Economics

CFA一级培训项目
讲师：Cherie
 Cherie
 工作职称：金程教育资深培训师，CFA FRM
 教育背景：新南威尔士大学金融学硕士
 工作背景：单晨玮老师毕业于新南威尔士大学金融学专业，学术功底深厚。单老
师曾亲自参与中国工商银行总行、中国银行总行、中国建设银行、民生银行总行、
杭州银行、杭州联合银行、国泰君安、南京审计学院、西安工业大学、西安外国
语大学等CFA培训项目。在金程讲授CFA培训课程，累计课时达6000小时，课程清
晰易懂，深受学员欢迎。
 讲授课程：CFA一、二、三级
 参与出版：曾参与出版了注册金融分析师系列丛书、金程教育CFA课堂笔记、CFA
冲刺宝典、CFA中文NOTES等公开出版物及内部出版物。并参与翻译CFA协会官方
参考书《企业理财》，《国际财务报告分析》等书籍。
 Topic Weightings in CFA Level I
Session NO. Content Weightings(%)
Study Session 1-2 Quantitative Methods 8-12

Study Session 3-4 Economics 8-12

Study Session 5-8 Financial Statement Analysis 13-17

Study Session 9-10 Corporate Issuers 8-12

Study Session 11-12 Equity 10-12

Study Session 13-14 Fixed Income 10-12

Study Session 15 Derivatives 5-8

Study Session 16 Alternative Investments 5-8

Study Session 17-18 Portfolio Management 5-8

Study Session 19 Ethical and Professional Standards 15-20

Framework  R8 Topics in Demand and Supply
Analysis
 R9 The Firm and Market
Economics Structures
 R10 Aggregate Output, Prices,
and Economic Growth
 R11 Understanding Business
Cycles
 R12 Monetary and Fiscal Policy
 R13 International Trade and
Capital Flows
 R14 Currency Exchange Rates
 Reading
8

Topics in Demand and Supply Analysis

 1. Demand and Supply

Framework 2. Elasticity
3. Substitution and Income Effects
4. Profit
5. Revenue
6. Product
7. Cost
8. Profit Maximization
9. Breakeven Point and Shutdown Point
10. Economies and Diseconomies of scale
Demand and
Supply

1-10
 Demand
 Demand function
 the quantity of demanded depends on income, the prices of other
goods, as well as other factors
Qdx=f (px, I, py…)
 Example
 Qd gas = 9 - 1.5Pgas + 0.02I + 0.11 PBT -0.008Pauto (BT: Bus Travel )
 Assuming I=40, PBT=25, Pauto=26
Qd gas =12.34 -1.5Pgas (demand function)
 Invert the function
P gas = 8.23 - 0.667Qd gas (inverse demand function)
The graph of the inverse demand function is called the demand
curve.
 Law of demand
 Demand decreased as the price increased

2-10
 Demand Curve

P($)

8.23
Demand function
Qgas=12.34-15Pgas
Inverse Demand function
Pgas=8.23-0.667Qgas

Q(gallons)
12.34

3-10
 Supply
 The Supply Function
 The quantity supply depends on the selling price, the costs of
production depending on technology, the cost of labor, and the cost of
other inputs into the production process.
Q s x=f (PX , W…)
 Example:
 QS tables= -300+1.5Ptables-8W-0.2Pwood
 Assuming W=12, P wood=150
 QS tables = -426+1.5Ptables (Supply Function)
 Invert the function
 P tables =284+0.667Qtables (Inverse Supply Function)
 The graph of the inverse supply function is called the supply curve.
 Law of supply
 Supply increased as the price increased

4-10
Supply Curve
P($)

400
Supply function:
Qtables=-426+1.5Ptables
284 Supply curve (Inverse supply function):
Ptables=284+0.667Qtables

174 Q(tables)

5-10
 Demand and Supply Curves
 Movements along demand and supply curves.
 A change in the market price that simply increases or decreases the
quantity supplied or demanded is represented by a movement along
the curve.
 Shifts in demand and supply curves.
 A change in one of the independent variables other than price will result
in a shift of the curve itself.

6-10
 Movements along Demand and Supply Curves

Price Price

Supply

Demand P1
P0

P0
P1

Q0 Q1 Q0 Q1 Quantity
Quantity

Change in Quantity Demand Change in Quantity Supplied

7-10
 Shifts in Demand and Supply Curves

Price Price

An increase in
Original supply
demand A decrease in
supply

A decrease Original demand An increase in

in demand supple

Quantity Quantity

8-10
 Market Equilibrium
 Equilibrium price and the equilibrium quantity
 When have a market supply and market demand curve for a good, we
can solve for the price at which the quantity supplied equals the
quantity demanded. We define this as the equilibrium price and the
equilibrium quantity.

P
S

E
P*

O Q
Q*

 E: market equilibrium.
 At the price, the quantity of supply=the quantity of demand.
9-10
 Consumer Surplus
 Marginal value (MV or MB or MU) is the benefit derived from consuming
one additional unit of a good or service.
 The difference between the total value to consumers of the units of a good
that they buy and the total amount they must pay for those units is called
consumer surplus.

A
MV (MU) curve == Demand curve
CS

P*

O Q
Q*
10-10
Price elasticity of
demand

1-9
 Elasticity

Price Elasticity of
demand

Elasticity Cross Elasticity of

Demand
Other elasticity of
demand
Income Elasticity of
Demand

2-9
 Price Elasticity of Demand
 Definition
 Price elasticity is a measure of the responsiveness of the quantity
demanded to a change in price.
 The price elasticity of demand:

Qxd
d %Qxd Qxd  Qxd  Px 
Px  Px 
E Px = = = d 
%Px  x 
Q
where: Px

change in value ending value - beginning value

Percent change = =
average value ( ending value +beginning value )
2

3-9
Example
 Example
 Qxd = 8,400 - 400Px+ 60I - 10Py
 choose $3 for Px
 $50 (thousands) for I
 $20 (thousands) for Py
d
ΔQ P 3
 = - 400 
d x x
E px
=
ΔP Q d
10000
= - 0.12
x
x

 own-price elasticity of demand

4-9
 Price Elasticity of Demand
 Price elasticity
 When elasticity<1, the demand is said to be inelastic;
 When elasticity>1, the demand is said to be elastic;
 When elasticity=1, demand is said to be unit elastic, or unitary elastic.

Price Price

Elastic Inelastic

Quantity Quantity

5-9
 Price Elasticity of Demand
 Perfectly elastic
 A perfectly elastic demand curve is horizontal, and its elasticity is
infinite. If the price increases, quantity demanded goes to zero.
 Perfectly inelastic
 A perfectly inelastic demand curve is vertical, and elasticity is zero. If
the price changes, there will be no change in the quantity demand.

Price Price

Perfectly Perfectly
Elastic Inelastic

Quantity Quantity

6-9
 Price Elasticity of Demand
 The relationship between price elasticity of demand and total revenue.
 Total revenue is maximized at the price and quantity where demand is
unit elastic (price elasticity =-1) and so decreases with both price
increases or price decreases from that level.
 When price is in the elastic (inelastic) region of the demand curve, a
price increase will decrease (increase) total revenue.

7-9
Price Elasticity of Demand

Price($)

8 (a) High Elasticity

Price
7 Elasticity = - 2.6
decreasing
6
(b) Unitary Elasticity
5 Elasticity = - 1
Price
4
increasing
(c) Inelasticity
3 Elasticity = - 0.2
2
1

10 20 30 40 50 60 70 80 Quantity

8-9
 Factors that Influence the Elasticity of Demand
 Availability of substitutes
 If good substitutes are available, a price increase in one product will
induce consumers to switch to a substitute good.
 The relative amount of income spent on the good
 When the portion of consumer budgets spent on a particular good is
relatively small, demand for that good will tend to be relatively inelastic.
 Time period since the price change
 The price elasticity of demand for most products is greater in the long
run than in the short run.

9-9
Cross Elasticity

1-3
 Cross-Price Elasticity of Demand
 Cross elasticity of demand measures the change in the demand for a good
in response to the change in price of a substitute or complementary good.

%Q d  Q d   Py 
E dPy = x
= x
  d 
%Py  Py   Qx 
 Cross elasticity of demand is positive for substitute goods. (Example:
apple and pear)
 Cross elasticity of demand is negative for complement goods.
(Example: car and gas)

2-3
Example
 Qxd = 8,400 - 400Px+ 60I - 10Py

 choose $3 for Px

 $50 (thousands) for I

 $20 (thousands) for Py

d
ΔQ P 20
 = -10  = - 0.02  cross-price elasticity
d x y
E py
=
ΔP Q d
10000
y
x

3-3
Income Elasticity

1-3
 Income Elasticity of Demand
 Income elasticity of demand measures the sensitivity of the quantity of a
good or service demanded to a change in a consumer’s income.
 The formula for income elasticity of demand is

d %Qxd  Qxd   I 
E = =  
%I  I   Qxd 
I

 The application of income elasticity

 Normal goods: positive income elasticity, demand rises with income.
(> 0).
 Luxuries: high positive elasticity, demand rises strongly with income
(>1).
 Necessities: normal but low elasticity (between 0～1).
 Inferior goods: negative income elasticity, demand falls with income
(<0).

2-3
Example
 Qxd = 8,400 - 400Px+ 60I - 10Py

 choose $3 for Px

 $50 (thousands) for I

 $20 (thousands) for Py

d
ΔQ I 50
 = 60  = 0.3  income elasticity of demand
d x
EI = ΔI d
10000
Q x

3-3
Substitution and
Income Effects

1-4
 Substitution and Income Effects
 Substitution effect
 When the price of Good X decreases, the relative price of Good X
against other goods will decrease. Consumer equilibrium moves along
the indifference curve, which leads to an increase in the demand of
Good X.
 Income effect
 When the price of Good X decreases, consumer’s real purchasing power
will change. Real income increases, and budget constraint moves, which
lead to a change in the demand of Good X.

2-4
 Normal and inferior goods
 Income effect & Substitution effect共同作用决定需求量变化
 When decrease in the price of Good X:
 Normal goods: the substitution effect is positive, and the income effect
is also positive—consumption of Good X will increase.
 Inferior goods: the substitution effect is positive, and the income effect
is negative but smaller than the substitution effect—consumption of
Good X will increase.
 Giffen goods: the substitution effect is positive, and the income effect is
negative and larger than the substitution effect—consumption of Good
X will decrease.
 Normal good is one for which the income effect is positive.
 Inferior good is one for which the income effect is negative.

3-4
 Giffen Goods and Veblen Goods
 Giffen goods:
 Income effect （inferior goods） > Substitution effect
 Demand curve has positive slope
 Veblen goods (Conspicuous goods):
 Consumer cannot truly value a good until the price is known.
 Price is used by the consumer to signal the status in the society.
 High price high value  high demand quantity (extremely)
 Have a positively sloped demand curve (eg: luxury automobile or
very expensive piece of jewelry) firstly.
 But when price increases, the slope may be negative.
 Two important distinctions between Giffen goods and Veblen goods.
 First, Giffen goods are inferior goods (negative income effect), while
Veblen goods certainly are not.
 Second, the existence of Giffen goods is theoretically supported by our
rules of consumer choice, while the existence of Veblen goods is not.

4-4
Profit

1-3
 Accounting Profit and Economic Profit
 Accounting profit is the difference between total revenue and total
accounting cost.
 Accounting profit = total revenue – total accounting (explicit) cost
 Economic profit is also referred to as abnormal profit. It is equal to
accounting profit less implicit opportunity costs.
 Economic profit= accounting profit - implicit opportunity costs
 Implicit costs are the opportunity costs of resources supplied to the
firm by its owners.
 For private firms, the implicit costs include
 The opportunity cost of owner-supplied capital;
 The opportunity cost of the time;
 Entrepreneurial ability of the firm’s owners.
 For publicly firms, implicit costs are only the opportunity cost of
equity owners’ investment.
 Economic profit = total revenue – total economic costs

2-3
 Normal Profit
 Normal profit is the accounting profit that makes economic profit zero.
 Accounting profit = economic profit + normal profit

Revenue

Economic
profit
Accounting
profit
Implicit
cost
Economic cost
Accounting cost Explicit (Opportunity cost)
= explicit cost cost

3-3
Product

1-4
 Total, Average, Marginal Products
 Total product (TP) is sum of the output from all inputs during a time
period; usually illustrated as the total output (Q) using labor quantity (L)
 Average product (AP) is total product divided by the quantity of a given
input; measured as total product divided by the number of worker hours
used at that output level (Q/L)
 Marginal product (MP) is the amount of additional output resulting from
using one more unit of input assuming other inputs are fixed; measured by
taking the difference in total product and dividing by the change in the
quantity of labor (∆Q/∆L).

2-4
Total, Average, Marginal Products
L TP (QL) APL MPL
0 0 - -
1 100 100 100
2 210 105 110
3 300 100 90
4 360 90 60
5 400 80 40
6 420 70 20
7 350 50 -70

3-4
 Law of Diminishing Returns
 The law of diminishing marginal returns states that as more and more
resources (such as labor) are devoted to a production process, they increase
output but at an ever decreasing rate.

1. MP is the slope of TP, when

MP=0, TP is maximized.
TP
2. When MP>AP, AP increase;
When MP<AP, AP decrease;
When MP=AP, AP is maximized.

AP=TP/L
L
MP=𝛥TP/𝛥L
4-4
Revenue

1-7
 Total, Average, and Marginal Revenue
 Total revenue (TR) for any firm that charges a single price to all customers
is calculated as price multiplied by quantity sold, or TR=∑P*Q.
 Average revenue (AR) is equal to total revenue divided by the quantity
sold, AR=TR/Q.
 Marginal revenue (MR) is the increase in total revenue from selling one
more unit of a good or service.

2-7
Total, Average, and Marginal Revenue
Q P TR AR MR
1 70 70 70 70
2 65 130 65 60
3 60 180 60 50
4 55 220 55 40
5 50 250 50 30
6 45 270 45 20
7 40 280 40 10
8 35 280 35 0

3-7
Example
 Assume demand for a product can be specified as

QD  50  2P

 We can get

P  25  0.5QD
TR  P  QD  25QD  0.5QD2
TR 25QD  0.5QD2
AR    25  0.5QD
QD QD
MR  25  QD

4-7
 Total, Average, and Marginal Revenue
 Under perfect competition
 The individual firm has virtually no impact on market price, price taker.
 The individual seller faces a horizontal demand curve over relevant
output ranges at the price level established by the market.
 Under perfect competition, MR=P=AR

5-7
 Total, Average, and Marginal Revenue
 Under imperfect competition
 Firms face downward-sloping demand curve, price searchers.
 Average revenue (AR) and marginal revenue (MR) will decline as
quantity of goods sold increase. AR is not equal to MR for any quantities
greater than zero.
 Total revenue (TR) is maximized when MR=0.
 The relationship between MR, P, and price elasticity of demand:
MR=P[1-1/Ep]

6-7
 Marginal Revenue
 MR is equal to price with an adjustment equal to quantity times the slope of
demand curve.
TR   P  Q 
MR  TR / Q
TR   P  Q    Q  P 

MR 
 P  Q    Q  P   P  Q  P 
Q Q Q
 P Q 
 P 1   
 Q P
 1  1
= P  1    P 1  
 e  e

 A perfectly competitive firm faces a demand curve with a slope of zero.

Substituting 0 for ∆P/∆Q into the expression given, it becomes clear that
MR is equal to price for the perfectly competitive firm.

7-7
Cost

1-7
 Long Run and Short Run
 Long term & short term

 The short term/run is defined as a time period for which quantities of

some resources are fixed, such as buildings, technology and
equipment.

 The technology of production is fixed in the short run and is a constraint

on a firm’s ability to increase production.

 Typically, economists treat labor and raw materials as variable in the

short run, holding plant size, capital equipment, and technology
constant. All of these factors become variable in the long run.

