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General Information
23.9.
Introduction
Ch. 1,2
30.9.
National Accounting
Ch. 10, 11
7.10.
Production and Growth
Ch. 12
14.10.
Saving and Investment
Ch. 13
21.10.
Unemployment
Ch. 15
28.10.
The Monetary System
Ch. 16, 17
4.11.
International Trade (incl. Basic Concepts of Supply/Demand/Welfare) Ch. 3, 7, 9
11.11.
Open Economy Macro
Ch. 18
18.11.
Open Economy Macro
Ch. 19
25.11.
Aggregate Demand and Aggregate Supply
Ch. 20
2.12.
Monetary and Fiscal Policy
Ch. 21
9.12.
Phillips Curve
Ch. 22
16.12.
Overview / Q&A
Exam
•
•
•
•
Tuesday, January 13
15:15-16:45h
Room HG F1
Closed book
(allowed: non-programmable calculator, dictionary)
• Repetition exam: tba
Lecture 6 The Monetary System
(Fisher Effect & Costs of Inflation)
Principles of Macroeconomics
KOF, ETH Zurich, Prof. Dr. Jan-Egbert Sturm
Fall Term 2008
The Fisher Effect
• The Fisher effect refers to a one-to-one
adjustment of the nominal interest rate to
the inflation rate.
• According to the Fisher effect, when the rate
of inflation rises, the nominal interest rate
rises by the same amount.
• The real interest rate stays the same.
The Nominal Interest and Inflation Rate in the US
Percent
(per year)
15
12
Nominal interest rate
9
6
Inflation
3
0
1960
1965
1970
1975
1980
1985
1990
1995
2000
German inflation and
nominal interest rates, 1960-2001
12
11
10
9
8
% per year
7
6
5
4
3
2
1
0
1960
-1
1965
1970
1975
1980
inflation rate
1985
nominal interest rate
1990
1995
2000
THE COSTS OF INFLATION
• A Fall in Purchasing
Power?
• Inflation does not in
itself reduce people’s
real purchasing
power.
A common misperception
• Common misperception:
inflation reduces real wages
• This is true only in the short run, when
nominal wages are fixed by contracts.
• In the long run, the real wage is
determined by labor supply and the
marginal product of labor, not the price
level or inflation rate.
• Consider the data…
Average hourly earnings & the CPI (US)
Hourly
Hourlyearnings
earnings
inin2001
2001dollars
dollars
16
16
perhour
hour
$$per
14
14
12
12
66
44
22
Average
Average
hourly
hourly
earnings
earnings
200
200
175
175
150
150
125
125
10
10
88
250
250
225
225
Consumer
Consumer
Price
PriceIndex
Index
100
100
75
75
50
50
25
25
00
00
1964
1964 1968
1968 1972
1972 1976
1976 1980
1980 1984
1984 1988
1988 1992
1992 1996
1996 2000
2000
CPI(1983=100)
(1983=100)
CPI
18
18
THE COSTS OF INFLATION
•
•
•
•
•
Shoeleather costs
Menu costs
Relative price variability
Tax distortions
Confusion and
inconvenience
• Arbitrary redistribution of
wealth
Shoeleather Costs
• Shoeleather costs are the resources wasted
when inflation encourages people to reduce
their money holdings.
• Inflation reduces the real value of money, so
people have an incentive to minimize their
cash holdings.
• Less cash requires more frequent trips to the
bank to withdraw money from interestbearing accounts.
Shoeleather Costs
• The actual cost of reducing your money
holdings is the time and convenience you
must sacrifice to keep less money on hand.
• Also, extra trips to the bank take time away
from productive activities.
Menu Costs
• Menu costs are the costs of adjusting prices.
• During inflationary times, it is necessary to
update price lists and other posted prices.
• This is a resource-consuming process that
takes away from other productive activities.
Relative-Price Variability and the
Misallocation of Resources
• Inflation distorts relative prices.
• Consumer decisions are distorted, and
markets are less able to allocate resources to
their best use.
Inflation-Induced Tax Distortion
• Inflation exaggerates the size of capital
gains and increases the tax burden on this
type of income.
• With progressive taxation, capital gains are
taxed more heavily.
