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GSIAS – North American Economy Economics 101 Lesson Overview Microeconomics • Supply/Demand/Equilibrium Govt. Policies Effect (Drugs/Min. Wage/Taxes) • Economic Models Perfect Competition / Monopolies Macroeconomics • GDP Circular Flow Model • Economic Growth and Production • Interest Rates and Inflation • Open Economy Macroeconomics 2-2 Macro vs. Micro Economics Microeconomics is the study of how individual households and firms make decisions and how they interact with one another in markets. Prices and selection of products Macroeconomics is the study of the economy as a whole. Its goal is to explain the economic changes that affect many households, firms, and markets at once. Inflation Unemployment Economic Growth Demand • The quantity demanded of any good is the amount of the good that buyers are willing and able to purchase. • Law of demand: the claim that the quantity demanded of a good falls when the price of the good rises, other things equal THE MARKET FORCES OF SUPPLY AND DEMAND 4 The Market Demand Curve for Lattes P Qd (Market) $0.00 24 $5.00 1.00 21 $4.00 2.00 18 3.00 15 4.00 12 5.00 9 6.00 6 P $6.00 $3.00 $2.00 $1.00 Q $0.00 0 5 10 15 THE MARKET FORCES OF SUPPLY AND DEMAND 20 25 5 Demand Curve Shifters • The demand curve shows how price affects quantity demanded, other things being equal. • These “other things” are non-price determinants of demand (i.e., things that determine buyers’ demand for a good, other than the good’s price). • Changes in them shift the D curve… $6.00 P $5.00 $4.00 $3.00 $2.00 $1.00 $0.00 THE MARKET FORCES OF SUPPLY AND DEMAND 0 5 10 15 20 25 30 Q 6 Summary: Variables That Influence Buyers Variable A change in this variable… Price …causes a movement along the D curve # of buyers …shifts the D curve Income …shifts the D curve Price of related goods …shifts the D curve Tastes …shifts the D curve Expectations …shifts the D curve THE MARKET FORCES OF SUPPLY AND DEMAND 7 ACTIVE LEARNING 1 Demand Curve Draw a demand curve for music downloads. What happens to it in each of the following scenarios? Why? A. The price of iPods falls B. The price of music downloads falls C. The price of CDs falls 8 Supply • The quantity supplied of any good is the amount that sellers are willing and able to sell. • Law of supply: the claim that the quantity supplied of a good rises when the price of the good rises, other things equal THE MARKET FORCES OF SUPPLY AND DEMAND 9 The Market Supply Curve P QS (Market) $0.00 0 1.00 5 2.00 10 $4.00 3.00 15 $3.00 4.00 20 $2.00 5.00 25 6.00 30 P $6.00 $5.00 $1.00 Q $0.00 0 5 10 15 THE MARKET FORCES OF SUPPLY AND DEMAND 20 25 30 35 10 Supply Curve Shifters • The supply curve shows how price affects quantity supplied, other things being equal. • These “other things” are non-price determinants of supply. • Changes in them shift the S curve… $6.00 P $5.00 $4.00 $3.00 $2.00 $1.00 $0.00 0 THE MARKET FORCES OF SUPPLY AND DEMAND 5 10 15 20 25 30 35 Q 11 Summary: Variables that Influence Sellers Variable A change in this variable… Price …causes a movement along the S curve Input Prices …shifts the S curve Technology …shifts the S curve # of Sellers …shifts the S curve Expectations …shifts the S curve THE MARKET FORCES OF SUPPLY AND DEMAND 12 ACTIVE LEARNING 2 Supply Curve Draw a supply curve for tax return preparation software. What happens to it in each of the following scenarios? A. Retailers cut the price of the software. B. A technological advance allows the software to be produced at lower cost. C. Professional tax return preparers raise the price of the services they provide. 13 Supply and Demand Together P $6.00 S D $5.00 $4.00 $3.00 Equilibrium: P has reached the level where quantity supplied equals quantity demanded $2.00 $1.00 Q $0.00 0 5 10 15 20 25 30 35 THE MARKET FORCES OF SUPPLY AND DEMAND 14 Surplus (a.k.a. excess supply): when quantity supplied is greater than quantity demanded P $6.00 D Surplus S $5.00 Example: If P = $5, then QD = 9 lattes $4.00 and QS = 25 lattes $3.00 $2.00 resulting in a surplus of 16 lattes $1.00 Q $0.00 0 5 10 15 20 25 30 35 THE MARKET FORCES OF SUPPLY AND DEMAND 15 Surplus (a.k.a. excess supply): when quantity supplied is greater than quantity demanded P $6.00 D Surplus $5.00 S Facing a surplus, sellers try to increase sales by cutting price. This causes QD to rise and QS to fall… $4.00 $3.00 …which reduces the surplus. $2.00 $1.00 Q $0.00 0 5 10 15 20 25 30 35 THE MARKET FORCES OF SUPPLY AND DEMAND 16 Surplus (a.k.a. excess supply): when quantity supplied is greater than quantity demanded P $6.00 D Surplus $5.00 S Facing a surplus, sellers try to increase sales by cutting price. This causes QD to rise and QS to fall. $4.00 $3.00 Prices continue to fall until market reaches equilibrium. $2.00 $1.00 Q $0.00 0 5 10 15 20 25 30 35 THE MARKET FORCES OF SUPPLY AND DEMAND 17 EXAMPLE 2: A Shift in Supply EVENT: New technology P reduces cost of producing hybrid cars. S1 S2 STEP 1: S curve shifts because P1 STEP 2: event affects cost of production. P2 S shifts right D curve event does not shift, because reduces STEP 3: production because cost, The shift causes price technology is not of makes productionone more to fall the factorsatthat profitable anyaffect given and quantity to rise. demand. price. THE MARKET FORCES OF SUPPLY AND DEMAND D1 Q1 Q2 Q 18 EXAMPLE 3: A Shift in Both Supply and Demand EVENTS: price of gas rises AND new technology reduces production costs STEP 1: Both curves shift. STEP 2: P S1 S2 P2 P1 Both shift to the right. STEP 3: Q rises, but effect on P is ambiguous: If demand increases more than supply, P rises. THE MARKET FORCES OF SUPPLY AND DEMAND D1 Q1 Q2 D2 Q 19 EXAMPLE 3: A Shift in Both Supply and Demand EVENTS: price of gas rises AND new technology reduces production costs STEP 3, cont. But if supply increases more than demand, P falls. P S1 P1 P2 D1 Q1 THE MARKET FORCES OF SUPPLY AND DEMAND S2 Q2 D2 Q 20 APPLICATION: Does Drug Interdiction Increase or Decrease Drug-Related Crime? • One side effect of illegal drug use is crime: Users often turn to crime to finance their habit. • We examine two policies designed to reduce illegal drug use and see what effects they have on drug-related crime. • For simplicity, we assume the total dollar value of drug-related crime equals total expenditure on drugs. • Demand for illegal drugs is inelastic, due to addiction issues. ELASTICITY AND ITS APPLICATION 21 Policy 1: Interdiction Interdiction reduces the supply of drugs. Since demand for drugs is inelastic, P rises proportionally more than Q falls. Price of Drugs S1 P2 initial value of drugrelated crime P1 Result: an increase in total spending on drugs, and in drug-related crime ELASTICITY AND ITS APPLICATION new value of drugrelated crime S2 D1 Q2 Q1 Quantity of Drugs 22 Policy 2: Education Education reduces the demand for drugs. Price of Drugs new value of drugrelated crime D2 D1 S P and Q fall. Result: A decrease in total spending on drugs, and in drug-related crime. ELASTICITY AND ITS APPLICATION initial value of drugrelated crime P1 P2 Q2 Q1 Quantity of Drugs 23 The Minimum Wage Min wage laws do not affect highly skilled workers. They do affect teen workers. Studies: A 10% increase in the min wage raises teen unemployment by 1-3%. SUPPLY, DEMAND, AND GOVERNMENT POLICIES W unemployment S Min. wage $5 $4 D 400 550 L 24 CASE STUDY: Who Pays the Luxury Tax? • 1990: Congress adopted a luxury tax on yachts, private airplanes, furs, expensive cars, etc. • Goal of the tax: raise revenue from those who could most easily afford to pay – wealthy consumers. • But who really pays this tax? SUPPLY, DEMAND, AND GOVERNMENT POLICIES 25 CASE STUDY: Who Pays the Luxury Tax? Demand is price-elastic. The market for yachts P Buyers’ share of tax burden S PB In the short run, supply is inelastic. Tax Sellers’ share of tax burden PS D Q SUPPLY, DEMAND, AND GOVERNMENT POLICIES Hence, companies that build yachts pay most of the tax. 26 DWL and the Size of the Tax Initially, the tax is T per unit. Doubling the tax causes the DWL to more than double. P new DWL S T 2T initial DWL Q2 APPLICATION: THE COSTS OF TAXATION Q1 D Q 27 Revenue and the Size of the Tax The Laffer curve shows the relationship between the size of the tax and tax revenue. Tax revenue The Laffer curve Tax size APPLICATION: THE COSTS OF TAXATION 28 THE MEASUREMENT OF GROSS DOMESTIC PRODUCT • Gross domestic product (GDP) is a measure of the income and expenditures of an economy. • GDP is the total market value of all final goods and services produced within a country in a given period of time. The Circular-Flow Diagram • The Circular-Flow Diagram: a visual model of the economy, shows how dollars flow through markets among households and firms • Two types of “actors”: households firms • Two markets: the market for goods and services the market for “factors of production” THINKING LIKE AN ECONOMIST 30 FIGURE 1: The Circular-Flow Diagram Households: Own the factors of production, sell/rent them to firms for income Buy and consume goods & services Firms Households Firms: Buy/hire factors of production, use them to produce goods and services Sell goods & services THINKING LIKE AN ECONOMIST 31 FIGURE 1: The Circular-Flow Diagram Revenue G&S sold Markets for Goods & Services Firms Factors of production Wages, rent, profit THINKING LIKE AN ECONOMIST Spending G&S bought Households Markets for Factors of Production Labor, land, capital Income 32 THE COMPONENTS OF GDP GDP (Y) is the sum of the following: Consumption (C) Investment (I) Government Purchases (G) Net Exports (NX) Y = C + I + G + NX Productivity • Recall one of the Ten Principles from Chap. 1: A country’s standard of living depends on its ability to produce g&s. • This ability depends on productivity, the average quantity of g&s produced per unit of labor input. • Based on: -Physical Capital -Human Capital -Natural Resources -Technical Knowledge 34 THE MARKET FOR LOANABLE FUNDS • Financial markets coordinate the economy’s saving and investment in the market for loanable funds. • The market for loanable funds is the market in which those who want to save supply funds and those who want to borrow to invest demand funds. Supply and Demand for Loanable Funds • Loanable funds refers to all income that people have chosen to save and lend out, rather than use for their own consumption. • The supply of loanable funds comes from people who have extra income they want to save and lend out. • The demand for loanable funds comes from households and firms that wish to borrow to make investments. Supply and Demand for Loanable Funds • Interest rate the price of the loan the amount that borrowers pay for loans and the amount that lenders receive on their saving in the market for loanable funds, the real interest rate Supply and Demand for Loanable Funds • Financial markets work much like other markets in the economy. • The equilibrium of the supply and demand for loanable funds determines the real interest rate. Figure 2 An Increase in the Supply of Loanable Funds Interest Rate Supply, S1 S2 1. Tax incentives for saving increase the supply of loanable funds . . . 5% 4% 2. . . . which reduces the equilibrium interest rat e . . . Demand 0 $1,200 $1,600 3. . . . and raises the equilibrium quantity of loanable funds. Loanable Funds (in billions of dollars) THE FEDERAL RESERVE SYSTEM • The Federal Reserve (Fed) serves as the nation’s central bank. Three Primary Functions of the Fed • Regulates banks to ensure they follow federal laws intended to promote safe and sound banking practices. • Acts as a banker’s bank, making loans to banks and as a lender of last resort. • Conducts monetary policy by controlling the money supply. The Federal Open Market Committee • Open-Market Operations To increase the money supply, the Fed buys government bonds from the public. To decrease the money supply, the Fed sells government bonds to the public. BANKS AND THE MONEY SUPPLY • Banks can influence the quantity of demand deposits in the economy and the money supply. Money Creation with FractionalReserve Banking • When a bank makes a loan from its reserves, the money supply increases. • The money supply is affected by the amount deposited in banks and the amount that banks loan. Deposits into a bank are recorded as both assets and liabilities. The fraction of total deposits that a bank has to keep as reserves is called the reserve ratio. Loans become an asset to the bank. Money Creation with FractionalReserve Banking • When one bank loans money, that money is generally deposited into another bank. • This creates more deposits and more reserves to be lent out. • When a bank makes a loan from its reserves, the money supply increases. THE CLASSICAL THEORY OF INFLATION • Inflation is an increase in the overall level of prices. • Hyperinflation is an extraordinarily high rate of inflation. The Level of Prices and the Value of Money • The quantity theory of money is used to explain the long-run determinants of the price level and the inflation rate. • Inflation is an economy-wide phenomenon that concerns the value of the economy’s medium of exchange. • When the overall price level rises, the value of money falls. Money Supply, Money Demand, and Monetary Equilibrium • The money supply is a policy variable that is controlled by the federal govt. • Through instruments such as open-market operations, the govt. directly controls the quantity of money supplied. • Money demand has several determinants, including interest rates and the average level of prices in the economy. Money Supply, Money Demand, and Monetary Equilibrium • People hold money because it is the medium of exchange. The amount of money people choose to hold depends on the prices of goods and services. • In the long run, the overall level of prices adjusts to the level at which the demand for money equals the supply. Figure 2 An Increase in the Money Supply Value of Money, 1 /P (High) MS1 MS2 1 1 1. An increase in the money supply . . . 3 2. . . . decreases the value of mone y . . . Price Level, P /4 12 / 1.33 A 2 B 14 / (Low) 3. . . . and increases the price level. 