CFA - Economics.pptx

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Reading #14:
Topics in Demand and Supply Analysis

Own-Price Elasticity of Demand
Own-Price Elasticity is a measure of the responsiveness of the quantity demanded to a change in price
Own-Price Elasticity =
%𝐂𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐪𝐮𝐚𝐧𝐭𝐢𝐭𝐲 𝐝𝐞𝐦𝐚𝐧𝐝𝐞𝐝
%𝐂𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐩𝐫𝐢𝐜𝐞
A quantity demanded is very responsive to a change in price → Demand is elasticity
A quantity demanded is not very responsive to a change in price → Demand is inelastic
P
Q
D
Perfectly inelastic demand
(Elasticity = 0)
P
Q
D
Perfectly elastic demand
(Elasticity = ∞)
Reading #14: Topic in Demand and Supply Analysis

PREDICTING
DEMAND
ELASTICITY
Availability and closeness of substitute
Few or no goods substitutes for a good → Demand is relatively inelastic
One or more goods substitutes for a good → Demand is very elastic
Discretionary or non-discretionary
The more a good is seen as being necessary, the less elastic its demand is likely to be
Time allowed to respond to change in price
Elasticity of demand tends to be greater, the longer the time period since the price change
Portion of income spent on a good
The larger the portion of income that is spent on a good, the more elastic an individual’s demand
for that will be

0
1
2
3
4
5
6
7
8
9
0 10 20 30 40 50 60 70 80 90
Price Elasticity Along a Linear Demand Curve
Quantity
Price ($)
(a) High elasticity
(b) Unitary elasticity
Elasticity = -1.0
(c) Low
elasticity
• Elasticity is not slope for demand
• Price elasticity of demand and total
revenue (P*Q)
• Greatest total revenue
→ elasticity = -1.0
• Inelastic range: Price increase will
increase total revenue (%decrease
in quantity demand lower than
%increase in price)
• Elastic range: Price increase will
decrease total revenue (%decrease
in quantity demand higher than
%increase in price)

Income Elasticity of Demand
 Normal goods: An increase in income will lead to an increase in demand → Elasticity > 0
 Inferior goods: An increase in income will lead to a decrease in demand → Elasticity < 0
Income elasticity =
%𝐂𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐪𝐮𝐚𝐧𝐭𝐢𝐭𝐲 𝐝𝐞𝐦𝐚𝐧𝐝𝐞𝐝
%𝐂𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐢𝐧𝐜𝐨𝐦𝐞
Cross-price Elasticity of Demand
 Cross price elasticity > 0: The goods are substitute
 Cross price elasticity < 0: The goods are complement
Income elasticity =
%𝐂𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐪𝐮𝐚𝐧𝐭𝐢𝐭𝐲 𝐝𝐞𝐦𝐚𝐧𝐝𝐞𝐝 𝐨𝐟 𝐠𝐨𝐨𝐝 𝟏
%𝐂𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐪𝐮𝐚𝐧𝐭𝐢𝐭𝐲 𝐝𝐞𝐦𝐚𝐧𝐝𝐞𝐝 𝐨𝐟 𝐠𝐨𝐨𝐝 𝟐

Distinguish between normal goods and inferior goods
Substitution effect Income effect
Normal good Buy more because the good is relatively
cheaper than its substitutes
Buy more because the increase in income
raises the total consumption level
Inferior good Buy more because the good is relatively
cheaper than its substitutes
Buy less because the increase in real income
prompts the consumer to buy less of the
inferior good in favor of its preferred
substitutes
Giffen good
• An inferior good for which the negative income effect
outweighs the positive substitution effect when price
fall
• For giffen good, the demand curve is positive sloped
Veblen good
• Higher price increases desirability
• Increasing price, increasing status (high status good)
• High end designer/luxury goods
• Positively sloped demand curve for some individuals

Marginal product
• The amount of additional output resulting from using one more unit of input assuming other inputs are fixed
• The difference in total product and dividing by the change in quantity of labor
Marginal product of labor =
∆ Total product
∆QL
Marginal
product
increasing
Marginal
product
decreasing Marginal
product
negative
Product function
Total
output
Quantity of labor
A B
Describe the phenomenon of diminishing marginal returns

Output quantity
TC
TVC
TFC
TC = TFC + TVC
Cost
• Total fixed costs (TFC) is the cost of
inputs that do not vary with the
quantity of output and cannot be
avoided over the period of analysis
• Quasi-fixed cost: Some of these
costs will remain constant over some
range of output but will increase if
output is increase beyond some
quantity
• Total variable cost (TVC) is the cost
of all inputs that vary with output
over the period of analysis
• Total cost (TC) is the sum of all costs
Interpret total, average, marginal, fixed and variable costs

Interpret total, average, marginal, fixed and variable costs Cost
Output quantity
MC
AVC
ATC
AFC
ATC = AFC + AVC
• Marginal costs (MCs) as the addition
to cost of producing one more unit
MC =
∆𝑇𝐶
∆𝑄
• Average total costs (ATC) =
𝑇𝐶
𝑄
• Average fixed costs (AFC) =
𝑇𝐹𝐶
𝑄
• Average variable costs (AVC) =
𝑇𝑉𝐶
𝑄

Shutdown and Breakeven Under Perfect Competition
Cost
Output quantity
MC
AVC
ATC
P2
P1 Breakeven
Operate in SR
Shutdown in LR
Shutdown in SR and LR
Breakeven analysis
• A firm is said to breakeven if its TR = TC
or AR = ATC
• At the breakeven point, a firm covers all
its economics cost (total accounting
costs + implicit opportunity costs) and
just earns a normal profit
• Normal profit: when revenues is equal
to economic costs. Normal profit is
equal to earning a rate of return on
capital just equal to the rate of return
that an investor could expect to earn in
an risky alternative investment
• Firms operating in a very competitive
market with no barrier to entry, in the
long run is unable to earn a positive