Inflation-Induced Tax Distortion
• The income tax treats the nominal interest
earned on savings as income, even though
part of the nominal interest rate merely
compensates for inflation.
• The after-tax real interest rate falls, making
saving less attractive.
Table 1 How Inflation Raises the Tax Burden on Saving
Confusion and Inconvenience
• When the CB increases the money supply
and creates inflation, it erodes the real value
of the unit of account.
• Inflation causes dollars at different times to
have different real values.
• Therefore, with rising prices, it is more
difficult to compare real revenues, costs, and
profits over time.
A Special Cost of Unexpected Inflation:
Arbitrary Redistribution of Wealth
• Unexpected inflation redistributes wealth
among the population in a way that has
nothing to do with either merit or need.
• These redistributions occur because many
loans in the economy are specified in terms
of the unit of account—money.
Lecture 7 International Trade
Principles of Macroeconomics
KOF, ETH Zurich, Prof. Dr. Jan-Egbert Sturm
Fall Term 2008
MARKETS AND COMPETITION
• A market is a group of buyers and sellers of a
particular good or service.
• The terms supply and demand refer to the
behavior of people . . . as they interact with
one another in markets.
DEMAND
• Quantity demanded is the amount of a good
that buyers are willing and able to purchase.
• Law of Demand
• The law of demand states that, other things
equal, the quantity demanded of a good falls
when the price of the good rises.
The Demand Curve: The Relationship between Price and
Quantity Demanded
• Demand Curve
• The demand curve is a graph of the relationship
between the price of a good and the quantity
demanded.
SUPPLY
• Quantity supplied is the amount of a good
that sellers are willing and able to sell.
• Law of Supply
• The law of supply states that, other things equal,
the quantity supplied of a good rises when the
price of the good rises.
The Supply Curve: The Relationship between Price and
Quantity Supplied
• Supply Curve
• The supply curve is the graph of the relationship
between the price of a good and the quantity
supplied.
SUPPLY AND DEMAND TOGETHER
• Equilibrium Price
• The price that balances quantity supplied and
quantity demanded.
• On a graph, it is the price at which the supply
and demand curves intersect.
• Equilibrium Quantity
• The quantity supplied and the quantity
demanded at the equilibrium price.
• On a graph it is the quantity at which the supply
and demand curves intersect.
Figure 1 The Equilibrium of Supply and Demand
Price of
Ice-Cream
Cone
Supply
Equilibrium
Equilibrium price
$2.00
Equilibrium
quantity
0
1
2
3
4
5
6
7
8
Demand
9 10 11 12 13
Quantity of Ice-Cream Cones
Figure 2 How an Increase in Demand Affects the Equilibrium
Price of
Ice-Cream
Cone
1. Hot weather increases
the demand for ice cream . . .
Supply
New equilibrium
$2.50
2.00
2. . . . resulting
in a higher
price . . .
Initial
equilibrium
D
D
0
7
3. . . . and a higher
quantity sold.
10
Quantity of
Ice-Cream Cones
Figure 3 How a Decrease in Supply Affects the Equilibrium
Price of
Ice-Cream
Cone
S2
1. An increase in the
price of sugar reduces
the supply of ice cream. . .
S1
New
equilibrium
$2.50
Initial equilibrium
2.00
2. . . . resulting
in a higher
price of ice
cream . . .
Demand
0
4
7
3. . . . and a lower
quantity sold.
Quantity of
Ice-Cream Cones
Welfare Economics
• Welfare economics is the study of how the
allocation of resources affects economic
well-being.
• Buyers and sellers receive benefits from
taking part in the market.
• The equilibrium in a market maximizes the
total welfare of buyers and sellers.
Welfare Economics
• Equilibrium in the market results in
maximum benefits, and therefore
maximum total welfare for both the
consumers and the producers of the
product.
• Consumer surplus measures economic
welfare from the buyer’s side.
• Producer surplus measures economic
welfare from the seller’s side.
CONSUMER SURPLUS
• Willingness to pay is the maximum amount
that a buyer will pay for a good.
• It measures how much the buyer values the
good or service.
• Consumer surplus is the buyer’s willingness
to pay for a good minus the amount the
buyer actually pays for it.
