Economics Sparkchart and Notes

SPARKCHARTS AND NOTES
By Audrey Wang
Economics Spark-chart and notes

Intro
Definition
1. How limited resources are allocated
2. Scarcity
Economic Policy
1. Positive economics (objective analysis)
2. Normative economics (subjective beliefs)
Basic concepts
1. Marginal costs
2. Marginal benefits
3. Opportunity cost
4. Economic decision rule: Take action only if MB
> MC or opportunity cost < benefit
5. Resource: Land (all natural resources)+ Labor
(all productive human attributes) + Capital
(productive equipment or machinery )
6. Law of Increasing cost
As more of a product is produced, the
opportunity cost increases because some
resources are most adept at the production of
one good than another.
7. Law of Comparative Advantage
Trade is beneficial even when one party
has an absolute advantage in everything.
8. Ceteris paribus
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Production Possibilities Curve

1. Input: land, labor, capital, entrepreneurship,
technology
Basic economic questions:

1.
2.
3.
Types of economic systems
1. Capitalism
Based on private property and market
forces
Individuals answer the basic questions.
a. Welfare capitalism: the market still
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operates but the government plays an

increasing role in the regulation of
markets in order to better provide for the
basic welfare of all its citizens.
b. Free market: allocative efficiency +
unequal distribution
2. Socialism
Based on government ownership of
property and control of economic decisions
3. Communism
Based on individuals goodwill toward on e
another
Society answers the basic questions.
Command economy: The central government
decides what will and will not be produced. (E.g.:
Cuba, DPRK)
Mixed economy
The Circular flow diagram
The US economy
1. Business + households + government
2. Factor markets
Household supply labor and are paid wages
Goods markets
Household purchase the productive output
of businesses
3. Business
Sole
proprietorship,
partnership,
Corporation
4. Government:
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Collect taxes in order to spend money in

ways society deems fit; develop rules to guide
relationships
between
business
and
households
Supply and demand

Demand
1. Law of demand
The quantity demanded rises as price falls
(for normal goods), others being constant.
2. Movements along the demand curve: a
change in price
3. Shifts in demand curve: TRIBE
a. Changes in Tastes and desires
b. Changes in the price of substitute and
complement goods (Related goods)
c. Changes in Income
d. Changes in the number of Buyers
e. Changes in Expectations about future
income or future price levels
4. The market demand curve is the horizontal
sum of all individual demand curves.
5. A change in quantity demanded: movement
along the curve; A change in demand:
movement of the curve
Supply:
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1. LAW OF SUPPLY
The quantity supplied rises as price rises,
others being constant.
2. Shifts in supply curve: ROTTEN
a. Changes in Resource costs
b. Changes in the prices of Other goods
(substitutes and joint products)
c. Changes in Technology
d. Changes in Taxes and subsidies
e. Changes in supplier Expectations about
future prices
f. Changes in the Number of suppliers
3. The market supply curve
*Supply does not affect demand. The price
does.
The function of prices: disciplinarians, signals,
rationers
Market equilibrium and the invisible hand
1. The invisible hand theory states that prices
will adjust to achieve equilibrium
2. When there is a surplus, prices tend to fall
3. When there is a shortage, prices tend to rise.
4. The market is in equilibrium when the
quantity demanded = quantity supplied
Government involvement in market equilibrium
1. Price floor (e.g.: minimum wage)
2. Price ceiling (e.g.: rent control)
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3. Tax, tariff, quota

a. Excise (sales) tax is a tax levied on a
specific good at the time it is purchased
b. An income tax
c. Tariffs are taxes on imports
d. Quotas are limits on how much of a good
can be imported or sold in a particular
country
Total revenue and elasticity

Total revenue
Price * quantity demanded = TR
1. Unit elastic / proportional change
TR
unchanged
2. Elastic / greater than proportional change
TR drops
3. Inelastic / less than ~
TR increases
Price elasticity of demand= (%quantity
demanded) / (%price)
% Quantity demanded = ( Q) / [(Q1+Q2)/2]
1. Elastic: >1, inelastic: <1, perfectly elastic:
infinity
PED of LR is larger than that of SR.
2. Cross price elasticity of demand:
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(%quantity demanded of Y) / (%price of