2-7
 Total, Fixed, and Variable costs
 Total fixed cost (TFC) is the cost of inputs that do not vary with the
quantity of output and cannot be avoided over the period of analysis.
 Total variable cost (TVC) is the cost of all inputs that vary with output over
the period of analysis.
 Total cost (TC) is the sum of all costs (fixed or variable, explicit and implicit)
of producing a specific level of output.

3-7
 Cost
 Total cost = total fixed cost + total variable cost

 Marginal cost = change in total cost / change in output

 Average fixed cost = total fixed cost / output

 Average variable cost = total variable cost / output

 Average cost = total cost / output = AFC+AVC

4-7
Total, Average, Marginal, Fixed, Variable costs

Cost
TC

TVC

TFC

TC (total cost) = total fixed cost+ total variable cost

5-7
 Total, Average, Marginal, Fixed, Variable costs
 Relationships between ATC, AVC, AFC & MC curves in the short run.

Cost
ATC=AFC+AVC

MC

ATC

AVC
X

AFC
X
Q

6-7
 Total, Average, Marginal, Fixed, Variable costs
 AFC slopes downward.
 The vertical distance between the ATC and AVC curves is equal to AFC.
 ATC and AVC are U-shaped.
 MC declines initially, then increases.
 MC intersects AVC and ATC at their minimum points.
 Minimum point on the ATC curve represents the lowest cost per unit,
but it is not necessarily the profit-maximizing point.
 TFC do not vary with output, so MC reflects only changes in TVC.

7-7
 Profit
Maximization

1-2
 Profit Maximization
 Profit maximization occurs when
 The difference between total revenue (TR) and total costs (TC) is the
greatest;
 Marginal revenue (MR) equals marginal cost (MC); (MR=MC)
 The revenue value of the output from the last unit of input
employed equals the cost of employing that input unit.

2-2
Breakeven Point
and Shutdown
Point

1-5
 Breakeven Point and Shutdown Point
 Under perfect competition

Breakeven and Shutdown Point

Cost

MC
ATC

Operate in SR
AVC
P1 A Breakeven point

Shutdown in LR
P2 B
Shutdown point

Shutdown in SR and LR
Q
2-5
 Breakeven Point and Shutdown Point
 Under perfect competition

Revenue-Cost
Short-Run Decision Long-Run Decision
Relationship
AR > ATC Stay in market Stay in market
AR = ATC Breakeven point

AVC < AR < ATC Stay in market Exit market

AR = AVC Shutdown point

Shut down production to
AR < AVC Exit market
zero

3-5
 Breakeven Point and Shutdown Point
 Under imperfect competition

Revenue-Cost
Short-Run Decision Long-Run Decision
Relationship

TR > TC Stay in market Stay in market

TR=TC Breakeven point

TVC < TR < TC Stay in market Exit market

TVC=TR Shutdown point

TR < TVC Shut down production to zero Exit market

4-5
 Economies of Scale and Diseconomies of Scale
 The downward sloping segment of the long-run average total cost curve
indicates the economies of scale.
 The upward sloping segment of this long-run average total cost curve
indicates that diseconomies of scale are present when average unit costs
rise as the scale of the business increase.

Cost

LATC
Economy of Diseconomy
scale of scale

Constant returns to scale

Q* Q

5-5
 Reading
9

The Firm and Market Structures

 1. Identification of Market Structure
Framework 2. Perfect Competition
3. Monopolistic Competition
4. Oligopoly
• Kinked demand curve model
• Cournot duopoly model
• Nash equilibrium model
• Stackelberg dominant firm model
5. Monopoly
6. Concentration Measures
 Market Structure
Factors and Perfect
Competition

1-6
 Market Structure
Number Degree of Barriers to Pricing Power The
Type of Product Entry of Firm example in
sellers Differentiation our life
Some
Perfect Homogeneous/
Many Very Low None agricultural
competition Standardized
products
Monopolistic Some retail
Many Differentiated Low Some
competition products

Steel,
Homogeneous/ Some or
Oligopoly Few High automobile,
Standardized Considerable
oil

Pure Public
One Unique Product Very High Considerable
monopoly sectors

2-6
 Perfect Competition
 The assumption of perfect competition
 There are a large number of potential buyers and sellers
 The products offered by the sellers are virtually identical
 There are few or easily surmountable barriers to entry and exit
 Sellers have no market-pricing power
 Non-price competition is absent
 A price taker is a firm that cannot influence the market price and that sets
its own price at the market price.
 Individual firm’s demand schedule is perfectly elastic (horizontal, Price =
Demand = Marginal Revenue = Average revenue).

3-6
 Perfect Competition
 Firm and Market in Perfect Competition

Market Firm
P P
S S

P* P*

D
Q Q

4-6
 Perfect Competition
 Perfectly competition firm’s short-run equilibrium
 Profit max: MR=MC
 MR=P=AR=D（price taker）

Cost / P

MC
Economic profit ATC

MR = AR = P

Profit maximizing
output

5-6
 Perfect Competition
 Perfectly competition firm’s long-run equilibrium
 The long-run equilibrium output level for perfectly competitive firms is
where MR=MC=ATC, which is where ATC is at a minimum. At this
output, economic profit is zero and only a normal return is realized.
 In equilibrium, each firm is producing the quantity for which
P=MR=MC=ATC, so that no firm earns economic profits.

Cost / P MC
ATC

MR = AR = P

Q* Q

6-6
Monopolistic
Competition

1-5
 Monopolistic Competition
 The following market and product features define monopolistic
competition:
 There are a large number of independent sellers
 Each firm has relative small market share;
 Each seller produces a differentiated product
 The most distinctive factor in monopolistic competition is product
differentiation.
 Firms compete on product quality, price and marketing;
 Firms are free to enter and exit;
 Firms in monopolistic competition face downward-sloping demand
curves and the curves are highly elastic because competing products are
perceived by consumers as close substitutes.

2-5
 Monopolistic Competition
 Product development and marketing
 Innovation and product development
 Less-elastic demand curve, earn economic profit;
 Close substitutes and imitations will eventually erode the initial
economic profit;
 Continually look for innovative product features.
 Brand names
 Provide information to consumer by providing them with signals about
the quality of the branded product.
 Advertising
 High for firms in monopolistic competition;
 Inform consumers about the unique features of the product;
 Advertising costs are greater, and increase the ATC curve
 Output increase;
 If advertising leads to enough of an increase in output (sales), it can
actually decrease a firm’s average total cost.

3-5
 Monopolistic Competition
 Short-run equilibrium in monopolistic competition
 In the short-run, the profit-maximizing choice is the level of output
where MR=MC.
 Because the product is somewhat different from that of the competitors,
the firm can charge the price determined by the demand curve.

Price Economic profit ATC

MC

P1

C1

MR = MC D

MR
Q
Q*
4-5
 Monopolistic Competition
 Long-run equilibrium in monopolistic competition
 In the long run for the monopolistic competitive firm, economic profit
will fall to zero.
 In long-run equilibrium, output is still optimal at the level where
MR=MC.

Price ATC
MC

P1 = C1

MR = MC
D

MR
Q
Q*
5-5
Oligopoly

1-11
 Oligopoly
 Oligopoly is a form of market competition characterized by:
 A small number of sellers
 Interdependence among competitors
 Large economies of scale
 Significant barriers to entry
 Either similar or differentiated products
 Compared to monopolistic competition, an oligopoly market includes fewer
firms, has higher barriers to entry, and its products are less elastic.
 In contrast to a monopolist, oligopolies are highly dependent upon the
actions of their rivals when making business decisions.
 Four models of oligopoly
 Kinked demand curve model
 Cournot duopoly model
 Nash equilibrium model (prisoner’s dilemma)
 Stackelberg dominant firm model
2-11
 Kinked Demand Curve Model
 The kinked demand curve model of oligopoly is based on the assumption
that each firm believes that if it raises its price, others will not follow, but if it
cuts its price, other firms will cut theirs.
 Qk is the profit-maximizing level of output and the price at which the
kink is located is the firm’s profit maximizing price.
 Shortcoming:
 It is incomplete because what determines the market price (where
the kink is located) is outside the scope of the modele.
 Between range A and B, the optimum Q is constant, can't determine
price.

3-11
Kinked Demand Curve Model

Kinked Demand Curve in Oligopoly Market

Price
MC1
More elastic
MC
Kink MC2
PK
MR1

B Less elastic

QK MR2
Quantity

4-11
 Cournot Model
 Cournot model
 Only two firms competing (e.g. A duopoly).
 Both have identical and constant marginal costs of production
 Each firm knows the quantity supplied by the other firm in the previous
period and assumes that is what it will supply in the next period.
 Firms determine their quantities simultaneously each period and, under
the assumptions of the Cournot model, these quantities will change
each period until they are equal.
 When each firm selects the same quantity, there is no longer any
additional profit to be gained by changing quantity, and we have a
stable equilibrium.

5-11
 Cournot Model
 Cournot model could be explained as the following
 Aggregate market demand: Q=450-P, Q=q1+q2,
 The supply function is represented by constant marginal cost MC=30.
 Rearranging the aggregate demand function in terms of price, we get:
P=450-Q=450- q1 - q2, and MC=30
 Total revenue for each of the two firms:
 TR1=Pq1=(450-q1-q2) X q1=450q1-q12-q1q2
 TR2=Pq2=(450-q1-q2) X q2=450q2-q22-q1q2
 MR1=ΔTR1 / Δq1=450-2q1-q2
 MR2= ΔTR2 / Δq2=450-2q2-q1

6-11
 Cournot Model
 Cournot model could be explained as the following
 For the profit-maximizing output, set MR=MC, or
 450-2q1-q2=30 and 450-2q2-q1=30
 Because q1=q2 under Cournot’s assumption, insert this solution into the
demand function and solves as: 450-2q1-q1= 450-3q1= 30.
 Therefore, q1 = 140, q2 = 140, and Q=280
 The price is P = 450 – 280 =170

7-11
 Nash Equilibrium Model
 Nash equilibrium is reached when the choices of all firms are such that
there is no other choice that makes any firm better off (increases profits or
decrease loss) .
 The assumption is made that each participating firm does the best it can,
given the reactions of its rivals.
 The firms in the oligopoly market have interdependent actions. The
actions are non-cooperative, with each firm making decisions that
maximize its own profits.
 The firms do not collude in an effort to maximize joint profits.
 The equilibrium is reached when all firms are doing the best they
can, given the actions of their rivals.

8-11
 Nash Equilibrium Model
 Prisoners’ Dilemma is a game that illustrates that the best course of action
for an oligopoly firm, when engaging in collusion with another oligopoly
firm, is to cheat.
Prisoner B is silent Prisoner B confesses
A gets 6 months A gets 10 years
Prisoner A is silent
B gets 6 months B goes free
A goes free A gets 2 years
Prisoner A confesses
B gets 10 years B gets 2 years

 Best overall outcome is for both to remain silent and get sentences of
six months. But it is not equilibrium.
 The Nash equilibrium is for both prisoners to confess, and for each to
get a sentence of two years.
 Confess/confess is the Nash equilibrium since neither prisoner can
unilaterally reduce his sentence by changing to silence.

9-11
 Collusion
 Collusion is when firms make an agreement among themselves to avoid
various competitive practices, particularly price competition.
 If the two parties comply with the collusion, the market is just like a
monopoly firm, which will make less outputs and higher price.
 Collusive agreements to increase price in an oligopoly market will be
more successful (have less cheating) when
 There are fewer firms;
 Products are more similar (less differentiated);
 Cost structures are more similar;
 Purchases are relatively small and frequent;
 Retaliation by other firms for cheating is more certain and more
severe;
 There is less actual or potential competition from firms outside the
cartel.

10-11
 Dominant Firm Model
 Dominant firm model
 A single firm has a significantly large market share
 Greater scale;
 Lower cost structure.
 Market price is essentially determined by the dominant firm (price
maker)
 The other competitive firms take this market price as given (price taker)
 If the other companies in the market attempts to gain market share by
undercutting the price set by the dominant firm, the market share of the
dominant firm will increase.
 Over time, the dominant company’s market share tends to decrease as profit
attract entry by other companies.

11-11
Monopoly

1-9
 Monopoly
 A monopoly is characterized by
 A single seller of a well-defined product for which there are no good
substitutes
 High barriers to the entry of other firms into the market for the product
 Types of barriers
 Legal barriers to entry create legal monopoly. A legal monopoly is a
market in which competition and entry are restricted by the granting of
a public franchise, government license, patent or copyright.
 Example: radio and television station
 Natural barriers to entry create natural monopoly, which is an industry
in which one firm can supply the entire market at a lower price than two
or more firms can (Economies of scale)
 Example: electric utility

2-9
 Monopoly
 A monopolist faces a downward sloping demand curve.
 Just as price searchers with low entry barriers will expand output until
MR=MC, so do monopolists. This will maximize profit. Positive economic
profits can exist in the long run due to the high entry barriers.
 The monopolists want to maximize profits, not price. So they will not
charge the highest possible price.
 Compared to a perfect competitive industry, the monopoly firm will produce
less total output and charge a higher price.

3-9
 Monopoly
 Monopolist’s demand, marginal revenue, and cost structure
 To maximize profit, monopolists will expand output until marginal
revenue (MR) equals marginal cost (MC). (MR=MC)
 The relationship between MR and price elasticity, Ep, is: MR=P[1-1/Ep]
 Economic profit = (P*- ATC*) ×Q*

Cost / P
Economic profit

MC

P*
ATC
ATC*
MR = MC

D
MR
Q
Q*

4-9
 Price Discrimination
 Price discrimination is the practice of charging different consumers
different prices for the same product or service.
 First-degree price discrimination, where a monopolist is able to charge
each customer the highest price the customer is willing to pay.
 In second-degree price discrimination, the monopolist offers a menu of
quantity-based pricing options designed to induce customers to self-
select based on how highly they value the product.
 Third-degree price discrimination happens when customers are
segregated by demographic or other traits.

5-9
Example
 Nicole’s monthly demand for visits to her health club is given by the
following equation: QD = 20 - 4P, where QD is visits per month and P is
euros per visit. The health club’s marginal cost is fixed at €2 per visit.

1. If the club charged a price per visit equal to its marginal cost, how
many visits would Nicole make per month?

2. How much consumer surplus would Nicole enjoy at that price?

3. How much could the club charge Nicole each month for a
membership fee?

6-9
Example
 Correct Answer:
1. QD = 20 - 4(2) = 12. Nicole would make 12 visits per month at a
price of €2 per visit.
2. Nicole's consumer surplus can be measured as the area under her
demand curve and above the price she pays for a total of 12 visits,
or (0.5)(12)(3) = 18. Nicole would enjoy a consumer surplus of €18
per month.
3. The club could extract all of Nicole’s consumer surplus by charging
her a monthly membership fee of €18 plus a per-visit price of €2.
This pricing method is called a two-part tariff because it assesses
one price per unit of the item purchased plus a per-month fee
(sometimes called an “entry fee”) equal to the buyer’s consumer
surplus evaluated at the per-unit price.
7-9
 Government Regulation
 Government regulation
 Average cost pricing is the more common form of regulation at the
point where ATC=D. This will
 Increase output and decrease price.
 Ensure the monopolist a normal profit (but no economic profit)
since price=ATC.
 Marginal cost pricing which is also referred to as efficient regulation,
forces the monopolist to reduce price to the point where MC=D. this will
 Increase output and reduce price.
 Causes the monopolist to incur a loss since price is below ATC.
 Such a solution requires a government subsidy in order to provide
the firm with a normal profit.

