Markets for goods and services to consumers are referred to as goods markets or product markets.

Markets for factors of production (raw materials, goods and services used in production) are referred to as factor markets.

Goods and services used in the production of final goods and services are referred to as intermediate goods.

The quantity supplied is greater at higher prices. The quantity demanded is greater at lower prices.

A demand function provides the quantity demanded as a function of price of the good or service, the prices of related goods or services, and some measure of income.

A supply function provides the quantity supplied as a function of price of the good or service and the prices of productive inputs, and depends on the technology used to produce the good or service.

Using values for all the variables other than price and inverting a demand (supply) function produces a demand (supply) curve.

The change in quantity demanded (supplied) in response to a change in price represents a movement along a demand (supply) curve, not a change in demand (supply).

Changes in demand (supply) refer to shifts in a demand (supply) curve.

Demand is affected by changes in consumer tastes and typically increases (shifts to the right) with increases in income, increases in the price of substitute goods, or decreases in the price of complementary goods.

Supply is increased (shifted to the right) by advances in production technology and by decreases in input prices (prices of factors of production).

The aggregate or market demand (supply) function is calculated by summing the quantities demanded (supplied) at each price for individual demand (supply) functions.

In free markets, the equilibrium price is the price at which the quantity demanded equals the quantity supplied. When the market price is greater than the equilibrium price, the quantity supplied is greater than the quantity demanded (excess supply), and competition among suppliers for sales will drive the price down towards the equilibrium price. When the market price is less than the equilibrium price, the quantity demanded is greater than the quantity supplied (excess demand), and competition for the product among buyers will drive the price up towards the equilibrium price.

A stable equilibrium is one for which movement of the price away from its equilibrium level results in forces that drive the price back towards equilibrium. An unstable equilibrium is one for which a movement of the price away from its equilibrium level results in forces that move the price further from its equilibrium level.

While price equilibria are typically stable, if the supply curve is downward sloping and less steep than the demand curve, the resulting equilibrium is unstable.

Given an individual’s demand function for Good X, Q_DX = f (price of Good X, price of Good A, price of Good B, income), we can insert values for income and the prices of related goods A and B to get quantity demanded as a function of only the price of Good X. We can invert this function (solve for P_X) to get a demand curve (i.e., price as a function of quantity demanded).

Given a firm’s supply function for Good X, Q_SX = f (price of Good X, price of input A, price of input B) for a specific production technology, we can insert values for input prices to get quantity supplied as a function of only the price of Good X. We can invert this function (solve for P_X) to get a supply curve (i.e., price as a function of quantity supplied).

The aggregate or market demand (supply) function is calculated by summing the quantities demanded (supplied) for individual demand (supply) functions. Inverting an aggregate demand (supply) function produces an aggregate demand (supply) curve.

A common value auction is an auction for a good (e.g., rights to mineral extraction) which has the same value to all bidders, even though this value may not be known with certainty at the time of the auction. The highest bidder may be the one who most overvalues the item (winner’s curse).

A private value auction is an auction for a good (e.g., Van Gogh painting) for which the value is different to each bidder. Bidders are not expected to bid amounts greater than their private value of the item.

In an ascending price or English auction, the highest bidder wins the item and pays the amount bid.

In a sealed bid auction, each bidder’s bid is unknown to other bidders and the high bidder wins the item and pays the amount bid. The value to each bidder is referred to as the bidder’s reservation price. The bid made by the winner may be less than his reservation price.

In a second price or Vickrey auction, the winning (highest) bidder pays the amount bid by the second-highest bidder. In this format, there is no incentive for a bidder to bid less than his reservation price.

In a descending price or Dutch auction, the auction begins with a high price which is reduced in increments until a buyer accepts the price. When multiple units are available, bidders may accept the price for some units and the price is subsequently reduced incrementally until the last of the available units are accepted.

The auction of U.S. Treasury securities is done with a modified Dutch auction in which all bidders pay the price at which the last of the units available are purchased. Non-competitive bids may be placed, which are filled in their specified amounts at the final price.

The equilibrium quantity and price lead to optimal allocation of resources because the allocation maximizes the difference between the cost of producing and the total value to consumers of the traded quantity of a good.

Consumer surplus is the excess consumers would be willing to pay above what they actually pay for the equilibrium quantity of a good or a service and is represented by the triangle bounded by the demand curve, the equilibrium price, and the left-hand axis. For a linear demand curve, consumer surplus can be calculated as the area of the triangle, or ½ × equilibrium quantity × (price at which quantity demanded is zero − equilibrium price).