X)
Positive: substitute
Negative: complement
3. Determinants of Price Elasticity of Demand
a. Time: SR versus LR, whether supply
adjusts to the changes in demand
b. Ratio of the cost of a particular product to
the total budget of the consumer; the
higher the ratio, the larger the elasticity.
c. Competitive structure of the market and
consumer choices
4. Income Elasticity of Demand
(%quantity demanded) / (%income)
5. Price elasticity of supply
(%quantity supplied) / (%price)
Theory of consumer choices and behavior

1. The consumer is rational.
2. The consumer can rank goods.
3. The consumer understands diminishing
marginal utility.
4. The consumer faces constraints of prices and
incomes.
5. The utility-maximizing rule:
MU1/P1=MU2/P2=MU3/P3=
Consumer surplus
1. Substitution effect
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As the price of a particular good decreases,

a consumer may buy more of this good
relative to the price of a substitution good.
2. Income effect
As the price of a particular good decreases,
a consumer can afford more of it and other
goods.
Government and Private sector

Externalities
Either the buyer of the seller does not
capture all of the benefits of a transaction.
1. Positive externality
Government grants a subsidy to private
producers.
Supply increases price falls
2. Negative externality (E.g. : pollution)
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Government imposes a tax to economize

efficiency,
Supply decreases price increases
Social costs
Costs incurred by the public (i.e.: polluted
waterways) that are not captured by the
market
MSC > MPC (MC)
Marginal social costs incorporate marginal
private costs
Social costs = Private costs + the value of
externalities
Social costs equal private costs when
government either taxes negative externalities
or subsidizes positive externalities by the
amounts of externalities.
Efficiency
1. Technological
The identification of those inputs that have
the greatest effect on output per $ of input
expenditure
2. Allocative
3. Pareto optimality
The optimal point for society when any Further
improvement for some come at the expense
of others.
Public goods and private goods
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1. Nonexclusive + distributive
2. The MC of one more unit of a pure public
good is 0.
3. Pure public goods are not marketable or
divisible.
4. Quasi-public goods
a. Congestible public goods: distributive
e.g.: a bridge with heavy traffic during rush
hours
b. Price excludable public goods
e.g.: co-payment for health insurance
Bases for government interference:

1. Market failure
a. The buyer and seller are not able or willing
to agree on the terms of transaction.
b. Failure of the market mechanisms to
achieve optimal or efficient outcomes.
Efficient outcome: MSB=MSC
A complete market failure: a public good
2. Externalities
a. Equilibrium price: MBP (Private MB) =
MSC
The curve needs to be moved to reach
MSB = MSC
MSC = MCP + Externality
MSB = MBP + Externality
b. Positive externality
The price is too high and the output is too
low
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c. Negative externality
The market equilibrium price is too low and
the equilibrium quantity is too high.
MSC = MCP + Tax
3. Information (might be considered a public
good)
4. Meritorious nature
5. Efficient allocation of resources
R = public good benefits/ public good costs,
R>1
R > private good benefits/private good costs
6. Income redistribution
7. Competitive market monopoly
8. Stabilization prices/business cycle
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Cost, production, supply

Law of diminishing marginal utility
Relationships among AC, MC and product curves
1. MC, ATC, AVC, AFC
2. APP & MPP, shut-down position
APP = total output/variable input
MPP = change in output/change in input
TPP peaks when MPP is negative
Shut-down position: given that MC increases
as MPP drops, if MR > MC then the firm
continues.
Economies of scale
Constant, increasing and decreasing returns
to scale
SR & LR
1. Law of diminishing marginal productivity:
(SR phenomenon)
Production increases at an increasing rate
production increases at a decreasing rate
decreases
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Costs
1. Fixed costs: TFC & AFC + Variable costs: TVC
& AVC
2. Total costs
3. Values of a large-size firm
a. Internal economies of scale (relatively
small firm)
More expertise + fixed costs spread over a
larger output
b. External economies of scale
Derived from the large-scale advanced
industrial economy
c. Economic costs
Implicit (opportunity) costs & explicit costs
Economic profits: income - explicit &
implicit costs
Accounting profits: income explicit costs
Which
means:
Economic
profits
<
accounting profits
Product markets
Product markets
1. Perfect competition:
a. A large number of sellers
b. Firms are price-takers
c. Homogeneous product
d. Infinitely elastic demand
e. No barriers to entry or exit
f. LR economic profit = 0
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Price = Min (AC) = MC = MR