8-9
Government Regulation

P*

PAC

ATC

PMC
MC
MR D

Q* Q

9-9
Concentration
Measures

1-2
 Concentration Measures
 Concentration measures
 The N-Firm Concentration Ratio: the sum of the market share for largest
N firms in a market in percentage aspect.
 advantage: simple to compute, and easy to be understood
 disadvantage: does not directly quantify market power
limitation: the ratio is insensitive to the merger of two firms with
large market shares.
 The Herfindahl-Hirschman Index (HHI): summing the squares of the
market shares for each company in an industry.
 If there are M firms in the industry with equal market shares, then the
HHI equals (1/M). For example, an HHI of 0.2 would be analogous to
having the market shared equally by 5 firms.
 limitation: barriers to entry are not considered in either case. Even
a firm with high market share may not have much pricing power if
barriers to entry are low and there is potential competition.
2-2
 Reading
10

Aggregate Output, Prices, and Economic Growth

 1. GDP
Framework • Definition

• GDP Deflator

• GDP Measurement
2. Aggregate demand and aggregate
supply
3. Economic growth and sustainability
GDP

1-15
 Gross Domestic Product (GDP)
 Gross domestic product (GDP) measures:
 The total market value of all final goods and services produced in a
country within a certain time period.
 The aggregate income earned by all households, all companies, and the
government within the economy during a given period (income
definition).
 Intuitively, GDP measures the flow of output and income in the economy.
GDP represents the broadest measure of the value of economic activity
occurring within a country during a given period.

2-15
 GDP and GNP
 GNP (Gross National Product) measures the market value of all final
goods and services produced by factors of production supplied by residents
of a country, regardless of whether such production takes place within the
country or outside of the country.
 Difference
 GDP includes, and GNP excludes, the production of goods and services
or income to capital owned by foreigners within that country.
 GNP includes, and GDP excludes, the production of goods and services
or income to capital owned by its citizens outside of the country.
 GDP is more closely related to economic activity within a country and so
to its employment and growth.

3-15
 Nominal and Real GDP
 Nominal GDP: the total value of all goods and services produced by an
economy, valued at current market prices.
Nominal GDPt   Pt  Q t
where
Pt = Prices in year t
Qt = Quantity produced in year t
 Real GDP: is calculated relative to a base year. By using base-year prices and
current-year output quantities, real GDP growth reflects only increases in
total output, not simply increases (or decreases) in the money value of total
output.

where Real GDPt   PB  Q t

PB = Prices in the base year
Qt = Quantity produced in year t

4-15
 GDP Deflator
 Implicit price deflator for GDP (GDP deflator) is a price index that can be
used to convert nominal GDP into real GDP, taking out the effects of
changes in the overall price level.

Nominal GDP
GDP deflator = 100
Real GDP

5-15
 GDP Measurement
 The Value-of-Final-Output Method (以最终产品的价格计算OUTPUT)
 Expenditure Approach—summing the values of all final goods and
services produced.
 The Sum-of-Value-Added Method (以原材料和中间附加值累和计算
OUTPUT)
 Summing the additions to value created at each stage of production and
distribution. An example of the calculation for a specific product is
presented in the following figure.

6-15
 GDP Measurement
Value of Final Product Equals Income Created
Receipts at Value Added
Each (=Income Created)
Stage at Each Stage
Receipts of farmer from Value added
0.15 0.15
miller by farmer
Receipts of miller from Value added
0.46 0.31
baker by miller
Receipts of baker from Value added
0.78 0.32
retailer by baker
Receipts of retailer from Value added
1.00 0.22
final customer by retailer
1.00 1.00
Value of Total value added =
final output Total income created

7-15
 GDP Measurement
 GDP can be calculated as the sum of all the spending on newly produced
goods and services, or as the sum of the income received as a result of
producing these goods and services.
 Under the expenditure approach, GDP is calculated by summing the
amounts spent on goods and services produced during the period.
 Under the income approach, GDP is calculated by summing the
amounts earned by households and companies during the period,
including wage income, interest income, and business profits.
 For the whole economy, total expenditures and total income must be equal,
so the two approaches should produce the same result.

8-15
 GDP Measurement
 Income approach
 GDP = Gross domestic income (GDI)
= Net domestic income + Consumption of fixed capital CFC + Statistical
discrepancy
 CFC: measure of the wear and tear (depreciation) of the capital
stock that occurs in the production of goods and services.

9-15
 GDP Measurement
 Gross domestic income (GDI): income received by all factors of production
used in the generation of final output.
 Gross domestic income
= Compensation of employees
+ Gross operating surplus
+ Gross mixed income
+ Taxes less subsidies on production
+ Taxes less subsidies on products and imports

10-15
 GDP Measurement
 Personal income (household primary income)
 A broad measure of household income and measures the ability of
consumers to make purchases.
 One of the key determinants of consumption spending.
 Primary Household Income = compensation of employees + net
mixed income + net property income
 Household disposable income (HDI) = personal income – net current
transfers paid (pay taxes and receive transfer payments)
 Household net saving = HDI
- household final consumption expenditures
+ net change in pension entitlements

11-15
 GDP Measurement
 Expenditure approach
 GDP = C +I+G+(X-M) = (C+GC) + (I + GI) + (X-M)
 where
 C = Consumer spending on final goods and services
 I = Gross private domestic investment, which includes business
investment in capital goods (e.g., fixed capital such as plant and
equipment) and changes in inventory (inventory investment)
 G = Government spending on final goods and services for both current
consumption and investment in capital goods = GC + GI
 X = Exports
 M = Imports

12-15
 GDP Measurement
 Expenditure approach
 In practice, GDP measured by expenditure approach may differ because
of the use of different data sources.
 For example, Statistics Canada measures Canadian GDP as follows:
 GDP = Consumer spending on goods and services
+ Business gross fixed investment
+ Change in inventories
+ Government spending on goods and services
+ Exports – Imports
+ Statistical discrepancy

13-15
 Components of GDP
 The components of GDP:
 Consumption: function of disposable income.
 Personal income ↑ or taxes ↓ → both consumption and saving ↑
 Marginal propensity to consume (MPC): the proportion of
additional income spent on consumption
 MPC + MPS =1 (MPS: marginal propensity to save)
 Investment: a function of expected profitability and the cost of
financing
 Expected profitability depends on the overall level of economic
output.
 Financing costs are reflected in real interest rates.
 Government purchases: be viewed as independent of economic
activity
 Net exports are a function of domestic disposable incomes (which
affect imports), foreign disposable incomes (which affect exports).

14-15
 Saving, Investment, Fiscal and Trade Balance
 Total expenditures can be stated as
GDP = C + I + G + (X - M) ①
 Total income, which must equal total expenditures, can be stated as
GDP = C+S+T ②
where:
C = consumption spending
S = household and business savings
T = net taxes (taxes paid minus transfer payments received)
① = ② → S = I + (G - T) + (X - M)
如果S上升，I不变，必须被G-T财政赤字
增加，和net export增加所抵消。
Fiscal Trade
Saving多了，或被政府花了，或流出国
balance balance 外（经常账户流入，资本账户流出）

Also we can get: (G - T) = (S - I) - (X - M)

 A government deficit (G - T > 0) must be financed by some combination
of a trade deficit (X - M < 0) or an excess of private saving over private
investment (S - I > 0). 政府财政赤字来源：net saving；X-M<0
经常账户赤字，资本账户流入。
15-15
 Aggregate
Demand Curve

1-13
 Aggregate Demand Curve
 Aggregate demand (AD) represents the quantity of goods and services
that households, businesses, government, and international customers want
to buy at any given level of prices.
 Aggregate demand curve
 The aggregate demand curve represents the combinations of aggregate
income and the price level at which two conditions are satisfied.
 Aggregate expenditure equals aggregate income 商品市场均衡
 The available real money supply is willingly held by households and
businesses 货币市场均衡
 The downward slope of the aggregate demand curve results from three
effects
 1) Wealth effect
 2) Interest rate effect
 3) Real exchange rate effect
 Assuming nominal money supply is held constant.
2-13
 Aggregate Demand Curve
 1）Wealth effect （P/I改变的影响）
 The wealth effect is based on the concept of purchasing power of
nominal wealth, including nominal value of the money held by
consumers, physically or in bank account.
 Price level↑, nominal wealth不变 → real value of money↓ → the quantity
of goods and services decreases.
物价水平上涨，在名义财富不变的情况下，购买力下降，能够购买的商品和
服务的总量下降。 Price
level

B
PB
A
PA

Aggregate
YB YA income
3-13
 Aggregate Demand Curve
 2）Interest rate effect （货币需求改变的影响）
 A higher price level creates greater demand for money, which raises
the interest rate. The higher interest rate decreases demand for
investment and consumption expenditures, which leads to less demand
for goods and services.
 Price level ↑ → money demand ↑ → interest rate ↑ → AD ↓
 Business invest less, because their borrowing costs increases;
 Consumption is decrease, especially for large purchases such as
automobiles or residential real estate, which are usually
purchased with loans.
 A lower price level leads to a lower demand for money, which leads to
a lower interest rate. The lower interest rate increases demand for
investment and consumption expenditures, which leads to more
demand for goods and services.

4-13
 Aggregate Demand Curve
 3）Real exchange rate effect （真实汇率改变影响进出口）
 An increase in the domestic price level causes appreciation of the real
exchange rate and makes domestic goods more expensive in other
countries, reducing exports. It also makes non-domestic goods less
expensive domestically, increasing imports. The result is lower demand
for domestic goods and services.
 Price level ↑ → real exchange rate ↑ → export ↓, import ↑ →
demand for domestic goods and services ↓
 A decrease in the domestic price level (assuming the price level
abroad remains unchanged) leads to a depreciation of the real exchange
rate. This decrease in the real exchange rate makes domestic goods less
expensive in other countries, increasing exports, and non-domestic
goods more expensive domestically, decreasing imports. The result is
higher demand for domestic goods and services.

5-13
 Aggregate Demand Curve
 3）Real exchange rate effect (Con’t)
 An additional channel affecting exchange rates involves the interest rate
effect.
 When interest rates increase (because of a higher price level, a
higher money demand), non-domestic investors increase their
demand for the domestic currency in the foreign exchange market
because they want to earn the higher return on their savings. This
increased demand causes the domestic currency to appreciate,
which in turn increases the real exchange rate. (真实汇率对AD的影
响同上）
 When interest rates decrease (because of a lower price level),
domestic savers seek higher returns in non-domestic markets. This
increased supply of the domestic currency in the foreign exchange
market causes the domestic currency to depreciate, which in turn
decreases the real exchange rate.
6-13
 Money Demand
 The amount of wealth that the citizens of an economy choose to hold in the
form of money — as opposed to bonds or equities — is known as the
demand for money. There are three basic motives for holding:
 Transaction demand: The size of the transactions balances will tend to
increase with the average value of transactions in an economy. Generally
speaking, as gross domestic product (GDP) grows over time,
transactions balances will also tend to grow.
 Precautionary demand: are held to provide a buffer against unforeseen
events that might require money. Precautionary balances will also tend
to rise with the volume and value of transactions in the economy, and
therefore, GDP as well.
 Speculative demand: (sometimes called the portfolio demand for
money) relates to the demand to hold speculative money balances
based on the potential opportunities or risks that are inherent in other
financial instruments (e.g., bonds). The speculative demand for money
will tend to fall as the returns available on other financial assets rises.
7-13
 Money Supply
 The supply of money is determined by the
central bank and is not affected by changes in
interest rates. Thus the supply of money curve is Interest rate
vertical. Money Supply
 At lower interest rates, firms and households
choose to hold more money. At higher interest
rates, the opportunity cost of holding money
increases, and firms and households will desire
to hold less money and more interest-bearing
financial assets.
 Classification of Money i
Money Demand
 Narrow money is the amount of notes
(currency) and coins in circulation in an
economy plus balances in checkable bank
deposits.
 Broad money includes narrow money plus Real Money
any amount available in liquid assets, which
can be used to make purchases.

8-13
 Aggregate Demand Curve
 Movement along AD curve
 Change in price level
 Shifts in AD curve
 Household wealth;
 Consumer and business expectations;
 Capacity utilization;
 Monetary policy;
 Growth in global economy;
 Exchange rate;
 Fiscal policy. Price
level

AD1 AD2
Real GDP

9-13
 Shifts in the Aggregate Demand Curve
 GDP = C + I + G + NX. For changes in each of the following factors that
increase aggregate demand (shift AD to the right), we identify which
component of expenditures is increased.
 Increase in household wealth: As the value of households‘ wealth
increases (real estate, stocks, and other financial securities), the
proportion of income saved decreases and spending increases,
increasing aggregate demand. This dynamic, often referred to as the
wealth effect. (C increases).
 Business expectations: When businesses are more optimistic about
future sales, they tend to increase their investment in plant, equipment,
and inventory, which increases aggregate demand (I increases).
 Consumer expectations of future income: When consumers expect
higher future incomes, due to a belief in greater job stability or
expectations of rising wage income, they save less for the future and
increase spending now, increasing aggregate demand (C increases).
 High capacity utilization: When companies produce at a high
percentage of their capacity, they tend to invest in more plant and
equipment, increasing aggregate demand (I increases).
10-13
 Shifts in the Aggregate Demand Curve
 Expansionary monetary policy: When the rate of growth of the money
supply is increased, banks have more funds to lend, which puts downward
pressure on interest rates. Lower interest rates increase both investment and
consumers' spending. Thus, the effect of expansionary monetary policy is to
increase aggregate demand (C and I increase).
 Note that if the economy is operating at potential GDP (LRAS) when the
monetary expansion takes place, the increase in real output will be only
for the short run.
 In the long run, subsequent increases in input prices decrease SRAS and
return output to potential GDP.
 Expansionary fiscal policy: Expansionary fiscal policy refers to a decreasing
government budget surplus (or an increasing budget deficit) from
decreasing taxes, increasing government expenditures, or both.
 A decrease in taxes increases disposable income and consumption,
while an increase in government spending increases aggregate demand
directly (C increases for tax cut, G increases for spending increase).
11-13
 Shifts in the Aggregate Demand Curve
 Exchange rates
 A decrease in the relative value of a country's currency will increase
exports and decrease imports.
 Both of these effects tend to increase domestic aggregate demand (net
X increases).
 Global economic growth
 GDP growth in foreign economies tends to increase the quantity of
imports (domestic exports) foreigners demand.
 By increasing domestic export demand, this will increase aggregate
demand (net X increases).
 Note that for each factor, a change in the opposite direction will tend to
decrease aggregate demand.

12-13
 Shifts in the Aggregate Demand Curve
Impact of Factors Shifting Aggregate Demand
An Increase in the
Shifts the AD Curve Reason
Following Factors
Stock prices Rightward: Increase in AD Higher consumption
Housing prices Rightward: Increase in AD Higher consumption
Consumer confidence Rightward: Increase in AD Higher consumption
Business confidence Rightward: Increase in AD Higher investment
Capacity utilization Rightward: Increase in AD Higher investment
Government spending a
Government spending Rightward: Increase in AD
component of AD
Lower consumption and
Taxes Leftward: Decrease in AD
investment
Lower interest rate, higher
Bank reserves Rightward: Increase in AD investment and possibly higher
consumption
Exchange rate (foreign
Lower exports and higher
currency per unit Leftward: Decrease in AD
imports
domestic currency)
Global growth Rightward: Increase in AD Higher exports
13-13
 Aggregate
Supply Curve

1-4
 Aggregate Supply Curve
 Aggregate Supply Curve
 The aggregate supply (AS) curve describes the relationship between
the price level and the quantity of real GDP supplied, when all other
factors are kept constant. That is, it represents the amount of output
that firms will produce at different price levels.
 We need to consider three aggregate supply curves with different time
frames:
 The VSRAS curve is perfectly elastic.
 The SRAS curve is upward sloping.
 The LRAS curve is perfectly inelastic. In the long run, wages and
other input prices change proportionally to the price level, so the
price level has no long-run effect on aggregate supply. We refer to
this level of output as potential GDP or full employment, or
natural, level of output.

2-4
 Aggregate Supply Curve

VSRAS: Price level will not

Price Aggregate Supply Curve affect real output.
Level LRAS: Prices adjust
LRAS SRAS proportionally with the
price of input. Price level
will not affect real output.
SRAS: downward
VSRAS stickiness of wages
• P↑, constant nominal
wage→ real wage↓
→cost↓→employ more
Real Output workers → Y↑. Vise
Versa.

