Shared Flashcard Set


Undergraduate 3

Additional Economics Flashcards





Circular Flow Diagram


Flow of money

1)      hhlds spend $$$ (on goods & services)

2)      firms generate revenues and pay wages, rent, profit for use of FOP

3)      translates into income for households


Flow of FOP as well as goods and services

1)      hhlds provide FOP to and are hired by firms

2)      firms sell goods & services

3)      goods & services purchased by hhlds


Circular Flow Diagram



Production Possibilities Frontier (PPF)



Graph that depicts combinations of output that an economy can produce given: (1) available resources (FOP) and (2) technology.

Illustrates economic concepts of:


            opportunity cost


            economic growth*



Production Possibilities Frontier (PPF)


A, B, and C all represent the most efficient allocation of resources for the economy


Point X means that the country's resources are not being used efficiently 

- country is not producing enough cotton or wine given the potential of its resources 


Point Y represents an output level that is currently unreachable by this economy

- Change in technology

-new curve would represent the new efficient allocation of resources.  




Characteristics of Free Trade



With trade...

1)      Involvement is voluntary

2)      Parties are self-motivated (no intention to make others better off)

3)      Both parties gain (made “better off”)




Comparative advantage implies there are gains to be had from trade (GFT)

          Further, suggests specialization is appropriate.


Specialization: focus majority of resources on 1 good


          don’t necessarily produce same bundle as whatconsume

          complete specialization possible but rare


Absolute Advantages


          based on productivity

Spain à  AA in Olive oil

Greece à AA in Cheese

Note: Producer can have AA in one, both, or neither good(s), but CA only in 1 good



The Gains From Trade



[  Consumption w/Trade  >  Autarky consumption  ]

Sources of extra Olive oil & Cheese...

  1. “Vive la difference”: every difference creates oppty for trade and oppty to get “richer”
  2. Specialize in what you’re better at producing (CA), i.e. low-cost

        necessary but not sufficient!!!...

  1. Must trade, otherwise won’t specialize

        trade allows to reach preferred consumption bundle

  1. Get more when specialize and trade w/o working harder



Production v. Consumption Possibilities



Production Possibilities (PP)

          combo.s of output that an individual/firm/economy can produce (given available resources—i.e., FOP—and technology).

Consumption Possibilities (CP)

          combo.s of output that an individual/firm/economy can consume (given available FOP and technology).

Systems of Production:

  1. Autarky = self-sufficiency; consume only what you produce, somewhere on your PPF (PP = CP)
  2. Trade = interdependent; can consume more than what you would have produced alone, beyond your PPF (CP > PP)


Absolute v. Comparative Advantage


Q: When we decide to trade, how do we know what to specialize in (e.g. what to export, and for that matter, what to import)?


Absolute advantage: comparison of producers based on their level of productivity

          a producer is said to have an absolute advantage if s/he can produce (in total) more of a good than another producer, w/in the same amount of time

Comparative advantage: comparison of producers based on their opportunity costs of production (on efficiency)      

          A producer has a comparative advantage if s/he has a lower opportunity cost of production, i.e. gives up less production of good B to produce good A.



Types of Markets


1.       Perfectly Competitive market:

-           many buyers and many sellers.

-          e.g., agricultural markets, retail services, stock market

-           Therefore NO single buyer(s) or seller(s) has control over market price.

2.       Monopoly market:

-          Many buyers

-         only one firm producing a given product

-          e.g., public utilities (cable), small town (gas or food stores)

-          As a result, the firm has market power or control over market price.


3.       Oligopolies:

-           fall somewhere in between in terms of the number of firms as well as their control over market price, i.e. they have some market power

-          e.g., manufacturing (steel, auto), pharmaceuticals, cereal, beverages (soft drinks, beer)

o   Cartels (a cooperative form of oligopoly) fall into this category.

