Download Textbook of Economics

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Draft Economics Textbook - Version March 23, 2014
by Petr Mach
Students of my classes of Microeconomics and Macroeconomics who want to pass exams can use
this draft textbook as a useful study material.
Comments and recommendation let be sent to [email protected]
Textbook of Economics
---Still a Draft---
[Shaking hands – symbol of a voluntary contract]
Petr Mach
Contents
Preface..................................................................................................................................................... 4
Part A: Microeconomics .......................................................................................................................... 5
Lesson 1: What is Economics............................................................................................................... 5
Master’s Extension: Private and Public goods .................................................................................. 12
Lesson 2: Comparative Advantage and Opportunity Cost ................................................................ 15
Master’s Extension: Comparative Advantage in Foreign Trade ........................................................ 17
Lesson 3: Utility ................................................................................................................................. 17
Master’s Extension: Decision Making under Risk.............................................................................. 23
Lesson 4: Consumer Choice ............................................................................................................... 25
Master’s Extension: Inter-Temporal Choice ...................................................................................... 29
Lesson 5: Demand and Supply........................................................................................................... 31
Master’s Extension: State Interventions to the Demand and Supply ............................................... 41
Lesson 6: Income, Goods, and Tastes, and Fashion .......................................................................... 47
Master’s Extension: Black Markets ................................................................................................... 48
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Lesson 7: Loans Market ..................................................................................................................... 52
Master’s Extension: Pareto Efficiency of a Loan ............................................................................... 54
Lesson 8: Market Models .................................................................................................................. 56
Master’s Extension: ........................................................................................................................... 62
Lesson 9: Profit maximization in the short run ................................................................................. 64
Master’s Extension: Price Discrimination .......................................................................................... 67
Lesson 10: Production Function ........................................................................................................ 68
Master’s Extension: ........................................................................................................................... 68
Lesson 11: General Equilibrium ......................................................................................................... 68
Master’s Extension: Production Possibilities Frontier....................................................................... 68
Part B: Macroeconomics ....................................................................................................................... 69
Lesson 1: Price Level .......................................................................................................................... 69
Master’s Extension: Costs of Inflation and deflation ........................................................................ 76
Lesson 2: Aggregate Production ........................................................................................................ 78
Master’s Extension: Long Term Economic Growth ........................................................................... 85
Lesson 3: Evolution of Money ........................................................................................................... 88
Master’s Extension: Money Stock and the Multiplication of Deposits ............................................. 94
Lesson 4: Quantity Theory of Money ................................................................................................ 98
Master’s Extension: The Money Supply and Demand for Money................................................... 100
Lesson 5: Aggregate Demand and Aggregate Supply ...................................................................... 102
Master’s Extension: Seigniorage ..................................................................................................... 105
Lesson 6: Aggregate Supply in the Short Run.................................................................................. 108
Master’s Extension: Business Cycle ................................................................................................. 111
Lesson 7: Say’s Law of Markets and Keynesian economics............................................................. 112
Master’s Extension: Hoarding and the Demand for Cash Balances ................................................ 113
Lesson 8: Foreign Exchange Market ................................................................................................ 116
Master’s Extension: Exchange Rate Theories .................................................................................. 119
Lesson 9: Monetary Policy............................................................................................................... 119
Master’s Extension: Adjustment processes of the Balance of Payments ....................................... 121
Lesson 10: Fiscal Policy and Public Debt ......................................................................................... 121
Master’s Extension: ......................................................................................................................... 123
Lesson 11: Currency Unions and Currency Separations .................................................................. 124
Master’s Extension: Optimum Currency Area Theory..................................................................... 127
Annex 1: Model exam - Microeconomics ........................................................................................ 133
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Annex 2: Model exams - macroeconomics ..................................................................................... 144
Annex 3: Final State Exam ............................................................................................................... 150
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Preface
This book has been prepared for both bachelor’s level and master’s level college or university
students of economics courses.
For most bachelor students this book will probably be their first encounter with the economic
science. No previous knowledge of economics is therefore required. It is explained from the
groundings.
Each chapter includes Master’s Extension, which is intended for the master’s level only. For the
graduate students all parts preceding Master’s Extension are prerequisite.
The book covers both microeconomics and macroeconomics. It starts with microeconomics (Part A)
and continues with macroeconomics (Part B). Both parts are however independent so that the parts
can be read or taught in the opposite order.
The book includes 11 chapters in each part. It thus covers standard semester courses of
microeconomics and macroeconomics consisting of 11 lectures of 90 minutes each.
Selected chapters of the book can be used also for the basic courses of money and finance as it
includes micro- and macroeconomic fundamentals of finance.
Economics is not about counting. Economics is a science about human behaviour. Authors are aware
that many students have deficiencies in mathematics as many of them had finished high school years
ago. Therefore where mathematics is necessary a Math Box is included.
Each chapter is followed by Numerical Examples that can be used in seminars to practice the
acquired knowledge. The examples and their variants can be used as test questions at final exams.
One can ask why we have created this new book when many other books are available in the market.
First, this book is shorter in comparison with other books used at universities. These days many
students study economics at colleges rather than at universities so that they need less profound
knowledge.
Second, the book is written in simple English, as I am not a native speaker of English myself. This can
be an advantage for foreign students whose mother tongue is different from English.
Third, the book does not contain some questionable Keynesian theories that tend to suggest that the
government can increase production by its interventions, like the IS-LM model and the concept of
fiscal multipliers. Instead of that it contains profound understanding of the crowding-out effect, the
assumption that there are always trade-offs – spending money one ways is always at the expense of
other ways. Instead of Keynesian demand for money it contains classical “Cambridge” demand for
money, etc. Simply, this book is more classical and less Keynesian – it builds more on Smith, Bastiat,
Hayek, and Friedman and less on Keynes, Hicks, and Krugman.
!!This version is still a draft!! Any comments and recommendations are welcome at
[email protected]. Help improve the final version that is to be printed.
Petr Mach
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Part A: Microeconomics
Lesson 1: What is Economics
Scarcity. Allocation of Means. Broken Window. Goods. Means of Production. Capital. Robinson
Crusoe. Externalities. Exchange.
Economics is a social science that studies intentional human behaviour. Economics is not, which is a
common mistake, a practical discipline that teaches you how to make money – for this you should
study other subjects only loosely related to economics, such as marketing, management, and finance.
Economics does not teach how to behave. One does not even need to study economics to become
rich and successful. Economics only helps us understand why people behave as they behave.
Definition: Economics is a science that studies the behaviour of people who make decisions
about how to use scarce means to alternative uses to achieve their ends.
Economics therefore does not study all human behaviour. Some behaviour, namely that driven by
emotions, sentiments, and instincts is left to other sciences such as psychology and biology.
People have means (time, land, money, etc.) that they can spend (i.e. allocate). The means are scarce
which means that they are available in a limited quantity. There are always alternative opportunities
to which we can allocate our limited means.
Rational people tend to allocate the scarce means to such uses that give them greater satisfaction in
comparison with other alternative uses. Economics is only about this. The highest goal of human
behaviour is one’s own happiness, satisfaction, or contentment – whatever you call it. In economics
we call the level of one’s satisfaction the utility.
The fact that we have limited means and alternative allocations forces us to make decisions. This is
common to people regardless their wealth. Even billionaires have limited means. Unfortunately for
them, they have only billions of dollars and they cannot spend more.
What is seen and what is not seen
Never forget that there are always trade-offs: If we decide to spend scarce means in one way we
cannot spend them in another way. If we decide to spend our CZK 20 for an ice-cream we cannot
spend the same CZK 20 for a hamburger. If the producers of ice-cream attract us to spend CZK 20 at
their shops, the producers of ice-cream will enjoy revenues greater by CZK 20 but producers of other
things will suffer revenues less CZK 20.
If you see one industry prosper it would be a mistake to believe that all industries prosper as well.
French economist Frédéric Bastiat said that bad economists are those who make conclusion only
from events that are visible. There are always events that are usually hidden. A good economist
should be able to abstract and to imagine events that are not seen.
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“Have you ever witnessed the anger of the good shopkeeper, James Goodfellow, when his
careless son has happened to break a pane of glass? If you have been present at such a
scene, you will most assuredly bear witness to the fact that every one of the spectators, were
there even thirty of them, by common consent apparently, offered the unfortunate owner
this invariable consolation—"It is an ill wind that blows nobody good. Everybody must live,
and what would become of the glaziers if panes of glass were never broken?"
Now, this form of condolence contains an entire theory, which it will be well to show up in
this simple case, seeing that it is precisely the same as that which, unhappily, regulates the
greater part of our economical institutions.
Suppose it cost six francs to repair the damage, and you say that the accident brings six
francs to the glazier's trade—that it encourages that trade to the amount of six francs—I
grant it; I have not a word to say against it; you reason justly. The glazier comes, performs his
task, receives his six francs, rubs his hands, and, in his heart, blesses the careless child. All this
is that which is seen.
But if, on the other hand, you come to the conclusion, as is too often the case, that it is a
good thing to break windows, that it causes money to circulate, and that the encouragement
of industry in general will be the result of it, you will oblige me to call out, "Stop there! Your
theory is confined to that which is seen; it takes no account of that which is not seen."
It is not seen that as our shopkeeper has spent six francs upon one thing, he cannot spend
them upon another. It is not seen that if he had not had a window to replace, he would,
perhaps, have replaced his old shoes, or added another book to his library. In short, he would
have employed his six francs in some way, which this accident has prevented.”
Fredéric Bastiat (1801-1850), French economist.
Consumption and Production
Consumption is the process through which we satisfy our needs. To consume we must first produce.
Then we can consume what we have produced or we can trade our production for the production of
others.
Production is the process in which special goods, called the means of production are employed to
produce goods. The means of production are 1) Labour, 2) Land, and 3) Capital.
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To produce things we need usually all three kinds of the means of production. If you operate vending
machines, you need some staff to service the machines, you need to rent some area where the
machine is placed, and you need the machines. If you operate u bus from Prague to Brno, you need a
driver, you need to pay for the road and terminals, and you need the bus. If you produce software,
you need the programmers, you need premises, and you need computers.
The volume of Labour and Land is limited to the quantity available. The volume of labour is limited to
the volume of the working force – number of people in the working age. The volume of land is
limited to the area of the Earth and can be enlarged only by building above or under the surface.
Accumulation of Capital
On the other hand, capital can be accumulated to infinity. Capital goods include tools, machines, and
buildings. They are not produced for immediate consumption they are used to produce other goods.
Capital goods are acquired by saving wealth which can be invested in the means of production. By
saving people actually decrease their present consumption. The capital goods they create increase
production and thus increase the consumption in the future.
Assume Robinson Crusoe in a desert island. He can pick up berries all the day. Then he is struck with
an idea: Why not make a net to be able to catch more fish in the future? Making a net would take
him one day during which he will not be able to pick berries or to catch fish by hand. To make a net
he must sacrifice his present consumption. This requires forward looking. Sacrifice of the present
consumption means decreasing your present standard of living. One must be able to see in the future
and to be willing to risk. The ability to look forward and to take the risk should be rewarded by an
increase in consumption in the future, although one must be aware of the fact that the investments
can fail.
Beavers build wonderful dams, spiders make admirable webs, and ants build complex building-hills –
but they do it same for million years. Animals never make new tools that would help them build their
constructions. They can never increase their standards of living in the long run. Capital formation is
probably inherent only to human beings.
Production, Exchange, Gift, and Theft
People gain satisfaction through the consumption of goods and services. Goods can be obtained
through several ways, namely through the production and through exchange. There are also other
ways of getting a good: To steal it from others or to get it as a gift. Why do some people steal? Why
do some people give their wealth to others? Economics finds answers also to those questions.
The main driving force of human behaviour is the self-interest – i.e. the desire to increase our own
well being. The other driving force is benevolence – the desire to increase well being of other people
at our expense. It is driven by sentiments such as compassion or love.
„It is not from the benevolence of the butcher, the brewer or the baker, that we expect our dinner,
but from their regard to their own self interest. We address ourselves, not to their humanity but to
their self-love, and never talk to them of our own necessities but of their advantages …he intends only
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his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end
which was no part of his intention.“ Adam Smith, The Wealth of Nations, 1776
Adam Smith, a Scottish economist (1723 – 1790) was lecturer at the University of Edinburgh and
Professor at the Glasgow University, and a private tutor. In 1778 he worked as the chief customs
official of the Kingdom of Scotland. As the author of the Wealth of Nations (1773) he is considered to
be the founder of the science of the economics.
Voluntary contract
A contract is a deal in which two parties voluntarily agree on exchanging values, providing a service
or of a good for compensation. Contracts are concluded by expressing will by both contracting
parties. The will may be expressed in writing by signing a contract, or by acting. If a child buys icecream the purchasing contract is concluded by offering money for ice-cream. If a man enters a city
bus the contract on transportation is concluded by entering. If you buy something on the internet a
contract may be concluded by clicking on buttons like “proceed”, “buy”, “order”, etc.
If two people voluntarily exchange goods they both believe that they will be better off. This is called
the miracle of exchange. Although the physical volume of goods does not change total utility
increases. Simply put, through exchange things find new owners whom they can serve better.
Assume two prehistoric men, a hunter and a gatherer. The hunter has meat and the gatherer has
berries. The hunter has enough meat for himself and his family and he has some excess meat that is
only of low utility for him. The gatherer has enough berries for himself and the family, and still he has
some excess berries that are not of high utility for him. They can trade their surpluses – excess meat
for excess berries and both can be better off. Both can increase their standard of living through
exchange.
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But wouldn’t it be better for the hunter simply to kill the gatherer and to take all berries from him? If
he trades his meat for berries he receives only part of the berries – and he gives up some meat. If he
killed him he could have everything from him. If there is no chance to meet the gatherer again, killing
him might be a reasonable option. If the two can meet repeatedly they can benefit from repeating
cooperation.
Is it only production that creates value? What about trade? Trade – or exchange of goods – also
increases value of things because by trade things gain greater values as people trade always things of
less value for things of greater value. We can trade things directly or we can use the service of the
middlemen. If we sell a house we can try to find the buyer directly – or we can use the service of real
estate agents. We can buy milk directly from farmers or we can use the service of a supermarket that
intermediates the exchange. If we use the service of middlemen it is because we believe that using
their service is less costly than finding the counterpart ourselves. Trade also creates value.
Most things have their owners. Ownership is a relation between men and things. It involves rights to
property, collectively referred to as a title. It includes the right to use, sell, give, rent, or destroy the
property.
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Without ownership we could not trade – we can trade only what belong to us. Consequently without
ownership we could not increase our utility through exchange of goods.
Ownership is the product of labour. Because each free man owns himself one also has the right to
the fruits of his own labour. We become owners of things through our own production or property
can be passed upon us through inheritance. Sometimes people become owners by dishonest ways,
through theft.
Miracle of ownership
“Give a man the secure possession of bleak rock, and he will turn it into a garden; give him a nine
years lease of a garden, and he will convert it to a desert,” said Arthur Young an English economist
(1787)
The ownership matters. Whether we own something or not influences the way how we deal with it.
Sometimes we use our own property, sometimes we deal with the property of someone else –
because we have rented it, because we are hired to administer it, and so on.
People tend to best care of such things that they actually own and they tend to abuse thing that they
don’t own. If people own things they bear all the consequences of their behaviour.
Moral hazard
Situations in which the user of a property does not bear all the costs of his behaviour contains the
temptation not to take the long term consequences into account and to take advantage of his
behaviour at the expense of the owner.
Asymmetry of information
Moral hazard exists also in trade where the two parties of a contract have different volume of
information of the good on sale. The party that has more information has the temptation not to
disclose the whole information if it would decrease the value of the thing in the eyes of the potential
counterpart.
If you sell a used car or a used house you are tempted not to tell some drawbacks because it would
decrease the price you would get. If you are a doctor you are tempted to encourage the patient to
more procedures than is necessary because you will get more money from the insurance company. If
you are a manager of a company you are tempted not to tell the owners all the information because
they could lay you off or decrease the bonuses.
Externalities
When we use our own property we bear the cost and we take the benefits. However in a human
society people are neighbours and using one’s own property affects the others, positively or
negatively to some extent. Some elements of our activities cross borders of our neighbours’ property
and this cannot be prevented. These external effects are called external benefits or positive
externalities if they are beneficial to our neighbours. They are called external costs or negative
externalities if they are harmful to our neighbours.
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If we listen to music in our home, we have paid for the music and we have the pleasure of listening to
it. The sound of the music can however be heard by our neighbours behind the wall. If the
neighbours like the music it is a positive externality to them. If they resent the music then it is a
negative externality to them.
Our activity can create positive externality to some people and negative to other people
simultaneously.
If our neighbours run a bakery we can smell the bread. It can be a positive externality to us if it smells
good or a negative externality if it smells bad to us. Our neighbour can heat their homes and we can
benefit from it since we can save money as we need less heating. It can be a negative externality if
they run a server room and they increase the temperature in our rooms to much even in the summer
time. The neighbour can have an unsecured Wi-Fi. It can be a positive externality to us as we can surf
the internet at their expense. Our neighbour can build a house near our land and thus shading our
own garden or windows. It can be a positive externality if we like the shadow or a negative
externality if we preferred sunshine. Sound, heat, sunshine, radio waves, smell – all these things are
able to cross the borders of our property or our own body –sometimes even through concrete walls.
If our neighbour is a bee keeper his bees can fly through and above the fences. They can be a positive
externality to us if we grow fruit trees and we have better produce as the bees pollinate blossoms of
our trees. Without the bee keeper we would have to rely only on butterflies and humblebees. The
bees can be a negative externality if we run an open air bathing establishment and bees stinging our
customers or our own children make us worse off.
Externalities exist. If they are positive we don’t complain. If they are negative, we can ask politely the
neighbours to reduce them (like to turn down the volume of sound), we can negotiate with them, or
we can ask the government (police, courts) to step in and to force the neighbours to reduce the
externalities. The courts will have to decide whether the extent of the externality is abnormal or not.
Compensation
Think of a bee keeper who receives a financial compensation from the neighbouring owner of an
orchard. The orchard produces more fruit as bees pollinate them. It makes sense to pay
compensation because otherwise the beekeeper could move his hives farther from the orchard and
the produce of fruit would go down.
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Master’s Extension: Private and Public goods
Rivalry. Excludability. Private Goods. Public Goods. Common Goods. Club Goods. Free Riding.
Tragedy of Commons. Friedman’s Four Ways of Spending Money. Principal vs Agent.
Goods have their properties. The nature of these properties leads to different ways of providing
them. The two basic properties of goods are the rivalry in consumption and the excludability from
consumption.
Rivalry in Consumption
Some goods can be consumed unless their availability decreases. Other goods diminish as they are
consumed. If you watch TV you consume the radio signal unless you diminish it for other people. On
the other hand if you use a Wi-Fi at school you decrease its speed for others. If the church bells tell
you what is the time you can consume this information and as you listen to it you don’t diminish the
availability of it to others. This property of a good – whether it diminishes as it is consumed – is called
rivalry in consumption.
Because the consumption by one consumer diminishes availability to others, consumers are in
rivalrous positions. If there is only one vacant place at a parking lot two drivers wanting to park their
cars are in rivalrous positions. If there are more available places they rival for the best place. If only
100 students can attend the class applicants are in rivalrous positions. In the market the rivalry is
sorted out by prices. If there are more applicants than what is the capacity of classes the school can
increase the tuition fees. If there are more drivers who want to park their cars than what is the
number of parking lots the operator of the parking place can increase the park charges. The rivalry is
won by those who can afford to pay more. If there are no charges the drivers are usually satisfied
upon the principle “first come, first served”.
If the consumption by one consumer does not diminish the availability of the good then the
consumers are not in rivalrous positions.
Excludability from consumption
With some goods it is difficult or even impossible to prevent people from consumption if they are not
willing to pay. Such good is called non-excludable. If you run a lighthouse (you operate a port and you
decided to build a lighthouse to navigate ships to your port to increase your revenues as you charge
ships for anchoring). The lighthouse can however serve other ships that only pass by and you are not
able to charge them or to switch off the light as they see it.
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For most goods it is possible to exclude from consumption those who don’t pay. If you run a vending
machine you technically give the bottle only to those who insert coins in. If you run bus
transportation from Prague to Brno, you let in the bus only those who have paid for their tickets. If
you attend the school you receive cards and only those who have paid tuition fees can get in. Most
goods are excludable.
Goods that are both rivalrous and excludable are called the Private goods. Goods that are both nonrivalrous and non-excludable are called Public goods. This distinction is independent from ownership
– whether they are owned and operated by private individuals or by the government.
The goods that are non excludable and rivalrous in the same time are called common goods, or
shortly commons. Example of such a good is fish in oceans. No one owns them no one is able to
charge for the catch and the volume of fish in the oceans is limited. Another example is free parking
at public streets if the local government is not able to establish the system of charging.
The goods that are non-rivalrous and excludable are called club goods. Access to the goods can be
restricted only to those who pay a regular fee or otherwise qualify for membership. An example is a
satellite TV. It can be restricted to those who pay a monthly fee and as you have paid you can watch
unlimited quantity of movies. Or you can pay a fee for a news web site and then you can read as
many articles as you wish.
The phenomenon of free riding is associated with the provision of public good. As it is not possible to
exclude consumers who have not paid there will be consumers who will “free ride” i.e. use the
service without paying. If a church has paid a clock and bells to inform its members that it is time to
pray or go to mass it is the church members who have financially contributed to the bells. The church
cannot prevent other people from using the service. If you hear the bells ringing it can remind you
that it is time to go to pub, for instance.
If the city of Prague decides to build 100 public clock at the street corners, it was the Prague
taxpayers who have financed it. They are not however able to prevent the visitors from Brno to take
advantage of the clocks.
The existence of free riding costs the operators nothing as there are zero marginal costs of providing
the service. It can only cause some envy.
The phenomenon called the tragedy of commons is associated with the existence of common goods.
If the good diminishes as one uses it and it is not excludable people can exploit or overuse it. It can
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lead to the complete exploitation. Overfishing can lead to extinction of all fish in the seas.
Overgrazing can turn pastures into deserts.
Inability of local government to introduce a system of charged parking can lead to overparking –
damaging of cars parking too close together, abuse of parking lots by cars that can hardly drive and
serve only as pub advertisements.
The phenomenon of non-excludability means that there are many goods for free in this world
provided voluntarily by the providers of common and public goods.
Friedman’s four ways of spending money
According to Milton Friedman, there are four distinct ways of spending money:
1. You spend your own money on yourself.
2. You spend your own money on someone else.
3. You spend someone else's money on yourself.
4. You spend someone else's money on someone else
http://www.youtube.com/watch?v=5RDMdc5r5z8&feature=player_detailpage
These categories can be sorted in a table:
On Whom Spent
Whose Money
You
Someone else
Yours
I
II
Someone else’s
III
IV
If you spend your own money you mind how much you spend. If you spend on yourself you mind the
utility it can bring you.
Category I You shop in a supermarket, for example. You clearly have a strong incentive both to
economize and to get as much value as you can for each dollar you do spend.
•
Category II refers to your spending your own money on someone else. You shop for Christmas
or birthday presents. You have the same incentive to economize as in Category I but not the
same incentive to get full value for your money, at least as judged by the tastes of the
recipient. You will, of course, want to get something the recipient will like – provided that it
also makes the right impression and does not take too much time and effort. (If, indeed, your
main objective were to enable the recipient to get as much value as possible per dollar, you
would give him cash, converting your Category II spending to Category I spending by him.)
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•
Category III refers to your spending someone else’s money on yourself – lunching on an
expense account, for instance. You have no strong incentive to keep down the cost of the
lunch, but you do have a strong incentive to get your money’s worth.
•
Category IV refers to your spending someone else’s money on still another person. You are
paying for someone else’s lunch out of an expense account. You have little incentive either to
economize or to try to get your guest the lunch that he will value most highly. However, if you
are having lunch with him, so that the lunch is a mixture of Category III and Category IV, you
do have a strong incentive to satisfy your own tastes at the sacrifice of his, if necessary.
Milton Friedman (1912-2006), American economist, Nobel Prize winner. Professor at the University
of Chicago, Founder of monetarism, a school of taught.
Lesson 2: Comparative Advantage and Opportunity Cost
Opportunity Costs. Comparative Advantage. Division of Labour.
Definition: Opportunity cost is the cost of an activity measured in terms of the value of the next best
alternative forgone. It is what we could have if we did the other alternative of the two best
alternative activities available instead of what we had chosen as the very best one.
Definition: Comparative advantage is the ability of a party to produce a particular good or service at
a lower opportunity cost over another. Comparative advantage implies cooperation, specialization,
the division of labour and trade, since two parties can produce more if they specialise according to
their comparative advantages.
People are different; they have therefore different opportunity costs and different comparative
advantages. They will be therefore involved in the division of labour and cooperation. This
cooperation can be organized in several ways.
People can cooperate within small communities such as families and they can share the products of
their labour. They can trade their products in the market. People can live in a dictatorship where it is
the government who decides who makes what and how it is distributed.
Example
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Annie and Betty produce sweaters and cakes. Anne is more productive in making
both – sweaters and cakes. Anne can produce 4 sweaters in an hour or she can
produce 8 cakes in an hour. Betty can produce 2 sweaters in an hour or she can
produce 2 cakes in an hour. Find out
how many sweaters and how many
cakes each of them can produce in one
hour if each of them makes both
products for themselves and if each
must have one sweater. Then find out how many sweaters
and cakes they can produce if they specialize according to
their comparative advantage. Find out the interval in which
they set the price of one sweater in terms of cakes.
Solution
how many sweaters she
can make in an hour
or how many cakes
she can make in an hour
Annie
4
8
Betty
2
2
how many of it they make in one hour
without division of labour
sweaters
cakes
Annie
1
6
Betty
1
1
how many of it they make in one hour
with the division of labour
sweaters
cakes
Annie
0
8
Betty
2
0
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It is evident that 2 sweaters and 8 cakes are more than 2 sweaters and 7 cakes. With the division of
labour they will work for the same long time as if they did not specialize and still they can make 1
more cake in total.
