Ben C. Davis

Chapter 1 - How economists think

• control of people can be done through pricing and financial incentives
• People are always greedy, they're just controlled by the market and it's supply and demand
• The opportunity cost is what does something cost outside of its monetary cost, time, etc
• 2 types:
  • Micro: is study of how households and firms make decisions in markets. Individual decisions.
  • Macro: overall decisions, trade, governments, employment, policies, long-term goals

Chapter 2 - Division of Labour

• divide the production of a good into smaller sub tasks
• Increases yield and efficiency of the production of goods
• Involves the factory production people, as well as the supply of parts
• Everything in the economy, everything is the result of the division of labour
• Benefits for firms:
  • Individuals can optimise what they're better at doing
  • Specialisation allows for higher productivity at a specific task
  • Allows someone to take advantage of economies of scale
• Economies of scale: where larger factories can optimise so that the average cost of production falls as production increases
• Highly specialised stores and other things because of a greater division of labour. This allows for relatively higher wages in a city
• Economies of scale and division of labour entirely applies to global economies too. The divisions of labour and value chain can be split across nations
• Value of anything is based on supply and demand - its price
• Price is how divisions of labour interact in an economy, providing incentives and limits
• Markets coordinates: what is made, how is it made, and who's going to consume it
• The free market is so extremely successful that it allows individuals to know worry about its continued existence. Stores will carry on being open.

Chapter 3 - Supply and Demand

• Any market involves buyers and sellers:
  • Combined force of sellers = supply
  • Combined force of buyers = demand
• The framework predicts an equilibrium, where the quantity demanded and quantity supplied are equal
• Quantity is not the same as supply (the same for demand), rather supply is a function that describes the overall curve of supply across the range of prices. Therefore prices changes does not affect supply, instead for supply to change the entire curve would have to move. Things like manafacturing, weather and taste for products changes this curve
• Three markets:
  • Goods / services market - households demand, business suppliers
  • Labor market - households suppliers, business demands
  • Financial capital market - savers (business or household) supply capital while all borrowers are demanders of capital
• Prices reflect a value in exchange not in use, simply supply and demand
• Equilibrium should reflect an efficiency in the market

Chapter 4 - Price Floors and Ceilings

• Price ceiling - government mandated
  • Forces below equilibrium, therefore they'll be low supply at that price
  • People might be using or their ways to get money from black market
  • People won't move as they locked into that low price
• Price floor - government mandated for a minimum price
  • Government will pay farmers if they have to sell low
  • Causes high supply quantity, low demand quantity
• Price regulation creates an unbalanced market which can have negative consequences on other unintended people
  • It can't pick who it helps, it's only based on price
  • It's better to help just one side of the market without setting price - subsidy building or helping buyers
  • Delink income of producers with what they produce

Chapter 5 - Elasticity

• Elasticity refers to how much quantity demanded or supplied changes in response to a change in price.
• = change in demand supplied or demanded / change in price
• Inelastic demand = elasticity is less than 1, so percentage change in supplied or demanded is less than the percentage increase in price.
• Elastic demand = elasticity is greater than 1, so percentage change in supplied or demanded exceeds the percentage increase in price.
• Unitary elasticity is the case where elasticity is 1, where the change in quantity is equal to the change in price
• Raising prices will bring in more revenue if demand is inelastic but not if demand is elastic

Chapter 6 - Labour market and wages

• Demand for labor is a relationship between the wage and the quantity of work desired by employees. A higher way will make businesses demand a lower quantity of labor in the same way that a lower price will make consumers demand less of a good.
• Wages do not shift demand for labor. Changes in tech do, along with changes in demand for a certain output.
• Labor demand is determined by the productivity of workers, that is, workers will be hired only up to the point where the business is confident that they will produce more than their wages.
• Usually workers don’t have an ability to increase their working hours, therefore higher wages doesn’t change the quantity of labor supplied.
• Equilibrium is different depending on the situation, some cultures expect more or less working hours for example.
• Minimal wage is a price floor that isn’t necessasrily a good idea. Is the gain in income to those who receive a higher minimum wage worth some workers losing their jobs?
• Government training, subsiding, and tax credits are a better solution.n.
• Labour unions serve two functions: keep wages high by threatening; and building better comms with employers and ultimately a more productive workforce.
• Lower wages aren’t the only indicator of discrimination, society may discriminate at any early point so the option to hire someone else doesn’t exist
• Take home compensation is a part of someones salary