• The area below the demand curve and above
the price measures the consumer surplus in
the market.
Figure 4 How the Price Affects Consumer Surplus
(a) Consumer Surplus at Price P
Price
A
Consumer
surplus
P1
B
C
Demand
0
Q1
Quantity
Copyright©2003 Southwestern/Thomson Learning
PRODUCER SURPLUS
• Producer surplus is the amount a seller is
paid for a good minus the seller’s cost.
• It measures the benefit to sellers
participating in a market.
• The area below the price and above the
supply curve measures the producer surplus
in a market.
Figure 5 How the Price Affects Producer Surplus
(a) Producer Surplus at Price P
Price
Supply
P1
B
Producer
surplus
C
A
0
Q1
Quantity
MARKET EFFICIENCY
• Consumer surplus and producer surplus
may be used to address the following
question:
• Is the allocation of resources determined by free
markets in any way desirable?
MARKET EFFICIENCY
Consumer Surplus
= Value to buyers – Amount paid by buyers
and
Producer Surplus
= Amount received by sellers – Cost to sellers
MARKET EFFICIENCY
Total surplus
= Consumer surplus + Producer surplus
or
Total surplus
= Value to buyers – Cost to sellers
MARKET EFFICIENCY
• Efficiency is the property of a resource
allocation of maximizing the total surplus
received by all members of society.
• An allocation is Pareto efficient if no
individual can be made better off without
another being made worse off
MARKET EFFICIENCY
• In the equilibrium of a competitive market
• the sum of consumer surplus and producer
surplus is maximized
• consumer surplus cannot be raised without
lowering producer surplus
Figure 6 Consumer and Producer Surplus in the Market Equilibrium
Price A
D
Supply
Consumer
surplus
Equilibrium
price
E
Producer
surplus
B
Demand
C
0
Equilibrium
quantity
Quantity
MARKET EFFICIENCY
• Three Insights Concerning Market Outcomes
• Free markets allocate the supply of goods to the
buyers who value them most highly, as
measured by their willingness to pay.
• Free markets allocate the demand for goods to
the sellers who can produce them at least cost.
• Free markets produce the quantity of goods that
maximizes the sum of consumer and producer
surplus.
International Trade
• What determines whether a country
imports or exports a good?
• Who gains and who loses
from free trade among countries?
THE DETERMINANTS OF TRADE
• Equilibrium Without Trade
• Assume:
• A country is isolated from the rest of the world and
produces steel.
• The market for steel consists of the buyers and sellers
in the country.
• No one in the country is allowed to import or export
steel.
Figure 7 The Equilibrium without International Trade
Price
of Steel
Domestic
supply
Consumer
surplus
Equilibrium
price
Producer
surplus
Domestic
demand
0
Equilibrium
quantity
Quantity
of Steel
The Equilibrium Without International Trade
• Equilibrium Without Trade
• Results:
• Domestic price adjusts to balance demand and
supply.
• The sum of consumer and producer surplus
measures the total benefits that buyers and sellers
receive.
The World Price and Comparative Advantage
• If the country decides to engage in
international trade, will it be an importer or
exporter of a good?
Comparative Advantage
• Differences in the costs of production
determine the following:
• Who should produce what?
• How much should be traded for each product?
Comparative Advantage
• Differences in Costs of Production
• Two ways to measure differences in costs of
production:
• The number of hours required to produce a unit
of output.
• The opportunity cost of sacrificing one good for
another.
Absolute Advantage
• The comparison among producers of a good
according to their productivity—absolute
advantage
• Describes the productivity of one person, firm,
or nation compared to that of another.
• The producer that requires a smaller quantity of
inputs to produce a good is said to have an
absolute advantage in producing that good.
Opportunity Cost and Comparative Advantage
• Compares producers of a good according to
their opportunity cost.
• Whatever must be given up to obtain some
item
• The producer who has the smaller
opportunity cost of producing a good is said
to have a comparative advantage in
producing that good.
Comparative Advantage and Trade
• Comparative advantage and differences in
opportunity costs are the basis for
specialized production and trade.
• Whenever potential trading parties have
differences in opportunity costs, they can
each benefit from trade.