3-4
 Shifts in the SR Aggregate Supply Curve
Impact of Factors Shifting Aggregate Supply
An Increase in Shifts SRAS Shifts LRAS Reason
Supply of labor Rightward Rightward Increases resource base
Supply of natural resources Rightward Rightward Increases resource base
Supply of human capital Rightward Rightward Increases resource base
Supply of physical capital Rightward Rightward Increases resource base
Productivity and
Rightward Rightward Improves efficiency of inputs
technology
Nominal wages Leftward No effect Increases labor cost
Input prices (e.g., energy) Leftward No effect Increases cost of production
Anticipation of higher costs
Expectation of future
Rightward No effect and/or perception of
prices
improved pricing power
Business taxes Leftward No effect Increases cost of production
Subsidy Rightward No effect Lowers cost of production
Exchange rate Rightward No effect Lowers cost of production
4-4
 Effect of
Combination of
AD and AS

1-9
 Long-Run Macroeconomic Equilibrium
 The exhibit shows the long-run full employment equilibrium for an
economy.
 In this case, equilibrium occurs where the AD curve intersects the SRAS
curve at a point on the LRAS curve.
 Because equilibrium occurs at a point on the LRAS curve, the economy
is at potential real GDP. Both labor and capital are fully employed, and
everyone who wants a job has one.
 In the long run, equilibrium GDP is equal to potential GDP.
Price level LRAS

SRAS0

P0

AD0
Real Output (GDP)
GDP*
2-9
 Recessionary Gap
 Phenomenon:
 AD leftward shifts, employ less, increase in unemployment rate,
economic recession.
 GDP Expected<GDP potential
 Decrease in price, and decrease in GDP
 Solution: back to full employment
 Auto mechanism: prices decrease, increase in unemployment, nominal
wages decrease. The decrease in price will relatively increase real
purchasing power, thus pushing SRAS shifts right back to full
employment. However, the mechanism will take a long term to be
effective.
 Government interference: loosening fiscal policy (increase G and
decrease T) and monetary policy (decrease r), pushing AD back to
potential GDP and increasing price level as well.

3-9
Recessionary Gap
Price Long-run AS
Level

A Short-run AS

P1
B
P2

AD1
AD2
Real GDP
Y2 Y1

4-9
 Inflationary Gap
 Phenomenon:
 AD rightward shifts
 GDP Expected>GDP potential
 Price increases.
 Solution: The higher than potential GDP cannot be sustainable, since the
excessive usage of resources will reduce it to potential GDP.
 Auto mechanism: The increase in wages and input costs will reduce
SRAS, and push GDP to GDP potential.
 Government interference:
 Fiscal policy: Decrease G, increase T.
 Monetary policy: decrease money supply, or increase interest rate.

5-9
Inflationary Gap

LRAS
Price
Level
C

P3 SRAS1

P2
B
P1
AD2
A

AD1

Y1 Y2 Real GDP

6-9
 Stagflation
 Phenomenon:
 Aggregate supply decrease, price increases, GDP decreases, inflation
increases, unemployment rate increases.
 Reasons:
 Increase in input costs decreases aggregate supply.
 Solutions:
 Auto mechanism: (need long time to adjust)
 Decrease in GDP, increase in unemployment.
 Decrease in wages, decrease in input prices, SRAS shifts right, and reach
full employment.
 Government interference: (dilemma)
 Expansionary fiscal policy: Increase G, decrease T, resulting in more
inflation.
 Contractionary monetary policy: increase required reserves, decrease
money supply, or increase interest rate, resulting in further recession.
A central bank will most likely allow the economy to self-correct.
7-9
Stagflation

Price level LRAS

SRAS1

SRAS0

PLR
PSR 2
P0
1

AD0

Real Output (GDP)

GDP1 GDP*

8-9
 Effect of combined changes in AS and AD

Effect on
Effect on Real
Change in AS Change in AD Aggregate Price
GDP
Level
Increase Increase Increase Indeterminate

Decrease Decrease Decrease Indeterminate

Increase Decrease Indeterminate Decrease

Decrease Increase Indeterminate Increase

9-9
Economic
Growth

1-11
 Economic Growth and Sustainability
 Economic growth is calculated as the annual percentage change in real
GDP or the annual change in real per capita GDP:
 Growth in real GDP measures how rapidly the total economy is
expanding.
 Per capita GDP, defined as real GDP divided by population, measures
the standard of living in each country and the ability of the average
person to buy goods and services.
 The sustainable rate of economic growth is measured by the rate of
increase in the economy’s productive capacity or potential GDP.
 It is important to note that economists cannot directly measure
potential output.
 Instead, they estimate it using a variety of techniques that we will
discuss.

2-11
 Production Function
 A production function describes the relationship between output and labor,
the capital stock, and productivity.
 Economic output can be thought of as a function of the amounts of
labor and capital that are available and their productivity, which
depends on the level of technology available. That is:
Y = A ×f (L, K) (Y  AK  L1  )
where: Cobb-Douglas production function
Neoclassical or Solow growth model
Y = aggregate economic output
L = size of labor force
K = amount of capital available
A = total factor productivity
 Total factor productivity is a multiplier that quantifies the amount of
output growth that cannot be explained by the increases in labor and
capital.
3-11
 Production Function
 The neoclassical model makes three assumptions about the production
function that provide a link to microeconomics.
 1) First, it assumes that the production function has constant returns to
scale.
 This means that if all the inputs in the production process are
increased by the same percentage, then output will rise by that
percentage. Thus, doubling all inputs would double output.
 2) Second, the model assumes that the production function exhibits
diminishing marginal productivity with respect to any individual input.
 3) Finally, the model assumes no positive or negative externalities are
associated with the use of the inputs.

4-11
 Production Function
 Growth accounting equation
 growth in potential GDP = growth in technology + WL(growth in
labor) + WC (growth in capital)
 where WL and Wc are labor's percentage share of national income and
capital's percentage share of national income.
 The growth accounting equation can be further modified to explain growth
in per capita GDP.
 growth in per-capita potential GDP= growth in technology + WC
(growth in the capital-to-labor ratio)
 Assuming the number of workers and a remain constant, increases in
output can be gained by increasing capital per worker (capital
deepening) or by improving technology (increasing TFP).

5-11
 Production Function
 Diminishing marginal productivity of capital has two major
implications for potential GDP and long-term growth:
 Long-term sustainable growth cannot rely solely on capital
deepening investment that increases the stock of capital relative to
labor. More generally, increasing the supply of some input(s) relative to
other inputs will lead to diminishing returns and cannot be the basis for
sustainable growth.
 Given that developing countries have relatively less capital, their
productivity of capital is high. All else the same, the growth rates of
developing countries should exceed those of developed countries. As a
result, there should be a convergence of incomes between developed
and developing countries over time.

6-11
 Production Function
 Labor productivity data can be used to estimate the rate of sustainable
growth of the economy. A useful way to describe potential GDP is as a
combination of aggregate hours worked and the productivity of those
workers:
Potential GDP = Aggregate hours worked X Labor productivity
 Transforming the above equation into growth rate, we can get the following:
Potential growth rate = Long-term growth rate of labor force +
Long-term labor productivity growth rate

7-11
 Sources of Economic Growth
 Factors influencing economic growth

Growth in potential GDP = Growth in TFP + WL(Growth in labor) + WC(Growth in capital)

Technology
Human capital Physical
Total hours worked
Public infrastructure Capital
Natural resources Stock
Other factors
Labor force
Working age population ×
× Average hours
Participation rate Worked per worker

8-11
 Sources of Economic Growth
 Technology: improvements in technology increase productivity and potential
GDP. More rapid improvements in technology lead to greater rates of economic
growth.
 TFP growth = Growth in potential GDP − [WL (Growth in labor) +WC
(Growth in capital)]
 Labor supply: the labor force is the number of people over the age of 16 who
are either working or available for work but currently unemployed.
 It is affected by population growth, net immigration, and the labor force
participation rate. Growth of the labor force is an important source of
economic growth.
 Total hours worked = Labor force × Average hours worked per worker
 Human capital: the education and skill level of a country's labor force can be
just as important a determinant of economic output as the size of the labor
force.
 Because workers who are skilled and well-educated (possess more human
capital) are more productive and better able to take advantage of advances
in technology, investment in human capital leads to greater economic
growth.
9-11
 Sources of Economic Growth
 Physical capital stock: a high rate of investment increases a country's stock
of physical capital. A larger capital stock increases labor productivity and
potential GDP. An increased rate of investment in physical capital can
increase economic growth.
 Natural resources: raw material inputs, such as oil and land, are necessary
to produce economic output. These resources may be renewable (e.g.,
forests) or nonrenewable (e.g., coal). Countries with large amounts of
productive natural resources can achieve greater rates of economic growth.
 Although natural resources are an important factor in growth, they are
not necessary for a country to achieve a high level of income provided
it can acquire the requisite inputs through trade.

10-11
 Sources of Economic Growth
 Public infrastructure
 Examples: Roads, water systems, mass transportation, airports, and
utilities are all examples of public infrastructure or public capital.
 Infrastructure assets have few substitutes and generate significant
economies of scale, so they have the characteristics of a natural
monopoly.
 A key feature of public capital is that they create externalities.
 Other factors driving growth
 Researchers have focused on the positive externalities associated with
research and development and public education.
 The key point for economic growth is that there may be constant or
increasing returns to the inputs, and thus the economy is no longer
constrained by diminishing marginal productivity.
 Externalities also have a negative effect on growth, with pollution
being the primary example.
11-11
 Reading
11

Understanding Business Cycles

 1. Business cycles

Framework 2. Theories of business cycles

3. Economic indicators
4. Unemployment
5. Inflation
 Business Cycle
and Four Phases

1-8
 Business Cycles
 Business cycles are recurrent expansions and contractions in economic
activity affecting broad segments of the economy. In duration, business
cycles vary from more than one year to 10 or 12 years.
 Two primary segments: the expansion, or the upswing, and the
contraction, or the downturn
 With two key turning points: peaks and troughs

Level of National Economic Activity

Peak

Peak

Trough
Time
2-8
 Business Cycles
 Types of business cycle
 1) Classical cycle: refers to fluctuations in the level of economic
activity (e.g., measured by GDP in volume terms).
 The contraction phases between peaks and troughs are often short,
while expansion phases are much longer.

3-8
 Business Cycles
 Types of business cycle
 2) Growth cycle refers to fluctuations in economic activity around the
long-term potential or trend growth level.
 The focus is on how much actual economic activity is below or
above trend growth in economic activity.
 Compared to the classical view of business cycles, peaks are
generally reached earlier and troughs later in time.

4-8
 Business Cycles
 Types of business cycle
 3) Growth rate cycle refers to fluctuations in the growth rate of
economic activity (e.g., GDP growth rate).
 Peaks and troughs are mostly recognized earlier than when using
the other two definitions.

5-8
 Business Cycles
 Practical Issues
 The classical cycle definition is rarely used.
 In line with how most economists and practitioners view the cycle, we
will generally be using the growth cycle concept in which business
cycles can be thought of as fluctuations around potential output.

6-8
 Business Cycles
 Four phases of business cycle
 The overall business cycle can be split into four phases: recovery,
expansion, slowdown, contraction.

7-8
 Business cycles
 Four phases of business cycle
 Recovery
 Economy starts at trough and output below potential.
 Activity picks up, and gap starts to close.
 Expansion
 Economy enjoying an upswing, with activity measures showing
above-average growth rates.
 Slowdown
 Economy at peak.
 Activity above average but decelerating. The economy may
experience shortages of factors of production as demand may
exceed supply.
 Contraction
 Economy goes into a contraction, (recession, if severe).
 Activity measures are below potential. Growth is lower than normal.

8-8
Credit Cycles

1-3
 Credit cycles
 Credit cycles describe the changing availability—and pricing—of credit.
They describe growth in private sector credit (availability and usage of loans),
which is essential for business investments and household purchases of
real estate.
 When the economy is strong or improving, the willingness of lenders
to extend credit, and on favorable terms, is high.
 Conversely, when the economy is weak or weakening, lenders pull back,
or “tighten” credit, by making it less available and more expensive.
 This frequently contributes to the decline of such asset values as real
estate, causing further economic weakness and higher defaults.
 This is because of the importance of credit in the financing of
construction and the purchase of property.

2-3
 Credit cycles
 Applications of credit cycles
 Loose credit conditions often lead to asset price and real estate bubbles
that burst when capital market outflows and drawdowns occur mostly due
to weaker fundamentals.
 Credit cycles tend to be longer, deeper, and sharper than business cycles.
 Consequences for policy
 Investors pay attention to the stage in the credit cycle because
 It helps them understand developments in the housing and construction
markets;
 It helps them assess the extent of business cycle expansions as well as
contractions, particularly the severity of a recession if it coincides with
the contraction phase of the credit cycle;
 It helps them better anticipate policy makers’ actions.
 Whereas monetary and fiscal policy traditionally concentrate on reducing
the volatility of business cycles, macro-prudential stabilization policies that
aim to dampen financial booms have gained importance.

3-3
Business Cycle
Fluctuations

1-11
 Business Cycle Fluctuations
 Business cycle phases

2-11
 Business Cycle Fluctuations
 Unemployment
 Levels of employment lag the cycle
 Recovery
 Layoffs slow.
 Businesses rely on overtime before moving to hiring.
 Unemployment remains higher than average.
 Expansion
 Businesses move from using overtime and temporary employees to
hiring.
 Unemployment rate stabilizes and starts falling
 Slowdown
 Businesses continue hiring but at a slower pace.
 Unemployment rate continues to fall but at slowly decreasing rates.
 Contraction
 Businesses first cut hours, eliminate overtime, and freeze hiring,
followed by outright layoffs.
 Unemployment rate starts to rise.
3-11
 Business Cycle Fluctuations
 Business conditions
 Recovery
 Excess capacity during trough, low utilization, little need for capacity
expansion.
 Interest rates tend to be low — supporting investment.
 Expansion
 Companies enjoy favorable conditions.
 Capacity utilization increases from low levels.
 Over time, productive capacity may begin to limit ability to respond
to demand.
 Growth in earnings and cash flow gives businesses the financial
ability to increase investment spending.
 Slowdown
 Business conditions at peak, with healthy cash flow.
 Interest rates tend to be higher—aimed at reducing overheating and
encouraging investment slowdown.
 Contraction
 Companies experience fall in demand, profits, and cash flows
4-11
 Business Cycle Fluctuations
 Capital spending
 Recovery
 Low but increasing as companies start to enjoy better conditions.
 Capital expenditures focus on efficiency rather than capacity.
 Upturn most pronounced in orders for light producer equipment.
 Expansion
 Customer orders and capacity utilization increase.
 Companies start to focus on capacity expansion.
 Slowdown
 New orders intended to increase capacity may be an early indicator
of the late stage of the expansion phase.
 Companies continue to place new orders as they operate at or near
capacity.
 Contraction
 New orders halted, and some existing orders canceled.
 Initial cutbacks may be sharp and exaggerate the economy’s
downturn.
5-11
 Business Cycle Fluctuations
 Inventory to sales ratio
 Recovery
 Sales decline slows.
 Production upturn follows but lags behind sales growth.
 Begins to fall as sales recovery outpaces production.
 Expansion
 Sales increase.
 Production rises fast to keep up with sales growth and to replenish
inventories of finished products.
 Ratio stable.
 Slowdown
 Sales slow faster than production; inventories increase.
 Ratio increases. Signals weakening economy.
 Contraction
 Businesses produce at rates below the sales volumes necessary to
dispose of unwanted inventories.
 Ratio begins to fall back to normal.
6-11
 Consumer Behavior
 Consumer Confidence
 Consumer confidence plays a significant role in spending decisions and
reflects expectations of future incomes and employment prospects.
 Consumer Spending
 The exhibit shows how consumer spending changes through the
economic cycle, and it splits consumer spending into three parts: (1)
durable goods, (2) non-durable goods, and (3) services.
 Spending on durables is the most cyclical part, while spending on
non-durables is the least cyclical.
 Spending on services, which include both more and less cyclical
sub-components, in aggregate fits between the durable and non-
durable goods categories.
 It is also worth noting that consumer spending, including that on
durables, while cyclical, is less cyclical than investment spending by
firms.