Producer surplus is the excess that suppliers receive over the total cost to produce those units and is represented by the triangle bounded by market price, the supply curve, and the left-hand axis. For a linear supply curve, producer surplus can be calculated as ½ × equilibrium quantity × (equilibrium price − price at which quantity supplied is zero).

Imposition of an effective maximum price (price ceiling) by the government results in excess demand, while imposition of an effective minimum price (price floor) results in excess supply.

Imposition of an effective quota reduces supply. Payment of a subsidy to producers increases supply.

Imposition of a tax on suppliers reduces supply. Imposition of a tax on consumers reduces demand.

Elasticity is measured as the ratio of the percentage change in one variable to a percentage change in another. Three elasticities related to a demand function are of interest:

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|own price elasticity| > 1: demand is elastic

|own price elasticity| < 1: demand is inelastic

cross price elasticity > 0: related good is a substitute

cross price elasticity < 0: related good is a complement

income elasticity < 0: good is an inferior good

income elasticity > 0: good is a normal good

An indifference curve shows all combinations of two goods among which a specific consumer is indifferent (i.e., all combinations of the two goods along an indifference curve are equally preferred).

An opportunity set is all the combinations of goods that are affordable to a specific consumer.

A budget constraint for two goods is all combinations of goods that will, given the prices of the two goods, just exhaust a consumer’s income.

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Given a budget constraint and a specific consumer’s indifference curves, the consumer’s most preferred combination of two goods along the budget constraint is represented by the point where one of the consumer’s indifference curves is just tangent to the budget constraint.

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When the price of a good decreases, the substitution effect leads a consumer to consume more of that good and less of goods for which prices have remained the same.

A decrease in the price of a good that a consumer purchases leaves her with unspent income (for the same combination of goods). The effect of this additional income on consumption of the good for which the price has decreased is termed the income effect.

For a normal good, the income effect of a price decrease is positive—income elasticity of demand is positive.

For an inferior good, the income effect of a price decrease is negative—income elasticity of demand is negative. An increase in income reduces demand for an inferior good.

A Giffen good is an inferior good for which the negative income effect of a price decrease outweighs the positive substitution effect, so that a decrease (increase) in the good’s price has a net result of decreasing (increasing) the quantity consumed.

A Veblen good is also one for which an increase (decrease) in price results in an increase (decrease) in the quantity consumed. However, a Veblen good is not an inferior good. The increase in consumption when the price of the good increases is due to a perception that a higher price makes consuming the good more desirable in some way, perhaps conveying higher status.

accounting profit = total revenue − total accounting (explicit) costs

Positive economic profit has a positive effect on the market value of equity. Negative economic profit has a negative effect on the market value of equity.

Normal profit is the accounting profit for which economic profit equals zero, which occurs when accounting profit is equal to implicit opportunity costs:

normal profit = accounting profit – economic profit

Economic rent to a factor of production is the difference between its earnings and its opportunity cost. When the supply curve is perfectly elastic, there is no economic rent. Perfectly inelastic supply results in the greatest economic rent.

When all units are sold at a single price, total revenue is price multiplied by quantity sold and average revenue is equal to price. Marginal revenue is the increase in total revenue from selling one more unit of a good or service.

Under perfect competition, each firm faces a horizontal demand curve so that price, average revenue, and marginal revenue are all equal. Under imperfect competition, firm demand curves are negatively sloped so that a greater quantity can be sold only by decreasing price. In this case, marginal revenue is less than average revenue and price.

Fixed costs are those costs that do not vary directly with the quantity produced (e.g., plant and equipment). Variable costs are those that vary directly with the quantity produced (e.g., labor, raw materials). Total cost of a given output is equal to total fixed costs plus total variable costs.

Marginal cost is the increase in total variable costs for one additional unit of output. For a given level of fixed costs, marginal cost first decreases and then (at some quantity of output) begins to increase.

Average fixed cost (AFC) is fixed cost per unit of output and declines with greater quantities of output.

Average variable cost (AVC) is variable cost per unit of output and first decreases and then increases with greater quantities.

Average total cost (ATC) is total cost per unit of output and is equal to average fixed costs plus average variable costs.

Both AVC and ATC are at their minimum values where they are equal to marginal cost.

The vertical distance between the ATC and AVC curves is equal to AFC.

Under perfect competition:

• The breakeven quantity of production is the quantity for which price (P) = average total cost (ATC) and total revenue (TR) = total cost (TC).
• The firm should shut down in the long run if P < ATC so that TR < TC.
• The firm should shut down in the short run (and the long run) if P < average variable cost (AVC) so that TR < total variable cost (TVC).

Under imperfect competition (firm faces downward sloping demand):

• Breakeven quantity is the quantity for which TR = TC.
  