§  e.g. diamonds (DeBeers), oil (OPEC)


Shifters of Demand



  1. Changes in Income (depends on whether good is normal or inferior)

Normal goods (e.g. wine, luxury cars, designer clothes)

          are those for which an increase (decrease) in income raises (lowers) demand

          (+) relation between income and demand

Inferior goods (e.g. cheap beer, Ramen noodles)

          are those for which an increase (decrease) in income lowers (raises) demand

          (-) relation between income and demand

  1. Changes in the Price of Related Goods (depends on whether good under comparison is a substitute or a complement)

Substitute goods (e.g. beer and wine, pretzels and chips)

          are those for which a rise (fall) in the price of one good raises (lowers) demand for the related good

          (+) relation between the price of one good and the demand for the other

Complementary goods (e.g. PB&J, hot dogs and hot dog buns)

          are those for which a rise (fall) in the price of one good lowers (raises) the demand for the related good

          (-) relation between the price of one good and the demand for the other

3.  Changes in Tastes and Preferences (all other factors that impact demand—other than the own-price of the good, changes in income, and changes in the prices of related goods)

·         EX. reputed physicians confirm that eating dark chocolate will boost your life expectancy (+)


4.       Changes in Expectations

·         e.g., if you expect goods to be cheaper in the future, you may reduce your demand for those goods now

  1. Change in the Number of Buyers (Consumers)

*changes in Demand SHIFT the entire demand curve


Shifts of Supply

  1. Changes in Input prices

          e.g. changes in the cost of materials, wages paid to labor, rent paid on land, buildings, and machinery

          market for pencils: the price of graphite falls (+)

          market for tomatoes: the price of fertiziler rises (-)

  1. Changes in Production Technology

          e.g. invention of a new process that raises

        productivity (+)

  1. Any other changes that could limit or boost production

          market for Oil: new oil fields come on-line (+)

          market for Oranges: cold snap in FL (-)

          Change in the Number of Sellers (Producers)


4. Changes in Expectations

          e.g., if producers expect the price of their good to rise next week, then they will hold back on production now

*changes in Supply SHIFT the entire supply curve



Market Equilibrium


1)      Where the value of a good (or service) to consumers is equal to the cost of production for producers

2)      Where Qs = Qd

3)      No tendency to want to move fm this point!

note: P*, Q* are the equilibrium market price and quantity prevailing in a competitive market

The market in Disequilibrium:

P > P*  à  Qs > Qd  (surplus)

P < P*  à  Qd > Qs  (shortage)



CPI and the inflation rate (be able to calculate)





Inflation (Π) demonstrates how fast prices for consumersare rising

          the rate of inflation is percentage change in CPI (or prices)

          expressed as a %


Π rate = [ (CPI1980 – CPI1950) / CPI1950 ] * 100%




CPI problems associated with fixed consumer basket (substitution bias / intro. new goods / quality changes)




  1. Does not account for consumer substitution toward relatively cheaper goods over time

          e.g., switch to cheaper soda from coffee, but quantities of goods in basket are fixed

  1. Does not account for introduction of new goods

          can choose b/w goods in and out of basket, but what’s included in basket overall is fixed

          e.g., more goods à value of $ greater (raises purchasing power), can buy more things with same money

3             3.   Does not account for quality changes of goods and services

          e.g., better quality à get more for your money

If counted, all of the above would lower the COL, but they are NOT… Thus CPI can overstate true inflation



Comparison with GDP Deflator



GDP deflator (G.D.) measures the average level of prices in the economy but differs from CPI:

          G.D. includes all goods and services produced rather than consumed (CPI) and thus excludes imported goods

          G.D. automatically changes group of goods and services over time as composition of GDP changes. CPI is consistent


Correcting for Inflation



Inflate 1985 salary…

                ( CPI2010 / CPI1985 ) x salary 1985

                ( 218 / 108 ) x $20,000 = $40,370

Between 1985 and 2010 prices nearly doubled (rose by a factor of two) and the value of your dad’s 1985 salary in 2010 would be $40,370.

What was the rate of inflation (from 1985 to 2010)?