7-11
 Consumer Behavior
 Consumer Spending

8-11
 Consumer Behavior
 Income Growth
 Growth in income is normally a good indicator of consumption
prospects.
 Consumer spending based on a concept termed permanent income.
 Saving Rates
 A rise in the saving rate, usually measured as a percentage of income,
may indicate caution among households and signal economic
weakening.
 At the same time, the greater the stock of savings in the household
sector and the wider the gap between ongoing income and spending,
the greater the capacity for households to increase their spending.

9-11
 Housing Sector Behavior
 Factors Impacting Housing Sector:
 Interest rates: Because many home buyers finance their purchase with a
loan (called mortgage in some countries), the sector is especially sensitive
to interest rates. Home buying and consequently construction activity
expand in response to lower loan interest rates and contract in response to
higher loan interest rates.
 Housing prices relative to income: When housing prices are low relative to
average incomes, and especially when mortgage rates are also low, the cost
of owning a house falls and demand for housing increases.
 Speculative activity: If housing prices have risen rapidly in the recent past,
for instance, many people will buy to gain exposure to the expected further
price gains even as the purchase in other respects becomes harder to
rationalize. Such behavior can extend the cycle upward and may later result
in a more severe correction. This result occurs because “late buying” activity
invites overbuilding.
 The role of demographics: the proportion of the population in the 25- to
40-year-old segment is positively related to activity in the housing sector
because these are the ages of greatest household formation.
10-11
 External Trade Sector Behavior
 Cyclical fluctuations of imports and exports
 Typically, imports rise, all else equal, with the pace of domestic GDP
growth because rising domestic demand increases purchases of goods
and services, by consumers and business, from abroad. Thus, imports
respond to the domestic cycle.
 Exports are more dependent on cycles in the rest of the world. If
these external cycles are strong, all else equal, exports will grow even if
the domestic economy should experience a decline in growth.
 The role of the exchange rate
 When a nation’s currency appreciates, foreign goods seem cheaper than
domestic goods to the domestic population, prompting, all else equal, a
relative rise in imports.
 At the same time, such currency appreciation makes that nation’s
exports more expensive in global markets and may reduce exports.

11-11
 Theories of
Business Cycle

1-5
 Theories of the Business Cycle
 Neoclassical Economics (so-called Real Business Cycle RBC)
 Stress the importance of movements in the supply curve.
 Technological progress, natural disasters, changes in relative prices
of key inputs, other supply side constraints, or changes in firm
expectations lead to changes in the position of the supply curve.
 RBC models of the business cycle conclude that expansions and
contractions represent efficient operation of the economy in response to
external real shocks; the level of economic activity at any time is
consistent with maximizing expected utility. （市场是有效的，效用始终
可以达到最大化）
 Governments should not to intervene in the economy with
discretionary fiscal and monetary policy.
 外部冲击影响了AS，AS的改变引起了经济周期，主张政府不要干预经济

2-5
 Theories of the Business Cycle
 The Austrian School
 The so-called Austrian school, another “non-intervention” theory,
shares many views of the neoclassical economists.
 In contrast to the neoclassical school, however, it focuses on the role of
money.
 Austrian economists argue that low interest rates and excessive
credit growth during boom times result in over-investment in
projects with low returns, causing failure and a move into recession.
 They argue that following a period of overinvestment, companies
will realize that they have overinvested, resulting in a sudden drop in
investment with a negative shock for aggregate demand.
 Austrian school sees business cycles arising from government (and
central bank) policies as the cause of overinvestment and subsequent
failure, they suggest that policy makers should rarely intervene in the
economy.
 政府政策引起投资改变从而引起经济周期，主张政府不要干预经济

3-5
 Theories of the Business Cycle
 Monetarism
 For monetarists, other than maintaining steady growth of the money
supply, government should play only a very limited role in the
economy. They reject active management of aggregate demand.
 According to the monetarist school, business cycles may occur both
because of exogenous shocks and because of government intervention.
So, it is better to let aggregate demand and supply find their own
equilibrium than to risk causing further economic fluctuations.
 In contrast to neoclassical economists, a key part of monetarist
thought is that the money supply needs to continue to grow at a
moderate rate. If it falls, as occurred in the 1930s, the economic
downturn could be severe; whereas if money grows too fast, inflation
will follow.
 由于外部冲击和政府干预（主要是货币供应量的改变）引起的经济周期，
主张政府不要干预经济
4-5
 Theories of the Business Cycle
 Keynesianism
 Keynesians see an active role for the government in managing
aggregate demand. Movements in the AD curve, therefore, have large
consequences on the overall output of the economy.
 Keynesian-oriented theories give limited importance to the supply curve.
Instead of thinking about it as being rather steep, these theories see
prices being sticky in the short run, leading to a relatively flat AS
curve.
 It is argued that nominal wages, as one of the most important
prices in the economy, are generally rigid and not downward flexible;
workers do not want to see their nominal compensation decrease.
 Keynesian economists advocate government intervention in the
form of fiscal policy.
 While Keynes accepted the possibility that markets would reach the
equilibrium envisioned by neoclassical economists over the long run, he
famously quipped that “in the long run, we are all dead”.
 由于AD改变引起的经济周期，主张政府干预经济
5-5
Economic
Indicators

1-8
 Economic Indicators
 Economic indicators are variables that provide information on the state of
the overall economy.
 Types of economic indicators
 Leading economic indicators: have turning points that usually precede
overall economy.
 In the United States, for instance, The Conference Board, a US
industry research organization, publishes a composite leading
indicator known as the Conference Board Leading Economic
Index (LEI) that consists of 10 component parts.
 Coincident economic indicators: have turning points that are usually
close to overall economy.
 Lagging economic indicators: have turning points that are usually later
to overall economy.

2-8
Economic Indicators

3-8
 Economic Indicators
Leading Reason

Business will cut overtime before laying off

Average weekly hours, workers in a downturn and increase it before
manufacturing rehiring in a cyclical upturn.
Move up and down before the general economy.

Average weekly initial claims

A very sensitive test of initial layoffs and rehiring.
for unemployment insurance

Because businesses cannot wait too long to meet

Manufacturers' new orders for demands for consumer goods or materials
consumer goods and without ordering.
materials Orders tend to lead at upturns and downturns &
captures business sentiment

4-8
 Economic Indicators
Leading Reason
Reflects the month on month change in new orders for
ISM new order
final sales. Decline of new orders can signal weak demand
index
and can lead to recession.
Manufacturers' new
Captures business expectations and offers first signal of
orders for non-defense
movement up or down. Important sector.
capital goods
Average consumer Optimism tends to increase spending. Provides
expectations for early insight into the direction ahead for the whole
business conditions economy.
 These indicators are all survey based
 ISM new order index: The Institute of Supply Management (ISM) polls its members to
build indexes of manufacturing orders, output, employment, pricing, and comparable
gauges for services.
 A diffusion index usually measures the percentage of components in a series that
are rising in the same period. It indicates how widespread a particular movement in
the trend is among the individual components.
5-8
 Economic Indicators
Leading Reason
Building permits for new Signals new construction activity as permits required
private housing units before new building can begin.

Stocks tends to anticipate economic turning points;

S&P 500 Stock Index
useful early signal.

A vulnerable financial system can amplify the effects

Leading Credit Index
of negative shocks, causing widespread recessions.

 Leading credit index: Aggregates the information from six leading financial
indicators, which reflect the strength of the financial system to endure stress.

6-8
 Economic Indicators

Leading Reason

LT (10 or 30 year) bond yields express market

Interest rate spread
expectations about the direction of short-term interest
between 10-year
rates. As rates ultimately follow the economic cycle up
treasury yields and
and down, a wider spread, by anticipating short rate
overnight borrowing
increases, also anticipates an economic upswing and
rates (federal funds rate)
vice versa.

 Interest rate spread: Inversion of the yield curve occurs when ST interest rate
exceed LT rates – meaning that ST rates are expected to fall and activity is
expected to weaken.

7-8
 Economic Indicators
 Surveys
 The composite indicators for region- or country-specific business cycles
often make use of economic tendency surveys.
 The Use of Big Data in Economic Indicators
 The vast increase in this information and academic developments regarding
the use of big data have in recent years increased the number of variables
that go into these composite indicators.
 E.g., principal components analysis
 Nowcasting
 Policy makers and market practitioners use real-time monitoring of
economic and financial variables to continuously assess current
conditions.
 GDPNow
 “GDPNow” is “best viewed as a running estimate of real GDP growth
based on available data for the current measured quarter.”
 The objective is to forecast GDP for the current quarter in real time based
on data as they are released throughout the quarter.

8-8
Unemployment

1-4
 Key Terms in the Labor Market
 Labor force: number of people who either have a job or are actively looking for
a job.
 This number excludes retirees, children, stay-at-home parents, fulltime
students, and other categories of people who are neither employed nor
actively seeking employment.
 Employed: number of people with a job.
 This figure normally does not include people working in the informal sector
(e.g., unlicensed cab drivers, illegal workers, etc.)
 Unemployed: People who are actively seeking employment but are currently
without a job.
 Long-term unemployed: People who have been out of work for a long
time (more than three to four months in many countries) but are still looking
for a job.
 Frictionally unemployed: People who are not working at the time of filling
out the statistical survey because they are taking time to search for a job
that matches their skills, interests, and other preferences better than what is
currently available, or people who have left one job and are about to start
another job. Frictional unemployment is short-term and transitory in nature.
2-4
 Key Terms in the Labor Market
 Underemployed
 Person who has a job but has the qualifications to work a significantly
higher-paying job.
 Discouraged worker
 Person who has stopped looking for a job. Perhaps because of a weak
economy, the discouraged worker has given up seeking employment.
 When economy returns to be good, the unemployment rate will
increase because the discouraged workers enter the labor force and has
not found the job.
 Voluntarily unemployed
 Person voluntarily outside the labor force.
 For example: a jobless worker refusing an available vacancy for which
the wage is lower than their threshold or those who retired early.

3-4
 Key Terms in the Labor Market
 Unemployment rate: The ratio of unemployed to labor force.
number of unemployed
Unemployment rate  100
labor force
 Unemployment rate is a lagging economic indicator of the business
cycle.
 Because every individual provides a different type and quality of labor,
some segments of the economy may have trouble finding enough
qualified workers even during a contraction. As a result, the non-
accelerating inflation rate of unemployment (NAIRU), also called the
natural rate of unemployment (NARU), can be higher than the rate
associated with the absence of cyclical unemployment. (自然失业率：充
分就业下的失业率 or 不会造成通胀的失业率)
 Participation rate (or activity ratio): The ratio of labor force to total
population of working age (i.e., those between 16 and 64 years of age).
labor force
Labor force participation rate= 100
Working  age population
4-4
Inflation

1-10
 Inflation, Deflation and Disinflation
 Inflation refers to a sustained rise in the overall level of prices in an
economy.
 Inflation rate is the percentage increase in the price level, index — that
is, the speed of overall price level movements..
 Hyperinflation: an extremely fast increase in aggregate price level, which
corresponds to an extremely high inflation rate — for example, 500% to
1,000% per year.
 Deflation: a sustained decrease in aggregate price level, which corresponds
to a negative inflation rate — that is, an inflation rate of less than 0%.
 Disinflation
 A decline in the inflation rate.
 Disinflation is very different from deflation because even after a period
of disinflation, the inflation rate remains positive and the aggregate
price level keeps rising (although at a slower speed).

2-10
 Inflation Measurement
 The consumer price index (CPI): most countries use a CPI specific to the
domestic economy to track inflation.
 Analysts who compare price indexes for different countries should be
aware of differences in their composition.
 The weights assigned to each good and service reflect the typical
consumer’s purchasing patterns, which are likely to be significantly
different across countries and regions.
 There can be differences in how the data are collected.
 Central banks typically use consumer price indexes to monitor inflation
and evaluate their monetary policies.
 The CPI for the United States covers only urban areas using a household
survey, which is why it is called the CPI-U.
 Using business surveys, the personal consumption expenditure (PCE)
price index covers all personal consumption in the United States.
3-10
 Inflation Measurement
 Producer price index (PPI)/Wholesale price index (WPI): reflect future
CPI
 Reflect the price changes experienced by domestic producers in a
country.
 Include: fuels, farm products (such as grains and meat), machinery and
equipment, chemical products (such as drugs and paints), transportation
equipment, metals, pulp and paper, and so on.
 The differences in the weights can be much more dramatic for the PPI
than for the CPI because different countries may specialize in different
industries.
 GDP deflator reflects the prices of the goods and services produced
domestically.

4-10
 Inflation Measurement
 For both consumer and producer prices, analysts and policymaker often
distinguish between headline inflation and core inflation.
 Headline inflation refers to price indexes for all goods.
 Core inflation usually refers to the inflation rate calculated based on a
price index of goods and services except food and energy.
 Policy makers often choose to focus on the core inflation rate
when reading the trend in the economy and making economic
policies As they try to avoid overreaction to short-term
fluctuations in food and energy prices that may not have a
significant impact on future headline inflation.

5-10
 Example-CPI Calculation
Time May 2017 June 2017
Goods Quantity Price Quantity Price
Rice 50kg ￥3/kg 70kg ￥4/kg
Gasoline 70liters ￥4.4/liter 60liters ￥4.5/liter

 Laspeyres index calculation (set the price index in May 2017 to 100)
 For May 2017, the total value of the consumption basket is:
Value of rice + Value of gasoline=(50*3)+(70*4.4)=￥458
 For June 2017, the total value of the consumption basket is:
Value of rice + Value of gasoline=(50*4)+(70*4.5)=￥515
515
Laspeyres index  100  112.45
458
 Paasche index calculation

Paasche index06/ 2017 

 70  4    60  4.5  100  116.03
 70  3   60  4.4 
 Fisher index calculation
Fisher index06/2017  I P  I L  116.03 112.45  114.23
6-10
 Measures of Inflation: Price Index
 A price index created by holding the composition of the consumption basket
constant is called a Laspeyres index..
 Three factors cause a Laspeyres index of consumer prices to be biased upward
as a measure of the cost of living:
 New goods. New products are frequently introduced, but a fixed basket of
goods and services will not include them. In general, this situation again
creates an upward bias in the inflation rate.
 Quality changes. As the quality of the same product improves over time, it
satisfies people’s needs and wants better. One such example is the quality of
cars. Over the years, the prices of cars have been rising while the safety and
reliability of cars have been enhanced. If not adjusted for quality, the
measured inflation rate will experience another upward bias.
 Substitution. As the price of one good or service rises, people may
substitute it with other goods or services that have a lower price. This
substitution will result in an upward bias in the measured inflation rate
based on a Laspeyres index.