Shutdown and Breakeven Under Perfect Competition
Cost
Output quantity
MC
AVC
ATC
P2
P1 Breakeven
Operate in SR
Shutdown in LR
Shutdown in SR and LR
• If AR > ATC, the firm should stay in
the market in both the short and
long run
• If AR > AVC, but AR < AVC, the firm
should stay in the market in short run
but will exit the market in the long
run
• If AR < AVC, the firm should shut
down in the short run and exit the
market in the long run

Shutdown and Breakeven Under Imperfect Competition
Revenue – Cost relationship Short – run decision Long – run decision
TR >= TC Stay in market Stay in market
TR > TVC but TR < TFC + TVC Stay in market Exit market
TR < TVC Shut down production to
zero
Exit market

SRATC1
SRATC2
SRATC3
SRATC4
SRATC5
SRATC6
SRATC7
SRATC8
LRATC
Economies of scale Diseconomies of scale
Q* = minimum efficient scale
Cost
Output
Describe how economies of scale and diseconomies of scale affect costs

Reading #15:
The Firm and Market Structures

Reading #15: The Firms and Market Structures
Characteristics of perfect competition, monopolistic competition, oligopoly and pure monopoly
Perfect
competition
Monopolistic
Competition
Oligopoly Monopoly
Number of sellers Many firms Many firms Few firms Single firm
Barriers to entry Very low Low High Very high
Nature of substitute products
Very good
substitutes
Good substitutes
but differentiated
Very good
substitutes but
differentiated
No good
substitutes
Nature of competition Price only
Price, marketing,
features
Price, marketing,
features
Advertising
Pricing power None Some
Some to
significant
Significant

Perfect Competition
P
Q
D = P = MR
Profit Maximizing output for
A Price Taker
MC
Q*
P
Q
Demand = MR = AR
Price – taker demand
P
Q
Market
S
D
A firm will continue to expand production until MR = MC
Marginal revenue is the price because all additional units are
assumed to be sold at the same market price
A firm maximize profit by producing and
selling the quantity for which MR = MC

Short run Profit Maximization
P
Q
MC ATC
MR
Profit maximizing
output
Economic
profit
(a) Marginal approach
Q
Revenue
Q
TC
(b) Total approach
TR – TC is
maximum
Profit maximizing
output
TR
Q
Short run Profit
Maximization
• MR = MC
• In short run, firms
can earn positive
economic profit
• MR = P = AR = MC

Equilibrium in a Perfectly Competitive Market
Price and Cost
Q
MC
ATC
P*
(a) Marginal approach
Q*
Long run Profit Maximization
• MR = P = AR = MC = ATC
• Earn no economic profit
• Earn normal profit
• Produce the quantity for
which ATC is a minimum
Revenue
Q
(b) Total approach
Q*
P*

Short – run loss
Price
Quantity
MC
AVC
AVC
MR = P
Economic loss
Economic loss
• Loss appears when P < ATC
• AVC < P < ATC → Minimizing loss
• If P = AVC, the firm is operating at
shutdown point
• If P < AVC, the firm will shut down.
This will limits loss to its fixed costs

Short – run adjustment to an increase in demand
Quantity
Price
SR Industry Supply
D1
D2
P1
P2
Q1 Q2
Price
Quantity
P1
P2
MC = SR Firm Supply
D1
D2
Q1Firm Q2Firm
Market Firm

Effects of permanent increase in Demand
Firm
Quantity
Price
MC
ATC
P1
P2
q1 q2
MR0
MR1
Quantity
Price
D1
D2
P1
P2
Q1 Q2
Industry
S0 S1
Q0

Monopolistic Competition
Short-run out put decision for a firm
MR = MC → Maximizing economic profits
Price for product = P*
Positive economics profit = P* - ATC*
→ attract competitors to enter market
Quantity
Price
MR
D
ATC*
P*
ATC
MC
Q
Quantity
Price
MR
D
ATC*, P*
ATC
MC
Q
Long-run out put decision for a firm
Entry of new firms shifts demand curve to
the point ATC* = P*
Economics profits = 0
→ attract no new firm

Firm output under Monopolistic Competition and Perfect Competition
Quantity
Price
MR
D
P
ATC
MC
Q
Quantity
Price
D
P
ATC
MC
Q

Reading #16:
Aggregate output, prices and economic growth

GDP is total
market value of
all final goods
and services
produced within
the economy in
a given period
of time
The values used in calculating GDP are market values of final goods and services—that
is, goods and services that will not be resold or used in the production of other goods
and services.
Goods and services provided by government are included in GDP even though they are
not explicitly priced in markets. They are valued at their cost to the government.
GDP also includes the value of owner – occupied housing, just as it includes the value of rental
housing services. Values are estimated for inclusion in GDP
Transfer payments made by the government (e.g., unemployment, retirement, and welfare
benefits) are not economic output and are not included in the calculation of GDP
Calculate and explain GDP using expenditure and income approach

Calculate and explain GDP using expenditure and income approach
Expenditure approach
GDP = Summing amounts of
spent goods and services during
the period of time
Income approach
GDP = Summing amounts
earned by households and
companies during the period,
including wage income, interest
income, and business profits.

