COMM 220 Midterm notes

To calculate the “real price of something” for a given year.

𝐶𝑃𝐼(𝑟𝑒𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑦𝑒𝑎𝑟)
𝑥 𝑛𝑜𝑚𝑖𝑎𝑙 𝑝𝑟𝑖𝑐𝑒 𝑖𝑛 𝑦𝑒𝑎𝑟 𝑋
𝐶𝑃𝐼 (𝑦𝑒𝑎𝑟 𝑋)
Percentage growth of CPI.

𝐶𝑃𝐼(𝑐𝑢𝑟𝑟𝑒𝑛𝑡)−𝐶𝑃𝐼(𝑏𝑎𝑠𝑒 𝑦𝑒𝑎𝑟)
𝑥 100
𝐶𝑃𝐼(𝑏𝑎𝑠𝑒 𝑦𝑒𝑎𝑟)

Highest Real Wage

𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝑤𝑎𝑔𝑒
𝑃𝑟𝑖𝑐𝑒 𝑖𝑛𝑑𝑒𝑥

Steeper (when slope increase ex: from 0.33 to 0.40)

Flatter (inverse of steeper)
A shift of the supply curve is caused by (shifts caused by a change in any other determinant
besides the price of the good)

 Wages
 Interest charges
 Technology
 Production cost
 Material costs
 Complements and substitutes
“Change in quantity supplied” = movement along the supply curve
“Change in supply” = shifts in supply
Income effect: as price decreases the purchasing power increases
Substitution effect: as price increases buyers switch to less expensive substitutes
As shift of the demand curve (like supply curve any change in other determinant besides the
price of good will cause a shift)
Normal Good: When income increase demand increase
Inferior Good: When income increase demand decrease
Total market demand: represents the sum of quantity demanded by all consumers in the
market at the various price levels
Shortage: When demand is greater than supply
Price elasticity of demand (slope of demand curve equation with Q as dependent variable)
𝑃 ∆𝑄 %∆𝑄
𝑥 = %∆𝑃
𝑄 ∆𝑃
Arc price elasticity of demand: gives average elasticity between 2 points
*Price elasticity of supply is positive while price elasticity of demand is negative
*Companies use point formula to estimate what a small change in P will do to sales, and the arc
formula for larger planned changes in P.
Perfectly Elastic demand: demand curve is horizontal and elasticity is “∞”
Perfectly Inelastic demand: demand curve is vertical and elasticity is “0”
*Note as P decrease in the Elastic part TR will increase and as P decrease in the inelastic part TR
will decrease
(Elastic part): P (increase), TR (decrease)
(Inelastic part): P (increase), TR (increase)
Factors that influence the degree of Price Elasticity of demand:

 Closeness of substitutes
 Proportion of income spent (the more income spent the more elastic is the demand)
 Time elapsed since the latest change in P (the more time we allow for consumers to
react to the price change, the more elastic the response will be)
Factors that influence the degree of price elasticity of Supply:

 Availability of inputs
 Time elapsed since the latest change in P
Cross elasticity of demand
*Elasticity for substitutes is always positive and elasticity for complements is always negative
Income elasticity of demand
*For Normal good elasticity is positive and for Inferior good elasticity is negative
Total Revenue= P x Q
Average revenue= (P x Q)/ Q or TR/Q
Marginal Revenue= ∆TR/∆Q
*To MAX PROFIT choose Q such that MC=MR
In a perfectly competition choose Q such that MC=P
The shut-down point is at AVC=MC
When P>ATC = Economic profit
When P=ATC = zero economic profit
When P<ATC = Economic losses
Price ceiling (for consumers): A regulated Maximum price a producer can receive. It is in effect
if it is set below equilibrium. If ∆CS is negative than the policy is not worth it. The elasticity of
demand is the key to determine the effectiveness to a policy.
Price floor (for producers): A regulated Minimum price a producer can receive. Minimum wage
and minimum price is an example of price floor.
Price support: The government doesn’t just set a minimum price at which firms’ output can be
sold. The government also purchases the excess output that is necessary to keep the price at
the support level.
Production Quotas: These are limits on quantities that can be produced and are therefore
represented on diagrams as a vertical line intercepted by the supply curve.
Partial Tariff: In a free trade with P (w) below domestic equil. P. Consumers will only be willing
to pay P (w) therefore the domestic price = P (w) and imports will be Q (d)-Q(s). But tariff brings
the price to P* and government will collect T x amount of imports
Sales taxes: In that case the specific dollar amount of the sales tax causes a vertical shift upward
in the supply curve by an amount equal to the sales tax.
*The general rule is the less elastic side of the market ears a larger proportion of the tax.
Subsidy: Opposite of sales tax, a subsidy is a cash gift by the government to producers in order
to increase the output of a socially desirable product.
*The less elastic benefits the most from subsidies
Unemployed (U): number of those who are