7-10
 Measures of Inflation: Price Index
 Solutions to Biases in Laspeyres Index
 Many countries adjust for the quality of the products in a basket, a
practice called hedonic pricing.
 New products can be introduced into the basket over time.
 The solution to substitution bias is to use chained price index formula:
 Paasche index: Using the current composition of the basket
instead of a constant basket of products.
 Fisher index: geometric mean of the Laspeyres index and Paasche
index.
Formula:
IF  IP  IL

8-10
 Cost-push inflation
 Cost-push inflation: An inflation that results from an initial increase in costs is
called cost-push inflation.
 Considering cost-push inflation, analysts may look at commodity prices
because commodities are an input to production.
 But because wages are the single biggest cost to businesses, practitioners
focus most particularly on wage-push inflation, which is tied to the labor
market.
 Whereas the lower the unemployment rate, the greater the likelihood
shortages will drive up wages.
 The greater each worker’s output per hour (productivity), the lower the
price businesses need to charge for each unit of output to cover hourly
labor costs. And by extension, the faster output per hour grows, the
faster labor compensation can expand without putting undue pressure
on businesses’ costs per unit of output.
The equation for this unit labor cost (ULC) indicator, as it is called,
is as follows: ULC = W/O (ULC = unit labor costs, O = output per
hour per worker, W = total labor compensation per hour per
worker)
9-10
 Demand-pull Inflation
 The search for indicators from the demand-pull side of the inflation
question brings practitioners back to the relationship between actual and
potential real GDP and industrial capacity utilization.
 The higher the rate of capacity utilization or the closer actual GDP is
to potential, the more likely an economy will suffer shortages,
bottlenecks, a general inability to satisfy demand, and hence, price
increases.
 The more an economy operates below its potential or the lower the
rate of capacity utilization, the less such supply pressure will exist and
the greater likelihood of a slowdown in inflation, or outright deflation.
 Taking a different perspective, Monetarists contend that inflation is
fundamentally a monetary phenomenon.
 Excess money causes inflationary pressure by increasing liquidity,
which ultimately causes a rapid rise in demand.

10-10
 Reading
12

Monetary and Fiscal Policy

 1. Monetary Policy

Framework • Money Multiplier

• Quantity Theory of Money
• Fisher Effect
• Monetary Policy Tools
• Neutral Interest Rate
• Limitation of Monetary Policy
2. Fiscal Policy
• Fiscal Policy Tools
• Fiscal Multiplier
• Limitation of Fiscal Policy
Money Creation
Process

1-4
 Monetary Policy
 Monetary policy refers to the central bank’s actions that affect the
quantity of money and credit in an economy in order to influence economic
activity.
 Monetary policy is said to be expansionary when the central bank
increases the quantity of money and credit in an economy.
 When the central bank is reducing the quantity of money and credit in
an economy, the monetary policy is said to be contractionary.
 Goals for Monetary Policies:
 Maintain stable prices;
 Produce positive economic growth.

2-4
 Functions of Money
 Functions of money:
 Medium of exchange or means of payment
 Unit of account
 Store of value

3-4
 How Money is Created
 How Do the Banks Create Money ?

Reserve Loan
Bank1 100
Bank2 10 90
Bank3 9 81
… … …

Ms=100/(1-0.9)=1000

new deposit 100

Money created =   1000
reserve requirement 0.1

1 1
Money multiplier =   10
reserve requirement 0.1

4-4
Fisher Effect

1-5
 Quantity Theory of Money
 The quantity theory of money states that quantity of money is some
proportion of the total spending in an economy and implies the quantity
equation of exchange
money supply  velocity  price  real output  MV  PY 
 Price multiplied by real output is total spending so that velocity is the
average number of times per year each unit of money is used to buy goods
or services. The equation of exchange must hold with velocity defined in this
way.
 Monetarists believe that velocity and the real output of the economy change
only slowly.
 Assuming that velocity and real output remain constant, any increase in
the money supply will lead to a proportionate increase in the price
level.
 An increase in the money supply is thought in the long run simply to lead to
an increase in the price level while leaving real variables like output and
employment unaffected—is known as money neutrality.
 A fundamental assumption when monetary policy is used to influence
the economy: Money is not neutral in the short run.
2-5
 Fisher Effect
 The Fisher effect states that the nominal interest rate is simply the sum of
the real interest rate and expected inflation.
 R Nom  R Real  E  I
 RNom = nominal interest rate
 RReal = real interest rate
 E[I] = expected inflation
 The idea behind the Fisher effect is that real rates are relatively stable,
and changes in interest rates are driven by changes in expected
inflation. This is consistent with money neutrality.
 Investors are exposed to the risk that actual inflation may differ from
expected inflation. Investors require an additional return (a risk premium) for
bearing this risk, which we can consider a third component of a nominal
interest rate.
R Nom  R Real + E  I +RP
RP = risk premium for inflation uncertainty

3-5
 Expected Inflation
 Expected inflation is clearly the level of inflation that economic agents
expect in the future.
 Expected inflation can give rise to:
 Menu costs: at a micro level, high inflation means that businesses
constantly have to change the advertised prices of their goods and
services.
 Shoe leather costs: in times of high inflation, people would naturally
tend to hold less cash and would therefore wear out their shoe leather
(or more likely the engines of their cars) in making frequent trips to the
bank to withdraw cash.

4-5
 Unexpected Inflation
 Unexpected inflation can be defined as the level of inflation that we experience
that is either below or above that which we expected; it is the component of
inflation that is a surprise.
 Unexpected inflation is most costly:
 When inflation is higher than expected, borrowers gain at the expense of
lenders as loan payments in the future are made with currency that has less
value in real terms.
 Conversely, inflation that is less than expected will benefit lenders at the
expense of borrowers.
 In an economy with volatile (rather than certain) inflation rates, lenders will
require higher interest rates to compensate for the additional risk they face
from unexpected changes in inflation.
 Higher borrowing rates slow business investment and reduce the level
of economic activity.
 Unanticipated (unexpected) inflation can reduce the information content of
market prices.
5-5
Objectives of
Central Bank

1-4
 Role and Objectives of Central Bank
 Role of central bank
 Sole supplier of currency
 Banker to the government and other banks
 Lender of last resort
 Supervise banks
 Holder of gold and foreign exchange reserves
 Conductor of monetary policy
 Objectives of a central bank
 Control inflation so as to promote price stability
 Stability in exchange rates with foreign currencies
 Full employment
 Sustainable positive economic growth
 Moderate long-term interest rates
2-4
 Qualities of Effective Central Banks
 Independence
 It should be free from political interference.
 Independence should be thought of in relative terms (degrees of
independence) rather than absolute terms.
 Independence can be evaluated based on both operational
independence and target independence.
 Operational independence means that the central bank is allowed
to independently determine the policy rate.
 Target independence means the central bank also defines how
inflation is computed, sets the target inflation level, and determines
the horizon over which the target is to achieved.

3-4
 Qualities of Effective Central Banks
 Credible
 Central banks should follow through on their stated intentions.
 If government with large debts, instead of a central bank, set an inflation
target, the target would not be credible because the government has an
incentive to allow inflation to exceed the target level.
 A credible central bank's targets can become self-fulfilling prophecies.
Actual inflation will then be close to that level.
 Transparent
 Transparency on the part of central banks aids their credibility.
Transparency means central banks periodically disclose the state of the
economic environment by issuing Inflation Reports.

4-4
Monetary Policy
Tools

1-6
 Tools of the Central Bank
 Policy Rate
 In the United States, the federal funds rate is the rate that banks charge
each other on overnight loans of reserves.
 In the United Stated, banks can borrow funds from the Fed. The rate at
which banks can borrow reserves from the Fed is termed the discount
rate. For the European Central Bank (ECB), it is called the refinancing rate.
 One way to lend money to banks is through a repurchase agreement.
The Bank of England uses this method, and police rate is called the two-
week repo (repurchase) rate.
 A lower rate reduces banks’ cost of funds encourage lending, and tends
to decrease interest rates.
 A higher policy rate increases banks’ cost of funds discourage lending,
and tends to increase interest rates.
 Policy rate ↓ → 融资成本低，释放流动性 （扩张的货币政策）
 Policy rate ↑ → 融资成本高，收紧流动性 （紧缩的货币政策）
2-6
 Tools of the Central Bank
 Reserve requirements
 Reserve requirement ↑ → available funds for lending ↓→ money supply ↓
→ interest rate ↑
 This tool only works well to increase the money supply if banks are
willing to lend and customers are willing to borrow.
 存款准备金 ↑ → 紧缩的货币政策
 存款准备金 ↓ → 扩张的货币政策
 Open market operations
 Central bank buy securities – funds available funds for lending ↑ -
money supply ↑ - interest rate ↓
 This tool is the Fed’s most commonly used tool.
 央行买债券 → 扩张的货币政策
 央行卖债券 → 紧缩的货币政策
3-6
 Neutral Interest Rate
 An economy’s long-term sustainable real growth rate is called the real
trend rate or, the trend rate.
 The neutral interest rate of an economy is the growth rate of the money
supply that neither increases nor decreases the economic growth rate
 Neutral interest rate = real trend rate of economic growth +
inflation target
 Policy rate> Neutral rate: contractionary
 Policy rate< Neutral rate: expansionary
 Inflation will place impact on monetary policy.

4-6
 Monetary Transmission Mechanism
 The monetary transmission mechanism refers to the ways in which a change in
monetary policy, specifically the central bank’s policy rate, affects the price level
and inflation.
 Banks’ short-term lending rates will increase in line with the increase in
the policy rate. The higher rates will decrease aggregate demand as
consumers reduce credit purchases and businesses cut back on investment
in new projects.
 Bond prices, equity prices, and asset prices in general will decrease as
the discount rates applied to future expected cash flows are increased. This
way have a wealth effect because a decrease in the value of householders’
assets may increase the savings rate and decrease consumption.
 Both consumers and businesses may decrease their expenditures
because their expectations for future economic growth decrease.
 The increase in interest rates may attract foreign investment in debt
securities, leading to an appreciation of the domestic currency
increases the foreign currency prices of exports and can reduce demand for
the country’s export goods.
 Taken together, these effects act to decrease aggregate demand and put
downward pressure the price level. 5-6
 Different Targets Used by Central Banks
 Central banks have used various economic variables and indicators over the
years to make monetary policy decisions.
 Interest rate targeting
 Increasing the money supply when specific interest rates rose above
the target band and decreasing the money supply when rates fell
below the target band.
 Inflation targeting
 The most common inflation rate target is 2%, with a permitted
deviation of (+-)1% so the target band is 1% to 3%.
 Exchange rate targeting
 That is, they target a foreign exchange rate between their currency
and another (often the U.S. dollar).
 As an example, consider a country that has targeted an exchange
rate for its currency versus the U.S. dollar. If the foreign exchange
value of the domestic currency falls relative to the U.S. dollar, the
monetary authority must use foreign reserves to purchase their
domestic currency in order to reach the target exchange rate.

6-6
 Limitation of
Monetary Policy

1-3
 Limitation of Monetary Policy
 The transmission mechanism for monetary policy does not always
produce the intended results
 Long-term rates may not rise and fall with short-term rates because
of the effect of monetary policy changes on expected inflation.
 Monetary tightening may be viewed as too extreme, increasing the
probability of a recession, making long-term bonds more attractive
and reducing long-term interest rates.
 Bond market participants that act in this way have been called bond
market vigilantes.

2-3
 Limitation of Monetary Policy
 Another situation in which the transmission mechanism may not
perform as expected is if demand for money becomes very elastic and
individuals willingly hold more money even without a decrease in short-
term rates. Such a situation is called a liquidity trap.
 Increasing growth of the money supply will not decrease short-term
rates under these conditions because individuals hold the money in
cash balances instead of investing in interest-bearing securities.
 If an economy is experiencing deflation even though money supply
policy has been expansionary, liquidity trap conditions may be
present.
Deflation is more difficult for central banks to reverse (mindset)
 Another reason standard tools for increasing the money supply might
not increase economic is that even with increasing excess reserves,
banks may not be willing to lend.
 Banks decreased their lending, even as money supplies were
increased and short-term rates fell.
 With short-term rates near zero, economic growth still poor, and a real
threat of deflation, central banks began a policy termed quantitative
easing.
3-3
Fiscal Policy

1-8
 Fiscal Policy
 Fiscal policy refers to the government’s decisions about taxation (T) and
spending (G).

 T-G

 >0 (budget surplus)

 <0 (budget deficit)

 =0 (budget balanced)

 Objectives of fiscal policy may include

 Influencing the level of economic activity and aggregate demand

 Redistributing wealth and income among segments of the population

 Allocating resources among economic agents and sectors in the

economy.

2-8
 Fiscal Policy
 Fiscal policy refers to a government’s use of spending and taxation to meet
macroeconomic goals.
 Keynesian economists believe that fiscal policy, through its effect on
aggregate demand, can have a strong effect on economic growth
when the economy is operating at less than full employment.
 Monetarists believe that the effect of fiscal stimulus is only temporary
and that monetary policy should be used to increase or decrease
inflationary pressures over time. Monetarists do not believe that
monetary policy should be used in an attempt to smooth cyclical
changes in economic activity.

3-8
 Fiscal Policy Tools
 Spending Tools
 Current spending: involves spending on goods and services that are
provided on a regular, recurring basis—including health, education, and
defense.
 Such spending will have a big impact on a country’s skill level and
overall labor productivity.
 Capital spending: includes infrastructure spending on roads, hospitals,
prisons, and schools.
 This investment spending will add to a nation’s capital stock and
affect productive potential for an economy.
 Transfer payments: are welfare payments made through the social
security system and, depending on the country, comprise payments for
state pensions housing benefits, tax credits and income support for
poorer families, child benefits, unemployment benefits, and job search
allowances.
 Transfer payments exist to provide a basic minimum level of income
for low-income households, and they also provide a means by which
a government can change the overall income distribution in a
society.
4-8
 Fiscal Policy Tools
 Justification for spending tools
 Provide services such as national defense that benefit all the residents in
a country.
 Invest in infrastructure to enhance economic growth
 Support the country's growth and unemployment targets by directly
affecting aggregate demand
 Provide a minimum standard of living.
 Subsidize investment in research and development for certain high-risk
ventures consistent with future economic growth or other goals (e.g.,
green technology)

5-8
 Fiscal Policy Tools
 Revenue Tools
 Direct taxes are levied on income, wealth, and corporate profits and
include capital gains taxes, national insurance (or labor) taxes, and
corporate taxes. They may also include a local income or property tax
for both individuals and businesses.
 Indirect taxes are taxes on spending on a variety of goods and services
in an economy—such as the excise duties on fuel, alcohol, and tobacco
as well as sales (or value-added tax)—and often exclude health and
education products on social grounds. 影响更快

6-8
 Fiscal Policy Tools
 Desirable attributes of tax policy
 Simplicity to use and enforce
 Efficiency, having the least interference with market forces and not
acting as a deterrent to working.
 Fairness is quite subjective, but two commonly held beliefs are
 Horizontal equality: people in similar situations should pay similar
taxes
 Vertical equality: richer people should pay more in taxes
 Sufficiency, in that taxes should generate sufficient revenues to meet
the spending needs of the government.

7-8
 Fiscal Multiplier
 Fiscal multiplier

 Fiscal multiplier = 1 1

1  MPC(1-t) 1  b  (1-t)

 MPC: Marginal propensity of consumption (b)

 The fiscal multiplier is inversely related to the tax rate (higher tax rate
decreases the multiplier) and directly related to the marginal propensity
to consume (higher MPC increases the multiplier).

8-8
Limitations of
Fiscal Policy

1-4
 Limitations of Discretionary Fiscal Policy
 Limitations of Discretionary Fiscal Policy
 Economic forecasts might be wrong, leading to incorrect policy
decisions.
 Complications arise in practice that delay both the implementation of
discretionary fiscal policy and the impact of policy changes on the
economy. The lag can be divided into three types:
 Recognition lag: Discretionary fiscal policy decisions are made by a
political process. The state of the economy is complex, and it may
take policymakers time to recognize the nature and extent of the
economic problems.
 Action lag: The time governments take to discuss, vote on, and
enact fiscal policy changes.
 Impact lag: The time between the enactment of fiscal policy
changes and when the impact of the changes on the economy
actually takes place. It takes time for corporations and individuals to
act on the fiscal policy changes, and fiscal multiplier effects occur
only over time as well.