Sum-of-value-added and value-of-final-output methods of calculating GDP
Value-of-final-output
Vale-of-final-output method =
Expenditure approach
Sum-of-value added
GDP = summing the additions
to value created at each stage
of production and distribution.
Stage of
production
Sales value
($)
Value added
($)
Raw material 100 100
Manufacturing 350 250
Retail 400 50
Sum of value
added
400

Compare nominal and real GDP and calculate and interpret the GDP deflator
Nominal GDP is the total value of all goods
and services produced by an economy,
valued at current market prices.
Nominal GDPt = 𝑖=1
𝑁
𝑃𝑡, 𝑖 ∗ 𝑄𝑖, 𝑡
Real GDP measures the output of the
economy using prices from a base year,
removing the effect of changes in prices
Real GDPt = 𝑖=1
𝑁
𝑃𝑖, 𝑡 − 5 ∗ 𝑄𝑖, 𝑡
Nominal GDP Real GDP
The GDP deflator is a price index that can be used to convert nominal GDP into real GDP, taking out
the effects of changes in the overall price level. The GDP deflator is based on the current mix of
goods and services, using prices at the beginning and end of the period.
GDP deflator for year t = 𝑖=1
𝑁
𝑃𝑡,𝑖 ∗𝑄𝑖,𝑡
𝑖=1
𝑁
𝑃𝑖,𝑡−5 ∗𝑄𝑖,𝑡

Compare GDP, national income, personal income, and personal disposable income
GDP = C + I + G + (X – M)
C = Consumption spending
I= Business investment
G = Government purchase
X = Export
M = Import
GDP = national income + capital
consumption allowance + statistical
discrepancy
Expenditure approach Income approach

The IS and LM curves and how they combine to generate the aggregated demand curve
Factors that
determine the
components of
GDP
Consumption is a function of disposable income. An increase in personal income or a decrease in
taxes will increase both consumption and saving. Additional disposable income will be consumed
or saved.
Net exports are a function of domestic disposable incomes (which affect imports), foreign
disposable incomes (which affect exports), and relative prices of goods in foreign and domestic
markets.
Government purchases may be viewed as independent of economic activity to a degree, but tax
revenue to the government, and therefore the fiscal balance, is clearly a function of economic
output.
Investment is a function of expected profitability and the cost of financing. Expected profitability
depends on the overall level of economic output. Financing costs are reflected in real interest
rates, which are approximated by nominal interest rates minus the expected inflation rate.

Real
interest rate
6%
5%
4%
Real
income
Y1 Y2 Y3
Real
interest rate
6%
5%
4%
Real
income
Y1 Y2 Y3
The IS curve illustrates the negative relationship
between real interest rate and real income rate
The LM curve illustrates the positive relationship
between real interest rate and real income rate

Real
interest
rate
A
B
C
Income
YA YB YC
LM curve.
Lower M/P
(higher P)
LM curve
LM curve.
Higher M/P
(lower P)
IS Curve
Price
level
PA
PB
PC
Output
YA YB YC
AD
curve
The aggregate demand curve slopes downward because higher price levels reduce real wealth, increase real
interest rates → domestically produced goods more expensive than goods produced abroad → reduce quantity of
domestic output demanded

Explain the aggregate supply curve in the short run and long run
Price
level
LRAS
Output
Potential
GDP
SRAS
VSRAS
The aggregate supply (AS) curve describes the relationship
between the price level and the quantity of real GDP supplied,
when all other factors are kept constant
• In the very short run: perfectly elastic
(wages, input costs, output prices are fixed)
• In the short run: Input prices are fixed so
businesses expand real output when output
price increases
• In the long run: AS is fixed at full
employment or potential real GDP

Causes of movement along and shifts in AD and AS
Price
level
Output
AD AD1
Increase in consumers’ wealth
Business expectation
Consumer expectations of future income
High capacity utilization
Expansionary monetary policy
Expansionary fiscal policy
Exchange rates
Global economic growth

Price
level
Output
AS
AS1
Labor productivity
Input prices
Expectations of future income
Taxes and government subsidies
Exchange rate

Price
level
Output
AS AS1
Increase in the supply and quality of labor
Increase in the supply of natural resources
Increase in the stock of physical capital
Technology
NOTE:
• Factors affecting SRAS may not affect LRAS
• Factors affecting LRAS do affect both LRAS and SRAS

Price
level
Output
AD
AS In contrast with shifts in the aggregate demand and aggregate
supply curves, movements along these curves reflect the
impact of a change in the price level on the quantity
demanded and the quantity supplied. Changes in the price
level alone do not cause shifts in the AD and AS curves,
although we have allowed that changes in expected future
prices can.

If the economy is in short run equilibrium, but at a level of output above or below full – employment
GDP, it is in long run disequilibrium. The difference between real GDP and full employment is called a
recessionary gap or output gap
Price
level
Output
Price
level
Output
Recessionary gap
(Below full-employment output)
→ unemployment
→ quality of L↑
→ wages ↓
→ SRAS shifts right
Inflationary gap
(above full-employment output)
→ expansion
→ need more workers
→ wages ↑
→ SRAS shifts left

Price
level
Output
Price
level
Output
Type of change Real GDP Unemployment Price level
Increase in AD Increase Decrease Increase
Decrease in AD Decrease Increase Decrease
Increase in AS Increase Decrease Decrease
Decrease in AS Decrease Increase Increase
Short-Run Macroeconomic Effects
LRAS
SRAS1
SRAS0
AD1
AD0
LRAS SRAS1
SRAS0
AD1
AD0

