemployment is costly
1) May lead to permanent unemployment
d) Other unemployment issues:
i) Discouraged workers: would like to have a job, but they have not looked for work
in the past four weeks
1) Counted as out of the labour force
2) Willing and ready to work but have given up on job search
3) Could be counted as unemployed but they are not
ii) Involuntary part-time workers are people who like to work full-time but cannot
find a full-time job
1) Counted as employed

8.3 Types of Unemployment

a) Frictional unemployment: occurs when workers are between jobs
i) Short duration, low economic cost
ii) May increase economic efficiency
b) Cyclical unemployment: increase in unemployment during economic slow-downs
i) Depends on the duration of the recession
ii) Economic cost is the decline in real GDP
c) Structural unemployment: Long term, chronic unemployment in a well-functioning
economy
i) Lack of skills, language barriers, or discrimination
ii) Structural shifts in production create a long-term mismatch between workers and
market needs
iii) High economic, psychological and social costs
8.4 Impediments to Full Employment
a) Minimum Wage Laws
i) Creates (NB - NA) unemployment
ii) Workers who find a minimum wage job get a higher wage,
while others are unemployed
b) Labour Union
i) Benefits the already employed at the expense of unemployed
(Decreases wages for on-union workers)
ii) Introduces inefficiencies by charging price above equilibrium
iii) Benefits: Reduced workers' exploitation, increase productivity)
c) Unemployment benefits and government regulations:
i) Reduces the costs of unemployment and incentivise unemployed to search longer
and less intensely
ii) To work efficiently, unemployment benefits should be for a limited time and is
less than the income received when working
iii) Health and safety regulations can reduce the demand for labour by increasing
employer costs and this will increase unemployment and lower wages

8.5 Economic Growth and Labour productivity

a) Economic growth: percentage change in real GDP
b) Real GDP per capita: reflects the amount of goods and services available to a person in
the economy → indicator of standard of living
c) Compound Interest: Pays interest on the original deposit and all previously accumulated
interest
d) Growth rates: Growth Rates in GDP Per Capita has the same effect as interest rates
i) Relatively small growth has a very large effect over a long period
e) Years to double = 72 / interest rate
f) Real GDP per capita:
i)
𝑌
=
𝑌
×
𝑁 Average labour productivity
𝑃𝑂𝑃 𝑁 𝑃𝑂𝑃
ii) Y = Real GDP
iii)
iv)
N = Number of people employed
POP = population
Fp of t population employed

g) Understanding Growth: In the long run, increases in output per person arises primarily
from increases in average labour productivity
8.6 Determinants of Average Labour Productivity
a) #1 Human Capital: comprises the talents, education, training, and skills of workers
i) Human capital increases workers’ productivity
ii) Incentives can be used to build human capital (Premium paid to skilled workers)
b) #2 Physical Capital: More and better capital increases output and worker productivity
i) However, there are limits to increasing productivity by adding capital because of
diminishing returns
ii) Diminishing returns to capital: occurs if an addition of capital with other inputs
held constant increases output by less than the previous increment of capital
c) #3 Land and other Natural Resources:
i) E.g. Land for farming, raw material for manufacturing
ii) Resources can be obtained through international markets
d) #4 Technology: New technologies is the most important for productivity improvement
e) #5 Entrepreneurship and Management: Entrepreneurs create new economic
enterprises
i) Essential to dynamic, healthy, growing economy
ii) Policies should channel entrepreneurship in productive ways
1) Taxation policy and regulatory regime to attract entrepreneurs
2) Value innovation
f) #6 Political and Legal Environment:
i) Encourage people to be economically productive
ii) Provide incentives for people to exploit opportunities in the market

8.7 Policies to Promote Economic Growth

a) #1 Promote Growth with Human Capital: Governments support education and training
programs
i) Government pays because education has positive externalities
b) #2 Promote Growth with Savings and Investment:
i) Government policies can encourage new capital formation and saving in the
private sector:
1) Individual Retirement Accounts (IRAs) are an incentive for individuals to
save
2) Government periodically offers investment tax credits
ii) Government can invest directly in capital formation:
1) Construction of infrastructure such as roads, bridges, airports, and dams
2) Highway system reduced costs of transporting goods, making markets
more efficient
c) #3 Promote growth with R&D support: Government sponsors research for specific
projects and industries
Lecture 9: Capital Formation, Financial Markets and Money Supply
9.1.1 Saving, Wealth and National Saving
a) Savings: current income minus spending on current needs
i) Saving rate: saving / income
b) Wealth: Assets - Liabilities
i) Assets: Anything of value that one owns
ii) Liabilities: Debts one owes
iii) Change in wealth = Saving + Capital Gains - Capital Losses
1) Capital gains increase the value of existing assets (Higher value for
stocks)
2) Capital losses decrease the value of existing assets (Car accident damages
bumper and front headlight
c) Flow Value: measured over a period of time
i) Income, Saving etc.
d) Stock Value: defined at a point in time
i) Wealth, Debt etc.
ii) The flow of savings causes the stock of wealth to change
iii) A high rate of savings today leads to an improved SOL in the future

