Principles economics 1 book

Chapter 1 The Big Ideas:

Incentives matter. By incentives we mean rewards and penalties that motivate behaviour.
Big idea 1:
 Economists do think that people respond in predictable ways to incentives of all kinds. Fame,
power, reputation, sex and love are all important incentives. Economist even think that
benevolence responds to incentives.
Big idea 2:
 When self-interest aligns with the broader public interest we get good outcomes, but when self-
interest and the social interest are at odds we get bad outcomes.
 Adam smith: When markets work well, those who pursue their own interest end up
promoting the social interest as if led to do so by an ‘invisible hand’.
 Markets do not always align self-interest with the social interest. The invisible hand is missing.
Markets incentives can for example be too strong. (Exp. Fishermen sometimes have too strong an
incentive to catch fish, thereby driving to stock of fish into collapse.) Market incentives can also
be too weak.
Big idea 3:
 The inevitability of trade-offs is the consequence of a big fact about the world, scarcity. The great
economic problem is how to arrange our scarce resources to satisfy as many of our wants as
possible. Trade-offs are closely related to another important idea in economics, opportunity cost.

Opportunity cost:
Opportunity cost of a choice is the value of the opportunities lost.
 Concept of opportunity cost important for 2 reasons.
 First is you don’t understand the opportunities you are losing when making a choice you
won’t recognize the real trade-offs that you face.
 Second most of the time people do respond to changes in opportunity cost.

Big idea 4:
 Thinking on the margin is just making choices by thinking in terms of marginal benefits and
marginal cost.
Big idea 5:
 Real power of trade is the power to increase production through specialization. Through the
division of knowledge the sum total of knowledge increases an din this way so does productivity.
 Trade also allows us to take advantage of economies of scale, the reduction on cost created when
goods are mass-produced.
 The theory of comparative advantage days that when people or nations specialize in goods in
which they have a low opportunity cost, they can trade to mutual advantage.
Big idea 6:
 Wealth and economic growth can diminish problems. Wealth matters and understanding
economic growth is one of the most important tasks of economics.
Big idea 7:
 What makes a country rich? The most proximate cause is that wealthy countries have lots of
physical and human capital per worker and they produce things in a relatively efficient manner,
using the latest technological knowledge.
 New ideas require incentives and that means an active scientific community and the freedom and
incentive to put new ideas into action. Ideas aren’t used up when they are used and that has
tremendous implications for understanding the benefits of trade, the future of economic growth
and many other topics.
Big idea 8:
 No economy grows at a constant pace. Economics advance and recede, rise and fall, boom and
bust. When the tools of monetary and fiscal policy are used appropriately these tools can reduce
swings in unemployment and GDP.
 Macroeconomic theory is to understand both the promise and the limits of monetary and fiscal
policy in smoothing out the normal booms and busts of the macroeconomy.
Big idea 9:
 Inflation, one of the most common problems in macroeconomics, refers to an increase in the
general level of prices. It is caused by a sustained increase in the supply of money.

Chapter 2:
Three benefits of trade:
1. Trade makes people better off when preferences differ.
2. Trade increases productivity through specialization and the division of knowledge
3. Trade increases productivity through comparative advantage.
Trade and preferences:
 Trade creates value by moving goods from people who value them less to people who value them
more. Trade makes people with different preferences better off.

Specialization, productivity, and the division of knowledge.

 In a world without trade, no one can afford to specialize. As trade develops so does specialization
and specialization turns out to vastly increase productivity. Knowledge increases productivity so
specialization increases total output. All of this knowledge is possible, however, only because
each person can specialize in the production of one good and then trade for all desired goods.
 Every increase in world trade is an opportunity to increase the division of knowledge and extend
the power of the human mind
Comparative advantage:
 We say that a country has an absolute advantage in production if it can produce the same good
using fewer inputs than another country.
The production possibility frontier:
 Production possibility frontier shows all the combinations of goods that a country can produce
given its productivity and supply of inputs.
Opportunity cost and comparative advantage:
 Countries have a comparative advantage in producing goods for which it has the lower
opportunity cost. Comparative advantage not only explains trade patterns it also tells us that a
country (or person) will always be the low-cost seller of some good. The reason is clear. The
greater the advantage a country has in producing A, the greater the cost to it of producing B.
 Countries with high productivity can always benefit by trading with lower-productivity countries,
and countries with lower productivity need never fear that higher-productivity countries will
outcompete the in a production of all goods. Trade unites humanity.
Trade makes globalisation possible.