• The firm should shut down in the long run if TR < TC.
• The firm should shut down in the short run (and the long run) if TR < TVC.

The long-run average total cost (LRATC) curve shows the minimum average total cost for each level of output assuming that the plant size (scale of the firm) can be adjusted. A downward sloping segment of a long-run average total cost curve indicates economies of scale (increasing returns to scale). Over such a segment, increasing the scale of the firm reduces ATC.

An upward sloping segment of a long-run average total cost curve indicates diseconomies of scale, where average unit costs will rise as the scale of the business (and long-run output) increases.

A flat portion of a long-run average total cost curve represents constant returns to scale and LRATC is constant over that range of output.

A firm’s minimum efficient scale is represented by the minimum point on the LRATC curve and is the firm size that will minimize average unit costs. In perfect competition, firms will eventually all operate at minimum efficient scale.

The short run is a time period during which quantities of some firm resources are fixed. A firm may continue to operate in the short run with economic losses as long as price is greater than AVC because the losses are less than total fixed costs. The firm is “maximizing profit” by minimizing losses.

In the long run, all factors of production are variable so a firm will maximize profits at the quantity for which marginal revenue equals marginal cost as long as price is greater than ATC. If price is less than ATC, the firm has economic losses and will minimize losses in the long run by going out of business and reducing ongoing losses to zero.

For a decreasing cost industry, as industry output increases, input (factor) prices decrease as the industry demand for inputs increases. This results in a negatively sloped long-run industry supply curve.

For a constant cost industry, the price of resources does not change as industry output expands, resulting in a horizontal long-run industry supply curve.

For an increasing cost industry, as industry output increases, input (factor) prices increase as the industry demand for inputs increases. This results in a positively sloped long-run industry supply curve.

The marginal product of labor increases initially as additional units of labor are employed. For example, four workers may produce more than twice the output of two workers. This is referred to as a situation in which the MPL is increasing.

Holding physical capital constant, as labor is increased beyond some quantity, the incremental output from each additional worker declines. This is referred to as the point of diminishing marginal returns or decreasing marginal productivity.

The marginal revenue product (MRP) of labor is the additional revenue that a firm would get from selling the additional output (marginal product) of one more unit of labor. A firm can increase profits by hiring additional units of labor, as long as the MRP of labor is greater than the cost of one more unit of labor. A firm should employ more labor until the MRP of labor just equals the wage. Beyond this quantity of labor, the value of the additional output of one more worker is less than the worker’s wage.

The optimal combination of labor and capital inputs is reached when the ratio of the marginal product of capital to its cost is equal to the ratio of the marginal product of labor to its cost, which is output per dollar of input cost. That is, MP_capital / P_capital = MP_labor / P_labor.

When this condition is met, costs for the associated level of output are at a minimum. If the MP_capital / P_capital < MP_labor / P_labor so that the output per dollar of capital is less than the output per dollar of labor, a firm can reduce costs by employing more labor and less capital to produce the same output.

Perfect competition is characterized by:

• Many firms, each small relative to the market.
• Very low barriers to entry into or exit from the industry.
• Homogeneous products that are perfect substitutes, no advertising or branding.
• No pricing power.

Monopolistic competition is characterized by:

• Many firms.
• Low barriers to entry into or exit from the industry.
• Differentiated products, heavy advertising and marketing expenditure.
• Some pricing power.

Oligopoly markets are characterized by:

• Few sellers.
• High barriers to entry into or exit from the industry.
• Products that may be homogeneous or differentiated by branding and advertising.
• Firms that may have significant pricing power

Monopoly is characterized by:

• A single firm that comprises the whole market.
• Very high barriers to entry into or exit from the industry.
• Advertising used to compete with substitute products.
• Significant pricing power.

Perfect competition:

• Price = marginal revenue = marginal cost (in equilibrium).
• Perfectly elastic demand, zero economic profit in equilibrium.

Monopolistic competition:

• Price > marginal revenue = marginal cost (in equilibrium).
• Elasticity > 1 (elastic but not perfectly elastic), zero economic profit in long-run equilibrium.

Oligopoly:

• Price > marginal revenue = marginal cost (in equilibrium).
• Elasticity > 1 (elastic), may have positive economic profit in long-run equilibrium, but moves toward zero economic profit over time.

Monopoly:

• Price > marginal revenue = marginal cost (in equilibrium.
• Elasticity > 1 (elastic), may have positive economic profit in long-run equilibrium, profits may be zero because of expenditures to preserve monopoly.

Under perfect competition, a firm’s short-run supply curve is the portion of the firm’s short-run marginal cost curve above average variable cost. A firm’s long-run supply curve is the portion of the firm’s long-run marginal cost curve above average total cost.

