Managerial Economics

Lecture 1
Equilibrium - situation in which sellers / buyers have no incentive to change their behaviour:
• Market P reached level at which Qs = Qd, determined by interaction of S and D
• Equilibrium P - price balances Qs and Qd / Equilibrium Q - Qs and Qd at equilibrium P
• Factors in uencing S - input prices, technology, number of rms, expectations

Demand:
• Increase in income lead to increase in demand - it depends
• Normal good – good for which, other things equal, increase in income leads to increase in D
• Inferior good – good for which, other things equal, increase in income leads to decrease in D
• Factors in uencing D - income, prices of related goods, tastes, number of buyers, expectations
• Substitutes - 2 goods for which increase in P of one leads to increase in D for other
• Complements - 2 goods for which increase in P of one leads to decrease in D for other

Supply:
• Input prices - when price of input - labor, capital, materials rises, supply decreases
• Technology - technological advances reduce production costs and supply increases
• Supply increases with number of sellers / Market supply - sum of individual supplies

Demand and supply side, expectations - D changes not only when something occurs but also
when people expect that something will occur - does not matter whether expectations correct

Taxes:
• Governments levy taxes to raise revenue / discourage market activity
• When good is taxed, Q sold is smaller / buyers and sellers share tax burden
• Ad valorem tax - percentage tax, it will be higher for high-priced items - steep curve
• Per unit tax - tax on each unit of output sold, shifts S up vertically by amount of tax - in per unit

Price ceiling - legal P max at which good can be sold, use to protect consumers from conditions
could make commodities highly expensive, not binding if above Ep, leading to shortage:
• Shortages - because QD > QS, P is becoming lower than E, so lines, not enough for everyone

Price oor - legal Pmin at which good can be sold, use to keep certain prices from going too low:
• Not binding if below Ep / Binding if set above Ep, leading to surplus
• Binding price oor causes surplus - because QS > QD, unsold items
• Shortages or surpluses typically result from government controls of prices

CS - di erence between max consumer willing to pay for good and amount actually paid:
• Needs to be positive for purchase to occur
• Willingness to pay - maximum price customer is willing to pay for product
• Willingness to accept - min amount that person is willing to accept to sell good
PS - di erence between amount producer willing to supply goods for and actual amount received
by him when he makes trade, needs to be positive for sale to occur

Lecture 2
Elasticity - degree which consumers / producers change D, S in response to P / income changes:
• Inelastic demand - Qd not respond strongly to P changes, ePD < 1 - prescription drugs
• Elastic Demand - Qd responds strongly to changes in P, ePD > 1 - electronics
• Perfectly Inelastic - Qd does not respond to P changes, vertical, ePD = 0 - live saving drug
• Perfectly Elastic - Qd changes in nitely with any change in P, horizontal ePD = in nity - gold
• Unit Elastic - Qd changes by same percentage as P, elasticity is = 1
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 Price elasticity of demand - how much Qd responds to change in P of that good:
• % change in Qd / % change in P
• ((Q2 - Q1) / ((Q2 + Q1) / 2)) / ((P2 - P1) / (P2 + P1) / 2))

Point elasticity - ePD at speci c point on D curve:

• E = dxi/dpi*pi/xi
• Slope = dxi/dpi

ePD - determinants, D tends to be more elastic:

• Close substitutes large number / good is luxury / narrowly de ned market / longer time period

Income Elasticity of D - how Qd responds to change in consumers’ income:

• %dQd / %d YD; Point income elasticity of demand = Eid=dxi/dI*I/xi
• Inferior goods - εID < 0 / Normal goods - εID > 0 /
• Necessities - 0 < εID < 1 / Luxuries - εID > 1

Cross-Price Elasticity - how Qd of good changes as P of another changes:

• Percentage change in Qd of 1 good / Percentage change in P of good 2
• Point-cross elasticity = dxi/dpj*pj/xi
• Substitutes – cross-price elasticity is > 0
• Complements – cross-price elasticity is < 0

Elasticity of S - how much Qs of good responds to change in P of good:

• Percentage change in Qs / Percentage change in P
• Time period - supply is more elastic in LR in most markets

Lecture 3
Theory of preferences - how to identify, quantify individual's preferences over set of alternatives,
how to construct appropriate preference representation functions for decision making:
• ≽ - is at least as good as / > - is better than / ∼ is as good as
• Completeness - for each x, y from set X, either x ≽ y or y ≽ x or both
• Transitivity - for each x, y from set X, if x ≽ y and y ≽ z, then x ≽ z
• Independence - tA + (1-t) C ≽ tB + (1 - t) C
• Continuity - A > B > C, so probability that B is equally good as pA + (1 - p)C
• Strict convexity - y ≽ x and z ≽ x, y ≠ z / Nonsatiation - more is better
• Utility - total satisfaction received from consuming a good or service.

Decoy E ect - consumers change preferences between two options in event option 3 appears -
price of lure, which makes one of previously presented options more attractive, dominant in terms
of perceived value - quantity, quality, additional characteristics, etc. Lure is not intended for sale,
its purpose is to push consumers to more expensive purchase

IC - combo of 2 goods which give consumer equal Us, slope of IC = MU1 / MU2 = MRS
• MRS - how many units of good #2 consumer willing to give to obtain additional unit of good #1
• MRS = 3, so consumer is willing to sacri ce 3 cookies for 1 chocolate bar

BL - possible combos of 2 goods which can be purchased with given YD and Ps:
• 2 goods, amounts of goods are non-negative x1 ≥ 0, x2 ≥ 0
• Consumers can spend at most their income I ≥ p1x1 + p2x2
• BL = p1x1 + p2x2; Optimum = MUa / MUb = Pa / Pb

Slope of BL = – p1/p2 - amount units of good #2 consumer give to obtain

additional unit of good #1 - cookie p2 is 1 CZK, chocolate bar p1 is 10 CZK, 1
chocolate bar costs 10 cookies
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 Total e ect:
• Income e ects - when P of product reduced, consumers can buy same amount of goods, but
spending less money - more funds for other purchases
• Substitution e ect - consumer has incentive to buy cheap product instead of other that have
become relatively expensive. Consumers tend to replace expensive goods with cheaper ones

Explanation, normal good - Px decreasing, so BL AB begins to rotate around A, so

AB1, new IC - new point E1. Thus, if X0 units were purchased, now purchased in
amount of X1 with e ect of P reduction - TE. SE, reduced Px tends to buy more X
with same income. Assume - Utility of consumer same unchanged, i.e. consumer
remains on same IC

Explanation, gi en product - start at Q2, rise in P rice, reduces BL for rice to B2.
But, fall in YD causes large income e ect that outweighs substitution e ect.
Demand for rice rises to Q3 with a big fall in demand for meat

Lump Sum Principle - taxes on individual's PP superior taxes on speci c:

• Income tax allows to decide freely how to allocate remaining income
• Tax on speci c good will reduce individual's PP and distort his choices
• Tax on good x would shift the utility-maximizing choice from point A to B

MRTS - amount of units of #1 factors can be reduced while increasing other

factor by one, so that output remains unchanged = dL / dK = MPL / MPK
• Isoquant - all combos of two factors that produce given output
• Isocost - all combos of factors that cost same to employ

Law of diminishing marginal returns - adding an additional factor of production

results in smaller increases in output at particular point, stages:
• Increasing returns - adding to one production variable is likely to improve output
• Diminishing returns - TP increases at continuously decreasing rate till MP = 0
• Negative returns - production negative returns

Return to scale - volume of output from changes in scale of production:

• If number of all factors increases by a, output volume also increases by a - constant
• If output increases by more than a - increasing return on scale
• If output increases by less than a - diminishing return on scale

Edgeworth box - model consisting of ICs of 2 entities, allows determine

conditions for achieving optimal distribution of economic goods, C of which
achieves highest possible level of utility for participants of exchange = MRS

Lecture 5
Coordination problem - coordination of production ows through vertical chain may be
compromised when activity purchased from independent market rm rather performed in-house
• Incentives problem - market rms subject to discipline of market, must be innovative to survive

Transaction costs - there may be costs of transacting with independent market rms that can be
avoided by performing activity in-house - сosts of discovering relevant prices / coordinating when
tasks uncertain / negotiating, concluding separate contract for each exchange

Integration:
• Vertical integration - when company expands control over its supply chain
• Horizontal integration - company acquires company in same industry that sells similar product
• Tapered integration - mixture of vertical integration and market exchange
• Franchiser - gives partial ownership rights to franchisees
• Strategic alliances, joint ventures - two or more rms create, jointly own new independent rm
• Close-knit semi formal relationships - implicit contracts
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 • If there is large market outside rm for input, then “buy”
• Firm with large share will bene t more from vertical integration
• Firm with multiple product lines will bene t more from vertical integration
• Asset speci city is signi cant, vertical integration preferred

