UD Econ Comps Study Guide

8/2/2019 UD Econ Comps Study Guide

1/23

Comprehensive Exam Review Sheet

Microeconomics

Scarcityit indicates that a choice must be made as well as varying degrees of demand for something.

Arbitragethe practice of taking advantage of price differences between markets. In perfect

competition, arbitrage is would not exist and there would be no price differential betweenidentical goods. Due to the price differentials, arbitrage activity tends to reallocate goods,shifting them from lower-valued uses to higher-valued uses.

Supply and demand - In microeconomic theory, demand is defined as the willingness and ability of aconsumer to purchase a given product in a given frame of time. Supply and demand dictatescarcity. MORE!!!

Market prices as indicators of scarcityIn general, the higher the demand for a product or good, thehigher the price of the product or good; This is also true in interesting situations such as beingstuck in a desert with a bag diamonds and a can of water.

Concept of a market economy - is an economic system based on the division of labor in which theprices of goods and services are determined in a free price system set by supply and demand.This is often contrasted with a planned economy, in which a central government determines theprice of goods and services using a fixed price system.

Division of labour or specialization is the specialization of cooperative labour in specific,circumscribed tasks and roles, intended to increase the productivity of labour.

A free price system or free price mechanism (informally called the price system or the pricemechanism) is an economic system where prices are set by the interchange of supply anddemand, with the resulting prices being understood as signals that are communicated betweenproducers and consumers which serve to guide the production and distribution of resources.

Through the free price system, supplies are rationed, income is distributed, and resources areallocated. A free price system contrasts with a controlledorfixed price system where prices areset by government, within a controlled marketor planned economy.

Supply Theory

The basic assumptionfirms want to maximize profit; profit = revenuecost

Definition of Supply

Supply is defined as the quantity of a product that a producer is willing and able to supply onto themarket at a given price in a given time period. The basic law of supply is that as the price of acommodity rises, so producers expand their supply onto the market. A supply curve shows arelationship between price and quantity a firm is willing and able to sell.

Cost - In economics, business, retail, and accounting, a cost is the value of money that has been usedup to produce something, and hence is not available for use anymore. In economics, a cost is analternative that is given up as a result of a decision. Opportunity cost, also referred to aseconomic costis the value of the best alternative that was not chosen in order to pursue thecurrent endeavouri.e, what could have been accomplished with the resources expended in theundertaking. It represents opportunities forgone.


2/23

Production Functionrepresents the quantitative relationship between inputs and outputs.

Total production curve is a short run production function

Long Runall costs are variable

Isoquants - In economics, an isoquant is a contour line drawn through the set of points at which thesame quantity of output is produced while changing the quantities of two or more inputs. Whilean indifference curve helps to answer the utility-maximizing problem of consumers, theisoquant deals with the cost-minimization problem of producers. Isoquants are typically drawnon capital-labor graphs, showing the tradeoff between capital and labor in the productionfunction, and the decreasing marginal returns of both inputs. Adding one input while holdingthe other constant eventually leads to decreasing marginal output, and this is reflected in theshape of the isoquant. A family of isoquants can be represented by an isoquant map, a graphcombining a number of isoquants, each representing a different quantity of output.

Returns to scale - Returns to scale refers to a technical property of production that examines changes inoutput subsequent to a proportional change in all inputs (where all inputs increase by a constantfactor). If output increases by that same proportional change then there are constant returns to scale(CRTS). If output increases by less than that proportional change, there are decreasing returns to scale(DRS). If output increases by more than that proportion, there are increasing returns to scale (IRS).

The basic idea is that there should be an average decreasing cost as a firm increases in productive size.This is also related to natural monopolies because there can only be so many firms for a specificproduct (such as planes). At a certain size, it is no longer competitive to increase production.

Isocost line - An isocost line is a line showing combinations of inputs that would yield the same cost.

Short Run Costsat least one fixed cost

Total Product Curve - The idea is that there will eventually be diminishing returns with increasedlabor. Diminishing Total returns, which implies reduction in total product with everyadditional unit of input. This occurs after point A in the graph.


3/23

Marginal Product - MP= Y/X or Y/L = (the change ofY)/(the change ofX). The marginalproduct or marginal physical product is the extra output produced by one more unit of aninput.

Diminishing Average returns, which refers to the portion of the APP curve after its intersection withMPP curve. 3. Diminishing Marginal returns, refers to the point where the MPP curve startsto slope down and travels all the way down to the x-axis and beyond. Putting it in a

chronological order, at first the marginal returns start to diminish, then the average returns,followed finally by the total returns.

Average Product - Average product" (APL) is defined as output per unit of labor input: Q/L.

Financial Factorsfirm is a price taker not price maker.

Short-run cost curves (seven of them)

(Total) Fixed Costunchanged by most other factors; FC = Constant (straight line)


4/23

(Total) Variable CostVC = wLTotalCostTC = FC + VC = rK +wK (Fixed plus Variable)Average Fixed CostAFC = FC/QAverage Variable CostAVC = VC/QAverage Total CostATC = TC/QMarginal CostMC = TC/Q = w (1/MPL)

AFC + AVC = ATC

Long Run Cost

Revenuedepends on demandPerfect competitionprice taker = horizontal demand curve

Perfect competition describes a market in which there are many small firms, all producinghomogeneous goods. In the short term, such markets are productively inefficient as output will notoccur where mc is equal to ac, but allocatively efficient, as output under perfect competition willalways occur where mc is equal to mr, and therefore where mc equals ar. However, in the long term,such markets are both allocatively and productively efficient.[1]In general a perfectly competitivemarket is characterized by the fact that no single firm has influence on the price of the product it sells.Because the conditions for perfect competition are very strict, there are few perfectly competitivemarkets.