2-4
 Limitation of Fiscal Policy
 Additional macroeconomic issues may hinder usefulness of fiscal policy:
 Misreading economic statistics: The full employment level for an
economy is not precisely measurable. If the government relies on
expansionary fiscal policy mistakenly at a time when the economy is
already at full capacity, it will simply drive inflation higher.
 Crowding-out effect: Expansionary fiscal policy may crowd out private
investment, reducing the impact on aggregate demand.
 Supply shortages: If economic activity is slow due to resource
constraints (low availability of labor or other resources) and not due to
low demand, expansionary fiscal policy will fail to achieve its objective
and will probably lead to higher inflation.
 Limits to deficits: There is a limit to expansionary fiscal policy. If the
markets perceive that the deficit is already too high as a proportion of
GDP, funding the deficit will be problematic. This could lead to higher
interest rates and actually make the situation worse.
 Multiple targets: If the economy has high unemployment coupled with
high inflation, fiscal policy cannot address both problems
simultaneously. 3-4
 Ricardian Equivalence
 Ricardian Equivalence: Increases in the current deficit mean greater
taxes in the future.
 To maintain their preferred pattern of consumption over time, taxpayers
may increase current savings (reduce current consumption) in order to
offset the expected cost of higher future taxes.
 If taxpayers reduce current consumption and increase current saving by
just enough to repay the principal and interest on the debt the
government issued to fund the increased deficit, there is no effect on
aggregate demand.
 If taxpayers underestimate their future liability for servicing and repaying
the debt, so that aggregate demand is increased by equal spending and tax
increases, Ricardian equivalence does not hold.

4-4
 The size of a
national debt
relative to GDP

1-4
 National Debt
 Debt ratio: Aggregate national debt to GDP.
 Arguments for being concerned with the size of fiscal deficit:
 Higher deficits lead to higher future taxes. Higher future taxes will lead
to disincentives to work and entrepreneurship. This leads to lower long-
term economic growth.
 If markets lose confidence in the government, investors may not be
willing to refinance the debt. This can lead to the government defaulting
(if debt is in a foreign currency) or having to simply "print money" (if the
debt is in local currency). Printing money would ultimately lead to
higher inflation.
 Increased government borrowing will tend to increase interest rates, and
firms may reduce their borrowing and investment spending as a result,
decreasing the impact on aggregate demand of deficit spending. This is
referred to as the crowding-out effect because government borrowing is
taking the place of private sector borrowing.

2-4
 National Debt
 Arguments against being concerned with the size of fiscal deficit:
 If the debt is primarily being held by domestic citizens, the scale of the
problem is overstated.
 If the debt is used to finance productive capital investment, future
economic gains will be sufficient to repay the debt.
 Fiscal deficits may prompt needed tax reform.
 Deficits would not matter if private sector savings in anticipation of
future tax liabilities just offsets the government deficit (Ricardian
equivalence holds).
 If the economy is operating at less than full capacity, deficits do not
divert capital away from productive uses. On the contrary, deficits can
aid in increasing GDP and employment.

3-4
 Implementation of Fiscal Policy
 Fiscal policy is implemented through changes in taxes and spending. This is
called discretionary fiscal policy
 During recessions, actions can be taken to increase government
spending or decrease taxes. Either change tends to strengthen the
economy by increasing aggregate demand, putting more money in the
hands of corporations and consumers to invest and spend.
 During inflationary economic booms, actions can be taken to
decrease government spending or increase taxes. Either change tends to
slow the economy by decreasing aggregate demand, taking money out
the hands of corporations and consumers, causing both investment and
consumption spending to fall.

4-4
Interaction of
Monetary and
Fiscal Policy

1-4
 Interaction of Monetary and Fiscal Policy

Monetary Fiscal Private Public

Interest rate Output
policy policy spending spending

Tight Tight higher lower lower lower

Easy Easy lower higher higher higher

Tight Easy higher lower higher higher

Easy Tight lower higher lower varies

2-4
 Interaction of Monetary and Fiscal Policy
 Easy fiscal policy/tight monetary policy: If taxes are cut or government
spending rises, the expansionary fiscal policy will lead to a rise in aggregate
output. If this is accompanied by a reduction in money supply to offset the
fiscal expansion, then interest rates will rise and have a negative effect on
private sector demand. We have higher output and higher interest rates, and
government spending will be a larger proportion of overall national income.
 Tight fiscal policy/easy monetary policy: If a fiscal contraction is
accompanied by expansionary monetary policy and low interest rates, then
the private sector will be stimulated and will rise as a share of GDP, while the
public sector will shrink.

3-4
 Interaction of Monetary and Fiscal Policy
 Easy monetary policy/easy fiscal policy: If both fiscal and monetary policy
are easy, then the joint impact will be highly expansionary—leading to a rise
in aggregate demand, lower interest rates (at least if the monetary impact is
larger), and growing private and public sectors.
 Tight monetary policy/tight fiscal policy: Interest rates rise (at least if the
monetary impact on interest rates is larger) and reduce private demand. At
the same time, higher taxes and falling government spending lead to a drop
in aggregate demand from both public and private sectors.

4-4
 Reading
13

International Trade and Capital Flows

 1. Comparative Advantage
Framework 2. Trade Restrictions

3. Balance of Payments

4. International Organization

5. Trading Blocs, Common Markets, and

Economic Unions
Comparative
Advantage

1-6
 The Benefits of Trade
 The benefits of trade include:
 gains from exchange and specialization;
 gains from economies of scale as companies add new markets for their
 products;
 greater variety of products available to households and firms;
 increased competition and more efficient allocation of resources.

2-6
 Absolute and Comparative Advantage
 A country is said to have an absolute advantage in the production of a
good if it can produce the good at lower cost in terms of resources than
that of another country.
 A country is said to have a comparative advantage in the production of a
good if its opportunity cost in terms of other goods that could be
produced instead is lower than that of another country.
 The law of comparative advantage holds that trading partners can be
made better off if they specialize in the production of goods for which they
are the low-opportunity cost producer and trade for those goods for which
they are the high-opportunity cost producer.
 A country gains from international trade when it exports those goods
for which it has a comparative advantage and imports those goods
for which it does not.
 As long as opportunity costs differ, two countries can both benefit
from trade.

3-6
 Absolute and Comparative Advantage
 If two countries have different opportunity cost of producing goods, each
will have a comparative advantage in some goods, and trade will increase
the total production and consumption possibilities in both countries,
improving economic welfare.
 When each country specializes in the good for which they have a
comparative advantage and trades each other, there are clear gains existed.

A B
Product

X 10 9

Y 5 3

4-6
 Ricardian Model
 In the Ricardian model, labor is the only (variable) factor of production.
Differences in labor productivity, reflecting underlying differences in
technology, are the source of comparative advantage and hence the key
driver of trade in this model.
 In the two-country model, if countries vary in size, the smaller country
may specialize completely, but may not be able to meet the total demand
for the product.
 The larger country may be incompletely specialized, producing and
exporting the good in which it has a comparative advantage but still
producing ( and consuming) some of the good in which it has a
comparative disadvantage.
 It is important to recognize that although differences in technology may
be a major source of comparative advantage at a given point in time,
other countries can close the technology gap or even gain a technological
advantage.
5-6
 Heckscher-Ohlin Model
 In the Heckscher—Ohlin Model (also known as the factor-proportions
theory), both capital and labor are variable factors of production.
 Differences in the relative endowment of these factors are the source
of a country's comparative advantage.
 A country has a comparative advantage in goods whose production is
intensive in the factor with which it is relatively abundantly endowed,
and would tend to specialize in and export that good.
 It allows for the possibility of income redistribution through trade.
 Favorable impact on the abundant factor, and a negative impact
on the scarce factor.
 The price of the relatively less scare (more available) factor of
production in each country will increase.
 The good that a country imports will fall in price (that is why they
import it), and the good that a country exports will rise in price.

6-6
 Trade
Restrictions

1-9
 Reasons for Trade Restrictions
 Have support from Ecomomists
 Infant industry: Protection from foreign competition is given to new
industries to give them an opportunity to grow to an internationally
competitive scale and get up the learning curve in terms of efficient
production methods.
 National security: Protect producers of goods crucial to the country's
national defense so that those goods are available domestically in the event
of conflict.
 Little support in theory
 Protecting domestic jobs: While some jobs are certainly lost, and groups
and regions are negatively affected by import restrictions, other jobs (in
export industries or growing domestic goods and services industries) will be
created, and prices for domestic consumers will be less without import
restrictions.
 Protecting domestic industries: Industry firms often use political influence
to get protection from foreign competition, usually to the detriment of
consumers, who pay higher prices

2-9
 Types of Trade Restrictions
 Types of trade restrictions include:
 Tariffs: taxes on imported good collected by the government.
 Quotas: limits on the amount of imports allowed over some period.
 Export subsidies: government payments to firms that exports goods.
 Minimum domestic content: requirement that some percentage of
product content must be from the domestic country.
 Voluntary export restraint: a country voluntarily restricts the amount
of a good that can be exported, often in the hope of avoiding tariffs or
quotas imposed by their trading partner.

3-9
 Tariffs and Quotas
 Tariff placed on imported good increases the domestic price, decreases the
quantity imported, and increases the quantity supplied domestically.
 Domestic producers gain, foreign exporters lose, and the domestic
government gains by the amount of the tariff revenues.
 Quota restricts the quantity of a good imported to the quota amount.
 Domestic producers gain, and domestic consumers lose from an
increase in the domestic price.
 The right to export a specific quantity to the domestic country is
granted by the domestic government, which may or may not charge for
the import licenses to foreign countries.
 If the import licenses are sold, the domestic government gains the
revenue.

4-9
 Welfare Effects of an Import Tariff or Quota

Importing
Price Domestic Country
Supply
Consumer
-(A+B+C+D)
surplus

Producer
+A
Pt surplus
A B C D Domestic
P* Tariff
Demand
revenue or +C
Quota rents

0 Quantity National
Q1 Q2 Q3 Q4 -B-D
welfare

5-9
 Voluntary Export Restraint and Export Subsidies
 Voluntary export restraint (VER) refers to a voluntary agreement by a
government to limit the quantity of a good that can be exported
 It results in a welfare loss to the importing country equal to that of an
equivalent quota with no government charge for the import licenses;
that is, no capture of the quota rents.
 Export subsidies are payments by a government to its country’s exporters
 Export subsidies benefit producers (exporters) of the good but increase
prices and reduce consumer surplus in the exporting country.
 In a small country, the price will increase by the amount of the subsidy
to equal the world price plus the subsidy.
 In the case of a large exporter of the good, the world price decreases an
some benefits from the subsidy accrue to foreign consumers, while
foreign producers are negatively affected.

6-9
 Effects of Trade Restrictions
Tariff Import Quota Export Subsidy VER
Importing Exporting Importing
Impact on Importing country
county country country
Producer
Increases Increases Increases Increases
surplus
Consumer
Decreases Decreases Decreases Decreases
surplus
Mixed (depends on
whether the quota Falls
Government No change
Increases rents are captured by (government
revenue (rent to
the importing country spending rises)
foreigners)
through sale of licenses
or by the exporters)
Decreases in Decreases in small
National Small country country
welfare Could increase Decreases Decreases
Could increase in large
in large
country
country
7-9
 Effects of Trade Restrictions

Tariff Import Quota Export Subsidy VER

Importing Importing Exporting Importing

Impact on
country country country country

Price Increases Increases Increases Increases

Domestic
Decreases Decreases Decreases Decreases
consumption

Domestic
Increases Increases Increases Increases
production

Imports Imports Imports

Trade Exports increase
decrease decrease decrease

8-9
 Capital Restrictions
 Some countries impose capital restrictions on the flow of financial capital
across borders.
 Commonly cited objectives of capital flow restrictions include the following
 Reduce the volatility of domestic asset prices.
 In times of macroeconomic crisis, capital flows out of the country can
drive down asset prices drastically, especially prices of liquid assets such
as stocks and bonds.
 Maintain fixed exchange rates.
 For countries with fixed exchange rate targets, limiting flows of foreign
investment capital makes it easier to meet the exchange rate target and,
therefore, to be able to use monetary and fiscal policy to purse only the
economic goals for the domestic economy.
 Keep domestic interest rates low.
 By restricting the outflow of investment capital, countries can keep their
domestic interest rates low and manage the domestic economy with
monetary policy, as investors cannot pursue higher rate in foreign
countries.
 Protect strategic industries.
9-9
Balance of
Payments

1-6
 Balance of Payments (BOP)
 Balance of payments (BOP) is a double-entry bookkeeping system that
summarizes a country’s economic transactions with the rest of the world for
a particular period of time, typically a calendar quarter or year.
 Every transaction involves both a debit and credit.
 the sum of all debit entries should equal the sum of all credit entries,
and the net balance of all entries on the BOP statement should equal
zero.
 In practice, however, this is rarely the case because the data used to
record balance of payments transactions are often derived from
different sources.

2-6
 BOP Components
 Current account measures the flows of goods and services.
 Merchandise trade: consists of all raw materials and manufactured goods
bought, sold, or given away.
 Services include tourism, transportation, and business and engineering
services, as well as fees from patents and copyrights on new technology,
software, books, and movies.
 Income receipts include foreign income from dividend on stock holdings
and interest on debt securities.
 Unilateral transfers are one-way transfers of assets, such as money
received from those working abroad and direct foreign aid.

3-6
 BOP Components
 Capital account consists of capital transfers and the acquisition and
disposal of non-produced , non-financial assets.
 Capital transfers
 Debt forgiveness and goods and financial assets that migrants bring
when they come to a country or take with them when they leave.
 The transfer of title to fixed assets and of funds linked to the
purchase or sale of fixed assets, gift and inheritance taxes, death
duties, and uninsured damage to fixed assets.
 Sales and purchases of non-financial assets that are not produced
assets include rights to natural resources and intangible assets, such as
patents, copyrights, trademarks, franchises, and leases.

4-6
 BOP Components
 Financial account records investment flows.
 Government-owned assets abroad include gold, foreign currencies,
foreign securities, reserve position in the IMF, credits and other long-
term assets, direct foreign investment, and claims against foreign banks.
 Foreign-owned assets in the country are divided into foreign official
assets and other foreign assets in the domestic country. These assets
include domestic government and corporate securities, direct
investment in the domestic country, domestic country currency, and
domestic liabilities to foreigners reported by domestic banks.

5-6
 Different Factors Influence the BOP
 Relation between the trade deficit, saving, and domestic investment:
X-M = private savings + government savings – investment
 Lower levels of private saving, larger government deficits, and high rates
of domestic investment all tend to result in or decrease a current
account deficit.
 Savings and investments
 Low private or government savings in relation to private investment in
domestic capital requires foreign investment in domestic capital.
 Borrowing from foreign countries to finance high consumption (low
savings) increase the domestic country’s liabilities without any increase
to its future productive power.
 Borrowing from foreign countries to finance a high level of private
investment in domestic capital, the added liability is accompanied by an
increase in future productive power because of the investment in capital.

6-6
 International
Organization and
Trading Blocs

1-6
 International Monetary Fund (IMF)
 International Monetary Fund (IMF):
 Provides a forum for cooperation on international monetary problems
 Facilitates the growth of international trade and promotes employment,
economic growth, and poverty reduction
 Supports exchange rate stability and an open system of international
payments
 Lends foreign exchange to members when needed, on a temporary basis
and under adequate safeguards, to help them address balance of
payments problems
 After the global financial crisis of 2007-2009, the IMF has redefined and
deepened its operations by:
 Enhancing its lending facilities
 Improving the monitoring of global, regional, and country economies
 Helping resolve global economic imbalances
 Analyzing capital market developments
 Assessing financial sector vulnerabilities

2-6
 World Bank Group
 World Bank Group’s main objective is to help developing countries fight
poverty and enhance environmentally sound economic growth. For
developing countries to grow and attract business, they have to
 Strengthen their governments and educate their government officials
 Implement legal and judicial systems that encourage business
 Protect individual and property rights and honor contracts
 Develop financial systems robust enough to support endeavors ranging
from micro credit to financing larger corporate ventures
 Combat corruption
 TheWorld Bank’s two closely affiliated entities—the International Bank for
Reconstruction and Development (IBRD) and the International
Development Association (IDA)—provide low or no-interest loans and
grants to countries that have unfavourable or no access to international credit
markets. Unlike private financial institutions, neither the IBRD nor the IDA
operates for profit.
3-6
 World Trade Organization (WTO)
 World Trade Organization (WTO)
 The WTO provides the legal and institutional foundation of the
multinational trading system. It is the only international organization
that regulates cross-border trade relationships among nations on a
global scale.
 It was founded on 1 January 1995, replacing the General Agreement
on Tariffs and Trade (GATT) that had come into existence in 1947.
 The GATT was the only multilateral body governing international
trade from 1947 to 1995.

