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ECONOMICS-MSCSM1-33 (PhD Economics) After this lesson you should be able to: • Explain economic concepts models used in your industry and the economy • Discuss micro and macroeconomic issues that affect the working of the economy • Determine the difference between micro and macroeconomic policies and their effects on the domestic and world economy. • Introduction Microeconomics –Price theory • Consumer Behaviour • Production and cost • Firm Organisation • Distribution and Welfare • Macroeconomics: consumption, investment, BOP, policy analysis, Economic Growth. SCOPE OF ECONOMICS ECONOMICS IS CONCERNED WITH ALLOCATION OF LIMITED RESOURCES TO SATISFY COMPETING ENDS. Introduction: Economic Problem • Needs and Wants are Unlimited • Resources to satisfy needs and wants are Limited • Subsequently leads to scarcity of goods & services (therefore need to economise) CONTINUE • In that respect you need to allocate scarce resources toward competing ends. • This implies that we should make choices – by making choices that will lead to satisfying our needs and wants or get the best value in use. • How does society deal with scarcity? Continue 1. Economic Growth (GDP). 2. Improve the use of Available Resources. 3. Reduce Wants & Needs. HOW DO YOU ACHEIVE THE ABOVE? Continue • Through: 1. Allocative efficiency 2. Productive Efficiency 3. Equity 4. Full Employment Problems of Economic organisation Three Fundamental Problems. 1. What commodities/services shall be produced and in what quantities? That is, how much and which of alternatives goods and services shall be produced? For example: oranges, butter, wheat for bread, maize, water, shoes, clothes. When in what quantities? Continue 2. How shall goods/services be produced? That is by whom and with what resources and in what technological manner are they to be produced. Who farms? who produces for exports – diamonds, shoes, gas, coal etc? In what quantities? Continue 3. For whom shall the goods/services be produced? That is who is to enjoy and get the benefits of the goods and services produced? Continue • The what, How and for Whom questions in a free market economy are determined primarily by a system of prices (or markets, of profits and losses). Continue • Scarcity – The What to produce, How & for Whom could not be a problem if resources were unlimited. Scarcity – implies resources are limited, therefore, make choices. We assume that human beings are rationale, that is they will try to make choices that will maximize their satisfaction (utility). Continue • Economics is derived from Geek word meaning the management of household – hence use house wife example – house keeping allowance should push you as far as possible get the most out of it. Maximize utility from limited resources she seeks to obtain the maximum satisfaction for the family- certain goods are obtained i.e. Necessities (quantities by habits) Continue • Streets full of competing goods make choices. Cost/benefit looked at for each good. Opportunity Cost In all walks of life, having this means going without “that” we therefore speak of opportunity cost. The cost of something in terms of alternative forgone (more accurately in terms of the best alternative sacrificed). DG. Economic Growth The meaning of Economic Growth The resources are limited, while needs/wants are unlimited. If the economy is experiencing unemployed resources, the economy’s actual output is below its potential output. DG PRODUCTION POSSIBILITY FRONTIER Continue • Point U the economy is producing inside the production possibility curve. At this point output can be increased in the short-term policy measures that should absorb the idle or unemployed resources and move to I (one). • Full – employment does not mean the economy will grow. Full – employment implies that the existing resources are fully employed. Continue • Growth is a long- term phenomenon • Full employment simply means the economy is producing at a point on the productionpossibility curve “I” growth means over time the production-possibility curve pushes outward to curves II & III. Growth mainly refers to the standard of living rather than to output only. • Growth examples: Improvement happens gradual- country examples – China, Asian Tigers, South Korea, Taiwan, Singapore, Thailand, Hong-Kong to a lesser extent – Malaysia &Indonesia. • With this growth you get more taxation revenue and better standard of living for all in the country. Achieving Growth Factors Producing Growth 1. A rise in the productivity of existing factors of production. This can be done by improvement of organization, training of workers, better use of capital equipment, better working conditions for labour force. Continue 2. An increase in the available stock of factors of production. a) Rise in labour input (population growth) b) Development