9.1.1 Savings
a) National Savings (S): Current income - spending on current needs
i) Current Income: GDP or Y
ii) Spending on current needs: exclude all investment spending (I)
iii) SNATIONAL determines a country’s ability to invest in new capital goods
iv) Assuming NX=0,
v) S=Y-C-G
b) Private Savings: household plus business saving
i) SPRIVATE = Y - T NET - C
ii) Business savings is revenues - operating costs - dividends to shareholders
iii) Business savings can purchase new capital equipment
c) Public Savings: amount of the public sector’s income that is not spent on current needs
i) Public sector income = Net taxes
ii) Public sector spending on current needs = G
iii) SPUBLIC = T - G
iv) SNATIONAL = SPRIVATE + SPUBLIC
tax
tryout
tax
Net
 d) Government Budget: Government spending = Net tax receipts
i) Balanced budget: Government spending = Net tax receipts
ii) Budget surplus: (T-G) > 0 (Public savings)
iii) Budget deficit (T-G) < 0 (Occurs during recession)
e) 3 Reasons for Household Saving:
i) #1 Life-cycle saving: meet long-term objectives
1) Retirement
2) Purchase a home
3) Children’s college attendance
ii) #2 Precautionary saving: protection against setbacks
1) Loss of Job
2) Medical Emergency
iii) #3 Bequest saving: leave an inheritance
1) Mainly for higher income groups
f) Reasons of Low Savings: Savings rate may be depressed by
i) Generous safety measure such as Social Security Medicare, and other government
programs for the elderly
ii) Confidence in prosperous future
iii) Any many more …

9.2 Investment and Capital Formation

a) Investment: Creation of new capital goods and housing
b) Investment Decision: Benefit of investment (VMP of machines) versus cost of
investment (include interest rate and opportunity cost)

Example 1: Larry and the Lawn Mower

- Cost of lawn mower = $4000
- Interest of loan = 6% of $4000
= $240
- Assume mower can be resold for $4000
- Net revenue = $6000
- Taxes = 20% of $6000
= $1200
Larry could earn $4400 after tax working somewhere else.
- Opportunity cost = $4400

If Larry continues the business,

Net benefit = $6000 - $4400 - $1200 - $240
= $160
 higher interestrate lower interest rate
causes bank to lend encourages peopleto
and borrow andspend
9.3 Demand and Supply of Saving g morefrom
earn interest
a) Supply of savings (S): amount of savings that would occur at each real interest rate
i) Quantity supplied increases as r increases
b) Demand for investment (I): amount of savings borrowed at each real interest rate
c) Equilibrium interest rate: amount of savings = investment funds demanded
f
d) Technological Improvement: raises marginal productivity of capital
i) Increases demand for investment funds
ii) Higher interest rate
iii) Higher level of savings and investment
e) Government budget deficit increases
Nettaxes O

É
i) Reduces national savings
leading to
ii) Higher interest rate
iii) Lower level of savings and investment
iv) Private investment is crowded out
f) The Allocation of Saving: The financial system improves the allocation of saving:
i) Provides information to savers about the possible uses of their funds
ii) Help savers share the risks of individual investment projects
1) Risk sharing makes funding possible for projects that are risky but
potentially very productive

wayof
9.4 Bonds and Stocks
Government borrowing money
a) Bond: legal promise to repay a debt
i) Principal amount: amount originally lent
ii) Maturation date: date when principal amount will be repaid
iii) Term: length of time from issue to maturation
iv) Coupon payments: periodic interest payments to bondholder
v) Coupon rate: interest rate that is applied to the principal to determine the coupon
payment
b) Coupon rate depends on:
i) Bond’s term: Longer term, higher coupon rate
ii) Issuer’s credit risk: Probability of issuer defaulting repayment (Higher risk, higher
coupon rate)
iii) Tax treatment for coupon payments: Lower taxes, lower coupon rate
 c) Selling a Bond: Bond prices and interest rates are inversely related
i) (Bond Price)(interest rate) = (Bond payment)
Example 1:
Two-year government bond with principal $1000 sold for $1000 on 1/1/12
- Coupon rate: 5%
- $50 paid on 1/1/13
- $1050 paid on 1/1/14
Selling bond on 1/1/13, with current market coupon rate to be 6%
(Bond price)(1.06) = $1050 → Bond price = $991

d) Stocks: Claim to partial ownership of a firm

i) Dividends: periodic payment determined by management
ii) Prices are determined in the stock market by supply and demand
e) Risk Premium: Rate of return investor require risky assets - rate of return on safe assets
f) Diversification: Spreading one’s wealth over a variety of investments to reduce risk