A perfectly competitive market may have several distinguishing characteristics, including:

Many buyers/Many SellersMany consumers with the willingness and ability to buy theproduct at a certain price, Many producers with the willingness and ability to supply theproduct at a certain price.

Homogeneous ProductsThe products of the different firms are EXACTLY the same, e.g.salt.

Low-Entry/Exit BarriersIt is relatively easy to enter or exit as a business in a perfectlycompetitive market.

Perfect Information - For both consumers and producers. Firms Aim to Maximize Profits - Firms aim to sell where marginal costs meet marginal

revenue, where they generate the most profit.

Short Run Long Run (perfect competition)
http://en.wikipedia.org/wiki/Perfect_competition#cite_note-0http://en.wikipedia.org/wiki/Perfect_competition#cite_note-0http://en.wikipedia.org/wiki/Perfect_competition#cite_note-0http://en.wikipedia.org/wiki/Perfect_competition#cite_note-0


5/23

Profit MaximizationFirms will produce up to the point where MR = MC. Since MR = price, thenthe firm will increase production till MC = Price; therefore, MR = MC = P = D at that point forthe firm.

Zero-profit Maximization - The rate of profit tends to coincide with the rate of interest. Profits in theclassical meaning do not tend to disappear in the long period but tend to normal profit. Withthis terminology, if a firm is earning abnormal profit in the short term, this will act as a trigger

for other firms to enter the market. They will compete with the first firm, driving the marketprice down until all firms are earning normal profit only.

Economic Profit versus Accounting Profit - Pure economic profit is the increase in wealth that aninvestor has from making an investment, taking into consideration all costs associated with thatinvestment including the opportunity cost of capital. An economic profit arises when its revenueexceeds the total (opportunity) cost of its inputs, noting that these costs include the cost of equitycapital that is met by "normal profits." A business is said to be making an accounting profit if itsrevenues exceed the accounting cost of the firm. Economics treats the normal profit as a cost, so whendeducted from total accounting profit what is left is economic profit (or economic loss).

Other casesnegative sloping demand curveA Monopoly is one case where the firm would be faced with a negative sloping demand curve.

Marginal revenue of a straight line demand curveMR = P = D (in perfect competition)

Elasticity and marginal (and total) revenue - The relation between the price elasticity of demandand the marginal revenue curve indicates that a monopoly is only able to maximize profit byproducing a quantity of output that falls in the elastic range of the demand curve. A monopolycannot maximize profit in the inelastic range of demand because this involves negativemarginal revenue, and by virtue of the profit-maximizing equality between marginal revenueand marginal cost, it requires negative marginal cost, which is just not a realistic possibility.

The demand curve for a perfect competitor is its marginal cost curve (above average variable

cost). This was mentioned earlier (see graph on previous page).


6/23

MonopolyIt is a single seller (one firm) that makes up the entire market/industry.

Profit MaximizationProduction is increased until marginal revenue (MR) equals marginal cost(MC). Also note that if the price (based on the demand curve) is less than the average total cost(ATC), then the firm is going to produce at a loss.

Consumer welfare comparison with perfect competition - According to the standard model, inwhich a monopolist sets a single price for all consumers, the monopolist will sell a lowerquantity of goods at a higher price than would firms under perfect competition. Becausethe monopolist ultimately forgoes transactions with consumers who value the product orservice more than its cost, monopoly pricing creates a deadweight loss referring to potentialgains that went neither to the monopolist nor to consumers. Given the presence of thisdeadweight loss, the combined surplus (or wealth) for the monopolist and consumers isnecessarily less than the total surplus obtained by consumers under perfect competition. Whereefficiency is defined by the total gains from trade, the monopoly setting is less efficient

than perfect competition.

Price discrimination - Price discrimination exists when sales of identical goods or services aretransacted at different prices from the same provider. In a theoretical market with perfectinformation, no transaction costs or prohibition on secondary exchange (or re-selling) toprevent arbitrage, price discrimination can only be a feature of monopoly and oligopolymarkets, where market power can be exercised. Otherwise, the moment the seller tries to sellthe same good at different prices, the buyer at the lower price can arbitrage by selling to theconsumer buying at the higher price but with a tiny discount. Theoretically, a monopoly could

make the most profit by charging each person the maximum price they would be willing to payat each part of the demand curve up to the limit of profitability.

Monopolistic CompetitionThe short run is much like that for a monopoly. However, because thereare several firms competing, the long term ends up with firms making normal profit (zeroeconomic profit).

Monopolistically competitive markets have the following characteristics:

There are many producers and many consumers in a given market, and no business has totalcontrol over the market price.


7/23

Consumers perceive that there are non-price differences among the competitors' products. There are few barriers to entry and exit[1]. Producers have a degree of control over price.