Chapter 3:

The most important tools in economics are supply, demand, and the
idea of equilibrium.
Demand curve:
A demand curve is a function that shows the quantity demand at
different prices. The quality demanded is the quantity that buyers are
willing and able to buy at a particular price. The lower the price the
greater the quantity demand.
 Demand curves can be read in two ways, horizontal and
vertical.

Consumer surplus is the consumers gain from exchange. Adding up consumer surplus for each
consumer and for each unit = total consumer surplus. On a graph total consumer surplus is the
shaded area beneath the demand curve and above the price.
 Calculation consumer surplus: base x height/ 2
An increase in demand shifts the demand curve outward, up and to the right.
A decrease in demand shifts the demand curve inward, down and to the left.
Demand shifters:
 Income: When an increase in income increases the demand for a good we say the good is
a normal good. A good for which an increase in income decreases the demand is called
an inferior good.
 Population: More people more demand.
 Price of substitutes and complements: A decrease in the price of a substitute will
decrease demand for the other good. Complements are things that go well together such
as ground beef and hamburger buns. Demand for a good increases when the price of a
complementary good decreases. Most companies want the substitutes to be expensive
and the complements to be cheap.
 Expectations: If there is an expectation of a reduction of a good
in the future increases the demand for the good today.
 Tastes
The supply curve:
The supply curve is a function showing the quantity of oil that suppliers
would be willing and able to sell at different prices or more simply, the
supply curve shows the quantity supplied at different prices. The higher
the price the greater the quantity supplied. This is often called the ‘law
of supply’.

The producer surplus is the producer’s gain from exchange, or the difference between the market
price and the minimum price at which a producer would be willing to sell a particular quantity.
Adding the producer surplus for each producer for each unit, we can find total producer surplus. The
total producer surplus is the area above the supply curve and below the price.
Consumer surplus measures the consumers benefit from trade and producers surplus the benefit for
the producers.
Supply shifters:
 Technological innovation and changes in the price inputs: A reduction In input prices also
reduces the cost and the supply curve will be shifting down and to the left.
 Taxes and subsidies: A tax on output is the same ad an increase in costs.
 Expectations: Suppliers that expect prices will increase in the future have an incentive to
sell less today so that they can store goods for future sale. It shifts the supply curve to the
left. The shifting supply in response to price expectations is the essence of speculation.
 Entry or exit of producers: The entry of more firms means that at any price a greater
quantity lumber was available, the supply curve shifted to the right.
 Changes in opportunity costs: A decrease in opportunity cost shifts the supply curve
down and to the right.

Chapter 4:

The equilibrium price and quantity are the only price and quantity that in a free market are stable.

Equilibrium and the adjustment process:

Competition will push prices down whenever there is a surplus. A surplus is a situation in which the
quantity supplied is greater than the quantity demanded. As competition will push prices, the
quantity demand will increase and the quantity supplied will decrease. Competition will push
prices up whenever there is a shortage. A shortage is a situation in which the quantity demanded
is greater than the quantity supplies.
The equilibrium price is stable because at the equilibrium price the quantity demanded is exactly
equal to the quantity supplied. Because every buyer can buy as much as they want at the
equilibrium price.
Finally at the equilibrium price the quantity demanded is equal to the quantity supplied and the
quantity is called the equilibrium quantity.
Sellers compete with other sellers and buyers with other buyers.

Free market maximizes producer plus consumer surplus:

Gains from trade push the quantity toward the equilibirum quantity.
A free market maximizes the gains from trade, we mean three closely relatedthings:
1. The goods are bought by the buyers with the highest willingness to pay.
2. The goods are sold by the sellers with the lower cost.
3. There are no unexploited gains from trade and no wastful trades.
Under the right conditions, the pursuit of self-interest leads not to chaos but to a beneficial order. The
maximization of consumer plus producer surplus in markets populated solely by self-interested
individuals is one application of this central idea.

Terminology
Big difference between demand and quantity demand. An increase in the quantity demanded is a
movement along a fixed demand curve. An increase in demand is a shift of the entire demand
curve.
Rule of thumb: what chages the equilibrium price and quantity are shifts in demand and supply.

Summary:

1. Market competition brings about an equilibrium in which the quantity supplied is equal to
the quantity demanded.
2. Only one price/quantity combination is a market equilibrium and you should be able to
identify this equilibrium in a diagram.
3. The sum of the consumer and producer surplus is maximized at the equilibrium price and
quantity and no other price/quantity combination maximizes consumer plus producer
surplus.
4. A change in demand is not the same thing as a change in quantity demanded. And a change
in supply is not the same as a change in quantity supplied.