Division of labour pays. After one hour of work Betty can retain one sweater of the 2 she has
produced and she can offer one of them to Annie. How many cakes Annie should be willing to give up
for one sweater? On what price will the girls agree on? Betty should require at least 1 cake for her
additional sweater because she could make 1 cake instead her second sweater. Annie should not be
willing to give more than 2 cakes for 1 sweater because she could make 1 sweater instead of 2 last
cakes she made. The girls should therefore agree on a price between 1 and 2 cakes for 1 sweater.
Even if the girls don’t like the market and they prefer to do good to other people instead of trading
they will still be better off if they specialize according to their comparative advantage. Assume that
they found a workshop to produce sweaters and cakes for the poor. They can feed more people if
they divide labour according to the comparative advantage.
Master’s Extension: Comparative Advantage in Foreign Trade
Barriers to Trade. Tariffs. Quotas.
When we speak of “international trade” it does not mean that nations, or states, trade. It is
individuals and firms who trade. All conclusions about comparative advantages that we have learned
of cooperation of two individuals are valid also if there is a political frontier between them.
Bluntly, drawing a line on a map between Annie and Betty cannot change anything on the fact that
Annie should make cakes and Betty should make sweaters.
If governments prevent trade by imposing tariffs, quotas, and other barriers they prevent taking
advantage of the division of labour according to the comparative advantage. The existence of tariffs
and quotas causes that people produce things at higher opportunity costs than what they could if the
trade was free.
Lesson 3: Utility
Utility Function. Marginal Utility. Rationality.
Definition:
Utility is the individual level of satisfaction from consumption. Utility function is a relation between
the utility and the quantity of one or more goods consumed.
Utility is difficult or perhaps impossible to measure, however it does not mean that it does not exist.
Before people invented thermometer it was difficult or impossible to measure temperature but yet it
existed. A man does not need to have a thermometer to recognize whether to wear a sweater or to
take off a pullover. Similarly a man does not need to have a utility-meter to recognize whether to
watch TV one more hour, to take one more cake, to turn up the volume of music by one grade or to
buy one more magazine. A man consumes more of something if he believes that his scarce resources
(money, time etc.) can be spent better in a way that gives him greater utility.
18
If you feel you will be better off going to bed you simply switch off the TV. If you feel you will be
better off watching more you will watch more.
If you feel that spending time and money talking on phone with your girlfriend makes you better off
than using your time and money in an alternative way, you will be talking on. Exactly at a time when
you feel that continuing in the call is wasting of your time and money and you believe you would be
able to use your scarce means in a way that would give you greater utility you will stop the call and
return to your unfinished work.
You will buy another magazine if you feel that your CZK 50 cannot be spent in a way that gives you
greater utility.
As you consume more of something the total utility gained from the consumption increases less and
less. From a certain level of consumption an additional unit (i.e. consuming too much) can even
decrease your total utility. While the total utility is the combined utility of all units consumed, the
marginal utility is the utility gained from an additional unit consumed. A rational person does not
consume too much – a rational person stops his consumption as soon as his marginal utility (the
utility of consuming another unit) minus the cost of another unit is at zero.
This property of the utility function is called the law of diminishing marginal utility and it means that
the utility function is concave.
The utility can be described by the total utility, or by the marginal utility. The marginal utility of n-th
unit is the increase in the total utility between n-th and n-th minus 1 unit. Always as the total utility
reaches its maximum the marginal utility is zero. As the total utility decreases with further increasing
consumption the marginal utility is negative.
The concept of rationality
A rational human being will never consume if his marginal utility is to be negative. But are people
always rational? Not always. Little children usually don’t have enough experience to recognize
whether they should stop their consumption. The decision making of adult people can be influenced
by alcohol that can reduce their ability to be rational.
Assume the utility of a child taking rides on a merry-go-round. Assume that the child gets the rides
for free. His marginal utility, the subjective satisfaction of getting another ride is decreasing.
There is a certain point behind which he says that he doesn’t want rides any more. It is when his
marginal utility gets to zero. In theory the marginal utility can be negative – one can be sick if he gets
another ride.
Assume that the child wants a sixth ride. The parents ask him “Do you want one more ride?” The
child answers “Yes, please, I like it and I believe that my marginal utility will be still positive!” There
must be the parents who tell him “No, you should know that marginal utility is decreasing and the
fact that you had positive marginal utility from your fifth ride does not mean that you will have a
positive marginal utility from your sixth one. I guess that your marginal utility would turn to negative.
Therefore we will not let you for the sixth ride.”
19
Or the child can eat ice-cream. He had three ice-creams and asks for the forth one. He believes that
he will still have a positive marginal utility. There must be the parents who would tell him “No, you
will not get another one. You would get a belly-ache; your marginal utility would be negative.”
Assume a utility of a man drinking beer in an open bar where he gets beer for free. Again his
marginal utility, subjective satisfaction of drinking another beer is decreasing. Even if the beer is free
there is a point at which he will refuse another beer.
It may happen that his mind is influenced by alcohol and if friends encourage him to take the sixth
beer he has not enough will to refuse. The other day after a headache and hangover he thinks. “I
wander why I did not end with five beers. My total utility could be higher lest I did not take the sixth
one.”
Economists know that people are not always rational. People sometimes behave irrationally. People
also learn by trial and error and most of them tend not to repeat the same errors. Sometimes the
mind of people may be influenced by drugs, or they could fall in love etc.
But mostly people are able to choose what is good for them. And above all, the utility is subjective –
no one else than one who consumes is able to better determine what is good for him.
Optimum
People consume such quantities that their marginal utilities per one monetary unit are equal. If you
have the opportunity to consume something that gives you greater utility you will do it.
At the margin the optimum of a consumer is
𝑀𝑈1 𝑀𝑈2
𝑀𝑈𝑛
=
=. . . =
𝑃1
𝑃2
𝑃𝑛
Example
A woman consumes coffee and cakes. Marginal utility of another coffee is 50. Its price is 25. Marginal
utility of another cake is 40. What shall be the maximum price of the cake so that the woman buys
another cake instead of another coffee?
Solution
𝑀𝑈𝑐𝑜𝑓𝑓𝑒𝑒 𝑀𝑈𝑐𝑎𝑘𝑒
=
𝑃𝑐𝑜𝑓𝑓𝑒𝑒
𝑃𝑐𝑎𝑘𝑒
50
40
=
25 𝑃𝑐𝑎𝑘𝑒
𝑃𝑐𝑎𝑘𝑒 = 20
The utility could be described by a table, by a chart or by an algebraic function.
Assume that the total utility of someone from the consumption of beer can be described as follows:
Q
1
2
3
4
5
6
20
TU
MU
100
100
180
80
240
60
270
30
290
20
280
-10
How much should he consume if one beer costs CZK 35? Remember the definition of economics and
you will see that this answer cannot be answered. If he is rational he should not consume his sixth
beer if the marginal utility is negative. But whether he should buy one, two, three, four or five
depends on the utility of alternative uses of his budget – and on the size of his budget.
Assume that the utility from the consumption of meal can be described as follows:
Q
TU
MU
1
240
240
2
470
230
3
680
210
4
830
150
5
930
100
6
990
60
Assume that the meal costs CZK 100.
One must always consider what gives him greater utility per one unit of means spent.
Marginal utility per one monetary unit =
𝑀𝑈
𝑃
If we compare two goods we will always consume one that gives us the greatest utility per one unit
of money (if we have enough money to buy it).
Let’s consider unitary marginal utilities for the consumption of beer and meals.
Q
𝑀𝑈𝑏𝑒𝑒𝑟
𝑃𝑏𝑒𝑒𝑟
1
100
= 2.85
35
2
80
= 2.28
35
3
60
= 1.71
35
4
30
= 0.85
35
5
20
= 0.57
35
𝑀𝑈𝑚𝑒𝑎𝑙
𝑃𝑚𝑒𝑎𝑙
240
= 2.4
100
230
= 2.3
100
210
= 2.1
100
150
= 1.5
100
100
= 1.0
100
6
−10
35
= −0.28
60
= 0.6
100
A rational person will start with his first beer which gives him greatest utility per one CZK. Then he
orders a cigar which gives him utility 2.4 per one crown spent and continues with his second cigar.
Then he gets his second beer that gives him utility per one crown spent of 2.28. He goes to his third
cigar with the utility per crown at 2.1. Then he goes to the third beer and then to the fourth and fifth
cigar. Next he chooses fourth beer and sixth cigar and finally his fifth beer. He would consume all his
beers and cigars in this order but how many of them he will actually consume depends on his budget.
Assume that his budget is CZK 370. He spends 35 for his first beer. After his firs cigar he spends
(35+100=135). After his second cigar he has spent (35+100+100=235). After his second beer he has
spent (35+100+100+35=270). After his third cigar he has spent (35+100+100+35+100=370). He has
consumed two beers and three cigars and his budget is over.
21
Example
Assume it is possible to measure your utility. Your budget is CZK 500 for beer and meals for the
following week. 𝑀𝑈𝑏𝑒𝑒𝑟 = 250 − 25𝑄𝑏𝑒𝑒𝑟 and 𝑀𝑈𝑚𝑒𝑎𝑙 = 250 − 25𝑄𝑚𝑒𝑎𝑙 . How much beer and
how many meals should you buy if 1 beer costs 25 and 1 meal costs 50?
Solution
22
To maximize your utility per your spending you buy goods with the highest marginal utility per 1
monetary unit spent.
𝑀𝑈𝑏𝑒𝑒𝑟
= 10 − 𝑄𝑏𝑒𝑒𝑟
𝑃𝑏𝑒𝑒𝑟
𝑀𝑈𝑚𝑒𝑎𝑙
= 5 − 0.5𝑄𝑚𝑒𝑎𝑙
𝑃𝑚𝑒𝑎𝑙
Your budget constraint is
𝑃𝑏𝑒𝑒𝑟 ∙ 𝑄𝑏𝑒𝑒𝑟 + 𝑃𝑚𝑒𝑎𝑙 ∙ 𝑄𝑚𝑒𝑎𝑙 = 𝐵𝑢𝑑𝑔𝑒𝑡
25 ∙ 𝑄𝑏𝑒𝑒𝑟 + 50 ∙ 𝑄𝑚𝑒𝑎𝑙 = 500
You optimize consumption at
𝑀𝑈𝑏𝑒𝑒𝑟
𝑃𝑏𝑒𝑒𝑟
=
𝑀𝑈𝑚𝑒𝑎𝑙
𝑃𝑚𝑒𝑎𝑙
which is where
10 − 𝑄𝑏𝑒𝑒𝑟 = 5 − 0.5𝑄𝑚𝑒𝑎𝑙
from which we get
5 + 0.5𝑄𝑚𝑒𝑎𝑙 = 𝑄𝑏𝑒𝑒𝑟
Putting this to the budget constraint we get
25(5 + 0.5𝑄𝑚𝑒𝑎𝑙 ) + 50 ∙ 𝑄𝑚𝑒𝑎𝑙 = 500
125 + 62.5𝑄𝑚𝑒𝑎𝑙 = 500
𝑄𝑚𝑒𝑎𝑙 = 6
Since 5 + 0.5𝑄𝑚𝑒𝑎𝑙 = 𝑄𝑏𝑒𝑒𝑟 = 5 + 0.5 ∙ 6 = 8
You should spend your budget of CZK 500 so that you buy 6 meals for CZK 50 and 8 beers for
CZK 25.
What is your total utility?
Total utility is the antiderivative of marginal utility.
2
Therefore 𝑇𝑈𝑏𝑒𝑒𝑟 = 250𝑄𝑏𝑒𝑒𝑟 − 12.5𝑄𝑏𝑒𝑒𝑟
2
𝑇𝑈𝑚𝑒𝑎𝑙 = 250𝑄𝑚𝑒𝑎𝑙 − 12.5𝑄𝑚𝑒𝑎𝑙
The total utility of the consumption of both 𝑇𝑈𝑚𝑒𝑎𝑙 + 𝑇𝑈𝑏𝑒𝑒𝑟 is
2
2
𝑇𝑈 = 𝑇𝑈𝑚𝑒𝑎𝑙 + 𝑇𝑈𝑏𝑒𝑒𝑟 = 250𝑄𝑚𝑒𝑎𝑙 − 12.5𝑄𝑚𝑒𝑎𝑙
+ 250𝑄𝑏𝑒𝑒𝑟 − 12.5𝑄𝑏𝑒𝑒𝑟
What is the optimum at the given budget constraint?
We must find the maximum provided
25 ∙ 𝑄𝑏𝑒𝑒𝑟 + 50 ∙ 𝑄𝑚𝑒𝑎𝑙 = 500
23
5 + 0.5𝑄𝑚𝑒𝑎𝑙 = 𝑄𝑏𝑒𝑒𝑟
2
𝑇𝑈 = 250𝑄𝑚𝑒𝑎𝑙 − 12.5𝑄𝑚𝑒𝑎𝑙
+ 250(5 + 0.5𝑄𝑚𝑒𝑎𝑙 ) − 12.5(5 + 0.5𝑄𝑚𝑒𝑎𝑙 )2
2
2
𝑇𝑈 = 250𝑄𝑚𝑒𝑎𝑙 − 12.5𝑄𝑚𝑒𝑎𝑙
+ 1250 + 125𝑄𝑚𝑒𝑎𝑙 − 12.5(25 + 5𝑄𝑚𝑒𝑎𝑙 + 0.25𝑄𝑚𝑒𝑎𝑙
)
To find the maximum we should put the derivative of this function to zero.
𝑑𝑇𝑈
= 250 − 25𝑄𝑚𝑒𝑎𝑙 + 125 − 62.5 − 6.25𝑄𝑚𝑒𝑎𝑙 = 0
𝑑𝑄𝑚𝑒𝑎𝑙
187.5 = 31.25𝑄𝑚𝑒𝑎𝑙
𝑄𝑚𝑒𝑎𝑙 = 6
Master’s Extension: Decision Making under Risk
Expected Utility. Aversion to Risk.
The future is always uncertain. Whenever consequences of our actions come in the future we take
the risk. The risk reflects the fact that the real outcome of our activities can differ from what we
expect. The expected utility of a risky action is the weighted average of the possible outcomes and
the weights are probabilities of occurrence of each outcome.
𝐸 = 𝑈1 ∙ 𝑝1 + ⋯ + 𝑈𝑛 ∙ 𝑝𝑛
whereas
𝑝1 + ⋯ + 𝑝𝑛 = 1
Because of the concave shape of the total utility function most people are risk averse – they prefer
certainty to a risky action with expected outcome of the same value.
U(certainty)>E
Assume your total utility of having no apple is zero, of one apple 10 and of having two apples 18.
Assume that you have one apple and you are offered a bet: You bet one apple and you can end up
either with no apple at all if you lose or with two apples if you win. If the probability of winning is 50
%, then your expected utility is 9. You will conclude that certainty of having one apple is superior to
the bet with a fair chance that you can have either two apples or nothing.
Example
Assume that your gross income is 1 million, taxes are 50 % and your net income would be 0.5 million.
If you risk not declaring your income to the authorities and if they don’t catch you, you could enjoy 1
million. If they catch you, you would pay the taxes plus a penalty and your net income would be 0.1
million. The probability that they catch you is 2 %. Your total utility of having the income of 0.1
million is 1, of having 0.5 million is 3 and of having 1 million is 4. What is your expected utility? Will
you declare your income or not?
Solution
24
Your expected utility is
𝐸 = 0.02 ∙ 1.0 + 0.98 ∙ 4.0 = 3.922
which is greater than 3 so that you will not declare your income to the Tax Authority.
Diversification
An English saying says: Don't put all your eggs in one basket. If you put all of your eggs into one
basket and something happens to the basket such as you dropping it, all of your eggs break and you
have nothing left compared to distributing your eggs into two or more baskets so if something
happens to the one, you still have your others eggs. If you invest all of your money into one company
and the company fails, you have lost all of your money. Don't put all of your eggs in one basket.
Example
Have an investment of CZK 1000, with 50 % probability of the profit of 10 % and 50 % probability of
the loss of 10 %. Expected result of the investment is 0.
Probability
Result
50 %
+100
50 %
-100
Expected result
0,5 x (+100) + 0,5 x (-100) = 0
Have 2 independent investments of CZK 500, each with 50% probability of the profit of 10% and 50%
probability of the loss of 10% for each investment. Expected result of the investment is 0, same as
without diversification. However probability of 10% loss or 10% profit of the whole investment is
reduced to 25%.
Probability
Situation 1 (+50, +50)
25 %
Situation 2 (-50, +50)
25 %
Situation 3 (+50, -50)
25 %
25
Situation 4 (-50, -50)
25 %
You can see that by diversification you can reduce the risk of the loss of 100 (only the Situation 4)
from 50 % to only 25 %.
Lesson 4: Consumer Choice
Budget Line. Indifference Map. Indifference Curve. The Demand.
If a person consumes two goods his total utility is a summation of total utilities of both goods, like in
the function of total utility for beer and meals we had in lecture 3.
2
2
𝑇𝑈 = 𝑇𝑈𝑚𝑒𝑎𝑙 + 𝑇𝑈𝑏𝑒𝑒𝑟 = 250𝑄𝑚𝑒𝑎𝑙 − 12.5𝑄𝑚𝑒𝑎𝑙
+ 250𝑄𝑏𝑒𝑒𝑟 − 12.5𝑄𝑏𝑒𝑒𝑟
Graphically it is a three dimensional function. It show that your overall total utility increases both
with increases in the consumption of one good as well as with the other good.
2500
2000
2000-2500
1500
1500-2000
1000
1000-1500
500
500-1000
0
0-500
12
10
8
6
4
2
0
2
4
6
8
10
12
14
You can see the level lines – combinations of quantities of one and the other good that together give
you the same level of satisfaction.
This demonstration of the Total utility curve can be transformed into a two dimension chart. Imagine
that we look at the 3-D utility function from above: You will see only the two coordinates that
represent the quantities of the goods and the level lines.
Indifference map
The level lines are called the indifference curves, because we can say that the consumer is indifferent
to get any combination which gives him the same total utility.
26
The point D represents greater utility than A, B, and C. As 7 units of Y plus 4 units of Y must be better
than 7 units of Y and just 1, 2, or 3 units of X.
The budget constraint
The budget constraint represents combinations that we can afford at a given budget.
For two goods the constraint is
𝑃𝑋 ∙ 𝑄𝑋 + 𝑃𝑌 ∙ 𝑄𝑌 = 𝐵𝑢𝑑𝑔𝑒𝑡
If the two gods are beer and cigars, if your budget is CZK 198, the price of a beer is CZK 24 and the
price of a cigar is CZK 16 the budget constraint is
16𝑄𝑋 + 24𝑄𝑌 = 198
It is one equation with two unknown variables – it means that it has an infinite number of solutions.
It is also a linear combination. It means that graphically all solutions lie on a line.
27
Optimum
The budget line crosses some indifference curves and passes off the others. There is one indifference
curve that is only touched at one point by the budget line. This is the optimal combination of the
consumption of X and Y because all other combinations on the budget line lie on indifference curves
representing lower utility.
28
For this indifference curve the budget line is it tangent line. At this point the slope of the indifference
curve is identical with the slope of the budget line.
Derivation of the demand
What happens with the Budget line if the price of X-good increases or decreases? It hangs on the Yaxis – you can still afford the same quantity of Y – and it shifts to the left on the X-axis if the price of X
goes up, and to the right if the price of X goes down. If the price doubles, the Budget line doubles its
slope.
If the price of the good X goes up and the Budget line tilts to the left the new optimum arises. The
quantity of X that we will demand will decrease.
Thus we find a relation between the price and the quantity of goods that an individual wants to buy
at a given budget. This relation is called the individual demand. It shows that individual quantity
demanded depends negatively on the price.
29
Master’s Extension: Inter-Temporal Choice
Decreasing and constant marginal yield of capital. Choice between Charity and Consumption.
People can spend their income now or in the future.
30
31
Lesson 5: Demand and Supply
Demand. The Law of Demand. Income Effect. Substitution Effect. Elasticity of Demand. Consumer
Surplus. Supply. The Law of Supply. Producer Surplus. Market Equilibrium.
The demand is a relation between the price of a good and the quantity buyers want to buy at given
prices. The law of demand states that people buy more of a good when its price decreases and less
when its price increases provided that other things are equal.
The market demand is the summation of all individual demands. Assume Adam demands 6 apples a
week if it costs CZK 5 Eve demands 2 apples. If there are only Adam and Eve in the market then the
market demand for apples will be 8 apples at the price CZK 5.
32
In the demand the price is the independent variable and the quantity demanded is the dependent
variable – one that depends on the price. This relation can be demonstrated by a table, by a graph, or
by an algebraic function.
Example
Consider the demand for coke from a vending machine in the school’s lobby. Assume that people buy
60 bottles of coke per day if the price is CZK 20 and they buy 50 bottles of coke
Demonstration of the demand by a table
Price
Quantity demanded
CZK 20
60
Demonstration of the demand by a graph
CZK 25
50
33
Coordinates
In some textbooks the price is depicted at the vertical coordinate, in other it is depicted at the
horizontal coordinate. In this book we will depict the price always at the vertical coordinate though
we will be aware of the fact that the price is the independent variable.
Shape of the demand
In some textbooks the demand is graphically demonstrated as a line in some textbook it is
demonstrated as a curve. The law of demand does not tell us whether a demand is always a line or a
curve, it only tells us that it decreases.
Demonstration of the demand by an algebraic function
We can generally state that the quantity is a function of Price:
𝑄 = 𝑓(𝑃)
If we assume that a demand can be expressed as a line we can define it by two parameters: the
intercept 𝑎 and the slope 𝑏. Because we will depict the price at the vertical coordinate it will be
practical to separate the price on one side of the equation even if we know that the quantity
demanded depends on the price.
𝑃 =𝑎−𝑏∙𝑄
34
Exercise:
You run a vending machine. Estimate the demand curve as a line if you sold 50 bottles when your
price was CZK 25 and 60 bottles when your price was CZK 25.
Solution:
Demand as a line is represented by the general equation 𝑃 = 𝑎 − 𝑏𝑄
We get two equations with two unknown variables:
1) 25 = 𝑎 − 50𝑏
2) 20 = 𝑎 − 60𝑏
Subtract the second equation from the first one and get
5 = 10𝑏
𝑏 = 0.5
so that
𝑎 = 25 + 50 ∙ 0.5 = 50
The demand function is therefore
𝑃 = 50 − 0.5𝑄
Alternative solution:
35
The slope of the demand curve is ∆𝑃/∆𝑄 which is
25−20
60−50
=
5
10
= 0.5
The substitution effect and the income effect
There are two reasons why the quantity demanded decreases with an increase in the price: The
substitution effect and the income effect.
The substitution effect
If one good becomes more expensive than another good then the other good becomes relatively
cheaper. The relative price is the price of one good in terms of another good.
Relative price
The relative price of a good is the price in terms of another good. The nominal price is the price of a
good in terms of money.
Example:
The price of a bottle of coke increases from CZK 25 to CZK 30. The price of a cup of coffee remains at
CZK 10. Compute the change in the relative price of coke in terms of coffee and the change in the
relative price of coffee in terms of coke.
Solution:
36
If a coke costs CZK 25 and a cup of coffee costs CZK 10 it means that a coke costs 2.5 of a cup of
1
coffee and a cup of coffee costs 2.5 = 0.4 a coke. When a coke costs CZK 30 it means that a coke
costs 3.0 of a cup of coffee and a cup of coffee costs
1
3.0
= 0.33 of a bottle coke. Even if the nominal
price of coffee in terms of money did not change its relative price in terms of coke has changed.
As the price of a good increases people tend to demand more of another good as its price relatively
decreases.
The income effect
As the price of a good increases then the real income of people decreases. People can afford to buy
less.
Real income
Real income is the income in terms of goods that we can buy for it. The nominal income is the
income in terms of money.
Example
Your nominal income is CZK 10 000. The price of a meal is CZK 100. Your real income in terms of
meals is 100 meals: You can afford to buy 100 meals for your income. As the price of a meal increases
to CZK 125 your real income in terms of meals decreases to 80 meals. You can afford to buy only 80
meals for your income.
The law of supply
The supply is the relation between the price of a good and the quantity people want to sell at given
prices. The law of supply states that people sell more of a good when its price increases and less
when its price decreases.
Market Equilibrium
Market Equilibrium is a situation in a market when the price is such that the quantity that people
wish to demand is the same as the quantity that people wish to supply.
Example
Assume that the demand can be described as 𝑃 = 40 − 0.5𝑄 and the supply as 𝑃 = 10 + 𝑄. Find the
equilibrium.
Solution
40 − 0.5𝑄 = 10 + 𝑄
30 = 1.5𝑄
𝑄 = 20
𝑃 = 10 + 20 = 30
37
Searching the equilibrium price
Normally the price equalizes the demand and the supply. A school that charges tuition too low will
find that there are more applicants than places. It will see that it must increase the price. If on the
other hand it charges too much it will see that there are few applicants and it should decrease the
price.
Sometimes it is not easy to estimate the price that clears the market. (Typically for goods that are
unique.) Then an auction can take place. In auction people bid their proposals to find the one who is
willing to pay the highest price.
English Auction
English auction is an open ascending price auction. This type of auction is arguably the most common
form of auction in use today. Participants bid openly against one another, with each subsequent bid
higher than the previous bid. An auctioneer may announce prices, bidders may call out their bids
themselves, or bids may be submitted electronically with the highest current bid publicly displayed
Dutch Auction
Dutch Auction is an open descending price auction. In the traditional Dutch auction the auctioneer
begins with a high asking price which is lowered until some participant is willing to accept the
auctioneer's price. The winning participant pays the last announced price. The Dutch auction is
named for its best known example, the Dutch tulip auctions.
First come, first served
38
Sometimes it is not possible to adjust the price so that it clears the market. If the price cannot come
to the equilibrium a shortage or an over-supply occurs. A supermarket sets its prices so that it
maximizes the profit. It is however not possible to increase the prices in demand peaks and queues
take place. An ambulance or the post office cannot increase the price at peaks so they usually
establish an order-number system.