Economies of scale - cost advantages rm obtain due to scale of operation, with cost per unit of
output decreasing with increasing scale - LRAC

Labour - rms’ boundaries do not narrow as individuals specialise in ex ante elds

• When rm mediate labor e ciently division, rm boundaries not change as individuals specialise
• When markets mediate division of labor e ciently, rms’ boundaries should narrow
• Agency costs - incurred by company due to interests con ict of owners / managers - audit
• In uence costs - managers spend time, e ort seeking to in uence decision being made by their
superiors in favour of organisation subunits within which managers work

Principal-Agent Relationship - principal hires agent to take actions a ect payo to principal,
agency problems arise when objectives of principal and agent are di erent:
• Actions of agent are not observable by principal - hidden action
• Information owned by agent is not observable by principal - hidden information

Fight against agency problems:

• Expending resources on monitoring management / Performance-based incentives

Causes of transaction costs:

• Incomplete contracts – people exploit incomplete contracts to act opportunistically
• Why contracts incomplete - bounded rationality, di culties specifying, measuring performance
• Asymmetric information - problem with monitoring quality

Holdup Problem - rm holds up partner attempting to renegotiate deal terms, rm can pro t by
holding up when contracts incomplete:
• Rent - pro t you expect to get when everything goes as planned
• Quasi-rent - di erence between rent and pro t from next best option
• Larger quasi-rent, larger magnitude of hold-up problem
• Raise transaction costs - di cult contract negotiations, more frequent renegotiations

Di erences in technical and agency e ciency, ∆C = ∆T + ∆A

• ∆T = min cost under vertical integration – min cost under market exchange, ∆T > 0
• ∆A = transaction cost under vertical – transaction cost under market exchange
• ∆C < 0 – vertical integration is preferred / ∆C > 0 – market exchange is preferred

Firm should make, rather than buy:

• Assets that provide competitive advantages / Tie up distribution channel
• Asset easily obtained from market - not source of competitive advantage
• Capture pro t margin of market rms / Insure against risk of high input prices

Firm should buy, rather than make:

• Avoid making cost - choosing buy doesn’t eliminate expenses of associated activity
• Ricardian rent - price of land totally determined by demand for land

Lecture 6
Monopoly - single seller of its product, which have no close substitutes, products not identical:
• Occasion for use - share characteristics but may di er in way they used
• Pro t maximisation = MR = P*(1+1/ePD) = MC; If ePD → – ∞, then MR=P
• MR > 0 - elastic, so P > MR = MC; MR = 0 - unit elastic; MR < 0 - inelastic
• Not price takers, but price makers / In LR - no economic pro t

Lerner index - bigger di erence between P and MC, bigger monopoly power:
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 • (P-MC / P) = L

Rothschild index:
• R = eT / eF; Monopoly: R = 1 / Perfect competition: R = 0
• eT - industry-level price elasticity
• eF - rm-level price elasticity

Measures of Market Structure N- rm concentration ratio – combined market share of largest

N rms - All six of largest rms produce 15% each, so 6 x 15 = 90%

Measures of Market Structure HHI - when relative size of largest rms is important - full market:
• Her ndahl-Hirschman index – sum of squared market shares si, so HHI = SUMi(si2)
• HHI in market with N equal size rms = 1/N
• All six of largest rms produce 15% each, remaining 10% of output is divided
among 10 equally sized producers, so HHI = 6 x 0.15^2 +10 x 0.01^2 = 0.136

Monopsony - monopoly for labour, one company is responsible for S jobs

Lecture 7
Perfect competition:
• Homogeneous, interchangeable product / Large number of buyers and sellers
• Sellers, buyers have perfect technology info, P / No barriers to entry and exit
• Consumer can in uence price / Firms and consumers are price-takers
• Pro t maximisation, where P = MR = MC; Firms price-takers
• Demand for rm’s production rm - does not depend on Q, P is given
• n LR, P = min ATC / LR market supply curve is horizontal at P
• More ePD - lower optimal markup, lower L index / No economic pro t in LR

Exit in LR - rm exits if TR would get from producing is less than TC:

• Exit if TR < TC; Exit if TR/Q < TC/Q; Exit if P < ATC

Enter in LR - will enter industry if such action would be pro table:

• Enter if TR > TC; Enter if TR/Q > TC/Q; Enter if P > ATC

Competitive Firm’s LRS Curve:

• Optimum amount of output is given by P = MC with P ≥ ATC
• Competitive rm’s MC curve that lies above ATC

Competitive Firm’s SRS Curve:

• Optimum amount of output is given by P = MC with P ≥ AVC
• Portion of MC curve that lies above AVC is competitive rm’s SR S curve

Firm behaviour in SR:

• Shutdown - SR decision not produce during speci c period of time because market conditions /
Has FC in SR; Shut down if TR < VC; Shut down if TR/Q < VC/Q; Shut down if P < AVC

Monopolist does not have S curve:

• Price is endogenous, so determines Q and P

Monopoly’s pro t:
• Pro t = (TR/Q - TC/Q) / Q = (P - ATC) * Q
• Pro t per unit = (P - ATC)
• Monopolist will receive economic pro ts as long as P > ATC
• Accounting pro t = TR - TC; Economic = TR - Explicit - Implicit

Why do monopolies exist:

• Structural barriers - ownership of key resource, economies of scale, network externalities
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 • Legal barriers - government monopoly, patents, copyright / Strategic barriers

Lecture 8
Oligopoly - small number of rms in industry, homogeneous or di erentiated output:
• Decisions of one rm a ects P and Q of industry

Cournot model - at what Q do rms achieve Pe at which they will receive maximum pro t:
• Each rms chooses amount of its Q / Price clears market, so Qd = Qs
• Each rm considers Q of others as given, chooses amount that maximises pro t
• Pe - optimal P for both competing rms, at which they will receive maximum pro t
• Fixed number exists rms on market, so N > 1; Output can not be adjust quickly
• Entrance to market of new companies and exit from it does not exists
• Companies maximise their experience / act without cooperation / If 2 rms identical - same Q
• Each expects other to choose equilibrium amount
• C oligopoly produces less than perfect competition, but more than monopoly

Explanation - If P = a - bQ, Q = q1 + q2, so a - b(q1+q2) = a - bq1 - bq2

• Pro t 1 = Pq1 - c1q1 = aq1 - bq1^2 - bq2q1 - c1q1
• Pro t 2 = Pq2 - c2q2 = aq2 - bq2^2 - bq1q1 - c1q1
• D pro t by q1 for pro t 1 and by q2 pro t 2 which equal to 0
• A - 2bq1 - bq2 - c1 = 0; A - 2bq2 - bq1 - c2 = 0

Cartel - association of oligopolists who agree to jointly decide on level of market P and Q of
products produced, behave like single oligopolist, task of pro t max for two rms is to choose
output levels q1 and q2 that would maximise total pro t of industry:
• Pro t = (a-bq1-bq2)*(q2+q1) - cq1 - cq2

Instability of cartel:
• If rm increases output, it lowers price, and thereby other rms’ pro t
• Each rm maximises its pro t and not industry pro t
• Lower rm’s market share, larger discrepancy between max of own pro ts and industry pro ts

Bertrand model - each rm chooses its P and sells output at this P:

• There are at least two rms on market that produce homogeneous product
• Firms behave non-cooperative / MC of rms same, constant / Q di cult to change
• Firms compete by setting P for their products, choose them independently / P changeable
• After choosing P, rms produce volume of goods equal to amount of D for their products
• If prices di erent, consumers demand cheaper product / quickly adjust output
• If prices same, goods of all rms purchased in equal shares / P - nally same as MC
• Cooperative way - rms agree in which they charge monopoly P, serve each half of D

Stackelberg model - duopolist can choose behaviour, to strive to be leader or follower:

• Follower - decisions about pro t-max Q, assuming opponent's output is set
• Leader - sophisticated in understanding market situation, knows response curve of opponent,
incorporates it into his pro t function and maximises pro ts by acting like monopolist
• Leader starts, followers’ choice based on choice of leader
• FF - Cournot model; LL - P war or agreement

Explanation - If P = a - bQ, Q = q1 + q2, c1 = c2, so

• P1 = q1 * (a - bq1 - bq2) - c1q1
• P2 = q2 * (a- bq1 - bq2) - c2q2
• q1= (a - c) / 2b; q2 = (a - c) / 4b; - so to be leader is more better in terms of pro t
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 Lecture 9
Nash equilibrium - E, when each participant in game chooses strategy that is
optimal for him if other participants in game adhere to certain strategy
Prisoner’s dilemma - rational players will not always cooperate with each other,
even if it is in their interests