4-6
 Trading Blocs
 Regional integration is popular because eliminating trade and investment
barriers among a small group of countries is easier, politically less contentious,
and quicker than multilateral trade negotiations under the World Trade
Organization (WTO).
 Free trade areas （自贸区，上海自贸区，海南自贸区）
 All barriers to import and export of goods and services among member
countries are removed.
 Customs union （关税同盟，英国与爱尔兰）
 All barriers to import and export of goods and services among member
countries are removed.
 All countries adopt a common set of trade restrictions with non-members.
 Common market （共同市场，东非共同市场，南美共同市场）
 All barriers to import and export of goods and services among member
countries are removed.
 All countries adopt a common set of trade restrictions with non-members.
 All barriers to the movement of labor and capital goods among member
countries are removed.
5-6
 Trading Blocs
 Economic union （欧盟，经济共同体，经济联盟，一带一路）
 All barriers to import and export of goods and services among member
countries are removed.
 All countries adopt a common set of trade restrictions with non-members.
 All barriers to the movement of labor and capital goods among member
countries are removed.
 Member countries establish common institutions and economic policy
for the union.
 Monetary union （欧元区）
 All barriers to import and export of goods and services among member
countries are removed.
 All countries adopt a common set of trade restrictions with non-members.
 All barriers to the movement of labor and capital goods among member
countries are removed.
 Member countries establish common institutions and economic policy for
the union.
 Member countries adopt a single currency.

6-6
 Reading
14

Currency Exchange Rate

 1. Nominal and Real Exchange Rate
Framework 2. Foreign Exchange Market
3. Percentage Change in Foreign Exchange
Rate
4. Cross Rate
5. Forward Discount or Premium
6. Interest Rate Parity
7. Exchange Rate Regimes
8. Effects of Exchange Rates on Countries’
International Trade and Capital Flows
 Basic Concept
and Calculation

1-11
 Nominal and Real Exchange Rate
 Exchange rate is simply the price or cost of units of one currency in terms
of another.
 Nominal exchange rate: the price that we observe in the marketplace for
foreign exchange.
 Currencies trade in foreign exchange markets based on nominal
exchange rates.
 Real exchange rate: the focus shifts from the quotations in the foreign
exchange market to what the currencies actually purchase in terms of real
goods and services.
 FX real (d/f) = FX nominal (d/f) *CPIf /CPId
 Changes in real exchange rates can be used when analyzing economic
changes over time.
 When the real exchange rate (d/f) increases, exports of goods and
services have gotten relatively less expensive to foreigners, and
imports of goods and services from the foreign country have gotten
relatively more expensive over time.
2-11
Example
 At a base period, the CPI of the U.S. and Euro are both 100, and the
exchange rate is $1.70 per euro. Three years later, the exchange rate is
$1.60 per euro, and the CPI has risen to 110 in the U.S. and 112 in the
Euro. What is the real exchange rate?

 Correct Answer:
 The real exchange rate is $1.60 per euro * 112/110 = $1.629 per
euro.

3-11
 Spot Rates and Forward Rates
 Spot rates are exchange rates for immediate delivery of the currency.
 Spot markets refer to transactions that call for immediate delivery of
the currency. In practice, the settlement period is two business days
after the trade date.
 Forward rates are exchange rates for currency transactions that will occur in
the future.
 Forward markets are for an exchange of currencies that will occur in the
futures. Both parties to the transaction agree to exchange one currency
for another at a specific future date.

4-11
 Participants in the Foreign Markets
 Sell side: large multinational banks
 Buy side
 Corporations: regularly engage in cross-border transactions, purchase
and sell foreign currencies as a result, and enter into FX forward
contracts to hedge the risk of expected future receipts and payments
denominated in foreign currencies.
 Investment accounts: hold foreign securities, and may both speculate
and hedge with currency derivatives.
 Real money accounts: refer to mutual funds, pension funds,
insurance companies, and other institutional accounts that do not
use derivatives.
 Leveraged accounts: refer to the various types of investment firms
that do use derivatives, including hedge funds, firms that trade for
their own accounts, and other trading firms of various types.

5-11
 Participants in the Foreign Markets
 Buy side
 Governments and government entities: including sovereign wealth
funds and pension funds, acquire foreign exchange for transactional
needs, investment, or speculation
 Central bank sometimes engage in FX transactions to affect
exchange rates in the short term in accordance with government
policy
 Retail market: refers to FX transactions by households and relatively
small institutions and may be for tourism, cross-border investment, or
speculative trading.

6-11
 Indirect & Direct Foreign Exchange Quotations
 Direct quote is the value of one unit of a foreign currency in units of the
home currency. (D/F)
 Indirect quote is the amount of a foreign currency for one unit of the home
currency. (F/D)
 Base currency: the currency in which the quote represents one unit.
 Price currency: the currency for which the quote represents a number of
units.
 The foreign currency is the base currency for a direct quote.
 The home currency is the base currency for an indirect quote.
 Two-sided price: When a client asks a bank for an exchange rate quote, the
bank will provide a “bid” (the price at which the bank is willing to buy the
currency) and an “offer” (the price at which the bank is willing to sell the
currency).

7-11
 Currency Exchange Rates
 A currency selling at a forward premium is considered “strong” relative to
the second currency and is expected to appreciate.
 A currency selling at a forward discount is considered “weak” and is
expected to depreciate.

 Example

 3X/Y changes to 2X/Y

 1Y=3X, now changing to 1Y=2X

 Y is weak relatively; X is strong relatively.

8-11
Percentage Change in Foreign Exchange Rate
 Consider a USD/EUR exchange rate that has changed from 1.42 to 1.39
USD/EUR.
 The percentage change in the USD price of a euro is simply:
 1.39/1.42-1=-0.0211=-2.11%
 Because the USD price of a euro has fallen, the euro has
depreciated relative to the dollar. It is correct to say that the
EUR has depreciated by 2.11% relative to the USD.
 To calculate the percentage appreciation of the USD, we need to
convert the quotes to EUR/USD.
 1/1.42 USD/EUR = 0.7042 EUR/USD
 1/1.39 USD/EUR = 0.7194 EUR/USD
 The change in the euro price of a USD as:
 0.7194/0.7042 -1 = 0.0216 = 2.16%
 It is correct to say that the USD has appreciated 2.16% with
respect to the EUR.

9-11
 Cross Rate
 Cross rate is calculated with two exchange rates involving three different
currencies.

 Example:
 0.60 USD/AUD , 10.70 MXN/USD
 MXN/AUD = USD/AUD * MXN/USD = 0.60 * 10.70 = 6.42
 1.7799 CHF/USD , 2.2529 NZD/USD
 CHF/NZD = (CHF/USD) / (NZD/USD) = 1.7799 / 2.2529 = 0.7900

10-11
 Forward Discount or Premium
 Forward discount or premium
 With the convention of giving the value of the quoted currency (the first
currency) in terms of units of the second currency, there is a premium on
the quoted currency when the forward exchange rate is higher than the
spot rate and a discount otherwise.
 If the forward rate is higher than the spot rate  the points >0  the
base currency is trading at a forward premium.
 If the forward rate is lower than the spot rate  the points <0  the
base currency is trading at a forward discount.
 Occasionally, one will see the forward rate or forward points
represented as a percentage of the spot rate rather than as an absolute
number of points.

11-11
Interest Rate
Parity

1-2
 Interest Rate Parity (IRP)
 Interest rate parity (IRP) holds when any forward premium or discount just
offsets differences in interest rates so that an investor will earn the same
return investing in either currency. Approximated by equating the difference
between the domestic interest rate and the foreign interest rate to the
forward premium or discount.
 Interest rate parity relationship
 F (forward), S (spot) X/Y, rX and rY is the nominal risk-free rate in X and Y
𝐹 1+𝑟𝑋
 =
𝑆 1+𝑟𝑌
𝐹−𝑆 1+𝑟𝑋 𝑟𝑋 −𝑟𝑌
 = −1= ≈ 𝑟𝑋 − 𝑟𝑌
𝑆 1+𝑟𝑌 1+𝑟𝑌
 The forward rate will be higher than (be at a premium to) the spot rate if the
nominal risk-free rate in X is higher than that in Y.
 More generally, and regardless of the quoting convention, the currency with
the higher (lower) interest rate will always trade at a discount (premium) the
forward market.

2-2
Exchange Rate
Regimes

1-5
 Exchange Rate Regimes
 Virtually every exchange rate is managed to some degree by central banks.
The policy framework that each central bank adopts is called an exchange
rate regime.
 An ideal currency regime would have three properties:
 (1) the exchange rate between any two currencies would be credibly
fixed;
 (2) all currencies would be fully convertible;
 (3) each country would be able to undertake fully independent
monetary policy in pursuit of domestic objectives, such as growth and
inflation targets.
 However, these conditions are inconsistent. In particular, a fixed exchange
rate and unfettered capital flows severely limit a country’s ability to
undertake independent monetary policy. Hence, there cannot be an ideal
currency regime.

2-5
 Exchange Rate Regimes
 Countries That Do Not Have Their Own Currency
 A country can use the currency of another country (formal
dollarization) not create money/currency.
 A country can be a member of a monetary union in which several
countries use a common currency (eg: Euro)
 Countries That Have Their Own Currency
 A currency board system (CBS)
 is an explicit commitment to exchange domestic currency for a
specified foreign currency at a fixed exchange rate (notable
example of such an arrangement is Hong Kong, central bank is not
the last resort)

3-5
 Exchange Rate Regimes
 Countries That Have Their Own Currency：
 Fixed parity: A simple fixed-rate system differs from a CBS in two important
respects. There is a band of up to ±1 percent around the parity level within
which private flows are allowed to determine the exchange rate.
 The monetary authority stands ready to spend its foreign currency
reserves, or buy foreign currency, in order to maintain the rate within
these bands.
 Target zone: has a fixed parity with fixed horizontal intervention bands that
are somewhat wider—up to ±2 percent around the parity—than in the
simple fixed parity regime. The wider bands provide the monetary authority
with greater scope for discretionary policy.
 Crawling peg: the exchange rate is adjusted periodically, typically to adjust
for higher inflation
 Passive crawling peg: a series of exchange rate adjustments over time
is announced and implemented
 Active crawling peg: can influence inflation expectations, adding some
predictability to domestic inflation

4-5
 Exchange Rate Regimes
 Countries That Have Their Own Currency：
 Fixed parity with crawling bands: Initially, a country may fix its rates to a
foreign currency to anchor expectations about future inflation but then
gradually permit more and more flexibility in the form of a pre-
announced widening band around the central parity.
 Managed floating exchange rates: A country may simply follow an
exchange rate policy based on either internal or external policy targets—
intervening or not to achieve trade balance, price stability, or employment
objectives. Such a policy, often called dirty floating, invites trading partners
to respond likewise with their exchange rate policy and potentially decreases
stability in foreign exchange markets as a whole.
 Independently floating rates: the exchange rate is left to market
determination and the monetary authority is able to exercise independent
monetary policy aimed at achieving such objectives as price stability and full
employment.

5-5
 Impact of
Exchange Rates

1-8
 Impact of Exchange Rates
 Exports – imports = (private savings - investment in physical capital) +
(tax revenue -government spending)
 or X - M ≡ (S - I) + (T - G)
 Trade surplus: X - M > 0
 The sum of the excess of private saving over investment plus the
government surplus (government saving) must also be positive.
 Private savings plus government savings exceed domestic
investment in physical capital (plant and equipment).
 If T-G < 0, private savings (S) must exceed investment (I) by more
than the amount of government borrowing. This excess of savings
goes to foreign investment, that is , a capital flow into foreign
financial assets to offset the trade surplus.
 Trade deficit, X – M < 0
 The combination of government savings and private savings will be
less than domestic investment.
 Therefore, some of that investment must be funded by other
countries’ purchases of domestic financial asset.
2-8
 Elasticity Approach
 Two approaches to exam how changes in exchange rates affect the
balance of trade:
 Elasticity approach;
 Absorption approach.
 Elasticity approach
Imports exports
 M

imports  exports  X

imports  exports
 M
: elasticities  as positive numbers  of demand for imports

 X
: elasticities  as positive numbers  of demand for emports

 Given Marshall-Lerner condition:     

X X M M
 1  0
 When import expenditures=export revenues,  =
X M  
X M
1
 εx > - (WM/Wx)(εM -1)
 εM > 1- (Wx/WM) εx

3-8
 Elasticity approach
 The elasticity approach tells us that currency depreciation will result in a
greater improvement in the trade deficit when either import or export
demand is elastic.
 Currency depreciation will have a greater effect on the balance of trade
when import or export goods are primarily luxury goods, goods with close
substitutes, and goods that represent a large proportion of overall spending.
 Elasticity of demand is greater for goods with close substitutes, goods
that represent a high proportion of consumer spending, and luxury
goods in general.
 Goods that are necessities, have few or no good substitutes, or
represent a small proportion of overall expenditures tend to have less
elastic demand.
 One shortcoming of the elasticity approach is that it only considers trade
flows and ignores capital flows, which must also change as a result of a
currency depreciation that improves the balance of trade.

4-8
 J-Curve
 The J-Curve
 Import and export contracts delivery and payment in the future , import
and export quantities may be relatively insensitive to currency
depreciation in the short run means currency depreciation may worsen a
trade deficit in the short run.
 Given the existence of such contracts and the resulting insensitivity of both
import and export quantities to currency depreciation, import expenditures
may rise in the short run as export prices rise, and export revenues may fall
as export prices (in the domestic currency) fall, even when the Marshall-
Lerner condition is met.
 This short-term increase in the deficit followed by a decrease when the
Marshall-Lerner condition is met.

5-8
J-Curve

Balance of trade

Trade restrictions

Before
currency
depreciates

Time

6-8
 Absorption Approach
 Y = C+ I + G + X - M  X-M = Y – (C + I + G); (C + I + G) means
domestic absorption of goods and services.
 If the economy is at full employment, however, the trade balance
cannot improve unless domestic expenditure declines. If expenditure
does not decline, then the depreciation will put upward pressure on
domestic prices until the stimulative effect of the exchange rate change
is negated by the higher price level and the trade balance reverts to its
original level.
 If there is excess capacity in the economy, then by switching demand
toward domestically produced goods and services, depreciation of the
currency can increase output/ income. Because some of the additional
income will be saved, income rises relative to expenditure and the trade
balance improves.

7-8
 Absorption Approach
 How might depreciation of the currency reduce domestic expenditure
relative to income?
 The main mechanism is a wealth effect.
 A weaker currency reduces the purchasing power of domestic-currency-
denominated assets (including the present value of current and future
earned income).
 Households respond by reducing expenditure and increasing saving in
order to rebuild their wealth.
 As real wealth is rebuilt, the effect on saving is likely to be reversed—
resulting in only a temporary improvement in the trade balance.
 Thus, in the absence of excess capacity in the economy, currency
depreciation is likely to provide only a temporary solution for a chronic
trade imbalance.
 Lasting correction of the imbalance requires more fundamental changes
in expenditure/saving behavior (e.g., a policy shift that improves the
fiscal balance or an increase in saving relative to capital investment
induced by an increase in real interest rates).
8-8
 It’s not the end but just beginning.
Life is short. If there was ever a moment to follow your passion and
do something that matters to you, that moment is now.
生命苦短，如果你有一个机会跟随自己的激情去做你认为重要的事，
那么这个机会就是现在。
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