Reading #17:
Understanding Business Cycle

Reading #17: Understanding Business Cycle
Describe the business cycle and its phases
Business
Peak
Contraction
(recession) Recessionary Trough
Expansion
(Recovery)
Average
Time
Real GDP
The business cycle is characterized
by fluctuation in economic activity
Two consecutive quarters of growth
in real GDP as the beginning of an
expansion an two consecutive
quarters of declining real GDP as
indicating the beginning of an
contraction
Business cycle recur, but they DO
NOT recur at regular intervals

Resource Use Fluctuation
Business
Peak
Contraction
(recession) Recessionary Trough
Expansion
(Recovery)
Average
Time
Real GDP
The ratio of inventory to sales in
many industries trends toward a
normal level in times of steady
economic growth.
When expansion approaching peak:
Firms reduce production
When contraction reaching trough:
Firms increase output

Important
determinants of
the level of
economic
activity in the
housing sector
Mortgage rates: Low interest rates tend to increase home buying and construction while high
interest rates tend to reduce home buying and construction
Demographic factors: The proportion of the population in the 25- to 40-year- old segment is
positively related to activity in the housing sector because these are the ages of greatest
household formation.
Speculative activity: Higher prices led to more construction and eventually excess building. This
resulted in falling prices that decreased or eliminated speculative demand and led to dramatic
decreases in housing activity overall.
Housing costs relative to income: When incomes are cyclically high (low) relative to home costs,
including mortgage financing costs, home buying and construction tend to increase (decrease).
Housing Sector Activity

Trough
Contraction /
recession
Peak
Expansion
• GDP growth rate changes from
negative to positive.
• High unemployment rate, increasing
use of overtime and temporary
workers.
• Spending on consumer durable goods
and housing may increase.
• Moderate or decreasing inflation rate.
• GDP growth rate increases.
• Unemployment rate decreases as hiring
accelerates.
• Investment increases in producers’
equipment and home construction.
• Inflation rate may increase.
• Imports increase as domestic income
growth accelerates.
• GDP growth rate decreases.
• Unemployment rate decreases but
hiring slows.
• Consumer spending and business
investment grow at slower rates.
• Inflation rate increases.
• GDP growth rate is negative.
• Hours worked decrease, unemployment
rate increases.
• Consumer spending, home construction,
and business investment decrease.
• Inflation rate decreases with a lag.
• Imports decrease as domestic income
growth slows.
External Trade Sector Activity

Types of
unemployment
Cyclical unemployment is positive (negative) when the economy is
producing less (more) than its potential real GDP.
Structural unemployment results from long-term economic changes that
require workers to learn new skills to fill available jobs.
Frictional unemployment results from the time it takes for employers
looking to fill jobs and employees seeking those jobs to find each other.
A person is considered unemployed if he is not working, is available for work, and is actively
seeking work. The labor force includes all people who are either employed or unemployed. The
unemployment rate is the percentage of labor force participants who are unemployed.

Inflation is a persistent increase in the price level
over time. If inflation is present, the prices of almost
all goods and services are increasing.
Deflation occurs when there is a persistent decrease in
price level (i.e., a negative inflation rate). Deflation is
commonly associated with deep recessions.
Disinflation refers to an inflation rate that is
decreasing over time but remains greater than zero.
Hyperinflation is inflation that accelerates out of control.
Hyperinflation is said to be able to destroy country’s
monetary system and bring about social and political
upheavals.
Explain inflation, hyperinflation, disinflation, and deflation

Consumer price index (CPI) measures the cost of a
fixed basket of goods and services compared to the
cost in a base period
CPI =
Cost of basket at current price
Cost of basket at base period price
∗ 100
Explain the construction of indexes used to measure inflation Category Percent of Index
Food
Energy
All items less food and energy
13.9%
6.6%
79.5%
Commodities less food and
energy commodities:
Apparel
New Vehicles
Used cars and trucks
Medical care commodities
Alcoholic beverages
Tobacco and smoking products
3.2%
3.8%
2.1%
1.8%
1.0%
0.7%
Services less energy services:
Shelter
Medical care
Transportation services
33.3%
6.6%
5.9%
Item Quantity Price in base
year
Current price
Cheeseburgers 200 2.50 3.00
Movie tickers 50 7.00 10.00
Gasoline 350 1.50 3.00
Digital watches 100 12.00 9.00
Example: Calculating a price index
The following table shows price information for a simplified
basket of goods

Distinguish between cost – push and demand – pull inflation
Cost-push inflation: Increase in wages or other
input prices decreases SRAS, increase P
LRAS
SRAS1
SRAS0
AD0
AD1
GDP* GDP1
Real
GDP
Price level
Demand-pull inflation: Increase in aggregate
demand above full employment increase P
LRAS
SRAS1
SRAS0
AD0
AD1
GDP* GDP1
Real
GDP
Price level

Distinguish between cost – push and demand – pull inflation
 Average weekly hours in manufacturing
 Initial claims for unemployment
 Manufacturer’s new orders for
consumer goods and material
 ISM new order index
 Manufacturer’s new orders for non-
defense capital goods excluding aircraft
 Building permits for new private
housing unit
 S&P 500 Index
 Leading credit index
 10-year Treasury to Fed funds interest
rate spread
 Consumer’s expectations
 Average duration of
unemployment
 Inventory-sales ratio
 Change in unit labor-cost
 Average bank in prime lending
rate
 Commercial and industrial loans
outstanding
 Ratio of consumer installment
debt to income
 Change in consumer price index
for services
 Employment on non-agricultural
payrolls
 Aggregate real personal income
 Industrial production index
 Manufacturing and trade sales
Leading indicators Coincident indicators Lagging indicators