Firms operating under monopolistic competition, oligopoly, and monopoly do not have well-defined supply functions, so neither marginal cost curves nor average cost curves are supply curves in these cases.

All firms maximize profits by producing the quantity of output for which marginal cost equals marginal revenue. Under perfect competition (perfectly elastic demand), marginal revenue also equals price.

Firms in monopolistic competition or that operate in oligopoly or monopoly markets all face downward sloping demand curves. Selling price is determined from the price on the demand curve for the profit maximizing quantity of output.

Whether a firm operates in perfect competition, monopolistic competition, or is a monopoly, profits are maximized by producing and selling the quantity for which marginal revenue equals marginal cost. Under perfect competition, price equals marginal revenue. Under monopolistic competition or monopoly, firms face downward-sloping demand curves so that marginal revenue is less than price, and the price charged at the profit-maximizing quantity is the price from the firm's demand curve at the optimal (profit-maximizing) level of output.

Under oligopoly, the pricing strategy is not clear. Because firm decisions are interdependent, the optimal pricing and output strategy depends on the assumptions made about other firms' cost structures and about competitors' responses to a firm's price changes.

A concentration ratio for N firms is calculated as the percentage of market sales accounted for by the N largest firms in the industry and is used as a simple measure of market structure and market power.

The Herfindahl-Hirschman Index measure of concentration is calculated as the sum of the squared market shares of the largest N firms in an industry and better reflects the effect of mergers on industry concentration.

Neither measure actually measures market power directly. Both can be misleading measures of market power when potential competition restricts pricing power.

Gross domestic product (GDP) is the market value of all final goods and services produced within a country during a certain time period.

Using the expenditure approach, GDP is calculated as the total amount spent on goods and services produced in the country during a time period.

Using the income approach, GDP is calculated as the total income earned by households and businesses in the country during a time period.

The expenditure approach to measuring GDP can use the sum-of-value-added method or the value-of-final-output method.

• Sum-of-value-added: GDP is calculated by summing the additions to value created at each stage of production and distribution.
• Value-of-final-output: GDP is calculated by summing the values of all final goods and services produced during the period.

Nominal GDP values goods and services at their current prices. Real GDP measures current year output using prices from a base year.

The GDP deflator is a price index that can be used to convert nominal GDP into real GDP by removing the effects of changes in prices.

The four components of gross domestic product are consumption spending, business investment, government spending, and net exports. GDP = C + I + G + (X − M).

National income is the income received by all factors of production used in the creation of final output.

Personal income is the pretax income received by households.

Personal disposable income is personal income after taxes.

The IS curve shows the negative relationship between the real interest rate and levels of aggregate income that are equal to planned expenditures at each real interest rate.

The LM curve shows, for a given level of the real money supply, a positive relationship between the real interest rate and levels of aggregate income at which demand and supply of real money balances are equal.

The points at which the IS curve intersects LM curves for different levels of the real money supply (i.e., for different price levels, holding the nominal money supply constant) form the aggregate demand curve. The aggregate demand curve shows the negative relationship between GDP (real output demanded) and the price level, when other factors are held constant.

The short-run aggregate supply curve shows the positive relationship between real GDP supplied and the price level, when other factors are held constant. Holding some input costs such as wages fixed in the short run, the curve slopes upward because higher output prices result in greater output (real wages fall).

Because all input prices are assumed to be flexible in the long run, the long-run aggregate supply curve is perfectly inelastic (vertical). Long-run aggregate supply represents potential GDP, the full employment level of economic output.

Changes in the price level cause movement along the

aggregate demand or aggregate supply curves.

Shifts in the aggregate demand curve are caused by changes in household wealth, business and consumer expectations, capacity utilization, fiscal policy, monetary policy, currency exchange rates, and global economic growth rates.

Shifts in the short-run aggregate supply curve are caused by changes in nominal wages or other input prices, expectations of future prices, business taxes, business subsidies, and currency exchange rates, as well as by the factors that affect long-run aggregate supply.

Shifts in the long-run aggregate supply curve are caused by changes in labor supply and quality, the supply of physical capital, the availability of natural resources, and the level of technology.

A recessionary gap occurs when real GDP is less than potential real GDP, causing downward pressure on input prices.

An inflationary gap occurs when real GDP is greater than potential real GDP, causing upward pressure on input prices.

Stagflation is simultaneous high inflation and weak economic growth, which can result from a sudden decrease in short-run aggregate supply.

