Comprehensive Exam Review Sheet

Microeconomics
Scarcity it indicates that a choice must be made as well as varying degrees of demand for something. Arbitrage the practice of taking advantage of price differences between markets. In perfect competition, arbitrage is would not exist and there would be no price differential between identical goods. Due to the price differentials, arbitrage activity tends to reallocate goods, shifting them from lower-valued uses to higher-valued uses. Supply and demand - In microeconomic theory, demand is defined as the willingness and ability of a consumer to purchase a given product in a given frame of time. Supply and demand dictate scarcity. MORE!!! Market prices as indicators of scarcity In general, the higher the demand for a product or good, the higher the price of the product or good; This is also true in interesting situations such as being stuck in a desert with a bag diamonds and a can of water. Concept of a market economy - is an economic system based on the division of labor in which the prices of goods and services are determined in a free price system set by supply and demand. This is often contrasted with a planned economy, in which a central government determines the price of goods and services using a fixed price system. Division of labour or specialization is the specialization of cooperative labour in specific, circumscribed tasks and roles, intended to increase the productivity of labour. A free price system or free price mechanism (informally called the price system or the price mechanism) is an economic system where prices are set by the interchange of supply and demand, with the resulting prices being understood as signals that are communicated between producers and consumers which serve to guide the production and distribution of resources. Through the free price system, supplies are rationed, income is distributed, and resources are allocated. A free price system contrasts with a controlled or fixed price system where prices are set by government, within a controlled market or planned economy. Supply Theory The basic assumption firms want to maximize profit; profit = revenue cost

Definition of Supply Supply is defined as the quantity of a product that a producer is willing and able to supply onto the market at a given price in a given time period. The basic law of supply is that as the price of a commodity rises, so producers expand their supply onto the market. A supply curve shows a relationship between price and quantity a firm is willing and able to sell. Cost - In economics, business, retail, and accounting, a cost is the value of money that has been used up to produce something, and hence is not available for use anymore. In economics, a cost is an alternative that is given up as a result of a decision. Opportunity cost, also referred to as economic cost is the value of the best alternative that was not chosen in order to pursue the current endeavouri.e, what could have been accomplished with the resources expended in the undertaking. It represents opportunities forgone.

Production Function represents the quantitative relationship between inputs and outputs. Total production curve is a short run production function Long Run all costs are variable Isoquants - In economics, an isoquant is a contour line drawn through the set of points at which the same quantity of output is produced while changing the quantities of two or more inputs. While an indifference curve helps to answer the utility-maximizing problem of consumers, the isoquant deals with the cost-minimization problem of producers. Isoquants are typically drawn on capital-labor graphs, showing the tradeoff between capital and labor in the production function, and the decreasing marginal returns of both inputs. Adding one input while holding the other constant eventually leads to decreasing marginal output, and this is reflected in the shape of the isoquant. A family of isoquants can be represented by an isoquant map, a graph combining a number of isoquants, each representing a different quantity of output. Returns to scale - Returns to scale refers to a technical property of production that examines changes in output subsequent to a proportional change in all inputs (where all inputs increase by a constant factor). If output increases by that same proportional change then there are constant returns to scale (CRTS). If output increases by less than that proportional change, there are decreasing returns to scale (DRS). If output increases by more than that proportion, there are increasing returns to scale (IRS). The basic idea is that there should be an average decreasing cost as a firm increases in productive size. This is also related to natural monopolies because there can only be so many firms for a specific product (such as planes). At a certain size, it is no longer competitive to increase production. Isocost line - An isocost line is a line showing combinations of inputs that would yield the same cost. Short Run Costs at least one fixed cost Total Product Curve - The idea is that there will eventually be diminishing returns with increased labor. Diminishing Total returns, which implies reduction in total product with every additional unit of input. This occurs after point A in the graph.

Marginal Product - MP = Y/X or Y/L = (the change of Y)/(the change of X). The marginal product or marginal physical product is the extra output produced by one more unit of an input. Diminishing Average returns, which refers to the portion of the APP curve after its intersection with MPP curve. 3. Diminishing Marginal returns, refers to the point where the MPP curve starts to slope down and travels all the way down to the x-axis and beyond. Putting it in a chronological order, at first the marginal returns start to diminish, then the average returns, followed finally by the total returns. Average Product - Average product" (APL) is defined as output per unit of labor input: Q/L. Financial Factors firm is a price taker not price maker. Short-run cost curves (seven of them)

(Total) Fixed Cost unchanged by most other factors; FC = Constant (straight line)