                [ (218 – 108) / 108 ] x 100% ~ 102 percent



Interest rates (nominal vs. real) bond rates (corporate and government)


Nominal rate of interest (i)                          i = r + Π

          usually reported (e.g. earn on savings accounts, pay on credit cards)

          includes inflation rate

          can change due to changes in r or Π

          rate at which number of $s in account increases over time


Real rate of interest (r)                  r = i – Π

          excludes inflation rate

          based on the level of savings and investment in an economy

          accounts for changes in value of the $


Corporate Bonds

          ic = r +Π + ρ*                  (entail risk)


Government Bonds   (ρ = 0)        (no risk)

          non-indexed:    in = r        (short-term)

          indexed:          ii = r +Π      (longer-term)

ρ = default / risk premium


Factors of production (K, L, H, N, A)


  1. Natural Resources (N)

      inputs provided by nature (e.g., land, wind, solar, water)

  1. Labor (L)


  1. Physical Capital (K)

      stock of equipment and structures (e.g., machines, tools)

  1. Human Capital (H)

      worker knowledge and skills acquired thrutraining and education

  1. Technology (A)

      understanding of how to most efficientlyproduce goods (e.g., Henry Ford invents assembly-line process)



Productivity and economic growth (relation to real GDP)


·      Similarly, it is important to note that the growth rate of the economy (an indicator of how productive an economy is) is measured as the growth rate or % change in specifically real GDP.

  • When we calculate the growth rate of the economy it tells us whether we are being more/less productive(producing more or less) over time
  • A productive economy--one that is producing and selling more g&s--is an indicator of economic growth
  • As the economy grows it means that it is generating ahigher level of income (remember GDP is a measure of an economy’s income and expenditures) and we enjoy a higher standard of living



 Savings and Investment (S = I in closed economy)


(Solve for) Investment…

I = Y – C – G

I = total income – consumption - gov’t purchases

I = national savings

I = S

*(for a closed economy, investment is equal to savings)*


We can break down national savings (S)…

I = S = private savings + public savings


Public (federal budget) vs. private saving… calculate



I = S = (Y – T – C) + (T – G)


Private savings : Y – T – C

          total income left after taxes and expenditures on consumption


Public savings : T – G

          tax revenues to the government net of government purchases

          More on public savings and the budget (next slide)


Budget surplus : T > G                   

          gov’t generates more in revenues than it spends

          c.p., as public savings (rises) à S (rises)


Budget deficit : T < G

          gov’t spends more than it obtains in tax revenues

          c.p., as public savings (falls) à S (falls)


Balanced budget : T = G

          gov’t breaks even in terms of revenues and expenditures

          c. p., if public savings (remains constant) à S (no change)


Financial system


·         savers channel funds to borrowers so that they can invest (in physical capital)

·         Matters because it encourages savings and investmentas a government policy aimed at raising inputs, thereby promoting economic growth.



Stock Markets 


New York Stock Exchange (orig. 1792)

          lists close to 2,800 companies

          listed companies are among the world’s best and range from “blue-chip” companies, to world-leaders in technology, to young, high-growth enterprises

          Blue chip: stock of a large, national company with a solid record of stable earnings and/or dividend growth and a reputation for high quality management and/or products. More generally, anything of very high quality. (

American Stock Exchange (est’d 1921)

          lists over 700 companies

          bulk of trading consists of index options (computer technology index, institutional index, major market index) and shares of small to medium-size companies is predominant

          1998 merger between the NASD and the AMEX resulted in the Nasdaq-Amex Market Group (oversees both NASDAQ and AMEX but still operate as separate markets)


National Association of Securities Dealers Automated Quotations (est’d 1971)

          largest U.S. electronic stock market (approx. 3,300companies)

          it lists more companies and, on average, trades more shares per day than any other U.S. market

          home to category-defining co.s that are leaders across all areas of business including technology, retail, communications, financial services, transportation, media and biotechnology.

          carries securities for newer and smaller companies


Loanable funds market (6 cases)

…effects of changes in policies toward interest income & corporate tax breaks



Loanable funds market (6 cases)

…effects of changes in policies toward interest income & corporate tax breaks


Case 1: Taxes and effect on Savings

  1. taxes on interest income rise

          lowers incentive to save, SLF or S (falls)

2.       r  rises (otherwise have a shortage of funds in the market)

          lowers incentive to borrow, quantity funds borrowed (for investment) drops

Case 2: Taxes and effect on Investment

  1. corporate tax break increases

          raises incentive to borrow, DLF or I (rises)