9.5 Commercial Banks and Money Creation

a) Money: any asset that can be used in making purchases
b) Measuring Money Supply:
i) M1: Currency + Demand Deposit after money creation deposit amount
ii) Deposits refer to deposits which can make withdrawal with cheque but did not
pay deposit interest rate (Current Account)
c) Money Creation:
i) Money multiplier = 1/reserve deposit ratio
ii) Reserve Deposit Ratio = Bank Reserves / Bank Deposits
Example 1:
Example 2:
Gorgonzola residents hold 500,000 guilders as currency
- Deposit 500,000 guilders in the banks
- Reserve deposit ratio = 10%
- Bank deposits = 500,000/0.1 = 5,000,000 guilders
- Money supply = 500,000 cash + 5,000,000 deposits
= 5,500,000 guilders
(Money supply = Currency held by public + Bank reserves / Reserve deposit ratio)

9.6 Central Bank and Money Supply

a) Banking panics: occurred when customers believe one or more banks might be bankrupt
i) Depositors rush to withdraw funds
ii) Banks have inadequate reserves to meet demand and Banks close (Bank run)
iii) Central bank prevent bank panics by
1) Supervising and regulating banks
2) Loaning banks funds if needed
b) Central Bank: Responsible for monetary policy and controls money supply to control
nominal interest rate through three methods:
i) Open market operation
ii) Discount window
iii) Reserve Deposit Ratio
c) Open-market operation:
i) Open market purchase: Purchase of government bonds from the public by the
central bank increases money supply
1) Central bank pays bondholder with new money
2) Receipts are deposited and this leads to a multiple expansion of money
supply
 ii) Open market sale: Sale of government bonds by central bank to the public
decreases money supply
1) Bondholder pays with cheque
2) Bank reserves decrease and leads to a multiple contraction of money
supply
Example 1: Increasing Money Supply
An economy has 1,000 shekels in currency and bank reserves of 200 shekels
- Reserve deposit ratio = 200 / 1000 = 0.2
- Money supply = 1,000 + (200 / 0.2) = 2,000 shekels
Central bank pays 100 shekels for a bond held by the public
- Assume that all 100 shekels are deposited
- Money supply = 1,000 + (300/0.2) = 2,500 shekels
- 100 shekel increase in reserves leads to a 500 shekel increase in money supply

d) Discount window: Central bank offers lending facility to banks, called discount window
lending
i) Bank needs reserves can borrow from the central bank at the discount rate.
ii) Discount rate: rate that the central bank charges the bank when borrowing
iii) Lending increases reserves and money supply
iv) Higher discount rate reduced lending and money supply
v) Lower discount rate increases lending and money supply
e) Reserve Deposit Ratio: central bank decides on the reserve deposit ratio, r, the
percentage of deposits which the banks must keep as required reserves
i) Higher reserve deposit ratio means banks must keep more deposits as reserves and
lend out less money → Decrease in money supply
ii) Lower reserve deposit ratio means banks can keep less deposits as reserves and
lend out more loans → Increase money supply
iii) Money multiplier = 1 / reserve deposit ratio

9.7 Money Demand and Money Supply

a) Demand for money: Amount of wealth held in the form of money - Liquidity preference
i) Marginal Benefit of holding money: ability to make transactions
ii) Marginal Cost of holding money: interest forgone when holding interest-bearing
assets
iii) Quantity of money demanded increases with income and price level
iv) Technologies such as online banking and ATMs have reduced the demand for
money
v) Demand for money depends on:
1) Nominal interest rate: Higher interest rate, lower quantity of money
demanded
 2) Real income or output: Higher level of income, greater the quantity of
money demanded
3) Price Level: Higher the price level, greater the quantity of money
demanded
b) Shifts in Demand Curve:
i) An increase in output
ii) Higher price levels
iii) Foreign demand for dollars
iv) Technological advances (money demand decreases)

c) Supply of Money:
i) Supply of money is vertical
ii) Central bank policy is stated in terms of interest rate
iii) Initial Equilibrium at E
iv) Central bank increases money supply to MS’
1) New equilibrium at F
2) Interest rates decrease to i’ to convince the market
to hold the new, larger amount of money