If people are served in the order as they came the allocation is called “First come, first served”.
Physical queue where people wait behind each other, order numbers, or waiting lists for operations
are typical examples of this kind of allocation.
In this case not those who are willing to pay the highest price are served but those who are willing to
wait.
Example
Assume that the demand can be described as 𝑃 = 200 − 𝑄 and the supply can be described as 𝑃 =
50 + 1.5𝑄. Assume that the price is at 𝑃 = 100 and cannot be adjusted. Find the shortage that will
occur.
Solution
The equilibrium price
200 − 𝑄 = 50 + 1.5𝑄
150 = 2.5𝑄
𝑄 = 60
The equilibrium price is therefore 𝑃 = 200 − 𝑄 = 140. If the price is lower the quantity demanded
will be greater than the quantity supplied. The quantity demanded will be
100 = 200 − 𝑄
𝑄 = 100
The quantity supplied will be
100 = 50 + 1.5𝑄
𝑄 = 33.33
The shortage will be 100 − 33.33 = 66.67 unsatisfied customers.
Elasticity of Demand
The operator of vending machines finds that if his price is CZK 26 per one bottle of coke he sells 30
bottles per day and if his price is CZK 24 he sells 70 bottles per day. Compute the price elasticity of
the demand for coke from the vending machine.
𝐸𝑃𝐷 =
𝑟𝑒𝑙𝑎𝑡𝑖𝑣𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦
𝑟𝑒𝑙𝑎𝑡𝑖𝑣𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒
39
We will use the formula for the arc elasticity, where the base of each fraction is the compromise
between the original and the new level of quantity and price.
𝐸𝑃𝐷 =
𝐸𝑃𝐷 =
70−30
0,5(70+30)
26−24
0,5(26+24)
𝑄2 −𝑄1
0,5(𝑄1 +𝑄2 )
𝑃1 −𝑃2
0,5(𝑃1 +𝑃2 )
=
40
50
2
25
=
40 25
∙
= 10
50 2
Between 𝑃 = 26 and 𝑃 = 24 the elasticity is 10. A decrease in prices by 1 % leads to an increase in
quantity by 10 %.
Value
Perfectly inelastic demand
Ed = 0
- 1 < Ed < 0
Inelastic or relatively inelastic demand
Ed = - 1
Unit elastic, unit elasticity, unitary elasticity, or
unitarily elastic demand
- ∞ < Ed < - 1
Elastic or relatively elastic demand
Ed = - ∞
Perfectly elastic demand
40
Demand and Revenues
Consumer surplus
41
Definition: Consumer surplus is the difference between what consumers would be willing to pay
and what they have actually paid. Graphically it is the difference between the demand curve and
the constant line representing the price.
Assume that the demand for coke from a vending machine is 𝑃 = 50 − 0,5𝑄. The price was set at 25
per one bottle. Compute the consumer surplus.
Solution:
The consumer surplus is the difference between what consumers are willing to pay and what they
actually pay. At 25 the quantity demanded is 50:
𝑃 = 50 − 0,5𝑄
25 = 50 − 0,5𝑄
25 = 0,5𝑄
50 = 𝑄
Then the area of the triangle between the demand curve and the price level is
𝐶𝑜𝑛𝑠𝑢𝑚𝑒𝑟 𝑠𝑢𝑟𝑝𝑙𝑢𝑠 =
(50 − 25) ∙ 50
= 625
2
Master’s Extension: State Interventions to the Demand and Supply
Price floors. Price ceilings. Intervention purchases. Minimum Wage. Shortage. Tax incidence. Laffer
Curve.
42
A voluntary contract is a deal beneficial for both contracting parties. Any state intervention breaks
this property of contract. If the intervention forces someone or forbids someone to do something
there will be someone who will be better off and someone who will be worse off.
Price floors
Examples:
EU: intervention prices of milk and butter
CZ: Minimum vage, Solar electricity prices
Price ceilings
43
Examples:
EU: Regulation of the prices of mobile roaming
CZ: Rent control
Instrument: Intervention purchases and sales:
44
Tax Incidence
45
Elastic Demand:
46
Inelastic demand
Assume that the demand for fuel can be described as 𝑃 = 30 − 2𝑄 and the supply for fuel can be
described as 𝑃 = 10 + 3𝑄. Find the equilibrium price and quantity. Then the government imposes a
tax on fuel of CZK 12 per litre. Compute the new equilibrium price and quantity and find out how the
tax falls upon consumers and how it falls upon producers.
The equilibrium before imposing the tax is
30 − 2𝑄 = 10 + 3𝑄
20 = 5𝑄
𝑄=4
𝑃 = 10 + 3 ∙ 4 = 22
The tax on a good shifts the supply curve up by the tax. The new supply will therefore be
𝑃 = 22 + 3𝑄
The new equilibrium will be
30 − 2𝑄 = 22 + 3𝑄
47
8 = 5𝑄
𝑄 = 1.6
𝑃 = 22 + 3 ∙ 1.6 = 26.8
The price has been increased from 22 to 26.8 – by 4.8. Of CZK 12 the amount of 4.8 falls upon
consumers, the rest 7.2 falls upon producers.
Lesson 6: Income, Goods, and Tastes, and Fashion
Substitutes and Complements. Normal and Inferior Goods.
The law of demand as we learned in the previous lesson stated that people buy more of a good when
its price decreases and less when its price increases provided that other things are equal. But other
things are not usually equal. It can happen that you decrease the price of your product and find that
the quantity demanded has decreased instead of increased.
Does it mean that the law of demand does not work? No, it does work. It only means that the
increased implied by the law of demand was outdone by other factors.
The other factor can move the whole demand or change its slope and elasticity. The parameters of
the demand are never constant.
So what are the factors that determine the position and the shape of the demand function?
They are mainly the income, the prices of other goods, and the tastes of consumers.
Income, normal and inferior goods
An increase in the income normally shifts the demand to the right: The more money we make the
more of a thing we want at given prices.
This however doesn’t work for all goods. There are goods that you demand more if your income goes
down. We call these goods the inferior goods.
Examples include second hand clothes, cheap salami, holidays at domestic campsites.
Prices of other goods
If other goods become cheaper or expensive the demand for our good can increase or decrease. Any
two goods can be substitutes, complements or independent.
Example
Ski Rental and Ski Lift are complements. Ski rent costs CZK 200 per day and Ski lift costs 400 per day.
Your budget is CZK 1200 for how many days should you rent ski and for how many days should you
buy tickets to the lift?
Solution
Your budget constraint is
48
1200 = 200𝑥 + 400𝑦
where 𝑥 is the number of days of ski rental and 𝑦 is the number of days of the ski lift. The goods are
complements that you consume at the ratio 1:1, therefore at 𝑥 = 𝑦
1200 = 200𝑥 + 400𝑥
𝑥=2
Example
Car hire and petrol are complements. Car hire costs CZK 5 per kilometre. Fuel consumption of the car
is 10 litres per 100 km. The price of fuel is CZK 35 per litre. Your budget for the weekend trip is CZK
2000. How many kilometres should you drive and how many litres of fuel should you buy?
Solution
Your budget constraint is
2000 = 5𝑥 + 35𝑦
where 𝑥 is the number of kilometres for which you will rent the car and 𝑦 is the number of litres of
fuel. You need 10 litres per 100 km so that you need 0.1 litre per 1 km. The goods are complements
that you must consume in the ratio 1:0.1, the number of litres must be one tenth of the number of
kilometres 𝑦 = 0.1𝑥
2000 = 5𝑥 + 35 ∙ 0.1𝑥 = 8.5𝑥
𝑥 = 235.3
𝑦 = 23.53
You should buy 23.53 litre and drive 235.3 km.
Master’s Extension: Black Markets
Black Market. Enforcement.
Some goods, like marihuana, are illegal. It does not mean that they are not supplied and demanded.
Then there exists a black market. If something is illegal it means that there are additional costs – the
risk premium that the suppliers require as they face the risk of being caught and punished plus costs
to prevent the police to get you, like the usage of false identities. The higher costs push the supply up
and the increased supply push the price up. The risk premium and other costs work as a tax.
Laffer Curve
Theory
Laffer Curve, named after American economist Arthur Laffer (see box) illustrates a relation between
tax revenues (dependent variable) and the tax rate. Tax revenues grow at decreasing incerases with
49
each increase in the tax rate. At some tax rate the tax revenues cease to grow and any further
increase in the tax rate translates into a decrease in the tax revenues.
This has several reasons:
1) Taxes tend to increase the prices of goods. Because of the law of demand the quantity demanded
of a good therefore decreases with an increase in the tax. If the relative increase in the rate is lower
than the relative decrease in the quantity demanded, the total of the tax revenues decreases.
2) Taxes can be avoided or evaded. The higher is the tax rate, the higher is the incentive of the
taxpayer to avoid the tax. This reduces the tax base.
3) Taxes distort markets nad thus make consumers to allocate scarse means to suboptimal uses. This
slows down economic growth and reduces the tax base even further.
The maximum of the curve represents the rate of tax at which the tax revenues are maximized. It
would be a mistake to call this point the „optimum“. It can be the optimum from the point of view of
the ministry of finance however from the taxpayer’s point of view it is the poit at which he pays the
most to the government.
Definition
Laffer curve shows the relationship between the tax revenue collected by the government
and the tax rates. The increases in the tax revenues are smaller with each increase in the
tax rate and from a certain point they are negative.
Graph
50
Arthur Laffer. American economist. Born 1940. 1981-1989 advisor to president Ronald
Reagan. Laffer has coined the notion of the „supply side economics“, a school of
macroeconomic thought that argues that overall economic well-being is maximized by
lowering the barriers to producing goods and services. It was a reaction to the Keynesian
call for the stimulation of the aggregate demand by the government and the central bank
activism.
Example – Laffer Curve
Assume that the demand for fuel can be described as 𝑃 = 30 − 2𝑄 and the supply for fuel can be
described as 𝑃 = 10 + 3𝑄 + 𝑇
Find the tax revenues maximizing rate of tax.
Solution:
First find the equilibrium 𝑄
51
30 − 2𝑄 = 10 + 3𝑄 + 𝑇
5𝑄 = 20 − 𝑇
1
𝑄 =4− 𝑇
5
Tax revenues is the product of the tax rate 𝑇 and of the quantity demanded 𝑄. Therefore
1
𝑇 ∙ 𝑄 = 4𝑇 − 𝑇 2
5
To find at what 𝑄 the function has the maximum we can differentiate the equation and put the
derivative equal to zero.
𝑑𝑇𝑄
2
=4+ 𝑇 = 0
𝑑𝑄
5
𝑇 = 10
The tax maximizing rate of the tax is 10.
At what rate the revenues will be at zero?
1
𝑇 ∙ 𝑄 = 4𝑇 − 𝑇 2 = 0
5
1
We can divide both sides of the equation by 5 𝑇 and we get
20 − 𝑇 = 0
What will be the total tax revenue?
1
Total tax revenues are 𝑇 ∙ 𝑄. 𝑄 = 4 − 5 𝑇 . At 𝑇 = 10 we find that 𝑄 = 2. Therefore the maximum
tax revenue 𝑇 ∙ 𝑄 is 20.
52
Questions:
1. The dependent variable in the Laffer curve is
a) Tax revenues
b) Tax rates
c ) Quantity demanded of a good
2. As the tax rate increases
a) Tax revenues always decrease
b) Tax revenues always increase
c) Tax revenues first increase and then decrease
3. The Laffer curve is
a) concave
b) convex
c) It is first concave and then convex
Lesson 7: Loans Market
Demand for Loans. Supply of Loans. Interest Rate. Yield to Maturity.
53
Money can be lent and borrowed. The price of lending and borrowing money is called the interest.
The interest rate is the percentage of the amount lent paid by the borrower to the lender for one
year. If money is lent and borrowed for a period of 𝑛 years a compound interest must be counted.
𝑃𝑉 =
𝑉𝑛
(1 + 𝑖)𝑛
wehere 𝑉𝑛 is the amount paid in the 𝑛th year and 𝑃𝑉 is the present value of your investment (the
amount invested at the present time).
Example
How much money will you get after one year if you lend 100 CZK at the interest rate of 3 %?
𝑉1 = 100 000 ∙ (1 + 0.03)1 = 103 000
Example
How much money will you get in half a year if you lend CZK 100 000 at the annual interest rate of 5
%?
𝑉0.5 = 100 000 ∙ (1 + 0.05)0.5 = 102 469
Example
How much money do you need to lend today at the annual interest rate of 5 % if you want to get CZK
500 000 in 10 years?
𝑃𝑉 =
500 000
= 306 956
(1 + 0.05)10
The nominal versus the real interest rate
The nominal interest rate tells us what will be the percentage increase in the volume of money we
get back in the future in comparison with how much money we lend today.
The real interest rate tells us what will be the percentage increase in the volume of goods that we
well be able to buy in the future in comparison with what we could buy for money we lend today.
(1 + 𝑖𝑟 ) =
(1 + 𝑖)
(1 + 𝜋)
where 𝜋 is the percentage increase in the price of goods you buy.
Assume that you have CZK 100 000. You can either spend it now or you can lend the money at the
nominal interest rate 5 %. The inflation rate or the percentage increase in the prices of goods that
you buy is 2 %. What will be your real interest rate?
Assume that the price of goods you buy is CZK 100. If you spent your CZK 100 000 today you would
be able to buy 1000 goods. If you lend CZK 100 000 at the nominal interest rate of 5 % so that you
54
will have CZK 105 000 and the price of goods will go up to 102, you will be able to buy 1029,4 goods,
or 2,94 % more. The real interest rate is 2,94 %.
Volume of money lent and borrowed depends on the interest rate. The demand for loans is
sometimes called the investment curve and the supply of loans is sometimes called the savings curve.
According to the law of demand if something is more expensive we well demand less of it. Therefore
at higher interest rate people will demand less money on loans. According to the law of supply
people tend to supply more of something if it is more expensive. Therefore people will supply more
loans in the market if interest rates are high.
There is always one interest rate at which the volume of money to be lent and borrowed is equal.
Master’s Extension: Pareto Efficiency of a Loan
The present value of an investment is the sum of the present values of all future payments.
𝑃𝑉 =
𝑉1
𝑉2
𝑉𝑛
+
+ ⋯+
2
(1 + 𝑖) (1 + 𝑖)
(1 + 𝑖)𝑛
This formula can be typically used for the calculation of the present value of a bond that will pay
annual interest payments 𝑉1 to 𝑉𝑛−1 in the years 1 to 𝑛, and the principal amount 𝑉𝑛 in the year 𝑛.
55
What if we know the present value (the market price of a bond) and need to calculate the yield to
maturity? The following formula can be used.
𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝑉𝑎𝑙𝑢𝑒−𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐𝑒
𝑌𝑇𝑀 ≅
𝐴𝑛𝑛𝑢𝑎𝑙 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 + 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑦𝑒𝑎𝑟𝑠 𝑡𝑜 𝑚𝑎𝑡𝑢𝑟𝑖𝑡𝑦
0.5(𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝑉𝑎𝑙𝑢𝑒 + 𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐𝑒)
Example:
Compute the approximate yield to maturity of a bond with nominal value of EUR 1000, annual
interest rate 5% (i.e. annual payment of EUR 50), and maturity of 6 years.
Solution:
𝑌𝑇𝑀 ≅
50 +
1000−990
6
0.5(1000 + 990)
=
50 +
10
6
0.5 ∙ 1990
=
50 +
10
6
0.5 ∙ 1990
=
51.67
= 5.19%
995
Marginal yield of investment is decreasing. People have investment opportunities and they invest
first in opportunities with highest yield. In practice it is not smoothly decreasing. Assume that your
budget for investments is 100 000. You decide to invest first 50 000 in your education where you
expect yield of 45 % as your investment will increase your salaries in the future. You invest your next
10 000 in getting the driving licence where you expect yield of 30 %. You invest your next 20 000 in
your pension plan with tax allowance which turns into yield of 8 %. You deposit your remaining 20
000 on a savings account where you expect yield of 3 %.
Marginal yield
50%
45%
40%
35%
30%
25%
20%
15%
10%
5%
1
5
9
13
17
21
25
29
33
37
41
45
49
53
57
61
65
69
73
77
81
85
89
93
97
0%
Assume two persons each having decreasing marginal yield of capital investment. Person A
(depicted from the left and on the left axis) has investment budget Y1 and the person B (depicted
from the right and on the right axis) has investment budget Y2.
If person 1 had more money
56
Lesson 8: Market Models
Competition. Price taking. Price making. Perfect Competition. Monopolist Competition. Oligopoly.
Monopoly.
Competition is a process in which firms compete for the money of consumers through offering them
goods and services of various qualities and at various prices to maximize the profits. In this process
firms that are not able to satisfy the needs of consumers at acceptable costs leave the market and
new producers who believe that they are able to satisfy the needs of consumers at acceptable costs
enter the market. Competition is a dynamic process in which the players come and leave and the
products come and leave.
There are products that prevail for centuries, such as a loaf of bread, and products that exist weeks
or years. There are products that are in the market for decades but are under permanent innovation
– such as computers or cars. Gramophones and typewriters are not offered in the market any more,
and new products such as eBook readers are provided. Some companies go bankrupt after several
month of existence some exist for decades.
Creative Destruction
Schumpeter
To survive and to prosper in this competition firms must permanently improve their products and
their production processes to minimize costs. Permanent innovation is core of the competition
process.
Even if there is only one firm offering a particular product it must compete with producers of other
things for the consumers’ money.
Market models
57
Firms behave differently if there are many competitors in the market or if there are only few, if they
produce identical or different products in comparison with their competitors.
If the competition is strong – if many producers supply identical products the price is determined in
the market usually in stock exchanges. Firms are price takers –they take the price as it is determined
in the market. The demand for the production of each individual firm is flat – it’s absolutely elastic. If
the firm increased its price it would lose all customers.
If the competition is not that strong, if there are not so many firms and each offers products that are
different to some extent from what the competitors do, than firms are price makers. They have the
power to determine their own price. The demand for the production of each individual firm is
decreasing – it has normal elasticity and if the firm increased its price it would lose some customers
but not all of them.
To analyze how firms behave we can categorize them into several groups according to the strength
of the competition. We distinguish several “market models”:
1)
2)
3)
4)
Perfect competition
Monopolist Competition
Oligopoly
Monopoly
Remember that these models try to describe the reality and we do not try to say that any of them is
superior. Their names as they are commonly used in economics may be misleading.
Perfect competition
There are many producers and none of them is able to influence the market price. Everyone is too
small to be able to influence the market price by its own supply which is only a fraction of the whole
market supply. All of them produce identical good, i.e. a homogenous product. For these reasons the
demand for the production of each individual firm is absolutely elastic. It is easy to enter and to leave
the market. The firm is a price taker. At the market price they are able to sell any volume of
production – so that they tend to supply the quantity up to the point where the marginal costs match
the price taken from the market. Despite the name be aware that it is no ideal. No one would be
happy is all meals available were identical burgers, if all T-shirts and cars and apartments were the
same.
This model applies only to limited goods, mostly commodities whose price is determined in
commodity or stock exchanges. Typical examples of firms that fit to the perfect competition model
are farmers who produce wheat, corn or milk. If you want to produce wheat or milk it is easy. You
don’t need schools to do it you don’t need special permission and licences. You can hire a land
tomorrow, seed it and you can have wheat next year. If you wanted to produce milk you would be
probably able to buy a cow and to hire a piece of land tomorrow after a 30 minute searching on the
internet, wouldn’t you?
Another example is securities. If you own a share or a bond of a company listed in a stock exchange
you must accept the price determined in the market and you cannot argue that your particular share
is better than the shares supplied by others.
58
Monopolist competition
In the monopolist competition there are many firms in the market but they don’t produce absolutely
identical products. The demand for the production of each firm is decreasing. It means that the firm
is price maker – it determines its own price. If it increases the price it will sell more. Whether the
revenues increase or decrease depend on the elasticity of demand. The entry into business is not as
easy as in the perfect competition but is still relatively easy. Buyers have some cost if they want to
change their suppliers.
Example is restaurants. Many people are able to open their own restaurant although it lasts and it is
necessary to overcome some obstacles. Each restaurant offers meals and drinks but they can differ in
quality, location, they can provide Wi-Fi or free parking or not, the waiters can be nice or not etc.
Another example is petrol stations. They all provide identical petrol however the product differs in
location, whether they have a shop, toilets etc.
You can recognize that it is not the perfect competition if you observe different prices. Why this
restaurant or that petrol station can charge more than others? It is because their products are more
attractive to customers. There are also some costs for customers if they want to change the supplier.
If your favourite restaurant or petrol station has closed or if they have upset you will have to bear
additional cost if you will have to visit a restaurant or a petrol station more remote.
Oligopoly
Oligopoly is a situation in the market where there are few suppliers due to high barriers to entry to
the business. This may be caused by high investment cost or by legal barriers.
Examples are banks, mobile operators, or automobile factories.
One would think that it is easy to establish a bank – you need a website, agreements with other
banks to transfer money from bank to bank. But banks are required to have at least CZK 500 million
of capital. Not everybody has so much money. Mobile operators need frequencies that they must
usually buy from governments. They also need to operate thousands of transmitters. The fixed cost is
high in this business. If you want to start a car factory you also need to invest a lot to design, motor
and pressers.
The products of all companies differ. Banks have similar but different services. Mobile operators have
different number of clients – and calling to clients of the same operator is usually cheaper. They have
different coverage of the territory by signal. Cars are similar but they differ in design, consumption of
fuel noise etc.
Therefore the demand for the production of each firm is decreasing. It means that the firm is price
maker – it determines its own price. If it increases the price it will sell more. Whether the revenues
increase or decrease depend on the elasticity of demand.
Monopoly
Monopoly means that only one firm operates in the market. The demand for the production of this
firm is therefore identical with the market demand.
59
There are several causes of this situation. According to causes we distinguish:
A monopoly due to ownership of a unique factor of production
A monopoly due to unique innovation
A natural monopoly
A legislative monopoly
Revenues
The main difference between the perfect competition on the one hand and the other models on the
other hand is in the demand for the production of the firm.
In the perfect competition the demand is flat, in the other models it is normally decreasing. This has
a consequence for the revenues.
The total revenues is the product of the price the firm charges and the quantity of goods it sells.
𝑇𝑅 = 𝑃 ∙ 𝑄
In the perfect competition the total revenues grow linearly to infinity. In the other models the total
revenues.
60
In all cases the total costs increase with the increasing production. The profit is maximized at
different quantities for the firm in the perfect competition and for the firm in the other models.
Profit maximization
We assume that firms tend to maximize their profit. The volume of their production will therefore be
such 𝑄, where the positive difference between total revenues and total costs is maximized:
61
𝑇𝑅 − 𝑇𝐶 = 𝑚𝑎𝑥
Mathematically a function has its maximum where its tangent line is flat – where it has its slope
equal to zero. The slope of a function is its derivative. The derivative of the Total revenues function is
the Marginal revenues function. The derivative of the Total cost function is the Marginal cost
function. The derivative of a difference of two functions is the difference of their derivatives. The
profit is therefore maximized where
𝑑(𝑇𝑅 − 𝑇𝐶)
=0
𝑑𝑄
𝑑𝑇𝑅 𝑑𝑇𝐶
−
=0
𝑑𝑄
𝑑𝑄
𝑀𝑅 − 𝑀𝐶 = 0
or where
𝑀𝑅 = 𝑀𝐶
Graphically, the firm’s optimum is where the tangent lines to the Total revenues function and to the
Total cost function are parallel, i.e. have identical slope.
Example
The demand for the production of a firm can be described as P=10. What market model applies to
this situation?
Answer
If the demand is flat (constant) it must be the perfect competition
Example
Assume that Total Revenue can be described as 𝑇𝑅 = 10𝑄 and Total cost can be described as 𝑇𝐶 =
5 + 0.1𝑄 2. Find the Profit function and find its maximum.
Solution
𝑃𝑟𝑜𝑓𝑖𝑡 = 𝑇𝑅 − 𝑇𝐶 = 10𝑄 − 5 − 0.1𝑄 2
Maximum of the Profit function is where its derivative equals zero:
𝑑(10𝑄 − 5 − 0.1𝑄 2 )
=0
𝑑𝑄
10 − 0.2𝑄 = 0
10 = 0.2𝑄
𝑄 = 50
62
Master’s Extension:
Game Theory. Cooperation. Prisoner’s Dilemma. Cartel.
People cooperate – they make contracts – to increase their well-being. A contract is a promise of
contracting parties to fulfil obligations. Breaking a contract involves a penalty imposed eventually by
court. There are many situations in which contracts are not enforceable by courts: Illegal contracts
(such as collusions or sale of illegal goods and services) or informal contracts that lack a written proof
or a witness.
In these cases people are tempted to break the contract if they can get better off after breaking.
Each contracting party then takes into account consideration of what the other party may do.
Situations like this can be described by the Game Theory, namely by the Prisoner’s dilemma model
game. Each contracting party can either keep the contract or to break it. In the language of the game
theory keeping the contract is called cooperation and breaking the contract is called defection. The
decision of each party whether to cooperate or to defect depends on whether the other party might
cooperate or defect. If a party can be better off if he defects if the other party both cooperates or
defects the decision will definitely be to defect. If a party can be better off if he cooperates
regardless if the other party cooperates or defects the decision will definitely be to cooperate. In
these cases the decision is dominant solution. If the dominant solution gives a result that is worse
for both parties in comparison with other solutions the solution is called the Nash Equilibrium.
The set of possible solutions is called the payoff matrix.
Especially if there is no opportunity to repeat the game (non cooperative games) the player can end
up in the Nash Equilibrium. If games can be repeated the players can benefit from cooperation.