(Total) Variable Cost VC = wL Total Cost TC = FC + VC = rK +wK (Fixed plus Variable) Average Fixed Cost AFC = FC/Q Average Variable Cost AVC = VC/Q Average Total Cost ATC = TC/Q Marginal Cost MC = TC/Q = w (1/MPL) AFC + AVC = ATC Long Run Cost Revenue depends on demand Perfect competition price taker = horizontal demand curve Perfect competition describes a market in which there are many small firms, all producing homogeneous goods. In the short term, such markets are productively inefficient as output will not occur where mc is equal to ac, but allocatively efficient, as output under perfect competition will always occur where mc is equal to mr, and therefore where mc equals ar. However, in the long term, such markets are both allocatively and productively efficient.[1] In general a perfectly competitive market is characterized by the fact that no single firm has influence on the price of the product it sells. Because the conditions for perfect competition are very strict, there are few perfectly competitive markets. A perfectly competitive market may have several distinguishing characteristics, including:

Many buyers/Many Sellers Many consumers with the willingness and ability to buy the product at a certain price, Many producers with the willingness and ability to supply the product at a certain price. Homogeneous Products The products of the different firms are EXACTLY the same, e.g. salt. Low-Entry/Exit Barriers It is relatively easy to enter or exit as a business in a perfectly competitive market. Perfect Information - For both consumers and producers. Firms Aim to Maximize Profits - Firms aim to sell where marginal costs meet marginal revenue, where they generate the most profit.

Short Run

Long Run (perfect competition)

Profit Maximization Firms will produce up to the point where MR = MC. Since MR = price, then the firm will increase production till MC = Price; therefore, MR = MC = P = D at that point for the firm. Zero-profit Maximization - The rate of profit tends to coincide with the rate of interest. Profits in the classical meaning do not tend to disappear in the long period but tend to normal profit. With this terminology, if a firm is earning abnormal profit in the short term, this will act as a trigger for other firms to enter the market. They will compete with the first firm, driving the market price down until all firms are earning normal profit only.

Economic Profit versus Accounting Profit - Pure economic profit is the increase in wealth that an investor has from making an investment, taking into consideration all costs associated with that investment including the opportunity cost of capital. An economic profit arises when its revenue exceeds the total (opportunity) cost of its inputs, noting that these costs include the cost of equity capital that is met by "normal profits." A business is said to be making an accounting profit if its revenues exceed the accounting cost of the firm. Economics treats the normal profit as a cost, so when deducted from total accounting profit what is left is economic profit (or economic loss). Other cases negative sloping demand curve A Monopoly is one case where the firm would be faced with a negative sloping demand curve. Marginal revenue of a straight line demand curve MR = P = D (in perfect competition) Elasticity and marginal (and total) revenue - The relation between the price elasticity of demand and the marginal revenue curve indicates that a monopoly is only able to maximize profit by producing a quantity of output that falls in the elastic range of the demand curve. A monopoly cannot maximize profit in the inelastic range of demand because this involves negative marginal revenue, and by virtue of the profit-maximizing equality between marginal revenue and marginal cost, it requires negative marginal cost, which is just not a realistic possibility.

The demand curve for a perfect competitor is its marginal cost curve (above average variable cost). This was mentioned earlier (see graph on previous page).

Monopoly It is a single seller (one firm) that makes up the entire market/industry. Profit Maximization Production is increased until marginal revenue (MR) equals marginal cost (MC). Also note that if the price (based on the demand curve) is less than the average total cost (ATC), then the firm is going to produce at a loss. Consumer welfare comparison with perfect competition - According to the standard model, in which a monopolist sets a single price for all consumers, the monopolist will sell a lower quantity of goods at a higher price than would firms under perfect competition. Because the monopolist ultimately forgoes transactions with consumers who value the product or service more than its cost, monopoly pricing creates a deadweight loss referring to potential gains that went neither to the monopolist nor to consumers. Given the presence of this deadweight loss, the combined surplus (or wealth) for the monopolist and consumers is necessarily less than the total surplus obtained by consumers under perfect competition. Where efficiency is defined by the total gains from trade, the monopoly setting is less efficient than perfect competition.

Price discrimination - Price discrimination exists when sales of identical goods or services are transacted at different prices from the same provider. In a theoretical market with perfect information, no transaction costs or prohibition on secondary exchange (or re-selling) to prevent arbitrage, price discrimination can only be a feature of monopoly and oligopoly markets, where market power can be exercised. Otherwise, the moment the seller tries to sell the same good at different prices, the buyer at the lower price can arbitrage by selling to the consumer buying at the higher price but with a tiny discount. Theoretically, a monopoly could make the most profit by charging each person the maximum price they would be willing to pay at each part of the demand curve up to the limit of profitability. Monopolistic Competition The short run is much like that for a monopoly. However, because there are several firms competing, the long term ends up with firms making normal profit (zero economic profit). Monopolistically competitive markets have the following characteristics:

There are many producers and many consumers in a given market, and no business has total control over the market price.

Consumers perceive that there are non-price differences among the competitors' products. There are few barriers to entry and exit[1]. Producers have a degree of control over price.

Product Differential Products under monopolistic competition vary in such ways as by brands or levels of service. Costs are higher due to the expenditures to differentiate products.