If aggregate demand increases relative to long-run aggregate supply, output and prices increase in the short run, and in the long run resource prices (especially wages) increase, decreasing short-run aggregate supply and increasing prices further until output returns to the full employment level on the long-run aggregate supply curve.

A decrease in aggregate demand relative to long-run aggregate supply has the opposite effects, reducing the price level and output initially, followed by decreases in resource prices that increase short-run aggregate demand, which decreases the price level further and increases output to its long-run equilibrium level.

Sources of economic growth include increases in the supply of labor, increases in human capital, increases in the supply of physical capital, increasing availability of natural resources, and advances in technology.

The sustainable rate of economic growth is determined by the rate of increase in the labor force and the rate of increase in labor productivity.

The business cycle has four phases:

1. Expansion: Real GDP is increasing.
2. Peak: Real GDP stops increasing and begins decreasing.
3. Contraction: Real GDP is decreasing.
4. Trough: Real GDP stops decreasing and begins increasing.

Expansions feature increasing output, employment, consumption, investment, and inflation. Contractions are characterized by decreases in these indicators.

Business cycles are recurring, but do not occur at regular intervals, can differ in strength or severity, and do not persist for specific lengths of time.

Inventory to sales ratios typically increase late in expansions when sales slow and decrease near the end of contractions when sales begin to accelerate. Firms decrease or increase production to restore their inventory-sales ratios to their desired levels.

Because hiring and laying off employees have high costs, firms prefer to adjust their utilization of current employees. As a result, firms are slow to lay off employees early in contractions and slow to add employees early in expansions.

Firms use their physical capital more intensively during expansions, investing in new capacity only if they believe the expansion is likely to continue. They use physical capital less intensively during contractions, but they are more likely to reduce capacity by deferring maintenance and not replacing equipment than by selling their physical capital.

The level of activity in the housing sector is affected by mortgage rates, demographic changes, the ratio of income to housing prices, and investment or speculative demand for homes resulting from recent price trends.

Domestic imports tend to rise with increases in GDP growth and domestic currency appreciation, while increases in foreign incomes and domestic currency depreciation tend to increase domestic export volumes.

Neoclassical economists believe business cycles are temporary and driven by changes in technology, and that rapid adjustments of wages and other input prices cause the economy to move to full-employment equilibrium.

Keynesian economists believe excessive optimism or pessimism among business managers causes business cycles and that contractions can persist because wages are slow to move downward. New Keynesians believe input prices other than wages are also slow to move downward.

Monetarists believe inappropriate changes in the rate of money supply growth cause business cycles, and that money supply growth should be maintained at a moderate and predictable rate to support the growth of real GDP.

Austrian-school economists believe business cycles are initiated by government intervention that drives interest rates to artificially low levels.

Real business cycle theory holds that business cycles can be explained by utility-maximizing actors responding to real economic forces such as external shocks and changes in technology, and that policymakers should not intervene in business cycles.

Frictional unemployment results from the time it takes for employers looking to fill jobs and employees seeking those jobs to find each other. Structural unemployment results from long-term economic changes that require workers to learn new skills to fill available jobs. Cyclical unemployment is positive (negative) when the economy is producing less (more) than its potential real GDP.

A person is considered unemployed if he is not working, is available for work, and is actively seeking work. The labor force includes all people who are either employed or unemployed. The unemployment rate is the percentage of labor force participants who are unemployed.

Inflation is a persistent increase in the price level over time. An inflation rate is a percentage increase in the price level from one period to the next.

Disinflation is a decrease in the inflation rate over time. Deflation refers to a persistent decrease in the price level (i.e., a negative inflation rate).

A price index measures the cost of a specific basket of goods and services relative to its cost in a prior (base) period. The inflation rate is most often calculated as the annual percentage change in a price index.

The most widely followed price index is the consumer price index (CPI), which is based on the purchasing patterns of a typical household. The GDP deflator and the producer or wholesale price index are also used as measures of inflation.

Headline inflation is a percentage change in a price index for all goods. Core inflation is calculated by excluding food and energy prices from a price index because of their high short-term volatility.

A Laspeyres price index is based on the cost of a specific basket of goods and services that represents actual consumption in a base period. New goods, quality improvements, and consumers’ substitution of lower-priced goods for higher-priced goods over time cause a Laspeyres index to be biased upward.

A Paasche price index uses current consumption weights for the basket of goods and services for both periods and thereby reduces substitution bias. A Fisher price index is the geometric mean of a Laspeyres and a Paasche index.

Cost-push inflation results from a decrease in aggregate supply caused by an increase in the real price of an important factor of production, such as labor or energy.

Demand-pull inflation results from persistent increases in aggregate demand that increase the price level and temporarily increase economic output above its potential or full-employment level.