 Seeking work
 Available for work
 Of age 16 and over
Employed (E): number of those who are employed in either full or part-time jobs
Labour force (LF): Unemployed + Employed
Unemployment rate: (U/LB) x 100
Participation rate: (LB/working age adult population) x 100
Earnings: Is the wage rate per unit of time x units of time worked
Total compensation: earnings PLUS payments in kind (employer provided health, disability
insurance, vacation pay)
Income: Total compensation PLUS unearned income, which includes dividends or interest
received on investments and transfer payments.
*There are 3 Markets

 Market for labour

 Market for capital (Stocks)
 Market for products
The amount of output that firms produce, and the combination of capital (K) and Labour (L)
that they use to produce depends on 3 things

 Demand for the firms’ product

 The amount of K and L the firm can acquire at given input prices
 The choice of production technologies available
*The demand for labour is inversely related to wages rate
Differentiate (with the example of machinists)

 Firm Demand (bombardier)

 Industry demand (Bombardier, airbus)
 Market demand (all companies who need machinists)
Reservation wage: A wage below which the worker would refuse the job or quit. Reservation
wages differ between workers as they are driven by individual preferences.
Economic rent: The amount a workers’ actual wage exceeds the reservation wage is his or her
economic rent.
 AFTER MIDTERM

Short run – a time period where at least one input is fixed

Long run – a time period when all inputs are variable
Average product: AP= Q/L
Marginal product: MP=∆q/∆L
*the derivative of the (q) function will give you your MP
Maximize total output: MP=0
Maximize AP: AP=MP
MRP: MP of inputs x MR from output
*if MRP > ME then hire more L
Maximize profit by reaching a close difference between MRP and ME
Payroll taxes and labour demand: The payroll tax X will cause a vertical shift downward in the D
for labour. The amount of the vertical shift downward is equal to the amount of the payroll tax
X.
Wages subsidies and labour demand: The market demand for labour would shift upward by the
amount of the subsidy. These would have the effect of raising equilibrium wages and increasing
employment.
Production function: q= f (K, L)
Isoquant Map: An isoquant is a curve that shows all possible combinations of 2 inputs that yield
the same level of output. (It is impossible for isoquants to cross) **
Calculating the MRTS: MP of capital / MP of labour (If labour is on the vertical axis)
- The more substitutable the inputs are, the less convex the isoquants will be
- The less substitutable the inputs are, the more convex the isoquants will be
*Most of the time substitutability is a function of time, the longer the time period, the more
substitutability of inputs becomes possible.
Cost minimizing input choice
The cost of capital= depreciation+ interest rate
The cost of labour= wage rate
The isoexpenditure Line : An isoexpenditure line shows all possible combinations of labour and
capital that can be purchased for a given amount of total cost B.
Numerical example of isoexpenditure line: Suppose the company has a budget of 300$ to
spend per hour for K and L, the price of labour is 30$ per hour and the price of capital is 60$.
Then the isoexpenditure equation is: 300$= $30K + $60L
(Important notion page 112) **
Demonstration problem of K and L should company X hire to minimize cost of inputs
Step 1: Find MRTS
Step 2: use MP(k)/MP(L) = P(K)/P(L) to find the optimal ratio.
Step 3: Use your new L (L=4.76K) in the isoexpenditure equation and solve for K
Do the same to solve for L using new K.
Supply of labour
Main labour supply decisions:

 Whether to participate in the labour force

 Whether to seek part-time or full time work
 How long to work either at home or for pay
The income Effect
When wages increase

 Income effect: The increase in wages implies an increase in potential wealth and
income. Since leisure is a normal good, as income rises the demand for leisure rises and
the demand for work falls (negative slope)
 Substitution effect: The increase in wages represents an increase in the opportunity cost
of leisure, so demand for work hours rises (positive slope)
Total utility (U): is the level of satisfaction derived from consuming given quantities of a good or service
and (MU) marginal utility is the change in total utility due to a one unit change in quantity consumed.