Short run

Long run

Oligopoly - An oligopoly is a market form in which a market or industry is dominated by a small number of sellers (oligopolists). The word is derived from the Greek for few (entities with the right to) sell. Because there are few participants in this type of market, each oligopolist is aware of the actions of the others. The decisions of one firm influence, and are influenced by, the decisions of other firms. Strategic planning by oligopolists always involves taking into account the likely responses of the other market participants. This causes oligopolistic markets and industries to be at the highest risk for collusion. Compete or Collude? If pure Oligopoly rules, then there will be a kinked demand curve, competitors will follow price cuts but not price increases, and this gives rise to stable prices

If Collusion takes place, then firms will collude to behave as a monopolist. Why cartels tend to be unstable Cartels are unstable because all firms have motive to cut prices to gain profit from the deadweight loss. Introduction to Game Theory for the previous reason, all firms usually come to some common price that all profit from greater than they would in perfect competition, but not as great as a monopoly. The Microeconomic Theory of Income Distribution Factor payments are determined by supply and demand Labor-wages Demand for Labor increases with an increase in the MPL. VMPL = P(MPL) Productivity and wages are positively related and demand for labor comes from the demand for a product. No demand for a product equals no labor demand to produce it. Wages differentials (think Adam Smith) connect the positive and negative attributes of a job with wages. An increase in wage yields an increase in leisure and decrease in labor (work) Land-rents Growing corn in Manhattan is not a good idea unless the rent is low enough that a person could make a profit and the opportunity cost is low. Rent is for the productive services of the land. Capital-interest Interest = price of credit; demand comes from borrowers; supply comes from savers/investors. Interest is the value of something at the current time versus in the future plus economic profit. IF Fed increases Ms => Banks increase SLF => i down. Positive time preference is the main reason people borrow money.

Time Preference They can also be thought of as inter-temporal indifference curves. The sharper the slope, the greater the present time preference; the shallower the slope, the greater the future time preference

Interest as the price of credit Interest is the current value versus in the future + economic profit Competitive equalization of the rate of return An activity that is generally expected to be profitable (greater than expected return) wont turn out to be profitable (above normal rate of return) due to competition through arbitrage. Profits (above normal rate of return) are the result of uncertainty Entrepreneurship one of the situations where a person can make an above normal rate of return or profit because of the uncertainty connected with the business/project. They can temporarily create a monopoly based on new ideas, new products, etc. Do barriers to competition cause profit? For Monopolies because of costly entry to the market and economies of scale. Demand Theory Individual Preferences Utility It is the satisfaction obtained by the consumer from consuming a good. Total Utility It is the aggregate level of satisfaction or fulfillment that a consumer receives through the consumption of a specific good or service. Each individual unit of a good or service has its own marginal utility, and the total utility is simply the sum of all the marginal utilities of the individual units. Classical economic theory suggests that all consumers want to get the highest possible level of total utility for the money they spend. In order to maximize total utility (which is the inherent goal of all consumers), consumers will look to combine different combinations of goods and services. Given their limited resources (money), consumers will make choices in an attempt to increase their total utility with each additional unit of consumption. TU = U/Q Marginal Utility - The additional utility, or satisfaction of wants and needs, obtained from the consumption or use of an additional unit of a good. It is specified as the change in total utility

divided by the change in quantity. Marginal utility indicates what each additional unit of a good is worth to a consumer. MU = TU/ Q Cardinal vs. Ordinal - Economists distinguish between cardinal utility and ordinal utility. When cardinal utility is used, the magnitude of utility differences is treated as an ethically or behaviorally significant quantity. On the other hand, ordinal utility captures only ranking and not strength of preferences. An important example of a cardinal utility is the probability of achieving some target. Marginal Utility => Demand curves It explains why the demand curve is downward sloping

Indifference Curves - In microeconomic theory, an indifference curve is a graph showing different bundles of goods, each measured as to quantity, between which a consumer is indifferent. That is, at each point on the curve, the consumer has no preference for one bundle over another. In other words, they are all equally preferred. One can equivalently refer to each point on the indifference curve as rendering the same level of utility (satisfaction) for the consumer. Finally, the curve higher up is always preferable to the one below it at any point on it because the person is getting a larger amount of the combined goods than was possible one the lower curve.