The non-accelerating inflation rate of unemployment (NAIRU) represents the unemployment rate below which upward pressure on wages is likely to develop.

Wage demands reflect inflation expectations.

Leading indicators have turning points that tend to precede those of the business cycle.

Coincident indicators have turning points that tend to coincide with those of the business cycle.

Lagging indicators have turning points that tend to occur after those of the business cycle.

A limitation of using economic indicators to predict business cycles is that their relationships with the business cycle are inexact and can vary over time.

Money is defined as a widely accepted medium of exchange.

Functions of money include a medium of exchange, a store of value, and a unit of account.

Three factors influence money demand:

• Transaction demand, for buying goods and services.
• Precautionary demand, to meet unforseen future needs.
• Speculative demand, to take advantage of investment opportunities.

Money supply is determined by central banks with the goal of managing inflation and other economic objectives.

Central bank roles include supplying currency, acting as banker to the government and to other banks, regulating and supervising the payments system, acting as a lender of last resort, holding the nation’s gold and foreign currency reserves, and conducting monetary policy.

Central banks have the objective of controlling inflation, and some have additional goals of maintaining currency stability, full employment, positive sustainable economic growth, or moderate interest rates.

Policy tools available to central banks include the policy rate, reserve requirements, and open market operations. The policy rate is called the discount rate in the United States, the refinancing rate by the ECB, and the two-week repo rate in the United Kingdom.

Decreasing the policy rate, decreasing reserve requirements, and making open market purchases of securities are all expansionary. Increasing the policy rate, increasing reserve requirements, and making open market sales of securities are all contractionary

Effective central banks exhibit independence, credibility, and transparency.

• Independence: The central bank is free from political interference.
• Credibility: The central bank follows through on its stated policy intentions.
• Transparency: The central bank makes it clear what economic indicators it uses and reports on the state of those indicators.

Monetary policy influences market interest rates, asset prices, growth expectations, and exchange rates. These factors in turn influence domestic and net external demand, which affects economic growth and inflation.

A central bank that wants to stimulate the economy would purchase securities to reduce interbank and other short-term interest rates, which also tends to reduce long-term rates. These lower interest rates increase investment demand by businesses and consumer demand for financed items. Lower real rates lead to currency depreciation, which increases foreign demand for exports. The increase in aggregate demand from increases in investment, consumption, and net exports increases employment, real GDP, and inflation.

Most central banks set target inflation rates, typically 2% to 3%, rather than targeting interest rates as was once common. When inflation is expected to rise above (fall below) the target band, the money supply is decreased (increased) to reduce (increase) economic activity.

Developing economies sometimes target a stable exchange rate for their currency relative to that of a developed economy, selling their currency when its value rises above the target rate and buying their currency with foreign reserves when the rate falls below the target. The developing country must follow a monetary policy that supports the target exchange rate and essentially commits to having the same inflation rate as the developed country.

Reasons that monetary policy may not work as intended:

• Monetary policy changes may affect inflation expectations to such an extent that long-term interest rates move opposite to short-term interest rates.
• Individuals may be willing to hold greater cash balances without a change in short-term rates (liquidity trap).
• Banks may be unwilling to lend greater amounts, even when they have increased excess reserves.
• Short-term rates cannot be reduced below zero.
• Developing economies face unique challenges in utilizing monetary policy due to undeveloped financial markets, rapid financial innovation, and lack of credibility of the monetary authority.

Fiscal policy tools include spending tools and revenue tools. Spending tools include transfer payments, current spending (goods and services used by government), and capital spending (investment projects funded by government). Revenue tools include direct and indirect taxation.

An advantage of fiscal policy is that indirect taxes can be used to quickly implement social policies and can also be used to quickly raise revenues at a low cost.

Disadvantages of fiscal policy include time lags for implementing changes in direct taxes and time lags for capital spending changes to have an impact.

Arguments for being concerned with the size of fiscal deficit:

• Higher future taxes lead to disincentives to work, negatively affecting long-term economic growth.
• Fiscal deficits may not be financed by the market when debt levels are high.
• Crowding-out effect as government borrowing increases interest rates and decreases private sector investment.

Arguments against being concerned with the size of fiscal deficit:

• Debt may be financed by domestic citizens.
• Deficits for capital spending can boost the productive capacity of the economy.
• Fiscal deficits may prompt needed tax reform.
• Ricardian equivalence may prevail: private savings rise in anticipation of the need to repay principal on government debt.
• When the economy is operating below full employment, deficits do not crowd out private investment.