Prisoner’s Dilemma
Two men are arrested, but the police do not have enough information for a conviction. The police
separate the two men, and offer both the same deal: if one testifies against his partner
(defects/betrays), and the other remains silent (cooperates with/assists his partner), the betrayer
goes free and the one that remains silent gets a five-year sentence. If both remain silent, both are
sentenced to only one year in jail on a minor charge. If each ‘rats out’ the other, each receives a
three-year sentence. Each prisoner must choose either to betray or remain silent; the decision of
each is kept secret from his partner. The optimal decision for each is to betray the other, even
though they would be better off if they both cooperated.
If there is a chance that non-cooperation can be revenged (a repeated game), prisoners will probably
cooperate.
Payoff Matrix: Number of years in prison
Cooperate (remain silent)
Defect (betray)
63
Cooperate (remain silent)
1, 1
5, 0
Defect (betray)
0, 5
3, 3
Payoff Matrix: Profit of a Cartel
Major producers of oil make a cartel agreement – they both will decrease production and thus
increase the market price of oil. If they cooperate they both will make big profits (3). If they defect
they will have normal profits (1). If one defects and the other one cooperates the one who defects
has a superbig profit (5) and who cooperates has nothing (0). Since it is not possible to control
whether the other party defects or not and the agreement is not enforceable, they will end up
defect.
Cooperate
Defect
Cooperate
3, 3
0, 5
Defect
5, 0
1, 1
Payoff Matrix: Utility
Drivers pass by either with low beam lights or with high beam lights. They can make an informal
agreement to turn the lights to the low beam - by blinking the lights and accepting the offer. This
agreement is not enforceable. They will see normally (3) if they have both a low beam. If one has the
high beam while the other one has the low beam, the high beam sees well (5) and the low beam sees
almost nothing (0). If both have the high beam, both are dazzled and see badly (1).
64
Cooperate
Defect
Cooperate
3, 3
0, 5
Defect
5, 0
1, 1
Lesson 9: Profit maximization in the short run
Total Revenues. Marginal Revenues. Total Costs. Marginal Costs. Profit. Shutdown Point
Example
A girl sells matches in the street. She can buy a matchbox in
a nearby supermarket for CZK 1. She has no fixed costs. The
demand for matches is estimated as 𝑃 = 5 − 0.1𝑄
For how much should she sell the matchboxes if she wants
to maximize her profit?
Solution:
Profit is maximized at 𝑀𝐶 = 𝑀𝑅. Remind the rule that 𝑀𝑅
decreases twice as fast as the demand so that 𝑀𝑅 = 5 −
0.2𝑄. Alternatively you can derive 𝑀𝑅 from total revenues.
Total revenues are 𝑇𝑅 = 𝑃 ∙ 𝑄 . From the demand
equation 𝑃 = 5 − 0.1𝑄 get 𝑇𝑅 = 5𝑄 − 0.1𝑄 2. Get the 𝑀𝑅 by differentiating 𝑇𝑅:
𝑀𝑅 =
𝑑𝑇𝑅
= 5 − 0.2𝑄
𝑑𝑄
65
Then find 𝑄 for which 𝑀𝑅 = 𝑀𝐶:
5 − 0.2𝑄 = 1
From which we get 𝑄 = 20
Finally we must find 𝑃 at which she sells 20 matchboxes. For this we must put 20 to the demand
function:
𝑃 = 5 − 0.1 ∙ 20 = 3
She should sell matchboxes at CZK 3.
What will be her profit? Her total revenues are 𝑃 ∙ 𝑄 = 3 ∙ 20 = 60. Her total cost is CZK 1 per a box,
there are no fixed costs. Her total costs are therefore CZK 20. The profit is the difference between
total revenues and total cost, that is CZK 40.
Alternative solution
Total revenues is 𝑃 = 5 − 0.1𝑄 multiplied by 𝑄:
𝑇𝑅 = 5𝑄 − 0.1 ∙ 𝑄 2
Total costs can be got by anti-differentiating the marginal costs: 𝑇𝐶 = 1 ∙ 𝑄
The profit is is the difference between total revenues and total costs
𝑇𝑅 − 𝑇𝐶 = 5𝑄 − 0.1 ∙ 𝑄 2 − 𝑄 = 4𝑄 − 0.1 ∙ 𝑄 2
The maximum of the profit function is where its derivative equals zero.
𝑑(𝑇𝑅 − 𝑇𝐶)
= 4 − 0.2𝑄 = 0
𝑑𝑄
which is for 𝑄 = 20
66
Perfect competition
Farmer produces milk. The market price at which he sells each litre is CZK 18. His marginal cost is
𝑀𝐶 = 6 + 0.0003 ∙ 𝑄 2
67
How much milk should he produce and what will be his profit? His fixed cost is CZK 100.
Solution:
Profit is maximized at 𝑀𝑅 = 𝑀𝐶 . Because 𝑀𝑅 = 18 the optimum is
18 = 4 + 0.0003 ∙ 𝑄 2
40000 = 𝑄 2
𝑄 = 200
His total revenues are 200 times 18, CZK 3600.
What are his total costs?
We can integrate MC to get TC
𝑇𝐶 = 6𝑄 + 0.0001 ∙ 𝑄 3 + 𝐹𝐶
𝑇𝐶 = 1200 + 800 + 10 = 2010
His profit 𝑇𝑅 − 𝑇𝐶 is 3600 − 2010 = 𝐶𝑍𝐾 1590
Monopolist competition
Operator of vending machines has fixed costs for rental, electricity and
maintenance
𝐹𝐶 = 100 per day. His marginal cost (the wholesale price of a bottle of
coke) is constant at CZK 12 per bottle.
The demand for coke from the vending machine is
𝑃 = 50 − 0,5𝑄
At what price should the operator sell his coke if he wants to maximize
his profit?
𝑀𝐶 = 𝑀𝑅
12 = 50 − 𝑄
𝑄 = 38
At which price will he sell 38 bottles?
𝑃 = 50 − 0,5𝑄
𝑃 = 50 − 0,5 ∙ 38 = 31
Master’s Extension: Price Discrimination
68
I.
In first degree price discrimination, price varies by customer's willingness or ability to pay (Valuebased pricing). This arises from the fact that the value of goods is subjective. A customer with low
price elasticity is less deterred by a higher price than a customer with high price elasticity of demand.
From a social welfare perspective though, first degree price discrimination is not necessarily
undesirable. That is, the market is still entirely efficient and there is no deadweight loss to society. In
a market with first degree price discrimination, the seller simply captures all surplus.
II.
In second degree price discrimination, price varies according to quantity sold. Larger quantities are
available at a lower unit price. This is particularly widespread in sales to industrial customers, where
bulk buyers enjoy higher discounts. Sellers are not able to differentiate between different types of
consumers. Example: „Buy 3 for the price of 2“
III.
In third degree price discrimination, price varies by attributes such as location or by customer
segment, or in the most extreme case, by the individual customer's identity; where the attribute in
question is used as a proxy for ability/willingness to pay. Examples of this differentiation are student
or senior discounts. Extreme case is when a seller bargains with each customer individually.
Lesson 10: Production Function
Production Function. Isocost. Isoquant. Marginal Rate of Technical Substitution.
Master’s Extension:
Lesson 11: General Equilibrium
Edgeworth Box. Contract Curve
Master’s Extension: Production Possibilities Frontier
Oligopoly with Competitive Fringe.
69
Part B: Macroeconomics
Lesson 1: Price Level
Price level. Inflation. Deflation. Disinflation. Hyperinflation. Purchasing Power of Money.
Consumer Price Index.
The price level is the general level of prices. It is the average price in the economy. It is the weighted
arithmetic average of the prices of all individual goods in the economy.
𝑃 = 𝑝1 ∙ 𝑤1 + 𝑝2 ∙ 𝑤2 + ⋯ + 𝑝𝑛 ∙ 𝑤𝑛
where 𝑝1 … 𝑝𝑛 represent the prices of 𝑛 individual goods and the weights 𝑤1 … 𝑤𝑛 represent the
relative importance of the goods (i.e. how much people relatively spend for that good).
𝑤𝑥 =
𝑝𝑥 ∗ 𝑞𝑥
∑ 𝑞𝑛 ∗ 𝑞𝑛
whereas 𝑞1 … 𝑞𝑛 are quantities of individual goods. The sum of all weights is one.
The price level, the average price is the price of a composite good – a supergood that includes a bit
of everything - all goods in the economy in quantities relative to their importance.
Example
Assume a simplified economy that produces only 2 goods, beer and bread. One beer costs CZK 25
and one loaf of bread costs CZK 50. People buy 24 beers and 8 loafs of bread, so that the weight of
25∗24
beer is 25∗24+50∗8 = 60 % and the weight of bread is
50∗8
25∗24+50∗8
= 40 %. The sum of all weights is
1=100 %.
The average price is 𝑃 = 25 ∙ 0.60 + 50 ∙ 0.40 = 35 The average price is the price of a basket
consisting of 0.60 beer and 0.40 loaf of bread. Put 0.60 beer and 0.40 loafs of bread together and you
have the composite good.
It is a package, a basket that consists of 0.60 beers and 0.40 loafs of bread. In our example the
package costs CZK 35 and the economy therefore produces equivalent of 28,57 such packages.
Example
70
Assume that we have three items in our basket. First, a bottle of water which costs 15 crowns, a car
that costs 100 000 crowns, and a pair of shoes which costs 1000 crowns. People buy 1 million bottles
of water, 100 cars, and 50 thousand shoes. What is the price level?
Answer: Our spending on water is 15 million, on cars it is 10 million, and on shoes it is 50 million. The
total spending is therefore 75 million. The average price is 𝑃 = 15 ∙ 0.2 + 100 000 ∙ 0.133 + 1000 ∙
0.666 = 13 963
In reality, there are probably millions of goods. Practically it is difficult to measure all prices and
quantities of all goods. Statisticians therefore measure the average price of only a limited number of
items, usually of only about one thousand of them. Such a basket of about 1000 goods is called the
Consumer Price Index (CPI).
For example, in the Czech Republic the CPI includes 1000 items.
Inflation
The rate of inflation, shortly inflation, is the relative change in the price level.
𝑃
𝑃% = 𝑃1 − 1
0
where 𝑃1 is the price level in time 1 and 𝑃0 is the price level in time 0. Inflation is positive if the price
level increases and negative if the price level decreases.
If the price level goes from 10 to 12 the rate of inflation is 20 %.
If inflation is negative it is called deflation. If the rate of inflation is decreasing it is called disinflation.
Mathematical note:
Percentages are fractions of the total of 100. One per cent is one hundredth part.
Percentage form
0%
1%
10%
50%
100%
200%
Decimal form
0.00
0.01
0.10
0.50
1.00
2.00
Fraction form
0/100
1/100
10/100
50/100
100/100
200/100
71
5
100%
4.5
acceleration of
inflation to 30 %
4
3.5
deflation
10 %
steady
inflation
10 %
3
2.5
75%
50%
Disinflation
to zero
2
25%
1.5
1
0%
0.5
0
-25%
1
2
3
4
5
6
7
8
9
10
11
12
13
As the picture below shows, in 20 years from the creation of the Czech Republic, the price level has
grown by 150 % (i.e. it is 2.5 as big as 20 years ago). This huge increase was caused by inflation which
was on average less than 5 % per year. It show that even a relatively low rate of inflation leads to a
significant depreciation of money. Assume a 5 year old child that saved a CZK 5 coin. Then he could
buy a loaf of bread for it but he decided to save it. Now he has grown to a 24 year old student. He
today finds his old coin. He finds that today he can buy hardly 3 rolls for it.
Cause of inflation
Why does the price usually grow up? We will deal with this question later, for now we will only
remember famous sentence by Milton Friedman, that “Inflation is always and everywhere a
monetary phenomenon.” The inflation is usually the consequence of increasing of the money stock by
the government or its central bank.
If you pour more water in a bucket the water level grows. If someone pours more money in the
economy the price level grows.
Picture: Evolution of inflation and of the price level from 1993
72
2.6
160%
2.4
140%
2.2
120%
2.0
100%
1.8
80%
Míra inflace (pravá osa)
1.6
60%
Index 1992=100% (levá osa)
40%
1.2
20%
1.0
0%
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
1.4
If only low inflation can more than double the price level in 20 years what then about high rates of
inflation?
The extreme consequence of printing money is hyperinflation.
Example of hyperinflation is the situation in Argentina in 1980s. In 1981 prices went up by 131 %,
which means that the prices more than doubled in comparison with 1980. In 1981 prices went up by
209 %, to a level more than seven times as big as in 1980. (A thing that cost 100 pesos in 1980 cost
131 % more, 231 pesos in 1981, more than twice as more. Then prices went up by 209 % so that
thing that cost 231 pesos in 1981 cost 714 pesos in 1982. It is more than seven times as big as in
1980.) Then in 1983 the rate of inflation was 434 %. It meant that prices reached 38 times their level
of 1980 (2.31 x 3.09 x 5.34). When the inflation rate in 1989 reached 4923 %, prices were 1 790 968
times as big as in 1980. In 1990 prices were 25 million bigger than in 1980. All this was done with the
average rate of inflation of 876 % within ten years.
Picture: Hyperinflation in Argentina: Annual inflation rate and the Price level (1980=100%)
73
30,000,000
6000%
25,000,000
5000%
Míra inflace (pravá osa)
20,000,000
4000%
Index 1980=100% (levá osa)
15,000,000
3000%
10,000,000
2000%
5,000,000
1000%
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
0%
1980
0
Exercise:
How many times will the price level grow in 10 years if there is the annual inflation rate of 100 % (i.e.
prices double each year)? What will be the per cent increase in the price level?
Solution
𝑋 = (1 + 𝑃%)𝑛 = (1 + 1)10 = 210 = 1024
In ten years prices will be more than 1000 times as big. What cost 1 peso will cost 1024 pesos. The
price level will increase by 102,300 %. (100 % increase from 1 is in increase by 1 to 2. A 1000 %
increase from 1 is an increase by 10 to 11. A 100,000 % increase from 1 is an increase by 1000 to
1001. A 102,300 % increase from 1 is an increase by 1023 to 1024.)
Exercise:
Compute the CPI if it includes only 3 items: 1) beer, 2) sending a text message, and 3) a bottle of
coke. The price of one beer is CZK 25, the price of sending one text message is CZK 1, and the price of
a bottle of coke is CZK 25. The consumers consume per year 100 beers, send out 500 text messages,
and buy 400 bottles of coke. Compute the price level.
Anticipation of inflation
People make their expectations about the future inflation. Whether we expect low or high inflation is
important for our investment decisions. If you expect low inflation you can decide to save your
wealth in the form of cash. If you expect high inflation you can decide to protect yourself from
inflation by investing into alternative assets such as arts, commodities, other currencies, real estates,
etc.
In our expectations we can trust estimates of other people – central bank’s or government’s
predictions, expectations of independent analysts, or we can derive our own expectation
independent of the estimates of others.
74
We usually estimate the future inflation upon the past inflation. If the inflation was 3 % last year we
can trust that it can be again about 3 % in the forthcoming year. If the inflation rate was decreasing in
the past three years from 6 % to 5 % and to 4 % we can believe that it will be at about 3 % next year.
But we can never be sure.
If the expectation is not met – i.e. if the inflation is different from what we had expected – we speak
of unanticipated inflation.
Purchasing power of money
The purchasing power of money is the volume of things that we can buy for a unit of money.
Assume that you have one dollar and that one hamburger costs 1 dollar. We can say that the
purchasing power of one dollar is one hamburger. One dollar buys you one hamburger. What if the
price of the hamburger doubles to two dollars? The purchasing power of one dollar goes down. One
dollar now buys you just half a hamburger. The dollar depreciates in terms of goods it can buy.
1
Purchasing power of money 𝑃𝑃 = 𝑃 is the inverse function of the price level.
𝑃𝑃 =
1
𝑃
While the prices of all other goods are expressed in terms of money that we must spend on it, the
purchasing power of money is expressed in terms of things that we can get for it.
If the price of a roll increases from CZK 1 to CZK 2, the purchasing power of money decreases from 1
roll to half a roll. Generally speaking, if the price level doubles, the purchasing power decreases to a
half. If the price level triples, the purchasing power goes to one third.
11
10
9
7
6
5
4
3
2
1
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1
1.1
1.2
1.3
1.4
1.5
1.6
1.7
1.8
1.9
2
2.1
2.2
2.3
2.4
Purchasing power
8
Price Level
75
What is the relation between the relative change in the purchasing power and inflation?
1 + 𝑃𝑃% =
1
1 + 𝑃%
or
𝑃𝑃% =
1
−1
1 + 𝑃%
where 𝑃𝑃% is the relative change in the purchasing power and 𝑃% is the relative change in the price
level, i.e. the rate of inflation.
If the inflation rate is 100 %, money loses half of its value. If the inflation rate is 300 %, money loses ¾
of its value. If there is deflation of 50 %, the value of money increases by 100 %.
Depreciation / Appreciation rate (PP%)
125%
100%
75%
50%
25%
0%
-25%
-50%
0%
50%
100%
150%
200%
250%
300%
-50%
-75%
-100%
Inflation rate (P%)
Example:
The inflation rate is 10 % what will be the percent change in the purchasing power?
𝑃𝑃% =
1
− 1 = −0.909 = −9.09%
1 + 0.1
If the inflation rate is 10 % we will buy 9.09 % less for each coin and note.
Example:
Calculate the percent change in the purchasing power if the rate of inflation is 100 %.
𝑃𝑃% =
1
− 1 = −0.5 = −50%
1+1
If the inflation is 100 % we will buy half the products as before the prices increased (a decrease by 50
%).
76
Master’s Extension: Costs of Inflation and deflation
Cost of Inflation. Menu Cost. Redistribution of wealth. Expectations. Adaptive and Rational
Expectation. Sacrifice Ratio. Credit Freeze.
People usually don’t like inflation. There are many reasons why inflation is costly
•
Change in the Purchasing power
•
„Menu cost“ – cost of price changing
•
Shoe-leather costs
•
Redistribution between debtors and creditors if expectations are not met
•
Deflation costs – credit freeze
Change in the purchasing power
With inflation your money loses value. If the inflation rate is 3 %, you will see that in one year you
will buy approximately 3 % less goods for your money than what you could buy if you had not saved
it and spent it as you earned it. If the inflation rate is 100 % you will lose 50 % of the value of money.
If a meal in the school cafeteria costs CZK 100 it will cost CZK 200 in one year if the inflation rate is
100 % (see the section Purchasing power). The inflation steals wealth from you. The word inflation
means blowing up. Inflation sucks your saving off.
source: bastay.com
„Menu cost“ – the cost of price changing
The higher is the inflation rate the more often restaurants – and other businesses – must print new
pricelists, which is costly.
77
Shoe leather cost
People tend to protect themselves from inflation. They metaphorically wear off their shoes faster
and need new ones as they visit banks more often to look for alternative investments. because of
inflation people must read investment contracts and pension fund plans just to save the value of
their money.
Redistribution between debtors and creditors
People are able to adjust to inflation. Debtors and creditors can include their expectations of inflation
to the agreed interest rates.
The real interest rate represents by what percent more things you can buy for your nominal principal
and interest.
𝐼𝑅𝑟𝑒𝑎𝑙 =
1 + 𝐼𝑅𝑛𝑜𝑚𝑖𝑛𝑎𝑙
−1
1 + 𝑃%
Therefore it is possible to include the expected inflation into the nominal interest rate and the loans
market can work even in the inflationary environment.
𝐼𝑅𝑛𝑜𝑚𝑖𝑛𝑎𝑙 = (1 + 𝐼𝑅𝑟𝑒𝑎𝑙 )(1 + 𝑃%𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 )
For small rates we can say that the nominal interest rate equals approximately to the sum of the real
interest rate and the inflation.
𝐼𝑅𝑛𝑜𝑚𝑖𝑛𝑎𝑙 ≅ 𝐼𝑅𝑟𝑒𝑎𝑙 + 𝑃%𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑
The problem is when expectations are not met – if the actual inflation rate differs from expectations.
Such situation leads to the redistribution of wealth between debtors and creditors.
If the actual inflation is greater than expected than the real interest rate is less than expected which
makes the debtors better off and the creditors worse off. On the other hand if the actual inflation is
less than expected than the real interest rate is greater than expected which makes the debtors
worse off and the creditors better off.
If the inflation rate is too volatile it is difficult to make expectations. The risk that the inflation rate
will be different from expectation increases. The higher risk leads to higher interest rates and it can
deter some people from investing. The more volatile inflation rate is the more harmful it is.
Exercise
Compute the real interest rate if the nominal interest rate was 6 % and the inflation rate was 2 %.
𝐼𝑅𝑟𝑒𝑎𝑙 =
1 + 𝐼𝑅𝑛𝑜𝑚𝑖𝑛𝑎𝑙
1.06
−1 =
− 1 = 0.03921 = 3.921% ≅ 4%
1 + 𝑃%
1.02
Deflation costs
Deflation is inflation with the negative mark. It can therefore lead to similar menu costs and to the
redistribution between debtors and creditors. But deflation has one specific cost for which some
economists believe that deflation can be more dangerous than inflation.
78
As we mentioned above the nominal interest rates can be adjusted for the expected inflation rates.
Nominal interest rate are however not able to adjust to deflation which is greater than the required
real interest rate.
𝐼𝑅𝑟𝑒𝑎𝑙
𝑃%
𝐼𝑅𝑛𝑜𝑚𝑖𝑛𝑎𝑙
(approximately)
3%
10 %
13%
3%
2%
5%
3%
0%
3%
3%
-2%
1%
3%
-5%
-2% Impossible!
No one will be willing to lend CZK 100 to get just CZK 98 back after one year – it is better not to lend
your excess capital to anybody and to hold your capital fallow.
Deflation can cause a “credit freeze” – people won’t be willing to lend money, capital will remain
wasted and many investment opportunities won’t be realized and economy will slow down.
See chapter 7 on Pareto efficiency of a loan to see that if people cannot lend and borrow money a
cost of missed opportunity will arise. Deflation thus can hinder economic growth.
Modest deflation (at a rate less than the required real interest rate) is not harmful and the nominal
interest rates can be adjusted for such deflation.
Lesson 2: Aggregate Production
Gross Domestic Product. Nominal and Real Growth. Business Cycle. Unemployment. Cyclical
Unemployment
Production (𝑌), is theoretically the volume of goods that the economy as a whole produces within a
given time, typically a year. Because the production consists of millions of goods which is impossible
to sum up together – as 1 pencil is not the same volume as 1 car, we can say that 𝑌 is the number of
composite goods – uniform baskets that include all goods. 𝑌 is the number of these baskets that the
economy can produce.
This volume usually changes over time. Annual change in production (𝑌%) can be computed as
follows:
79
𝑌% =
𝑌2
−1
𝑌1
Going back to the example at the beginning of the Lesson on inflation, the production is 𝑌 = 28,57
uniform baskets of goods that include 0.6 beer and 0.4 meal each. As the package costs CZK 35 and
the economy produces 28,57 such packages, we can say that the nominal value (value in terms of
money) of the production is 35 times 28.57 (the price of the basket times the number of baskets),
that is CZK 1000.
If one year the volume of real production is 28,57 and the next year it is 30 then the annual change is
5 %. We call it a real change, or a real growth, since it reflects the change in the physical volume of
things that are produced.
Statisticians are however not able to find out how many such composite goods the economy
produces. Instead they try to find out a measure called the GDP, gross domestic product, which can
be estimated in several ways.
We can assume that the nominal value of things that people produce is identical with the volume of
money that people earn and this is equal to the volume of money that people spend.
Statisticians can ask firms what is the value of things that they have produced and sold. Or they can
ask people what is the nominal value of all incomes they have received. Or they can ask people what
is the nominal value of their spending. The number they get is called the nominal GDP.
Statisticians can however never find out exact number, they never ask all people and all producers.
They only estimate the GDP.
Income method
We can get the GDP summing up all incomes. Income is a compensation for the employment of the
factors of production. The aggregate income consists of revenues of labour (wages, salaries and
royalties), capital (dividends, interest receipts), and land (rentals).
𝐺𝐷𝑃 = 𝑤𝑎𝑔𝑒𝑠 𝑎𝑛𝑑 𝑟𝑜𝑦𝑎𝑙𝑡𝑖𝑒𝑠 + 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑎𝑛𝑑 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑒𝑐𝑒𝑖𝑝𝑡𝑠 + 𝑟𝑒𝑛𝑡𝑎𝑙𝑠
Sales of final goods are split among the owners of labour, land, and capital. All sales are in the end
someone’s income.
Assume that the economy produces 1000 things each per CZK 1. The overall sales are CZK 1000. This
amount represents not only the aggregate production, but also the aggregate income. Assume that
workers receive CZK 500 as wages. The owners of the firm and the landowners receive CZK 300. The
remaining CZK 200 is paid to the suppliers. But this amount again splits among workers, owners and
suppliers and so on. The sales equal incomes.
Sold
Incomes of workers, capitalists, and landowners
production=
1000 = 500 (wages)
300 (dividends
and rents)
80
200 
(supplies)
100 (wages)
60 (dividends
and rents)
40 
(supplies)
20 (wages)
15 (dividends
and rents)
5  (supplies)
3 (wages)
1 (dividends
and rents)
1 (supplies)
0.5(wages)…
Expenditure method
In the long run, people spend what they earn.
The statisticians can ask people how much money they have spent, or specifically – how much they
have spent on private consumption (𝐶) , how much they have invested (𝐼) and how much the
government has spent on goods and services (𝐺). Part of this spending could be spent on imported
goods (𝐼𝑀). As we want to get the volume of production, we must deduct the imports from total
spending. On the other hand foreigners could buy part of our production (𝐸𝑋). Exports should be
therefore added to the total domestic spending. The total domestic spending should therefore be
increased by the difference between exports and imports – the net exports (𝑁𝑋).
𝐺𝐷𝑃 = 𝐶 + 𝐼 + 𝐺 + 𝑁𝑋
If we get the GDP in this way – we have its nominal value – the nominal GDP.
People can only spend what they earn or what they borrow. If they borrow from other residents, the
other residents don’t spend what we spend above what we have earned. Domestic loans don’t
increase or decrease spending in comparison with what was earned.
Now consider foreign loans.
