Principles of Microeconomics

Chapter 2 – Thinking Like an Economist

Economists play two roles:
 Scientists – try to explain the world
 Policy Advisors – try to improve it

The Economist as a Scientist

 As scientists, economists employ the scientific method. This refers to a
dispassionate development and testing of theories about how the world works.
 An assumption would be that they simplify the complex world and make it easier
to understand. An example is to study international trade, assume two countries
and two goods.
 Economists use models to study economic issues. They make a highly simplified
representation of a more complicated reality. Examples are: teeth model at the
dentist’s office, a model of the human anatomy from high school biology class, a
road map, etc.
Circular-flow diagram
 Visual model of the economy
 Shows how dollars flow through markets among households and firms
Two decision makers
 Firms and households
Interacting in two markets
 Market for goods and services
 Market for factors of production (inputs)
Production Possibilities Frontier (PPF)
 A graph: combinations of output that the economy can possibly produce
 Given the available – factors of production and technology.
Examples:
 Two goods: computers and wheat
 One resource: labor (measured in hours)
 Economy has 50,000 labor hours per month available for production
Microeconomics - The study of how households and firms make decisions and how
they interact in markets
Macroeconomics - The study of economy-wide phenomena, including inflation,
unemployment, and economic growth.

Positive statement: descriptive

- Attempt to describe the world as it is; describes a relationship
- Confirm or refute by examining evidence: “Minimum-wage laws cause
unemployment”
Normative statement: prescriptive
- Attempt to prescribe how the world should be: “The gov’t should raise the
minimum wage”
- Value judgment
Note: a statement need not be true to be positive.

Why Economists Disagree

 Economists often give conflicting policy advice
 Can disagree about the validity of alternative positive theories about
the world
 May have different values and, therefore, different normative views
about what policy should try to accomplish
Propositions that Economists mostly agree on
- Laws that limit the resale of tickets for entertainment and sports events make
potential audience members for those events worse off on average (80%)
- A ceiling on rents reduces the quantity and quality of housing available (93%)
- Tariffs and import quotas usually reduce general economic welfare (93%)
- The US should not restrict employers from outsourcing work to foreign countries
(90%)
- The US should eliminate agricultural subsidies (85%)
- Local and state gov’ts should eliminate subsidies to professional sports
franchises (85%)
- Cash payments increase the welfare of recipients to a greater degree than do
transfers-in kind of equal cash value (84%)
- A large federal budget deficit has an adverse effect on the economy (83%)
- The US should not ban genetically modified crops (82%)
 - A minimum wage increases unemployment among young and unskilled workers
(79%)
- Gov’t subsidies on ethanol in the US should be reduced or eliminated (78%)

Summary
 Economists are scientists
 Make appropriate assumptions and build simplified models
 The circular-flow diagram and the production possibilities frontier
 Microeconomists study decision making by households and firms and their
interactions in the marketplace
 Macroeconomists study the forces and trends that affect the economy as a whole
 A positive statement is an assertion about how the world is
 A normative statement is an assertion about how the world ought to be
 As policy advisers, economists make normative statements
 Economists sometimes offer conflicting advice
 Differences in scientific judgments
 Differences in values
Chapter 3 – Interdependence and the Gains from Trade
100% of economists agree that the trade with China makes most Americans better off
because, among other advantages, they can buy goods that are made or assembled
more cheaply in China.
Example:
 Two countries:
 The U.S. and Japan
 Two goods:
 Computers and wheat
 One resource:
 Labor, measured in hours
 How much of both goods each country produces and consumes
 If the country chooses to be self-sufficient
 If it trades with the other country
 Production Possibilities in the U.S.
 The U.S. has 50,000 hours of labor available for production, per month
 Producing one computer requires 100 hours of labor
 Producing one ton of wheat requires 10 hours of labor
Exports and Imports
 Imports – goods produced abroad and sold domestically
  Exports – goods produced domestically and sold abroad

Summary
 Interdependence and trade are desirable
 Allow everyone to enjoy a greater quantity and variety of goods and
services
 Comparative advantage: being able to produce a good at a lower opportunity
cost
 Absolute advantage: being able to produce a good with fewer inputs
 The gains from trade are based on comparative advantage, not absolute
advantage
 Trade makes everyone better off
 It allows people to specialize in those activities in which they have a
comparative advantage
 The principle of comparative advantage applies to countries as well as to people
 Economists use the principle of comparative advantage to advocate free trade
among countries

Chapter 4 – The Market Forces of Supply and Demand

 Market
 A group of buyers and sellers of a particular good or service
 Buyers as a group
Determine the demand for the product
 Sellers as a group
Determine the supply of the product