Explanation - imagine reasoning of one of prisoners. If partner is silent, it is better

to betray him and go free. If partner testi es, it is better to also testify against him, if
you silent - risk to stay in prison for 10 years, so“testify” dominates. So, another
prisoner comes to same conclusion

Pareto optimal:
• One outcome o is at least as good for every agent as another outcome o’
• One strictly prefers o to o’ - e.g. o:(7;8) and o’:(7;2)

Sequential-move games:
• Strategic situations in which there is strict order of play
• Players making moves - know what players who gone before have done
• Fair game - if value of game is zero, there is no loss or gain for any player
• Pure strategy – certain reaction of player to possible behaviours of other players
• Mixed strategy – probabilistic reaction of player to behavior of other players

Lecture 10
Percentage contribution margin:
• PM = (P - MC) / P = 1 / ePD
• If PM > – 1/ePD, then MR > MC, rm should lower its price
• If PM < – 1/ePD, then MR < MC, rm should raise its price
• P = 10, MC = 5, so (10-5) / 10 = 0,5; ePD = 3, so 0,5 > 1 / 3, so lower P

Price discrimination - practice of charging consumers di erent prices for same good:
• First-degree - set consumer’s maximum willingness to pay for that unit
• Third-degree price discrimination - company charges di erent P to di erent consumer groups
• Firm must have market power to price discriminate / info about di erent amounts people will
pay for its product / must be able to prevent resale, or arbitrage

Uniform Pricing versus First- Degree Price Discrimination:

• Uniform pricing - Qm at price Pm
• Producer does not capture all of CS, so deadweight loss
• First-degree - producer sells Q1 units, highest reservation P - no deadweight loss
• Does not have to reduce its price on all other units it is already selling, so MR = P

Second-degree price discrimination, Q discounts - sellers o er Q discounts, it

costs them less to sell larger Q:
• With uniform pricing, rm captures a producer surplus RTMZ
• Block tari - rm charges P $11 for rst 9 units and P $8 for three additional units
• Producer surplus = $99, areas RTMZ + JKLM

Block tari – consumer pays one P for units consumed in 1 block of output - up to
given Q and di erent - usually lower P for any additional units consumed in 2 block

Multipart tari – tari / price, that consists of two or more separate prices - subscription charge
and usage charge, can not easily capture all surplus because of reasons:
• D di ers from one consumer to next
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 • Firms do know D of individual consumers - rms o er customers menu of subscription and
usage charges, and then allow each consumer to select best combination

Pricing strategies, deterrence - some P strategies used deter potential competitors, bundling:
• Manufacturer of o ce supplies - incumbent
• Sticky notes, where MC = AC = $15, Ps = $30, Qs = 1 mil
• Plain note paper MC = AC = $5, Pp =$10, Qp =1mil
• Pro t = ($30 – $15) x 1 + ($10 – $5) x 1 = $20 mil.
• Several rms considering entering plain note paper market, sticky note - patent
• If entry occurs, price of plain note paper drops to $7.50
• Incumbent’s market share shrinks and its pro t falls to $15.5 mil.
• Incumbent - buy bundle consisting of one box of sticky and one box of plain note paper for $37
• If customers bought plain note paper from competitors, they would pay $7.50
• Altogether they would pay $30 + $7.50 = $37.50, so $37 < $37.50, customers - incumbent

Lecture 11
Lottery - any event for which outcome is uncertain:
• Expected value - measure of average payo that lottery will generate = O1*P1+O2*P2…
• Probability distribution - depiction of all possible payo s in lottery and their associated P
• Probability of any particular outcome is between 0 and 1, sum is 1
• Сertainty equivalent of lottery - xed payment that makes agent indi erent to lottery

Expected utility - Ex of utility levels decision maker receives from payo s in lottery:
• EU = PrA * utility if A occurs + Pr B * utility if B occurs + Pr C * utility if C occurs
• u = x^0,5, so EU = 0.3 * u $120 + 0.4 * u$100 + 0.3 * u $80 = 0,3 * 120^0,5 +0,4 * 100^0,5…

St. Petersburg paradox - paradox when people agree to play for a small reward, and larger it is,
less desire there is to play, individuals willing to pay relatively small amount of money to
participate in game in which mathematical expectation of winning is in nitely high

Explanation - tossing coin until given side of it falls, amount of winnings determined by number of
coin tosses before given side falls out. At 1 toss, if "eagle" falls, 1st player pays 2nd player 1 rub.
In second case, 2nd player will receive 2 rubles; in third-4 rubles... Probability of winning is 50%.
Expectation of winning on rst roll is π × 1 rub, or 0.5 × 1 rub = 0.5 rub. On second, it will be 0.5 ×
0.5 × 2 rubles = 0.5 rubles. Total Ex is sum of expectations at each stage of game and will be 0.5
rub + 0.5 rub + 0.5 rub +...

Risk neutrality - indi erent between sure thing and lottery with same Ex, so EU = u(EX):
• PrA * u120 + PrB*x u100 + PrC * u80 = u (PrA x 120 + PrB x 100 + PrC x 80)

Risk aversion - individual prefers sure thing to lottery of equal expected value:
• EU = u(EX – RP); EU < u(EX)

Risk seeking - prefers lottery to sure thing that is equal to Ex of lottery:

• u(EX+RP) = EU; EU > u(EX)

Asymmetric information - situation in which one party knows more about

its own characteristics or actions than another party

Moral hazard — one of parties, somehow protected from risk, will act di erently than in absence
of such protection; risk that one of participants in transaction entered into agreement with unfair
intentions, provided false info about their assets, liabilities or creditworthiness, or has incentive to
take atypical risks before entering into contract in attempt to make pro t; probability existence of
contract will change behaviour of one or all of parties involved in it
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Adverse selection - situation, where individuals have hidden characteristics and in which
selection process results in pool of individuals with undesirable characteristics - loan
• Low quality products crowed-out high-quality products
• Assume consumers willing to pay $100 for high-quality good and $10 for a low-quality good
• Consumers do not observe quality - they know that 80% of high-quality goods and 20 % of low
• How much are they willing to pay for a good?
• Ex = 0.8 x $100 + 0.2 x $10 = $82
• Since $82 < $100, producers of high-quality goods are not willing to sell
• Since $82 > $10, producers of low-quality goods are willing to sell
• So, there are only low-quality goods in market -100 % and consumers are willing to pay $10

Signalling as advertising:
• Firms selling high-quality goods can signal high quality by conspicuous expenditures
• Only high-quality producers are willing to spend money on advertising
• Consumers are aware of this and therefore can distinguish

Explanation:
• Assume - each rm from previous example can choose to spend $85/unit on advertising
• In 1 period, advertised goods are sold for $100, non-advertised goods are sold for $10
• In 2 - goods sold at their true value; however, if LQ sold for $100 in 1 period - do not buy in 2
• If high-quality rm chooses to advertise, it’s pro t per unit is: $100 + $100 – $85 = $115
• If high-quality rm chooses not to advertise, it’s pro t per unit is: $10 + $100 = $110
• High-quality rm chooses to advertise because $115 > $110
• Low-quality rm chooses to advertise, it’s pro t per unit is: $100 + $0 – $85 = $15
• Low-quality rm chooses not to advertise, it’s pro t per unit is: $10 + $10 = $20
• Low-quality rm chooses not to advertise because $20 > $15

Lecture 12
Learning curve - process of production repeated, productivity may rise due to experience

Entry Barriers:
• High sunk entry costs, FC / specialised capital equipment / government licences / marketing
• High AC - incumbent controls essential resources / exploits learning curve / enjoys
economies of scale and scope / enjoys marketing advantages

Entry deterrence - existing rm acts in manner to prevent entry of new potential rms to market
• Incumbent’s pro t before entry πM = (PM – ACM) * QM
• Incumbent’s pro t after entry: πC = (PC – ACC) * QC

Challenger decreases incumbent’s pro t in two ways:

• They take market share away from incumbents / decrease P

Limit Pricing:
• If challenger knows incumbents cost / market D functions, then
shouldn’t be deterred by limit price - so incumbent shouldn’t use limit price
• Limit pricing works only if challenger is imperfectly informed about market conditions

Lecture 13
Externality - impact of one’s action on welfare of others, positive or negative:
• Not transmitted through P system / may exist in consumption and production

Costs:
• Private cost - production costs included in market price of a good
• External cost - caused by production / C by persons not involved in transaction
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 • Social cost - total amount of costs of market participants and third parties
• MPC - additional costs due to increase in Q by one unit = dpc / dq
• MEC - change in cost to parties other than producer or buyer of good due to production of
additional unit of good - $50 to produce unit. Production results in pollution which causes $60
worth of damage to another company's plant, so MEC is $60 = dec / dq
• MSC = MPC + MEC = dsc / dq