2.       r   rises (otherwise have a shortage of funds in the market)

          raises incentive to save, quantity funds saved increases

Case 3: State of the Federal Budget

        note: affects only the SLF through public savings, b/c this is what we use to measure the budget

Deficit : government is dissaving, SLF or S (falls)

  1. r (rises), otherwise have a shortage of funds in the market

          lowers incentive to borrow, quantity funds borrowed (for investment) drops

Surplus : government is saving more, SLF or S (rises)

  1. r (falls), otherwise have a surplus of funds in market

          raises incentive to borrow, quantity funds borrowed (for investment) increases 


Identify (3) types of UE


Frictional Unemployment

Unemployment that is always present, resulting fromtemporary transitions made by workers.

Tends to be shorter term on an individual level.

e.g., normal labor turnover (people moving between jobs, careers, locations)


Structural Unemployment

Unemployment resulting from major changes in the basic composition of the economy. Tends to have long termconsequences (and is more painful than frictional UE).

e.g., Evolution from an industrial to technological based economy…

          mid-20th century, US textile companies discover cheaper labor South of the Border (US textile workers out of luck)

          introduction of computers eliminates many jobs


Cyclical Unemployment

Unemployment that varies with the business cycle--particularly economic downturns.

          Occurs due to inadequate demand for goods and services. Low (C) and/or (I) and/or (G)

…or possibly a severe (-) production shock

e.g. economy-wide shock: we experience a recession (decline in economic activity... on average, production and incomes are falling) which         results in layoffs and cutbacks

Responsible for actual UE deviating from its natural rate


CPS categories when gathering data for UE stats



          includes only “adult” population (age 16 and older)

          those who have worked some of previous workweek at a paid job (exception: unpaid work in family business)

          considered part of the labor force



          without a job… but searching and available for employment (within the last month; otherwise considered “marginally attached” or “discouraged”, see slide 15)

e.g. temporarily laid off or waiting to start new job

          considered part of the labor force


Not in Labor Force:

NILF: neither employed nor unemployed

          have taken themselves out of the labor market for various reasons…

e.g. homemakers, retirees, full-time students, active duty military, institutionalized (nursing homes & prisons) 


Special cases of marginally attached and discouraged workers


          Marginally attached: not looking but would like to work & available (worked or looked sometime in the last year, but more than month ago)

        A subset of this group is…

          Discouraged workers: not looking because…

        Nothing available in line of work

        Lack necessary human capital

        Discriminatory reasons

        Just plain old couldn’t find a darn thing

Q: Should they be counted as UE rather than NILF?

        If so, then NILF is overstated & UE is significantly understated


UE stats: LF, LFPR, UE rate (be able to calculate)



LF = employed + unemployed

Labor Force Participation Rate: proportion of the adultpopulation that is part of the labor force


LFPR = ( LF / Pop. ) * 100 = %


Unemployment Rate: proportion of the labor force that isunemployed

UE rate = ( UE / LF ) * 100 = %


Underemployment and U-3 vs. U-6


          U-3 is the “official” UE rate (8.8%) and includes…

        Total UE as percent of civilian labor force

        U-4 also includes discouraged workers (9.4%)

          U-5 also includes remaining marginally attached (10.3%)

          U-6 also includes the underemployed (15.7%)



Job creation (# jobs necessary per month)




Even in good times, approximately 150,000 jobs must be created each month simply to keep up with population growth

        Various government economists estimated that in January 2011 about 145,000 jobs would be created

        However, only 36,000 new jobs were added



Things that worsen UE





Wages paid above the market equilibrium (wage) in the labor market result in UE, or a surplus of workers...


Minimum wage laws (labor market)

          a price control (i.e., price floor) that raises UE



          collective bargaining: unions w/ firms re:wages and conditions

          raises the cost of labor (w) above what it would be in a perfectly competitive labor market (10-20% higher on avg.)

          balances market power of firms but raises UE


Efficiency Wage Theory

          some firms pay above market wage to gainbetter quality workers and promote greater productivity



Implications of minimum wage (+/-)


Pros...   (social benefits)

          reduces exploitation (e.g., from monopsonies)

          allows people to afford basic necessities

          could raise consumption and thus demand for g&s, increasing employment over longer term


          raises UE among low wage (less skilled) workers (e.g., teenagers)

          higher “input” prices (i.e., wages) causes inflation and slows economic growth


Things that help to reduce UE


Gov’t Policies that help to lessen UE over time…


            UE insurance (or benefits)

        protects workers’ incomes so they can spend time searching for a job and get back to work sooner

Employment agencies

        helps with “job search”, matching a worker’s particular skills to the “right” job

Public training programs

        helps workers to learn new skills



How Monetary System evolved …and why?