 Competitive market
- Many buyers and many sellers, each has a negligible impact on market
price
 Perfectly competitive market
- All goods are exactly the same
- Buyers and sellers are so numerous that no one can affect the market
price, “Price takers”

 Quantity demanded
- Amount of a good that buyers are willing and able to purchase
 Law of demand
- Other things equal
 - When the price of a good rises, the quantity demanded of the good
falls
- When the price falls, the quantity demanded rises

 Market demand
- Sum of all individual demands for a good or service
- Market demand curve: sum the individual demand curves horizontally
o To find the total quantity demanded at any price, we add the
individual quantities

 The demand curve

- Shows how price affects quantity demanded, other things being equal
 These “other things” are non-price determinants of demand
- Things that determine buyers’ demand for a good, other than the
good’s price
 Changes in them shift the D curve…
 Number of buyers
- Increase in # of buyers
o Increases quantity demanded at each price
o Shifts D curve to the right

- Decrease in # of buyers
o Decreases quantity demanded at each price
o Shifts D curve to the left

Demand Curve Shifters

 Income
 Normal good, other things constant
An increase in income leads to an increase in demand: Shifts D curve to
the right
 Inferior good, other things constant
An increase in income leads to a decrease in demand: Shifts D curve to
the left

 Prices of related goods, substitutes

 Two goods are substitutes if
An increase in the price of one leads to an increase in the demand
for the other
 Example: pizza and hamburgers
An increase in the price of pizza increases demand for hamburgers,
shifting hamburger demand curve to the right
 Other examples:
 Coke and Pepsi, laptops and tablets, music CDs and music
downloads

 Prices of related goods, complements

 Two goods are complements if
An increase in the price of one leads to a decrease in the demand
for the other
 Example: computers and software
If price of computers rises, people buy fewer computers, and
therefore less software; Software demand curve shifts left
 Other examples:
College tuition and textbooks, bagels and cream cheese, eggs and
bacon

 Tastes
 Anything that causes a shift in tastes toward a good will increase demand
for that good and shift its D curve to the right
 Example:
The Atkins diet became popular in the ’90s, caused an increase in
demand for eggs, shifted the egg demand curve to the right

 Expectations about the future

 Expect an increase in income, increase in current demand
 Expect higher prices, increase in current demand
 Example:
If people expect their incomes to rise, their D for meals at
expensive restaurants may increase now

Supply
 Quantity supplied
 Amount of a good
 Sellers are willing and able to sell
 Law of supply
 Other things equal
 When the price of a good rises, the quantity supplied of the good rises
 When the price falls, the quantity supplied falls
 Market supply
 Sum of the supplies of all sellers of a good or service
 Market supply curve: sum of individual supply curves horizontally
To find the total quantity supplied at any price, we add the
individual quantities
  The supply curve
 Shows how price affects quantity supplied, other things being equal
 These “other things”
 Are non-price determinants of supply
 Changes in them shift the S curve…

Supply Curve Shifters

 Input prices
 Supply is negatively related to prices of inputs
 Examples of input prices: wages, prices of raw materials
 A fall in input prices makes production more profitable at each output price
Firms supply a larger quantity at each price
The S curve shifts to the right
 Technology
Determines how much inputs are required to produce a unit of
output
 A cost-saving technological improvement has the same effect as a fall in
input prices, shifts S curve to the right
 Number of seller
 An increase in the number of sellers
Increases the quantity supplied at each price
Shifts S curve to the right

 Expectations about future

 Example: Events in the Middle East lead to expectations of higher oil
prices
Owners of Texas oilfields reduce supply now save some inventory
to sell later at the higher price
S curve shifts left
 Sellers may adjust supply* when their expectations of future prices change
(*If good not perishable)
 Surplus (excess supply) - quantity supplied is greater than quantity demanded
 Shortage (excess demand) - quantity demanded is greater than quantity
Three steps to analyzing changes in equilibrium
1. Decide whether the event shifts the supply curve, the demand curve, or, in some
cases, both curves
2. Decide whether the curve shifts to the right or to the left
3. Use the supply-and-demand diagram
Compare the initial and the new equilibrium
Effects on equilibrium price and quantity
Shift vs. Movement Along Curve
 Change in supply:
 A shift in the S curve
 Occurs when a non-price determinant of supply changes (like technology
or costs)
 Change in the quantity supplied:
 A movement along a fixed S curve
 Occurs when P changes
 Change in demand:
 A shift in the D curve
 Occurs when a non-price determinant of demand changes (like income or
# of buyers)
 Change in the quantity demanded:
 A movement along a fixed D curve
 Occurs when P changes

How Prices Allocate Resources

 “Markets are usually a good way to organize economic activity”
 In market economies
 Prices adjust to balance supply and demand
 These equilibrium prices
 Are the signals that guide economic decisions and thereby allocate scarce
resources