Marginal Rate of Substitution - In economics, the marginal rate of substitution is the rate at which a consumer is ready to give up one good in exchange for another good while maintaining the same level of satisfaction. As with time preference, the slope of the curve dictates what good the person prefers more than the other. Cases

Normal, well-behaved, convex See graph above Perfect Substitutes - One good is a perfect substitute for another only if it can be used in exactly the same way. In that case the utility of a combination is an increasing function of the sum of the two amounts, and theoretically, in the case of a price difference, there would be no demand for the more expensive good. Perfect Complements - A perfect complement is a good that has to be consumed with another good. Many goods in the real world exhibit characteristics close to perfect complementariness. An example would be a left shoe and a right. Because of this, shoes are naturally sold in pairs, and the ratio between sales of left and right shoes will never shift noticeably from 1:1 - even if, for example, someone is missing a leg and buys just one shoe. Bads Neuters How to represent one good being relatively preferable

If P1 decreases => Slope decreases, Horizontal intercept increases and vice versa Budget Constraints Expenditures cannot exceed income Representation Algebra Diagram Effect of a Change Price Income Consumer Optimization Equi-marginal condition in consumption - We will use the utility theory to explain consumer demand and to understand the nature of demand curves. For this purpose, we need to know the condition under which I, as a consumer, am most satisfied with my market basket of consumption goods. We say that a consumer attempts to maximize his or her utility, which means that the consumer chooses the most preferred of goods from what is available. Can we see what a rule for such an optimal decision would be? Certainly I would not expect that the last egg I am buying bring exactly the same marginal utility as the last pair of shoes I am

buying, for shoes cost much more per unit than eggs. A more sensible rule would be: If good A costs twice as much as good B, then buy good A only when its marginal utility is at least twice as great as good B's marginal utility. This leads to the equimarginal principle that I should arrange my consumption so that every single good is bringing me the same marginal utility per dollar of expenditure. In such a situation, I am attaining maximum satisfaction or utility from my purchases. This is clear concept of equimarginal principle. Tangency - the state of being tangent; having contact at a single point or along a line without crossing. Individual Demand Curve vs. market demand curve - The market demand curve is the horizontal summation of individual demand curves. Individual demand is the key initiator of the production process. It is independent of all factors other than the preference curve, prices and income constraint. The law of demand: lower the price, greater amount demanded, i.e. demand curve is negatively sloped. Effect of price changes on optimal quantities Income and substitution effects

Giffen goods - A Giffen good is an extreme type of inferior good. In economics and consumer theory, a Giffen good is that which people consume more of as price rises, violating the law of demand. To understand how this happens, consider the example of a Giffen good for which there is the best evidence that it is a Giffen good. Households in the Hunan province of China were shown to buy more rice when they had to buy it at a higher price, and less when the price they paid was subsidised. The reason for this is that, even when expensive, rice was still the cheapest source of calories available. Therefore, when the price of rice was cut, households had more money left over after buying rice. Some of this was spent on buying more expensive foods (meat, vegetables and fruit), which reduced their need for rice. Compensated demand curve It is a demand curve which ignores the income effect of a price change. A compensated demand curve is therefore less elastic than an ordinary demand curve. Market Demand Curves Horizontal addition of individual demand curves Price elasticity of demand - The Price Elasticity of Demand (commonly known as just price elasticity) measures the rate of response of quantity demanded due to a price change. The formula for the Price Elasticity of Demand (PEoD) is: PEoD = (% Change in Quantity Demanded)/(% Change in Price)

If PEoD > 1 then Demand is Price Elastic (Demand is sensitive to price changes) If PEoD = 1 then Demand is Unit Elastic If PEoD < 1 then Demand is Price Inelastic (Demand is not sensitive to price changes)

Arc vs. point

Elastic Demand

Inelastic Demand

Income Elasticity of Demand - The Income Elasticity of Demand measures the rate of response of quantity demand due to a raise (or lowering) in a consumers income. The formula for the Income Elasticity of Demand (IEoD) is given by: IEoD = (% Change in Quantity Demanded)/(% Change in Income)

If IEoD > 1 then the good is a Luxury Good and Income Elastic If IEoD < 1 and IEOD > 0 then the good is a Normal Good and Income Inelastic If IEoD < 0 then the good is an Inferior Good and Negative Income Inelastic

Cross-price Elasticity of Demand The Cross-Price Elasticity of Demand measures the rate of response of quantity demanded of one good, due to a price change of another good. If two goods are substitutes, we should expect to see consumers purchase more of one good when the price of its substitute increases. Similarly if the two goods are complements, we should see a price rise in one

good cause the demand for both goods to fall. The common formula for the Cross-Price Elasticity of Demand (CPEoD) is given by: CPEoD = (% Change in Quantity Demand for Good X)/(% Change in Price for Good Y)

If CPEoD > 0 then the two goods are substitutes If CPEoD =0 then the two goods are independent (no relationship between the two goods If CPEoD < 0 then the two goods are complements

Price Elasticity of Supply The Price Elasticity of Supply measures the rate of response of quantity demand due to a price change. If you've already read The Price Elasticity of Demand and understand it, you may want to just skim this section, as the calculations are similar. We calculate the Price Elasticity of Supply by the formula: PEoS = (% Change in Quantity Supplied)/(% Change in Price)

If PEoS > 1 then Supply is Price Elastic (Supply is sensitive to price changes) If PEoS = 1 then Supply is Unit Elastic If PEoS < 1 then Supply is Price Inelastic (Supply is not sensitive to price changes)