Emission standards, emissions:

• Government would have to know D for output and PMC
• How much pollution would each rm produce
• Monitoring compliance with standards - more exible, better incentives
• Government does not have to know cost of lowering emissions for each rm
• Firms - decide by how much reduce emissions, how are they going to do that

Market for emission permits:

• Government sets xed amount of permits / Permits are then allocated to rms
• These permits give rms „right to pollute“
• Market failure is solved by creation of market
• Firms can buy and sell these permits
• Setting xed amount resembles emission standards
• Possibility to trade with permits - incentives as emission fees

Common ownership - negative externalities may occur in case of

common ownership, resource can be used by anyone

Congestion pricing - dynamic pricing strategy designed to regulate D

by increasing prices without increasing S

Positive external e ect – amount of bene ts of third parties as result of

production / consumption of goods that not re ected in its market price
under production; individuals consider private bene ts, no external e ects,
possible solution to positive externality - subsidy
• MEB - additional bene t imposed on third parties by C of an extra unit
• MPB - bene ts enjoyed by individual consumers of particular good

Knowledge and positive externality:

• Knowledge of individual may inspire creation of new knowledge by another
• Knowledge spillovers may occur within industry or across industries
• Concentration of rms in one area is important factor a ecting innovation

Property rights and coase theorem:

• CT - if ownership rights de ned, transaction costs are 0, allocation of resources
will remain constant regardless distribution changes of ownership rights
• If parties not know costs - bargaining may not e ciently
• Both parties must be willing to enter into agreements mutually bene cial
• If one of parties simply refuses to bargain or to give other party acceptable
compensation, it may not be possible to achieve e cient resource allocation

Explanation - 2 rms near— factory without external in uences and dentist who occupies next
room. They work peacefully, with pro t - dentist 600, factory 200. Then factory decides to upgrade
- new machine, which will give them +200 pro t, so 400 - against dentist's 600. Problem - new car
noise, customers began to leave, he began to lose pro t, now earns 300, so o ers
factory 200 kickback so that they don't turn machine. Owner - agrees. Dentist now
has 400 = 600 - 200 > 300, owner of factory has 400 - as planned

Public goods:
• Public good - good that is non-excludable and non-rival
• Excludability - property of good whereby person can be prevented from using
• Rivalry - property of good, one person’s use diminishes other people’s use
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 Free-rider problem - person who receives bene t of good - avoids paying for it:
• Since people can’t be excluded from enjoying bene ts of PG, individuals may withhold paying
for good hoping that others will pay for it / Prevents private markets from supplying PG

Macroeconomics
Lecture 1
GDP - market value of nal goods and services produced in economy during given period:
• GDP per person - country's economic output / population
• Nominal GDP - value of nal goods, services produced over certain period in current prices
• Real GDP - market value of goods, services produced in economy, adjusted for in ation
• Potential GDP - level economy capable produce if workforce fully employed, capital fully utilise
• Output gap - comparison between actual GDP and potential GDP
• Net domestic product = GDP - depreciation
• GNI = GDP + income by citizens from abroad - income taken out from country
• GNP - goods, services value by country's residents, businesses - regardless production location

GDP by expenditure method = C + I + NX + G

• Net export = Export - Import
• Consumption = durable goods, non-durable goods, services - all private consumption
• Investment = xed investment, business investment in equipment, do not include purchases of
nancial products - classed as saving, no human capital investment
• Government spending = expenditures sum on nal goods, services, salaries, purchase of
weapons for military, investment expenditure by government, transfers

GDP by production method = Value of all goods, services - Cost of goods, services

GDP by income method - sum of incomes of owners of economic resources:

• Rent, interest, pro t, depreciation, wages - in market sector, salaries - public sector
• Indirect taxes, tax is related to product

Gross investment - amount company invested in asset without factoring depreciation:

• Gross investment = net investment + capital depreciation
• GI is car for 5000$, depreciation is 3 years by 1000$, so 2000$ is net investment

Fiscal policy - public sector – general government sector:

• State budget / Budgets of local governing units – regions, cities, villages / health insurance
• Budgets of extra-budgetary funds - State Fund for Transport / Public universities

Maastricht criteria - nancial, economic indicators of country necessary for joining Euro zone.
State budget must have positive or zero balance, exceptionally:
• State budget de cit is allowed - not higher than 3% of GDP at end of nancial year
• National debt < 60% of GDP at end scal year, or should approach level with con dence

Lecture 2
Keynesian consumption function: C = Ca + cYD, how household’s C varies with YD:
• Ca - min amount people need to maintain life, not depend on income; C + S = Y - T = YD
• MPC = dC / dY = 0 to 1 c - % change in consumption for change in YD
• APC = C / YD - how much person’s YD spent on consumption
• Shows planned, desired consumer spend level for speci c level of income / Only for ST
• Consumption depends on current YD and not depend on interest
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 • Psychological law - people adjusted on average to increase C as income
increases, but not by as much as increase in their income

Keynesian savings function: S = YD - C = -Sa + sYD - how S varies with YD

• - Sa - would be undertaken even if household sector had no income
• MPS = s - percentage increase in S for any change in YD = dS / dY = 0 to 1
• sYD – induced savings / MPC + MPS = APC + APS = 1
• APS = S / YD - share of income going to savings
• Motives for saving - expensive goods / tourism / Security in old age….

Inter-temporal allocation, Fisher - how rational forward looking consumers choose C for
present, future to maximise lifetime satisfaction / Fixed price level
• Factors determines C and S - current income and interest
• Perfect certainty - consumer knows his current and future income
• Prefers balanced consumption path over time - consumption smoothing
• P1 = С1 = Y1 - S1 / Increase in i will lead to reduce C1 and increase C2
• P2 = С2 = Y2+S1(1+r) = Y2+(Y1-C1)*(1+r) = C1+C2 / (1+r) = Y1+Y2 / (1+r)
• P2: Y2, consumes, not save, uses S including i on made in advance in 1 period
• IC - combinations of C which brings same TU for 2 periods
• Slope - willingness to substitute between C periods
• Optimal choice – choose combo of 1,2 periods, highest IC
• Budget constraint - all combinations of 1 / 2 period C consumer can a ord
• Revenue growth in 1st or 2nd periods - budget constraint right
• Slope is - (1+i) / R1 = Y1 + Y2 / (1+r) / R2 = Y1 * (1+i) + Y2
• Income e ect - income change, can lead to IC movement - right or left
• Savers - higher i means greater income because of higher interest payment
• Borrowers - higher i reduce income available for spending - negative
• Substitution e ect - interest increase - fall C1, increase C2, S will increase
• Borrowing constraints - if banks refuse to give loans, consumer can have C = current income

Modigliani's Life cycle - consumer seeks to smooth consumption levels throughout life by saving
portion of YD during working age and spending S after retirement:
• Consumers try to ensure same level of C during life by saving during periods of high income and
spending S during periods of low income / C depends on current income and assets
• Sharp drop in income - retirement, common motive for LT S is motive for S for old age
• People foresee decline in income in old age - make S to avoid signi cant decline
• People plan C in LT, aiming to implement it as rationally throughout live
• C = (W + R*Y) / T; Consumption aggregate function= α * W+ β * Y
• α - marginal propensity to consume in accumulated wealth
• β - marginal propensity to consume from income
• T – number of years for labor activity and pension
• R – planned number of years to work
• Y – expected average annual earnings during working period
• W - initial real wealth - property, assets...