Chapter 7 - Financial markets and means of supply

• People sometimes feels the price in the goods or labor market is fair, but rarely feel the entire system is unfair - the do with the financial capital market where payment interest is the price of the market.

• Perhaps because interests payments are intangible

• Money lending used to be a sin, still is in islam

• Financial investment in stocks and others is the supply side of the market. Physical investment is the demand side.

• Quantity of capital in the market (personal saving) doesn’t increase with the interest rate, seems instead to be based on habits and cultural patterns.

• Demand of capital will be less enthusiastic as the interest rate rises.

• Rate of return (interest rate) is dependent on three factors: compensation for expected inflation, compensation for the level or risk, and compensation for the time value of money (not using money now).

• Real interest rate is the interest rate minus the inflation rate

• Present discounted value is a way of directly comparing costs and benefits that occur at different points in time.

  • What any future expense would be worth in the present (taking into account the available interest rate)
  • PDV = (FV)/(1 + r)t, where FV is future value, r is the interest rate and t is years.

• PDV is used in business to compare investment expenses incurred in the present with returns to be received in the future.

• Retained earnings are profit and can be is used to invest in the future

• Companies raising money:

  • Companies can borrow with from a bank or by using bonds, both involve and interest payment
  • Can also raise money through equities - corporate stock - gives the owners part ownership of the company. Stock provides no guarantee the owner of the stock will be financially better off.
  • Often used for smaller companies

Chapter 8 - Personal Investing

• Compound interest is interest being paid on earlier interest
  • Future value = PV(1+r)t where PV is present value and r is interest rate
  • Can result in a lot of money given time period
• Any investment needs to be considered along 4 dimensions:
  • Rate of return
  • Risk
  • Liquidity
  • Tax status
• All things equal, risk is a bad thing.
• Risk can be diversified
• Liquidity refers to how easy it is to sell an investment
  • Bank accounts are very liquid
  • House is not
  • More liquidity is good
• Risk and return are inversely correlated
  • Bank accounts = poor rate of return
  • Money markets are slightly better
  • Certificates of deposit are not liquid but better return
• Diversified portfolio is better than bank account or certificate of deposit, especially over a long period
  • This is if it’s made of blue chip
  • Growth stock more risky
• Gold and metals is extremely risky but high rate of return
• The random walk theory holds that all past information that is available about a stock is part of the current price. Therefore what moves a price is unpredictable.
• All investments advice is based on one starting point: start saving sooner rather than later

Chapter 9 - From Perfect Competition to Monopoly

• Three broad types of firms:
  • Proprietorship - individual
  • Partnerships - owned by the partners
  • Corporations - stand alone run by their ownership
• Perfect competition is the highest level of competition = many procures of goods compete to sell at the lowest price
  • Small firms selling identical products
  • Price-takers
  • Entry and exist are easy
  • Profits low
  • Prices closely reflect cost of production
  • Rarely ‘perfect’
• Monopoly
  • When a single seller has all or most of the sales
  • Creates a barrier to entry for other firms
  • How:
    • A patent
    • By law like US post
    • Merger of larger companies or collusion
    • Natural occurs when production of good has economies of scale relative to the size of market demand, and give the large, established firm an advantage over any new entrants
  • Have power to set prices and to earn consistently above-average profits
  • Will set it’s price according to the elasticity of demand for its product, with the price being higher the more inelastic the demand
• Monopolistic competition
  • Closer to perfect competition than monopoly
  • Occurs when many small firms compete by selling differentiated profits
  • Has some power to choose its price, but as people can enter the market, it cannot earn above-average profits in the long run.
  • Some power to determine price based on elasticity of demand, but less than monopoly
  • Encourages innovation because you can make a lot of profit in the short run
• Oligopoly
  • Closer to monopoly than perfect competition
  • When a small number of firms have most or all of the sales in a given market
  • May compete against each other, meaning that could create perfect competition and have lower profits or they may act together as if they were a monopoly and earn higher-than-normal profits