Elasticity and Revenue When the price elasticity of demand for a good is inelastic (|Ed| < 1), the percentage change in quantity demanded is smaller than that in price. Hence, when the price is raised, the total revenue of producers rises, and vice versa. When the price elasticity of demand for a good is elastic (|Ed| > 1), the percentage change in quantity demanded is greater than that in price. Hence, when the price is raised, the total revenue of producers falls, and vice versa. When the price elasticity of demand for a good is unit elastic (or unitary elastic) (|Ed| = 1), the percentage change in quantity is equal to that in price. When the price elasticity of demand for a good is perfectly elastic (Ed is undefined), any increase in the price, no matter how small, will cause demand for the good to drop to zero. Hence, when the price is raised, the total revenue of producers falls to zero. The demand curve is a horizontal straight line. A banknote is the classic example of a perfectly elastic good; nobody would pay 10.01 for a 10 note, yet everyone will pay 9.99 for it. When the price elasticity of demand for a good is perfectly inelastic (Ed = 0), changes in the price do not affect the quantity demanded for the good. The demand curve is a vertical straight line; this violates the law of demand. An example of a perfectly inelastic good is a human heart for someone who needs a transplant; neither increases nor decreases in price affect the quantity demanded (no matter what the price, a person will pay for one heart but only one; nobody would buy more than the exact amount of hearts demanded, no matter how low the price is). __________________________________________________________________________________

Things You Need for Comps Macroeconomics and Finance

GDP - The best way to understand the U.S. economy is by looking at Gross Domestic Product (GDP), which is the statistic used to measure the economy. In other words, the U.S. economy, as measured by GDP, is everything produced by all the people and all the companies in the U.S. GDP = Y = total expenditures = C + I + G + NX; (Consumption spending, Investments, Government purchases, and Net Exports/Imports) Nominal GDP Anything produced within a nation within a year. It does note included calculations for inflation. Real GDP It is nominal GDP adjusted for inflation (price changes). GDP per capita It is GDP divided per person within a nation. This is not a perfectly accurate measure of the average income of people within a nation because of people like Bill Gates and such. (Imagine the average income in a homeless shelter with Bill Gates visiting it.) Inflation It is an ongoing rise in the general level of prices quoted in units of money. The magnitude of inflationthe inflation rateis usually reported as the annualized percentage growth of some broad index of money prices. With U.S. dollar prices rising, a one-dollar bill buys less each year. Inflation thus means an ongoing fall in the overall purchasing power of the monetary unit. Measurement: price index - A price index is a normalized average (typically a weighted average) of prices for a given class of goods or services in a given region, during a given interval of time. It is a statistic designed to help to compare how these prices, taken as a whole, differ between time periods or geographical locations. In economics, the GDP deflator (implicit price deflator for GDP) is a measure of the change in prices of all new, domestically produced, final goods and services in an economy. GDP stands for gross domestic product, the total value of all final goods and services produced within that economy during a specified period.

Problems with: Redistribution - Economic expansion will be hindered in the absence of the "profit motive" that is lies at the heart of most business ventures. And without entrepreneurs the economy cannot expand, and in the end everybody suffers. Distorted price signals - Why were too many loans made in 2003-07? Too much easy money. It had to go somewhere. Why did a barrel of oil spike from $70 in August 2007 to $147 in July 2008? Because speculators had a greater faith in an oil future contract than they did the value of a US dollar. The dollar ceased to be a dollar. The most basic price signal of all could not be trusted. Resources used to cope Interest Rate - An interest rate is the price a borrower pays for the use of money they do not own, for instance a small company might borrow from a bank to kick start their business, and the return a lender receives for deferring the use of funds, by lending it to the borrower. Interest rates are normally expressed as a percentage rate over the period of one year.

Causes of Interest rate:

Deferred consumption. When money is loaned the lender delays spending the money on consumption goods. Since according to time preference theory people prefer goods now to goods later, in a free market there will be a positive interest rate. Inflationary expectations. Most economies generally exhibit inflation, meaning a given amount of money buys fewer goods in the future than it will now. The borrower needs to compensate the lender for this. Alternative investments. The lender has a choice between using his money in different investments. If she chooses one, she forgoes the returns from all the others. Different investments effectively compete for funds. Risks of investment. There is always a risk that the borrower will go bankrupt, abscond, or otherwise default on the loan. This means that a lender generally charges a risk premium to ensure that, across his investments, he is compensated for those that fail. Liquidity preference. People prefer to have their resources available in a form that can immediately be exchanged, rather than a form that takes time or money to realise. Taxes. Because some of the gains from interest may be subject to taxes, the lender may insist on a higher rate to make up for this loss.