d) Money and Prices: Sustained high inflation rates occur with a high
growth rate of the money supply
e) Quantity equation: Money x velocity = nominal GDP
i) MxV=PxY
ii) Velocity: measure of the speed of money changes hands in transactions for final
goods and services
iii) Nominal GDP: Price level x real GDP
iv) M is the money stock
f) Money and inflation in the Long Run:
i) Assume velocity is constant and real GDP is constant
ii) MxV=Px Y
iii) An increase in money supply by a given percentage would increase the price level
by the same percentage
iv) In the short run, changing M can affect Y
v) In the long run, changing M can only affect P
Lecture 10: Aggregate Expenditure and Stabilization Policy
10.1 Recession and Expansion
a) Recession: a period in which the economy is growing at a rate significantly below normal
i) Real GDP falls for two or more consecutive quarters
ii) Real GDP growth is well below normal, even if not negative
iii) Depression: severe recession
b) Business cycle:
i) Peak: Beginning of a recession
ii) Trough: End of a recession
iii) Expansion: Period in which economy is growing at a rate significantly above
normal
iv) Boom: Strong and long-lasting expansion

10.2 Potential Output and Output Gap

a) Potential output (Y*): maximum sustainable amount of output that can be produced by
an economy
i) Also known as the full employment output
b) Actual output (Y): Depends on actual amount of resources used in production
c) Output gaps: Difference between the economy’s actual and potential output, relative to
potential output, at a point in time
i) Output gap = [(Y - Y*) / Y*] x 100
ii) Recessionary gap: -ve output gap; Y < Y*
1) Output and employment are less than sustainable
2) Unemployment
3) u > u*
iii) Expansionary gap: +ve output gap; Y > Y*
1) Leads to inflation
2) u < u*
d) Natural rate of unemployment (u*): Sum of frictional and structural unemployment
i) Unemployment rate when cyclical unemployment = 0
ii) Occurs when Y is at Y*
 iii) Cyclical unemployment: difference between total unemployment (u), and u*
e) Okun’s law: relates cyclical unemployment changes to changes in output gap
i) One percentage point increase in cyclical unemployment is associated with a 2
percentage point increase in the output gap
ut
Example 1: output gap 24
Suppose the economy begins with:
- 1% cyclical unemployment
- 2% Recessionary gap of potential GDP
If unemployment increases to 2%, recessionary gap increases to 4%

f) Output gaps arise for two main reasons:

i) Market require time to reach equilibrium price and quantity
1) Firms change prices infrequently as cost are incurred when changing
prices
2) Firms adjust production to meet the demand at current prices
ii) Changes in total spending at preset prices affect output levels
1) When spending is low, output will be below potential output -
Recessionary
2) Excessive spending leads to actual output above potential output -
Overheating
3) Changes in economy-wide spending are the primary causes of output gaps
4) Government police can be used to close the output gap to stabilise the
economy
g) Long-Run Adjustment: Self-correcting mechanism
i) Firms eventually adjust to output gaps in the long run
1) If spending is less than potential output, firms will reduce prices
2) If spending is more than potential output, firms increase prices
ii) In the long run, production is at potential output levels determined by productivity
capacity and spending only influences price levels and inflation

10.3 The Keynesian Model

a) Keynesian Model Theory: optimal economic performance could be achieved, and
economic slumps could be prevented by influencing aggregate demand through activist
stabilization and economic intervention policies by the government.
b) Price level:
i) Short run: Price level is sticky due to menu costs PAE Y PAE
ii) Long run: Price level is flexible
PAEZ
1
I PAE

Y
YesY
 yy

10.4 Aggregate Expenditure and Multiplier

a) Planned aggregate expenditure (PAE): Total planned spending on final goods and
service
i) PAE = C + IP + G + NX
ii) Consumption
iii) Planned Investment
iv) Government spending
v) Net exports

Example 1: Planned Investment

Company A produces $5 million worth of kites per year
- Expected sale: $4.8mil
- Planned inventory: $0.2mil
- Capital expenditure on machineries: $1mil
- Total planned investment: $1.2mil
Scenario A
- Actual sales: $4.6mil
- Inventory investment increase to $0.4mil
- Actual investment: $1.4mil (more than planned)
Scenario B: ⎻
- Actual sales: $5mil
- Inventory investment decrease to: $0