Reading #18:
Monetary And Fiscal Policy

Reading #18: Monetary and Fiscal Policy
Compare monetary and fiscal policy
Fiscal policy: government’s
use of spending and
taxation to influence
economic activity.
Expansionary FP: Increase
spending and/or decrease
taxes
Contractionary FP:
Decrease spending and/or
increase taxes
Monetary policy: Central
bank’s actions that
influence quantity or
money
Expansionary MP: Increase
money supply, decrease
interest rate, increase AD
Contractionary MP:
Decrease money supply,
Increase interest rate
Three primary
functions
Medium of exchange /
means of payment
Unit of account
Store of value
Narrow money is the amount of notes and
coins in circulation in an economy plus balances
in checkable bank deposits
Broad money includes narrow money plus any
amount available in liquid assets, which can be
used to make purchases
Describe functions and definitions of money

Demand for
Money
Transaction demand: increases
with GDP
Precautionary demand: Money
held for unforeseen needs,
increases with GDP
Speculative demand: Money held
to take advantage of future
investment opportunities
Describe theories of the demand for and supply of money
MS
MD
At ihigh, there is excess supply of
money leading to purchases of
securities
At ilow, there is excess
demand for money
leading to sales of
securities
ihigh
i*
ilow
Nominal
interest rate
Quantity of money

Central bank’s short-term effects on interest rate
MS0
MD
5%
4%
Nominal
interest rate
Quantity of money
MS1
Central bank can affect interest rate by
adjusting the money supply
 An increase in the money supply will
decrease interest rate
 A decrease in the money supply will
increase interest rate

Describe the Fisher effect
The Fisher effect states that the nominal interest rate is simply the sum of the real interest
rate and expected inflation
RNom = RReal + E[I]
where:
RNom = nominal interest rate
RReal = real interest rate
E[I] = expected inflation
Investors are exposed to the risk that inflation and other future outcomes may be different
than expected. Investors require additional return (a risk premium) for bearing this risk,
which we can consider a third component of a nominal interest rate.
RNom = RReal + E[I] + RP
where:
RP = risk premium for uncertainty

Describe roles and objectives and tools of central banks
Sole supplier of currency
Banker to the government and other
bank
Regulator and supervisor of payments
system
Lender of last resort
Holder of gold and foreign exchange
reserves
Conduct of monetary policy
Control inflation
Stabilize the price
Stabilize exchange rate with foreign
currencies
Full employment
Sustainable positive economic growth
Moderate long-term interest rates
CENTRAL BANK
ROLE
OBJECTIVES
Policy rate Open market operations
Reserve requirements

Describe qualities of effective central banks
Effective central
banks
Independent: Free from political interference
 Operational independence: free to set policy rate
 Target independence: sets inflation target, measures inflation,
determines horizon to meet inflation
Credible: Bank follows through a stated intentions and policies
Transparent: bank discloses inflation reports, indicators they use
and how they use them

Contrast the use of inflation, interest rate and exchange rate targeting by central banks
Inflation-targeting framework:
 An dependent and credible central bank
 A commitment to transparency
 A decision-making framework that
considers a wide range of economic and
financial market indicators
 A clear and symmetric and forward-looking
medium term inflation target, sufficiently
above 0 percent to avoid the risk of
deflation but low enough to ensure
significant degree of price stability
Exchange rate targeting:
 Many developing countries choose to
operate monetary policy by targeting their
currency exchange rate rather than an
explicit level of domestic inflation
 Involving setting a fixed level or band of
values for the exchange rate against a
major currency
 When the central bank or monetary
authority chooses to target an exchange
rate, interest rates and conditions in the
domestic economy must adapt to this
target and domestic interest rates and
money supply can become volatile

When a central bank BUYS securities
INCREASE:
 Bank reserves
 Business investment
 Consumption of
house, auto and
durable goods
 Aggregate demand
 Employment
 Inflation
DECREASE:
 Interbank lending
rates
 Long-term and short-
term lending rates
 Domestic currency
Effects of expansionary monetary policy
 Market interest rate falls, less incentive to save
 Asset prices increase → wealth effect → consumption
spending increases
 Expectation for economic growth increase, may
expect further decreases in interest rates
 Domestic currency depreciates, import price increase,
export price decreases

Decide expansionary or contractionary monetary Limitations of monetary policy
 Neutral i/r = growth rate of MS that neither increases
nor decreases the economic growth rate
 Neutral i/r = real trend rate of economic growth +
inflation target
 Policy rate > neutral rate: Contractionary
 Policy rate < neutral rate: Expansionary
 Long-term rates may move oppositely to short-term
rates because of inflation expectations changes
 If monetary tightening is extreme, expectations of
recession may make long-term bonds more attractive,
decreasing long-term rates
 If demand for money is very elastic, people will hold
currency even as money supply increases, liquidity
trap
 Bank may desire to increase capital and not increase
lending in response to expansionary monetary policy
 Short-term rates cannot be below 0, limits a central
bank’s ability to act against deflation

Describe roles and objectives of fiscal policy
Expansionary Fiscal Policy
 Increase government spending
 Decreases taxes
 Increasing AD and budget deficit
Expansionary Fiscal Policy
 Decrease government spending
 Increases taxes
 Decreasing AD and budget deficit
Objectives of FP: influencing the level of economic activity and AD. Redistributing wealth and
income among segments of population; allocating resources among economic agents and
sectors in the economy

Spending tools
Transfer Payments
redistribute wealth, taxing some
and making payments to others
Current Spending
government purchases good and
services on an ongoing and
routine basis
Capital Spending
government spending on
infrastructure
Justification for spending tools:
• Provide services that benefit all the residents in a country
• Invest in infrastructure to enhance economic growth
• Support the country’s growth and unemployment targets
• Provide a minimum standard of living
• Subsidize investment in research and development