of natural resources c) Additional capital equipment. Distinguish between ‘widening’ and ‘deepening’ capital. Continue 3. Technological Change • Innovation can improve productivity • Technological improvement- a machine can replace the job done by men. 4. Fundamental Changes in the composition of the national output. As a country develops spending switches from : agriculture to manufacturing to services. Growth rates improve as countries industralize. Continue 5. Sustained Improvement in the terms of trade. • Improvement in terms of trade • BOP improvement • Increase of Imports How a free enterprise system solves the basic economic problem • The price system is used to solve the economic problem in a free market economy. • What things will be produced is determined by the dollar vote of consumers every day in their decision to purchase this good and not that good. Continue • How things are produced is determined by the competition of different producers. The method that is cheapest at any given time because of both physical efficiency and cost efficiency will displace a more costly method of production. Producers are forced to keep cost down by using efficient methods of production. Continue • For whom things are produced is determined by supply and demand in the markets for goods and services. From these marketsincome (rent, interest, wages, profits) are realised. • The competitive price system uses supplydemand markets to solve the trio of economic problems – what, How Supply-Demand Flow Chart Household, Firm (Businesses), Goods Market, Factor Market. Supply and demand discussion Consumer Behaviour and demand Economic Agents: Resource Owners• Provide inputs (The market dictate type of production) • Resource owners receive money income • The money income, make them consumers Entrepreneurs- continue • Organize production • Determine the supply of goods and services in the market • Receive profits • They also enter the market as consumers Consumers- All people who earn and use income from whatever source are referred to as consumers. Utility and Preference • The aim of every household is to spend limited money income in such a way that economic well – being is maximized. The nature of commodities • Goods and services consumed by household are called commodities • Commodities provide a flow of consumption services per unit of time. Full Knowledge • Assume each consumer has full binformation about consumption decisions • Consumer know goods/services in the markt • Consumer knows the prices and that these price will not change per unit of time due to the consumer action • Consumer know income per unit time For demand functions and Indifference curves (Assume) a) Consumer aware of the existence of some goods and services b) Prefers some goods to others c) Possesses money Income Consumer Preference Individual – household derives satisfaction or Utility from the services provided by the commodities consumed per unit time. Per given period the consumer consumes a variety of different commodities or commodity bundles. In order to achieve the objective of maximization of satisfaction or Utility for given level of income. Consumer ranks different commodity bundles and choose among the alternative bundles. COMMODITY BUNDLES i. ‘A’ and ‘B’: if ‘A’ provides more satisfaction than ‘B’ implies ‘A’ is preferred to ‘B’. If ‘A’ and ‘B’ provide same satisfaction implies consumer is indifferent between ‘A’ and ‘B’ . ii. If ‘A’ preferred to ‘B’ and ‘B’ preferred to ‘C’ then ‘A’ is preferred to ‘C’. Preference is a transitive relation –example: prefer a car to house and a house to lorry hence prefer car to a lorry. continue Similarly : If ‘A’ is indifferent to ‘B’ and ‘B’ is indifferent to C then ‘A’ is indifferent to C. You can also used this concept when dealing with different strategies in terms of preference. Rank ordering of commodity bundles Bundle amount(X ) amount(Y) rank order A 6 6 4 B 3 5 3 C 4 3 3 D 5 2 3 E 3 4 2 F 1 4 1 G 2 2 1 H 3 1 1 Continue • Bundle ‘A’ preferred to all other bundles • Indifferent among bundle B, C & D. ETC Utility and Preference More utility is assigned to A in the table . • Utility function provides an ordinal measurement of the utility provided by commodity bundles. THE UTILITY CONCEPT • The term Utility means the satisfaction that a consumer receives from whatever goods and services the individual consumes. • ‘Utility’ is the attribute possessed by a commodity or service to satisfy a human want/need, to yield satisfaction to the consumer. Continue • It is important to distinguish utility derived from unrelated items, and items which are related. For example: Bread and Clothes – the concept of utility works when the consumer, consumes the same good/service at specified time. Total and marginal Utility Total Utility • The total utility attained from a commodity refers to the entire