Product DifferentialProducts under monopolistic competition vary in such ways as by brands orlevels of service. Costs are higher due to the expenditures to differentiate products.

Short run Long run

Oligopoly - An oligopoly is a market form in which a market or industry is dominated by a smallnumber of sellers (oligopolists). The word is derived from the Greek forfew (entities with theright to) sell. Because there are few participants in this type of market, each oligopolist is awareof the actions of the others. The decisions of one firm influence, and are influenced by, thedecisions of other firms. Strategic planning by oligopolists always involves taking into accountthe likely responses of the other market participants. This causes oligopolistic markets andindustries to be at the highest risk for collusion.

Compete or Collude?If pure Oligopoly rules, then there will be a kinked demand curve,competitors will follow price cuts but not price increases, and this gives rise to stable prices
http://en.wikipedia.org/wiki/Monopolistic_competition#cite_note-gans-0http://en.wikipedia.org/wiki/Monopolistic_competition#cite_note-gans-0http://en.wikipedia.org/wiki/Monopolistic_competition#cite_note-gans-0http://en.wikipedia.org/wiki/Monopolistic_competition#cite_note-gans-0


8/23

If Collusion takes place, then firms will collude to behave as a monopolist.

Why cartels tend to be unstableCartels are unstable because all firms have motive to cut prices togain profit from the deadweight loss.

Introduction to Game Theoryfor the previous reason, all firms usually come to some commonprice that all profit from greater than they would in perfect competition, but not as great as amonopoly.

The Microeconomic Theory of Income Distribution

Factor payments are determined by supply and demand

Labor-wagesDemand for Labor increases with an increase in the MPL. VMPL = P(MPL)

Productivity and wages are positively related and demand for labor comes from the demand fora product.

No demand for a product equals no labor demand to produce it. Wages differentials (think Adam Smith) connect the positive and negative attributes of a job

with wages.

An increase in wage yields an increase in leisure and decrease in labor (work)Land-rentsGrowing corn in Manhattan is not a good idea unless the rent is low enough that a

person could make a profit and the opportunity cost is low. Rent is for the productive servicesof the land.

Capital-interestInterest = price of credit; demand comes from borrowers; supply comes fromsavers/investors. Interest is the value of something at the current time versus in the future pluseconomic profit. IF Fed increases Ms => Banks increase SLF => i down. Positive timepreference is the main reason people borrow money.


9/23

Time PreferenceThey can also be thought of as inter-temporal indifference curves. The sharper the

slope, the greater the present time preference; the shallower the slope, the greater the futuretime preference

Interest as the price of creditInterest is the current value versus in the future + economic profit

Competitive equalization of the rate of returnAn activity that is generally expected to beprofitable (greater than expected return) wont turn out to be profitable (above normal rate ofreturn) due to competition through arbitrage.

Profits (above normal rate of return) are the result of uncertainty

Entrepreneurshipone of the situations where a person can make an above normal rate of return or

profit because of the uncertainty connected with the business/project. They can temporarilycreate a monopoly based on new ideas, new products, etc.

Do barriers to competition cause profit?For Monopolies because of costly entry to the market andeconomies of scale.

Demand Theory

Individual Preferences

UtilityIt is the satisfaction obtained by the consumer from consuming a good.

Total UtilityIt is the aggregate level of satisfaction or fulfillment that a consumer receives throughthe consumption of a specific good or service. Each individual unit of a good or service has itsown marginal utility, and the total utility is simply the sum of all the marginal utilities of theindividual units. Classical economic theory suggests that all consumers want to get the highestpossible level of total utility for the money they spend. In order to maximize total utility (whichis the inherent goal of all consumers), consumers will look to combine different combinationsof goods and services. Given their limited resources (money), consumers will make choices inan attempt to increase their total utility with each additional unit of consumption. TU = U/Q

Marginal Utility - The additional utility, or satisfaction of wants and needs, obtained from theconsumption or use of an additional unit of a good. It is specified as the change in total utility


10/23

divided by the change in quantity. Marginal utility indicates what each additional unit of a goodis worth to a consumer. MU = TU/Q

Cardinal vs. Ordinal - Economists distinguish between cardinal utility and ordinal utility. Whencardinal utility is used, the magnitude of utility differences is treated as an ethically orbehaviorally significant quantity. On the other hand, ordinal utility captures only ranking andnot strength of preferences. An important example of a cardinal utility is the probability of

achieving some target.

Marginal Utility => Demand curves It explains why the demand curve is downward sloping

Indifference Curves - In microeconomic theory, an indifference curve is a graph showing differentbundles of goods, each measured as to quantity, between which a consumer is indifferent. Thatis, at each point on the curve, the consumer has no preference for one bundle over another. Inother words, they are all equally preferred. One can equivalently refer to each point on theindifference curve as rendering the same level of utility (satisfaction) for the consumer. Finally,the curve higher up is always preferable to the one below it at any point on it because theperson is getting a larger amount of the combined goods than was possible one the lower curve.

Marginal Rate of Substitution - In economics, the marginal rate of substitution is the rate at whicha consumer is ready to give up one good in exchange for another good while maintaining thesame level of satisfaction. As with time preference, the slope of the curve dictates what goodthe person prefers more than the other.