- Actual investment: $1mil (less than planned)

b) Consumption Function: C = C + (MPC)(Y - T)
i) C: Autonomous consumption (spending not related to the level of disposable
income
ii) MPC: Marginal propensity to consume
1) Increase in consumption spending when disposable income increases by
$1 (△C / △Y)
iii) (Y - T): Disposable income (Income after tax)
c) Effects on C:
i) Wealth effect: Tendency of changes in asset prices to affect a household’s wealth
and thus their consumption spending
ii) Interest effect: Higher rates increase the cost of using credit to purchase
consumer durables and other items
 d) Saving Function: S = - C + (mps)(Y - T)
i) MPS: Marginal propensity to save
1) Increase in saving when disposable income increases by $1
ii) MPC + MPS = 1
e) Planned Aggregate Expenditure (PAE)
i) Dynamic patterns in the economy
1) Declines in production leads to reduced spending
2) Reductions in spending lead to declines in production and income
ii) Consumption is the largest component of PAE
1) Consumption depends on output, Y
2) PAE depends on Y
iii) Two components of PAE:
1) Autonomous expenditure: spending that is independent of output
(intercept)
2) Induced expenditure: spending that is dependent of output

10.5 Short Run Equilibrium Output

a) Short-run Equilibrium: level of output at which planned spending is equal
to output
i) No change in output as long as price are constant
ii) Equilibrium condition: Y = PAE
Scenario 1: Output Greater than Equilibrium Scenario 1: Scenario 2:
Suppose output reaches 5,000
- Planned spending less than total output
- Unplanned inventory increases
- Business slow down production
- Output goes down

Scenario 2: Output Less than Equilibrium

Suppose output is only 4,500
- Planned spending is more than total output
- Unplanned inventory decreases
- Businesses speed up production
- Output goes up
Scenario 3: Fall in Planned Spending Scenario 3:
Autonomous consumption C: decreases by 10
- Downward shift in PAE curve
- Economy adjusts to a new lower level of equilibrium spending and
output, 4750
Suppose original equilibrium level 4800 represents potential output
- Recessionary gap develops
- Size of recessionary gap: 4800 - 4750 = 50
- 5 times the decrease in initial consumption spending
*Same process applies to decrease in IP, G, or NX*

b) Income-Expenditure Multiplier: effect of a one-unit increase in autonomous

expenditure on short-run equilibrium output.
i) Spending multiplier: 1 / (1 - MPC)
ii) Larger the MPC, greater the multiplier

Example 1:
Initial planned expenditure = 960 + 0.8Y
New planned expenditure = 950 + 0.8Y
- A 10 unit drop in consumption implied a 10 unit drop in autonomous expenditure
- Equilibrium changed from 4,800 to 4,750
- A $10 change in autonomous expenditure caused a $50 change in output → Multiplier =
5

10.6 Fiscal Policy (Government)

a) Stabilisation Policies: Government policies that are used to affect planned aggregate
expenditure to eliminate output gaps
i) Expansionary policies: increase planned expenditure
ii) Contractionary policies: decrease planned expenditure (Political considerations
make it difficult to use contractionary fiscal policies)
iii) #1 Fiscal policies: changes in government spending, transfers or taxes
iv) #2 Monetary policies: changes in money supply
b) Taxes and Transfers (Demand side): Total taxes - transfer payments
i) Lower taxes or higher transfers increase disposable income → Higher
consumption
ii) Tax multiplier: (- MPC) / (1 - MPC)
Example 1: Using Tax cuts to close a Recessionary Gap
Original planned spending: Y = 960 + 0.8Y
Autonomous spending decreases: Y = 950 + 0.8Y
Recessionary gap: 50
MPC = 0.8
- Tax multiplier = [(-0.8) / (1 - 0.8)] = - 4
- Taxes have to go down by 50/4 = $12.50

c) Supply-side fiscal policy:

i) Investment in infrastructure to increase Y*
ii) Decrease in income tax → increase in amount of workers willing to work →
aggregate supply increase
d) Limitations of fiscal policy:
i) Legislative process requires time
1) Change in fiscal policy may be slow
2) Long time lags in policy implementation
ii) Competing political objectives
1) National defence
2) Entitlement such as Medicare and income support
However, fiscal policy is useful to address prolonged periods of recession
e) Automatic stabilizers: increase government spending or decrease taxes when real output
decline
i) Built into laws so no decision is required
ii) Unemployment compensation, progressive income tax