Assumptions of utility theory:

Complete: Any 2 bundles can be compared and ranked

Reflexive: Any bundles is at least as good as an identical bundle

Transitive: if A>B and b>C than A>C

Monotonic: Goods being considered are normal. As income increases we prefer to consume more rather
than less of the good.
Marginal rate of substitution (MRS): slope MU(A)/ MU(B) and budget line is like the isoexpenditure for
firms

*The steepness and the degree of convexity of the indifference curve varies between individuals, since it
represents and individual’s personal preferences for money income versus leisure time.

Reservation wage: The reservation wage is the wage below which a person will not work.

The income effect affects more the people who works more hours***

Expected value: Is weighted average of the payoffs associated with all possible outcomes.

Variance: 0.25(40-E(x)) ^2 + 0.75(20-E(x)) ^2

Standard deviation: Square root of the variance: The units of the measurement in the standard deviation
are the same as units of the measurement for expected value. The standard deviation means the value
tends to vary by the (standard deviation value) around the (expected value)

Risk averse: Averse to risk means that this person prefers safety.

The risk premium: (A measure of the degree of risk aversion) is the amount of money the investor would
have to be paid to be indifferent (have the same TU) between the gamble and the certain income.

Reducing Risk: There are three basic ways of reducing risk

 Diversification
 Insurance
 Finding information

Market risk (Systematic Risk): Risk that influences the market in general (interest rates)

Unique risk (Unsystematic risk): Risks that affects a single asset or a small group of assets (change in
upper management).

Unique risk is reduced by diversification. *

The law of large numbers: While a single event may be random and unpredictable, the average outcome
of many similar events can be predicted. For example a single toss of a coin may or may not come up
heads. But over 1000 repetitions of coin tosses about half the coin flips should come up heads and the
other half tails.

**See page 149 to understand acquiring information problems and situations

Cash flows: Are the stream of income the assets pays

Capital gains or losses: Gains: When value of asset increases in value. Loss: when value of asset
decreases.

Inflation risk: Real return= Nominal return- inflation

Risk of portfolio: R(p)= R(f) + [ ((R(m)- R(f))/ 𝜎(m)] 𝜎(p)

Bubbles: AN increase in the price of a good based not on the fundamentals of demand or value, but
instead on a belief that the price will keep going up. Bubbles represent irrational behaviour. (big short of
2008)

Loss aversion behaviour: Once we have something we don’t want to lose it. If we don’t have something
we are not as sure of how we would value it.

An Overview of the Financial System

There are two ways that funds can be transferred from lenders to borrowers:

1. Directly: (Bonds)

2. Indirectly: A financial intermediary borrows funds from lenders and uses these to make loans to
borrowers.

Term to maturity: The maturity date is the date that the last payment is due on.

Brokers: are agents of investors who match buyers with sellers of securities.

The primary market: where new issues of securities are sold to initial buyers by the corporation or
government agency borrowing the funds.

The secondary market: where securities that have been previously issued can be resold example the
TSX.

Foreign Bonds: A bond sold in a foreign country and denominated in the currency of the country in
which the bond is sold.

Eurobonds: A bond denominated in a currency other than that of the country in which it is sold.

Eurocurrencies: Foreign currencies deposited in banks outside the home country.

Adverse selection: Is the problem created by asymmetric information before the transaction occurs.

Moral hazard: Is the problem created by asymmetric information after the transaction occur. Example
gambling with the fund.

Types of Financial Intermediaries:

Depository institutions:

 Chartered banks
 Trust and loan companies
 Credit unions and caisse populaire

Contractual Savings institutions

 Life insurance Companies

 Property and Casualty insurance Companies
 Pension Fund Companies and government retirement funds
Investment Intermediaries

 Finance companies
 Mutual fund companies
 Money market mutual fund companies
 Hedge funds
 Investment banks

8 Basic Facts

1. Stocks are not the most important source of external financing for business.

2. Issuing bonds is not the primary source of finance for businesses

3. Indirect finance, involving financial intermediaries is many times more important than direct finance
for businesses

4. Financial intermediaries, especially banks, are the most important source of external funds used to
finance business

5. The financial System is among the most heavily regulated sectors of the economy

6. Only large, well-established corporations have easy access to securities markets to finance their
activities

7. Collateral is a prevalent feature of debt contracts for both households and businesses.

8. Debt contracts typically are extremely complicated legal documents that place substantial restrictions
on the behaviour of the borrower.