Chapter 7, The price system:

A price is a signal wrapped up in an incentive. The price system creates rich connections between
markets and enables societies to mobilize vast amounts of knowledge toward common ends, yet
without a central planner.

Markets link to one another

Entrepreneurs are constantly on the lookout for ways to lower cost, and their cost-cutting measures
link markets that at first seem like that are a world away.
Higher energy costs increase the cost of producing most products.

Solving the great economic problem

Markets around the world are linked to one another. A change in supply or demand in one market
can influence markets for entirely different products thousands of miles away.
The great economic problem is to arrange our scare resources to satisfy as many of our wants a
possible. One way of doing this is to have a central planner to issue orders. The task of central
planning is impossibly complex. The central planning approach failed because of problems of
information and incentives.
The market solves the information problem by collapsing all the relevant information in the world
into a single number, the price. In addition to solving the information problem, the price system
also solves the incentive problem. It’s a consumers interest to pay attention to prices. When
prices increase they have the incentive to look for substitutes.

A price is a signal wrapped up in an incentive

Prices are incentives, signals and predictions.
Price signals and the accompanying profits and losses tell entrepreneurs what areas of the economy
consumers want expanded and what areas the want contracted. Entrepreneurs who fail to
compete with lower costs and better products take losses and their businesses contract or even
go bankrupt.

Arbitrage and speculation

Arbitrage means buying low and selling high.
Speculation is the attempt to profit from future price changes. Speculation is arbitrage through time..
Speculation is an especially risky type of arbitrage because speculators could be wrong. If the
speculator guess wrong, they will lose money and society will be worse off.
Speculators typically buy and sell in special markets called futures markets. Futures are standardized
contracts to buy or sell specified quantities of a commodity or financial instrument at a specified
time in the future. Future markets are not only for speculating but also for reducing risk.
Futures prices can be extraordinarily informative about future events.

Prediction markets
= a speculative market designed so that prices can be interpreted as probabilities and used to
make predictions.
The best known prediction market is called Iowa market.
Markets are a good way of aggregating information and prediction
markets have performed well relative to other methods of
predicting the future.
If all predictions were perfect , then predicted revenues would be
exactly equal to actual revenues and all the observations
would lie on the 45-degree red line. Movies above the red line
did better than predicted and under the red line worse.
Market predictions are centered on the 45-degree line which
means they are correct on average.
Market prices are signals that convey valuable information. Buyers and sellers have an incentive to
pay attention to and respond to prices and in doing so they direct resources to their highest value
uses.

Chapter 11:
To maximize profit you can ask yourself 3 questions:

1.What price to set?

To maximize profit you sell at the market price. The more and better the substitutes, the more elastic
the demand. Demand curves are more elastic in the long run. The long run is the time after al exit or
entry has occurred, and the short run as the period before exit and entry can occur. Economist say
that an industry is competitive when firm don’t have much influence over the price of their product
only with the following conditions:
 The product being sold is similar across sellers.
 There are many buyers and sellers, each small relative to the total market.
 There are many potential sellers.
Firms have a lot of influence when a firm selling a product for which there are neither many other
sellers nor potential sellers has considerable freedom to chose its price.

A sunk cost is a cost that cannot be recovered. It is a cost that you can not change. Fixes costs cant be
changed in the short run and so should be ignored for short-run decisions like what quantity to
produce but fixed costs can be changed in the long run so they should be focused on for long-run
decisions. Sunk costs are never relevant because they cannot be changed by any choice. Fixed
cost can only be changed in long-run decisions.
Maximizing profit requires taking into account explicit costs and also implicit costs. An explicit cost is
a cost that requires a money outlay, and an implicit cost does not require an outlay of money.
Accounting profits are usually more than economic profits. Accounting profit is the total revenue
minus explicit cost, and economic profit is total revenue minus total cost, including implicit
opportunity costs. Firms want to maximize economic profit not accounting profit.

2. What quantity to produce?

Profit = π = total revenue – total cost
Total revenue is price time quantity sold (PxQ). Total cost is the cost of producing a given quantity of
output.  Total cost (TC) = Fixed cost (FC) + variable cost (VC)
Fixed cost are cost that don’t vary with output, and variable cost do vary with output.
Marginal revenue (MR) is the change in total revenue from selling an additional unit. MR= ΔTR / ΔQ.
For a firm in a competitive industry MR=Price.
Marginal cost (MC) is the change in total cost from producing an additional unit. MC = ΔTC / ΔQ. To
maximize profit a firm in a competitive industry increase output until P=MC.