Price of credit Real vs. Nominal The nominal interest rate is the amount, in money terms, of interest payable. For example, suppose a household deposits $100 with a bank for 1 year and they receive interest of $10. At the end of the year their balance is $110. In this case, the nominal interest rate is 10% per annum. The real interest rate, which measures the purchasing power of interest receipts, is calculated by adjusting the nominal rate charged to take inflation into account. (See real vs. nominal in economics.) If inflation in the economy has been 10% in the year, then the $110 in the account at the end of the year buys the same amount as the $100 did a year ago. The real interest rate, in this case, is zero. Business Cycle - The business cycle is the periodic but irregular up-and-down movements in economic activity, measured by fluctuations in real GDP and other macroeconomic variables. Fiscal Policy Fiscal policy is the use of government spending and TAXATION to influence the economy. When the government decides on the goods and services it purchases, the transfer payments it distributes, or the taxes it collects, it is engaging in fiscal policy. Fiscal policy is said to be tight or contractionary when revenue is higher than spending ( G < T i.e., the government budget is in surplus) and loose or expansionary when spending is higher than revenue (G > T i.e., the budget is in deficit). Often, the focus is not on the level of the deficit, but on the change in the deficit. Thus, a reduction of the deficit from $200 billion to $100 billion is said to be contractionary fiscal policy, even though the budget is still in deficit. Monetary Policy It is the attempt by the Fed to establish a balance in the national income and growth in the economy by controlling the size of the money supply.

Monetary Theory Monetary policy is the process by which the government, central bank, or monetary authority of a country controls (i) the supply of money, (ii) availability of money, and (iii) cost of money or rate of interest, in order to attain a set of objectives oriented towards the growth and stability of the economy. For the US, the Fed can't control inflation or influence output and employment directly; instead, it affects them indirectly, mainly by raising or lowering a short-term interest rate called the "federal funds" rate. Most often, it does this through open market operations in the market for bank reserves, known as the federal funds market. Functions of money Money is often defined in terms of the three functions or services that it provides. Money serves as a medium of exchange, as a store of value, and as a unit of account. Medium of exchange. Money's most important function is as a medium of exchange to facilitate transactions. Without money, all transactions would have to be conducted by barter, which involves direct exchange of one good or service for another. The difficulty with a barter system is that in order to obtain a particular good or service from a supplier, one has to possess a good or service of equal value, which the supplier also desires. In other words, in a barter system, exchange can take place only if there is a double coincidence of wants between two transacting parties. The likelihood of a double coincidence of wants, however, is small and makes the exchange of goods and services rather difficult. Money effectively eliminates the double coincidence of wants problem by serving as a medium of exchange that is accepted in all transactions, by all parties, regardless of whether they desire each others' goods and services. Store of value. In order to be a medium of exchange, money must hold its value over time; that is, it must be a store of value. If money could not be stored for some period of time and still remain valuable in exchange, it would not solve the double coincidence of wants problem and therefore would not be adopted as a medium of exchange. As a store of value, money is not unique; many other stores of value exist, such as land, works of art, and even baseball cards and stamps. Money may not even be the best store of value because it depreciates with inflation. However, money is more liquid than most other stores of value because as a medium of exchange, it is readily accepted everywhere. Furthermore, money is an easily transported store of value that is available in a number of convenient denominations. Unit of account. Money also functions as a unit of account, providing a common measure of the value of goods and services being exchanged. Knowing the value or price of a good, in terms of money, enables both the supplier and the purchaser of the good to make decisions about how much of the good to supply and how much of the good to purchase. Money and price With money, considering the three major functions, price and money are positively related. Something considered more desirable and scarce will cost a larger amount of money. Money and interest In the short run, a decrease in the money supply will cause Money demanded (Md) to outweigh Money supplied (Ms). This will cause the Bonds supplied (Bs) to outweigh the Bonds demanded (Bd). This in turn will cause the interest rate to rise (i up), driving real interest up (r up) and lead to a decrease in the Demand for stocks (Ds). Finally, this will cause the Price of stocks to fall (Ps down). The same is true for vice versa.

Real interest rate = Nominal interest rate inflation rate (r = i pi) Ms down => Md > Ms => Bs > Bd => i up => (r up) => Ds down => Ps down Ms up => Md < Ms => Bs < Bd => i down => (r down) => Ds up => Ps up Measurements of money supply Each measure can be classified by placing it along a spectrum between narrow and broad monetary aggregates. The different types of money are typically classified as Ms. The number of Ms usually range from M0 (narrowest) to M3 (broadest) but which Ms are actually used depends on the system. The typical layout for each of the Ms is as follows:

M0: currency (notes and coins) in circulation and in bank vaults, plus reserves which commercial banks hold in their accounts with the central bank (minimum reserves and excess reserves). M0 is usually called the monetary base - the base from which other forms of money (like checking deposits, listed below) are created - and is traditionally the most liquid measure of the money supply. M1: currency in circulation + checkable deposits (checking deposits, officially called demand deposits, and other deposits that work like checking deposits) + traveler's checks. M1 represents the assets that strictly conform to the definition of money: assets that can be used to pay for a good or service or to repay debt. Although checks linked to checking deposits are gradually becoming less popular, debit cards linked to these deposits are becoming more popular. Like checks, debit cards, as a means to complete a transaction through their links to checkable deposits, can also be considered as a form of money. M2: M1 + savings deposits, time deposits less than $100,000 and money market deposit accounts for individuals. M2 represents money and "close substitutes" for money. M2 is a key economic indicator used to forecast inflation. M3: M2 + large time deposits, institutional money-market funds, short-term repurchase agreements, along with other larger liquid assets. M3 is no longer published or revealed to the public by the US central bank.