Chapter 10 - Antitrust and Competition

• Federal government has the power to prevent monopoly and to encourage competition
• Carried out in the us by the federal trade commission and the us department of justice
• It’s the commission’s job to determine if any firms are merging their way into monopoly or are engaging in any anticompetitive activities
• They must first determine how much competition exists in a market:
  • a four-firm concentration ratio is calculated by adding up the market shares of the four largest firms in an industry
  • The Herfindahl-Hirschman index is another measure, found by summing the square of the market share of each firm
• Defining a market is hard
  • Some will claim they are a small player in a big market, the government may claim the opposite
  • National vs international market definitions makes a difference
• Another method to measure competition
  • Look at relative prices between two areas they compete and areas they do no
• Some behaviour isn’t monopolistic but it is still anticompetitive
  • Price-fixing cartel for example
  • Price maintenance agreements
    • minimum price guarantee
  • Exlusive dealing
    • Only sell products from one provider
  • Tie-in sales
    • must by a second product to buy the first
  • Predatory pricing
    • Dropping prices when a new entrant to the market to drive them out

Chapter 11 - Regulation and Deregulation

• 20th century both airlines and train lines were regulated to stop them collapsing
• Competition doesn't work in companies that involve networks, like electricity or water piping.
• High entrance cost, low operating cost
• Very easy monopoly
• If two firms have networks, then both firms will compete too much and collapse all merge
• Regulation options:
  • Break large company into multiple competitors. But that's bad because a big company can take advantage of economies of scale to overcome the initial high price of entry. Small companies would then have to merge and then monopolise.
  • Cost + regulation - regulates prices based on cost of production plus a little more profit.
    • Firms don't have to worry about costs.
    • Are also incentivised to increase costs
  • Price cap regulation - set a price for a number of years.
    • Incentivised to cut production costs to earn profit
    • Good for consumers
    • Forced a market to lower its price
  • Danger - regulatory capture - danger of believing job of regulators is to protect industry instead of competition and consumers
• Regulators are assigned by politicians
  • Regulators can start to sympathise too much with industry
  • This causes it hard to regulatory strictly
• Deregulation
  • Meant that some people start to lose money, but then people innovate
  • Deregulation of at & t lead to innovation that led to modern tech
  • Why innovate if regulation gives you reliable profits?
• Bad regulation can be really bad
• Regulation doesn't mean total control, it can be to ensure safety or honesty

Chapter 12 - Negative Externalities and the Environment

• Strong environmentalists sometimes see the free market as the enemy
  • Often poor countries have the worst environmental problems
  • Some countries like Soviet Union that tried to eliminate the free market have terrible pollution problems
  • US has been getting cleaner for the last several decades
• Externalities (side-effects in programming)
  • Arise when a voluntary exchange between two parties directly affect a 3rd party who was not a buyer or a seller in the exchange
  • Based on the notion that the two parties directly involved in the transaction use their best judgement so that it benefits them both. 3rd parties affected by the transaction have no guarantee
• Pollution is negative externality
  • Because pollution isn’t privately felt by the producer (seller), they will tend to overproduce
• How to fix:
  • Command and control
    • A set of regulatory policies that specifies an amount pollution that can be legally emitted but prohibits any larger amount
    • Have been effective in the past
    • Inflexible and do not reward innovative ways of avoiding pollution or ways of reducing pollution beyond the legal standard
  • Pollution tax
    • Gives an incentive to reduce pollution
    • Because it’s a tax, it’s not politically attractive
    • It gives reason for continuous innovation - the more it reduces, the less in tax it pays
    • It provides cash to the government
    • It provides complete freedom in how pollution is reduced
  • Marketable Permits
    • A set of permits to emit a certain amount of pollution
    • Often scheduled to decrease over time
    • They may be traded
    • Has had some success in reducing sulphur dioxide under the 1990 clean air act
  • Property rights
    • No one has property rights to the air, so no one is needs the pay the cost of dirtying the air
    • If they did, then things would change
• Zero pollution is not a realistic policy. It would mean shutting down society. It’s a balance.