4 Money demand (High) (Low) 0 M1 M2 Quantity of Money Open-Economy Macroeconomics: Basic Concepts • An open economy interacts with other countries in two ways. It buys and sells goods and services in world product markets. It buys and sells capital assets in world financial markets. The Flow of Goods: Exports, Imports, Net Exports • Net exports (NX) are the value of a nation’s exports minus the value of its imports. • Net exports are also called the trade balance. The Flow of Goods: Exports, Imports, Net Exports • Factors That Affect Net Exports The tastes of consumers for domestic and foreign goods. The The prices of goods at home and abroad. exchange rates at which people can use domestic currency to buy foreign currencies. The Flow of Goods: Exports, Imports, Net Exports • Factors That Affect Net Exports The incomes of consumers at home and abroad. The costs of transporting goods from country to country. The policies of the government toward international trade. The Flow of Financial Resources: Net Capital Outflow • Net capital outflow refers to the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners. • A U.S. resident buys stock in the Toyota corporation and a Mexican buys stock in the Ford Motor corporation. The Flow of Financial Resources: Net Capital Outflow • When a U.S. resident buys stock in Telmex, the Mexican phone company, the purchase raises U.S. net capital outflow. • When a Japanese residents buys a bond issued by the U.S. government, the purchase reduces the U.S. net capital outflow. The Flow of Financial Resources: Net Capital Outflow • Variables that Influence Net Capital Outflow The real interest rates being paid on foreign assets. The real interest rates being paid on domestic assets. The perceived economic and political risks of holding assets abroad. The government policies that affect foreign ownership of domestic assets. The Equality of Net Exports and Net Capital Outflow • For an economy as a whole, NX and NCO must balance each other so that: NCO = NX • Why? When a nation is running a trade surplus (NX>0), it is selling more goods/services to foreigners than it is buying. What is it doing with the foreign currency received? Must be buying foreign assets. Capital is flowing out of the country (NCO>0). When a nation is running a trade deficit (NX<0), it is buying more goods and services from foreigners than it is selling. How is it financing the purchase? It must be selling assets abroad. Capital is flowing into the country (NCO<0). Saving, Investment, and Their Relationship to the International Flows • National saving (S) equals Y – C – G so: S = I + NX • or Saving = S = Domestic + Net Capital Investment Outflow I + NCO THE PRICES FOR INTERNATIONAL TRANSACTIONS: REAL AND NOMINAL EXCHANGE RATES • International transactions are influenced by international prices. • The two most important international prices are the nominal exchange rate and the real exchange rate. Nominal Exchange Rates • The nominal exchange rate is the rate at which a person can trade the currency of one country for the currency of another. Real Exchange Rates • The real exchange rate is the rate at which a person can trade the goods and services of one country for the goods and services of another. Figure 1 The Market for Loanable Funds Real Interest Rate Supply of loanable funds (from national saving) Equilibrium real interest rate Demand for loanable funds (for domestic investment and net capital outflow) Equilibrium quantity Quantity of Loanable Funds Figure 3 How Net Capital Outflow Depends on the Interest Rate Real Interest Rate Net capital outflow is negative. 0 Net capital outflow is positive. Net Capital Outflow The Market for Foreign-Currency Exchange Real Exchange Rate Supply of dollars (from net capital outflow) Equilibrium real exchange rate Demand for dollars (for net exports) Why does demand slope downward? Why is the Equil. Qty vertical? Equilibrium quantity Quantity of Dollars Exchanged into Foreign Currency The Effects of Government Budget Deficit 1. A budget deficit reduces the supply of loanable funds . . . (a) The Market for Loanable Funds Real Interest Rate r2 r 2. . . . which increases the real interest rate . . . S (b) Net Capital Outflow Real Interest Rate S B r2 A r 3. . . . which in turn reduces net capital outflow. Demand NCO Quantity of Loanable Funds Net Capital Outflow Real Exchange Rate E2 5. . . . which causes the real exchange rate to appreciate. E1 S S 4. The decrease in net capital outflow reduces the supply of dollars to be exchanged into foreign currency . . . Demand Quantity of Dollars (c) The Market for Foreign-Currency Exchange The Effects of an Import Quota (a) The Market for Loanable Funds Real Interest Rate (b) Net Capital Outflow Real Interest Rate Supply r r 3. Net exports, however, remain the same. Demand NCO Quantity of Loanable Funds Net Capital Outflow Real Exchange Rate E2 2. . . . and causes the real exchange rate to appreciate. Supply 1. An import quota increases the demand for dollars . . . E D D Quantity of Dollars (c) The Market for Foreign-Currency Exchange