The average cost of production is the cost per unit that is, the total cost of producing Q units divided
by Q. AC = TC / Q.
Rewrite some equations: Profit = TR -TC Profit = (TR/Q – TC/Q) x Q Profit = (P - AC) x Q.
When P > AC the firm is making profit when P < AC the firm is making loss. When marginal cost is
just below average cost the average cost curve is rising, so AC and MC must meet at the minimum
of the AC curve.

3.When to enter and exit the industry?

Firms seek profit so in the long run they will enter an industry when P > AC and exit when an industry
is P < AC. By zero profits/normal profits occur when P = AC. At this price the firm is covering all of
its cost, including enough to pay labour and capital their ordinary opportunity cost.

If P < AC the firm is making a loss and wants to exit the industry but it cannot do that immediately.
The firm is making a loss when TR<TC. To understand the firm’s optimal short-run decision we are
going to do something very similar. TC = FC + VC. The firm should shut down immediately only is
TR < VC or is P < VC/Q = AVC. VC/Q is the average variable cost or AVC.
If the price is so low that the firm can’t even cover its average variable cost, then the firm should
shut down immediately and exit as soon as possible. If the price is high enough to cover the
average variable cost but not all fixed costs the firm should minimize its losses by producing the
quantity such that P = MC but exit as soon as possible.

In an increasing cost industry, cost increase with greater industry output and this generates an
upward-sloping supply curve. In a constant cost industry costs do not change with changes in
industry output and this generates a flat supply curve. In a decreasing cost industry, costs
decreases with greater industry output and this generates a downward-sloping supply curve.
Increasing cost industries:
Costs rise as industry output increases. Any industry that buys a large fraction of the output of an
increasing cost industry will also be an increasing cost industry.
 Exp: The gasoline industry is an increasing cost industry because greater demand for gas
will push up the price of oil, which will in turn increase the price of gas.
Constant cost industries:
When an increase in demand hits a constant cost industry, the price rises in the short run as each firm
moves up its MC curve. But the expansion of old firms and the entry of new firms quickly pushes
the price down to the average cost. The long run supply curve is flat.
Decreasing cost industry:
These industries are important but very special because cost van not decrease forever. Economist use
the idea of decreasing cost industries to explain the history of industry clusters.
 Exp: Movie production in Hollywood, Flower distribution in Aalsmeer, Holland.
Once the cluster is established, however, constant or increasing costs are the norm.

Chapter 12, Competition and the invisible hand

First we show P = MC condition for profit maximization in a competitive market balances production
across firms in an industry in the way that minimizes the total cost of production.
Second we show that the entry P > AC and exit P < AC signals balance production across different
industries in just the way that maximizes the total value of production.

Invisible hand property 1: The minimization of total industry costs of production

Every firm in the same industry faces the same price. So in a competitive market with N firm the
following is true: P = MC1 = MC2 = … = MCN. Where MC1 is the marginal cost of firm 1.
Its remarkable that a free market could mimic an ideal central planner.
Costs are minimized when MC1 = MC2

Indivisible hand property 2: The balance of industries

Profit is a signal that our limited labour and capital are being used productively in satisfying our
wants. In a competitive market the incentives that entrepreneurs have to seek profit and avoid
losses align with the social incentive to move labour and capital out of low-value industries and
into high-value industries.
Profits encourage entry. As firms enter, supply increases and the price declines, which reduces profits.
Losses encourage exits. As firms exit supply decreases and the price increases which increases
profit. Thus there is a tendency for the profit rate in all competitive industries to go to zero.
Implication of invisible hand property 2 , is that the profit rate is all competitive industries tends
toward the same level.

Creative destruction
So although the great economic problem is never solved completely in a dynamic economy, resources
are always moving toward an increase in the value production. In a dynamic economy,
entrepreneurs listen to price signals and they move capital and labour from unprofitable
industries to profitable industries.
These dynamics illustrates a general feature of competitive markets that is called elimination
principle: above normal profits are eliminated by entry and below-normal profits are eliminated
by exit. The elimination principle serves as both a warning and an opportunity to entrepreneurs.

Chapter 14 Price discrimination and pricing strategy:

Price discrimination:
= Is selling the same product at different prices to different customers.
Profit maximizing quantity is found where marginal revenue equals marginal cost.
First principle of price discrimination:
 (1A): If the demand curves are different, it is more profitable to set different prices in
different markets than a single price that covers all markets.
 (1B): To maximize profit, the monopolist should set a higher price in markets with more
inelastic demand.
 (2): Arbitrage makes it difficult for a firm to set different prices in different markets,
thereby reducing the profit from price discrimination.
o Arbitrage = taking advantage of price differences for the same good in different
markets by buying low in one market and selling high in another market.