amount of satisfaction a consumer receives from consuming it at various rates. • An essential feature of utility concept is that one commodity may be substituted for another in consumption in such a way as to leave the level of utility unchanged. Continue Graphs- Total and marginal utility curves: Marginal Utility • Definition: The change in total utility resulting from a one unit change in consumption per unit of time is the marginal utility of a good. As the amount consumed of a good increases, the marginal utility (Mu) of the good (or the extra utility added by its last unit) tends to decrease Continue Quantity Total Utility Marginal Utility 0 0 1 4 4 2 7 3 3 9 2 4 10 1 5 10 0 ___________________________________ Type of utility • The ordinal utility function tells us about how the consumer ranks the bundles of goods. It tells us about preference. It does not tell us the intensity of that preference (or likes and dislike) • The ordinal utility function helps in understanding consumer theory, as long as we deal with choice in conditions of certainty. Continue • The cardinal utility function will rank the bundles and tell us about intensity of the likes and dislikes. The cardinal utility function measures utility in ‘utils’. Cardinal utility is useful when dealing with choice in the case of risk. Utility and Indifference Curve • When we talk of ordering we are getting to an indifference curve. Thus, link utility with indifference curves implies Iso-utility. Indifference Curve • An indifference curve is a locus of points or commodity bundles, among which the consumer is indifferent. Each point on an indifference curve yields the same total utility as any other point on that same indifference curve. If the utility function is given by U = F(X1, X2........Xn) where X is the amount of good 1 consumed, X2 the amount of good 2 consumed, and so on, then an indifference curve is defined as the set of all commodity bundles (X1......Xn) that satisfy the equation U(X1,X2..Xn)=c where c is the constant level of utility for that indifference curve. continue • Graphs of Indifference curves: Characteristics if Indifference Curves a) An indifference curve passes through each point in the commodity space. b) Indifference curves cannot intersect. c) Indifference curves are negatively sloped. d) Indifference curves are convex to the origin. e) The higher or further to the right is an indifference curve, the higher the bundles are on the curve in the consumers preference ordering, this is, bundles on higher indifference curves are preferred to bundles on lower indifference curves. Continue Graph of intersect: We start from the premise that consumers are rational, and that there is a transitive (consistent) relationship in indifference curves. Continue • If ‘R’ is preferred to ‘Q’, then ‘P’ should be preferred to ‘Q’, but P & Q are on the same indifference curve (hence inconsistent). Suppose you have bundles: 1, 2 , 3; and 1 preferred to 2 and 2 preferred to 3 then 1 is preferred to 3 (consistent hence rational). continue Graph: Indifference curves are negatively sloped. • The is particular shape involves what is colled a diminishing marginal rate of substitution between goods. This shape implies that the more of good X there is relative to good Y in the bundle to begin with, the more X is required to compensate the consumer for the loss of a given amount of Y. {MRSxy or MRSx for Y. This is diminishing}. Continue • The marginal rate of substitution of X for Y is the ratio of the amount of X needed to compensate for a small loss of Y to that loss of Y. It is given by the slope of the indifference curve which is negative and becomes more negative (it is diminishes) as we move down the curve from left to right. Continue Graph: Indifference curves are convex to origin. Convexity – means that the indifference curve lies above its tangent at each point. Equi-Marginal Principle • People will allocate their expenditures among goods in such a manner that the ratio of marginal utility to price (Mux/Px = Muy/Py etc) for each good is identical. In this way a consumer with a finite income will maximize the utility he can gain. If he/she deviated from this combination by buying more of some goods and less of others he/she would lose more utility than he/she would gain. Relative Price • The relative price of a commodity is the price of that good in terms of some other good. It represents the terms of trade or trading ratio between two goods. In the case of two goods X and Y , the relative price of X in terms of Y is the price ratio Px/Py , where px is the nominal price of X and Py is the nominal price of Y. The relative price of X in terms of Y : Px/Py tells how many units of Y must be given up to get 1 unit of X. Similarly, the ratio Py/Px is the relative price of Y in terms of X tell how many units of X must be given up to