Summary
 Economists use the model of supply and demand to analyze competitive
markets.
 Many buyers and sellers, all are price takers
 The demand curve shows how the quantity of good demanded depends on the
price.
 Law of demand: as the price of a good falls, the quantity demanded rises;
the D curve slopes downward
 Other determinants of demand: income, prices of substitutes and
complements, tastes, expectations, and number of buyers.
 If one of these factors changes, the D curve shifts
 The supply curve shows how the quantity of a good supplied depends on the
price.
 Law of supply: as the price of a good rises, the quantity supplied rises; the
S curve slopes upward.
  Other determinants of supply: input prices, technology, expectations, and number
of sellers.
 If one of these factors changes, supply curve shifts.
 The intersection of the supply and demand curves determines the market
equilibrium.
 At the equilibrium price, quantity demanded = quantity supplied
 The behavior of buyers and sellers naturally drives markets toward their
equilibrium.
 When the market price is above the equilibrium price, there is a surplus of
the good, which causes the market price to fall.
 When the market price is below the equilibrium price, there is a shortage,
which causes the market price to rise.
 To analyze how any event influences a market, we use the supply-and-demand
diagram to examine how the event affects the equilibrium price and quantity.
1. Decide whether the event shifts the supply curve or the demand curve (or
both).
2. Decide in which direction the curve shifts.
3. Compare the new equilibrium with the initial one.
 In market economies, prices are the signals that guide economic decisions and
thereby allocate scarce resources.

Chapter 10 – Measuring a Nation’s Income

 Gross Domestic Product (GDP)
 Measures total income of everyone in the economy.
 Also measures total expenditure on the economy’s output of goods and
services.
 Income equals expenditure
 For the economy as a whole
 Because every dollar a buyer spends is a dollar of income for the seller.
 The Circular-Flow Diagram
 Simple depiction of the macroeconomy
 Illustrates GDP as spending, revenue, factor payments, and income
 Preliminaries:
 Factors of production are inputs like labor, land, capital, and natural
resources.
 Factor payments are payments to the factors of production (e.g., wages,
rent).
 The government
 Collects taxes, buys goods and services
 The financial system
 Matches savers’ supply of funds with borrowers’ demand for loans
  The foreign sector
 Trades goods and services, financial assets, and currencies with the
country’s residents
 Gross Domestic Product (GDP) is the market value of all final goods & services
produced within a country in a given period of time.
 Goods are valued at their market prices, so:
 All goods measured in the same units (e.g., dollars in the U.S.)
 Things that don’t have a market value are excluded, e.g., housework you
do for yourself.
 GDP includes all items produced in the economy and sold legally in markets
 GDP excludes most items produced and sold illicitly. It also excludes most items
that are produced and consumed at home.
 Final goods: intended for the end user
 Intermediate goods: used as components or ingredients in the production of
other goods
 GDP only includes final goods—they already embody the value of the
intermediate goods used in their production.
 GDP includes tangible goods (like DVDs, mountain bikes, beer) and intangible
services (dry cleaning, concerts, cell phone service).
 GDP includes currently produced goods, not goods produced in the past.
 GDP measures the value of production that occurs within a country’s borders,
whether done by its own citizens or by foreigners located there.
 Usually a year or a quarter (3 months).
 Recall: GDP is total spending.
 Four components:
- Consumption (C)
- Investment (I)
- Government Purchases (G)
- Net Exports (NX)
 These components add up to GDP (denoted Y): Y = C + I + G + NX

 Consumption, C
 Total spending by households on goods and services
 Note on housing costs:
 For renters, C includes rent payments.
 For homeowners, C includes the imputed rental value of the house, but
not the purchase price or mortgage payments
Not included in C: purchases of newhousing
  Investment, I
 Total spending on goods that will be used in the future to produce more
goods
Business capital: business structures, equipment, and intellectual
property products
Residential capital: landlord’s apartment building; a homeowner’s
personal residence
Inventory accumulations: goods produced but not yet sold
“Investment” does not mean the purchase of financial assets like stocks and bonds.
 Government purchases (G)
 All spending on the goods and services purchased by the government
At the federal, state, and local levels.
 Excludes transfer payments
Such as Social Security or unemployment insurance benefits.
They are not purchases of goods and services
 Net exports, NX = exports – imports
 Exports: foreign spending on the economy’s goods and services
 Imports: are the portions of C, I, and G that are spent on goods and
services produced abroad
 Nominal GDP
 Values output using current prices
 Not corrected for inflation
 Real GDP
 Values output using the prices of a base year
 Is corrected for inflation
 For the base year
 Nominal GDP = Real GDP
 GDP deflator
 A measure of the overall level of prices.
= 100 x nominal GDP/real GDP
 Measures the current level of prices relative to the level of prices in the
base year
 Economy’s inflation rate
 Compute the percentage increase in the GDP deflator from one year to
the next
 Real GDP per capita
 Main indicator of the average person’s standard of living
 But GDP is not a perfect measure of well-being.
 Robert Kennedy issued a very eloquent yet harsh criticism of GDP:
Senator Robert Kennedy, 1968
 Gross Domestic Product does not allow for the health of our children, the
quality of their education, or the joy of their play. It does not include the
beauty of our poetry or the strength of our marriages, the intelligence of
our public debate or the integrity of our public officials. It measures neither
our courage, nor our wisdom, nor our devotion to our country. It measures
everything, in short, except that which makes life worthwhile, and it can tell
us everything about America except why we are proud that we are
Americans.”
 GDP does not value:
 The quality of the environment
 Leisure time
 Non-market activity, such as the child care a parent provides at home
 An equitable distribution of income
 Having a large GDP enables a country to afford
 Better schools, a cleaner environment, health care, etc.