Price discrimination is common

It is about how age correlates with what businesses really care about, which is how much the
customer is willing to pay.
Perfect price discrimination (PPD): each customer is charged their maximum willingness to pay.
All of the gains from trade go to the monopolist, this is bad for the customers but does have a
beneficial side effect: since the PPD monopolist gets all the gains from trade, the PPD monopolist
has an incentive to maximize the gains from trade, and maximizing the gains from trade means
deadweight loss.
All firms want to produce MR=MC. For a competitive firm, MR=P so competitive firms produce until
P=MC. For a single-price monopolist, MR<P. So the single-price monopolist produces less than the
competitive firm.

Tying and bundling

Tying:
Occurs when to use one good the consumer must use a second good that is sold by the same
firm. A firm can price discriminate by tying two goods and carefully setting their prices.
Bundling:
Is requiring that products be bought together in a bundle or package.
Bundling is most likely to be beneficial in a high-fixed-cost, low-marginal-cost industry. Bundling
doesn’t cost the company much profit, it increases the incentive to spend resources on the fixed
costs of development.
Chapter 19: Public goods and the tragedy of the commons
Four types of goods
Nonexcludable: a good is this if people who don’t pay cannot be easily prevented from using the
good. When one person’s use of a good reduces the ability of another person to use the same
good economist say the good is rival.
A good is nonrival if one person’s use of the good does not reduce the ability of another person to
use the same good.
These two factors, if a good is excludable or nonexcludable and whether it is rival or nonrival can be
used to divide goods into 4 types.

Private and public goods

Private goods = are excludable and rival. They can be provided by markets, someone who doesn’t pay
doesn’t get it. There is an incentive to buy it. Since these goods are rival, excludability doesn’t
result in inefficiency.
Public goods = are nonexcludable and nonrival. It is difficult to get people to pay from them voluntary.
Markets will tend to underprovide these goods. They are also nonrival, so the losses from the
failure to provide these goods can be large.
Free rider = enjoys the benefits of a public good without paying a share of the costs.
The benefit of public goods provide an argument for taxation and government provision.
Taxation means that some people will be turned into forced riders = someone who pays a share of the
cost of a public good but who does not enjoy the benefits.
The government should produce the amount that maximizes consumer plus producer surplus.
A public good is not defined as a good produced in the public sector.

Club goods
= are goods that are excludable but nonrival
A television show for example, you have to buy Netflix to watch it but it is nonrival because it does
not decrease the ability of another person watching.
Radio and broadcast television are peculiar goods because although they are public goods, nonrival
and nonexcludable they are provided in large quantities by markets. Advertisings works to make
money of these things.

Common resources and the tragedy of the commons

Common resources = are goods that are nonexcludable but rival. For example tuna in the ocean. Until
they are caught they are unowned (nonexcludable) and its difficult to prevent anyone from
fishing for tuna. But tuna are not public goods since when one person catches and consumes
tuna, that leaves fewer tuna for other people. Result of nonexcludability and rivalry is often the
tragedy of commons = the tendency of any resource that is unowned and hence nonexcludable to
be overused and underestimated.
 We typically call something a tragedy of the commons when the lack of maintenance is
so severe that exploitation is pushed beyond the point where the resource can reproduce
itself.
Chapter 27: the wealth of nations and economic growth
Wealth is important so there are a couple of questions to ask. Why are some nations wealth while
others are poor? Why are some nations getting wealthier faster than others? Can anything be
done to help poor nations become wealthy?

Key facts about wealth of nations and economic

growth
Fact one: GDP per capita varies enormously among
nations
 Explaining graph: most poor countries on the
left and goes into richer countries.
 In thinking about poverty, remember that GDP
per capita is simply an average, and there is a
distribution of income within each country.
Fact two: Everyone used to be poor
 Distribution of world income tells us that
poverty is normal. Only in the beginning of the
nineteenth century does it become clear that
some parts of the world began to grow at a rate unprecedented in human history.
 Economic growth is unusual but once economic growth begins it can make some parts of the
world rich while other parts languish at the levels of per capita GDP similar to the dark ages.
 A primer on growth rates:
o A growth rate is the percentage change in a variable over a given period.
o Economic growth: growth rate of rea; per capita GDP. Gt = ( Yt – Yt-1 / Yt-1 ) x 100%
Yt real per capita GDP in period t.
o Rule of 70 for determining the length of time necessary for a growing variable to
double. Rule of 70: if the annual growth rate of a variable is x% then the doubling
time is 70/x years.
Fact three: There are growth miracles and growth disasters
 Bad news is that most of the world is poor and more than 1 billion people live on incomes of
less than 3$ per day. But there is also good news. Despite being a relatively recent
phenomenon, economic growth has quickly transformed the world. It has raised the standard
of living.
 Growth-disasters tell us that economic growth is not automatic. Inquiring into the nature
causes of the wealth of nations is critical is we raise the standard of living and better the
human condition.