Free riders: People who do not pay for information

Interest: reflects the time value of money

Simple interest: Is the interest paid or received on only the initial investment (The principal). Bonds pay
interest to bond holders in this way. (P)+ (I x P x n)

Compounding interest:

Future Value: FV= P(1+i)^n

Present value: PV= P/ (1+i)^n

Returns= the capital (amount form periodic payment of dividends from stocks or interest on bonds) +
Capital gain or loss (change in price)

Income yield on a security: CF/P(0) x 100

Capital gain or loss: P(1)-P(0)/P(0) x 100

Total return= (CF+P(1)-P(0)/P(0)) x 100

Paper gains or paper losses: Meaning you’ve calculated them on paper but haven’t actually sold them.
REAL interest rate= nominal interest rate- expected inflation also called (Fisher relationship or effect)

Factors that cause nominal interest rates to change

1. Demand and supply for bonds

2. Demand and supply for money

3. The effects of changes in monetary policy

Demand for any financial asset is driven by: (Creates a shift in Demand for bonds)

1. Wealth

2. Expected return on one asset relative to alternative assets

3. Risk

4. Liquidity of the asset

*Quantity demanded for bonds is therefore negatively related to bond prices and positively related to
interest rates.

*Quantity supplied of bonds is positively related to bond prices and negatively related to interest rates

Shifts in the supply of bonds:

1. Expected profitability of investment opportunities

2. Expected inflation

3. Changes In the government budget

*An increase in expected inflation (fisher effect) affects both demand and supply of bonds. Demand
shifts to the left and supply shifts to the right.

Economic Recovery: will affect both demand and supply of bonds. The recovery means an increase in
wealth for bond holders so demand shifts right. It also means an increase in profitable investment
opportunities so supply also shifts to the right.

*when price of bonds decrease interest rates rise and when price of bonds increases interest rates fall.

*Money demand is negatively related to interest rates BS – BD = MD-MS

The demand for money can shift for 2 reasons:

1. Income effect: as the economy expands and income rises, wealth increases and people want to hold
more money.

2. Price level effect: when the price level rises, the same nominal amount of money does not buy as
many goods and services, so people want to hold more money. Increase in price = increase in money
demand.

1. Income effect of an increase in the money supply

An increase in the MS initially causes interest rates to fall, but that in turn stimulates an economic
expansion. We know form the demand and supply of bonds that in an economic expansion interest rates
rise and bond prices fall.

2. Price level effect of an increase in the money supply

An increase in the MS will cause economic expansion. An economic expansion leads to greater demand
for goods and services, which eventually leads to shortages and an increase in the price level as
aggregate demand shifts to the right. A rise in the price level shifts MD to the right and interest rate rise.

3. Expected inflation effect of an increase in the money supply

Assuming point (1) and (2) above are generally understood in the economy, an increase in the MS may
lead people to expect a higher price level in the future, so the expected inflation rate will be higher.
From the demand and supply of bonds, we know that an expected increase in the inflation rate leads to
lower bond prices and higher interest rates.

*The liquidity effect happen in the short-run (increase in money supply lowers interest rate) and
expected inflation effect occurs on the long-run depending on the speed of the reaction of people
creating shortage.

Default risk: This is the risk that the bond issuer will suffer financial distress and be unable to either pay
all the coupons or to repay the bond at maturity.

Firms frequently pay to have their bonds rated. The two leading bond rating firms in Canada are the
Canadian bond rating service and the dominion bond rating service.

Junk bonds: Very high yield, very low grade bonds.

The interest rate on corporate bonds:

iactual= i* + DRP + LP i*= the equilibrium interest rate on government bonds

DRP= default risk premium

LP= liquidity premium

Shape of the yield curve

1. Interest rates on bonds of different maturities move together over time

2. When short term interest rates are low, yield curves are more likely to have an upward slope. When
short-term interest rates are high, yield curves are more likely to slope downward and be inverted

3. Yield curves almost always slope upward

*if short-term rates are rising, then long-term rates will be rising, because long-term rates are the
average of short-term rates.