• Benefits of Trade
• Trade can benefit everyone in a society because
it allows people to specialize in activities in
which they have a comparative advantage.
The World Price and Comparative Advantage
• The effects of free trade can be shown by
comparing the domestic price of a good
without trade and the world price of the
good. The world price refers to the price that
prevails in the world market for that good.
The World Price and Comparative Advantage
• If a country has a comparative advantage,
then the domestic price will be below the
world price, and the country will be an
exporter of the good.
• If the country does not have a comparative
advantage, then the domestic price will be
higher than the world price, and the country
will be an importer of the good.
Figure 8 International Trade in an Exporting Country
Price
of Steel
Domestic
supply
Price
after
trade
World
price
Price
before
trade
Exports
0
Domestic
quantity
demanded
Domestic
demand
Domestic
quantity
supplied
Quantity
of Steel
Figure 9 How Free Trade Affects Welfare in an Exporting Country
Price
of Steel
Price
after
trade
Domestic
supply
Exports
A
B
Price
before
trade
World
price
D
C
Domestic
demand
0
Quantity
of Steel
Figure 10 How Free Trade Affects Welfare in an Exporting Country
Price
of Steel
Consumer surplus
before trade
Price
after
trade
Exports
A
B
Price
before
trade
World
price
D
C
Producer surplus
before trade
0
Domestic
supply
Domestic
demand
Quantity
of Steel
How Free Trade Affects Welfare in an Exporting Country
THE WINNERS AND LOSERS FROM TRADE
• The analysis of an exporting country yields
two conclusions:
• Domestic producers of the good are better off,
and domestic consumers of the good are worse
off.
• Trade raises the economic well-being of the
nation as a whole.
The Gains and Losses of an Importing Country
• International Trade in an Importing Country
• If the world price of steel is lower than the
domestic price, the country will be an importer
of steel when trade is permitted.
• Domestic consumers will want to buy steel at
the lower world price.
• Domestic producers of steel will have to lower
their output because the domestic price moves
to the world price.
Figure 11 International Trade in an Importing Country
Price
of Steel
Domestic
supply
Price
before
trade
Price
after
trade
World
price
Imports
0
Domestic
quantity
supplied
Domestic
quantity
demanded
Domestic
demand
Quantity
of Steel
Figure 12 How Free Trade Affects Welfare in an Importing Country
Price
of Steel
Domestic
supply
A
Price
before trade
Price
after trade
B
C
D
Imports
World
price
Domestic
demand
0
Quantity
of Steel
Figure 13 How Free Trade Affects Welfare in an Importing Country
Price
of Steel
Consumer surplus
before trade
Domestic
supply
A
Price
before trade
Price
after trade
B
World
price
C
Producer surplus
before trade
0
Domestic
demand
Quantity
of Steel
Figure 14 How Free Trade Affects Welfare in an Importing Country
Price
of Steel
Consumer surplus
after trade
Domestic
supply
A
Price
before trade
Price
after trade
0
B
C
D
Imports
Producer surplus
after trade
World
price
Domestic
demand
Quantity
of Steel
How Free Trade Affects Welfare in an Importing Country
THE WINNERS AND LOSERS FROM TRADE
• How Free Trade Affects Welfare in an
Importing Country
• The analysis of an importing country yields two
conclusions:
• Domestic producers of the good are worse off, and
domestic consumers of the good are better off.
• Trade raises the economic well-being of the nation
as a whole because the gains of consumers exceed
the losses of producers.
THE WINNERS AND LOSERS FROM TRADE
• The gains of the winners exceed the losses
of the losers.
• The net change in total
surplus is positive.
Summary
• The effects of free trade can be determined
by comparing the domestic price without
trade to the world price.
– A low domestic price indicates that the country has a
comparative advantage in producing the good and that
the country will become an exporter.
– A high domestic price indicates that the rest of the
world has a comparative advantage in producing the
good and that the country will become an importer.
Summary
• When a country allows trade and becomes
an exporter of a good, producers of the
good are better off, and consumers of the
good are worse off.
• When a country allows trade and becomes
an importer of a good, consumers of the
good are better off, and producers are
worse off.