Permanent-Income by Friedman - people form spending based on permanent income, trying

to ensure equal C of over life, based on Fisher:
• Form C - same C level can a ord with income combo of 1 / 2 periods, so C1 + C2 = Y1 + Y2
• Permanent income Yp - expected LT income from labour and assets - bonds, equities, salary
• Temporary income Yt - temporary random deviation from revenue - lottery
• YD = Yp + Yt
• C = a * Yp; a - constant coe cient, measures share of permanent income consumed

Lecture 3
SR-model - product below its potential level - output gap, su cient supply of capital and labour,
unemployment, xed price level and wages, product income determined by PAE
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 Equilibrium product:
• Level of product at which actual product equals planned expenditure, unplanned investment is 0
• Level of product at which planned expenditure line intersects the 45° line

Equilibrium in two-sector model of economy:

• GDP - how much is produced, supply / IP - autonomous, so horizontal line
• Planned expenditures - how many economic entities want to demand
• Consumption + Planned investments = Planned expenditures
• Equilibrium = PAE intersects curve at 45 ° where equals to GDP = 1 / (1-c) * (Ca+I)
• If PAE > GDP, rms decrease inventories, negative unplanned I, increase production
• If PAE < GDP, rms has higher inventories, positive unplanned I, reduce production
• E0 produced as much as is demanded, no reason to change production, so E
• Actual investments = Unplanned investments + Planned investments
• PAE = GDP = C + I = Ca + cGDP + I = two-sector, GDP equal to YD, Ip=I
• Ca + Ip are autonomous expenditures / Multiplier = dGDP=1/(1-c)*(dCa+dIp)
• PAE = C + I = expenditure method / C + S = I + C
• National income = Y = C + S = income method, so I = S
• Injections - what increase consumption and income, so investment
• Leakages - what decrease consumption and income, so savings
• I growth - increases PAE, additional income to producers, incentive to increase output
• S increase - reduces aggregate spending, lead to reduction in production
• Production demand decreases, rms make stocks - positive unplanned I
• Higher production demand - rms cover surplus demand from stocks - negative unplanned I

Households - rational, don’t spend all income, save - savings should bring income. Firms need
funds to ensure, expand production, household S converted to I of rms:
• Households through intermediaries - banks from whom rms loan
• Households spend S buying rms’ securities - direct investment

Equilibrium in three-sector model of economy:

• G A ects YD, collects taxes, purchases - increase PAE
• G - maintain public sector economy, ensuring production of public goods
• Gives transfers - gratuitously payments - pensions, stipendium, grants…
• Governmental expenditure < taxes - can buy securities from rms
• Governmental expenditure > taxes - issuing bonds
• PAE = GDP, so C + Ip + G = S + C + Ta - Tr, so S + T = I + G
• C = Ca + cYD = Ca + c(GDP - Ta - t*GDP + TR)
• Slope is given by multiplier - smaller because of t
• If t is zero, PAE has same slope as in two-sector, GDP2 is equilibrium
• Leakages - savings, net taxes decrease consumption
• Injections - investment, government purchases increase consumption
• GDP = 1 / (1-c(1-t)) * (Ca + cTR - cTa + I + G) / YD = Y - t + tr = C + S

Equilibrium in four-sector economy:

• NX = Xa - Ma - m*GDP / mGDP – induced imports
• Xa – autonomous exports - do not depend on domestic GDP
• Ma - autonomous imports - do not depend on domestic GDP
• m - part of additional monetary unit of Y, directed to C of imported goods - m is 0.15, 0.15 of
each monetary unit of income received will be spent on purchase of imported = dIm / dGDP
• PAE = GDP = 1 / (1-c(1-t)) * (Ca + cTR - cTa + I + G + Xa - Ma); m = 0, PAE same slope as 3s
• Leakages - savings, net taxes, imports; Injections - investment, government purchases, exports
• PAE = GDP, so C + I + G + NX = C + S + NT, so I + G + NX = S + NT

Lecture 4
Neoclassical model of investment:
• Inventories, xed investment - optimal Q of capital; optimal Q of capital vs. actual Q of capital
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MRP of capital - additional revenue due change of capital by unit:
• MRPk = MPPk * MR = dTR / dK, where k - amount of capital change
• Curve obtain if multiply downward sloping curve of MPK by constant price level
• MPPk - additional units produced when one unit of physical capital added
• Production function - max Q can be obtained from given number of inputs - K; L

MC of capital:
• MFCk = (r + delta) * Pk - additional cost for additional unit of capital
• Delta - depreciation rate
• Pk - price of capital
• r - real interest, which = nominal interest rate - expected price level
• PC – company can’t in uence interest, depreciation constant, MFCK horizontal

Optimal quantity of capital:

• MFCk = MRPk - maximising pro t condition
• If MRPK > MFCK - company which maximises pro t must increase units of capital
• If MRPK < MFCK - company which maximises pro t must reduce units of capital

Optimal quantity of capital and higher expected production - company uses K and L. If
company wants to increase production - hire L or K. If more, so MRPk - right. How much rm will
increase amount of K depends on:
• Q = production, positively / W = positively, wage rate
• R + d, negatively - additional cost of labour
• K - any other factors / v = demand of investment
• K* = v * Q = optimal quantity of capital, where v= (k*w) / (r+d)

Demand for investment:

• Investment during this year = It =K*_t - K*_(t-1)
• K*t = optimal quantity of capital of this year at end of year
• K*_t-1 = optimal quantity of capital of previous year at end
• It = e * ( K*t - K*(t-1)), where e is gradual adjustment factor - measure of approximation of
existing amount of capital to optimal for period t
• K* = v * Y
• It = v * Yt - v * Y_(t-1) - accelerator vs multiplier; It = e * v * dY

Fiscal and monetary policy investment:

• Revenue side – changes of taxes, expected changes of taxes, investment bene ts
• Monetary policy investment - changes of money Q and interest

Investment into inventories:

Total investment to inventories: dΖ = e * (r * S^e_t - Z_t-1) + e * (St^e - St)

Unplanned inventories: dΖ = e * (St^e - St)

Planned inventories: Z* = r * S^e;

• S^e - expected sales
• r - all other factors a ecting optimal inventory levels excluding expected sales
• Z* = optimal quantity of planned inventories
• Z_t-1 - actual quantity of investment

Lecture 5
Money - anything accepted as means of payment in economy, functions:
• Medium of exchange – money allows exchange of goods - buying / selling
• Unit of account – with money we can express value of goods – present, past, future
• Store of value - agents can hold part of their wealth in money
• MS – money Q available in economy for immediate use, CB full control
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 • MB = total currency in circulation + amount held by banks as reserves
• MD - money amount agents want to use as means of payment

Kinds of money:
• Commercial bank money / Cash, currency – banknotes or coin
• CB – reserves, serves for transactions between commercial banks, CB, not MS

Money aggregates:

Narrow aggregate M1:

• Cash - cash in hand of non-bank individuals + Overnight deposits
• M1 / MB = (Currency + Deposits) / (Currency + Reserves) = Multiplier

Intermediate aggregate M2:

• M2 = M1 + deposits with maturity to 2 years + deposits redeemable at period of notice up to 3m
• MB = Currency + Overnight deposits reserves + Term deposits + Excess reserves
• M2 / MB = Multiplier

Broad aggregate M3:

• M3 = M2 + money market fund shares + debt securities up to 2 years + REPO

MS increase:
• Open market purchases - CB buys government bonds from commercial – non-cash operation
• CB gives discount loan to commercial bank / CB reduces required reserve ratio / In ation lead

MS decrease:
• Open market sales - CB sells government bonds to commercial bank – non-cash operation
• Commercial bank pays o discount loan from CB / CB raises required reserve ratio

MS curve - quantity of money supplied at given interest rate, doesn’t depend on i, so vertical:
• If commercial banks can hold excess reserves, MS upward
• Higher interest, advantage for commercial banks to restrict reserve holdings, provide more loans

Quantity theory of money by Fisher - money serves as medium of exchange, amount of

money needed for circulation - by mass and price of goods:
• M * V = P * T = transaction version; M * Vy = P * Y = Income version
• M - amount of money in circulation
• V - transactions velocity of money - total value of transactions, constant
• T - amount of all products and services, constant
• Vy – income velocity of money
• P - average price of transaction
• Right part - shows volume of goods sold on market
• Left part - amount of money paid when purchasing goods

Money neutrality - in LT quantitative changes in MS will not have e ect on

level of real product, rate of interest, investment, employment, only lead to increase in P level

Explanation - MS1 increase to MS2 will have impact on MD growth - from MD1
to MD2 to MD3, so E3 will return to E1, interest will remain unchanged. MD
growing due fact real national product is growing due to impact of ST monetary
policy. So, AD1 to AD2 - real product grown increase in prices - large money
amount needed to maintain increased real product - from MD1 to MD2. ST E2 -
existing prices for nal goods have increased, P for production factors same.
Increase in P of production factors will be accompanied by reduction in output
and P increases. At LT E3, existing P for nal goods and factors of production
will level o , real product return. Existing employment will return to its natural
level
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 Quantity theory of money - Cambridge version - focus on
MD, money as store of value and medium of exchange:
• MD = k * P * Y
• Y = total real income
• P = average price of product
• k = money subjects want to hold at given income
• Some e ect of wealth and interest rate - not sure in future

Keynes ́ MD - households can hold their nancial wealth in:

• Financial assets – money with zero or low interest / non-
money assets bonds – high interest
• Low interest - households prefer liquidity / MВ depends on current income – can be unstable

Keynes ́ MD motives for holding money:

• Transactions motive – current transactions, higher income, higher number of transactions / MD
• Precautionary motive – unexpected expenditures. Higher income, higher precautionary motive
• Speculative motive – desire to avoid capital losses associated with storing it in form of securities
during periods of decline in their exchange value, depends on interest rate:
• Normal interest rate - rate that economic agents believe should be on market
• Actual interest rate – is rate that is really on market
• Normal > actual - agents expect actual interest rates will rise or equal to normal. Increase of
interest rate is connected with decrease in price of bonds - hold bonds, su er capital loss
Normal < actual - agents expect actual interest rates will decrease. Who will not hold bonds will
su er capital loss. At high rate, economic agents prefer to bonds