Cases


11/23

Normal, well-behaved, convexSee graph above

Perfect Substitutes - One good is a perfect substitute for another only if it can be used in exactly thesame way. In that case the utility of a combination is an increasing function of the sum of thetwo amounts, and theoretically, in the case of a price difference, there would be no demand forthe more expensive good.

Perfect Complements - A perfect complement is a good that has to be consumed with another good.Many goods in the real world exhibit characteristics close to perfect complementariness. Anexample would be a left shoe and a right. Because of this, shoes are naturally sold in pairs, andthe ratio between sales of left and right shoes will never shift noticeably from 1:1 - even if, forexample, someone is missing a leg and buys just one shoe.

Bads

Neuters

How to represent one good being relatively preferable

If P1 decreases => Slope decreases, Horizontal intercept increases and vice versa

Budget ConstraintsExpenditures cannot exceed income

Representation

Algebra

Diagram

Effect of a Change

Price

Income

Consumer Optimization

Equi-marginal condition in consumption - We will use the utility theory to explain consumerdemand and to understand the nature of demand curves. For this purpose, we need to know thecondition under which I, as a consumer, am most satisfied with my market basket ofconsumption goods. We say that a consumer attempts to maximize his or her utility, whichmeans that the consumer chooses the most preferred of goods from what is available. Can wesee what a rule for such an optimal decision would be? Certainly I would not expect that thelast egg I am buying bring exactly the same marginal utility as the last pair of shoes I am


12/23

buying, for shoes cost much more per unit than eggs. A more sensible rule would be: If good Acosts twice as much as good B, then buy good A only when its marginal utility is at least twiceas great as good B's marginal utility. This leads to the equimarginal principle that I shouldarrange my consumption so that every single good is bringing me the same marginal utility perdollar of expenditure. In such a situation, I am attaining maximum satisfaction or utility frommy purchases. This is clear concept of equimarginal principle.

Tangency - the state of being tangent; having contact at a single point or along a line without crossing.

Individual Demand Curve vs. market demand curve - The market demand curve is the horizontalsummation of individual demand curves. Individual demand is the key initiator of theproduction process. It is independent of all factors other than the preference curve, prices andincome constraint. The law of demand: lower the price, greater amount demanded, i.e. demandcurve is negatively sloped.

Effect of price changes on optimal quantities

Income and substitution effects

Giffen goods - A Giffen good is an extreme type of inferior good.In economics and consumer theory,a Giffen good is that which people consume more of as price rises, violating the law of demand. Tounderstand how this happens, consider the example of a Giffen good for which there is the bestevidence that it is a Giffen good. Households in the Hunan province of China were shown to buy morerice when they had to buy it at a higher price, and less when the price they paid was subsidised.

The reason for this is that, even when expensive, rice was still the cheapest source of calories available.Therefore, when the price of rice was cut, households had more money left over after buying rice.Some of this was spent on buying more expensive foods (meat, vegetables and fruit), which reducedtheir need for rice.

Compensated demand curveIt is a demand curve which ignores the income effect of a pricechange. A compensated demand curve is therefore less elastic than an ordinary demand curve.

Market Demand Curves

Horizontal addition of individual demand curves

Price elasticity of demand - The Price Elasticity of Demand (commonly known as just priceelasticity) measures the rate of response of quantity demanded due to a price change. The formula forthe Price Elasticity of Demand (PEoD) is:

PEoD = (% Change in Quantity Demanded)/(% Change in Price)

If PEoD > 1 then Demand is Price Elastic (Demand is sensitive to price changes) If PEoD = 1 then Demand is Unit Elastic If PEoD < 1 then Demand is Price Inelastic (Demand is not sensitive to price changes)

Arc vs. point


13/23

Elastic Demand Inelastic Demand

Income Elasticity of Demand - The Income Elasticity of Demand measures the rate of response ofquantity demand due to a raise (or lowering) in a consumers income. The formula for the IncomeElasticity of Demand (IEoD) is given by:

IEoD = (% Change in Quantity Demanded)/(% Change in Income)

If IEoD > 1 then the good is a Luxury Good and Income Elastic If IEoD < 1 and IEOD > 0 then the good is a Normal Good and Income Inelastic If IEoD < 0 then the good is an Inferior Good and Negative Income Inelastic

Cross-price Elasticity of DemandThe Cross-Price Elasticity of Demand measures the rate ofresponse of quantity demanded of one good, due to a price change of another good. If two goods aresubstitutes, we should expect to see consumers purchase more of one good when the price of itssubstitute increases. Similarly if the two goods are complements, we should see a price rise in one


14/23

good cause the demand for both goods to fall. The common formula for the Cross-Price Elasticity ofDemand (CPEoD) is given by:

CPEoD = (% Change in Quantity Demand for Good X)/(% Change in Price for Good Y)

If CPEoD > 0 then the two goods are substitutes If CPEoD =0 then the two goods are independent (no relationship between the two goods If CPEoD < 0 then the two goods are complements

Price Elasticity of SupplyThe Price Elasticity of Supply measures the rate of response of quantitydemand due to a price change. If you've already readThe Price Elasticity of Demandand understand it,you may want to just skim this section, as the calculations are similar. We calculate the Price Elasticityof Supply by the formula:

PEoS = (% Change in Quantity Supplied)/(% Change in Price)

If PEoS > 1 then Supply is Price Elastic (Supply is sensitive to price changes) If PEoS = 1 then Supply is Unit Elastic If PEoS < 1 then Supply is Price Inelastic (Supply is not sensitive to price changes)

Elasticity and Revenue

When the price elasticity of demand for a good is inelastic (|Ed| < 1), the percentage change in quantitydemanded is smaller than that in price. Hence, when the price is raised, the total revenue of producersrises, and vice versa.