Assume that people earn CZK 95 of which the government takes CZK 40. People also borrow CZK 5
from abroad and then spend CZK 38 on Consumption and CZK 22 on Investments. The government
spends CZK 40. Of the total domestic spending CZK 30 represents imports. On the other hand
foreigners have bought things from us for CZK 25. The net exports are CZK -5. The nominal GDP can
be estimated at 95.
𝐺𝐷𝑃 = 38 + 22 + 40 − 5 = 95
The GDP is equal to what people have earned.
Assume that people earn CZK 105 of which the government takes CZK 40. People lend CZK 5 to
foreigners and then they spend CZK 38 on Consumption and CZK 22 on Investments. The government
spends CZK 40. Of the total domestic spending 30 represents imports. On the other hand foreigners
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have bought things from us for CZK 35. The net exports are CZK 5. The nominal GDP can be estimated
at 105.
𝐺𝐷𝑃 = 38 + 22 + 40 + 5 = 105
The GDP is equal to what people have earned.
GDP growth
The GDP usually grows from year to year in real terms. People usually become more productive.
People today produce more than a century ago. Today they have better technologies, better tools,
better organization of work, and better knowledge how to produce things.
Sometimes the production decreases.
The Production Possibilities Frontier expands as people find how to produce things more efficiently,
i.e. how to more things at the same cost. If people are able to produce more of one or another good
the PPF expands to the right, upward, or right-upward.
This expansion can be result of a better allocation of the means of production or of technological
progress – turning smart ideas into practice.
The Production Possibilities Frontier can also shrink. This can be caused by natural disasters such as
earthquake, draught etc. or by bad decision regarding the allocation of the means of production. If
82
an individual makes a bad decision and invests massively into an enterprise that turns to be a
setback, this setback will be also reflected in the overall production. Mistakes of individuals however
are too small to affect the overall production visibly and they are usually offset by good investments
of other people.
Politicians on the other hand make decisions of significant portions of the GDP. If politicians make
bad decisions of the allocation of the means of production the GDP can be affected significantly.
Politicians can decide of huge infrastructure projects such as dams, power plants, space flights,
highways, bridges and tunnels, Olympic Games, etc. They can encourage people through various tax
and subsidy incentives, or by cheap credit, to invest in the solar power, automobiles, bio-fuels etc. If
these investments are less efficient than what would people do otherwise the result can be a
decrease in the GDP.
Real production
How can we get the real change in production if we always get the GDP in nominal terms? The real
growth can be computed from the nominal growth so that we take into account the rate of inflation.
𝑌% =
1 + 𝑌𝑛 %
−1
1 + 𝑃%
Assume that the statisticians find that in 2013 the nominal GDP was CZK 4125 billion while in 2012 it
was CZK 4100 billion. The inflation rate in 2012 was 2.10 %. What was the real change in the GDP?
𝑌% =
4125
4100
1.0210
− 1 = −1.46%
The real growth of GDP was -1.46 %.
Approximately
𝑌% ≅ 𝑌𝑛 % − 𝑃%
Exercise:
Assume that a country grows at 8 % in real terms each year in 20 years in a row. What will be the
total percent increase of the economy over 20 years?
𝑌20 = 𝑌0 ∙ (1 + 𝑌%)20 = 𝑌0 ∙ 1,0820 = 𝑌0 ∙ 4,66
In 20 years the economy would grow by 366 % (4.66-1).
Business cycle
The economy usually grows at a positive rate. From time to time it shrinks. The irregular fluctuation
in production is called the business cycle. The periods of growth greater than the long-term average
83
are called expansion or boom, the periods of slow growth below the long term average are called
recession.
Picture: Real GDP in the United States (constant prices of 2000)
30%
$50,000
Annual change in GDP
25%
$45,000
GDP per head (USD)
2008
2006
2004
2002
1988
-5%
2000
$20,000
1998
0%
1996
$25,000
1994
5%
1992
$30,000
1990
10%
1986
$35,000
1984
15%
1982
$40,000
1980
20%
$15,000
Picture: Real GDP in the Czech Rep. (constant prices of 2000)
350,000 Kč
30%
25%
Annual GDP change (%)
300,000 Kč
GDP per head (USD 2000)
20%
250,000 Kč
15%
10%
200,000 Kč
5%
150,000 Kč
2008
2006
2004
2002
2000
1998
1996
1994
1992
1990
1988
1986
1984
1982
1980
0%
-5%
100,000 Kč
Unemployment
People who are able and willing to work make up the labour force (old and disabled people and small
children don’t belong to the labour force). Part of the labour force can be unemployed.
The unemployment rate is the ratio of unemployed to the labour force.
𝑢=
𝑈𝑛𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑
𝑈𝑛𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑 + 𝐸𝑚𝑝𝑙𝑜𝑦𝑒𝑑
84
Why are some people unemployed? Is not Labour a useful good – a means of production? Useful
things can be created by labour – so why unemployed people don’t start their own business or why
don’t others offer them a job? Why are there such differences in the rate of unemployment?
Table: Unemployment in selected countries
Greece
Czech Republic
Germany
Switzerland
Source: The Economist
Unemployment rate
27,8 %
8,6 %
6,8 %
3,2 %
Frictional unemployment
Frictional unemployment is the number of people who are temporarily unemployed because of
looking for better jobs. They may live from their savings or they receive unemployment insurance
benefits. This friction – that firms close and new open, some hire more employees ad some release
them – exists in every vibrant economy. These people are unemployed voluntarily – as they could
either continue in their previous jobs or they could immediately start a new one – they just take
some time to find the best opportunity.
Cyclical unemployment
As the economy tends to shrink the unemployment rate tends to rise, and as the economy recovers
from recession the unemployment rate tends to go down. This relationship is known as the Okun’s
Law. If firms produce more they have three ways how to do it: They can a) increase the productivity
of labour – using workers more efficiently, b) ask the workers to work overtime, c) employ more
workers. If firms face an increase in the demand for their production they probably apply these
options in this order.
Okun’s Law can be described as the relation between the relative change in the GDP and the relative
change in unemployment.
𝑌% = 𝑘 − 𝑐 ∙ 𝑢%
where 𝑌% is the growth of the real GDP and 𝑢% is the change in the unemployment rate. The same
applies to situations of economic downturn. If the demand for production decreases firms can
reduce overtime employment or ask workers to work reduced time, they can let some workers idle,
or they can release some of them.
Fluctuation in economic output is called the business cycle. Fluctuation in unemployment due to the
economic cycle is called cyclical unemployment.
Structural unemployment
The overall unemployment minus frictional unemployment minus cyclical unemployment is called
structural unemployment. It is unemployment that we cannot blame on natural friction or on
economic recession.
85
It is caused by some structural deficiencies in the economy. Legislation on the minimum wage can
increase unemployment. High social benefits for those who do not work can increase
unemployment.
Some people believed that structural unemployment was caused by replacement of labour by
machines. In Britain of 19th century under the Industrial revolution there was a social movement of
the “Luddites”, textile workers who destroyed machines that as they believed depraved them of jobs.
According to the Say’s law of Markets employment of machines cannot decrease employment of
labour. The machines cost some money – and this money had to be paid to someone – workers who
made the machines, and workers of contractors of the producers of the machines. Machines increase
labour productivity, less people will be employed in textile industries but more people will be
employed in the production of machines. Also as the employment of machines increases
productivity, it also decreases prices or increases profits so there will be an increase in the demand
for other things and more people will be employed in other industries.
Master’s Extension: Long Term Economic Growth
Theory of Growth. Solow Model of Growth. Cobb-Douglass function. Index of economic Freedom.
GDP in real terms normally increases each year, typically by several per cent. This can be explained
by several reasons.
Table: Growth rates of selected countries in 2013
China
Switzerland
United States
Greece
Growth in the GDP
7,7 %
1,9 %
1,9 %
-3,6 %
People are inventive. They find ways how to make things at lower cost – or how to produce more at
given cost. Economic growth will take place if people have proper incentives – namely if they are free
to retain yields of their inventions and if they are free to trade.
Box: Index of economic freedom and the relation between economic freedom and growth
When people are free from overregulation, if they are free to retain what they earn, if people are
free to exchange goods with other people over borders, economy tends to grow faster. If high taxes
and regulations are imposed to people, if barriers to trade are raised economies tend not to grow.
The Heritage Foundation ranks countries according to their economic freedom.
86
One way how to produce more is investment. The more we invest the more we decrease our present
consumption but also increase the future production.
The model which relates economic growth to the level of investment is called Solow model of
economic growth.
87
Solow assumes that the GDP is a product of two variables – two factors of production, Capital and
Labour. The more we employ capital ad or labour the more we can produce. There are limits to the
volume of labour. We can work more only to some extent. But there are no limits to the volume of
Capital. Capital can be accumulated to infinity in the long run.
Formally we can say
𝑌 = 𝐹(𝐾, 𝐿)
In this function we don’t say how precisely production depends on capital and labour, however we
suppose that it depends on both of them positively.
We assume that this function has the property of constant returns to scale. Assume two identical
economics which differ only in size – the latter has twice more labour as well as twice more capital.
Then the latter will also produce twice more things. This can be formally written as that for any 𝑧
𝑧𝑌 = 𝐹(𝑧𝐾, 𝑧𝐿)
This is an expected property of the function. This assumption helps us further develop the theory of
growth.
1
Let’s assume that the volume of labour is constant and let’s transform the function by putting 𝑧 = 𝐿
and get
𝑌
𝐾
𝐾
= 𝐹 ( , 1) = 𝐹 ( )
𝐿
𝐿
𝐿
𝑌
𝐿
The production per worker can be replaced wit 𝑦 and the volume of existing capital per worker
𝐾
𝐿
can be replaced with 𝑘. We can then write:
𝑦 = 𝐹(𝑘)
The volume of production per worker, the real GDP, can be increased by increasing the volume of
capital per worker. This can be increased by making investment at the expense of consumption, in
other words by saving. Saving decreases consumption in the short run but its purpose is to increase it
in the long run.
We can say that of any gross domestic product 𝑌, part 𝑘𝑌 is invested in capital and (1 − 𝑘)𝑌 is spent
on consumption.
One possible expression of the Solow model is called the Cobb-Douglass function – it is function that
bears the assumption of constant returns to scale.
It assumes that
𝑌 = 𝐾 0.5 ∙ 𝐿0.5
How should be this interpreted? If the volume of capital is for instance 𝐾 = 4 (e.g. 4 million
machines) and the volume of labour 𝐿 = 9 (e.g. 9 million people), the annual production of the
economy is 𝑌 = 40.5 ∙ 90.5 = 6. The GDP will be 6 (e.g. 6 million things).
88
𝑌 𝐾 0.5 ∙ 𝐿0.5
𝐾 0.5
=
=( )
𝐿
𝐿
𝐿
𝑦 = (𝑘)0.5
4
2
If the volume of capital per worker is 9 then the production per worker will be 3, or two thirds of a
thing.
The production can be either consumed or invested.
Let’s assume – for the matter of simplification – that capital doesn’t wear off. It does not depreciate.
Each saving turned into investment turns into an increase in the volume of capital.
What happens if people in the economy decide to consume 50 % and save and invest 50 % of their
production (GDP)?
In the beginning there are 4 units of capital and 9 units of labour. The GDP is 6 things. People decide
to consume 3 things and they invest the remaining 3 things. This increases the volume of capital from
4 to 7 units. In the second year therefore the total production is 7,937 things. Again half of it is
consumed and half is invested. It increases the volume of capital to 10,969 and production to 9.936,
and so on. You can see that in only fourth year the GDP doubles. People are more productive
because they work with more capital.
Year K
L
Y
C
I
1
4
9
6
3
3
2
7
9
7,937
3,969
3,969
3
10,969
9
9,936
4,968
4,968
4
15,936
9
11,976
5,988
5,988
You can see that in our example in only three years of sacrifices and saving the consumption gets at
its original level. In the subsequent years it will be only higher.
Lesson 3: Evolution of Money
Functions. Origins. Double coincidence of exchange. Gold Standard. Fiduciary Money.
Money is a specific good that does not satisfy our needs directly – unlike other goods we don’t
consume money – we always use money to get other things that we want to consume.
Money has several practical functions:



Medium of Exchange
Standard of value and the unit of account
Store of value
Money as the Medium of Exchange
89
People can – and they did it before money was invented – trade goods for goods. This is called the
barter or the exchange in kind. For instance students could provide services to teachers instead of
paying for education. One whose parents are dentist could offer tooth repair, one whose family runs
car service could offer car repair etc, one whose family runs a farm can bring a piece of beef to the
school.
Exchange in kind has several drawbacks. First, transaction costs are high. A big piece of beef is heavy
to bring it to the school, it requires cool storage etc.
The main problem of barter is that in order to make a transaction the two contracting parties must
meet the double coincidence of exchange:
Party A must demand what Party B offers and Party B must demand what Party A offers. Otherwise
the contract cannot be made. If you offer one T-shirt for 12 apples you must stumble on someone
who offers apples and who in the same time needs your T-shirt. The chance that the two demands
meet is diminished as the double coincidence must take place.
With money exchange is easier. Everybody can accept money as the general medium of exchange.
You can simply sell your T-shirt for money and then you can buy what you need – apples for instance.
One who offers apples can sell them for money and then he can buy whatever he wants – your Tshirt or other things.
Standard of value and the unit of account
Things have their relative prices regardless whether money exists or not. If for instance one table
costs four chairs or 100 apples then 1 chair costs ¼ table or 25 apples.
It is practical to express the value of all things in terms of one standard of value. In the past such
standard of value was cattle in some economies. The standard of value is deeply rooted in our minds
and for most people it is their national currency. What is the value of a bottle of coke? A eurozone
inhabitant would say: 1 euro. A Czech would say: 25 crowns.
Store of value
If we want to defer consumption – to save for the future or to accumulate capital to invest - we can
simply reduce our consumption and to leave the unconsumed goods for the future. Cattle can
however die, apples can decay, and the storage of meat and milk requires refrigerators. If money
exists it is practical to save money instead of other goods.
If money is inflationary – if it loses its purchasing power because of inflation people look for
alternatives and invest in bonds, real estates, art, or gold.
How has money evolved?
Money has no single inventor. This great human invention has no person to celebrate for the
economy of using money.


Certain commodities that fit for exchange and kept value
Precious metals
90




Coins
Paper money backed by Gold
Fiduciary Money
Current Account Money backed by Fiduciary Money
Commodities and Precious metals
Things that served as the predecessors of money had to be




Precious
Durable
Divisible
Marketable
Things that were relatively precious bare value in relative small volume and therefore could be
carried in a pocket or in a small purse. You could exchange a cow for a relatively small volume of
something precious – garments, salt or spices, grain, or metals.
These things had to be durable, i.e. to resist rain, freeze or heat.
They had to be divisible and combinable so that you could accept only a fraction of a bigger piece
unless the whole lost its value.
They had to be marketable – so that most people would accept them.
As time went precious metals, especially copper, silver, and gold proved best fitting to the purpose of
exchange.
Coins
Metals such as gold served best as the medium of exchange. Gold was precious enough so that a very
small piece of it could buy you lots o things. Furthermore it glitters so that it is easy to find if you
drop it and glittery itself seems to be the trait of preciousness. Gold can be easily separated and
melted together again. It is very durable. It does neither rotten nor rust.
The only difficulty with gold was the necessity to verify its quality and weight.
Verification of quality could be coped with putting a stamp – a certification of its purity. And the
tradesmen had only to weigh the required weight on scales.
Then someone came up with an idea to stamp pieces of gold not only with the sign of quality but also
with the sign of weight. Such a piece of gold is a coin. The signs must be all around the coin –
otherwise it would be easy to separate smaller pieces of it without disturbing the signs. A coin that is
trustworthy must bear readable signs all around it. As the signs become worn off it is a signal that the
coin does not contain the quantity of gold written on it any more.
Paper money
Predecessors of banks were depositories to which people deposited golden coins for security
reasons.
91
If you deposited one pound of gold into a depository you got a certificate certifying your title to
withdraw one pound of gold. The depository had obligation to redeem certificates for coins on
demand. The reason for depositing coins in a depository was security. Depositories run safes and
putting coins in it reduced the risk of theft.
Paper notes were originally certificates issued by depositories to which people had deposited coins
made of precious metals.
Balance sheet of a Depository
The Depository accepted coins from a depositor, charged a storage fee for the service, and issued a
certificate (a bill of exchange). The Depository was not supposed to lend the coins out. The depositor
therefore didn’t gain any interest. At this stage the depository was not a bank yet. The coins
accepted were not owned by the depository, the coins were just in custody of the depository and
remained ownership of the depositor.
ASSETS
LIABILITIES
The house, the safe and other assets owned by
the Depository
Equity (Capital invested into the business by the
owner)
Golden coins (in custody)
Certificates/Bills of exchange
How banks arose from depositories?
Balance Sheet of a Bank of Issue
One day one depository got an idea: Why not to make an additional profit by lending part of the
deposited coins to a trusted borrower? Although the depositors could claim their coins anytime on
demand the practice showed that they never come at once to claim their deposits. It seemed that
coins simply lied fallow in the safes.
Originally it might have been fraud by the Depository, later the Client (depositor) knew that his
money would be lent out as he received Interest as compensation. The Deposit (Bank’s liability)
became kind of an Investment and the Depository becomes the real owner of deposited coins. Part
of the Deposits is kept at the bank as Reserves, part is lent out (=Assets). The Depository becomes a
bank.
ASSETS
LIABILITIES
The house, the safe and other assets owned by
the Bank
Equity (Capital invested into the business by the
owner)
92
Golden coins (held as a reserve)
Bank notes (liability to pay Golden Coins back)
Loans
The ratio of Gold coins held as the Reserve to the volume of issued bank notes had to be not too low
and not too high. If it was too low the bank could on the one hand lend out lots of money and to
make huge profits. On the other hand the risk that it won’t be able to redeem bank notes on demand
increased. If it was too high the bank could lend out only little loans so that it could gain only little
interest. It could attract only few depositors and would be driven out of the market.
What would happen if a client comes to the bank to claim his deposits and the bank is not able to
redeem the notes? The banker could apologize and promise to redeem it and to pay a compensation
for the delay as soon as his debtors pay back the loans. The depositor could agree with that or he
could file a suit against the banker and the court could proclaim bankruptcy. In the process of
bankruptcy the creditor could get his money back if the bank’s borrowers paid their loans back.
In the system of private bank notes there are two kinds of money. First there is the monetary base
consisting of coins of which part circulates in the economy and part is deposited in banks as the
reserve. Second there are the bank notes whose volume exceeds the volume of reserves as they are
partly backed by loans.
Central banking
Most countries have monopolized the banks’ right to issue bank notes in 19th or at the beginning of
the 20th century. They either had given the right to issue banknotes to one of the existing banks or
they established a state owned bank or nationalized an existing one.
The bank can either guarantee to redeem issued coins for gold (The Gold standard) or for another
currency in a given ratio (“fixed exchange rate”) or it can guarantee nothing and the acceptance of
money by the public is reinforced with the legal obligation for everybody to accept the money (Fiat
Standard).
Central bank’s Balance Sheet
ASSETS
LIABILITIES
The house, the safe and other assets owned by
the Central bank
Equity (Capital invested into the bank by the
state)
Golden coins or gold bars (Gold reserve)
Bank notes (liability to pay Golden Coins back
under the Gold standard or without any liability
under the fiat (fiduciary) money system)
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Foreign currencies (Foreign exchange reserves)
Deposits by the commercial banks
Government bonds and other interest bearing
assets
Loans provided to commercial banks
Commercial banks that operate in the market don’t accept gold deposits anymore. What they accept
is deposits of the central bank’s banknotes.
Although people tend to say how much money they “have” in a bank, the correct statement would
be how much money the bank “owes” to us.
Commercial Bank Balance Sheet
ASSETS
LIABILITIES
The house, the safe and other assets owned by
the Bank
Equity (Capital invested into the business by the
owner)
Central bank’s banknotes (held as a Reserve)
Deposits (recorded on current accounts)
Deposits at the Central bank (held as a Reserve)
Loans, Bonds and other interest bearing assets
Fractional reserves and bank runs
Banks hold cash reserves. They invest part of deposits in loans and securities that bear interest to
make more money. They believe that depositors never come at once to withdraw their deposits. The
banking based on this assumption is called fractional reserves banking. Some economists argue that
banks should hold 100% cash reserves against the current deposits.
Although in normal times it can hardly happen that all depositors claim their deposits at once it can
happen if there are gossips regarding the health of a bank or uncertainty regarding the future of the
currency. If people are afraid that they won’t be able to withdraw money from their bank in near
future (if the bank goes bankrupt or if the government imposes withdrawal restrictions) they would
hasten to withdraw as much money as possible. Then it can happen that the bank will not have
enough cash for everybody. People would make queues at branches and ATMs. Whether the bank
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really was close to bankrupt or not is unimportant. If people “run” to withdraw deposits no bank is
able to satisfy all clients if it is based on fractional reserves.
To avoid bankruptcy the bank can borrow money from the central bank or it can persuade the
government to issue some withdrawal restrictions.
Some economists say that the banking should be based on 100% reserves. If banks want to make
money by investing in loans and securities they should persuade clients to make savings deposits
(term deposits) payable not on demand but at firmly set maturity.
Master’s Extension: Money Stock and the Multiplication of Deposits
Monetary Base. Currency. Reserves. Deposit Multiplier. Money Stock. Money Multiplier. Velocity
of Circulation.
How much money do you have? How much money there is in the economy as a whole?
For most people money they have is the volume of cash they hold and the volume of money
recorded on their current accounts. Is it our money even if we have it borrowed? What if someone
has transferred money on a savings account and money there cannot be used as the medium of
exchange immediately? And what if someone invested in securities instead of putting money on a
saving account? Should we count it as money? It is not easy to determine what money is and what is
not. Central bankers and statisticians therefore distinguish several tiers of money – monetary
aggregates:
M1 – includes banknotes and coins in circulation plus money in current accounts
M2 – includes all in M1 plus deposits on savings bank accounts
M3 – includes all in M2 plus alternative financial assets such as bonds
Understanding how much money is in the economy is important since we believe that the quantity of
money influences the price level (see Chapter on the Quantity Theory). The more money is there the
higher the price level tends to be.
Money stock
The central bank creates money in cash that is called the monetary base. Part of it circulates in the
economy as Currency and is repeatedly used for transactions. Part lies in banks as Reserves.
𝑀𝐵 = 𝐶 + 𝑅
Whenever someone deposits cash in a bank, the volume of currency circulating in the economy
diminishes and the volume of bank reserves increases – but the volume of the monetary base does
not change. The monetary base increases only if the central bank either prints cash and releases it
into circulation or if it transfers to banks.
The central bank usually increases the monetary base so that it buys securities and foreign currencies
or that it lends money to commercial banks. Whenever the central bank buys a government bond,
buys a foreign exchange or provides a loan to a commercial bank the result is an increase in the
monetary base. Also whenever the central bank pays expenses (such as salaries) which are not
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covered by revenues (such as fees charged for its services or interest charged for its loans) it runs a
loss and increases the monetary base.
On the other hand whenever the central bank sells a bond, sells foreign exchange, receives
repayment of a loan or accepts a term deposit from a commercial bank the result is a decrease in the
monetary base. If the central banks receives revenues greater than expenses it runs a profit which
decreases the monetary base (at least until the profit is transferred to the government or other
owners of the central bank).
In other words, each issuance of the monetary base represents an increase in the central bank’s
liabilities and it is must be covered by an increase in central bank’s assets or by an increase in its
accounting loss.
The commercial banks can deposit the reserves in the central bank.
Multiplication of deposits
How much money do you have? Money is definitely not only the currency – the cash we have in our
wallets. If someone is asked how much money he has he would probably add up his cash plus the
volume of money on his bank accounts.
But does the balance that we see on our bank account balance sheets or on internet banking mean
that we really have the money? It would be more correct to say that the amount is the money that
the bank owes to us. Anyway it is money – as it keeps value and it can be used immediately for
payments.
The money stock, the volume of money in circulation therefore consists not only of cash in
circulation, it contains also the volume of current account balances, or briefly deposits, 𝐷.
𝑀 =𝐶+𝐷
Banks intermediate payments. Instead of paying in cash we can open a current account with a bank.
We deposit our cash on the account and when we want to pay money to someone else we simply
order our bank to decrease our deposits and to transfer money to the account of someone else. This
can be done by a written order, through internet banking, or using a credit card in a shop. Whatever
the mechanism is, the principle remains the same: we order our bank to transfer money from our
account to the account of our transaction counterpart. When we insert our credit card in a terminal
when we buy groceries it is the same thing as if we asked a messenger boy to run to our bank with a
written letter to our banker that we entrust it to decrease the balance at our account and to increase
by the same amount the balance of the account of the grocer.
The bank which received our deposit in cash can hold it in cash reserve or it can invest it in some
assets that bear interest. If it invests it in interest bearing assets (such as loans, mortgages,
commercial shares, or government bonds) it can offer us part of the interest as compensation for our
deposits or it can increase its profit.
It would be pity not to invest part of our cash deposits. Money lying in banks as reserves would be
idle would make no additional money.
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The bank must however keep part of our deposits in cash, because it must be able to redeem our
bank accounts on demand. The experience shows that the depositors hardly come at once together
to claim their deposits, i.e. current account balances, or briefly the deposits, 𝐷. It means that there is
some optimal ratio of cash reserves to current account balances – we call it reserve ratio, 𝑟. The
remainder (1 − 𝑟) ∙ 𝐷 can be invested to less liquid but interest bearing assets.
The inverted value of the reserve ratio is called the deposit multiplier and it tells us how many times
the deposits are greater that the bank reserves.
𝐷 =𝑅∙𝑑
𝐷=𝑅∙
1
𝑟
The reserve ratio must not be too low or too high.
If it is too low the bank risks a default. If almost all deposits are invested in interests bearing assets
the bank increases it revenues but on the other hand the risk that clients will claim their deposits and
the bank will not have enough cash increases. If the reserve ratio is too low, the bank can end up
bankrupt.