get 1 unit of Y. (trading ratio, opportunity cost, terms of trade). Theory of consumer behaviour Limited money Income: • Every consumer has limited income • The problem of the consumer is to spend the limited income in a way that gives him/her maximum satisfaction. • Assume that there are two goods X and Y bought in quantities x and y • Consumers income ‘M’ Fixed Continue • • • • • Amount spent on X is xPx Amount spent on Y is yPy M ≥ xPx + yPy Consider equality M = xPx + yPy this an equation of a straight line. Solve for y • Y = (1/py)M – (Px/Py) x Continue • Y = M/Py – (Px/Py)x (straight line) • Give Budget line. Continue Budget line: The budget line is the set of commodity bundles that can be purchased if the entire money income is spent. Its slope is the negative of the price ratio. continue Shifting the Budget line: Income (DG) If M income changes ∆M to M’ where M’ > M (price fixed). An increase in income will move the budget line to the right in the commodity bundle space. continue Price change (relative price) - DG Price of X change to P*x -(Px/Py) to – (P*x/Py) where P*x > Px - (P*x/Py) < - (Px/Py) Marginal rate of Substitution DG Suppose we have commodity, X and Y: Commodity ‘Y’ can be substituted for commodity “X” and the consumer remain with the same satisfaction . Continue • What the rate at which consumers are willing to substitute one commodity for another? • Bundle at point R [0X1 of X; 0Y of Y. • Bundle at point P[0X2 of X; 0Y2 of Y. • The consumer is willing to substitute X1X2 units of X for Y1Y2 units of Y. The rate at which he is willing to substitute X for Y is .... continue (0Y1 – 0Y2)/(0X2 – 0X1) = (RS/SP) = tanƟ The ratio shows that the consumer is willing to give away Y1Y2 of Y units to get 1 unit of X (same level of indifference curve). As the point R moves toward the tangent TT’ at point P the movement becomes very small and the slope is colled MRSx for Y continue • MRS: The marginal rate of substitution of X for Y measures the number of units of Y that must be sacrificed per unit of X gained so as to maintain a constant level of satisfaction. The marginal rate of substitution is the negative of the slope of an indifference curve at a point. It is defined only for movements along an indifference curve. The solution to the choice problem: Consumer Equilibrium • The consumer wants to maximize satisfaction given all consumption patterns available. Hence the consume wants to maximize utility. • Equilibrium at A because there are no forces at this point to move the consumer from A. The budget line is tangent to the indifference curve. Income Consumption Curve • We would like to know and predict how the consumer behaves, with respect to bundles of goods chosen when: a) Income changes b) Price of X changes c) Price of Y changes • Change in income, Px and Py constant • The slope of budget line does not change. Continue • The slope of budget line tells us how X is substituted for Y and depends on Px/Py the ratio of the prices. • An increase in income will lead to the budget line shifting to the right, and consumer will get more of X and Y. DG Price consumption curve • Holding Py and Income constant vary price of X. DG Demand Curve Distribution of Income • The Lorenz Curve: • The lorenz curve is used in the calculation of measures of inequality. The Lorenz curve plots cumulative percentages of total income received against cumulative percentages of income recipients, starting with the smallest income recipient. A point on the curve gives the percentage of the population that accounts for a given percentage of total income (DG) Short and Long run • Short run: refers to that period of time in which the input of one or more productive items are fixed (factor of production include – land , labour, capital). The changes in product output should be achieved using variable inputs e.g. Labour, fertilizer,; while, land and macinary remain fixed. continue • Long run: A period or time or planning period in which all inputs are variable. Things like land area, large capital equipment and machinery, farm building can be changed in response to the need to increase/decrease product output. The Production Function Concept: Production function refers to the physical relationships between a firm’s inputs of resources and its output of goods and services per unit of time, leaving prices output. continue • Generally production Function can be presented as: Q = f(K, L) two inputs Where: Q = output (product) K, L = inputs, capital and labour Isoquant • Definition – An isoquant is a curve in input space showing all possible combinations of inputs physically capable of producing a given level of output. (DG) • Isoquant slope downward to the right • Isoquants do not intersect • Isoquant are convex to the origin continue • Example: suppose digging a dam using labour and capital the more labour you use for