10.7 Monetary Policy (Central Bank)

a) Monetary Policy: Eliminate output by changing the money supply
i) Change in money supply → Change in nominal interest rate (interest rates affects
borrowing and investments) → change in PAE
ii) Recessionary Gap:
1) Decrease interest rate → Consumption and planned investment increase
→ PAE increase → Output increase via the multiplier
iii) Expansionary Gap:
1) Increase interest rate → Consumption and planned investment decrease →
PAE decrease → Output decrease via the multiplier
 sin tiger Impe
To 8
Example 1: Monetary Policy for a Recessionary Gap
PAE = 1,010 - 1000r + 0.8Y
Real interest rate, r = 5%
Short run equilibrium = 4,800
1000 r 40 5
Potential output = 5,000
- Recessionary gap = 200 v o 04
Multiplier: 5
- First change in spending required: 200 / 5 = 40 4l
Central Bank should decrease real interest rate to 1%
5 l 41 1 1
b) Central Bank Fights a Recession:
i) Expansionary gap can lead to inflation
1) Planned spending > normal output
levels at the established prices
2) Short-run unplanned decreases in
inventories
3) If gap persists, prices will increase
ii) Central bank attempts to close expansionary gaps
1) Raise interest rates
2) Decrease consumption and planned investment
3) Decrease planned aggregate expenditure
4) Decrease equilibrium output
Example 1: Monetary Policy for an Expansionary Gap
PAE = 1,010 - 1,000r +0.8Y
Real interest rate, r = 5%
Potential output: 4,600
- Expansionary gap = 200
Multiplier: 5
- First change in spending required: 200 / 5 = 40
- 1000 (change in r) = 40
- Change in r = 0.04
Central Bank should increase real interest rate to 9%

c) Pros of Monetary Policy:

i) Quickly decided and implemented
ii) More flexible and responsive than fiscal policy

d) Inflation and Stock Market:

i) Bad news about inflation causes stock prices to decrease
ii) Investors anticipate Central Bank to increase interest rate
 1) Slows down economic activity, lowering firm’s sales and profits
2) Lower profits → Lower Dividends → Lower stock prices
iii) Higher interest rates make non-stock financial instrument more attractive
1) Reduced the demand for stocks and stock prices falls
Lecture 11: Aggregate Demand, Aggregate Supply and Macroeconomic Policy
11.1 The Aggregate Demand Curve
a) Long Run Equilibrium: Occurs at the intersection of aggregate demand, aggregate
supply and potential output
i) Actual output = potential output
ii) Actual inflation rate = expected price level
b) Short Run Equilibrium: Occurs when the AD and AS curve intersect at a level of
output different from Y*
i) Contractionary Gap:
1) Point A in the graph
2) Actual output less than potential output
3) Slow or negative growth
4) Unemployment occurs
ii) Expansionary Gap:
1) Point B
2) Actual output is larger than potential output
3) Excess growth
4) Inflation
c) Aggregate Demand Curve: amount of output consumers, firms,
government, and customers abroad want to purchase at each
inflation rate.
i) Inflation increase → Consumption, Investment, Net exports decrease → PAE
decrease → output decrease
d) Shifts in AD Curve:
i) #1 Demand shocks: changes in planned spending not caused by a change in
output or a change in inflation rate
1) Consumer confidence
2) Consumer wealth
3) Business confidence
4) Opportunities for firms to purchase new technologies
5) Foreign demand for domestic goods
ii) #2 Stabilisation policy: Government policies used to affect planned aggregate
expenditure and eliminate output gaps
1) Fiscal policy: Changes in government spending or taxes
2) Monetary policy: Change in nominal money supply, which changes the
interest rate
11.2 The Aggregate Supply Curve
a) Aggregate Supply Curve: relationship between the amount of output firms want to
produce and the inflation rate
b) Shifts in AS Curve:
i) Changes in available resources and technology
1) Supply more output without having to increase price
ii) Changes in inflation expectations
1) If suppliers expect goods to sell at much higher prices in the future, they
will be less willing to sell in the current period → AS will shift to the left
iii) Inflation shock
1) Sudden change in normal behaviour of inflation (not related to an output
gap)
2) Sudden rise in price of oil increases price of
(a) Petrol, diesel fuel, jet fuel etc.
(b) Goods made with oil
(c) Transportation of most goods
c) Inflation Inertia: Inflation will remain relatively constant, have inertia, as long as the
economy is at potential output and there are no external shocks to the price level
d) Determinants of inflation rate:
i) Inflation expectations
1) Higher the expected rate of inflation, the more nominal
wages and cost of other inputs will increase →
Firms increase prices to cover cost
2) Low and stable inflation creates a virtuous circle that
keeps inflation low
3) High and stable inflation creates a vicious circle that
keeps inflation high
ii) Long-term wage and price contracts
1) Long-term contracts reduce the cost of negotiations between buyers and
sellers
2) Long-term contracts account for wage and price increases that are based
on current expectations about inflation
11.3 Aggregate Demand-Aggregate Supply Analysis
a) Demand Shock:
i) Favourable:
1) Aggregate demand increase
2) Results in an expansionary gap
ii) Adverse:
1) Aggregate demand falls
2) Results in recessionary gap
b) Supply shock:
i) Favourable:
1) Aggregate supply increase
2) Results in expansionary gap
ii) Adverse:
1) Aggregate supply falls
2) Results in recessionary gap
c) Expansionary Gap:
i) With expansionary gap, expected inflation increases and hence actual inflation
increase
ii) Workers demand for higher pay → firms employ fewer workers → Firms produce
less output
iii) Shift AS curve to AS 2
iv) Consumption and planned investment decrease → PAE
decrease
v) Output falls to Y*, inflation increases to π 2

d) Recessionary Gap:
i) With recessionary gap, expected inflation decreases
ii) Aggregate supply increase, shift right
iii) Output increase to Y*, inflation falls to π 2