Barter: direct exchange of g&s

        requires coincidence of wants


Commodity Money: intermediate good with intrinsic valueused in transactions

        e.g. sea shells, boulders...


Fiat Money: intermediate item used in transactions lacking market value in other uses

        faith in legal tender

        fiduciary monetary system


* Trend… to simplify and thus increase volume of transactions *




(3) Basic Functions of money (those things that are not considered money …and why?)





To be called “money” an asset needs to fulfill all three functions…


  Medium of Exchange

        readily acceptable as final payment in exchange for g&s


Unit of Account

        common measure of relative value of g&s

        can vary according to country (e.g., $, euro, peso)


Store of Value

        not perishable (i.e., apples wouldn’t work!)

        although can deteriorate due to inflation



Money is the most liquid asset

          immediately available to spend in exchange for g&s (without additional expense)

More liquid than (from least to most)…

          real estate; stocks & bonds; jewelry; gold; [associated w/brokerage fees, time delays, etc.]



Monetary Aggregates, i.e., official measures of the money supply (and how related to one another)



Monetary aggregates (official measures)…

M0: Physical Currency (the “monetary base”)

        currency (C): paper bills and coins in the hands of the public


M1: Currency + Deposits (therefore includes M0) $1.6 trillion

        deposits (D): checkable deposits that can be converted to currency “on demand”

        traveler’s checks also included (but miniscule)


M2: includes M1 + savings and time deposits (cds), money market and retirement accounts, etc.


Background and purpose of the Fed



The U.S. central bank...Federal Reserve

        According to the U.S. Constitution (Article I, Section 8), Congress has the power “to coin money” and “regulate the value thereof.” However, the Fed was est. in 1913

        Private entity; operates independent of the government


Its purpose...

    “Lender of Last Resort”

        Established to ensure liquidity and to help maintain solvency

Performs Monetary Policy

        Monopoly on money creation

        Supervises and regulates (sets standards for) member banks

liquid: bank has enough money on hand to meet the demands of its depositors

solvent: assets at least cover liabilities (insolvent suggests that a bank is “bankrupt”)



 Fed organization, details of… and who’s responsible for what (slides 12-16 in ch11 pwpt lecture)



  1. Board of Governors

Chairman Bernanke

1)      Presides over board meetings

2)      Directs Fed staff

3)      Testifies about Fed policy to Congress


        members appt’d by Pres. and confirmed by Senate

        14-year terms (except chairman… 4-yearterm)

        oversee district banks

Functions: set reserve requirements & approvediscount rates


  1. Federal Reserve District Banks

o   12 district banks (mostly eastern part of US)

o   Presidents chosen by regional bank board (from local banking / business community)


Functions: propose discount rates, provide currency,hold reserve balances and lend @ discount window, clear checks



  1. Federal Open Market Committee

o   Includes 7 BOG members + regional bankpresidents

o   Only 5 bank presidents vote (rotating basis)

o   President of NY Fed is always a voting member

Functions: makes monetary policy & in charge of open market operations (OMOs)



  1. Depository Institutions


          Commercial banks

        about 1/3 of which are members of the Federal Reserve System

          Credit Unions

        Savings and Loan Institutions


How Fractional Reserve Banking system functions… reserve requirements (RR) and money creation through loans



All banks required to hold fraction of deposits as reserves(not loanable)

reserve ratio (RR): portion of deposits held in reserve (bank vault or with Fed)

money multiplier (MM): factor by which money supply expands for each dollar held in reserve

        inversely (-) related to reserve ratio à MM = 1 / RR

Important(initial deposit * MM) = total money “created”

                                                                     (including initial deposit)


·         Determine level of money created given initial deposit and RR, used to find money multiplier (MM) 


Q1: Given a RR of 10 percent and an initial deposit of$100, how much money was created via the fractional reserve banking system?