Understanding the wealth of nations

Factors of production
The most immediate cause of wealthy nations is countries with a high GDP per capita have a lot of
physical and human capital per worker and that capital is organized using the best technological
knowledge to be highly productive.
Physical capital is the stock of tools including machines, structures and equipment.
Human capital is the productive knowledge and skills that workers acquire through education,
training, and experience. It is not something we are born with it is produced by an investment of
time and other resources in education, training and experience.
Technological knowledge is knowledge about how the world works that is used to produce goods and
services. We increase this knowledge with research and development

Incentives and institutions

Factors of production must be produced and cannot organize themselves. Physical, human and
technical capital must be organized to be productive. Countries with a high GDP per capita have
institutions that make it in people’s self-interest to invest in these capitals. The key to producing
and organizing the factors of production are institutions that create appropriate incentives.
Institutions are the rules of the game that structure economic incentives. They include laws and
regulations but also customs and organizations. There is considerable agreement that the key
institutions include the following:
 Property rights
o Under communal property, effort is divorced from payment so there is little
incentive to work. In fact there is incentive not to work and to free ride. Free
riding is someone who consumes a resource without working or contributing to
the resources upkeep.
o These rights are important institutions for encouraging investments in physical
and human capital. It also encourages technological innovation.
 Honest government
o No corruption should come from the taxes that are being paid by the inhabitants
of the country.
 Political stability
 A dependable legal system
o Sometimes property rights are poorly protected because there is to little
government. The legal system is of such low quality that no one knows for certain
who owns what. A good legal system facilitates contracts and protects private
parties from expropriating one another.
 Comparative and open markets
o Economies of scale are the advantages of large-scale production that reduces
average cost as quantity increases.
o Free trade opens a country up to new ideas and innovation, but free trade is not
just a matter of policy or choice is also depends on natural conditions.
Chapter 29: Saving, investment, and the financial system
Saving: is income that is not spent on consumption goods.
Investment: is the purchase of new capital goods.
Most of the trading on stock exchanges is thus not investment in the economic sense because it
simply transfers ownership of a stock from one person to another. From an economic point of
view, investment requires a purchase of new capital.

The supply of saving

Smooth consumption:
Path A (pink line): consumption is equal to income. After retirement
consumption drops because your income drops.
Path B (blue line): consumption is less than income during working
years because you save for retirement. And you can spend your
savings or dissaving.
The decline in life expectancy reduces saving rates, which in turn
reduces economic growth and the standard of living. Fluctuations
in income are another reason why people save.
Individuals are impatient:
Another reason why people save of fail to save is their level of impatience. Most individuals prefer to
consume now rather than later, so saving is not always easy. Time preference = the desire to have
goods and services sooner rather than later. The more impatient the person, the less likely they
have savings.
Marketing and psychological factors:
Often individuals save more if saving is presented as the natural or default alternative.
The interest rate:
Quantity of savings also depends on the interest rate, namely how much savers are paid to save.
Higher interest rates usually call forth more savings. Interest rate is a market price and it has the
same properties of market prices.

The demand to borrow

One reason people borrow is to smooth consumption. For example with college tuition. But not only
individuals borrow also businesses borrow. Strating businesses need investments in order to
make their idea and business stand out and grow. They also borrow to finance large projects.
The quantity of funds that people want to borrow also depends on the cost of the loan, or interest
rate. Businesses borrow when they expect that the return on their investments will be greater
than the cost of the loan. The demand to borrow follows the law of demand: the lower the
interest rate, the greater the quantity of funds demanded for investment as well as other
purposes.