11.4 Anti-Inflationary Monetary Policy

a) Anchored inflationary expectations: people's expectations of future inflation do not
change even if inflation rises temporarily
i) dampens response to an aggregate inflation shock
ii) Businesses and consumers believe the central bank will re-establish its target
inflation rate
iii) Shortens the time required to close the recessionary gap from the shock
1) Encourages central bank to maintain its original inflation target
 b) Credibility of monetary policy: degree to which the public believes the central bank will
defend its target inflation rate
i) Factors that affect credibility:
1) Degree of central bank's independence
2) The announcements of explicit inflation targets
3) Established reputation for fighting inflation
ii) Announced target of inflation adds to credibility of monetary policy and
strengthens anchoring
1) Reduce uncertainty in the financial markets

11.5 Effectiveness of Policymaking

a) Macroeconomic policy works best with
i) Accurate knowledge of current economic conditions
ii) Knowledge of the future path of the economy without policy
iii) Precise value of potential output
iv) Good control of fiscal and monetary policies
v) Knowledge of how and when the economy will respond to policy changes
b) Barriers to Perfect Policies:
i) Inside lag: delay between the time a policy change is needed and the time it is
implemented
1) Shorter for monetary policy than for fiscal policy
ii) Outside lag: delay between policy implementation and the major effects of the
policy occur
1) Longer for monetary policy than for fiscal policy
Lecture 12: Exchange Rate, International Trade and Capital Flow
12.1 Exchange Rate Determination
a) Nominal exchange rate: rate at which two currencies can be traded for each other
i) Number of foreign currency for one local currency
b) Changes in Exchange Rate:
i) Appreciation: increase in value of a currency relative to other currencies
ii) Depreciation: decrease in value of a currency relative to other currencies
12.2 Flexible and Fixed Exchange Rates
a) Flexible Exchange Rate: exchange rate whose value is not officially fixed but varies
according to the supply and demand for the currency in the foreign exchange market
i) Mostly used by industrialised countries
b) Fixed Exchange Rate: Exchange Rate set by the government policy
i) Can be set independently or by agreement with a number of other governments
ii) Mostly used by small and developing countries
iii) Pros:
1) Can create stability in trade and investment
2) Certainty of future value of the currencies
iv) Cons:
1) Sudden and unforeseen large changes are possible
2) Government may need to adjust reduce the fixed rate (devaluation),
increase the fixed rate (revaluation) or abandon the fixed rate to respond to
economic situations
3) Reduce the benefit of fixed exchange rate system
c) Supply of US Dollars in Foreign Exchange Market:
i) Higher the exchange rate, higher the supply of US Dollar
ii) This makes foreign goods cheaper
iii) When the US dollar appreciates, the quantity of dollars supplied increases to
finance imports
iv) Determinants of Supply:
1) Preference for foreign goods (Stronger the preference for foreign good,
greater the supply of local currency)
2) US Real GDP (higher GDP, greater the supply)
3) Real interest rate on Japanese assets and the real interest rate on US assets
(a) Supply of US dollars will be greater if
(i) Real interest rate on Japanese assets is higher
(ii) Real interest rate on US assets is lower
d) Demand for US Dollars in Foreign Exchange Market:
i) More foreign currency needed to buy a dollar, the smaller the quantity of dollars
demanded
 ii) When the dollar appreciates, the quantity of dollars demanded decreases as
foreigner import less
iii) Determinants of Demand:
1) Preference for US goods (stronger the preference for US goods, greater the
demand for US dollars)
2) Real GDP in Japan (higher GDP, greater the demand for dollars)
3) Real interest rate on Japanese assets and real interest rate on U.S. assets
(a) Demand for US dollars will be greater if
(i) Real interest rate on Japanese assets is lower
(ii) Real interest rate on U.S. assets is higher
e) Strong Currency:
i) Strong currency is unrelated to strong economy
ii) Strong currency means the value is high in terms of other currencies
iii) Strong currency reduce net exports
iv) Strong currency tends to attract inflow of foreign funds for investment in assets
f) Monetary Policy:
i) Tighter monetary policy → reduce money supply → higher interest rate
ii) Makes US assets more attractive than foreign assets → Demand for US dollars
increase, Supply of US dollar decrease → US dollar appreciates

iii) Monetary Policy is more effective in an open economy with flexible exchange
rates