Summary
 Gross Domestic Product (GDP) measures acountry’s total income and
expenditure.
 The four spending components of GDP include: Consumption, Investment,
Government Purchases, and Net Exports.
 Nominal GDP is measured using current prices. Real GDP is measured using the
prices of a constant base year and is corrected for inflation.
 GDP is the main indicator of a country’s economic well-being, even though it is
not perfect.
-TERMS-
CHAPTER 11
Consumer price index (CPI)
- Measure of the overall level of prices
- Measure of the overall cost of goods and services
- Bought by a typical consumer
- Computed and reported every month by the Bureau of Labor Statistics
CALCULATING THE CPI
- Fix the basket
- Find the prices
- Compute the basket’s cost
- Chose a base year and compute the CPI
- Compute the inflation rate
CPI this year-CPI last year
Inflation rate= ×100
CPI last year
PROBLEMS WITH CPI
Substitution Bias
- Over time, some prices rise faster than others
- Consumers substitute toward goods that become relatively cheaper, mitigating the
effects of price increases.
- The CPI misses this substitution because it uses a fixed basket of goods.
- Thus, the CPI overstates increases in the cost of living.
Introduction of New Goods
- The introduction of new goods increases variety, allows consumers to find products that
more closely meet their needs.
- In effect, dollars become more valuable.
- The CPI misses this effect because it uses a fixed basket of goods.
- Thus, the CPI overstates increases in the cost of living.
Unmeasured Quality Change
- Improvements in the quality of goods in the basket increase the value of each dollar.
- The BLS tries to account for quality changes but probably misses some, as quality is hard
to measure.
- Thus, the CPI overstates increases in the cost of living.
Each of these problems causes the CPI to overstate cost of living increases.
– The BLS has made technical adjustments,
but the CPI probably still overstates inflation by about 0.5 percent per year.
– This is important because Social Security payments and many contracts have
COLAs tied to the CPI.
Contrasting the CPI and GDP Deflator
• Imported consumer goods:
– Included in CPI
– Excluded from GDP deflator
• Capital goods:
– Excluded from CPI
– Included in GDP deflator (if produced domestically)
• The basket:
– CPI uses fixed basket
– GDP deflator uses basket of currently produced goods & services
– This matters if different prices are
changing by different amounts.
Correcting Variables for Inflation
• Indexation
– A dollar amount is indexed for inflation
if it is automatically corrected for inflation
by law or in a contract.
• The increase in CPI automatically determines:
– The COLA in many multi-year labor contracts.
– Adjustments in Social Security payments and federal income tax brackets.
Real vs. Nominal Interest Rates
• The nominal interest rate:
– Interest rate not corrected for inflation
– Rate of growth in the dollar value of a deposit or debt
• The real interest rate:
– Corrected for inflation
– Rate of growth in the purchasing power of a deposit or debt
Real interest rate= (nominal interest rate) – (inflation rate)
Example:
– Deposit $1,000 for one year.
– Nominal interest rate is 9%.
– During that year, inflation is 3.5%.
– Real interest rate
= Nominal interest rate – Inflation
= 9.0% – 3.5% = 5.5%
– The purchasing power of the $1000 deposit
has grown 5.5%.
-TERMS-
CHAPTER 12
Economic Growth around the World
• Because of differences in growth rates
– Ranking of countries by income changes substantially over time
Poor countries are not necessarily doomed to poverty forever, e.g. Singapore incomes were
low in 1960 and are quite high now
Rich countries can’t take their status for granted: They may be overtaken by poorer but
faster-growing countries
Productivity
A country’s standard of living depends on its ability to produce goods and services
• Productivity
– Quantity of goods and services
– Produced from each unit of labor input
– Productivity = Y/L (output per worker), where
Y = real GDP = quantity of output produced
L = quantity of labor
• Why productivity is so important
– Key determinant of living standards
When a nation’s workers are very productive, real GDP is large and incomes are high
– Growth in productivity is the key determinant of growth in living standards
When productivity grows rapidly, so do living standards
– An economy’s income is the economy’s output
Determinants of Productivity
• Physical capital, K
– Stock of equipment and structures used to produce goods and services