Friedman ́ s MD - subjects try to allocate wealth into di erent types of assets to maximise U at
certain risk. MD as property is fuelled by preference for liquidity, focus on store of value. Money is
only one form of assets - money, bonds, equities, real capital..:
• Md / P: f(Yp, rb - rm, rs − rm, π^e − rm)
• Md/P = demand for real money balances
• Yp - permanent income
• rb − rm = expected return on bonds - expected return on money
• rs − rm = expected return on stocks - expected return on money
• π^e − rm = expected in ation - expected return on money
• MD stable – depends on permanent income, interest has small e ect
• MS is independent of MD and unstable – because of reaction of CBs

MD curve - lower interest rate, higher amount of money demanded:

• If interest changes, move along curve – speculative motive demand changes

Money market equilibrium:

• If interest rate is i1, MD > MS - subjects want to hold more money than they hold, begin to sell
bonds, price of bonds decreases and interest rate increases
• If interest rate is i2, MD < MS - agents want to hold less money than they hold - begin to buy
bonds, price of bonds increases and interest decreases

Creation of commercial bank money:

• Money created by transactions between banks and non-banks
• Money created if bank makes loan, simultaneously creates matching deposit
• If customer ask for loan from commercial bank, bank gives him loan - loan at assets side in
balance, at same moment bank create deposit of customer - liabilities side of balance
• Amount of loans bank can provide is subject to certain limits of bank - e.g. pro tability or risk,
but also by monetary policy - by setting CB interest rates
• If customer uses money to buy from merchant who has account with same bank, bank only
transfers deposit to new customer - change in liabilities side
• If customer uses money to buy from merchant who has account with another bank, Bank 1
must use its reserves with CB. Our client's deposit disappears - bank 1 and appears as trader's
deposit with his bank - bank 2. Bank 1 reduces reserves to CB in same amount and CB
transfers these reserves to bank
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 Lecture 6
IS - LM - BP - interest clears goods, money, markets and BP under particular output:
• SR / Su cient S of K and L, product below potential level - output gap
• Fixed price level / Exogenous MS – CB fully controls MS

I = - bi
• I - planned investments
• bi = dI / di = investment sensitivity to interest rate - how much amount of I will change when
interest changes by 1% - more sensitive, more horizontal curve
• - autonomous investment which independent on product and on interest

С = |Сa + mpс (Y – Т- tY) - аR

• T - autonomous net taxes = Ta - Tr
• t - marginal tax rate = ΔT/ΔY, change in amount tax receipts when amount of income changes
• R - interest rate
• |Ca - autonomous consumption dependent interest rate
• A - change in consumer spending when interest changes by one percentage point a=ΔC/ΔR

Xn = Ex - Im - mpmY - er
• Ex - autonomous export, doesn’t depend on domestic product, depends on product abroad - if
it grows, foreign country imports more, domestic exports more
• Im - autonomous import - doesn’t depend on domestic product, depends on exchange rate -
depreciation makes imports expensive in terms domestic currency; tari s, export subsidies, etc.
• R - interest rate
• Xn – autonomous net exports
• mpm - how expenditure for purchase of imported goods at change of income per unit =ΔIm/ΔY
• e - sensitivity of Xn to interest - change in value of Xn when interest changes by 1% = ΔXn/ΔR

NX, interest rate - increase in interest in country increases ROI, capital in ows from abroad - D
for national currency growing, goods of given country become expensive, imported cheaper. D for
national goods for foreigners falling, reducing Ex, D for foreign goods growing, increasing imports

IS - set of all levels of interest and GDP at which total I equals total S. Q of PAE
depends on interest, total level of real output and real income depends on
amount of PAE - so real income should depend on interest

Explanation - IS from Keynesian cross and I. At interest R1, I is I1, corresponds

to EP1, amount of product is Y1. When interest decreases to R2, investment
increases to I2, Keynesian cross up to EP2, so Y2:
• Point A - planned expenditure is lower than actual product
• Point B - planned expenditure is higher than actual product

Shifts of IS - caused by changes in components of autonomous

expenditures C, I, G, Xn and autonomous net taxes or Tr - increase in
consumer, investment spending; growth in government spending,
reduction of autonomous taxes; increase in transfer payments; growth in
net exports - IS right, more interest and more Y

Multiplier - ratio of income growth to growth of autonomous expenditure:

• A = 1 / (1 - mpс (1 - t) + mpm)

LM - relationship between GDP and interest rate for MD = MS:

• E in market for nancial assets, where S = D
• If imbalance in money market - must have opposite imbalance in other nancial assets market
• Left of LM there is MS > MD, point right of LM is MD > MS
• Transactional motive, so MD > MS, so increase interest, so LM curve
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 Money market, nancial assets market - assets may be held in money / nancial assets:
• TMD = TMS; WN / P = L + DOFA = M / P + SOFA; (L + M / P ) + (DOFA - SOFA) = 0
• WN / P – real wealth
• L – money demand
• M/P – money supply
• SOFA – supply of other nancial assets
• DOFA – demand for other nancial assets

MD:
• MD = kY - hi
• Y - real income
• k = dL / dY - how MD change when income level changes by 1
• h - dL / dR - how MD change when interest changes by 1% point

LM shift curve - increase of MS:

• If CB increases MS, LM to right, new E, interest rate lower

Slope of LM = k / h = di / dY
• Higher k - more shifts to right, steep
• K decreases - LM curve will be at
• Reduce h - LM, it becomes steep
• Increase h - LM becomes at
• Interest elasticity of MD is 0 - vertical, no speculative demand

Liquidity trap - speculative MD is in nitely elastic at low interest. At very low levels
of income Y0, E in money market at E and E’ along at portion of MD for money
where eMD is extremely high. At higher income levels such as Y2 and Y3,
money market in E at F and F’ - increase in income would require a large
increase in the interest rate to restore money market equilibrium

BP - all foreign economic transactions between economy of given country

and economy of other countries occurred over certain period of time.
Country reports according to methodology of IMF

Current account:
• Goods – exports, imports of goods - part of international trade
• Services — invisible international trade - transportation, tourism, insurance
• Primary income - transfers of income from ownership of production factors - dividends, wages..
• Secondary income - contributions to international organisations, transfers

Capital account:
• Debt forgiveness / Goods, nancial assets migrants take with them as they enter, leave country

Financial account:
• Foreign direct investment - equity investments higher than 10% of capital
• Portfolio investment - equity investments lower than 10% of capital or bonds
• Other investment - loans and deposits / Reserve assets – reserves of CB

BP curve - all combinations of interests and real product in which BP is in E; BP = Xn + CF =dR

Explanation - BP consists: CA - NX goods, services and FA - capital movement.

BP must be 0. If CA de cit, FA - surplus. NX declining as product grows -
imports increase because foreign goods less expensive, NX fall. If product Y1,
NX surplus - NX1. Net capital ow depends on interest dif between domestic and
foreign. If domestic interest - vertical axis, same as foreign - no movement of
capital. If interest di erential increases - domestic interest increase, so capital
in ow - NFC is +. If domestic falls, di erential negative - out ow of capital, NFC
-. Point A - if CA surplus in left picture, FA must be in same de cit - NFC is -. To
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 be negative, we need to have low domestic interest - e.g. i1. If product rises to Y2 in top left
graph, imports growing, NX in de cit - NX2. If CA de cit - need to have FA surplus - top right.
Capital in ows occur when domestic interest rate rises to i2. So, we combine higher interest rate
with higher product Y2 to obtain second point B

Points outside:
• Above BP, surplus - interest is high, capital in ows, product is low, a ects NX - small de cit
• Below BP - de cit, interest is low - out ow of capital, product is high - NX negative

BP Slope - in uenced by capital mobility:

• Perfect capital mobility - no transaction, other costs in moving capital from country to another
• Perfect capital immobility - di cult and expensive to move capital between countries
• Normally BP will be positively sloped - capital can move, but some barriers or costs

Lecture 7
Perfect capital mobility - Fixed Exchange rate:

Explanation - Fiscal expansion, xed exchange rate - start at E0 - domestic

interest same as foreign. Government G, IS to IS1, so E1. Now domestic interest
above foreign - attract investors, higher D for domestic currency - appreciate. Fixed
exchange rate, CB intervene - buying foreign currency for domestic. CB increases
domestic MS - LM to right, so E2. Domestic interest returned to world level. E
increased, scal expansion e ective