12.3 Nominal and Real Exchange Rates

a) Real exchange rate: price of the average domestic good relative to the price of the
average comparable foreign good when prices are expressed in a common currency
i) The competitiveness of a country’s product is determined by the real exchange
rate, not the nominal exchange rate
Example 1: Real Exchange Rate
Choose between a U.S. computer and a comparable Japanese computer, based on price
- US computer costs US$2,400
- Japanese computer costs ¥242,000
- US$1 = ¥110
The Japanese computer cost is ¥242,000/(¥110/US$1) or US$2,200
- The Japanese computer is cheaper
- The relative price of the U.S. computer to the Japanese computer is US$2,400 / US$2,200
= 1.09
- U.S. computer costs 9% more than the Japanese one

b) Real exchange rate Formulas:

i) Real exchange rate = Price of domestic good / Price of foreign good in US$
ii) Real exchange rate = P / P f / e
iii) Real exchange rate = (P) (e) / Pf
iv) Real exchange rate = (US$2,400) (¥110/ US$1) / ¥242,000
v) Real exchange rate = 1.09

12.4 Purchasing Power Parity Theory

a) Purchasing power parity (PPP): nominal exchange rates are determined by price
differential between economies
i) In the long run, the currencies of countries that experience significant inflation
will tend to depreciate
b) The law of one price: if transportation costs are relatively small and there are no trade
restrictions, the price of an internationally traded commodity must be the same in all
locations
i) Suppose wheat in Sydney was half the price of wheat in Bangkok
1) Buy wheat in Sydney, increasing demand and price
2) Sell wheat in Bangkok, increasing supply and decreasing the price
3) Price adjusts until price of wheat is the same in both places
c) Limits to the PPP Theory
i) Theory works well in the long run but not in the short run
ii) Transport cost and trade restriction exists
iii) Not all goods and services are traded internationally
1) The greater the share of non-traded goods, the less precise the PPP theory
(a) For example, the market for haircuts is very local
iv) Not all internationally traded goods and services are perfectly standardized
commodities
Example 1: PPP
A bushel of grain costs
- A$ 5 in Sydney and
- ฿ 150 in Bangkok
- For the price of the bushel of grain to be the same in both countries, the implied nominal
exchange rate is A$ 1 = ฿ 30
- Suppose that Bangkok experiences inflation and the bushel of grain now costs ฿ 300 in
Bangkok
- The Australian dollar appreciates to A$ 1 = ฿ 60
- Price of the wheat is the same in both countries

12.5 Trade Balance and Net Capital Inflows

a) Trade Balance: Same as net exports
i) Trade surplus: Exports > Imports
ii) Trade deficit: Exports < Imports
b) International capital flows: purchases or sales of real and financial assets across
international borders
i) Capital inflows: purchases of domestic assets by foreign households and firms
ii) Capital outflows: purchases of foreign assets by domestic households and firms
iii) Net capital inflows (KI): capital inflows - capital outflows
iv) Capital flows are not counted as imports or exports since they refer to the
purchase of existing assets rather than currently produced goods and services

Example 1: Trade Balance (NX) and Net Capital Inflows (KI)

NX + KI = 0
U.S. resident purchases Japanese car for US$20,000
- Imports = US$20,000
Manufacturer holds US$20,000 in a U.S. bank account
- Option 1: purchase US$20,000 of U.S. goods and services so exports = US$20,000
- Option 2: purchase U.S. bonds or U.S. real estate
- NX = – US$20,000, KI = US$20,000
- Option 3: sell US dollars for yen
- Follow the US dollars and see what the purchaser does with them to determine
NX and KI
12.6 International Capital Flows
a) International Capital Flows:
i) Highly developed financial markets allow borrowing and lending across borders
ii) Transactions are subject to laws in the originating country and the target country
1) Size of international flows for a country depend on its regulations and
laws
2) Also depend on economic integration and political stability
iii) Lending is acquiring a real or financial asset
1) Buying a share of stock or a government bond or a parcel of land
iv) Borrowing is selling a real or financial asset
b) Roles of International Capital Flows:
i) Compensate for Trade Imbalances
1) Trade surplus means net capital outflows
2) Trade deficit means net capital inflows
ii) Efficient Allocation of Savings
1) International capital flows allow savers to invest in the most profitable
opportunities
(a) Independent of location
2) Fills savings gap in destination country