When the price elasticity of demand for a good is elastic (|Ed| > 1), the percentage change in quantitydemanded is greater than that in price. Hence, when the price is raised, the total revenue of producersfalls, and vice versa.

When the price elasticity of demand for a good is unit elastic (or unitary elastic) (|Ed| = 1), thepercentage change in quantity is equal to that in price.

When the price elasticity of demand for a good is perfectly elastic (Ed is undefined), any increase inthe price, no matter how small, will cause demand for the good to drop to zero. Hence, when the priceis raised, the total revenue of producers falls to zero. The demand curve is a horizontal straight line. Abanknote is the classic example of a perfectly elastic good; nobody would pay 10.01 for a 10 note,

yet everyone will pay 9.99 for it.

When the price elasticity of demand for a good is perfectly inelastic (Ed = 0), changes in the price donot affect the quantity demanded for the good. The demand curve is a vertical straight line; thisviolates the law of demand. An example of a perfectly inelastic good is a human heart for someonewho needs a transplant; neither increases nor decreases in price affect the quantity demanded (nomatter what the price, a person will pay for one heart but only one; nobody would buy more than theexact amount of hearts demanded, no matter how low the price is).

__________________________________________________________________________________
http://economics.about.com/cs/micfrohelp/a/priceelasticity.htmhttp://economics.about.com/cs/micfrohelp/a/priceelasticity.htmhttp://economics.about.com/cs/micfrohelp/a/priceelasticity.htmhttp://economics.about.com/cs/micfrohelp/a/priceelasticity.htm


15/23

Things You Need for CompsMacroeconomics and Finance

GDP - The best way to understand the U.S. economy is by looking at Gross Domestic Product (GDP),which is the statistic used to measure the economy. In other words, the U.S. economy, asmeasured by GDP, is everything produced by all the people and all the companies in the U.S.GDP = Y = total expenditures = C + I + G + NX; (Consumption spending, Investments,Government purchases, and Net Exports/Imports)

Nominal GDPAnything produced within a nation within a year. It does note included calculationsfor inflation.

Real GDPIt is nominal GDP adjusted for inflation (price changes).

GDP per capitaIt is GDP divided per person within a nation. This is not a perfectly accuratemeasure of the average income of people within a nation because of people like Bill Gates andsuch. (Imagine the average income in a homeless shelter with Bill Gates visiting it.)

InflationIt is an ongoing rise in the general level of prices quoted in units of money. The magnitude

of inflationthe inflation rateis usually reported as the annualized percentage growth ofsome broad index of money prices. With U.S. dollar prices rising, a one-dollar bill buys lesseach year. Inflation thus means an ongoing fall in the overall purchasing power of the monetaryunit.

Measurement: price index - A price index is a normalized average (typically a weightedaverage) ofprices for a given class of goods or services in a given region, during a given interval of time. Itis a statistic designed to help to compare how these prices, taken as a whole, differ betweentime periods or geographical locations. In economics, the GDP deflator (implicit price deflatorfor GDP) is a measure of the change in prices of all new, domestically produced, final goodsand services in an economy. GDP stands for gross domestic product, the total value of all final

goods and services produced within that economy during a specified period.

Problems with:

Redistribution - Economic expansion will be hindered in the absence of the "profit motive" that is liesat the heart of most business ventures. And without entrepreneurs the economy cannot expand,and in the end everybody suffers.

Distorted price signals - Why were too many loans made in 2003-07? Too much easy money. It hadto go somewhere. Why did a barrel of oil spike from $70 in August 2007 to $147 in July 2008?Because speculators had a greater faith in an oil future contract than they did the value of a USdollar. The dollar ceased to be a dollar. The most basic price signal of all could not be trusted.

Resources used to cope

Interest Rate - An interest rate is the price a borrower pays for the use of money they do not own, forinstance a small company might borrow from a bank to kick start their business, and the returna lender receives for deferring the use of funds, by lending it to the borrower. Interest rates arenormally expressed as a percentage rate over the period of one year.


16/23

Causes of Interest rate:

Deferred consumption. When money is loaned the lender delays spending the money onconsumption goods. Since according to time preference theory people prefer goods now togoods later, in a free market there will be a positive interest rate.

Inflationary expectations. Most economies generally exhibit inflation, meaning a givenamount of money buys fewer goods in the future than it will now. The borrower needs tocompensate the lender for this.

Alternative investments. The lender has a choice between using his money in differentinvestments. If she chooses one, she forgoes the returns from all the others. Differentinvestments effectively compete for funds.

Risks of investment. There is always a risk that the borrower will go bankrupt, abscond, orotherwise default on the loan. This means that a lender generally charges a risk premium toensure that, across his investments, he is compensated for those that fail.