Explanation - Fiscal restriction, xed exchange rate - start at E0 - domestic

interest rate same as foreign. Government lowers G, IS to IS1, so E1. Domestic
interest falls below world - capital out ow, domestic currency depreciate. CB
intervene - sells domestic currency for foreign, so demand for domestic - LM left, E2.
Domestic interest returns to world. E decreased, scal restriction is e ective

Explanation - Monetary expansion, xed exchange rate - start at E0 - domestic

interest same as foreign. CB increases MS - LM to LM1, so E1. Domestic interest
below world. Decline in domestic - out ow of capital, domestic currency depreciate.
Fixed exchange rate - CB buying domestic currency for foreign. CB increases
domestic MD - LM back. Real product not changed - monetary expansion ine ective

Explanation - Monetary restriction, xed exchange rate – start at E0 - domestic

interest same as foreign. CB decreases MS - LM to left, so E1. Domestic interest higher
than world. Increase in domestic lead to in ow of capital. Domestic currency demand -
appreciate. Fixed exchange rate - CB buying foreign currency - LM back. Real product
not changed - restriction ine ective

Perfect capital mobility - Flexible Exchange rate:

Explanation - Fiscal expansion, exible exchange rate - start at E0. Domestic

interest same as foreign. Government raises G, IS to IS1, so E1. Domestic interest
above foreign - attract investors, high demand for domestic - appreciates, so decline
in NX. NX is part of IS - shifts back. Decline in NX compensate G growth - ine ective

Explanation - Fiscal restriction, exible exchange rate - start at E0. Domestic

interest same as foreign. Government lowers G, IS to IS1, so E1. Domestic interest
below world - out ow of capital, so high supply of domestic - depreciates, lead to
increase in NX. NX is part of IS, IS back. No change of real product - ine ective
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 Explanation - Monetary expansion, exible exchange rate - start E0. Domestic interest same
as foreign. CB increases MS - LM to LM1, so E1. Domestic interest below world, so
out ow of capital - depreciates, so increase in NX. NX part IS, IS right - ML must be
ful lled. Product to Y2 - monetary expansion e ective

Explanation - Monetary restriction, exible exchange rate - start

at E0. Domestic interest same as foreign. CB decreases MS - LM to
LM1, so E1. Domestic interest higher world. Rising domestic interest
attract investors - domestic appreciates, so decline in NX. NX part of
IS, IS to left. Product decreased Y2 - restriction e ective

Perfect capital immobility - Fixed Exchange rate:

Explanation - Fiscal expansion, xed exchange rate - start at E0. Government

increase G - IS right, so E1. Higher real product leads to higher imports. High imports
create demand for foreign currency, domestic currency depreciate. Fixed exchange rate
- CB buys domestic currency for foreign or CB reduces domestic MS. LM to left. Real
product to Y0. Domestic interest increased, private expenditure was crowded out - I, C.
Fiscal expansion is ine ective

Explanation - Monetary expansion, xed exchange rate - start at E0 - CB will

increase MS – LM right, so E1. Higher real product leads to higher imports as m * GDP -
demand for foreign currency, domestic depreciate. Fixed exchange rate - CB buys
domestic currency for foreign, or CB reduces domestic MS. LM back. Real product
returned to Y0. Monetary expansion is ine ective

Perfect capital immobility - Flexible Exchange rate:

Explanation - Fiscal expansion, exible exchange rate - start at E0 - government

increase G - IS to right, so E1. Higher real product leads to higher imports - demand for
foreign currency, domestic - depreciates, so increase in NX - part of IS and BP - move
right, so E2, real product increased - e ective

Explanation - Monetary expansion, exible exchange rate - start at E0 - CB

increase MS – LM right, so E1. Higher real product leads to higher imports - demand for
foreign currency, domestic depreciates, so increase in NX - part of IS, BP - both to
right, so E2, real product increased. Monetary expansion is e ective, but not fully

Imperfect capital mobility - capital can move between countries, but response to
interest di erential is not so strong. Domestic interest does not match world rate. BP
iincreasing. Assume LM curve is steeper than BP - capital ow is more sensitive to
interest rate changes than money market

Explanation - Fiscal expansion, xed exchange rate - start at E0 - government

increase G - IS right, so E1. E1 above BP, so BP surplus - although higher real
product leads to increase in imports, rise in interest rates leads to capital in ows -
stronger than e ect of deterioration of NX. If BP surplus, domestic currency tends to
appreciate. CB buys foreign currency for domestic currency, CB increases MS - LM to
right - LM1, so E2. Real product grown - scal expansion is e ective, but not fully

Explanation - Monetary expansion, xed exchange rate - start at E0 - CB increases

MS - LM to right, so E1 - below BP, so BP de cit - higher real product leads to
increase in imports, decrease in interest rates leads to capital out ows. If BP de cit,
domestic - depreciate. CB buys domestic currency for foreign. CB decreases MS - LM
- back to E0 - no change of real product, monetary expansion is ine ective
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 Flexible Exchange rate - Fiscal expansion, exible exchange rate - start at E0.
Government increase G - IS right, so E1 - above BP, so BP surplus - although higher
real product leads to increase in imports, rise in interest rates leads to capital in ows.
This is stronger than e ect of deterioration of NX. If BP surplus, domestic currency
appreciates. CB does not intervene at exible exchange rate - appreciation of
domestic currency lead to a decline NX - part of IS - moves to left, but BP up, so new
E2. Real product has partially increased. Fiscal expansion is e ective, but not fully

Monetary expansion, exible exchange rate – start at E0 - CB increases MS - LM

right, so E1 - below BP, so BP de cit - higher real product leads to increase in imports,
decrease in interest - capital out ows. If BP de cit, domestic - depreciates. CB does
not intervene at exible exchange rate - depreciation of domestic currency will lead to
increase in NX. NX is part of IS - it moves right, but BP - it moves down, so E2. Real
product has increased. Monetary expansion is e ective, but not fully

Reaction of NX to devaluation of currency - at E - de cit, after depreciation of the

currency, NX exports will sink into larger de cit. Only in time will NX begin to improve.
There are contracts that cannot be terminated immediately after currency depreciates. Producers
also need some time to increase production

Marshall-Lerner condition - currency devaluation will only lead to improvement in

BP if sum of demand elasticity for imports and exports is greater than one:
• e_x = (dX/X) / (dE_CZK/USD / E_CZK/USD)
• e_x = (dM/M) / (dE_CZK/USD / E_CZK/USD)

Lecture 8
Exchange rate - price of one currency in terms of another currency:
• Direct quotation – amount units of home currency for one unit of foreign 27 CZK / EUR
• Indirect quotation – amount units of foreign currency for one unit of home 0,037 EUR / CZK
• Foreign Exchange - cashless form of currency / Foreign currency - cash form of currency
• Spread - di erence between buy and sell exchange rates
• Nominal - number of units of domestic currency can purchase 1 unit of foreign currency

Demand for CZK created by:

• CZ exporters of goods and services – if foreign customer buys CZ goods - creates demand for
CZK. If he pays in EUR, CZ company has costs in CZK so it will need to change EUR for CZK
• Foreign investors who invest in CZ – want to buy CZ rm’s shares, needs to obtain CZK

Supply of CZK created by:

• CZ importers of goods and services – if CZ customer wants to buy foreign goods, he needs to
obtain foreign currency rst. He creates CZK supply and demand for foreign currency
• CZ investors who invest in overseas – must obtain foreign currency rst

Depreciation - decrease in value of currency relative to other currencies:

• Due to market forces / in oating exchange rate system

Devaluation - o cial reduction of value of currency relative to other currencies:

• In xed exchange rate system

Appreciation - increase in value of currency relative to other currencies:

• Due to market forces / in oating exchange rate system

Revaluation - o cial rise in value of currency relative to other currencies:

• In xed exchange rate system
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 Fixed exchange rate system - value of exchange rate set by CB or government:
• CB must take steps to maintain value of exchange rate

Explanation - xed exchange rate system, CB interventions - CB sets central parity point target of
28CZK / USD and delimits band around +/- 7.5%.
• If exchange rate is within band, CB does not intervene
• If depreciation pressure higher than 30 CZK / USD - CB buy domestic currency for foreign
• If pressure for appreciation higher than 25 CZK / USD - CB buys foreign currency for domestic

Flexible exchange rate system - exchange rate varies according to S and D:

• Dirty managed oating – CB occasionally intervenes to change value of country's currency

Fixed exchange rate system advantages and disadvantage:

• Lower risk for traders and investors
• Prevention of in ation - home currency is xed against currency of country with low in ation
• Disadvantage - no ability by CB use independent monetary policy

Flexible exchange rate system advantages:

• CB has ability to use independent monetary policy / Eliminate speculative attacks on currencies
• Can prevent transmission of high in ation from one country to another