Chapter 13 - Positive externalities and technology

• Where he market produces too little of a good thing
• Appropriabolity - the ability to benefit financially from an invention
• Positive externalities: The inventor provides benefits to third party without compensation
• Patent: exclusive legal right to make sell use an invention for a specific amount of time, 20 years
• Copyright: legal protection against copying an original work of authorship, life of the author + 70 years
• Trademark: word or name that indicated the source of a good
• Trade secret: item of information that gives an advantage that is not well known, like Coca Cola recipe
• These protections only go so far to protect innovation and invention, so there are other methods to try to encourage its continuation:
  • Directly fund r&d
  • R&d tax credit
  • Subside the spread of information
• Patents can really block competition

Chapter 14. Public goods

• Producers of public goods will struggle to charge people for it
• Defined as a good that has:
  • Non-rivalrous - consumers don't fight over consumption - pizza vs national defence
  • Non-excludable - you can't exclude someone from reaping the benefits of the good
• Examples:
  • Tech research, knowledge, ideas
  • National defence
  • Education to a certain extent
• Free riders - people who benefit from the public good but don't chip in
• Public good is an extreme example of a public good
• Game theory - the problem of everyone pursuing rational self interest.
  • External penalties change things
• Contributing to the public good is mathematically identical to the game theory prisoner game
• Game theory applies to cartel oligopoly and international public good / arms race / using natural resources
• How to solve public goods:
  • For private public good, incentives / pledge drives / mild shaming
  • Government taxes

Chapter 15 - Poverty and Welfare Programs

• Discussing poverty requires defining a poverty line and firing out how to adjust that line both for families and over time
• Very important to think about in the 60s, but there was no official definition or event clear way to think about what it meant
• Mollie Orshansky based her definition on two notions:
  • How much it cost to buy a basic diet
  • Food was 1/3 of the family budget
• The line has remained mostly the same, but adjust for inflation
• Nowadays people spend much less than a 1/3 on food
• In-kind government benefits aren’t included in the measure of poverty
• It feel drastically in the 50s and 60s, rose in the 70s and has levelled off since
• It used to be that the elderly were disproportionally poor, now it’s single mothers
• Any policy to fix this will create incentive problems
  • No reward for any work up to the poverty line, if they’re being benefited up to it
  • Negative income tax arises when welfare benefits are reduced as the recipient earns additional income
  • A >= 100% negative income tax creates a poverty trap
• How to fix incentive problem:
  • Reduce the rate at which welfare is reduced as income is earned
  • Income tax credit gives additional income as they work, which offset withdrawal
  • Lots of in-kind benefits to further help