given capital the more difficult it becomes to substitute capital for labour. Additional labour will compensate for smaller and smaller amounts of capital. Suppose there is A & B resources to produce fixed output it becomes difficult to substitute A for B. That means addition of A compensate smaller amounts of B. continue • This principle is called diminishing marginal rate of technical substitution of A for B (MRTSab). • MRTSab is measured at any point on an isoquant or iso-product or equal product curve of the slope of the isoquant at that point. MRTSab – it is the amount of one resource lost that will be just compensated for by an addition unit of another resource (output being kept constant) The Law of diminishing returns • The law of diminishing returns states that: If the input of one resource is increased by equal increments per unit of time while the inputs of other resources are held constant, total product output will increase; but beyond some point the resulting output increases will become smaller and smaller. Returns to scale • The concept of returns to scale refers to what happens to output when every input is increased in equal proportion. 1. If successive equal increments of all factor inputs yield successively smaller increases in output we have deceasing (or diminishing) returns to scale. continue 2. If they yield equal increments in output we have constant returns to scale. 3. If they yield successively increasing increments in output we have increasing returns to scale. (DG) Cost function • Isocost- describe the quantities of capital and labour services that can be bought per unit of time for a given cost outlay. • C = wL + rK Solve for K K = C/r – (w/r)L Isoline continue • Show Equilibrium: Short –run profit maximization the marginal approach • Perfect competition-characteristics • Profit maximization by the marginal approach • DG The short run equilibrium is achieved at point E. At point E MR = MC In a perfectly competitive firm MR =P also MC =p=MR continue • To determine whether a firm is making a profit or a loss we compare price and average total cost (P, ATC) corresponding to the equilibrium rate of output. • If price is greater than unit cost the firm will make a profit in short run • If price per unit is less than unit cost there is a loss. Monopoly Profit Characteristic: DG The profit maximising monopolist will set output where MC = MR at X bar. The demand curve or AR will give the price. The monopolist cannot set both output and price. It has to set one of them (output or price) and the market will give the other. Profit is given by area OX(Bar)MP – oX (Bar)L Oligopoly • An oligopolistic exist in a market, if an action by one firm firm’s selling price provokes a reaction by another or its competitor and the reaction will , in turn, affect the original firm’s revenue. • Oligopoly is characterised by markets forms, where there is a small number of sellers. Classified as 2 to 20 firms form oligopoly. This could be the small number we are referring to. continue • Duopoly – is a special case of oligopoly, it is the lower limit of oligopolies. The oligopoly structure is between the two extremes it si perfect and monopoly. MACROECONOMICS Macroeconomics deals with: • Behaviour of the economy as a whole • Total output of goods and services • Growth of output • Rate of Inflation • Unemployment • BOP (Balance of Payment) • Exchange Rate Continue • • • • Consumption Investment and savings Government expenditure Foreign Trade KEY CONCEPTS Gross National Product (GNP) GNP gives the value of all goods and services produced in an economy per unit time, usually one year, but could be prepared on a quarterly basis. GNP can be given in: • Nominal or current dollar • Real or constant dollar continue • Nominal measures GNP at prevailing or current period prices. • Real or constant GNP use a base year. • Per capita: implies GNP/population • Potential real GNP: or potential output • Is the output that can be realized if there was full employment. continue • GNP (Gap) = potential GNP – Actual GNP this is an indicator that can be used to measure economic (slack) waste of productive resources due to higher level of unemployment • Productivity implies (output/workers) or output per worker continue • GDP – Gross Domestic Product: GNP excluding net property abroad. GDP is an estimate of incomes accruing to residents and generated within the country only continue Macroeconomics performance (indicators) • Growth in real GDP (increase implies strength in the economy). • Unemployment rate (increase) sign if weakness in the economy. AD & AS The main concern in macroeconomics is a) Level of output b) Price level or inflation rate Both indicators output/inflation rate are obtained by analysis of AD & AS. For many years AD has been used to manage the economies. But emphasis has shifted to supply side