2. Monopoly
a. One firm
b. No close substitutes
c. Firms are price makers.
d. Not perfectly inelastic
The downward sloping demand curve
indicates a pricing strategy/power
3. Monopolistic competition
a. Differentiated products
b. Medium-sized firms
c. Price > Min (AC), Price > MC but tend to
have zero profits
d. Less efficient than perfect competition
4. Oligopoly
a.
Relatively
few
sellers
who
act
interdependently or collusively to be pricemakers and to control markets and terms of
exchange
Perfect competition
1. Demand curve of market: downward sloping
Demand curve of firm: horizontal, implies
perfectly elastic demand function
2. P = MR: no pricing strategy
P = MC
P = Min (AC): firms are operating at zero
economic profit
Efficiency has been reached.
3. Shut-down decision *(SR)
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a. P < AVC shut-down, total losses = TFC

b. P >= AVC continue operation
P > AVC firms continue to operate as
long as MR > MC, up to the level of output
profits are maximized or losses are
minimized (level at which MR=MC)
c. Total profits = Q (opt. level of output) * (P
ATC)
d. Zero output is optimal in the SR when P <
AVC
LR
Consumer and producer surplus
Consumer surplus = total utility total cost
Formulas:
P=MR,
perfectly
competitive
firms
demand function;
P=MC, socially opt. price under LR perfect
competition
P=Min (AC), in the LR for perfectly
competitive firm
Monopoly
1. The downward-sloping demand curve implies
that P>MR
Profit = (P-ATC)*Q
Monopolist determines the output at MR=MC.
2. Lerner index: (P-MC)/P, measures pricing
power
3. Herfindahl Index: the sum of the squares of
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market shares of firms in a particular market,

used to measure the level of concentrated
power of firms in the industry.
4. Consequences:
a. Misallocation of resources
(e.g.: Dead-weight loss, inefficiency)
Dead-weight loss: the loss to society in the
form of a reduction of consumer surplus
from a competitive norm beyond any
surplus reduction from a monopoly profit.
b. Rent seeking
Rents: payments that suppliers receive that
are in excess of transfer earnings or are in
excess of what those suppliers could earn
elsewhere
c. Higher than competitive prices
d. Lower than competitive outputs
Price discrimination works best when
1. Separate markets for consumers based on
different price elasticities of demand
2. No opportunities for resale
3. The price differences are not based on cost
differences
4. The firm is a price-maker
Types of monopolies
1. Natural monopoly (electrical industry)
Power authority / public service commission
Fair rate of return (P=AC), 0 economic
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profits
2. Unregulated monopoly (MR=MC)
3. Regulated monopoly (P=MC)
a) Fair rate of return
b) Socially optimal price (= competitive)
c) subsidized
Imperfect competition
Inefficiency: underutilizing capacity
Game theory
Nash equilibrium
Monopolistic competition
1. relatively easy entry
2. Differentiated products
3. Advertising, non-price competition
4. Inefficient, excess capacity
5. Large numbers of buyers and sellers
6. LR equilibrium: zero economic profits P=ATC
(not min)
7. Allocatively inefficient: P>MC. (pricing
power)
8. P>MR, pricing strategy, to some extent
price-makers
9. The most common (not dominant) type of
market structure in the US
Oligopoly
1. Formidable barriers to entry
2. Differentiated or similar product
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3. Interdependence
4. Few firms control major shares of market
5. Allovatively inefficient, P>MC, excess profits
6. P>MR pricing strategy and non-price
competition
7. Price-makers
8.
Collusive
activities
and
cooperative
arrangements
9. The dominant type of market structure in US
economy
10.
Firms may be influenced by the likely
actions of rivals. Firms are more likely to
follow a price decrease but not follow a price
increase.
Resource markets with applications to