• Physical capital per worker, K/L

 – Productivity is higher when the average worker has more capital (machines,
equipment, etc.).
An increase in K/L causes an increase in Y/L
• Human capital, H
– Knowledge and skills workers acquire through education, training, and
experience
• Human capital per worker, H/L
– Productivity is higher when the average worker has more human capital
(education, skills, etc.).
An increase in H/L causes an increase in Y/L.
• Natural resources, N
– Inputs into production that nature provides (land, rivers, and mineral deposits)
• Natural resources per worker, N/L
– Other things equal, more N allows a country to produce more Y
An increase in N/L causes an increase in Y/L
• Technological knowledge
– Society’s understanding of the best ways to produce goods and services
– Technological progress means:
A faster computer, a higher-definition TV, or a smaller cell phone
Also, any advance in knowledge that boosts productivity: allows society to get more output
from its resources
e.g., Henry Ford and the assembly line.
Technological knowledge vs. Human capital
• Technological knowledge
– Refers to society’s understanding of how to produce goods and services
• Human capital
– Results from the effort people expend to acquire this knowledge
Both are important for productivity
The Production Function
• The production function Y = A F(L, K, H, N)
– A graph or equation showing the relation between output and inputs
– F( ) is a function that shows how inputs are combined to produce output
– “A” is the level of technology
– “A” multiplies the function F( ), so improvements in technology (increases in “A”)
allow more output (Y) to be produced from any given combination of inputs.
• The production function has the property
constant returns to scale:
– Changing all inputs by the same percentage causes output to change by that
percentage.
Doubling all inputs (multiplying each by 2) causes output to double:
2Y = A F (2L, 2K, 2H, 2N)
• Increasing all inputs 10% (multiplying each by 1.1) causes output to
increase by 10%:
1.1Y = A F(1.1L, 1.1K, 1.1H, 1.1N)
• If we multiply each input by 1/L, then
output is multiplied by 1/L:
Y/L = A F (1, K/L, H/L, N/L)
• This equation shows that productivity (Y/L, output per worker) depends on:
– The level of technology, A
– Physical capital per worker, K/L
– Human capital per worker, H/L
– Natural resources per worker, N,L
Economic Growth and Public Policy
• The ways public policy can affect
long-run growth in productivity and living standards:
• Saving and investment
• Diminishing returns and the catch-up effect
• Investment from abroad;
• Education
• Health and nutrition
• Property rights and political stability
• Free trade;
• Research and development
• Population growth
-TERMS-
CHAPTER 13
Financial Institutions
• Financial system
– Group of institutions in the economy that help match the saving of one person
with the investment of another
• Financial institutions
– Institutions through which savers can directly provide funds to borrowers
– Financial markets
o Financial intermediaries