  • MM = 1/RR = 1/.10 = 10
  • (initial deposit * MM) = amount of money created
  • $100 * 10 = $1000
  [note: this comes from $100 initial deposit plus $900 loaned out]


(3) Monetary Policy Tools of the Fed (what they are, how they are used, and relative likelihood of use)


Target the Federal Funds Rate (FFRvia Open Market Operations (OMOs)         

        FFR applies when banks borrow money from ea. other

        OMPurchase or OMSale of U.S. government bonds

        Target the federal funds rate (FFR)

        Most frequently used tool


Discount Rate (DR)

        Applies when banks borrow money from the Fed

        Usually 1 bp or basis point (i.e., 1 percent) higher than FFR


  Reserve requirements (RR)

        Regulated min. amount of reserves that banks must hold







                                I.            Targeting a lower FFR…

        Assume that the current FFR* is 5% and the target is 2%



Q: What should the Fed do? Expand the money supply

        creates surplus of money at current FFR*

        Banks eliminate surplus by cutting FFR (to stimulate borrowing)



          OMP:                    purchase bonds

          Lower DR:            cheaper to borrow from Fed

          Lower RR:            banks have more money to loan







II.            Objective is to maintain target FFR given unexpected decrease in demand for money…

        creates surplus of money at current FFR*


M.P. Responses (contract the money supply)

          OMS:                     sell bonds

          Raise DR:             discourages borrowing from the Fed

          Raise RR:             banks have less money to loan





Variables beyond Fed’s control …how Excess Reserves and Currency (vs. Deposits) also affect the money supply (M)





Things the Fed can’t control (that can affect M)...

  1. Amount of money households choose to hold as currency v. deposits (in banks)

       The more held as currency, the less money “created”

  1. Amount of excess reserves banks hold

       The more held in reserve, the less loaned out and the less money “created”



Difference btw Inflation, Deflation, Hyperinflation




·         the price level rises while the value of money falls

·         [ U.S. since 1945, 1970s, 1990s ]

·         continued rise in overall P-level



·         the price level falls

·         [ late 1800s (Ind. Rev. 1750 – 1830) ]

·         continued decline in overall P-level



·         the price level rises dramatically, more than 50% a month

·         [ Germany, 1923 (post WWI 1914-18) ]

[ NIS after fall of Soviet Union (1990s) ]


Relation btw P-level and Value of Money (VOM)



The value of money is inversely related to the overall P-level in the economy..

·         consumers require more money to buy sameamount of goods and services

·         value of $$$ = 1 / P



Understand that Quantity Theory of Money allows us to quantify (assign values to) the changes we see in the money market diagram (and therefore is related)



(1) How P-level determined.

         due to changes in M

(2) Why P-level changes over time...

         growth in M leads to growth in P-level (inflation)




Why does M*V = P*Q?


M * V

·         The amount of money in circulation and how quickly it changes hands (due to transactions) must



P * Q

·         The level of expenditures (or income generated) in the economy


What is the assumption of “Monetary Neutrality”? …and why is it important?




changes in M à only nominal NOT real variables

(i.e., money is “neutral”)



Be able to identify some of the real costs to society of inflation (e.g., shoeleather, …etc.)


Shoeleather costs

·         the resources wasted when inflation encourages people to reduce their money holdings. (keep money in bank to accrue interest)


Menu costs

·         the costs of price adjustments. The cost of deciding on new prices, the cost of printing new price lists, the cost of sending the new prices out…

Relative-price variability and the misallocation of resources

·         when inflation distorts relative prices, consumer decisions are distorted, and markets are less able to allocate resources to their best use.


Inflation-induced tax distortions

·         inflation tends to raise the tax burden  on income earned from savings


Confusion and inconvenience

·         because inflation causes dollars at different times to have different real values it is difficult to compute a firm’s…


Arbitrary redistributions of wealth

·         unexpected changes in prices redistribute wealth among debtors and creditors


What is an inflation tax and how does it work?