Labor
Connection between product markets &
resource markets
Linked by derived demand: the demand for a
resource such as labor is derived from the
product that the resource helps to produce
1. MRPL = MPPL * MRX (product produced)
Marginal revenue product of a resource such
as labor represents the demand for labor.
MRPL = MPPL * PX in
perfect
competitive
markets
2. MFC (marginal factor cost): the additional
cost for each additional unit of labor
In perfectly competitive labor markets, MFC
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= PL/ACL/WL
a) Continue to hire labor as long as MRP >
MFC up to the point where MRP=MFC
(criteria for profit-max for the hiring of
one resource)
b) Criterion for profit-maximization
MRPL / MFCL = MRPK / MFCK = ... = MRPN /
MFCN = 1
In perfectly competitive markets, MFC = P
c) Criterion for loss-minimization
MPPL / MFCL = MPPK / MFCK = ... = MPPN /
MFCN
Bases for wage inequality
1. Risk
2. Attractiveness of the job
3. Human capital investment
4. Discrimination
5. Immobility
6. Psychic income
7. Labor market imperfections
8. Government interference
Wage elasticity of demand: (%quantity
demanded) / (%Wage rate)
1. The higher the price elasticity of demand for
the product, the higher the wage elasticity of
demand
2. The higher the proportion of labor costs
relative to the total costs of production, the
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higher will be the wage elasticity of demand.

3. The greater number of substitute resources
available and the degree to which they are
substitutable, the higher will be the wage
elasticity of demand.
The demand for a resource (D = MRPL)
Perfectly competitive labor market
Imperfectly competitive labor market
Supply of resources (normal and backwardbending)
Rents: payments that suppliers receive that are
in excess of transfer earnings or are in excess of
what those suppliers could earn elsewhere
Transfer earnings: the minimum price we
must pay in order to assure a continuing supply
of goods and services
Income inequality
Lorenz curve
The Gini coefficient
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Inflation and Unemployment

Inflation: a sustained rise in overall price level
1. PPI (Producer Price Index)
2. GDP deflator
GDP deflator = GDP / Real GDP *100%
GDP deflator ignores import prices
3. CPI (Consumer Price Index): designated to
represent
the
average
consumers
expenditures (Monthly)
CPI = total cost this period / total cost base
period *100%
CPI overstates cost of living increases.
4. Real and nominal interest rate
Nominal interest rate = real interest rate +
inflation rate
Costs of inflation
1. Financial wealth is eroded
2. Misallocation of resources, Menu cost
3. Savings are discouraged
4. Redistribution of wealth from lenders to
borrowers
Fishers hypothesis:
Nominal interest rate = real interest rate +
expected inflation
(The Fed. government is the biggest borrower
in the US.)
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Unemployment
Occurs when the economy is functioning below
its potential
1. Unemployment rate (unemployed / civilian
labor force)
2. Labor force (>16), willing and able to work
3. Target rate of unemployment
Lowest sustainable rate of unemployment
believed to be achievable under existing
circumstances.
4. Different types of unemployment
5. Unemployment is related to economic output.
Okuns rule of thumb states that a 1%
decrease in unemployment rate is generally
associated with a 2% increase in economic
growth.
6. Full employment
Types of unemployment
1. Structural unemployment
2. Seasonal unemployment
3. Cyclically unemployment
4. Frictionally unemployment
National economic accounts

GDP:
The market value of all final goods and services
produced within a country, measured in the
span of a year and stated in terms of that years
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prices
1. GNP: the final output of the citizens and
businesses of a country, regardless of where
in the world the output is produced
2. GDP = GNP + net foreign factor income
Net foreign factor income = foreign sources
located domestically the income domestic
sources located internationally
3. Intermediate products do not count toward
GDP.
4. GDP measures market activity, not welfare or
happiness.
5. Three ways to calculate GDP:
a. Expenditure approach
b. Income approach
c. Production approach
Expenditure approach: C + I + G + (X-M)
1.
C (consumption), I (investment), G
(government expenditures), Net exports
(exports X imports M)
2. NDP (Net Domestic Product) = GDP
depreciation
Depreciation accounts for the gradual
wearing out of factories and equipment.
Income approach
GDP = Compensation of employees +
proprietors income + rental income + interest
income + corporate profits + taxes on
production and imports + depreciation
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1. National income: the total income earned by

citizens and businesses within a country in a
year
Income earned by households + profits
earned by firms (indirect business taxes +
depreciation)
2. Personal income
Capital income + labor income + transfer
payments
3. DPI (D: disposable)
Production approach
Only
the
value
measured
manufacturer is counted.
by
each
Real GDP and Nominal GDP