economics, hence, structural adjustment programs. continue • AD is the relationship between spending on goods and services and price • AS - show a relationship between the amount of output firms produce and the price level • Inflation is the rate of increase/decrease of price level. • Expansionary AD policies lead to an increase in inflation rate and low AD reduce inflation rate continue • Inflation = (Pt – Pt-1)/Pt-1 *100 • Remember CPI – consumer price index is not inflation t is current period, t-1 is previous period time Question: Briefly describe the inflation behaviour for Zimbabwe. continue Stabilization Policy The two broad policies used to influence the economy are: a) Monetary policy: In most countries this policy is controlled by central bank Instruments used • Open market operation continue • Changes in stock of money • Changes in the rate of interest (bank rate). This is the rate used by central bank on lending money to commercial banks. The bank rate is also used to control commercial banks. All other rates follow the movement of bank rate. continue b) Fiscal policy: this policy is under the control of the government of the day. Instruments used Tax rate Government spending (Budget surplus/deficit) These two policies affect the economy through the effects they have on AD. The policies are often referred to as demand management policies. continue • Stabilization policies are policies that moderate fluctuations of the economy. Fluctuations are experienced in: • Inflation rate • Output (GNP) • Unemployment The fluctuations in these variables can be off-set by stabilization policies. continue • In policies of stabilization politics is involved for example: inflation/unemployment levels. • Stabilization policy is known as countercyclical policy because it moderates trade cycle or business cycle. This means regular cycle of booms, declines, recessions and recoveries Business cycle DG Aggregate demand(AD) & aggregate supply(AS) • AS – we mean Gross national product (GNP) • AD – we mean Gross national expenditure (GNE) • DG- of AD & AS • AD – total demand for goods /services in the economy. The AD can be shifted through monetary and fiscal policy. AS – shows price level associated with each level of output. AS –can be shifted by use of fiscal policy. continue • Interaction of AD & AS give price level and output. National Income Accounting • National Income: A measure of the money value of the goods/services becoming available to the nation from economic activity. National Income Accounting Approach. 1. Income approach: • Profits, Employment, rent, dividends, wages, salaries continue 2. Expenditure Approach: • Consumption • Investment 3. Output (product) Approach: • Output of sectors NOTE THAT: Income = Expenditure = output (very important) GNE - deflator • The gross national expenditure (GNE) gives a measure of inflation known as GNE-deflator. • The GNE –deflator is the ratio of nominal GNE in a given year to real GNE. Basic models of Aggregate demand • Two sector economy: DG of household and firm • Three sector economy: DG of household, firm and government • Four sector economy: DG of household, firm, government and rest of the world GNP = C + I + G + X – M + NTI AS = AD Consumption Function • Assume: Consumption function is a linear function of income. • DG of consumption function • C = Ć + cY (consumption function) Where: Ć > 0 ; 0 < c < 1 and note that Ć is intercept; c is the slope. Continue • C is marginal propensity to consume • 1 unit increase in income results in c increase in consumption • 0 < c < 1 means out of $1 increase in income only a fraction goes to consumption. • Example: c = 0.8 then $1 increase in income mean only 80c goes to consumption or increase by 80c Consumption and Savings Since only a fraction of the increase in income goes to consumption, the other fraction goes to savings. 1–c Y=S+C S = Y – C by definition this is the saving function S = Y – C replace C by its equation Continue S = Y – (Ć + cY ) S = - Ć + (1-c)Y /// this is the saving function. Marginal propensity to save s = 1- c . The saving function is the mirror image of the consumption function. At low levels of income savings is –ve, C > Y at low incomes and ‘S’ is -ve while C < Y at higher incomes Continue Saving Function: DG of Savings and Income Equilibrium Income and output Y=C+I (Equilibrium Equation) C = a + cY (Consumption Equation) I = I(bar) Substitute Y = a + cY + I(bar) Y – cY = a + I(bar) Y(1-c) = a + I(bar) Y = {a + I(bar)}/[1-c] Equilibrium Income How saving and Investment determine Income • graph The multiplier concept • The multiplier is simply number which when multiplied by a change in some exogenous (independent) variable, gives a resulting change in aggregate income. • An increase in private investment will cause income and employment to expand; a decrease in investment will cause