*Research indicates the yield curve is better at predicting short-term and very long-term rates but is less
reliable for predicting interest rates of intermediate maturities (2-5 years)
(1- i2)2 -1 = return on a 2 year bond where the same interest rate “I” is paid in 2 consecutive years.

(1+ i1)(1+ ie2) -1 = return on investing in 1 year bonds for two years consecutively where ie is the
unknown 1 yr interest rate that will be available one year form today.

I1= spot rate on 1 year bond today

I2 = interest rate today on 2-year bond

Ie2 = forward rate, the expected rate in 1 years’ time on 1 year bond

* For a 3-year holding period you compare the return on a 3-year bond to the return on a 2-year bond
followed by an unknown rate on a 1-year bond

Ie3 = ((1 + i3)3 / (1 + i2)2) -1

Four criteria for judging the degree of international integration

1. Trade flow – The degree to which goods can move freely form countries where they are plentiful and
cheap to those where they are scarce and expensive

2. Capital flow – the degree to which physical (factories, technologies, etc. ) and financial capital (stocks
and bonds etc.) moves between countries

3. Labour flow – the degree to which labour can move freely between countries

4. Similarity of prices for the same goods in different markets. Differences should be mainly due to
transportation costs if barriers to trade are low

Measure of the importance of trade in a country

Trade-to-GDP ratio: (Exports+ Imports) / GDP

Advantages of Economic Integration

 Lower consumer prices and better choice in good

 Capital flow make more funds available for investment
 Rising immigration means higher income for migrants
 International organizations help to resolve disputes

Disadvantages of Economic Integration

 More competitive for firms and workers

 Capital flow increase the risk of spreading financial crisis internationally
 Rising immigration means more competition and rising tensions
 International organizations put pressure on countries to change the way they operate
 Free trade agreements mean more competition and pressure on domestic workers and firms
Labour productivity: Units of output/ Hours worked

*Absolute advantage is when one country can produce more of a good in an hour than its trading
partner

*Comparative advantage is when it can produce a unit of output at a lower opportunity cost than its
trading partner.

The slope of PPC is the opportunity cost of producing an extra unit of output

*Trade allows to consume over the PPC

Autarky: complete absence of trade

The gains from trade:

1. The gains from trade stem form comparative, not absolute advantage

2. Both countries will gain form trade of the world price falls between their opportunity costs of
production

Exchange rates and exchange rate systems

In a direct quote, the exchange rate is the number of units of foreign currency per unit of domestic
(Foreign/ C$)

In an indirect quote, the exchange rate is the number of units of domestic currency per unit of foreign
currency (C$/Foreign)

Hard peg: If the exchange rate is not allowed to vary

Soft peg: if exchange rate can fluctuate

Reasons for holding foreign currencies:

1. Trade and investment purposes

2. To take advantage of interest rate differentials or interest rate arbitrage

3. Speculation

The forward exchange rate (F) market: is a way of dealing with exchange rate risk. It is a market where
the exchange rate and amounts for the buying and selling of currencies for future delivery is specified on
contracts.

Purchasing power parity (PPP): the price of a good, taking exchange rates into consideration, should be
the same in all locations.

Real exchange rate:

RR= Nominal exchange rate ( Rn) x Foreign price/ domestic price

Interest rate parity: If interest parity holds, then buying a foreign asset should pay the same as in the
home country because the interest rate differential between the two countries should be offset by
changes in the nominal exchange rate.

If F>R then the home currency is expected to depreciate

If F<R then the home currency is expected to appreciate

Pure gold standard:

Nations keep gold as their international reserve. Gold is used to settle most international obligations
and nations must be prepared to trade it for their own currency for regular transactions.

Three rules for maintaining a gold standard:

1. The currency must have a fixed value in terms of gold

2. Nations must keep the supply of domestic currency in a fixed proportion to their supply of gold

3. Nations must provide gold in exchange for their home currency

Reasons why a group of countries might want to share a common currency:

1. It reduces transaction costs from trading multiple currencies

2. It eliminates price fluctuations caused by changes in exchange rates

3. It can reduce political friction between countries stemming from currency misalignment

4. It can reduce exchange rate fluctuations and create greater confidence in the financial system of the
country.