1. Nominal GDP: GDP at existing prices
2. Real GDP: nominal GDP / GDP deflator
The underground economy
Other things not included in GDP:
1. Second-hand sales
2. Transactions that are purely financial
3. Intermediate sales
Aggregate
supply
demand
and
aggregate
Aggregate demand is the demand of all goods

and services by all producers in the economy.
Aggregate supply is the supply of all goods and
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services
by
all
households,
governments and foreigners.
businesses,
Economic growth
1. Potential output
LR economic policy focuses on increasing
the economys potential output.
2. Productivity: Output/input
3. Per capita output
4. Sources of growth include accumulation of
capital through investment, increases in
available
resources,
and
technological
improvements.
1.
1.
1.
1.
1.
Peak
2.
Recession (at least 6 months)
3. Trough
4. Expansion
5. Recovery: the beginning of an expansion
6. Boom: extremely fast increase in output,
usually near the end of an expansion
7. Depression: very long and low recession
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Classical economic theory: predominant

1800~1930
Says law: supply creates its own demand.
Aggregate demand curve
1. AD = Aggregate expenditures = C + I + G +
(X-M)
2. Reasons that a decrease in the price level
leads to an increase in AD
a. Wealth effect
PL falls peoples real wealth increases
consume more
b. Interest rate effect
PL falls interest rate decreases
investment expenditures increases
c. International effect (Foreign purchase
effect)
PL falls cheaper domestic goods
exports increase, imports fall
3. Factors shifting AD curve
Anything that affects C or I or G or NX
(except price level) shifts AD. Also,
changes in money supply shift AD,
because an increase in money supply
would reduce interest rates and increase
interest-sensitive spending.
a) Changes in consumer spending
i. A rise in consumer confidence
()
ii. A tax hike (tax increase)
()
b) Changes in investment spending
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i. An increase in expected future sales()

ii. A decrease in welfare spending ()
c) Changes in government spending
i. An increase in military spending
()
ii. A decrease in welfare spending ()
d) Changes in net exports
i. A decrease in the value of dollar
()
ii. The French begin to loathe US goods.
()
Aggregate supply curve (in Keynesian
Theory)
1. LRAS: vertical
2. SRAS: upward sloping
3. Factors shifting AS curve
a) Changes in resource availability
i. Relaxing immigration laws ()
ii. Discovering new oil fields
()
b) Changes in productivity
i. New technologies
()
ii. Relaxing government regulations ()
c) Changes in expected PL (shifts only AS)
i. Expected price to be lower ()
The potential output curve
1. Vertical: changes in PL are not thought to
cause changes to the available economic
resources
LR Equilibrium
(Barrons P239)
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Amount of inventory reduction (P<PE)

Amount of inventory accumulation (P>PE)
Effect of a tax cut on an economy operation at

potential GDP
Effect of a reduction in AD
Fiscal Policy
Classical economics (Says Law)
1. Adam smith <Wealth of Nations>
2. Laissez-faire approach
3. Economists should focus on how to
encourage savings and investment in order to
increase economic growth over the long term
Keynesian economics & Fiscal policy (the
Great Depression)
1. John Maynard Keynes <the general theory of
employment, interest, and money>
2. The paradox of thrift:
Savings do not always equal investment.
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When savings do not translate into

investment, the aggregate expenditures in
the economy are reduced by new savings,
which moves the economy further into a
recession.
3. The government must take an active role in
encouraging AD by increasing government
spending or decreasing taxes.
4. Keynes points out that all other things are not
equal.
5. Keyness focus was on SR issues, and he
agreed with the classical approach only for
when the economy is at potential output.
Fiscal Policy
1. Recessionary gap <expansionary policy>
Until LRAS & AD & AS intercepts at the
same PL
2. Inflationary gap <Contractionary policy>
Unemployed < 5%
Inflationary gaps occur when SR equilibrium
has output above the potential output level.
Economies can operate at above-potential
output for brief periods of time if resources
are over-utilized.
3. Automatic stabilizers: prevent a recession
from becoming a depression.
MPC (Marginal Propensity to Consume)
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Marginal propensity to save (MPS) = 1