Equilibrium in the market for loanable funds

= occurs when suppliers of loanable funds (savers) trade with demanders of loanable funds
(borrowers) Trading in the market for loanable funds determines the equilibrium interest rate.
With a surplus of savings suppliers will bid the interest rate down as they compete to lend. With a
shortage of savings demanders would bid the interest rate up as they compete to borrow.
The role of intermediaries
Equilibrium is brought about with assistance of financial intermediaries = such as banks, bond
markets, and stock markets reduce the cost of moving savings from savers to borrowers and
investors.
Banks receive savings from many individuals, pay them interest, and then loan these funds to
borrowers., charging them interest. Banks earn profit by charging more for their loans than they
pay for savings. They coordinate lenders and minimize information costs.
Instead of borrowing from the bank you can borrow directly from the public. When a member of the
public lends money to a corporation, the corporation acknowledges its debt by using a bond. A
bond = a sophisticated IOU that documents who owes how much and when payment must be
made. All bonds involve a risk that when the payments come due, the borrower will not be able
to pay, this is called default risk. If a risky company wishes to borrow money they have to promise
a higher interest rate because lenders will demanded to be compensated for a greater risk of
default.
Collateral = something of value that by agreement becomes the property of the lender if the
borrower defaults.
Crowed out = the decrease in private consumption and investment that occurs when government
borrow more, makes the multiplier closer to 0.
Rate of return from a zero-coupon bond = face value – price / price x 100%
Sellers of bonds must compete to attract lenders, who compare the implied rate of return on bonds
with the rate of return on other assets.
Equally risky assets must have the same rate of return. This is called an arbitrage principle = buying
and selling of equally risky assets, ensures that equally risky assets earn equal returns. Second
interest rates and bond prices move in opposite directions. The inverse relationship between
bond prices and interest rates tells us that in addition to default risk, people who buy bond also
face interest rate risk.
Stocks are shares of ownership in a corporation. When new stocks are issued, that is called an initial
public offering (ipo) and this is the first time a corporation sells stock to the public in order to raise
capital.
 When a firm sells new shares to the public is typically use the proceeds to fund investments.

What happens when intermediation fails

Economic growth cannot occur without savings and those savings must be processed and
intermediated through banks etc. Counties without these institutions have smaller markets for
loans, use their savings less effectively and make fewer good investments.
Couple of things that may brake bridge between savers and borrowers:
 Insecure property rights
o Some banks don’t offer secure property rights to savers. Saved funds are not immune
from later confiscation, freezes or other restrictions. If individuals expect contracts to
be broken they will be reluctant to invest in the stock market.
o In a healthy economy, shareholders expect that managers are interested in building
their long-run relationships, rather than ripping off the company at every possible
opportunity.
o Trust is one of the most important asset in the world.
 Controls on interest rates
o Investments which is determined by the supply of savings, will fall below what it
would be at the market equilibrium.
 Politicized lending and government-owned banks
 o Government-owned banks are useful to authoritarian regimes that use the banks to
direct capital to political supporters. One study found that the larger the fraction of
government-owned banks a country had the slower the growth in per capita GDP and
productivity over the next several decades.
 Inflation
 Bank failures and panics
o Systematic problems in the banking systems usually leads to large-scale economic
crises.

The financial crisis of 2007-2008

Leverage:
 In the years leading up to the crises American borrowed to much especially on mortgages.
 The difference between the value of a house and the unpaid amount on the mortgage is
called owners’ equity, value of asset – debt, E = V – D. Lenders want buyers to have some
home equity because this protects them if the buyer defaults.
 Leverage ratio: the ratio of dept to equity, D/E. More leverage means that the same force can
be used to move bigger assets.
 Insolvent = firm has liabilities that exceed its assets. So more dept than the assets are worth.
 When times are good leverage makes everything better.
Securitization:
 Sometimes mortgages loans are ‘securitized’ or bundled together and sold on markets as
financial assets. The seller of a securitized asset gets up front cash while the buyer gets the
right to a stream of future payments.
 Positive side:
o The bank gets more liquid cash and makes its balance sheet safer, and the securitized
assets can be held as investments by institutions with a long-term perspective, such
as pension funds.
 Negative side:
o Banks securitize because they made bad, sloppy or under-researched loans in the
first place and they wish to dump them on unsuspecting people somewhere else.
Shadow banking system:
 Traditional banking system can be represented by a commercial bank, the bank where you
keep your checking account. Commercial banks fund themselves in large part through
deposits from people like yourself and businesses. The money comes from depositors
 There are also investment banks. Here the money comes from investors. Deposits are
government guaranteed but investments are not.
 In addition to investment banks the shadow banking system includes hedge funds, money
market funds and a variety of banking systems. What unites the, is that these financial
intermediaries act like banks but they have traditionally been less heavily regulated and
monitored than banks, and their deposits are not government guaranteed.
ess fluctuations:
are fluctuations in the growth
rate of real GDP around its
trend growth rate.
recession:
is a significant, widespread
decline in real income and
employment.
- unemployment rate
increases during recession
- all kinds of resources are
not fully employed
o some level of
unemployment is natural à
natural unemployment rate
o economy is operating
below its potential, when a lot
unemployed resources
and wasted resources
- in typical recession growth
rate might drop to – 5% in
some quarters
- in a boom economy can
grow at a rate of 7-8% or
higher
- GDP has so dips à
swinging (e.g. financial crisis)
- strong fluctuation à
business cycles
Inflation:
An increase in the average
level of prices.
- Inflation is measured by
changes in a price index
- the inflation rate is the
percentage change in a price
index from one year to the next
𝜋=
𝑃
Chapter 32: Business fluctuations
Business fluctuations = fluctuations in the growth rate of real GDP around its trend growth rate.
Recession = a significant, widespread decline in real income and employment.