If the reserve ratio is too high the bank does not risk defaulting but on the other hand it will not be
able to raise enough revenues. Clients can prefer banks that pay some interest on the current
deposits, they can leave the bank and the bank can end up bankrupt as well.
If a bank receives additional cash deposits it may observe that its reserve ratio is above the optimum.
So it can buy additional bonds or provide additional loans. If the reserve ratio of the bank is 10 % and
you deposit additional 1 million in cash to your bank account the bank can provide additional loans of
9 million – its assets will then consists of additional 1 million that you have deposited and of 9 million
in the form of claims to its new debtors. On liabilities the bank will have 1 million on your current
account that it owes to you and 9 million on its new debtors’ current accounts that it owes to them.
As soon as the debtors transfer these balances to the accounts of their contractors the bank owes
this 9 million to other people.
The bank has created additional money in the form of current account balances. Original cash of 1
million has transformed into 10 million of money in the form of current account money backed by 1
million of cash reserve.
Taking into account that the money stock consists of cash in circulation and of the deposits we can
write
𝑀 =𝐶+𝑅∙
1
𝑟
The volume of the money in the economy depends on the volume of the monetary base, on how the
monetary base is divided between the currency and the reserves and on the reserve ratio.
Of these variables the central bank controls only the monetary base. What is the ratio between the
money stock and the monetary base? We call this ratio the money multiplier, 𝑚.
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1
𝐶+𝑅∙
𝑀
𝑟
𝑚=
=
𝑀𝐵
𝐶 +𝑅
The division of the monetary base between currency in circulation and the reserves depends on the
decisions of millions of people about how much money they want to have in cash. Usually in
recessions or in the times of bank bankrupts people decide to hold more money in cash. The reserve
ratio depends on how often people tend to withdraw money from their bank accounts.
It is also important to realize that it is not only the central bank who creates money. The central bank
has the monopoly over the creation of cash, however the commercial bank create money in the form
of current account balances through the provision of credit.
𝑹∙
𝟏
𝒓
Current Account Money
(“Deposits“)
𝑹
𝑪
Reserves
Currency
Exercise
A bank receives a new cash deposit of CZK 200,000,000. Its reserve ratio is 8 %. How much money in
current account deposits can the bank create (or how much loans can it provide)?
Solution:
1
1
The deposit multiplier, 𝑑 = 𝑟 = 0.08 = 12.5. The volume of current account deposits will be
200,000,000 ∙ 12.5 = 𝐶𝑍𝐾 2,500,000,000
Exercise
A bank believes that it is sufficient to hold cash reserve representing 10 % of all current account
liabilities. The bank receives an additional deposit of CZK 10,000. How much money can the bank
create in the form of current account deposits (including the original deposit of 10,000)?
Exercise
The monetary base is 300, of which people use 200 as currency in circulation and they deposit the
remaining 100 in banks. The reserve ratio is 10 %. What will be the money stock and what will be the
money multiplier?
Exercise
The monetary base is 300 of which 100 is in circulation and 200 in banks. The reserve ratio is 10 %.
What is the money stock? Then because of the uncertainty regarding the future of banks people
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decide to have 200 in circulation and only 100 in banks. What will be the money stock? Will be there
an increase or a decrease of the money stock if the central bank does not change the monetary base
and people only withdraw 100 from banks?
Lesson 4: Quantity Theory of Money
Equation of Exchange. Velocity of circulation.
If you pay CZK 20 for an ice-cream to the ice-creamer, the ice-creamer may give the same coin
tomorrow to his son who buys a hamburger for it. Money is used repeatedly in the economy. The
average number each coin and note is used for buying final products is called the Velocity of
circulation of money (𝑉).
As people use money to buy goods and services, the volume of transactions can be expressed in two
ways.
On the one hand, people buy 𝑌 composite goods, each for the price 𝑃. The total turnover, or the
nominal GDP is therefore 𝑃 ∙ 𝑌.
On the other hand, people use the money, its total stock is 𝑀 and each unit of it is used 𝑉 times in a
year. The total turnover can be therefore expressed as 𝑀 ∙ 𝑉, or, since 𝑀 = 𝑀𝐵 ∙ 𝑚 as 𝑀𝐵 ∙ 𝑚 ∙ 𝑉.
Because both ways must be equal we can write down the following Equation of exchange:
𝑀∙𝑉 =𝑃∙𝑌
or
𝑀𝐵 ∙ 𝑚 ∙ 𝑉 = 𝑃 ∙ 𝑌
Relative version of the equation of exchange
Assume that in the period 1 there is
𝑀1 ∙ 𝑉1 = 𝑃1 ∙ 𝑌1
and in the period 0 there is
𝑀0 ∙ 𝑉0 = 𝑃0 ∙ 𝑌0
We can divide any side of the equation 1 with any side of the equation 0 to write:
𝑀1 𝑉1 𝑃1 𝑌1
∙ = ∙
𝑀0 𝑉0 𝑃0 𝑌0
which is
(1 + 𝑀%) ∙ (1 + 𝑉%) = (1 + 𝑃%) ∙ (1 + 𝑌%)
where 𝑀%, 𝑉%, 𝑃%, and 𝑌% represent relative changes in 𝑀, 𝑉, 𝑃, and 𝑌.
This can be simplified to
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𝑀% + 𝑉% ≅ 𝑃% + 𝑌%
Put it simply, growth in the money supply corresponds to the growth in the nominal GDP which
corresponds to the sum of the inflation rate and the real growth of the economy.1
This relation does not say anything about what depends on what. It has been believed that 𝑃 is the
independent variable influenced by the other ones. A greater quantity of money cannot make us rich.
It can make rich individuals but not the economy as a whole. If someone buys more things because
he has more money – the other people will be able to buy only the remaining production. As people
compete for the goods in the market the prices adjust.
But is 𝑃 the only dependent variable? Does always 𝑃 adjust to the change in the money stock?
Probably yes, in the long run. A change in the money stock or in the velocity of circulation can affect
the real GDP in the short run. Sometimes, prices are “sticky”. There are always delays – it takes some
time for prices to adjust to the new quantity of money if it is increased or decreased.
Exercise
Assume that the real volume of production in the economy (the real GDP) is 500 composite goods,
the price level is 20, the monetary base is 2000, the money multiplier is 2 and the velocity of
circulation of money is 2.5. Find out the nominal GDP.
Exercise
Assume you have initially Money stock M=500, V=7 and nominal GDP=3500. What will be the
inflation rate if V and real GDP (Y) remain unchanged and M is increased by 100 (to 600)?
Solution
The new nominal GDP is 4200 (600x7). Inflation is 20 %.
Exercise
The Money stock M=500 billion, velocity of circulation of money =7. What will be the inflation rate if
the velocity does not change, the real GDP (Y) grows by 2 %, and the Money stock is increased by 100
bn (to 600 bn)?
Solution
Money growth is 20 % (100 out of 500). Inflation will be approximately 18 % (or precisely 17,65 %).
Exercise
What should be the per cent change in the monetary base if the inflation target is 2 %, the money
multiplier and the velocity of money are constant and the real GDP is expected to shrink by 1 %?
1
In fact, there are more transactions than just transactions with the final goods just produced (i.e. the GDP) –
companies buy parts and supplies, people buy securities and second hand goods traded repeatedly. Putting Y
to the equation of exchange is a simplification, the total volume of things purchased (T) is greater than the
volume of final goods (Y). We can however assume that the growth in Y approximately corresponds to the
growth in T.
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Solution
Monetary base should increase approximately by 1 % (2+(-1)) or precisely by 0,98 % (1.02x0.99).
Master’s Extension: The Money Supply and Demand for Money
Why do people hold money? People hold money to store value, and to have liquidity in order to
make everyday transactions. The volume of money people hold depends on the interest rate. At
higher interest rates holding cash is costly. The interest yield foregone by not depositing money is the
price of holding money.
The relation between the volume of money people hold and the interest rate is called the demand
for money balances.
Cambridge demand for money
Economists at Cambridge University in England had a different approach.
Whenever people demand goods, they supply money. Whenever they supply goods, they demand
money. The price of goods is the number of units of money per one good. The price of money is the
number of goods per one unit of money, i.e. the purchasing power of money.
The money supply is the volume of money that people supply in the markets in order to get other
goods. It equals the money stock.
The money supply is independent of the price level, or of the purchasing power. As we could see, it
depends on the monetary base and on the money multiplier which depends on the reserve ratio and
on the distribution of the monetary base between the Currency in circulation and the banking
reserves.
But what about the demand for money?
The demand for money is a relation between the volume of money people demand as they supply
goods, and the purchasing power of money.
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It depends on the volume of goods people offer and on the prices of goods. It also depends on a
variable called the Cambridge constant.
𝑀𝐷 = 𝑘 ∙ 𝑃 ∙ 𝑌
The purchasing power of money is what money can buy – that is the “price” of money. As we express
the price of goods in terms of money, we can express the price of money in terms of goods. The price
of money in terms of goods is the purchasing power of money.
To express the demand for money graphically we can rearrange the equation so that we put the
purchasing power of money, or 𝑃−1 to the left side of the equation. It is common to depict the
demand function in the goods markets so that the price is on the vertical axis and the quantity of
good is on the horizontal axis. We can do the same with the demand of money.
𝑃−1 = 𝑘 ∙ 𝑌 ∙
1
𝑀𝐷
In this function the Cambridge constant (𝑘) and the real GDP (𝑌) are exogenous parameters. The
Cambridge constant (𝑘) represents a fraction of the real GDP. The money demanded (𝑀𝐷 ) is the
independent variable and the purchasing power of money (𝑃−1 ) is the dependent variable. Note the
difference between the demand of money in macroeconomics and the demand for goods in
microeconomics. In microeconomics, the price is the independent variable upon which the quantity
demanded depends.
The real production 𝑌 depends on the factors of production, 𝐿 and 𝐾 as we showed in previous
chapters. If you compare the Cambridge function of the demand for money with the equation of
1
exchange of the Quantity theory of money, you will find that 𝑘 equals 𝑉, where 𝑉 is the velocity of
circulation of money.
The demand for money is a rectangular hyperbola with the rectangle below the curve equalling 𝑘 ∙ 𝑌.
The demand for money increases as the real GDP increases.
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What happens if the money supply increases? The purchasing power goes down (which means that
the price level goes up). What happens if the demand for money increases? The purchasing power
goes up (which means that the price level goes down).
Exercise:
The Cambridge constant 𝑘 = 0.2, the money supply 𝑀 = 200, the real GDP 𝑌 = 10 , and the price
level is 𝑃 = 100. What happens if the money supply goes up by 100 %?
Solution: The money supply shifts to the right and thus the purchasing power halves from 1/100 to
1/200. This means that the price level doubles from 100 to 200.
Lesson 5: Aggregate Demand and Aggregate Supply
Price Level. Aggregate Production.
Aggregate demand is a relation between the price level and the aggregate production. It is a
graphical representation of the Quantity theory of Money.
In microeconomics a demand is a relation between the price of a good and the quantity demanded.
The cheaper something is the more of it people are willing to buy. It is therefore a decreasing
103
function and it is so for two reasons, effects that the change in the price has on the real income and
on the relative prices of other goods. The two effects are called the income effect and the
substitution effect. (see Lesson 5)
Like the market demand that you know from microeconomics, the Aggregate Demand is a decreasing
function. There is however a significant difference. There is no substitution effect. The aggregate
demand is the demand for everything that is produced in the economy. You cannot substitute your
aggregate demand from the GDP to something else. As there is only the income effect the aggregate
demand is a hyperbola.
𝑷 = (𝑀 ∙ 𝑉) ∙
1
𝒀
The area of each rectangle below the hyperbola is equal to (𝑀 ∙ 𝑉) - to the volume of Money stock
times the Velocity of Circulation. If the Money stock expands the Aggregate Demand expands, if the
Money stock shrinks the Aggregate Demand shrinks.
In this function the money stock (𝑀) and the velocity of circulation of money (𝑉) are exogenous
parameters. The real GDP (𝑌) is the independent variable and the price level (𝑃) is the dependent
variable. Note the difference between the aggregate demand in macroeconomics and the demand
for goods in microeconomics. In microeconomics, the price is the independent variable upon which
the quantity demanded depends. In macroeconomics the price level depends on the real GDP.
The aggregate supply is independent on the price level in the long run. There is no substitution
effect. We cannot substitute the production of the GDP for the production of something else. It
means that the Aggregate Supply is vertical, or it is a constant. Its value depends on other factors
that we have debated in the Lesson 1.
Inflation – an increase in the price level can be the consequence either of the changes in the
aggregate demand or of the aggregate supply. According to the causes of inflation we distinguish the
demand-pulled inflation and the supply-pushed inflation.
104
As the aggregate demand increases – because of an increase in the money stock – (the curve
expands to the right up) it pulls the price level with itself. As the aggregate supply declines it pushes
the price level up. In reality the existing inflation is the product of both – increases in the aggregate
demand and decreases in the aggregate supply.
Demand-pulled inflation
Supply-pushed inflation
Crowding-out effect
The aggregate demand consist of expenditures that can be grouped into four compounds: Private
consumption (C), private investments (I), Government purchases (G) and expenditures on net
exports.
We can say that
𝑀 ∙ 𝑉 = 𝑃 ∙ 𝑌 = 𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃 = 𝐶 + 𝐼 + 𝐺 + 𝑁𝑋
105
In reality one component can hardly be increased but at the expense of another component. For
instance the government can increase its spending – it must be financed through taxes (which would
decrease consumption spending) or through borrowing (which would decrease investments).
Without an increase in the Money stock one component of the aggregate demand can hardly be
increased unless other components decrease. This trade-off between individual components of the
aggregate demand is called the crowding-out effect. If the government increases its spending, it
crowds out (pushes out) other private expenditures.
Master’s Extension: Seigniorage
Seigniorage. Inflation Tax.
If someone counterfeits money and if he is not caught by the police he can buy goods for it and thus
increase his wealth. This increase of wealth is however at the expense of all other users of money. As
we learned in the chapter on the quantity theory of money an increase in the money stock decreases
the purchasing power of money. After any increase in the money stock prices tend to go up and all
holders of money can buy less for it. If one successfully counterfeits money the consequence is the
same as if he took a small amount from all other people.
If the government prints money the consequence is identical. The government can buy goods for it
and it can increase its wealth. This increase of wealth is however at the expense of the public.
The wealth that the government appropriates through printing money is called seigniorage.
There are basically three ways how the government can get money from us. It can impose explicit
taxes on us, it can borrow money from us, or it can print money and take the wealth from us through
inflation.
In reality the central bank can directly finance some public expenditures (it for instance can pay
salaries to public servants responsible for the bank supervision), or the government can simply print
money and to pay soldiers and ammunition with it during a war.
Mostly the government issues bonds to finance the budget deficit and the central bank buys these
bonds for newly created cash.
In all these cases it represents an increase in the monetary base. The newly printed money is used in
someone’s favour and at someone’s expense.
Seigniorage, as a percentage of GDP, is part of the GDP appropriated by the government by
spending the newly created money. It is simply the volume of the newly created money dividend
by the nominal GDP.
The volume of the newly created money is
∆𝑀𝐵 = 𝑀𝐵% ∙ 𝑀𝐵0
(For instance, if the monetary base was increased by 𝑀𝐵% = 20% from 𝑀𝐵0 = 500 the change in
the monetary base will be ∆𝑀𝐵 = 100.)
Seigniorage, 𝑠, is the increase in the monetary base divided by the nominal GDP
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𝑠=
𝑀𝐵% ∙ 𝑀𝐵0
𝑛𝑒𝑤 𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃
(Assume that the new nominal GDP after the change in the monetary base will be
𝑛𝑒𝑤 𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃 = 20 000.)
We must however take into account that the nominal GDP is affected by the increase in the
monetary base. Therefore we indicate it the “new” nominal GDP, i.e. the nominal GDP as it is
influenced by the increase in the monetary base.
If other variables remain constant, the nominal GDP increases as the monetary base increases.
(1 + 𝑀𝐵%) ∙ 𝑀𝐵0 = 𝑀𝐵1
𝑛𝑒𝑤 𝑛𝑜𝑚 𝐺𝐷𝑃 = 𝑃1 ∙ 𝑌1 = 𝑀1 ∙ 𝑉1 = 𝑀𝐵0 ∙ (1 + 𝑀𝐵%) ∙ 𝑚1 ∙ 𝑉1
Assume that the money multiplier is constant, 𝑚0 = 𝑚1 = 𝑚 = 4 and velocity of circulation is
constant 𝑉0 = 𝑉1 = 𝑉 = 10. Monetary base changes from 𝑀𝐵0 = 500 to 𝑀𝐵1 = (1 + 𝑀𝐵%) ∙
𝑀𝐵0 = 1.1 ∙ 500 = 600.
The new GDP will therefore be 𝑀𝐵0 ∙ (1 + 𝑀𝐵%) ∙ 𝑚1 ∙ 𝑉1 = 600 ∙ 4 ∙ 10 = 24 000
Therefore
𝑠=
𝑀𝐵% ∙ 𝑀𝐵0
𝑀𝐵%
=
𝑀𝐵0 ∙ (1 + 𝑀𝐵%) ∙ 𝑚 ∙ 𝑉 (1 + 𝑀𝐵%) ∙ 𝑚 ∙ 𝑉
or
𝑠=
(In
𝑠=
our
0.2
1
∙
1.2 4∙10
𝑀𝐵%
1
∙
(1 + 𝑀𝐵%) 𝑚 ∙ 𝑉
example
seigniorage
will
be
= 0.417%.)
We can assume that then money multiplier 𝑚 is constant and that the velocity of circulation 𝑉 is also
constant. Then we can write
𝑘=
1
1
1
=
=
𝑚1 ∙ 𝑉1 𝑚0 ∙ 𝑉0 𝑚 ∙ 𝑉
and
𝑠=
𝑀𝐵%
∙𝑘
(1 + 𝑀𝐵%)
It is a hyperbola that asymptotically approaches 𝑘 where 𝑘 is constant. It means that the government
can never appropriate a greater share in the GDP through printing money than what is 𝑘. The bigger
is 𝑚 and 𝑉 the less is 𝑘. The bigger is the growth in the monetary base the less effective it is as an
instrument to finance public expenditures.
Graph
107
s
k
MB%
Seigniorage can be also negative. If the central bank does not increase but decrease the monetary
base, seigniorage is negative. The government loses and the public gains. The central bank gives up
some assets (as it sells them for currency) so it gets poorer and the public enjoys an increase in the
purchasing power of money as prices go down due to a decrease in the monetary base.
If an increase in the monetary base is accompanied with some growth in the real GDP prices do not
necessarily grow. The public pays the seigniorage anyway as the growth in the monetary base
prevents deflation that would otherwise increase the purchasing power of money.
Exercise
Assume you that the Monetary Base MB=100, money multiplier m=5, velocity of money circulation
V=7 and nominal GDP=3500. What will be the inflation and seigniorage if m, V, and real GDP (Y)
remain constant, and MB is increased by 20 (to 120)?
Solution
New nominal GDP is 4200 (120x5x7). Inflation is 20 %. Seigniorage (inflation tax) is 20/4200 = 0,47%.
Alternative calculation: the rate of MB to GDP times 0,2/1,2=100/3500 x 0,2/1,2)
Exercise
MB=200, m=10, V=5, therefore Nom.GDP = 10,000. MB is changed by 10 %, real GDP grows by 4 %.
What will be the seigniorage? What will be the inflation rate?
108
Lesson 6: Aggregate Supply in the Short Run
Demand and Supply Shocks.
The aggregate supply is independent on the price level in the long run. As we mentioned, there is no
substitution effect in the aggregate supply. We cannot substitute the production of the GDP for the
production of something else.
Therefore, any increase in the aggregate demand (an increase in the money stock) translates only in
the increase in the price level.
AD
AS
P
In the short run, however, one substitution is possible. We can substitute labour for leisure. People
can work more or less.
The production will increase in the short run if people are encouraged to work overtime or on
Sundays. As they decide to return to normal the GDP will shrink back to normal again. The short run
aggregate supply is positively sloped.
Assume that the government prints up additional money and thus increases the aggregate demand.
The government uses the money to increase pensions. Pensioners happy for having pensions
increased decide to spend more in coffee houses for coffees and cakes. The confectioners are happy
for the increased demand. In the first place they don’t respond to the increased demand by
increasing prices if they have capacity to increase production at constant marginal costs.
They can ask employees to work overtime. Employees can work more in late evenings to produce
more cakes. This additional work is nevertheless at the expense of their leisure time. If they are
asked again to work overtime they will either refuse it or demand more money for that. At this
moment the only way out of the increased demand is the increase in the price of cakes.
Graphically the aggregate supply in the short run (SRAS) is not vertical but positively sloped.
109
AD
SRAS
P
Y
Sooner or later the consequence of an increase in the aggregate demand is an increase in prices.
Temporarily however the production can go up and only later it returns back. This temporary
increase in the production is rather the consequence of the fallacy that the increased demand is
based on the real increase in the productivity while it is based only on the increase in the nominal
money stock.
Such a sudden increase in the aggregate demand that temporarily leads to an increase in production
is called the positive demand shock. On the other hand a sudden decrease in the aggregate demand
that leads to a decrease in production is called the negative demand shock.
AD
P
AS
SRAS
Y
110
This short running effect is graphically depicted with an aggregate supply sloped upright.
Prices tend not to adjust immediately to the increase in the demand. Prices are often sticky, i.e.
inelastic. This leads not only to a temporary increase in the production when the aggregate demand
increases but also to a temporary decrease in the production when the aggregate demand decreases.
Exercise
Assume that the money stock 𝑀 = 500, the velocity of circulation of money 𝑉 = 5 and the short run
aggregate supply SRAS is 𝑃 = 50 + 10𝑌 . Find out the Aggregate Demand function. Assume that the
money stock is increased by 10 % to 550. Find out the growth in the real GDP in the short run and the
inflation rate in the short run and in the long run.
The aggregate demand function is:
𝑃=
𝑃=
𝑀∙𝑉
𝑌
500 ∙ 5
𝑌
500 ∙ 5
= 50 + 10𝑌
𝑌
2500 = 50𝑌 + 10𝑌 2
2500 = 50𝑌 + 10𝑌 2
10𝑌 2 + 50𝑌 − 2500 = 0
𝑌 2 + 5𝑌 − 250 = 0
𝑌=
−𝑏 ± √𝑏 2 − 4𝑎𝑐 −5 ± √25 + 1000
=
= 15.18
2𝑎
2
At the beginning the real GDP is 15.18.
𝑃 = 50 + 10 ∙ 15.18 = 208.2
The Price Level is 208.2.
After the increase in the Money stock the Aggregate Demand is
𝑃=
550 ∙ 5
𝑌
550 ∙ 5
= 50 + 10𝑌
𝑌
10𝑌 2 + 50𝑌 − 2750 = 0
𝑌 2 + 5𝑌 − 275 = 0
111
𝑌=
−𝑏 ± √𝑏 2 − 4𝑎𝑐 −5 ± √25 + 1000
=
= 15.17
2𝑎
2
Master’s Extension: Business Cycle
Short Run Aggregate Supply. Production Possibilities Frontier. Adjustment.
The demand shocks – let them be positive or negative – are eventually followed by a return to
normal. In other words, demand shocks cause fluctuation in production, or – as it is called - the
business cycle.
It is called a cycle although it occurs rather randomly while the word cycle implies regularity. Regular
cycles are usually caused by moves of the Earth around the Sun or by moves of the Earth around its
own axes. Some economic variables can be cyclical – e.g. consumption of electricity can be cyclical as
people need more electricity in days than in nights.)
So why does the economy fluctuate? Why demand shocks happen? Here are several theories that
explain the business cycle.
The Austrian theory of business cycle (ABC) assumes that the main cause of boom and busts is
excessive bank credit caused by central banks. Central banks provide cheap money – loans to banks
at low interest rates and thus distort loan markets, cause imbalances between savings and
investments. Without central bank intervention, interest rates would be higher – motivating more
savings and less investment. Central bank makes loans artificially cheap – savings decrease and
investments increase. This causes over-investment and the creation of “malinvestments” – inefficient
allocation of capital.
Political business cycle
Another idea of the business cycle is associated with the periods in which the governments change.
In democratic states elections are held usually in every four years. Governments want to be reelected and this can lead politicians to abuse power the year before election, to increase spending at
the expense of the balanced budget. They can boast with increased spending and possibly with a
better growth in the real growth of GDP. This fiscal expansion can be followed by a bust as the
change in government spending leads to a change in private spending.
Real business cycle theory
According to the Real Business Cycle theory the fluctuation in output is caused by real economic
shocks rather than by nominal shocks.
According to RBC theory, business cycles are „real“ so that they do not represent a failure of markets
to adapt but rather reflect the most efficient possible operation of the economy, given the structure
of the economy.
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If people suddenly change their demand from the product X to the product Y, we can theoretically
move smoothly from one point to another point at the PPF – to release means of production from
one product and to employ them in the production of the other product – and the overall GDP would
not be affected only it composition would change.
In the real world this change in the allocation of the means of production is not always smooth. The
adjustment path can include temporary unemployment or idleness of other means of production.
The size and length of this temporary unemployment depends on flexibility of markets.
Adjustment can be difficult in towns and areas dominated by several big companies. If for instant 30
% of the labour force of a town works in coal mines and the coal mines close down the released cole
miners will hardly find quickly a new job. Cities where the production is diversified are less vulnerable
– if one small company goes bankrupt its workers will easily find new jobs.
Sometimes busts can be caused by external real shocks such as earthquakes and draughts.
Lesson 7: Say’s Law of Markets and Keynesian economics
Say’s Law of Markets. Keynesian expenditures.
Say’s law of market as it is usually interpreted tells us that what people earn, they also spend in the
end of the day. People cannot get their income unless goods they had produced have been sold.
But people can save part of their earnings.