MPC
MPC = Change in Spending / change in
Income
Consumption increases as income increases,
but not as much.
Multiplier = 1 / (1 - MPC)
Total change in income = initial change in
spending * Multiplier
The Phillips Trade-off
Fiscal policy cannot remedy both unemployment
and inflation.
The Phillips curve: the inverse relationship
between unemployment and inflation. Y-axis:
Inflation, X-axis: Unem.
The Phillips curve is a vertical line in the LR,
showing that full output occurs in the LR at the
target unemployment rate regardless of the
annual inflation rate.
Shifts of the Phillips curve
1. If the AD curve , the economy slides up the
Phil. Curve
2. If the AD curve , the economy slides down
the P. curve
3. If the SRAS curve , the Phillips curve
4. If the SRAS curve , the Phillips curve
Stagflation
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The situation when an economy experiences

inflation and a recession simultaneously.
(AS curve shifts to the left while AD curve stays
the same.)
Using fiscal policy to fight stagflation
Supply-side economics is an attempt to shift the
recommend through less tax and government
regulation to accomplish the shift of AS curve
back to the right. But the policies have not been
effective. (Trickle-down economy)
Critiques of Fiscal Policy
1. Congress is too slow to act.
2. Crowding-out effects: the increase in interest
rates and subsequent decline in spending that
occurs when the government borrows money
to finance a deficit. This means that a change
in government expenditures could be offset by
a change in private expenditures in the
opposite direction.
3. Real business cycle critique: increases in AD
are only going to lead to inflationary gaps,
since they are an artificial component of
economy, and so inflation will result, but
nothing real will change (like the output or
unemployment rate).
4. Public choice critique: fiscal policy cannot be
effective if it is only used in one direction.
5. Supply side economics critique: Taxes and
government
spending
negatively
affect
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peoples incentives to work. Save and invest.

The economy would grow quicker if the
government were scaled back.
6. Rational expectations: if people think that
government
implements
expansionary
policies, the AS will shift to the left and the AD
will shift to the right, thus combating the
policy.
Government Budgets
Terminology
1. Nominal deficit: a shortfall of revenues
over payments in one year
2. Nominal surplus: an excess of revenues
(receipts) over payments (expenditures) in
one year
3. Debt: accumulated deficits surpluses
4.
Real deficit = Nominal deficit
Inflation*total debt
5. Debt burden = debt / assets
6. Debt service = (interest rate paid on debt)
* (total debt)
Money and Banking

The supply of money (credit cards)
1. Federal reserve: the central bank of US that
controls money supply
2. Transaction account: a checking account at a
bank or a similar account at some other
depository institution
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3.
Money: anything that society generally

accepts in payment for a good or service
4. Currency: coins or paper money
Savings Accounts and CDs
Savings accounts
An account at the depository institution
that earns interest while the funds are readily
available but cannot be withdrawn with
checks
Certificate of Deposit
Debt instrument that is similar to a savings
account except the interest rate is slightly
higher and the deposit cannot be drawn on
without penalty
The financial sector of the economy
1. Mirrors the real sector
2. Definition of investment: purchase of real
assets
3. Interest rates equilibrate supply and
demand in the financial sector.
4. The market price of financial asset is
determined by the market interest rate. The
price of the bond goes down as market
interest rates increase.
5. Money supply is vertical. Money demand is
downward sloping because people desire to
hold less money as interest rates increase.
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Money
1. Highly liquid
2. A medium of exchange
A unit of account
A store of wealth
M1: Currency + Transaction accounts +
travelers checks
M2: M1 + Savings accounts + CD + other
liquid assets
M3: M2 + foreign deposits
3. Fiat money: money not backed by any
precious commodity
Banks and the creation of money
1. Reserves
2. Reserve ratio
Cash on hand / the amount of checking
account deposits
3. Required reserve ratio
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4. Money multiplier = 1 / r (reserve