The Federal Reserve System (the Fed) The Federal Reserve System (also the Federal Reserve; informally The Fed) is the central banking system of the United States. Multiple expansion of deposits Multiple-Deposit Expansion The banking system's lending potential:
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Assuming that reserve ratio for all commercial banks is 20 percent and no excess reserves exists. Reserves lost by a single bank aren't lost the banking system as a whole. For Example: The reserves that are lost by bank A are attained by bank B, and those lost by Bank B are acquired by bank C etc. Thus, even though reserves are lost by individual banks, there is no loss of reserves for the banking system as a whole. An individual bank can lend only an amount to its excess reserves, but this commercial banking system can lend by a multiple of its excess reserves.

Commercial banks as a whole can create money by lending in a way different from the manner of individual banks in the group. The banking system magnifies any original excess reserves into a larger amount of newly created checkable-deposit money The checkable-deposit multiplier, or monetary multiplier, is simliar in concept to the the spending-income multiplier Monetary multiplier exists because the reserves and deposits lost by one bank becomes reserves of another bank. It magnifies excess reserves into a larger creation of checkable-deposit money. (when the excess reserve of a bank increases (because the federal reserve bank buy bonds) then, the commercial bank would loan out more of their excess reserve money to increase consumer's disposable income and to increase GDP. The monetary multiplier m is the reciprocal of the required reserve ratio R (the leakage into required reserves that occurs at each step in the lending process) Monetary Multiplier (money multiplier) = 1/ required reserve ratio OR m = 1/R eg. If you deposit $500 into a bank, and the reserve ratio is 20%, you multiply $500 by 1/.2 which results in a creation of $2500 dollars. When the reserved ratio changes because of the monetary policy, the money multiplier also changes. As Reserve Ratio increases, Money Multiplier decreases As Reserve Ratio decreases, Money Multiplier increases

The money multiplier:

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The Feds tools for controlling the money supply Required Reserve Ratio The reserve requirement (or required reserve ratio) is a bank regulation that sets the minimum reserves each bank must hold to customer deposits and notes. These reserves are designed to satisfy withdrawal demands, and would normally be in the form of fiat currency stored in a bank vault (vault cash), or with a central bank. As of 2006 the required reserve ratio in the United States was 10% on transaction deposits (component of money supply "M1"), and zero on time deposits and all other deposits. Reserve requirements affect the potential of the banking system to create transaction deposits. If the reserve requirement is 10%, for example, a bank that receives a $100 deposit may lend out $90 of that deposit. If the borrower then writes a check to someone who deposits the $90, the bank receiving that deposit can lend out $81. As the process continues, the banking system can expand the change in excess reserves of $90 into a maximum of $1,000 of money ($100+$90+81+$72.90+...=$1,000), e.g.$100/0.10=$1,000. In contrast, with a 20% reserve requirement, the banking system would be able to expand the initial $100 deposit into a maximum of ($100+$80+$64+$51.20+...=$500), e.g.$100/0.20=$500. Thus, higher reserve requirements reduce artificial money creation and help maintain the purchasing power of the currency in use With the simple formula D = A*(1/r) we can quickly and easily determine what effect an openmarket sale of bonds will have on the money supply. Discount Rate The discount rate is an interest rate a central bank charges depository institutions that borrow reserves from it. MORE!!!