Fiscal policy is implemented by governmental changes in taxing and spending policies. Delays in realizing the effects of fiscal policy changes limit their usefulness. Delays can be caused by:

• Recognition lag: Policymakers may not immediately recognize when fiscal policy changes are needed.
• Action lag: Governments take time to enact needed fiscal policy changes.
• Impact lag: Fiscal policy changes take time to affect economic activity.

A government has a budget surplus when tax revenues exceed government spending and a deficit when spending exceeds tax revenue.

An increase (decrease) in a government budget surplus is indicative of a contractionary (expansionary) fiscal policy. Similarly, an increase (decrease) in a government budget deficit is indicative of an expansionary (contractionary) fiscal policy.

Free trade among countries increases overall economic welfare. Countries can benefit from trade because one country can specialize in the production of an export good and benefit from economies of scale. Economic welfare can also be increased by greater product variety, more competition, and a more efficient allocation of resources.

Costs of free trade are primarily losses to those in domestic industries that lose business to foreign competition, especially less efficient producers who leave an industry. While other domestic industries will benefit from freer trade policies, unemployment may increase over the period in which workers are retrained for jobs in the expanding industries. Some argue that greater income inequality may result, but overall the gains from liberalization of trade policies are thought to exceed the costs, so that the “winners” could conceivably compensate the “losers” and still be better off.

A country is said to have an absolute advantage in the production of a good if it can produce the good at lower cost in terms of resources relative to another country.

A country is said to have a comparative advantage in the production of a good if its opportunity cost in terms of other goods that could be produced instead is lower than that of another country.

The Ricardian model of trade has only one factor of production—labor. The source of differences in production costs and comparative advantage in Ricardo’s model is differences in labor productivity due to differences in technology.

Heckscher and Ohlin presented a model in which there are two factors of production—capital and labor. The source of comparative advantage (differences in opportunity costs) in this model is differences in the relative amounts of each factor that countries possess.

Types of trade restrictions include:

• Tariffs: Taxes on imported good collected by the government
• Quotas: Limits on the amount of imports allowed over some period.
• Minimum domestic content: Requirement that some percentage of product content must be from the domestic country.
• Voluntary export restraints: A country voluntarily restricts the amount of a good that can be exported, often in the hope of avoiding tariffs or quotas imposed by their trading partners.

Within each importing country, all of these restrictions will tend to:

• Increase prices of imports and decrease quantities of imports.
• Increase demand for and quantity supplied of domestically produced goods.
• Increase producer’s surplus and decrease consumer surplus.

Export subsidies decrease export prices and benefit importing countries at the expense of the government of the exporting country.

Restrictions on the flow of financial capital across borders include outright prohibition of investment in the domestic country by foreigners, prohibition of or taxes on the income earned on foreign investments by domestic citizens, prohibition of foreign investment in certain domestic industries, and restrictions on repatriation of earnings of foreign entities operating in a country.

Trade agreements, which increase economic welfare by facilitating trade among member countries, take the following forms:

• Free trade area: All barriers to the import and export of goods and services among member countries are removed.
• Customs union: Member countries alsoadopt a common set of trade restrictions with non-members.
• Common market: Member countries alsoremove all barriers to the movement of labor and capital goods among members.
• Economic union: Member countries alsoestablish common institutions and economic policy for the union.
• Monetary union: Member countries also adopt a single currency.

The balance of payments refers to the fact that increases in a country’s assets and decreases in its liabilities must equal (balance with) decreases in its assets and increases in its liabilities. These financial flows are classified into three types:

• The current account includes imports and exports of merchandise and services, foreign income from dividends on stock holdings and interest on debt securities, and unilateral transfers such as money received from those working abroad and direct foreign aid.
• The capital account includes debt forgiveness, assets that migrants bring to or take away from a country, transfer of funds for the purchase or sale of fixed assets, and purchases of non-financial assets, including rights to natural resources, patents, copyrights, trademarks, franchises, and leases.
• The financial account includes government-owned assets abroad such as gold, foreign currencies and securities, and direct foreign investment and claims against foreign banks. The financial account also includes foreign-owned assets in the country, domestic government and corporate securities, direct investment in the domestic country, and domestic country currency.

Overall, any surplus (deficit) in the current account must be offset by a deficit (surplus) in the capital and financial accounts.

In equilibrium, we have the relationship:

exports − imports = private savings + government savings − domestic investment

When total savings is less than domestic investment, exports must be less than imports so that there is a deficit in the current account. Lower levels of private saving, larger government deficits, and high rates of domestic investment all tend to result in or increase a current account deficit. The intuition here is that low private or government savings in relation to private investment in domestic capital requires foreign investment in domestic capital.