ratio)
5. Change in money supply = money
multiplier * change in bank reserves
Monetary policy
The central bank changes the money supply and
thus also the interest rates, exchange rates,
inflation, unemployment and real GDP.
Tools of monetary policy:
1. Changing the reserve requirement ratio
2. Changing the discount rate
The discount rate is the interest rate the
Fed charges to banks for lending money to
them.
3. Executing open market operations
To expand the money supply, the Fed buys
government bonds from secondary markets,
which increases the banks reserves. (The
bank has more money.)
Secondary market: place where government
securities that have already been issued may
be bought / sold.
Structures
1. Federal Open Market Committee (FOMC): 12
members
2. Board of governors of the FED: 7 members,
14 years
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Monetary policy in the AS/AD framework

1. Changes in the money supply
a) Classical view : Q & V are constant
MV=PQ
M: money supply
V: velocity of money (nominal GDP/money
supply)
P: price level
Q: quantity of real goods sold
(PQ is also equal to the nominal GDP.)
An increase in the money supply shifts the
AD curve but the LRAS is not affected.
Monetary Neutrality: Policies in which a
change in the money supply would result in
a proportionate change in prices while real
variables such as unemployment rate
would be unaffected.
b) Monetarist view (Milton Friedman): Q & V
stable but not constant in the SR; critical of
the Fed
c) Keynesian view
A change in the money supply affects
economy through one channel: interest
rate.
Money supply increases interest rate
decreases borrowing and spending
increase AD increases
An increase in money supply lowers
interest rate
By Audrey Wang
Federal funds rate: the interest rate charged

when a bank makes a loan to another bank
2.
Expansionary & Contractionary monetary

policy
Economic Growth
Determinants of economic growth
1. Increase in the amount of resources
2.
Technological
advance
that
increase
productivity
Portrayal of economic growth
1. the production possibilities frontier shifts to
the right
2. The LRAS curve shifts to the right
2 general factors affecting economic growth
1. Resource availability, determined by
a) Land: discovery, technological advances
b) Labor: growth of the labor force
c) Capital: growth of the capital stock
2. Productivity of the available resources
a) More capital per unit of labor
b) Technological advances
c) Better educated and trained workforce
Exchange rates and International trade

Arguments for trade restrictions:
1. Promote domestic investment
By Audrey Wang
2. Infant industry argument

3. Diversity of production
4. Prevent dumping
Instituting trade restrictions
1. Import quota
The more restrictive the quota, the more to
the left the supply curve shifts.
2. Import tariff
Movement to the left along the supply
curve
3. Licensing requirements
Balance of payments
A balance of payments surplus will put an
upward pressure on the price of a nations
currency.
a. Current account: (X + II +T)
(Listing all short-term payment flows)
Net exports of goods and services (aka
Trade Balance), Net Investment Income,
and Net Transfers
b. Financial account:
Investment dollars flowing into the US
investment by US citizens abroad
c. Capital account
(Listing all long-term payment flows)
Foreign purchases of US assets US
purchase of foreign assets + change in
By Audrey Wang
official reserves
Net transfers: money our government
send as gifts / aid to foreigners how
much they send to us
Official reserves: governments holdings
of foreign currencies
Net investment income: amount US
citizens earned as interest and dividends
from abroad how much was paid to
foreigners in interest and dividends
Current account + financial account +
capital account = 0
1. Official transaction account
a. Supporting a currency
b. Selling a currency internationally
Markets, specialization, and growth
1. Comparative advantage:
2. Efficient production
Specialize and trade
3. As Adam Smith argued in The Wealth of
Nations, markets and specialization have led
to economic growth.
Exchange rates
1. It is determined by the intersection of supply
and demand for that currency.
2. Fixed exchange rate regimes
3. Flexible exchange rate regimes
By Audrey Wang
4. High exchange rates

a. Advantage: the price of imports is less,
and lower import prices help keep
domestic inflation low due to the
competitive pressures of foreigners.
b. Disadvantage: trade deficit
c. Disagreements upon best strategies
Determinants of exchange rates
1. Demand for a nations exports (taste)
2. Relative interest rates
3. Political stability
4. Relative level of income
5. Relative prices (theory of purchasing power
parity)
6. Speculation (self-fulfilling prophecy)
Managed float

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