Chapter 16 - Inequality

• Poverty is being below a certain line
• *Inequality *describes the gap between the poor and the rich
  • Inequality can rise while poverty falls
  • Inequality is the concern over the fairness in how rewards and disparities in society are justly distributed
• Measuring
  • Capture overall distribution of income by segmenting the distribution
• It’s hard to say if inequality is a bad thing (NOTE, lecture is from 2005 - things have changed)
  • Many reasons for it: lower incomes when your young, higher in middle age, low in old age
  • Some people make earning money a priority
• Mobility has not been increasing in a way that would offset the rise in inequality
  • Because of tech changes, globalisation and the changes in labor market institutions
  • Tech favoured the productivity of high-skill workers
  • Globalisation not so much as trade with low-wage countries is a fairly small share of overall trade (NOTE: this is probably outdated)
• Also increased because of new families: single mothers + high earners marrying each other
• How to decrease inequality:
  • Tax - currently high earners do pay a large percentage of tax
  • Increase benefits to low and middle earners
    • Tax credits to the poor
    • Spend on public goods and services that help poorer people such as schools, mass transit, libraries, and parks
    • Strengthen labor unions to increase minimum wage (although we know this doesn’t really work)

Chapter 17 - Imperfect Information and Insurance

• Real world full of imperfect information in markets and trade
• Ways of reducing the problem of information:
  • Warrantees, guarantees, and service contracts can reduce the risk of imperfect information in goods market
  • Licenses and certificates can reduce the issue in labor markets
  • In financial markets, requiring disclosure of financial records and history
  • Reputation if transactions are repeated
• Insurance markets rely on information
  • Hard to get the information so insurance markets often fall down
  • Spreads risk over a group
  • Everyone in the group pays a cost to offset potential unknown losses
  • Fundamental rule: the average person pays into insurance over time must be very similar to what the average person gets out
• Insurance problems:
  • Moral hazard is when people take fewer steps to avoid accidents because they have insurance
  • Adverse selection is people who are more likely to have an accident are more likely to buy insurance
• Fixed by:
  • deductibles, copayments and coinsurance and pooling people together into groups

Chapter 18 - Corporate and Political Governance

• Issues of political and corporate governance can be analysed with the analytical structure of what economist call the principal-agent problem
  • Politics: citizens are principals, politicians are agents
  • Corporate: shareholders are principals, top execs are agents
• Definition: the principal wants the agent to do something
  • Good example, employer employee relationship
• Often involves imperfect information
  • Hard to know if the agent is working hard
• Usually relatively few agents
• Problem: no one wants to oversee the agents, so often are not monitored at all
• Corporate
  • have a separation of ownership and control
  • Shareholders elect board of directors, but from nominations decided by the top execs
  • Some auditors haven;’t been very aggressive in questioning firms
  • Basically, lots of opportunity for manipulating of control
  • Stock is often thought of as a way of connecting control and incentive among to execs
• Government
  • Strictly rational person may decide a vote doesn’t matter
  • Special-interest group is a numerically small group but well organised
    • They pressure legislators to enact public policies that befits the group at the expense of the broader population
  • When negotiating legislation, a common request is to include pork-barrel spending which is legislation that benefits a single political district
  • *Log-rolling *is when two or more politicians agree to legislation together irrespective of broader benefit
  • Government has no mechanism like risk of liquidation to provide incentives for good performance
• Markets are amazingly useful at allocating scarce resources in a society, but there are lots of potential negatives: monopoly, negative externalities, inequality and more. Government can act to reduce these problems, but can often make things worse

Chapter 19 - Macroeconomics and GCP

• The aggregated top-down view of the economy, focused on issues like unemployment, inflation, economic growth, and the balance of trade
• Microeconomics has no language to discuss issues like growth, inflation, unemployment and trade deficits
• Behaviour that is relational to an individual has unexpected conclusions when everyone in a group acts in that way
• GDP is the standard measure of the size of a nation’s macroeconomy.
  • Defined as the total value of final goods and services produced in an economy in a year
  • Can be measured according to what is produced or what is demanded
  • The quantity supplied and demanded must be equal
• Measuring via production:
  • Based on 4 divisions: durable goods, nondurable goods, services, and structures
• Measuring via demand:
  • Demand for consumption, investment and trade
  • C + I + G + X - M = GDP
    • C = Consumption
    • I = Investment
    • G = Government
    • X = Exports
    • I = Imports
• Per-capita = divide GBP by the population
  • Real GDP per capita is a simple, rough way of comparing standard of living across times and places
  • Real = adjusted for inflation
• Factors not included in GBP:
  • ‘home production’
  • leisure
  • health
  • presence of inequality or poverty
• Measures final product, which includes the production of intermediate products and avoids double-counting
  • Transfers of ownership don’t show up in GBP, unless it involves new productiom
• Useful because countries with higher GDP per capita tend to have better personal consumption, clean air and water, and personal security
• Long-term gdp goes up
• *Four goal of macroeconomic policy**:*
  • Economic growth
  • Low unemployment
  • Low inflation
  • Sustainable balance of trade
• Framework to describe the 4 goals tradeoffs and relationships:
  • Aggregate supply-aggregate demand model