them to contract. continue • Income analysis shows that an increase in investment will increase national income by a multiplied amount – by an amount greater than itself, investment spending is high powered, double duty spending. continue • This amplified effect of investment on income is called the “multiplier”. It is a number that shows how much above unity is the increase in income resulting from each increase in investment. • Multiplier = ∆Y/ ∆I ; where, Y is income & I is investment, ∆ is change. Rearranging the formula we get: ∆Y = multiplier x ∆I Multiplier formula • The size of the multiplier is determined by MPC. • Series: Geometric progression • Show equation • Where, r is mpc, as long as value of r is less than 1 in absolute terms • Multiplier is reciprocal of mps. continue • ∆Y = (1/mps) *∆I • ∆Y = (1/1-mps)* ∆I • 1/1 +r and r is common ratio – in case of multiplier common ratio is mpc, • m = 1/1 – mpc • If mpc is 2/3 • m = 1/(1-2/3) = 3 • The larger the mpc the larger the multiplier will be. PRICES AND THE SUPPLY OF MONEY • changes in the money supply have an important role in causing the C + I + G spending to shift upward and downward -cost –push inflation -demand-push inflation Inflation Definition: By inflation we mean a time of generally rising prices for bread, car, agricultural products, rising salaries, rent, etc. Deflation means a time when most prices and costs are falling. continue • Galloping hyperinflation is when a price increase leads to wages and cost incease, which again lead to a further increase of prices, wages and costs (Discuss this kind of inflation giving examples). continue • Money: money is defined in terms of how it is used or what it can buy. The Role of money i. Medium of exchange ii. A store of wealth or value iii. A unit of account iv. A standard of deferred payment continue Money includes – coins and paper money outside banks, demand deposits (checking accounts) at commercial banks etc. Demand for money According to Keynes (1936) money demand falls into the following motives: continue 1.Transaction motive 2.Precautionary motive 3.Speculative motive Concept Transaction motive: The transaction demand for money shows how much money households want to hold in order to carry out their day-today transactions continue Concept Precautionary motive: The precautionary demand for money shows how money much money households wants to hold in order to meet any unforeseen emergencies. continue Concept Speculative motive: The speculative demand for money shows how much money households (speculators) want to hold at various market rates of interest (various bonds prices). continue Monetary policy tools 1. The legal reserve requirement – commercial banks keep a percentage of their demand deposits on reserves with central bank. 2. Open – market operations: open – market operations are the buying or selling of government bonds in the open market in order to effect the demand deposits of commercial banks and thereby the money supply. ELASTICITY OF DEMAND Price elasticity of demand: • Definition- A measure of the percentage change in one variable in respect of a percentage change in another variable. • ᶯ = {ΔQ/ΔP}/(Q/P) = marginal function/average function continue • Elasticity = proportional change in quantity/ proportional change in price. • Proportional change in quantity = ΔQi/Qi*100 • Proportional change in price = Δpi/Pi*100 Where: Δ is change in ; Qi is quantity; Pi = price of good or fare. Small change is known as point elasticity of demand. If Δ is large you get arc elasticity. continue If Law of demand is operates: a fall in price will result in a rise in demand . Compute elasticity of demand given the following: Price before change = $10, price change = $20 Quantity before change = 200; Quantity change = 100. • If answer is greater than 1 elastic • If answer less than 1 inelastic • If answer equal 1 Unitary Cross-Price Elasticity Assume good x and good y – (prices Px , Py) and quantity q Definition: The responsiveness of quantity demanded of one good to a change in the price of another good or continue Cross-elasticity of demand = proportional change in quantity of good x divided by proportional change in price of good y. (write the formula?) If cross elasticity is greater than zero the good is a substitute. If the cross elasticity is less than zero the good is a complementary good. ARC - Elasticity Cross-elasticity of demand = proportional change in quantity of good x divided by proportional change in price of good y. (write the formula?) If cross elasticity is greater than zero the good is a substitute. If the cross elasticity is less than zero the good is a complementary good. INCOME ELASTICITY Definition: Responsiveness of demand to a change in income is referred to as income elasticity of demand. Income Elasticity of Income = (ΔQ/Q ) / (ΔM/M) = ΔQ/ΔM * M/Q