Liquidity preference. People prefer to have their resources available in a form that canimmediately be exchanged, rather than a form that takes time or money to realise.

Taxes. Because some of the gains from interest may be subject to taxes, the lender may insiston a higher rate to make up for this loss.

Price of credit

Real vs. NominalThe nominal interest rate is the amount, in money terms, of interest payable. Forexample, suppose a household deposits $100 with a bank for 1 year and they receive interest of$10. At the end of the year their balance is $110. In this case, the nominal interest rate is 10%

per annum. The real interest rate, which measures the purchasing power of interest receipts, iscalculated by adjusting the nominal rate charged to take inflation into account. (See real vs.nominal in economics.) If inflation in the economy has been 10% in the year, then the $110 inthe account at the end of the year buys the same amount as the $100 did a year ago. The realinterest rate, in this case, is zero.

Business Cycle - The business cycle is the periodic but irregular up-and-down movements ineconomic activity, measured by fluctuations in real GDP and other macroeconomic variables.

Fiscal PolicyFiscal policy is the use of government spending and TAXATION to influence theeconomy. When the government decides on the goods and services it purchases, the transferpayments it distributes, or the taxes it collects, it is engaging in fiscal policy.

Fiscal policy is said to be tight or contractionary when revenue is higher than spending ( G < Ti.e., the government budget is in surplus) and loose or expansionary when spending is higherthan revenue (G > T i.e., the budget is in deficit). Often, the focus is not on the level of thedeficit, but on the change in the deficit. Thus, a reduction of the deficit from $200 billion to$100 billion is said to be contractionary fiscal policy, even though the budget is still in deficit.

Monetary PolicyIt is the attempt by the Fed to establish a balance in the national income andgrowth in the economy by controlling the size of the money supply.


17/23

Monetary TheoryMonetary policy is the process by which the government, central bank, ormonetary authority of a country controls (i) the supply of money, (ii) availability of money, and(iii) cost of money or rate of interest, in order to attain a set of objectives oriented towards thegrowth and stability of the economy.

For the US, the Fed can't control inflation or influence output and employment directly; instead,it affects them indirectly, mainly by raising or lowering a short-term interest rate called the

"federal funds" rate. Most often, it does this through open market operations in the market forbank reserves, known as the federal funds market.

Functions of moneyMoney is often defined in terms of the three functions or services that itprovides. Money serves as a medium of exchange, as a store of value, and as a unit ofaccount.

Medium of exchange. Money's most important function is as a medium of exchange tofacilitate transactions. Without money, all transactions would have to be conducted bybarter, which involves direct exchange of one good or service for another. The difficultywith a barter system is that in order to obtain a particular good or service from a supplier,one has to possess a good or service of equal value, which the supplier also desires. Inother words, in a barter system, exchange can take place only if there is a doublecoincidence of wants between two transacting parties. The likelihood of a doublecoincidence of wants, however, is small and makes the exchange of goods and servicesrather difficult. Money effectively eliminates the double coincidence of wants problem byserving as a medium of exchange that is accepted in all transactions, by all parties,regardless of whether they desire each others' goods and services.

Store of value. In order to be a medium of exchange, money must hold its value over time;that is, it must be a store of value. If money could not be stored for some period of timeand still remain valuable in exchange, it would not solve the double coincidence of wantsproblem and therefore would not be adopted as a medium of exchange. As a store of value,money is not unique; many other stores of value exist, such as land, works of art, and evenbaseball cards and stamps. Money may not even be the best store of value because itdepreciates with inflation. However, money is more liquid than most other stores of valuebecause as a medium of exchange, it is readily accepted everywhere. Furthermore, moneyis an easily transported store of value that is available in a number of convenientdenominations.

Unit of account. Money also functions as a unit of account, providing a common measureof the value of goods and services being exchanged. Knowing the value or price of a good,in terms of money, enables both the supplier and the purchaser of the good to makedecisions about how much of the good to supply and how much of the good to purchase.

Money and priceWith money, considering the three major functions, price and money arepositively related. Something considered more desirable and scarce will cost a larger amount ofmoney.

Money and interestIn the short run, a decrease in the money supply will cause Money demanded(Md) to outweigh Money supplied (Ms). This will cause the Bonds supplied (Bs) to outweighthe Bonds demanded (Bd). This in turn will cause the interest rate to rise (i up), driving realinterest up (r up) and lead to a decrease in the Demand for stocks (Ds). Finally, this will causethe Price of stocks to fall (Ps down). The same is true for vice versa.


18/23

Real interest rate = Nominal interest rateinflation rate (r = ipi)

Ms down => Md > Ms => Bs > Bd => i up => (r up) => Ds down => Ps down

Ms up => Md < Ms => Bs < Bd => i down => (r down) => Ds up => Ps up

Measurements of money supplyEach measure can be classified by placing it along a spectrumbetween narrow and broad monetary aggregates. The different types of money are typically

classified as Ms. The number of Ms usually range from M0 (narrowest) to M3 (broadest) butwhich Ms are actually used depends on the system. The typical layout for each of the Ms is asfollows:

M0: currency (notes and coins) in circulation and in bank vaults, plus reserves whichcommercial banks hold in their accounts with the central bank (minimum reserves and excessreserves). M0 is usually called the monetary base - the base from which other forms of money(like checking deposits, listed below) are created - and is traditionally the most liquid measureof the money supply.