Financial Markets
• Financial markets
– Savers can directly provide funds to borrowers
– The bond market:
A bond is a certificate of indebtedness
– The stock market:
A stock is a claim to partial ownership in a firm
Financial Intermediaries
• Financial intermediaries
– Institutions through which savers can indirectly provide funds to borrowers
– Banks
– Mutual funds: institutions that sell shares to the public and use the proceeds to
buy portfolios of stocks and bonds
Accounting Identities
• Gross domestic product (GDP, Y)
– Total income = Total expenditure
Y = C + I + G + NX
• Y = gross domestic product, GDP
• C = consumption
• I = investment
• G = government purchases
• NX = net exports
• Assume closed economy: NX = 0
• Y = C + I + G, so I = Y – C - G
• National saving (saving), S
• Total income in the economy that remains after paying for consumption and
government purchases
• By definition: S = Y – C – G
• It follows: Saving (S) = Investment (I) for a closed economy
– For T = taxes minus transfer payments
S = Y – C – G can be rewritten as:
S = (Y – T – C) + (T – G)
• Private saving, Y – T – C
– Income that households have left after paying for taxes and consumption
• Public saving, T – G
– Tax revenue that the government has left after paying for its spending
• Budget surplus: T – G > 0
– Excess of tax revenue over government spending = public saving (T-G)
• Budget deficit: T – G < 0
– Shortfall of tax revenue from government spending = – (public saving) = G – T
The Meaning of Saving and Investment
• Private saving
– Income remaining after households pay their taxes and pay for consumption.
– Examples of what households do with saving:
Buy corporate bonds or equities
Purchase a certificate of deposit at the bank
Buy shares of a mutual fund
Let accumulate in saving or checking accounts
• Investment
– Is the purchase of new capital
– Examples of investment:
General Motors spends $250 million to build
a new factory in Flint, Michigan.
You buy $5000 worth of computer equipment for your business.
Your parents spend $300,000 to have a new house built.
Investment is NOT the purchase of stocks and bonds!
Given: Y = 10.0, C = 6.5, G = 2.0, G – T = 0.3 (all in trillions)
• Public saving = T – G = – 0.3
• Net taxes: T = G – 0.3 = 1.7
• Private saving = Y–T–C = 10 – 1.7 – 6.5 = 1.8
• National saving S=Y–C–G = 10 – 6.5 – 2 = 1.5
• Investment = national saving = 1.5
The Market for Loanable Funds
• Loanable funds market
– A supply–demand model of the financial system
– Helps us understand:
How the financial system coordinates
saving & investment.
How government policies and other factors affect saving, investment, the interest rate.
• Assume: only one financial market
– All savers deposit their saving in this market.
– All borrowers take out loans from this market.
– There is one interest rate, which is both the return to saving and the cost of
borrowing.
• The supply of loanable funds comes from saving:
– Households with extra income can loan it out and earn interest.
– Public saving
If positive, adds to national saving and the supply of loanable funds.
If negative, it reduces national saving and the supply of loanable funds.
• The demand for loanable funds comes from investment:
– Firms borrow the funds they need to pay for new equipment, factories, etc.
– Households borrow the funds they need to purchase new houses.
-TERMS-
CHAPTER 14
• The financial system
– Coordinates saving and investment
• Participants in the financial system
– Make decisions regarding the allocation of resources over time and the handling
of risk
• Finance
Studies such decision making
Present Value:
The Time Value of Money
• The present value of a future sum:
– The amount that would be needed today to yield that future sum at prevailing
interest rates
• The future value of a sum:
– The amount the sum will be worth at a given future date, when allowed to earn
interest at the prevailing rate
Compounding
• Compounding:
– The accumulation of a sum of money where the interest earned on the sum
earns additional interest
• Because of compounding
– Small differences in interest rates lead to big differences over time.
• Example: Buy $1000 worth of Microsoft stock, hold for 30 years.
– If rate of return = 0.08, FV = $10,063
– If rate of return = 0.10, FV = $17,450
– Thus, a 2% increase in the rate of return leads to over $7000 of additional
interest earned over the 30 years.
The Rule of 70
• The Rule of 70:
– If a variable grows at a rate of x percent per year, that variable will double in
about 70/x years.
• Example:
– If interest rate is 5%, a deposit will double in about 14 years.
– If interest rate is 7%, a deposit will double in about 10 years.
Risk Aversion
• Most people are risk averse—they dislike uncertainty.
– Example: You are offered the following gamble. Toss a fair coin:
If heads, win $1000; If tails, you lose $1000
– Should you take this gamble?
If you are risk averse, the pain of losing $1000 would exceed the pleasure of winning
$1000.
Since both outcomes are equally likely, you should not take this gamble.
Managing Risk With Insurance
• How insurance works:
– A person facing a risk pays a fee to the insurance company, which in return
accepts part or all of the risk.
• Insurance
– Allows risks to be pooled, and can make risk averse people better off:
E.g., it is easier for 10,000 people to each bear 1/10,000 of the risk of a house burning
down than for one person to bear entire risk alone.
Two Problems in Insurance Markets
1. Adverse selection:
– A high-risk person benefits more from insurance, so is more likely to purchase it.
2. Moral hazard:
– People with insurance have less incentive to avoid risky behavior.
 3. Insurance companies
– Cannot fully guard against these problems, so they must charge higher prices.
– As a result, low-risk people sometimes forego insurance and lose the benefits of
risk-pooling.
Measuring Risk
• Standard deviation
– A statistic that measures a variable’s volatility—how likely it is to fluctuate.
– Used to measure the risk of an asset
– The higher the standard deviation of the asset’s return, the greater the risk
Reducing Risk
Through Diversification
• Diversification
– Reduces risk by replacing a single risk with a large number of smaller, unrelated
risks.
• A diversified portfolio
– Assets whose returns are not strongly related
– Some assets will realize high returns, others low returns.
– The high and low returns average out, so the portfolio is likely to earn an
intermediate return more consistently than any of the assets it contains.
• Firm-specific risk
– Affects only a single company
• Market risk
– Affects all companies in the stock market
• Diversification
– Can eliminate firm-specific risk
– Cannot eliminate market risk
Tradeoff Between Risk and Return
• Tradeoff:
– Riskier assets pay a higher return, on average, to compensate for the extra risk of
holding them.
– E.g., over the past 200 years, average real return:
On stocks, 8% (riskier asserts)
On short-term government bonds, 3%.
Asset Valuation
• When deciding whether to buy a company’s stock
– You compare the price of the shares to
the value of the company.
• Stocks are:
– Undervalued if Price < Value
– Overvalued if Price > Value
– Fairly valued if Price = Value
• Value of a share
= PV of any dividends the stock will pay
+ PV of the price you get when you sell the share
• Problem:
– When you buy the share, you don’t know what future dividends or prices will be.
• Fundamental analysis (one way to value a stock)
– The study of a company’s accounting statements and future prospects to
determine its value
Index Funds vs. Managed Funds
• An index fund
– A mutual fund that buys all the stocks in a given stock index.
• An actively managed mutual fund
– Aims to buy only the best stocks.
– Have higher expenses than index funds
EMH implies that returns on actively managed funds should not consistently exceed the
returns on index funds.
Market Irrationality
• Bubbles
– Occur when speculators buy overvalued assets expecting prices to rise further
• Possibility of speculative bubbles
– Value of the stock to a stockholder depends on:
Stream of dividend payments
Final sale price
• Debate: frequency and importance of departures from rational pricing
– Market irrationality
Movement in stock market is hard to explain - news that alter a rational valuation
– Efficient markets hypothesis
Impossible to know the correct/rational valuation of a company
Chapter 15: Unemployment
Labor Force Statistics
- Produced by Bureau of Labor Statistics (BLS), in the U.S. Dept. of Labor
o Based on regular survey of 60,000 households
o Based on “adult population” (16 yrs or older)
- BLS divides population into 3 groups:
o Employed: paid employees, self-employed, and unpaid workers in a
family business
o Unemployed: people not working who have looked for work during
previous 4 weeks
o Not in the labor force: everyone else
- Labor force = Employed + Unemployed
o The total # of workers