Chapter 20 - Economic growth

• Economic growth compounds over time
• PV(1 + g)^t = FV
  • g = growth rate percentage
  • t = years
  • FV = future size of economy
  • PV = present size
• Small differences in growth = huge change in future and standard of living
• This implies that catch-up growth would allow smaller nations to close the cap
• This hasn’t happened, economies have diverged not converged
• This is mostly because smaller economies haven’t started economic growth, if they did it’d be different
• Africa and India are poor not because of Western growth, it’s just their lack of development
• In the long run, internally generated growth is far more important to economic development that redistribution of wealth from those across the income distribution
• Sources of economic growth:
  • Productivity growth, measured as real output per hour worked, is a useful measure
  • Rooted in growth in physical capital, human capital, and especially new technology
• US potentially in new economy of productivity because of new technology

Chapter 21 - Unemployment

• Unemployment based on government surveys
  • You must respond as saying you don’t have work but are looking
  • Those not looking are ‘out of the labor force’, not unemployed
  • What about part-time and discouraged workers?
• Economists see unemployment in terms of the labor market: quantity demanded must equal quantity supplied at equilibrium
  • Therefore the only way someone wanting to work can’t find it is if the the wage is above the equilibrium level
  • This can happen because of:
    • Minimum wage
    • Explicit and implicit labor contracts
    • Fear of effects on moral
  • Why is unemployment bad?
    • Harms the individual
    • Reduces size of economy because it loses the potential of the work
    • Raises the need for government spending on welfare and social services
• Can be divided into two broad categories - Natural rate of unemployment - Describes the unemployment that occurs in an economy as a result of the dynamic ebb and flow of workers and industries, which occurs in the context of the laws and regulations that affect incentives of employers to hire or affect the incentives of the unemployed to take jobs - E.g tax on employment, layoff rules, preventing business expanding in certain areas - An expected outcome given social institutions - Can be reduced by providing the desired social protections but retain incentives to work and hire** ** - **Cyclical unemployment** - Results from recessions, where many businesses all at once don’t see enough demand for their services to justify hiring. They aren’t able to sell as much, thus need to reduce their workforce. - Policy solution is to pump up demand with temporary spending increases or tax cuts or reduction in interest rates

Chapter 22 - Inflation

• Represents an overall increase in the price level, measure over some combination of goods and services
• Measured by:
  • Defining a basket of goods, with quantity of each chosen to represent typical consumption levels, then tracking price changes over time
  • Instead of referring to cost absolutely, it’s done relative to a base level. Base level == 100
• Two varieties of inflation:
  • Consumer price index
  • GDP deflator
• Longstanding concern that calculating inflation using a basket of goods overstates the true rate of inflation
  • If a price rises for an item, people may substitute another, but the price index won’t capture this
  • Will not take into account benefits of quality improvements and new goods into account
• Why is inflation bad?
  • It’s isn’t necessarily
  • If you increase the value of money uniformly across the economy, prices rise to accommodate that change
  • In the real world, it’s isn’t evenly distributed and fully predictable
• Losers:
  • Those who lend money at a fixed rate of interest
  • Those who invested in a fixed-rate bond
• Winners:
  • Someone who borrowed at a fixed rate will gain from inflation
• indexing refers to the automatic adjustment to take inflation into account
• With significant inflation, price signals in the market becomes unclear: price increase means actually more expensive or just inflation?
  • Businesses who care too much about inflation will have too short-term a focus
• Higher inflation is a matter of too much money chasing too few a goods
• How to keep it at bay:
  • Reducing overall demand to ensure that these fewer pounds chasing goods
  • Raising taxes
  • Cut government spending
  • Raising interest rates
  • Will always be controversial because slowing an economy has obvious costs, reducing fairly low inflation foes not
• **Inflation hawks - **argue that an economy works best if inflation is zero
• **Inflation doves - **a little inflation isn’t a bad thing, as it can help an economy carry out wage cuts or price cuts where needed.