M1: currency in circulation + checkable deposits (checking deposits, officially called demanddeposits, and other deposits that work like checking deposits) + traveler's checks. M1represents the assets that strictly conform to the definition of money: assets that can be used topay for a good or service or to repay debt. Although checks linked to checking deposits aregradually becoming less popular, debit cards linked to these deposits are becoming morepopular. Like checks, debit cards, as a means to complete a transaction through their links tocheckable deposits, can also be considered as a form of money.

M2: M1 + savings deposits, time deposits less than $100,000 and money market depositaccounts for individuals. M2 represents money and "close substitutes" for money. M2 is a keyeconomic indicator used to forecast inflation.

M3: M2 + large time deposits, institutional money-market funds, short-term repurchaseagreements, along with other larger liquid assets. M3 is no longer published or revealed to thepublic by the US central bank.

The Federal Reserve System (the Fed)The Federal Reserve System (also the Federal Reserve;informally The Fed) is the central banking system of the United States.

Multiple expansion of depositsMultiple-Deposit Expansion

The banking system's lending potential:

Assuming that reserve ratio for all commercial banks is 20 percent and no excess reservesexists.

Reserves lost by a single bank aren't lost the banking system as a whole.o For Example: The reserves that are lost by bank A are attained by bank B, and those lost

by Bank B are acquired by bank C etc.

Thus, even though reserves are lost by individual banks, there is no loss of reserves for thebanking system as a whole.

An individual bank can lend only an amount to its excess reserves, but this commercial bankingsystem can lend by a multiple of its excess reserves.


19/23

Commercial banks as a whole can create money by lending in a way different from the mannerof individual banks in the group.

The money multiplier:

The banking system magnifies any original excess reserves into a larger amount of newlycreated checkable-deposit money

The checkable-deposit multiplier, or monetary multiplier, is simliar in concept to the thespending-income multiplier

Monetary multiplier exists because the reserves and deposits lost by one bank becomes reservesof another bank. It magnifies excess reserves into a larger creation of checkable-deposit money.(when the excess reserve of a bank increases (because the federal reserve bank buy bonds) then,the commercial bank would loan out more of their excess reserve money to increase consumer'sdisposable income and to increase GDP.

The monetary multiplier m is the reciprocal of the required reserve ratioR (the leakage intorequired reserves that occurs at each step in the lending process)

Monetary Multiplier (money multiplier) = 1/ required reserve ratio OR m = 1/Ro

eg. If you deposit $500 into a bank, and the reserve ratio is 20%, you multiply $500 by1/.2 which results in a creation of $2500 dollars.

When the reserved ratio changes because of the monetary policy, the money multiplier alsochanges.

o As Reserve Ratio increases, Money Multiplier decreaseso As Reserve Ratio decreases, Money Multiplier increasesThe Feds tools for controlling the money supply

Required Reserve RatioThe reserve requirement (or required reserve ratio) is a bank regulation

that sets the minimum reserves each bank must hold to customer deposits and notes. Thesereserves are designed to satisfy withdrawal demands, and would normally be in the form of fiatcurrency stored in a bank vault (vault cash), or with a central bank. As of 2006 the requiredreserve ratio in the United States was 10% on transaction deposits (component of money supply"M1"), and zero on time deposits and all other deposits.

Reserve requirements affect the potential of the banking system to create transaction deposits.If the reserve requirement is 10%, for example, a bank that receives a $100 deposit may lendout $90 of that deposit. If the borrower then writes a check to someone who deposits the $90,the bank receiving that deposit can lend out $81. As the process continues, the banking systemcan expand the change in excess reserves of $90 into a maximum of $1,000 of money

($100+$90+81+$72.90+...=$1,000), e.g.$100/0.10=$1,000. In contrast, with a 20% reserverequirement, the banking system would be able to expand the initial $100 deposit into amaximum of ($100+$80+$64+$51.20+...=$500), e.g.$100/0.20=$500. Thus, higher reserverequirements reduce artificial money creation and help maintain the purchasing power of thecurrency in use

With the simple formula D = A*(1/r) we can quickly and easily determine what effect an open-market sale of bonds will have on the money supply.

Discount RateThe discount rate is an interest rate a central bank charges depository institutionsthat borrow reserves from it. MORE!!!


20/23

Open Market OperationsThe purchase and sale of government bonds. The Fed buys governmentbonds when it wants to increase the money supply. The Fed sells more government bonds whenit wants to decrease the money supply.

Ms down => Md > Ms => Bs > Bd => i up => (r up) => Ds down => Ps down

Ms up => Md < Ms => Bs < Bd => i down => (r down) => Ds up => Ps up

The Government budget

Ways to finance the government budget:

Printing moneyThe government can simply increase its budget by printing more money. However,this will lead to excessive inflation if the money supply grows too rapidly. Example: MV = PY;When the money supply (M) increases greater than the basic inflation of prices (P) and the rateof growth in full employment real GDP (Y),then inflation will increase to compensate(Velocity is consider constant).