If people save money in banks the Say’s law works – money deposited in a bank is spent by those
who have borrowed it from the bank. The situation changes when people save (hoard) money at
homes. Saving money at home is called hoarding – or holding cash balances. Money saved at home is
money placed out of circulation.
113
According to Keynes people tend to spend their income according to a behavioural consumption
function:
𝐶 = 𝑐0 + 𝑐 ∙ 𝑌
Whereas the intercept of the consumption function 𝑐0 is the autonomous consumption and the
slope 𝑐 is the marginal propensity to consume. This function tells us that if people behave like this
than they do not necessarily adjust their expenditures to their income. People make financial
reserves in the form of cash savings. If the income is less than expected they use part of this reserve
and their spending is not reduced as much as the income. If the income is greater than expected they
accumulate cash reserves and their spending is not as much increased as is the income.
Assume – for the matter of simplification – that there are no other expenditures than private
consumption expenditures (𝐶).
It can happen then that income does not equal expenditures which can cause disturbances. If less
money is spent than either prices will go down or some goods remain unsold and some people can
lose their jobs. If more money is spent then either prices will go up or accumulated socks will be sold.
The volume of money in circulation depends not only
Why do people sometimes save money at homes if in banks money can bear interest, cannot be
stolen and can be readily used for transactions. The answer is that people prefer liquidity. Cash is the
most liquid asset, i.e. it can be easiest changed into other goods that we might need.
Master’s Extension: Hoarding and the Demand for Cash Balances
Say’s Law of Markets. Hoarding. Demand for Money Balances. Motives of Holding Cash. Keynesian
Cross.
114
According to John Keynes, there are three motives of holding cash instead of having invested money
in bonds or bank accounts:
1. The transactions motive: People prefer to have liquidity to assure basic transactions for the
days they don’t receive income. This volume is determined by the level of income: the higher
the income, the more cash balances people wish to hold for carrying out required spending.
2. The precautionary motive: People prefer to have liquidity reserve in the case of unexpected
problems that need unusual costs.
3. Speculative motive: people retain liquidity to speculate that bond prices will fall. When the
interest rate decreases people demand more money to hold until the interest rate increases,
which would drive down the price of an existing bond to keep its yield in line with the
interest rate. Thus, the lower the interest rate, the more money demanded (and vice versa).
We can explain the reason for holding cash using the concept of opportunity costs. If the opportunity
cost (the interest that we could have earned) is lower than the value of having money in cash we
would prefer cash.
If we save at homes the interest forgone is the price of holding cash. The higher is the nominal
interest rate the less money we would be willing to hold in cash.
We should add that people might be also afraid of bank bankruptcies. In some situations people
might prefer cash even if the interest rates are high. Anyway if people tend to hold cash they actually
115
decrease the volume if currency in circulation and thus the money stock which can have
consequences for the inflation rate, real growth and the unemployment.
Consequently, it is not always true that what is earned is spent. People can spend less than what they
earn – if they are saving cash balances, On the other hand people can spend more than what they
earn – if they are reducing their cash savings.
This can cause disturbances.
If prices were able to adjust smoothly this would lead to no disturbances – prices would simply
decrease if people spend less and increase if people spend more than what they earned.
Say’s law of markets as interpreted by John Maynard Keynes says: “The supply creates its own
demand”. As people make their product they receive money for it. They then use these revenues to
buy goods produced by other people.
Keynes argued that this might be true for a barter economy, where people change goods for goods,
but in an economy that uses money this might not be always true. Therefore he wanted to develop
his “general” theory of employment, interest and money, such that would describe working of both
the barter and the money economy.
Keynes believed that excess spending would increase employment as a higher aggregate demand will
encourage more production. Spending less than what was earned will lead to a decrease in
production and an increase in unemployment.
For Keynes this is a reason for the government to step in and to spend money in place of the people.
The government can either impose taxes and to take the money directly from the people or to print
new money.
116
Lesson 8: Foreign Exchange Market
Exchange rate. Depreciation. Appreciation. Balance of Payments. Adjustment Process of the
Balance of Payments.
Every day currencies are demanded and supplied. The price of a currency in terms of another
currency is called the exchange rate. The exchange rate can be expressed in terms of one or another
currency. For instance the exchange rate between the CZK and the euro can be expressed as 25 CZK
per 1 eur or as
1
25
= 0.04 eur per 1 CZK. Both ways of expressing the exchange rate are equivalent.
If one currency becomes cheaper in terms of another currency we call it depreciation, if it becomes
more expensive we call it appreciation. If the exchange rate between CZK and EUR changes from 25
to 24 CZK per 1 EUR we speak of appreciation of CZK against EUR or of depreciation of EUR against
CZK: EUR becomes cheaper. Now we can pay only 24 instead of 25 CZK per one euro, therefore euro
1
depreciates. Equivalently, CZK becomes more expensive, now you must pay 24 = 0.0416 eur per 1
CZK instead of
1
25
= 0.04 eur per 1 CZK.
If the exchange rate is fixed by the central bank and the exchange rate is changed by an
administrative regulation we speak of devaluation if the currency becomes cheaper and of
revaluation if the currency becomes more expensive. Devaluation is depreciation and revaluation is
appreciation of a currency.
117
Balance of Payments
Currencies appreciate and depreciate because of the moves of the supply and demand. People
supply and demand currencies for several reasons. The breakdown of the sources of the demand and
supply are called the Balance of Payments.
It is called a “balance” because each time the quantity demanded must be equal to the quantity
supplied of a currency. Whenever one buys a euro there must be someone who sells the euro.
If the supply of EUR increases CZK will tend to appreciate. If the demand increases CZK will tend to
depreciate.
Let’s look first at the supply side. Who sells euros in the foreign exchange market to buy CZK?
1) Exportation of goods. Exporters of Czech goods who sell their products in the euro-zone
receive euros and they need to buy CZK to pay employees and their Czech contractors.
2) Exportation of services. Foreign tourists or students who arrive to the Czech Republic buy
services as accommodation and education. They sell euros to buy CZK.
3) Income inflows. If Czechs work abroad or receive dividends from their investments abroad
and if they want to spend the money in the Czech Republic instead of spending this income
abroad they must sell euros and buy CZK.
4) Capital inflows. If foreigners want to invest their capital in the Czech Republic they need CZK
to buy assets here. They may also buy the Czech currency as an asset.
118
5) Central bank intervention. If the Czech central bank sells euros from its foreign exchange
reserves it buys CZK. Central banks do this to prevent depreciation. Such intervention has
three main monetary consequences – the currency appreciates, the stock of foreign
exchange reserves diminishes, and the domestic money stock diminishes. Whenever the
central bank buys the domestic currency it decreases the volume of money in circulation.
Such a decrease in the money stock is called monetary contraction.
Now let’s look at the demand side. Who sells CZK in the foreign exchange market to buy euros?
1) Importation of goods. Importers of foreign goods who sell their products in the Czech
Republic receive CZK and they need to buy euros to pay employees and their contractors in
the euro-zone.
2) Importation of services. Czech tourists or students who travel abroad buy services like
accommodation and education. They sell CZK and buy euros.
3) Income outflows. If foreigners work in the Czech Republic or receive dividends from their
Czech investments and if they want to spend the money in the euro-zone instead of spending
this income in the Czech Republic they must sell CZK and buy euros.
4) Capital outflows. If Czechs want to invest their capital in the euro-zone they need euros to
buy assets abroad. They may also buy euro as an asset.
5) Central bank intervention. If the Czech central bank buys euros it sells CZK. Central banks do
this to prevent appreciation. Such intervention has three main monetary consequences – the
currency depreciates, the stock of foreign exchange reserves increases, and the domestic
money stock expands. Whenever the central bank sells the domestic currency it increases
the volume of money in circulation. Such an increase in the money stock is called monetary
expansion.
Demand for EUR (outflows)
Supply of EUR (inflows)
Import of goods
Export of goods
Import of services (tourists travelling out, foreign
students)
Export of services (tourists travelling in, our
students studying abroad)
Income outflows (dividends and remittances
out)
Income inflows (dividends and remittances in)
Investments out
Investments in (FDI, portfolio inv.)
Speculation on depreciation of CZK
Speculation on appreciation of CZK
Central Bank Intervention against appreciation
of CZK (purchase of foreign exchange reserves)
Central Bank Intervention against depreciation
of CZK (sale of foreign exchange reserves)
119
You can estimate the future exchange rate if you have the information about intentions of who make
up the demand and the supply. If you know for example that a big investor plans an investment in
the Czech Republic you can expect an increase in the demand and therefore appreciation of CZK. If
you know that major investors plan to withdraw dividends from their Czech acquisitions you can
expect depreciation of CZK.
Master’s Extension: Exchange Rate Theories
Speculation. Purchasing Power Parity Theory. Law of One Price. Interest Rate Parity Theory.
Example
How can you make a profit if you expect appreciation of CZK within a month from CZK 25 per 1 EUR
to CZK 24 per 1 EUR?
Example
What exchange rate can you expect if now the exchange rate is USD 1.3 per 1 EUR, interest rate in
France is 2 % and interest rate in the US is 3 %?
Lesson 9: Monetary Policy
Monetary Policy. Exchange Rate Targeting. Monetary Targeting. Inflation targeting.
Monetary Policy is the process by which the monetary authority of a country, usually the central
bank, controls the supply of money through intervening into the exchange rate or the rate of
interest, or through the sale or purchase of bonds to attain objectives such as the inflation rate or the
exchange rate. The nominal value of an objective that the central bank wants to attain is called the
target.
Examples of monetary policy targets:
Monetary targeting (target is the given value of a monetary aggregate):



The central bank wants to increase the monetary base by 5 % per year
The central bank wants to increase the monetary aggregate M1 by 5 % per year
The central bank keeps the monetary base constant
Exchange rate targeting (target is the given value of the exchange rate):


The central bank wants to attain the exchange rate fixed to the euro at a given rate
The central bank wants to attain the rate of depreciation at 5 % per year
Inflation targeting (target is the given value of the inflation rate):



The central bank wants to attain stable price level, that is the inflation rate of 0%
The central bank wants to attain the inflation rate of 2%
The central bank wants to decrease the rate of inflation from 8% to 2% within 3 years.
120
Attaining one objective is always at the expense of other possible objectives. There is always a tradeoff. Recall the equation of exchange:
𝑀∙𝑉 =𝑃∙𝑌
or
𝑀𝐵 ∙ 𝑚 ∙ 𝑉 = 𝑃 ∙ 𝑌
If the central bank keeps the monetary base fixed there will be some change in the price level as the
other variables change. If the GDP grows by 5 % in real terms and other variables remain unchanged,
we can expect deflation of 5%.
If the central bank wants to have the exchange rate fixed, it must increase or decrease the foreign
exchange reserves and thus to decrease or increase the monetary base which can in turn decrease or
increase the price level. If the central bank must sell 5 billion from its exchange reserves to increase
the supply of euros to keep the exchange rate fixed at CZK 25 per 1 euro, it withdraws CZK 125 billion
from circulation. If the monetary base is thus decreased from 500 billion by ¼ and other variables
remain unchanged we can expect deflation of 25%.
If the central bank wants to keep the inflation rate at 2% and it sells or buys bonds or it lends or
borrows money with commercial banks whenever the inflation rate tends to deviate from the target,
it increases or decreases the monetary base or even appreciates or depreciates its currency as it
attracts or distracts foreign capital.
Necessity to inflate the money stock?
Free economies grow in the long run. If the central banks did nothing – if they never intervene in the
exchange rate, never lent or borrowed money, never traded the bonds – the result of this doing
nothing would be deflation.
If the central banks want at least to avoid deflation (some believe that deflation is harmful) they
must do something – to increase the monetary base directly each year somehow.
The problem is that increasing the monetary base often distorts markets, which is also harmful.
If the central bank issues money through the loans market, it affects the market interest rate which
can cause overinvestment due to too low interest rates or underinvestment due to too high interest
rates. If the central bank issues money through the foreign exchange market it distorts the market
exchange rate and thus artificially encourages exports or imports.
Economists have long been looking for a neutral way of issuing money.
David Hume
121
Master’s Extension: Adjustment processes of the Balance of Payments
Nominal and Real Convergence. Adjustment Processes of the Balance of Payments.
Balassa Samuelson Effect
Lesson 10: Fiscal Policy and Public Debt
Deficit. Debt. Crowding-out Effect.
When the expenditures of the state budget are greater than the revenues the balance is called a
deficit. When the revenues are greater than the expenditures the difference is called a surplus. To
pay for the expenditures for which the government does not have revenues the government must
borrow money (which can be secured either through a loan contract or through the issuance of
bonds). The sum of all previous deficits is the public debt.
The nominal GDP is the sum of all incomes in the economy in a year. The debt to GDP ratio tells us
symbolically what share of one year we would have to make money only to pay the debt.
𝑑𝑒𝑏𝑡 =
𝐷𝐸𝐵𝑇
𝑃∙𝑌
Assume that the debt is 1800 billion crowns and the nominal GDP is 4500 billion crowns. The debt to
GDP ratio is then 40%.
As the nominal GDP grows the debt can grow as well without increasing the debt to GDP ratio.
Exercise:
Assume that the debt is 1800 billion crowns and the nominal GDP is 4500 billion crowns. Next year
there will be growth of the real GDP of 1 % and the inflation rate 2 %. What must be the deficit so
that the debt to GDP ratio remains at 40 %?
Solution:
The new nominal GDP will be 4500 ∙ 1.02 ∙ 1.01 = 4635,9 billion crowns. To keep the debt to GDP
ratio at 40 % the debt must grow to 1854,36 billion crowns. The deficit must therefore be 54,36
billion crowns.
122
Crowding out effect
Whenever the government spends money, it is at the expense of someone else. The government
cannot expand the overall aggregate demand or the real GDP. To finance its expenditures, the
government can either take the money from the taxpayers, or it can print it up, or it can borrow it. It
is clear that if the government takes money from taxpayers the taxpayers will spend less. The overall
spending does not change.
In the Lesson 5 we learned that spending newly printed money is at the expense of all users of
money as an increase in the money stock decreases the purchasing power of money and raises the
price level.
If the government borrows money (through a loan contract or by issuing bonds) it spends it at the
expense of other would-be borrowers. This is called the crowding out effect. The government by its
loan crowds out other applicants from the banks.
It can be demonstrated in the following picture representing the loans market. There is the demand
for lendable funds (loans) and the supply of lendable funds (loans). There is an interest rate at which
the volume of lendable funds demanded equals the volume of lendable funds supplied.
If the government wants to borrow the volume of money represented by the distance AC the
demand curve shifts by AC to the right. This increase in the demand increases the equilibrium
interest rate. At this rate the quantity of lendable funds supplied is increased to 0C, as the savers are
lured by a higher interest rate for their saving deposits. The increase of private savings by BC
represents the decrease of private consumption by BC.
Also at the increased interest rate the volume of private borrowings, that is investments, shrinks by
AB to 0A. Total decrease of private spending is by AC. The increase in government spending by AC is
offset by the decrease in private spending on consumption and investments by AC.
Exercise
123
Assume that at the beginning the volume of lendable funds supplied and demanded is 500 million
crowns. The government decides to borrow 100 million crowns. This leads to an increase of the
interest rate which attracts an increase of savings (the volume of lendable funds supplied) by 20
million crowns. What will be the decrease in private investments?
Solution
The new volume of lendable funds supplied and demanded is 520 million crowns. Of this the
government borrows 100 million. The volume of funds available for private investments shrinks to
420 million from the original 500 million, that is by 80 million.
Master’s Extension:
International Crowding-out Effect. Country Default. Forms of default.
What if the government borrows from abroad? Then there is no crowding out of domestic
investments. There are however other crowding-outs.
Whether the government issues bonds denominated in the foreign currency or if a foreigner buys
bonds denominated in the domestic currency there will be an increase in the supply of the foreign
currency. This will lead to the appreciation of the domestic and the depreciation of the foreign
currency. The new exchange rate will boost imports (the quantity of euros demanded will be
greater). In the same time the total quantity of euros supplied will be greater but part of it will be at
the expense of exports.
Country default
Running deficits can end up in the “state bankruptcy” – or the sovereign default. The default means
that the debtor is not able to pay his due liabilities. In a private default a firm is not able to pay its
debt. Then a bankruptcy follows, all remaining assets go to an auction and then the firm is erased
from the registry of firms and ceases to exist. The sovereign default is a default of a sovereign debtor
that is of the state – an entity with its territory and the power to create legislation.
124
The default of the sovereign state does not mean that the debtor is forced to sell all its assets and
ceases to exist. It only means that it is not able to pay its liabilities (such as bonds, loans, invoices,
pensions, salaries) and that the creditors (those whom the state owes) don’t get their money.
The default usually happens when the state is not able to borrow money from anybody to pay its due
liabilities. It mostly happens if the state has to pay bonds issued in the past that have the maturity
now. The state is not able to raise taxes to pay up the bonds and if no one is willing to lend money to
the government the state defaults in paying up its old bonds. The bond holders don’t get their money
back. They cannot sue the state, because the state is a sovereign entity that does not have to obey
the courts. At most the creditors can ask their own government to pressure politically and
diplomatically to the government in default.
In March 2010 the government of Greece had a budget deficit of about 20 billion euro, or 10% of the
GDP. It was not able to sell bonds any more although it was promising a generous interest of 8%. 16
European Union members and the International Monetary Fund (IMF) provided a rescue loan of 110
billion euro for the following three years. The amount was meant to cover the budget deficits in the
following years and to cover liable payments of bonds payable within the following years. Later
Greece was not able to pay its old bonds to private holders of which some agreed to change them for
new bonds with fraction of the original face value and payable later in the farther future. The EU
members and the IMF agreed that the interest of their loan would be decreased and the maturity
prolonged to seven years. Greece defaulted on its loans.
Lesson 11: Currency Unions and Currency Separations
-.
Number of currencies in Europe has been fluctuating in the past 25 years from 25 in 1989 through 46
in late 1990s to 30 in 2013. Currencies rise and disappear. In 1990 the DDR Mark used by 16 million
Eastern Germans disappeared as the unification of Germany took place. New currencies were
established in 1990s as republics of multinational unions (The Soviet Union, Yugoslavia, CzechoSlovakia) declared independence and established their national currencies. In 2012 twelve western
European countries abolished their national currencies and adopted the European single currency,
the euro. Other European Union member countries followed.
Today 17 EU countries use the euro, 10 countries have their national currencies (UK, Sweden,
Denmark, The Czech republic, Poland, Latvia, Lithuania, Hungary, Bulgaria, Romania). Among other
European countries some have their national currencies (Iceland, Norway, Switzerland, Gibraltar, Isle
of Man, Jersey, Guernsey, Croatia, Bosnia-Herzegovina, Serbia, Turkey, Macedonia, Albania, Russia,
Moldova, Ukraine, Belarus, Transdniestria and others), some use currencies of other countries
(Liechtenstein, Andorra, Monaco, San Marino, Montenegro, Kosovo).
New currencies are usually established as new countries declare independence. But not all
independent countries have their national currencies. Liechtenstein uses the Swiss franc,
Montenegro and others use the euro.
125
Why countries sometimes have their national currencies and why they sometimes share a currency
with other nations?
Economist Robert Mundell named 17 reasons for joining a currency union and 17 reasons for having
a national currency (be able to explain at least 10 arguments for and 10 against):
Arguments against joining a currency union
•
Your country wants inflation rate different from the currency area rate
•
It wants to use the exchange rate as an instrument of employment policy to lower or raise
wages
•
It wants to use the exchange rate as a beggar-thy-neighbour policy to capture employment
from abroad
•
It wants to use money expansion or inflation tax to finance government spending
•
It does not want to sacrify seigniorage from the use of its money as international means of
payment
•
It wants to use seigniorage as a source of hidden or off-budget spending
•
A regime of fixed exchange rates could conflict with constitutional mandate to keep fixed
price level
•
Monetary integration would remove a vital symbol of national independence
•
It wants to optimize denominations to its per capita income
126
•
It wants to maintain monetary independence or seigniorage in the event of war
•
It wants to protect secrecy of its statistics
•
Authorities are not capable to achieve budget balance
•
Partners in OCA are politically unstable or prone to invasion by others
•
Partners are poorer and will expect aid or „equalization payments“
•
It does not want to accept the degree of integration implied
•
As a large country it does not want un unfriendly country to benefit from economies-of-size
adventages
Arguments for joining a currency union
•
Your country wants to gain the inflation rate of OCA
•
To reduce transaction costs in trade with major partners
•
To eliminate costs of printing and maintaining own currency
•
To participate in PPP area which would be fostered by a monetary union
•
To establish an anchor for policy
•
To remove discretion from monetary and fiscal authorities
•
To keep ER from being kicked around as a political football by vested interests
•
To establish automatic mechanism to enforce fiscal discipline
•
To have a multinational cushion against shocks
•
To participate more fully in the financial center
•
To provide a catalyst for political alliance or integration
•
To establish a power block against domination by others
•
To establish a competing international currency to the dollar and earn instead of pay
seigniorage
•
To establish an economic power bloc that will have more clout in international economic
discussion and trade talks
•
To delegate to a mechanism outsidethe domestic political process the enforcement of
monetary and fiscal discipline
•
To participate in restoring a reformed world monetary system
127
Recommended reading: Robert Mundell: Updating an agenda for a monetary union
Master’s Extension: Optimum Currency Area Theory
Economic homogeneity and heterogeneity. Stickiness of Prices. Labour Mobility. Asymmetric
Shocks.
Some economies are homogeneous, some are heterogeneous. Economic homogeneity means that
economic opportunities are evenly distributed across the whole economy. Heterogeneity means that
economic opportunities are not evenly distributed across various regions (parts) of the whole
economy. If there is heterogeneity people tend to move their capital to regions with better
opportunities. Assume two regions of one economy. If the quality of goods is better in the North and
the prices are equal, people will tend to go shopping from South to North. If there are new findings
of oil in the North capitalists will move their capital from South to North.
A currency area is an economy in which one single currency is used.
If a currency area is heterogeneous it makes sense to distinguish separately regional aggregate
demands and regional aggregate supplies.
The aggregate demand for the economy as a whole is the (horizontal) summation of regional
aggregate demands. The aggregate supply for the economy as a whole is the (horizontal) summation
of regional aggregate supplies.
Even if the whole aggregate demand is constant due to constant factors that define it (constant
Money supply, 𝑀, constant Velocity of circulation of money, 𝑉, constant real GDP, 𝑌) regional
aggregate demands can change. An increase in the Northern regional aggregate demand will be
offset by a decrease in the Southern regional aggregate demand, as people go shopping or invest
capital to the North, and the total aggregate demand will remain constant. The quantity of money in
the economy as a whole will not be changes however there will be a decrease in the stock of money
in the South and an increase in the stock of money in the North. There will be therefore different
consequences regarding economic variables such as the price level, real GDP and unemployment in
different regions.
If there are different opportunities in individual regions – if there are different changes in the
regional aggregate demands we speak of the asymmetric demand shocks. A change in the aggregate
demand which is evenly (symmetrically) distributed across regions affects all regions in the same
way. If there is for example an increase in the total money stock by 10% and the changes in regional
aggregate demands are symmetrically distributed – if there is a 10% increase in each regional
aggregate demand then we can expect the same consequences (same rates of inflation) in all
regions. If the demand shock is asymmetric, if it falls differently to individual regions then the
consequences will be different for individual regions.
There are also supply shocks. An earthquake or bad crop due to drought or flooding move the supply
curve to the left. If the whole area is affected in the same way such a negative supply shock is
symmetric. If only some parts (regions) are affected then such a shock is asymmetric.
128
Exercise
Assume an economy (a currency area) in which the money stock, 𝑀 = 100, Velocity of circulation of
money, 𝑉 = 5 , the real GDP, 𝑌 = 10, the Price level, 𝑃 = 50, and the nominal GDP, 𝑃𝑌 = 500. The
economy consists of two different regions, the South and the North. The stock of money in the North
is 𝑀𝑁 = 60 and the stock of money in the South is 𝑀 𝑆 = 40. The real GDP of the North is 𝑌 𝑁 = 6
and the real GDP of the South is 𝑌 𝑆 = 4. The Velocity of circulation of money is 𝑉 = 5 in both
regions. The price levels are 𝑃 𝑆 = 𝑃𝑁 = 50 in both regions.
Due to better opportunities in the North there is a move of capital of 𝑀𝑁 − 𝑀 𝑆 = 10 from South to
North. The money stock in the South decreases from 40 to 30 and the stock of money in the North
increases from 60 to 70. What will be the impact on the price levels in both regions if the regional
aggregate supplies are constant (vertical)?
Solution
Intuitive solution. In the North, there is an increase in the stock of money by one sixth, or by 16.67%.
Because the regional aggregate supply is constant, you can expect inflation of 16.67%, or the price
level of North will go from 50 to 58.33. In the South, there is a decrease in the stock of money by one
forth, or by 25%. Because the regional aggregate supply is constant, we can expect deflation of 25%,
or the price level of South will go from 50 to 37.5.
Algebraic solution (facultative). The aggregate demand is the hyperbole 𝑃 =
𝑀𝑉
𝑌
=
100∙5
𝑌
The aggregate supply is 𝑌 = 10. The regional aggregate demand of the South is 𝑃 𝑆 =
1
= 500 ∙ 𝑌
𝑀𝑆𝑉
𝑌𝑆
=
40∙5
𝑌𝑆
=
1
200 ∙ 𝑌 𝑆
(For detailed explanation of the aggregate demand function see Lesson 6.)