Revenue tools
Direct Taxes
levied on income or
wealth
• income taxes
• wealth taxes
• estate taxes
• corporate taxes
• ...
Indirect Taxes
levied on goods and
services
• sales taxes
• VATs
• excise taxes
• ...
Desirable attributes of tax policy:
• Simplicity to use and enforce
• Efficiency
• Fairness is quite subjective (horizontal
equality & vertical equality)
• Sufficiency

Advantages & disadvantages
Advantages Disadvantages
Social policies can be implemented very quickly via
indirect taxes
Direct taxes and transfer payments take time to
implement, delaying the impact of fiscal policy
Government revenue can be increased without
significant additional costs
Capital spending may takes a long time to
implement
𝑭𝒊𝒔𝒄𝒂𝒍 𝑴𝒖𝒍𝒕𝒊𝒑𝒍𝒊𝒆𝒓 =
𝟏
𝟏 − 𝑴𝑷𝑪(𝟏 − 𝑻)

National debt – GDP matters
Higher deficit
Higher future
taxes
Discentives to
work
Lower long-
term economic
growth
Lose
confidence in
government
Investors
refinance the
debt
Government
defaulting/
printing money
Higher inflation
Increased
government
borrowing
Increase
interest rates
Firms reduce
borrowing &
investment
Decrease the
impact on
aggregate
demand
Arguments For
Being Concern
With The Size Of
Fiscal Deficit

National debt – GDP matters
Arguments
Against Being
Concern With
The Size Of Fiscal
Deficit
If the debt is primarily being held by domestic citizens, the scale of problem is overstated
If the debt is used to finance productive capital investment, future economic gains will be
sufficient to repay the debt
Fiscal deficits may prompt needed tax reform
If the economy is operating at less than full capacity, deficits do not divert capital away from
productive users
Deficits would not matter if private sector saving in anticipation of future tax liabilities just
offsets the government deficits

Implementation of fiscal policy
Recognition Lag
Action Lag
Impact Lag
Macromic issues hinder usefulness of Fiscal Policy
Misreading economic statistics
Crowding-out effect
Supply shortages
Limits to deficits
Multiple targets

Interaction of monetary and fiscal policies
Monetary
Policy
Fiscal Policy Interest rates Output
Private Sector
Spending
Public Sector
Spending
Tight Tight higher lower lower lower
Easy Easy lower higher higher higher
Tight Easy higher higher lower higher
Easy Tight lower varies higher lower

Reading #19:
International Trade And Capital Flows

Reading #19: International Trade and Capital Flows
Compare gross domestic product and gross national product
Gross domestic product (GDP) Gross national product (GNP)
 Measures the market value of all final G&S
produced by factors of productions located
within a country/economy during a given
period of time
 Includes the production of G&S by foreigners
within that country
 Excludes the production of G&S by its citizens
outside the economy/country
 Measures the market value of all final G&S
produced by factors of productions supplied
by residents of a country
 Excludes the production of G&S by foreigners
within that country
 Includes the production of G&S by its citizens
outside the economy/country

Benefits and costs of international trade
Benefits Costs
 Lower cost to
consumers of imports
 Higher employment,
wages and profits in
export industries
 Displacement of
workers
 Lost profits in
industries competing
with imported goods
Comparative advantage and absolute advantage
Absolute advantage Comparative advantage
Refers to a lower cost in
terms of resources used
 Refers to the lowest
opportunity cost to
produce a product
 Law of comparative
advantage:
• Trade makes all countries
better
• Each country specializes
in goods they produce
most efficiently and
trades for other goods

Compare types of trade and capital restrictions and their economic implications
Tariffs: Taxes on good
collected by the government
Quotas: Limits on the
amount of imports allowed
over some period
Export subsidies:
Government payments to
firms that export goods
Minimum domestic content:
Requirement that some percentage of
product content must be from the
domestic country
Voluntary export restrain: A country
voluntarily restricts the amount of a
good that can be exported, often in the
hope of avoiding tariffs or quotas
imposed by their trading partners

Economic Implications of Trade Restrictions
When a tariff is imposed
 Domestic price ↑
 Quantity imported ↓
 Quantity supplied domestically ↑
Domestic producers gain, foreign exporters lose, and the
domestic government gains by the amount of the tariff
revenues.
A quota restricts the quantity of a good imported to the
quota amount.
 Domestic producers gain = Domestic consumers =
Increase in the domestic price.
 If the import licenses are sold, the domestic
government gains the revenue.
P
S
D
PW
PImport
T
Q
QS1 QD2
P2
P1
Tariffs revenue/Quota rents
Gain in
producer
surplus
QS2 QD1
Imports with protection
Imports with free trade

Economic Implications of Trade Restrictions
Export subsidies are payments by a government to its
country’s exporters. When subsidies are applied:
 Price ↑
 Producer surplus ↑
 Consumer surplus ↓
A voluntary export restraint (VER) refers to a voluntary
agreement by a government to limit the quantity of a
good that can be exported. VERs protect the domestic
producers in the importing country. They result in a
welfare loss to the importing country equal to that of an
equivalent quota with no government charge for the
import licenses; that is, no capture of the quota rents.
P
S
D
PW
PImport
T
Q
QS2 QD1
P2
P1
QS1 QD2
Imports with free trade
Imports with subsidies
Gain in
producer
surplus
Payments by
government