%M + %V = %P + %Y; 20% + 0% = __% + 3%; Then inflation = 17%

Borrowing from domestic public

Borrowing from domestic publicWhen the government exceeds its budget, it can borrow tofinance it from the domestic public. This can be good in a sense because when it pays back thepublic, the money remains in the nation as a whole. The downside can be that the domesticpublic does not have as much money to spend on goods and services at the current time. This,on a large scale, could cause a recession in certain consumer sectors.

Borrowing from foreignersWhen the government exceeds its budget, it can also borrow fromforeigners, both individuals and nations as a whole. The good side of this is that the budget in

the short term can expand enormously beyond that of domestic lending. However, payments forborrowing to foreigners leave the nation. If the amount borrowed from foreigners becomeslarge enough in combination with the interest rate, the nation could end up paying more ininterest to foreign nations and people than it gains from annual economic growth.

Effects of financing the deficit

The national debt: is it a problem?Yes, if it expands so far that interest paid outweighs annualeconomic growth. However, borrowing also allows a nation to increase its economic growthand spend more than would be possible if it had to balance its budget like an individual.

Long Run Macroeconomics

The determination and distribution of national incomeNational income = Nat nation Product(NNP) minus Indirect business taxes.

Basic open economy MacroeconomicsY = F(K,L); The economy is affected by the factors ofproduction. Those factors are capital (K) and labor (L), both of which are usually assumed to befixed. In addition, technology (A) is a third factor, although it cannot be calculated. Thefunction would be shown as follows: Y = AF(K,L)


21/23

The Marginal Product of Labor (MPL) is the extra amount of output the firm gets from oneextra unit of labor. This, on a large scale, means that when L increase, then Y increase but at adecreasing rate. The same is true for capital with the Marginal Product of Capital (MPK).

Economic Profit = Y(MPL x L)(MPL x K).Therefore, Y = (MPL x L) + (MPK x K) + economic profit.

Economic Growth TheoryIn economics, "economic growth" or "economic growth theory"typically refers to growth of potential output, i.e., production at "full employment," which iscaused by growth in aggregate demand or observed output.

Short Run Macroeconomics

Economic FluctuationsAn increase in unemployment = a decrease in real GDP growth;

MV = PY

An adverse supply shock => SRAS up, but the Fed can increase the AD to prevent a

reduction in output.

In the short run, prices dont change, but the output shifts instead. In the long run, output

remains at the optimum level, but prices shift accordingly.

The IS-LM modelIS stands for Investment and Savings, while LM stands for Liquidity and Money.

IS CurveIS curve is downward sloping because when real interest decreases, spending increases. Achange in either Government purchases or Taxation (G or T) will cause the IS curve to shift tothe right or left.

An increase in G will shift the IS curve to the right and vice versa.An increase in T will shift the IS curve to the left and vice versa.


22/23

The LM CurveThe LM curve is upward sloping because the higher the level of income, the higherthe demand for real money balances, and the higher the equilibrium interest rate. Changes inthe Money Supply will cause the LM curve to shift either up or down.

A Decrease in the Money Supply will raise the interest rate and cause the LM curve to

rise as well (and vice versa).

Short run macroeconomic Policy

The open economy in an IS-LM model

International Finance

The balance of payments - In economics, the balance of payments, (or BOP) measures the paymentsthat flow between any individual country and all other countries. It is used to summarize allinternational economic transactions for that country during a specific time period, usually ayear. The BOP is determined by the country's exports and imports of goods, services, andfinancial capital, as well as financial transfers. It reflects all payments and liabilities toforeigners (debits) and all payments and obligations received from foreigners (credits). Balanceof payments is one of the major indicators of a country's status in international trade, with netcapital outflow. As stated before, if debt to foreigners becomes too high in combination withinterest payments, then foreign payments may draw away from the growth of the economy.

Balance of Trade = InvestmentNational Savings

Meaning of a trade deficit or surplus

Trade Surplus Balanced Trade Trade DeficitExports > Imports Exports = Imports Exports < ImportsNet Exports > 0 Net Exports = 0 Net Exports < 0Y > C + I + G Y = C + I + G Y < C + I + GSavings > Investment Savings = Investment Savings < InvestmentNat Capital Outflow > 0 Net Capital Outflows = 0 Net Capital Outflows < 0

Causes

Is a trade deficit a problemNot necessarily because it allows a nation to spend beyond taxation. Inaddition, if it helps to expand the economy, then the expansion of the economy could actuallymake the size of the deficit as a percentage of the budget smaller. However, as stated before, ifthe deficit becomes too large, then a nation will end up giving up more of its economic growthto pay lender than expand, causing the economy to remain stagnant or shrink.

Exchange Rates - In finance, the exchange rates (also known as the foreign-exchange rate, forexrate or FX rate) between two currencies specifies how much one currency is worth in terms ofthe other. It is the value of a foreign nations currency in terms of the home nations currency.

Determination of the rate: fundamentals

Suppliers and demanders of foreign exchange


23/23

Types of foreign exchange transactions

Main theories of exchange rate determination

Interest Rate Parity

Purchasing Power Parity

Finance

Basic

Discounting

Financial Instruments

Financial Intermediaries

Money

Interest Rates

Financial Markets

Risk and Term Structure of Interest Rates

Efficient Markets Theory and the Stock Market

Banking and the Management of Financial Institutions

Derivatives

Documents

UD Econ Comps Study Guide