The aggregate demand curve

= shows all the combinations of inflation and real growth that are consistent with a specified rate
of spending growth (M + v)
Quantity theory in dynamic form is M-> + v -> = P -> + YR->. M is the growth rate of the money supply,
v is growth in velocity, P is growth rate of prices and Y is growth rate of real GDP.
 M-> + v-> = inflation + real growth
An AD curve tells us all the combinations of inflation and real growth that are consistent with a
specified rate of spending growth. Inflation is caused when more money chases the same goods.
Increased spending must flow into either a higher inflation rate or higher growth rate. Thus an
increase of spending growth, shifts AD curve outward, up and to the right. Increase in spending
can only be caused by an increase of M-> or v ->.

The long run aggregate supply curve

Solow growth rate = an economy’s potential growth rate, the rate of economic growth that would
occur given flexible prices and the existing real factors of production.
Inflation rate on y-as, and real growth on x-as.
Long-run aggregate supply curve = vertical at the Solow growth rate.
Real shocks = also called productivity shock, is any shock that increases or decreases the potential
growth rate. (rapid changes in economic conditions that increase or diminish the level or
productivity of capital and labour which in turn influences GDP and employment)A positive real
shock will move the LRAS to the right increasing real growth. The increase of supply reduces
inflation.

Short run aggregate supply curve

= shows the positive relationship between inflation rate and
real growth during the period when prices and wages are
sticky.
The rate of inflation that workers and producers expect is written in
E(π)
Nominal wage confusion = occurs when workers respond to their
nominal wage, that is, when workers respond to the wage
number on their pay checks rather than to what their wage can
buy in goods and services.
Menu costs = the costs of changing prices.

Shocks to the components of aggregate demand

National spending identity, Y = C + I + G + NX.
Changes in v->, can be broken down into changes in C->, I->, G->, or NX->. Factors including nominal
wage and price confusion, sticky wages, sticky prices, menu costs, and uncertainty create an
upward-sloped short-run aggregate supply curve.
A chock to C->.
The decrease in consumption purchases will temporarily reduce spending growth, C->.

Chapter 37: fiscal policy

Fiscal policy = federal government policy on taxes, spending and
borrowing that is designed to influence business fluctuations.
Crowd out = the decrease in private spending that occurs when
government spending increases.
Multiplier effect = the additional increase in spending caused by
the initial increase in government spending
The fundamental reason that fiscal policy can work is that when
resources are unemployed, the economy is operating
inefficiently. If spending more can employ unemployed
resources, than it can in principle pay for itself.
Opposing forces are multiplier effect and crowding out. If government spending increases by 100
billion and all of that additional spending crowds out the private sector spending, than the
multiplier is zero. If no private sector spending is crowded out the multiplier is 1. Fiscal policy
works better is them multiplier is greater than 1.
If people save their tax cuts instead of spending them, then the aggregate demand curve does not
shift out, the multiplier is zero and there are no systematic macroeconomics effects. This is called
Ricardian equivalence.

Fiscal policy is often intended to correct short-term problems in the business cycle. The list of
relevant lags:
 Recognition lag
 Legislative lag
 Implementation lag
 Effectiveness lag
 Evaluation and adjustment lag
Automatic stabilizers = are changes in fiscal policy that stimulate AD in a recession without the need
for explicit action by policymakers.

Common sense fiscal policy

Ideal fiscal policy will increase AD by spending in bad times and reduce AD by taxing and paying off
the bill in good times.
Ideal fiscal policy is counter-cyclical = fiscal policy that runs opposite or counter to the business cycle.
Spending more when the economy is in a recession and less when the economy is booming.

When is it needed:
1. The economy needs a short-run boost, even at the expense of the long run.
2. The problem is a deficiency in aggregate demand rather than a real shock
3. Many resources are unemployed and the fiscal stimulus, either tac cuts or expenditures, can
be targeted to those unemployed resources.
4. Government spending is efficient and productive.