·         an indirect tax, it is like a tax on everyone who holds money. No one receives a bill for inflation tax

·         gov’t prints money à M rises à P-level rises àΠ



How it’s possible to get into a hyperinflationary situation



         a common cause is the result of government attempting to raise money to cover G.

          (1) borrow, (2) tax, or (3) print money



Fisher Effect (how does inflation affect nominal interest rates?)




·         adjustment of the nominal interest rate to the inflation rate

·         Nominal interest rate = real interest rate + inflation rate ( I = r + π )


 When the P-level rises (i.e. there is Π)

·         nominal interest rate, “i” rises by same amount (1:1)

·         no effect on r

When the Fed increases the rate of money growth


·          the long-run result is both a higher inflation rate and a higher nominal interest rate



Which group benefits when expected is greater than actual inflation (and vice-versa)? 



Debtor- seller


Inflation actual < inflation expected

·         Creditor benefits, knows they’re going to get money

·         Debtors overestimates,


Open vs. Closed economy 



Closed economy...         (no interaction w/ROW*)



Open economy...           (interacts w/ROW)


         trade balance

         exchange rates


Different measures of the trade balance (NX), e.g. surplus, …etc.




Nix closed economy assumption (NX=0) such that...

Y = C + I + G + NX


Given: Net Exports = (X – M)...     Trade Balance ]

  1. If NX > 0 or (+) à       > M   trade surplus
  2. If NX < 0 or (-)  à       < M   trade deficit
  3. If NX = 0           à       = M   balanced trade


(6) factors that can affect the trade balance (NX) …including particularly, gov’t restrictions on trade (what is a quota, tariff, embargo?)



  1. Relative prices (Pd v. Pf)

        Pd falls relative to Pf : M / X more goods?

2.      Relative incomes

        Incomes relatively higher in U.S. : more likely to M / X more?

  1. Exchange rates

        Nominal and real

  1. Transportation costs

        The higher they are...

        Also, can affect who trade partners are

5.      Tastes and preferences

        e.g., champagne (France) v. sparkling wine (U.S.)

6.      Government policies re: international trade

        Restrictions lessen trade (e.g., quotas, tariffs, all-out embargo)


Nominal or currency (F/$) vs. Real exchange (GF/GD) rates …also, what it means to Appreciate vs. Depreciate


Nominal rate...

         “currency rate of exchange”

         rate can trade currency of one country for another

            (F / $1)


 Real rate...

         “rate of exchange of physical goods”

         rate can trade goods and services of one country for another

units of forn good / unit of dom good or ( G/ GD )


Appreciation: one unit of a currency now trades for agreater number of units of another currency

        $1 buys more euro      ($ gained value;strengthened)


Depreciation: one unit of a currency now trades for fewerunits of another currency

        $1 buys fewer euro     ($ lost value; weakened)



Be able to calculate GF/GD using Purchasing Power Parity (PPP) relation



Links the real and nominal exchange rates...

Real rate = (nominal rate * $-price)  /  F-price

GF / GD = [ (F / $) * P]   /  Pf




What two things does PPP relation allow us to do?



(1)    solve for the real exchange rate (what you can afford to buy in “real” terms)

(2)    explain the variation that we see in nominal exchange rates


What does PPP Theory say? How is it related to Law of One Price (what is this?)?



·         a unit of currency should buy (afford) the samequantity of goods in all countries


Related by

·         extension of the Law of One Price: that a good must sell for the same price everywhere

·         goods were not the same price, then a profit opportunity would exist and arbitrage* would occur.

o   *arbitrage: prices will adjust until they are equal



Aggregate Demand and Aggregate Supply (AD-AS) model of the economy




Market for all goods and services produced and consumed in an economy

Aggregate Demand (AD)

         Depicts various quantities of goods and services thathhldsfirmsgov’t, and foreigners want to buy at each price-level

Aggregate Supply (AS)

         Depicts various quantities of goods and services firmschoose to produce and sell at each price-level


Price-level (P)

         average price-level


Real output (Q)

         (natural rate of) output ; full employment



What constitutes a short run (SR) vs. Long run (LR) equilibrium?



SR equilibrium is where SRAS = AD

LR equilibrium is where LRAS = SRAS = AD

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