Motivations for and advantages of trading blocs, common markets, and economic unions.
Free Trade
Areas
Customs
Union
Common
Market
Economic
Union
Monetary
Union
Barriers to import and
export among members X X X X X
Common trade
restrictions for non-
member
X X X X
Free movement of labor
and capital goods X X X
Common institutions and
economic policy X X
Common and single
currency X

Describe the balance of payments accounts including their components
Current account
Merchandise
and services
Income
receipts
Unilateral
transfers
Capital account
Income
receipts
Unilateral
transfers
Financial account
Government-
owned assets
abroad
Foreign-
owned assets
in the
country
Balance of payments

Effect of consumers, firms, and governments to the balance of payments
Relation between the trade deficit, saving, and domestic investment:
X – M = private savings + government savings – investment
 An increase (decrease) in private government savings would improve
the balance of trade
 A trade deficit due to a decrease in private or government savings is
less desirable than trade deficit due to high domestic investment

Reading #20:
Currency Exchange Rates

Reading #20: Currency Exchange Rates
Define an exchange rate and distinguish between and real exchange rates and spot and forward exchange rates
DEFINITION
An exchange rate simply the price or cost of units of one currency in terms of another
Nominal exchange rate Quoted rate at any point in time
Real exchange rate Dollar cost of purchasing that same rate unit of G&S
Spot exchange rate Exchange rate for immediate delivery (settlement date: usually 2 days)
Forward exchange rate An agreement to buy or sell a specific amount of a foreign currency at
a future date at the quoted forward exchange rate (30, 60, 90 days)
Real exchange rate (d/f) = nominal exchange rate (d/f)
CPIforeign
CPIdomestic

Define an exchange rate and distinguish between and real exchange rates and spot and forward exchange rates
Question:
At a base period, the CPIs of the U.S. and U.K. are both 100, and the exchange rate is $1.70/£. Three years
later, the exchange rate is $1.60/£, and the CPI has risen to 110 in the United States and 112 in the U.K.
What is the real exchange rate?
Answer:
The real exchange rate is $1.60/£ × 112/110 = $1.629/£ which means that U.S. goods and services that cost
$1.70 at the base period now cost only $1.629 (in real terms) if purchased in the U.K. and the real exchange
rate, $/£, has fallen.

Describe functions of and participants in the foreign exchange market
The primary dealersin currencies and orginators
of forward foreign exchange (FX) contracts are
large multinational banks. This part of the FX
market is often called the sell side
Sell side: market makers – large multinational
banks
The buy side consists of the many buyers of
foreign currencies and forward FX contracts
Buy side: corporations, investment accounts,
goverments, retail market

The buyers
including
Corporations regularly engage in cross-
border transactions, purchase and sell
foreign currencies as a result, and enter
into FX forward contracts to hedge the
risk of expected future receipts and
payments denominated in foreign
currencies
Investment accounts of many types transact in
foreign currencies, hold foreign securities, and
may both speculate and hedge with currency
derivatives.
Real money accounts refer to mutual funds,
pension funds, insurance companies, and other
institutional accounts that do not use
derivatives.
Leveraged accounts refer to the various types
of investment firms that do use derivatives,
including hedge funds, firms that trade for
their own accounts, and other trading firms of
various types
Governments and government entities,
including sovereign wealth funds and
pension funds, acquire foreign exchange
for transactional needs, investment, or
speculation. Central banks sometimes
engage in FX transactions to affect
exchange rates in the short term in
accordance with government policy.
The retail market refers to FX transactions by
households and relatively small institutions and
may be for tourism, cross-border investment,
or speculative trading.
Describe functions of and participants in the foreign exchange market

Calculate and interpret the percentage change in a currency relative to another currency
• Consider a USD/EUR exchange rate that has changed from 1.42 to 1.39 USD/EUR. The percentage change
in the USD price of a euro is simply 1.39 / 1.42 – 1 = –0.0211 = – 2.11%.
• Because the USD price of a euro has fallen, the euro has depreciated relative to the dollar, and a euro now
buys 2.11% fewer U.S. dollars.
• It is correct to say that the EUR has depreciated by 2.11% relative to the USD.
• To calculate the percentage appreciation of the USD, we need to convert the quotes to EUR/USD. So our
beginning quote of 1.42 USD/EUR becomes 1/1.42 USD/EUR = 0.7042 EUR/USD, and our ending quote of
1.39 USD/EUR becomes 1/1.39 USD/EUR = 0.7194 EUR/USD.
• Using these exchange rates, we can calculate the change in the euro price of a USD as 0.7194 / 0.7042 – 1
= 0.0216 = 2.16%.
• In this case, it is correct to say that the USD has appreciated 2.16% with respect to the EUR.

Calculate and interpret currency cross-rates
THE CROSS RATE
The cross rate is the exchange
rate between two currencies
implied by their exchange rates
with a common third currency
Cross rates are necessary when
there is no active FX market in
the currency pair
The rate must be computed
from the exchange rates
between each of these two
currencies and a third currency,
usually the USD or EUR

Calculate and interpret currency cross-rates
The spot exchange rate between the Swiss franc (CHF) and the USD is CHF/USD = 1.7799, and the spot
exchange rate between the New Zealand dollar (NZD) and the U.S. dollar is NZD/USD = 2.2529.
Calculate the CHF/NZD spot rate?
Answer:
The CHF/NZD cross rate is:
(CHF/USD) / (NZD/USD) = 1.7799 / 2.2529 = 0.7900

Convert forward quotations expressed on a points basis or in percentage terms into an outright forward quotation
A
forward
exchange
rate
quote
Typically differs from the spot
quotation
Is expressed in terms of the difference
between the spot exchange rate and
the forward exchange rate
One way to indicate this is with points.
The unit of points is the last decimal
place in the spot rate quote
Example:
The AUD/EUR spot exchange rate is 0.7313 with
the 1-year forward rate quoted at +3.5 points.
What is the 1-year forward AUD/EUR exchange
rate?
Answer:
The forward exchange rate is 0.7313 + 0.00035 =
0.73165.