Chapter 23 - The Balance of Trade

• Balance of trade is perhaps the most misunderstood economic statistic

• Merchandise trade balance

  • Refers to the gap between exports and imports of goods
  • If imports are higher than exports, there’s a trade deficit
  • If exports are higher than imports, there’s a trade surplus
  • Because exported and imported services have become important, merchandise trade balance is a limited description of overall trade

• Current account balance

  • Single statistic that captures a comprehensive picture of a nation’s trade
  • Includes trade in goods, services, investment income, and unilateral transfers

• The balance of trade is intimately related to national savings and investment

  • Always involves flow of financial capital going back and forth across national borders
  • A trade deficit literally means the same thing as a nation that on net borrows from abroad
  • Conversely a trade surplus must be on net lending or investing abroad

• The national savings and investment identity:

  • Domestic savings + inflows of foreign capital = domestic investment + government borrowing
  • The quantity actually supplied of financial capital must equal the quantity actually demanded of financial capital
  • As it’s an identity, a change in one part must lead to a change in another
  • If the government borrows more, one of 3 things must happen:
    • more private-sector saving
    • more foreign borrowing
    • less domestic investment

• Trade deficits are not primarily determined by a higher level of trade of greater exposure to the world economy

• Trade deficits with any particular country doesn’t matter, it’s overall that matters

• High income countries tend to run trade surplus.

Chapter 24 - Aggregate Supply and Aggregate Demand

• Trying to accomplish the 4 goals is hard to do at the same time

• aggregate supply-aggregate demand is a macroeconomic framework for thinking about how these goals relate to each other and what trade-offs may arise

• Aggregate supply describes the productive ability of the macroeconomy

  • Limited by potential GDP (the amount the economy can produce if all resources are fully employed)
  • At potential GDP, cynical unemployment is zero
  • Shifts for two reasons:
    • Technological growth
    • Sharp changes in conditions of production
  • Productivity growth means potential gradually increases over time

• Aggregate demands:

  • Five components
    • Consumption
    • Investment
    • Government
    • Exports
    • Imports
  • Changes in any of the will shift aggregate demand

• Aggregate supply must equal aggregate demand

  • Say’s Law
    • Supply create its own demand
    • After all, each time a good or service is produced or sold, ti represents income that is earned from someone
    • Neoclassical economist emphasise this view today
    • The main challenge to this is the existence of recessions
    • If supply creates its own demand, it’s hard to explain why an economy ever shrinks in size
  • Keynes Law
    • Demand creates its own supply
    • Holds that an economy will often find it has unused productive capacity, but it needs a surge of aggregate demand to put that capacity to use.
    • Main challenge is that if demand is all that mattered, then government could make the economy as large as it wanted just by pumping demand through a large increase in government spending or legislating large tax cuts.

• In the short run, aggregate demand may not increase smoothly with aggregate supply for two reasons:

  • fluctuations in investor or consumer sentiment
    • can cause firms and consumers to bunch their demand at certain time periods
  • price and wage stickiness
    • when prices don’t immediately change, then unemployment and periods of shortage and surplus can occur
  • Aggregate demand can run behind or ahead of aggregate supply, which can lead to recession or inflation

• Aggregate demand < aggregate supply

  • Recessions occur when aggregate demand falls short of potential GDP.