The regional aggregate demand of the North is 𝑃𝑁 =
𝑀𝑁𝑉
𝑌𝑁
=
60∙5
𝑌𝑁
1
= 300 ∙ 𝑌 𝑁
The regional aggregate supply of the South is 𝑌 𝑆 = 4 and the regional aggregate supply of the North
is 𝑌 𝑁 = 6
The equilibrium price level of the South is the equation between the regional demand and the
regional aggregate supply, 𝑃 𝑆 = 200 ∙
1
𝑌𝑆
1
4
and 𝑌 𝑆 = 4, that is 𝑃 𝑆 = 200 ∙ = 50
The same for the North. The equilibrium price level of the North is the equation between the
1
regional demand and the regional aggregate supply, 𝑃𝑁 = 300 ∙ 𝑌 𝑁 and 𝑌 𝑁 = 6, that is 𝑃𝑁 = 300 ∙
1
6
= 50
Then there is the flow of money from South to North: The new stock of money in the South will be
𝑀 𝑆 = 30 and the new stock of money in the North will be 𝑀𝑁 = 70
1
1
The new equilibrium price in the South will be at 𝑃 𝑆 = 150 ∙ 𝑌 𝑆 and 𝑌 𝑆 = 4, that is 𝑃 𝑆 = 150 ∙ 4 =
37.5 which is a 25% decrease from 50.
129
The new equilibrium price level of the North will be at the equation between the regional demand
1
1
and the regional aggregate supply, 𝑃𝑁 = 350 ∙ 𝑌 𝑁 and 𝑌 𝑁 = 6, that is 𝑃𝑁 = 350 ∙ 6 = 58.33 which
is a 16.67% increase from 50.
Graphical solution.
The aggregate demand for the economy as a whole is a horizontal summation of the regional
aggregate demands. The aggregate supply for the economy as a whole is a horizontal summation of
the regional aggregate demands. The area of the rectangle bellow the demand curves represents the
nominal GDP.
After the shift of money from South to North there is a decrease in the Southern aggregate demand
and an increase in the Northern aggregate demand. This results in a decrease in prices in the South
and an increase in prices in the North – if prices are elastic.
130
Stickiness of prices and immobility of labour
In the previous example prices had changed smoothly according to the changes in the stocks of
money. The regional aggregate demand went up in the North and it went down in the South. As a
consequence the prices went up in the North and they went down in the South.
In reality many prices are “sticky” so that they don’t adjust smoothly, namely downwards. This
phenomenon is called the stickiness of prices.
Tradesmen usually adapt their prices to the demand. No farmer wants to have his produce got
rotten. If in the evening he still has unsold bananas he simply decreases the price so that he sells all
of them in the end of the day. Some prices however don’t adjust so easily, namely the wages. Job
contracts have usually notices of several months and workers will insist on their wages even if the
firms face a decrease in the demand for their products.
131
If a company cannot adjust the costs (wages) to revenues (decreased prices) it will go bankrupt.
Some workers will lose their jobs. They will become unemployed unless they find a job in areas
where there is an increase in the demand that is in the North in our example. If labour is “mobile”
they will find a job up North. If labour is not mobile they won’t find a job up North.
The mobility of labour means that the labour force (=people, workers) can easily move from places
where they lost their jobs to places where they can find new jobs. Whether labour force is mobile or
not depends on many factors. Some factors are legal: If there are various legal restrictions, if people
need various permits from the governments to apply for a job or if there are other legal obstacles
regarding taxation, registration of business, recognition of pension claims etc then labour cannot be
sufficiently mobile. If the legal framework or a language spoken in separate regions is different it will
be difficult for people to register for taxes, find accommodation etc and the labour force will not be
sufficiently mobile.
People are usually sufficiently mobile within one nation state – an area with identical language and
legal framework. It is easy to move from Ostrava to Prague if you lose a job in Ostrava, because you
use almost the same language as they do in Prague. You don’t have to register anything, you can use
your ID and you even don’t need to change your official address and documents. You don’t need to
change your bank nor don’t you need to find a new mobile operator. On the other hand it is more
difficult to find a new job in Germany if you are from Greece. The language is different, the legal
system is different.
A currency area within which labour is mobile can be called an optimum currency area. In such an
area there won’t be increase in unemployment due to a shift of the aggregate demand from one to
another region. There won’t be even differences in the price level as the increase in the stock of
money in one region will be accompanied by an increase in the production, and the decrease in the
stock of money in another region will be accompanied by a decrease in the production.
If one single currency (such as the euro) is used in a heterogeneous area, there will be persistent
significant differences in the rate of inflation and of unemployment in individual regions (states). This
defect of a currency union can be offset by fiscal transfers from regions in which private capital flows
to those from which it flows out. The money stocks in all regions can be thus kept constant and
differences in the rate of inflation and of unemployment can be avoided.
Going back to the above mentioned example:
If prices are sticky downwards (regional aggregate supplies are upward sloping) there will be some
decrease in the real GDP (and an increase in unemployment) in the South (the region from which
money flows out).
132
133
Annex 1: Model exam - Microeconomics
Model tests
134
Microeconomics – Test / Masters level
/ Version A
Name:__________________
Calculator is allowed. Use the other side for notes. Other sheets are not allowed.
1. Equilibrium. Find the market equilibrium price and quantity if the demand is P=50-2Q and the
supply is P=20+8Q
2. The supply is P=25+0.1 Q . What will be the supply if a tax of T=15 is imposed on the good.
3. Calculate the present value of a bond if you can expect the following payments: First coupon of
CZK 100 after one year, Second coupon of CZK 100 after 2 years and the Face value CZK 1000 also
after 2 years. The interest rate is 5 %.
4. Describe the comparative advantage in the following example and prove that specialization is
more efficient than the self-sufficiency (Calculate production if each country wants 100 t of Bread)
Output
Volume of Oil
Volume of Bread
it can produce on the whole territory it can produce on the whole territory
Country A 100 t
150t.
Country B
300 t
5. Give three examples of price discrimination.
400 t.
135
Microeconomics – Test / Masters level
/ Version B
Name:__________________
Calculator is allowed. Use the other side for notes. Other sheets are not allowed.
1. Equilibrium. Find the market equilibrium price and quantity if the demand is P=60-2Q and the
supply is P=20+3Q
2. The supply is P=30+0.2 Q . What will be the supply if a tax of T=10 is imposed on the good.
3. Calculate the present value of a bond if you can expect the following payments: First coupon of
CZK 200 after one year, Second coupon of CZK 200 after 2 years and the Face value CZK 1000 also
after 2 years. The interest rate is 4 %.
4. Describe the comparative advantage in the following example and prove that specialization is
more efficient than the self-sufficiency (Calculate production if each country wants 50 t of Bread)
Output
Volume of Oil
Volume of Bread
it can produce on the whole territory it can produce on the whole territory
Country A 100 t
200t.
Country B
300 t
5. Give three examples of price discrimination.
400 t.
136
Microeconomics – Test . masters level
Name:________________
Calculator is allowed. Use the other side for notes. Other sheets are not allowed.
1. Explain difference between English and Dutch auction
2. Explain graphically what happens with the demand, the supply, the equilibrium quantity and
equilibrium price if a tax is imposed on a good.
3. Calculate the present value of a bond if you can expect the following payments: First coupon of
CZK 100 after one year, Second coupon of CZK 100 after 2 years and the Face value CZK 1000 also
after 2 years. The interest rate is 5 %.
4. Describe the comparative advantage in the following example and prove that specialization is
more efficient than the self-sufficiency (Calculate production if each country wants 100 t of Bread)
Output
Volume of Oil
Volume of Bread
it can produce on the whole territory it can produce on the whole territory
Country A 100 t
150t.
Country B
320 t
200 t.
5. Explain what is the Contract Curve
6. Assume a cartel facing a Prisoner’s dilemma situation. Fill in the payoff matrix so that the
decision ends up in the Nash equilibrium. Explain.
Cooperate
Cooperate
Defect
Defect
137
138
Final Exam Bc Microeconomics
Version: A
NAME: ___________________________
Points: ___/100
1. Externalities. Give 4 examples of positive externalities
2. Comparative advantage. Adam and Boris run a cafeteria. Adam can prepare 1 hamburger in 60
seconds if he works in the kitchen and he can serve 1 customer in 50 seconds when he works at the
checkout. Boris can prepare 1 hamburger in 50 seconds and he can serve 1 customer in 40 seconds.
Who has the comparative advantage in which activity? How should they specialize? How many
hamburgers they can make and how many customers they can serve a) if they both spend 4 hours
preparing hamburgers and 4 hours serving customers, b) if they work 8 hours each and specialize
according to their comparative advantages?
3. Substitutes and Complements. Give an example of two complement goods. What happens if the
price of one of them decreases?
4. Consumer surplus. The demand for cars is P=800 000-Q. The price is 500 000. Compute the
consumer surplus.
139
5. Capital and Labour market. Your nominal salary has increased from CZK 12 000 to CZK 14 000. In
the meantime prices went up by 5 %. What is the percent change in the nominal salary? What is the
percent change in the real wage?
6. Demand. Estimate the demand function for hotdogs if you know that at the price P=30 people buy
100 hotdogs and at the price P=28 people buy 120 hotdogs.
7. Profit maximisation. You run a McDonalds restaurant. Your marginal cost per 1 hamburger is
constant at MC=12. The demand for hamburgers is P=30-0,1Q. What is the price that maximizes your
profit?
8. Market models. Explain the perfect competition.
9. Explain the Indifference Curve
10. Equilibrium. Find the market equilibrium price and quantity if the demand is P=50-2Q and the
supply is P=10+3Q
140
Final Exam Bc Microeconomics
Version: B
NAME: ___________________________
Points: ___/100
1. Externalities. Give 4 examples of negative externalities
2. Comparative advantage. Adam and Boris run a cafeteria. Adam can prepare 1 hamburger in 40
seconds if he works in the kitchen and he can serve 1 customer in 40 seconds when he works at the
checkout. Boris can prepare 1 hamburger in 30 seconds and he can serve 1 customer in 15 seconds.
Who has the comparative advantage in which activity? How should they specialize? How many
hamburgers they can make and how many customers they can serve a) if they both spend 2 hours
preparing hamburgers and 2 hours serving customers, b) if they work 4 hours each and specialize
according to their comparative advantages?
3. Substitutes and Complements. Give an example of two substitute goods. What happens if the
price of one of them decreases?
4. Consumer surplus. The demand for cars is P=1 000 000-Q. The price is 250 000. Compute the
consumer surplus.
141
5. Capital and Labour market. Your nominal interest rate is 10 %. The prices go up by 6 %. What is
the REAL interest rate?
6. Demand. Estimate the demand function for hotdogs if you know that people buy 200 hotdogs at
the price P=30 and they buy 100 hotdogs at the price P=50.
7. Profit maximisation. You run a café. Your marginal cost per 1 coffee is constant at MC=10. The
demand for coffee is P=30-0,1Q. What is the price that maximizes your profit?
8. Market models. Explain the oligopoly.
9. What is the isoquant?
10. Equilibrium. Find the market equilibrium price and quantity if the demand is P=50-2Q and the
supply is P=20+8Q
142
Test – Microeconomics (A)
Name:________________
1a. Give an example of the positive externality and describe why it is an externality.
1b. Give an example of a “public good“, and describe why it is a public good.
2. Describe what is Pareto efficiency.
3. Describe the consumer optimum in the indifference analysis (Draw a chart, describe axes).
4. Describe comparative advantage in the following example and prove that specialization is more efficient
than the self-sufficiency (Each country wants 100 t of Bread)
Output
Country A
Volume of Oil
it can produce on the whole territory
100 t
Volume of Bread
it can produce on the whole territory
150t.
Country B
320 t
200 t.
5. What is Marginal rate of technical substitution?
6. Short Run Total Costs is TC=200+9Q-2Q2+Q3 Marginal Costs is MC=9-4Q+3Q2 Marginal Revenues is
constant=40. Find the optimum volume of production. Calculate the average costs if you produce 200 units.
143
Note: for
=0:
144
Annex 2: Model exams - macroeconomics
145
Test – Macroeconomics (Bc level)
1. Describe the difference between inflation and the price level
2. Explain what is the business cycle
3. Explain what is the marginal propensity to consume
4. Explain four disadvantages (costs) of inflation
5. Calculate the change in the purchasing power if the inflation rate is 10 %
Name:________________
146
6. What are basic functions of money?
7. What shall be the rate of inflation if the velocity of money does not change, the money stock grows by 5 %
and the real GDP falls by 2 %.
8. Nominal GDP is 4000 bn. Velocity of money circulation is 4. Money multiplier is 5. Calculate the Monetary
base.
9. Assume you have initially Monetary base MB=300, money multiplier = 3, V=5 and nominal GDP=4500.
What will be the rate of inflation if V remains unchanged, real GDP (Y) goes up by 2 %, and MB is increased
by 50 (to 350) and the money multiplier goes from 3 up to 3.1?
10. If the exchange rate goes from 25 CZK per 1 euro to 26 CZK per one euro. Is it appreciation or
depreciation of CZK? Explain factors that can be behind such change in the exchange rate.
11. What does “disinflation” mean?
12. What does “deflation” mean?
13. The price level changes from 1500 to 1600 in one year. What is the inflation rate?
14. Calculate the relative change in the purchasing power of money if the inflation rate is 50 %.
147
15. What is the monetary base?
16. If a bank receives an additional cash deposit of CZK 1,000,000 and wants to have the reserve
ratio of 5 %, how much money it can create in the form of current account balances?
Model test - Ms level
1) Explain time lags in performing government (central bank’s) policy
2) What exchange rate of CZK to USD you can expect after one year if the exchange rate now is 20
CZK/USD, the 1-year interest rate in the US is 3% p.a. and the 1-year interest rate in the CZ is 2% p.a.
Can you expect appreciation or depreciation of the CZK?
3) Calculate what price you would pay for a bond with nominal value of EUR 1000, which matures in
2 years. There are no interest coupons and you demand the annual yield to maturity of 8%.
4) Assume that the central bank expands the volume of banknotes in circulation by 30 billion. Banks
have their reserve ratio of 10 %. (=their cash reserves are 10 % of the current account balances).
What increase of the current account balances you can expect if people deposit this additional 30
billion to the banks?
5) Apply the interest rate parity theory: The interest rate in the Czech Republic is 3 %. The interest
rate in Australia is 4 %. The exchange rate is 20 CZK per 1 AUD. What exchange rate can you expect
in one year? Will it be appreciation or depreciation of the CZK?
148
6) Nominal GDP is CZK 2000. Monetary base is CZK 500. Calculate the seigniorage if the monetary
base is increased by CZK 50.
7) The money stock changes from 500 to 600. Velocity of circulation remains constant. The real
GDP grows by 5 %. What will be the rate of inflation?
149
Model test 2 - Ms level
1) What exchange rate of CZK to USD you can expect after one year if the exchange rate now is 25
CZK/EUR, the 1-year interest rate in the US is 4% p.a. and the 1-year interest rate in the CZ is 2% p.a.
2) In the above mentioned situation can you expect appreciation or depreciation of the CZK?
3) Assume that the central bank expands the volume of banknotes in circulation by 30 billion. Banks
have their reserve ratio of 10 %. (=their cash reserves are 10 % of the current account balances).
What increase in the Money stock (Cash in circulation plus Deposits) can you expect if people deposit
20 billion to the banks and if they use the remaining 10 billion as currency?
4) Nominal GDP is CZK 2000. Monetary base is CZK 500. Calculate the seigniorage if the monetary
base is increased by CZK 50. Explain what is seigniorage!
5) The money stock changes from 500 to 600. Velocity of circulation remains constant. The real GDP
grows by 5 %. What will be the rate of inflation?
6) Explain the difference between the real and the nominal GDP
150
Annex 3: Final State Exam
List of topics for the final exam in Economics (Bachelor’s degree)
Business Management
A) Microeconomics A
1. Explain positive and negative externalities. Give examples and explain how people
can cope with them.
2. Explain the concept of Comparative advantage and opportunity costs.
3. What is the Utility function? Explain the relation between total and marginal utility?
Can utility be measured?
4. Explain the optimum of a consumer who chooses between two goods. Explain the
indifference curve. Derive the demand curve.
5. Explain the law of demand and the law supply. Explain the consumer surplus.
6. Explain substitutes and complements. How indifference curves look for complements
and for substitutes?
7. Explain the price elasticity of demand. Explain perfect elasticity and perfect
inelasticity.
8. Explain normal and inferior goods. Give examples.
9. Explain the demand for labour. Explain marginal revenue product of labour.
10. Explain the demand for capital, yield to maturity and the interest rate.
11. Explain market structures (perfect competition, monopolist competition, oligopoly,
and monopoly)
12. Explain the optimum of a firm in perfect competition.
13. Explain the optimum of a monopoly.
14. Explain marginal rate of technical substitution and the choice between two factors of
production.
15. Explain the contract curve and Pareto efficiency of points on the curve
B) Macroeconomics A
1. Explain inflation, disinflation, deflation, and hyperinflation. Explain the relation
between the inflation and the price level.
2. Explain the purchasing power of money and its relation with the price level.
3. Explain the difference between the nominal and the real economic growth. What is
the GDP?
4. Explain the relation between the GDP and unemployment. Define unemployment and
explain its forms. Explain the business cycle.
5. Explain the production possibility frontier. Derive it from the Edgeworth box.
6. Explain the functions of money. How has money evolved?
7. Explain the monetary base and the process of the multiplication of deposits.
151
8. Explain motives of holding cash and the demand for cash balances.
9. Explain the quantity theory of money and the equation of exchange, its relative and
the absolute version.
10. Explain the aggregate supply and aggregate demand. Explain the supply-pushed
inflation and the demand-pulled inflation.
11. Explain the aggregate supply in the short run.
12. Explain the foreign exchange market and the balance of payments.
13. Explain the central bank monetary policy.
14. Explain the crowding out effect.
15. Explain reasons for joining and leaving monetary unions.
Marketing Communication
A) Microeconomics A
1. Explain positive and negative externalities. Give examples and explain how people
can cope with them.
2. Explain the concept of Comparative advantage and opportunity costs.
3. What is the Utility function? Explain the relation between total and marginal utility?
Can utility be measured?
4. Explain the optimum of a consumer who chooses between two goods. Explain the
indifference curve. Derive the demand curve.
5. Explain the law of demand and the law supply. Explain the consumer surplus.
6. Explain substitutes and complements. How indifference curves look for complements
and for substitutes?
7. Explain the price elasticity of demand. Explain perfect elasticity and perfect
inelasticity.
8. Explain normal and inferior goods. Give examples.
9. Explain the demand for labour. Explain marginal revenue product of labour.
10. Explain the demand for capital, yield to maturity and the interest rate.
11. Explain market structures (perfect competition, monopolist competition, oligopoly,
and monopoly)
12. Explain the optimum of a firm in perfect competition.
13. Explain the optimum of a monopoly.
14. Explain marginal rate of technical substitution and the choice between two factors of
production.
15. Explain the contract curve and Pareto efficiency of points on the curve
B) Macroeconomics B (simplified version)
1. Explain inflation, disinflation, and hyperinflation. Explain the relation between the
inflation and the price level.
152
2. Explain the purchasing power of money and its relation with the price level.
3. Explain the difference between the nominal and the real economic growth. What is
the GDP?
4. Explain the relation between the GDP and unemployment. Define unemployment and
explain its forms. Explain the business cycle.
5. Explain the production possibility frontier.
6. Explain the functions of money. How money has evolved?
7. Explain the monetary base and the process of the multiplication of deposits.
8. Explain motives of holding cash and the demand for cash balances.
9. Explain the quantity theory of money and the equation of exchange, its relative and
the absolute version.
10. Explain the aggregate supply and aggregate demand. Explain the supply-pushed
inflation and the demand-pulled inflation.
11. Explain the aggregate supply in the short run.
12. Explain the foreign exchange market and the balance of payments.
13. Explain the central bank monetary policy.
14. Explain the crowding out effect.
15. Explain reasons for joining and leaving monetary unions.
Literature:
Sobel, R., Gwartney, J., Stroup, R., Macpherson, D.: Understanding Microeconomics. 13th
Edition. Cengage Learning. ISBN-13: 978-0-538-75619-8
Sobel, R., Gwartney, J., Stroup, R., Macpherson, D.: Understanding Macroeconomics. 13th
international ed. Mason, OH : South-Western Cengage Learning, 2011, ISBN 978-0538-75620-4
E-book: Royer Mallory: Textbook of Microeconomics
E-book: Hildreth Lanora: Textbook of Macroeconomics
153
List of topics for the final exam in Economics (Master’s degree)
Courses: NA_MaE_A Macroeconomics A, NA_MiE_A Microeconomics A
A) Microeconomics (15 topics)
1. Explain the theory of public and private goods. Explain Rivalry, Excludability, and the
concepts of the Tragedy of Commons and of the Free Riding.
2. Principal vs Agent. Explain the Principal vs Agent problem in corporate governance.
Explain how this problem can be tackled. Explain Friedman’s ways of spending
money.
3. Comparative Advantage in Foreign Trade. Explain benefits of international
specialisation in trade. Explain Pareto optimal intervals of prices of traded goods.
4. Explain external marginal costs and benefits. Give examples of bargaining of
compensations in the case of externalities. Explain the Coase Theorem.
5. Explain diversification, risk aversion and decision making under risk.
6. Inter-temporal Choice. Explain consumer’s choice between the present and future
consumption. Fisher Chart.
7. Bargaining and Auctions. Explain the Dutch and English auctions. Explain non-price
mechanisms to attain equilibrium of the demand and supply.
8. Tax Incidence. Explain the tax incidence for the elastic and inelastic demand. Explain
the dead weight loss of taxation, effects of price floors and ceilings.
9. Explain the Laffer curve.
10. Investment Opportunities Curve. Explain Pareto efficiency of lending and borrowing.
Explain debtor’s and the creditor’s position.
11. Explain the optimum of the oligopoly with competitive fringe.
12. Explain the cartel in Prisoners’ Dilemma situation.
13. Explain the General equilibrium in the Edgeworth chart and derive the PPF curve.
14. Explain the Dead Weight Loss in non-perfect competition models. How can it be
eliminated?
15. Explain types and examples of price discrimination.
B) Macroeconomics (15 topics)
1.
2.
3.
4.
5.
Explain costs of inflation and of deflation.
Explain the business cycle and its causes. Explain alternative theories.
Explain the theories of long term economic growth including the Solow model.
Explain the money multiplier and the process of multiplication of deposits.
Demand for Money Balances. How hoarding of currency affects macroeconomic
variables. Keynes’ motives for holding cash balances.
6. Explain the Cambridge demand for money.
7. Seigniorage. Explain seigniorage. How it is calculated. Who spends it.
154
8. Explain the Purchasing power parity theory of the exchange rate.
9. Explain the interest rate parity theory of the exchange rate.
10. Explain the monetary policy in flexible and fixed exchange rates.
11. Optimum Currency Area Theory. Capital and Labour mobility and effects on prices and
unemployment.
12. Explain time Lags in performing the Monetary and Fiscal Policies.
13. Crowding-out Effect. The deficit and debt. Explain at what condition a deficit does not
translates into an increase in the debt to GDP ratio.
14. Country Default. Forms of default. Bank Runs. Debt restructuring.
15. Constitutional Limitations on inflation, taxes and debt. Debt brakes.
List of topics for the final exam in Economics (Master’s degree) B
Courses: NA_MaE_B Macroeconomics B, NA_MiE_B Microeconomics B
A) Microeconomics (15 topics)
1. Explain the theory of public and private goods. Explain Rivalry, Excludability, and the
concepts of the Tragedy of Commons and of the Free Riding.
2. Principal vs Agent. Explain the Principal vs Agent problem in corporate governance.
Explain how this problem can be tackled. Explain Friedman’s ways of spending
money.
3. Comparative Advantage in Foreign Trade. Explain benefits of international
specialisation in trade. Explain Pareto optimal intervals of prices of traded goods.
4. Explain external marginal costs and benefits. Give examples of bargaining of
compensations in the case of externalities. Explain the Coase Theorem.
5. Explain diversification, risk aversion and decision making under risk.
6. Inter-temporal Choice. Explain consumer’s choice between the present and future
consumption. Fisher Chart.
7. Bargaining and Auctions. Explain the Dutch and English auctions. Explain non-price
mechanisms to attain equilibrium of the demand and supply.
8. Tax Incidence. Explain the tax incidence for the elastic and inelastic demand. Explain
the dead weight loss of taxation, effects of price floors and ceilings.
9. Explain the Laffer curve.
10. Investment Opportunities Curve. Explain Pareto efficiency of lending and borrowing.
Explain debtor’s and the creditor’s position.
11. Explain the optimum of the oligopoly with competitive fringe.
12. Explain the cartel in Prisoners’ Dilemma situation.
13. Explain the General equilibrium in the Edgeworth chart and derive the PPF curve.
14. Explain the Dead Weight Loss in non-perfect competition models. How can it be
eliminated?
155
15. Explain types and examples of price discrimination.
B) Macroeconomics (15 topics)
1.
2.
3.
4.
5.
Explain costs of inflation.
Explain the business cycle and its causes.
Explain the theories of long term economic growth.
Explain the money multiplier and the process of multiplication of deposits.
Demand for Money Balances. How hoarding of currency affects macroeconomic
variables. Keynes’ motives for holding cash balances.
6. Explain the Cambridge demand for money.
7. Seigniorage. Explain seigniorage.
8. Explain the Purchasing power parity theory of the exchange rate.
9. Explain the balance of payments.
10. Explain the monetary policy in flexible and fixed exchange rates.
11. Optimum Currency Area Theory. Capital and Labour mobility and effects on prices and
unemployment.
12. Explain time Lags in performing the Monetary and Fiscal Policies.
13. Crowding-out Effect. The deficit and debt.
14. Country Default. Forms of default. Bank Runs.
15. Constitutional Limitations on inflation, taxes and debt. Debt brakes.
Literature:
Sobel, R., Gwartney, J., Stroup, R., Macpherson, D.: Understanding Microeconomics. 13th
Edition. Cengage Learning. ISBN-13: 978-0-538-75619-8
Sobel, R., Gwartney, J., Stroup, R., Macpherson, D.: Understanding Macroeconomics. 13th
international ed. Mason, OH : South-Western Cengage Learning, 2011, ISBN 978-0-53875620-4
Varian, H.R.: Intermediate Microeconomics: A Modern Approach, 8th edition ISBN 978-0-39393424-3
Mankiw, G.: Macroeconomics 7th edition. Worth publishers. New York 2010. ISBN 978-14292-1887-0