• Unemployment rate (“u-rate”):

– % of the labor force that is unemployed
# of unemployed
u-rate =100 ×
Labor force
• Labor-force participation rate
– % of the adult population that is in the labor force
Labor force
Labor-force participation rate = 100 ×
Adult population
u-rate rises
A rising u-rate gives the impression that the labor market is worsening, and it is.
Discouraged workers
- would like to work but have given up looking for jobs
- classified as “not in the labor force” rather than “unemployed”
U-rate falls
A falling u-rate gives the impression that the labor market is improving, but it is not.
U-rate unchanged
because a person is “employed” whether they work full or part time.
WHAT DOES THE U RATE REALLY MEASURE?
 - The u-rate:
o Not a perfect indicator of joblessness or the health of the labor
market
 It excludes discouraged workers.
 It does not distinguish between full-time and part-time work, or
people working part time because full-time jobs not available.
 Some people misreport their work status
o Still a very useful barometer of the labor market & economy.

CYCLICAL UNEMPLOYMENT VS THE NATURAL RATE

There’s always some unemployment, though the u-rate fluctuates from year to
year.
- Natural rate of unemployment
o Normal rate of unemployment around which the actual unemployment rate
fluctuates
- Cyclical unemployment
o Deviation of unemployment from its natural rate
o Associated with business cycles, which we’ll study in later chapters

- Frictional unemployment
o Occurs when workers spend time searching for the jobs that best suit their
skills and tastes
o Short-term for most workers

- Structural unemployment
o Occurs when there are fewer jobs than workers

o Usually longer-term

JOB SEARCH
Workers have different tastes & skills, and
jobs have different requirements.
• Job search
– Process of matching workers with appropriate jobs
• Sectoral shifts
– Changes in the composition of demand across industries or regions of the
country.
– Displace some workers, who must search for new jobs appropriate for
their skills & tastes.
PUBLIC POLICY AND JOB SEARCH
- Government employment agencies
o Provide information about job vacancies to speed up the matching of
workers with jobs.
- Public training programs
o Aim to equip workers displaced from declining industries with the skills
needed in growing industries.
UNEMPLOYMENT INSURANCE
- A government program that partially protects workers’ incomes when they
become unemployed
- Increases frictional unemployment.
o People respond to incentives.
o UI benefits end when a worker takes a job, so workers have less incentive
to search or take jobs while eligible to receive benefits.
- Benefits of UI:
o Reduces uncertainty over incomes

o Gives the unemployed more time to search, resulting in better job matches
and thus higher productivity
MINIMUM WAGE LAWS
- May exceed the equilibrium wage for the least skilled or experienced workers,
causing structural unemployment.
- But this group is a small part of the labor force, so the min. wage can’t explain
most unemployment.
UNION
- Worker association that bargains with employers over wages, benefits, and
working conditions
- Exert their market power to negotiate higher wages for workers.
- The typical union worker earns 20% higher wages and gets more benefits than a
nonunion worker for the same type of work.
- Unions raise the wage above equilibrium:
o Quantity of labor demanded falls and unemployment results.