Explain the arbitrage relationship between spot rates, forward rates, and interest rates
When currencies are freely traded and forward currency contracts exist
The percentage difference between
forward and spot exchange rates
The percentage difference between the
two countries’ interest rates

This is because there is an arbitrage trade with a riskless
profit to be made when this relation does not hold - no-
arbitrage condition
For spot and forward rates expressed as price
currency/base currency, the noarbitrage relation
(commonly referred to as interest rate parity)
forward
spot
=
(1 + interest rateprice currency)
(1 + interest ratebase currency)

Calculate and interpret a forward discount or premium
The forward discount or forward
premium for a currency is
calculated relative to the spot
exchange rate.
The forward discount or premium
for the base currency is the
percentage difference between the
forward price and the spot price
 Consider the following spot and forward exchange rates as the
price in U.S. dollars of one euro.
 USD/EUR spot = $1.312
 USD/EUR 90-day forward = $1.320
 The (90-day) forward premium or discount on the euro =
forward/spot – 1 = 1.320/1.312 – 1 = 0.609%.
 Because this is positive, it is interpreted as a forward premium
on the euro of 0.609%. Since we have the forward rate for 3
months, we could annualize the discount simply by multiplying
by (12/3=) 4.
The forward quote > The spot quote
The dollar is expected to depreciate relative to
the euro
The forward < The spot quote
The forward discount for the euro relative to the
U.S. dollar.

Calculate and interpret the forward rate consistent with the spot rate and the interest rate in each currency
Example: Calculating the arbitrage-free forward exchange rate
Consider two currencies, the ABE and the DUB. The spot ABE/DUB exchange rate is 4.5671, the 1-year
riskless ABE rate is 5%, and the 1-year riskless DUB rate is 3%. What is the 1-year forward exchange rate
that will prevent arbitrage profits?
Rearranging our formula, we have:
Forward = spot
1 + IABE
1 + IDUB
= 4.5671
1.05
1.03
= 4.6558 (ABE
DUB)
Note that the forward rate is greater than the spot rate by 4.6558 / 4.5671 – 1 = 1.94%. This is
approximately equal to the interest rate differential of 5% – 3% = 2%. The currency with the higher
interest rate should depreciate over time by approximately the amount of the interest rate differential.

Describe exchange rate regimes
COUNTRY
WITHOUT
SOVEREIGN
CURRENCY
Formal dollarization Use the currency of another country
Monetary union
Several countries use a common currency
COUNTRY WITH
SOVEREIGN
CURRENCY
Currency board
Commits to a fixed rate of exchange of domestic for a foreign
currency
Conventional fixed peg
Maintain at peged rate (+/-1%) via direct intervention in the
FX markets or indirectly via monetary policy
Target zone Gives flexibility to maintain rate within a wider range
Crawling
peg
Passive crawling peg Exchange rate adjustments over time
Active crawling peg
Influence inflation expectations, adding some predictability
to domestic inflation
Managed floating
Does not have a target exchange rate, influences exchange
rate theough dirct intervention or monetary policy
Independently floating Market determined

Explain the effects of exchange rates on countries’ international trade and capital flows
Two approachs to answer how a
change in exchange rates affects
a country’s balance of trade
The elasticities approach focuses on
the impact of exchange rate changes
on the total value of imports and on
the total value of exports
The absorption approach to analyzing
the effect of a change in exchange
rates focuses on capital flows

The relation between the balance of trade and capital flows
Exports – imports ≡ (private savings – investment in physical capital) + (tax revenue – government spending)
X – M≡ (S – I) + (T – G)
(X-M)>0, trade surplus when private savings + government surplus exceeds domestic investment
(X-M)<0, trade deficit when private savings – domestic investments less than budget deficit

𝑊𝑋𝜀𝑋 + 𝑊𝑀 𝜀𝑀 − 1 > 0
𝑊𝑋 = proportion of total trade that is exports
𝑊𝑀 = proportion of total trade that is imports
𝜀𝑋 = price elasticity of demand for exports
𝜀𝑀 = price elasticity of demand for imports
WM = Imports Imports + Exports
WX = Exports (Imports + Exports)
The elasticities approach

J-curve
In the short run, import and export quantities may
be relatively insensitive to currency depreciation
Currency depreciation initially leads to a larger
trade deficit
In the long run, elasticities increase
Currency depreciation leads to a reduction in
the trade defecit
Before currency
depreciates
0
After currency depreciates
Time
Balance
of trade
J-Curve Effect

The absorption approach
Includes the effect of currency depreciation on capital flows as well as trade flows
𝐄𝐱𝐩𝐨𝐫𝐭𝐬 − 𝐈𝐦𝐩𝐨𝐫𝐭𝐬 = 𝐍𝐚𝐭𝐢𝐨𝐧𝐚𝐥 𝐈𝐧𝐜𝐨𝐦𝐞 − 𝐄𝐱𝐩𝐞𝐧𝐝𝐢𝐭𝐮𝐫𝐞𝐬
𝐁𝐚𝐥𝐚𝐧𝐜𝐞 𝐨𝐟 𝐓𝐫𝐚𝐝𝐞 = 𝐘 − 𝐄
For depreciation to improve the balane of trade:
Natinal income must increase relative to expenditures
National saving (private + government) must increase relative to domestic investment in physical capital

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