The International Monetary Fund facilitates trade by promoting international monetary cooperation and exchange rate stability, assists in setting up international payments systems, and makes resources available to member countries with balance of payments problems.

The World Bank provides low-interest loans, interest-free credits, and grants to developing countries for many specific purposes. It also provides resources and knowledge and helps form private/public partnerships with the overall goal of fighting poverty.

The World Trade Organization has the goal of ensuring that trade flows freely and works smoothly. Their main focus is on instituting, interpreting, and enforcing a number of multilateral trade agreements which detail global trade policies for a large majority of the world’s trading nations.

Currency exchange rates are given as the price of one unit of currency in terms of another. A nominal exchange rate of 1.44 USD/EUR is interpreted as $1.44 per euro. We refer to the USD as the price currency and the EUR as the base currency.

A decrease (increase) in a direct exchange rate represents an appreciation (depreciation) of the domestic currency relative to the foreign currency.

A spot exchange rate is the rate for immediate delivery. A forward exchange rate is a rate for exchange of currencies at some future date.

A real exchange rate measures changes in relative purchasing power over time.

real exchange rate (domestic/foreign) = spot exchange rate (domestic/foreign) × [image]

The market for foreign exchange is the largest financial market in terms of the value of daily transactions and has a variety of participants, including large multinational banks (the sell side) and corporations, investment fund managers, hedge fund managers, investors, governments, and central banks (the buy side).

Participants in the foreign exchange markets are referred to as hedgers if they enter into transactions that decrease an existing foreign exchange risk and as speculators if they enter into transactions that increase their foreign exchange risk.

For a change in an exchange rate, we can calculate the percentage appreciation (price goes up) or depreciation (price goes down) of the base currency. For example, a decrease in the USD/EUR exchange rate from 1.44 to 1.42 represents a depreciation of the EUR relative to the USD of 1.39% (1.42 / 1.44 − 1 = −0.0139) because the price of a euro has fallen 1.39%.

To calculate the appreciation or depreciation of the price currency, we first invert the quote so it is now the base currency and then proceed as above. For example, a decrease in the USD/EUR exchange rate from 1.44 to 1.42 represents an appreciation of the USD relative to the EUR of 1.41%: (1 / 1.42) / (1 / 1.44) − 1 = [image] − 1 = 0.0141.

The appreciation is the inverse of the depreciation, [image] − 1 = 0.0141.

Points in a foreign currency quotation are in units of the last digit of the quotation. For example, a forward quote of +25.3 when the USD/EUR spot exchange rate is 1.4158 means that the forward exchange rate is 1.4158 + 0.00253 = 1.41833 USD/EUR.

For a forward exchange rate quote given as a percentage, the percentage (change in the spot rate) is calculated as forward / spot − 1. A forward exchange rate quote of +1.787%, when the spot USD/EUR exchange rate is 1.4158, means that the forward exchange rate is 1.4158 (1 + 0.01787) = 1.4411 USD/EUR.

The condition that must be met so that there is no arbitrage opportunity available is:

[image]

If the spot exchange rate for the euro is 1.25 USD/EUR, the euro interest rate is 4% per year, and the dollar interest rate is 3% per year, the no-arbitrage one-year forward rate can be calculated as:

1.25 × (1.03 / 1.04) = 1.238 USD/EUR.

Exchange rate regimes for countries that do not have their own currency:

• With formal dollarization, a country uses the currency of another country.
• In a monetary union, several countries use a common currency.

Exchange rate regimes for countries that have their own currency:

• A currency board arrangementis an explicit commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate.
• In a conventional fixed peg arrangement, a country pegs its currency within margins of ±1% versus another currency.
• In a system of pegged exchange rates within horizontal bands or a target zone, the permitted fluctuations in currency value relative to another currency or basket of currencies are wider (e.g., ±2%).
• With a crawling peg, the exchange rate is adjusted periodically, typically to adjust for higher inflation versus the currency used in the peg.
• With management of exchange rates within crawling bands, the width of the bands that identify permissible exchange rates is increased over time.
• With a system of managed floating exchange rates, the monetary authority attempts to influence the exchange rate in response to specific indicators such as the balance of payments, inflation rates, or employment without any specific target exchange rate.
• When a currency is independently floating, the exchange rate is market-determined.

Elasticities (ε) of export and import demand must meet the Marshall-Lerner condition for a depreciation of the domestic currency to reduce an existing trade deficit:

W_Xε_X + W_I(ε_I − 1) > 0.

Under the absorption approach, national income must increase relative to national expenditure in order to decrease a trade deficit. This can also be viewed as a requirement that national saving must increase relative to domestic investment in order to decrease a trade deficit.