o “Insiders” – workers who remain employed, are better off.

 o “Outsiders” – workers who lose their jobs,
are worse off.
 Some outsiders go to non-unionized labor markets, which
increases labor supply and reduces wages in those markets.
Are unions good or bad? Economists disagree.
• Critics:
– Unions are cartels.
– They raise wages above equilibrium, which causes unemployment and/or
depresses wages in non-union labor markets.
• Advocates:
– Unions counter the market power of large firms, make firms more
responsive to workers’ concerns.
EFFECIENCY WAGES
- The theory of efficiency wages:
o Firms voluntarily pay above-equilibrium wages to boost worker
productivity.
Different versions of efficiency wage theory suggest different reasons why firms
pay high wages.
FOUR REASONS WHY FIRMS MIGHT PAY EFFICIENCT WAGES
- Worker Health
- Worker Turnover
- Worker Quality
- Worker Effort
The natural rate of unemployment consists of:
– Frictional unemployment: it takes time to search for the right jobs
• Even if there are enough jobs to go around
– Structural unemployment: when wage is above equilibrium, not enough
jobs
• Min. wages, labor unions, efficiency wages
In later chapters, we will learn about cyclical unemployment, the short-term
fluctuations in unemployment associated with business cycles.
CHAPTER 16: THE MONETARY SYSTEM
• Without money
– Trade would require barter: the exchange of one good or service for
another.
• Requires a double coincidence of wants: unlikely occurrence
that two people each have a good the other wants.
• Waste of resources: people spend time searching for others to
trade with
• Using money
o Solves those problems

THE THREE FUNCTIONS OF MONEY

- Medium of exchange
o Item that buyers give to sellers when they want to purchase goods
and services
- Unit of account
o Yardstick people use to post prices and record debts
- Store of value
o Item that people can use to transfer purchasing power from the
present to the future
THE TWO KINDS OF MONEY
- Commodity money:
o Takes the form of a commodity with intrinsic value
 Examples: gold coins, cigarettes in POW camps
- Fiat money:
o Money without intrinsic value, used as money because of
government decree
 Example: the U.S. dollar
THE MONEY SUPPLY
- The money supply (or money stock):
o Quantity of money available in the economy
- Currency:
o Paper bills and coins in the hands of the (non-bank) public
 - Demand deposits:
o Balances in bank accounts that depositors can access on demand
by writing a check
- M1 = $3.2 trillion (May 2016)
o Currency, demand deposits, traveler’s checks, and other checkable
deposits.
- M2 =$12.7 trillion (May 2016)
o Everything in M1 plus savings deposits, small time deposits, money
market mutual funds, and a few minor categories.
CENTRAL BANKS AND MONETARY POLICY
- Central bank:
o Institution that oversees the banking system and regulates the
money supply
- Monetary policy:
o Setting of the money supply by policymakers in the central bank
- Federal Reserve (Fed):
o The central bank of the U.S.

THE STRUCTURE OF FED

- The Federal Reserve System consists of:
o Board of Governors
 (7 members), located in Washington, DC
o 12 regional Fed banks
 Located around the U.S.
o Federal Open Market Committee (FOMC),
 includes the Board of Governors and
presidents of some of the regional Fed banks.
 The FOMC decides monetary policy.
BANK RESERVES
- In a fractional reserve banking system
o Banks keep a fraction of deposits as reserves and use the rest to
make loans.
- The Fed establishes reserve requirements
o Regulations on the minimum amount of reserves that banks must
hold against deposits.
 Banks may hold more than this minimum
- The reserve ratio, R
 o =fraction of deposits that banks hold as reserves
o =total reserves as a percentage of total deposits

THE MONEY MULTIPLIER

- Money multiplier = 1/R
o Amount of money the banking system generates with each dollar of
reserves
- In our example, R = 10%
o Money multiplier = 1/R = 10
o $100 of reserves creates $1,000 of money

A MORE REALISTIC BALANCE SHEET

- Assets:
o Besides reserves and loans, banks also hold securities.
- Liabilities:
o Besides deposits, banks also obtain funds from issuing debt and
equity.
- Bank capital:
o The resources a bank obtains by issuing equity to its owners
o Also: bank assets minus bank liabilities
- Capital requirement:
o A government regulation that specifies a minimum amount of capital,
o Intended to ensure banks will be able to pay off depositors and debts
- Leverage:
o The use of borrowed funds to supplement existing funds for
investment purposes