• Aggregate demand = aggregate supply

  • When aggregate demand and aggregate supply meat at potential GDP, there is a low rate of cynical unemployment.

• Aggregate demand > aggregate supply

  • Too much money changes too few goods
  • Inflation will result
  • If aggregate supply experiences a negative shock, such as higher oil prices, inflation can result

Chapter 25 - The Unemployment-Inflation Tradeoff

• Phillips curve - the relationship between inflation and unemployment

  • High inflation and low employment
  • Low inflation and high unemployment

• Why this relationship?

  • When aggregate demand outstrips aggregate supply, unemployment will be low but there’s too much money chasing too few goods
  • When there’s not enough demand, there’s more unemployment , but less inflation because of less demand

• This relationship no longer holds

• Keynesian and neoclassical economist differ on their views of the unemployment-inflation tradeoff

  • Keynesian

    • the macroeconomy is subject to a failure to coordinate aggregate demean and aggregate supply
    • They fear that the macroeconomy is inherently unstable
    • Demand may move sharply, but stick wages mean things don’t return to equilibrium very quickly
    • They believe economies will remain stuck below potential GDP
    • They tend to support more active government

  • Neoclassical

    • They hold that the economy does adjust towards potential GDP over time.
    • Believe the macroeconomy is stable
    • Fluctuations in the economy are a process of adjustment towards new technology, which in the long run leads to growth, so is a good thing.
    • Believe government intervention can do as much harm as good
    • They prefer clear rules so the markets can fully understand
    • Believe in fighting inflation fiercely, because in the long run it provides no reduction in unemployment or any other benefit

  • Both

    • Both believe in the natural state of unemployment
    • Both argue their focuses will lead to a better long term economy
    • Keynesian = low unemployment
    • Neoclassical = low inflation
    • Low inflation is good because it helps make longer term investments
    • Low unemployment is good because employment is investment and helps future growth

Chapter 26 - Fiscal Policy and Budget Deficits

• US government typically spends 20% of US GDP.
• Main federal taxes (95%): indivudla income, corporate income, payroll, and excise taxes on gasoline, cigerattes, and alcohol
• State and local governments must have balanced budgets, so cannot end up with a deficit, so are not included in federal budget
• Taxes need not match spending, this a government can have a budget deficit or a surplus.
• When government has a deficit, it uses bonds to borrow

Chapter 27 - Countercyclical Fiscal Policy

• Fiscal policy can be used to affect aggregated demand in an economy and this affect cynical unemployment.
• Expansionary or loose macroeconomic policy is a policy to increase aggregate demand
  • Tax cuts or spending increases is expansionary fiscal policy
• Contractionary or tight macroeconomic policy to reduce aggregate demand.
  • Tax increases or spending cuts is contractionary
• Countercyclical is the practice of having fiscal policy counterbalance the business cycle of recession and recovery
• Recession = producing less than potential GDP
  • then it can use expansionary fiscal policy to increase aggregate demand
• Opposite of recession = producing at or above than potential GDP
  • then it can use contractionary fiscal policy to retain aggregate demand
• Reducing aggregate demand will bring down inflation
• Automatic stabilisers are taxes and gov spending programs that automatically adjust to help stimulate aggregate demand when the economy is decking and to hold down aggregate demand as the economy is expanding.
  • Taxes naturally rise as the economy grows and shrink as the economy contracts, acting as natural stabilisers
  • Some spending programs aimed at low income people or unemployed tend to expand during recessions and contract during economic upswings, acting as stablisers
• There’s controversy if gov should use further countercyclical fiscal policies. By the time a policy is agreed, the circumstances will have changed
• Expansionary and contractionary can both be conducted with either tax cuts or spending increases

Chapter 28 - Budget Deficits and National Saving