Open Market Operations The purchase and sale of government bonds. The Fed buys government bonds when it wants to increase the money supply. The Fed sells more government bonds when it wants to decrease the money supply. Ms down => Md > Ms => Bs > Bd => i up => (r up) => Ds down => Ps down Ms up => Md < Ms => Bs < Bd => i down => (r down) => Ds up => Ps up The Government budget Ways to finance the government budget: Printing money The government can simply increase its budget by printing more money. However, this will lead to excessive inflation if the money supply grows too rapidly. Example: MV = PY; When the money supply (M) increases greater than the basic inflation of prices (P) and the rate of growth in full employment real GDP (Y),then inflation will increase to compensate (Velocity is consider constant). %M + %V = %P + %Y; 20% + 0% = __% + 3%; Then inflation = 17% Borrowing from domestic public Borrowing from domestic public When the government exceeds its budget, it can borrow to finance it from the domestic public. This can be good in a sense because when it pays back the public, the money remains in the nation as a whole. The downside can be that the domestic public does not have as much money to spend on goods and services at the current time. This, on a large scale, could cause a recession in certain consumer sectors. Borrowing from foreigners When the government exceeds its budget, it can also borrow from foreigners, both individuals and nations as a whole. The good side of this is that the budget in the short term can expand enormously beyond that of domestic lending. However, payments for borrowing to foreigners leave the nation. If the amount borrowed from foreigners becomes large enough in combination with the interest rate, the nation could end up paying more in interest to foreign nations and people than it gains from annual economic growth. Effects of financing the deficit The national debt: is it a problem? Yes, if it expands so far that interest paid outweighs annual economic growth. However, borrowing also allows a nation to increase its economic growth and spend more than would be possible if it had to balance its budget like an individual. Long Run Macroeconomics The determination and distribution of national income National income = Nat nation Product (NNP) minus Indirect business taxes. Basic open economy Macroeconomics Y = F(K,L); The economy is affected by the factors of production. Those factors are capital (K) and labor (L), both of which are usually assumed to be fixed. In addition, technology (A) is a third factor, although it cannot be calculated. The function would be shown as follows: Y = AF(K,L)

The Marginal Product of Labor (MPL) is the extra amount of output the firm gets from one extra unit of labor. This, on a large scale, means that when L increase, then Y increase but at a decreasing rate. The same is true for capital with the Marginal Product of Capital (MPK). Economic Profit = Y (MPL x L) (MPL x K). Therefore, Y = (MPL x L) + (MPK x K) + economic profit. Economic Growth Theory In economics, "economic growth" or "economic growth theory" typically refers to growth of potential output, i.e., production at "full employment," which is caused by growth in aggregate demand or observed output.

Short Run Macroeconomics Economic Fluctuations An increase in unemployment = a decrease in real GDP growth;

MV = PY An adverse supply shock => SRAS up, but the Fed can increase the AD to prevent a reduction in output. In the short run, prices dont change, but the output shifts instead. In the long run, output remains at the optimum level, but prices shift accordingly. The IS-LM model IS stands for Investment and Savings, while LM stands for Liquidity and Money. IS Curve IS curve is downward sloping because when real interest decreases, spending increases. A change in either Government purchases or Taxation (G or T) will cause the IS curve to shift to the right or left. An increase in G will shift the IS curve to the right and vice versa. An increase in T will shift the IS curve to the left and vice versa.

The LM Curve The LM curve is upward sloping because the higher the level of income, the higher the demand for real money balances, and the higher the equilibrium interest rate. Changes in the Money Supply will cause the LM curve to shift either up or down. A Decrease in the Money Supply will raise the interest rate and cause the LM curve to rise as well (and vice versa). Short run macroeconomic Policy The open economy in an IS-LM model International Finance The balance of payments - In economics, the balance of payments, (or BOP) measures the payments that flow between any individual country and all other countries. It is used to summarize all international economic transactions for that country during a specific time period, usually a year. The BOP is determined by the country's exports and imports of goods, services, and financial capital, as well as financial transfers. It reflects all payments and liabilities to foreigners (debits) and all payments and obligations received from foreigners (credits). Balance of payments is one of the major indicators of a country's status in international trade, with net capital outflow. As stated before, if debt to foreigners becomes too high in combination with interest payments, then foreign payments may draw away from the growth of the economy. Balance of Trade = Investment National Savings Meaning of a trade deficit or surplus Trade Surplus Exports > Imports Net Exports > 0 Y>C+I+G Savings > Investment Nat Capital Outflow > 0 Causes Is a trade deficit a problem Not necessarily because it allows a nation to spend beyond taxation. In addition, if it helps to expand the economy, then the expansion of the economy could actually make the size of the deficit as a percentage of the budget smaller. However, as stated before, if the deficit becomes too large, then a nation will end up giving up more of its economic growth to pay lender than expand, causing the economy to remain stagnant or shrink. Exchange Rates - In finance, the exchange rates (also known as the foreign-exchange rate, forex rate or FX rate) between two currencies specifies how much one currency is worth in terms of the other. It is the value of a foreign nations currency in terms of the home nations currency. Determination of the rate: fundamentals Balanced Trade Exports = Imports Net Exports = 0 Y=C+I+G Savings = Investment Net Capital Outflows = 0 Trade Deficit Exports < Imports Net Exports < 0 Y<C+I+G Savings < Investment Net Capital Outflows < 0

Suppliers and demanders of foreign exchange

Types of foreign exchange transactions

Main theories of exchange rate determination Interest Rate Parity Purchasing Power Parity Finance Basic Discounting Financial Instruments Financial Intermediaries Money Interest Rates Financial Markets Risk and Term Structure of Interest Rates Efficient Markets Theory and the Stock Market Banking and the Management of Financial Institutions Derivatives