PPP - purchasing power of various world currencies to one another:

• Absolute - PP of certain goods amount in country must be equal to PP of this amount abroad, if
translate this amount at current exchange rate into foreign currency = P$/Prub = ExRate/rub
• Relative - expansion of PPP to include changes in in ation over time

Explanation - goods in Switzerland 40% expansive than US. If US in ation 5%, Swiss 5%, prices
will be increasing by 5% in both, Switzerland still 40% expensive than U.S. After, in ation could be
di erent but exchange rate may change - but if US in ation is 5%, Swiss is 0%, Swiss Franc could
appreciate and become expensive against $ by 5% - Switzerland 5% more expensive in $ terms

Law of one price - goods must have same price in all locations:
• If there are di erences in prices, commodity arbitrage will take place
• Same currency - high D at place with lower P, high S at place with higher P, but nally - same P
• Locations with di erent currencies, there will be change of exchange rate
• Transport costs may be cause of di erences in prices

Exchange Rate Deviation Index - how actual rate lower than exchange rate from PPP:
• 1 - market exchange rate and PPP are same
• > 1 - domestic currency undervalued against parity
• < 1 - domestic currency overvalued against parity
• E_d/f / E_d/fppp

Big Mac index - compare price of Big Mac in country with its average price in US States:

Explanation - in CZ Big Mac costs CZK80 and $5 in US, so 80 / 5 = 16 - exchange rate

correspond to parity. Current rate was 20, so (16 - 20) / 20 = 20% undervaluation

Real exchange rate - ratio of domestic and foreign P levels:

• Foreign P level converted into domestic currency units via nominal exchange rate
• How many goods in country can be traded for one of that good in another:
• R_d/f = E_d/f * Pf / P_d
• E_d/f - nominal exchange rate

Interest rate parity - in absence of arbitrage - relationship between exchange rates and level of
interest rates in two countries - investors will be indi erent to where to invest, no in ation, assets
same liquidity, risk, assets di er only in return rates, ST, connected with movement of capital
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 • Covered - no-arbitrage condition could be satis ed through use of forward contracts
• Uncovered - no-arbitrage condition could be satis ed without use of forward contracts

Fisher e ect - changes in in ation annual rate lead to changes in nominal interest rates:
• i = r + P^e
• i — nominal interest rate
• r — real interest rate
• P— expected in ation rate

Fisher Synthesis of PPP and interest rate parity:

• Equality of real interest rates in Czech Republic and USA
• Reason - if in one country there is higher real interest rate - capital in ow

Explanation - domestic interest rising, higher than foreign. Uncovered interest rate parity -
domestic currency appreciates. Fisher - rising nominal interest rates increase in ation - domestic
expected in ation will be higher. Expected In ation di erential will increase, which according to
relative version of PPP leads to expected depreciation of domestic currency

Lecture 9
Structure of population:
• Economically active population - employed, unemployed
• Economically inactive population - students, children less 15, pensioners…
• Unemployed - > = 15 aged who not employed, seeking job, available for work within 14 days

Unemployment rate = percentage of unemployed in workforce:

• u = U / (L+U) * 100%
• U - number of unemployed
• L - number of employed
• L + U - labor force

General UR in CZ - share of unemployed in total LF in percentage. Data from Labour Force

Survey - visit households and ask for information on employment and unemployment

Share of unemployed persons - used in CZ, share of available job applicants registered at
labour o ce aged 15–64 years, not from LM, but from total population of given age
• Registered UR - percentage of unemployed registered with labour o ces in labour-force

Frictional unemployment - ST, related to time spent searching for job, occurs when looking for
work after being red, changing jobs voluntarily, young people rst look for work

Structural unemployment - LT, associated with technological changes in production that change
structure of D for labor:
• Skills - if employee red from one industry can not get job in another because of lack of skills
• Place - one district with high unemployment another with low unemployment – poor transport

Cyclical unemployment - during economic recession - hits whole economy

Seasonal unemployment - due to seasonal developments - agriculture during winter

Natural rate of unemployment = frictional + structural + seasonal, full employment:

• Demographic changes - high proportion of young people in LF, so higher NUR - young people
have higher frictional unemployment - they often change jobs, graduate universities
• Structural changes - signi cant changes in economy - higher NUR
• Replacement ratio – di erence between incomes if person has got job and if unemployed
UR not change - constant workforce size, number of canceled jobs = number of newly created:
• zE = nU
• Z - ration of job less; N - rate of nding job
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 Flows of workers between employment, unemployment and non-participation:
• Some employed leave work and become economically inactive - pensioners
• Some economically inactive persons take up employment directly - post-graduate students
• Some people change their jobs / Some unemployed people give up further job search
• Some economically inactive persons - students do not nd job and become unemployed
• UR unchanged - constant size of workforce, number of canceled jobs = number of new created

Aggregate LM - workers do not care how many CZK receive - but how many goods they can buy
with wage - care about real wage W/P. Firms care about nominal wages they pay relative to price
of goods - also care about real wage W/P:
• D_L = f (W/P); S_L = f (W/P)

Сlassical model of LM - full employment is norm of market economy, based on principle of self-
regulation of LM, best economic policy is policy of non-interference of state:
• Main market regulator is wages / Companies - expressing demand, employees - supply
• Economy tends to make full use of its resources / Output corresponding to full employment
• With growth of general level of wages, LD falls, LS increases / nominal wage move

Explanation - at intersection of D and S - full employment. If P drops to P1, real

wage at nominal wage would be higher, so W0/P1, so S > D. Nominal wages - ex,
wages drop to W1. Real wage to initial level and employment is at full employment.
If wage falls - pro table for employers hire additional workers, which increases LD

Keynesian model of LM, xed nominal wage:

• Nominal wages xed in ST - due to collective agreements

Explanation - If P to P1, real wage rises to W0 / P1. Companies L1 amount of

labour - involuntary U arises. Recession - decline in GDP. Nominal wages xed, so real wages
rising - behaving counter- cyclically at start of recession - when new collective agreements
concluded that nominal wages, and thus real wages, may fall and market may be cleared

New Keynesian model of LM:

• Tried to explain Keynesian microeconomic foundations
• Why prices, wages can be sticky – why not adjust instantly to changes in economic conditions
• Due to wage and price stickiness economy may fail to attain full employment

Nominal rigidities - nominal price is stable to change:

• Menu costs – costs to rms resulting from changing their prices - change if there is bene t
• Imperfect competition – oligopoly, monopolistic competition, monopsony, oligopsony

Real rigidities - something holds one price or wage xed to relative value of another:
• Implicit contract - agreement between employer / employee about quantity of labour and wage
• E ciency wages – rms want to pay more than reservation wage - lowest wage rate at which
worker would be willing to accept particular job. Higher wage - higher productivity. Higher
wages - companies reduce frictional unemployment and costs of nding and training
new employees who replace those who leave. Company cannot increase wages
forever - will stop wage increase when ALC go above MPL = revenue

Monetarist model of LM by Friedman - rms know how P develops:

Explanation - employees have info barrier, do not know how P develops - use
expected P level. Companies to attract new employees will raise nominal wages W1,
but nominal wage growth is lower than price growth - real wages drop to W1 / P1.
Employees do not know that P level has risen, they take nominal wage growth as real
wage growth and o er L1 quantity of labour. Over time, employees will understand
that they were wrong that real wage has fallen and will demand nominal wage growth
- move back to E0 - to L*.
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 Theory of real economic cycle – employment uctuations caused by S shocks.
Positive - increased productivity of production factors - eg development of
information technology. Or may be negative - e.g. rising oil P. If S shock positive,
product grows. As soon as product grows - LD increases. If supply of labour has
positive slope - employment increases. Price growth accompanied by nominal
wage growth

Lecture 10
CPI - measure of weighted average of prices of consumer goods and
services basket, contains representative products and each has xed
weight for some time:
• Problems of xed baskets – new product, innovation….
• Index by which measures price level for given moment of time
• In ation - rise in price level; we have to compare two time moments

PPI - in manufacturing measure rate of change in prices of products sold as they

leave producer, exclude taxes, transport, trade margins

GDP De ator - measures changes in prices for all of goods / services produced in economy,
measures in ation, de ation, larger than CPI, which has selected basket of goods and services

Types of in ation based on CPI:

• Over year / year month and corresponding month of previous year / reference, previous month

HICP - measure changes over time in prices of consumer goods, services acquired by
households, comparable measure of in ation, used for in ation assessment convergence required
under Maastricht criteria for accession to EUR - price performance sustainable and average
in ation not more than 1.5 percentage points above rate of three best performing member states

Unexpected in ation – redistribution of wealth from creditors to debtors. If P rise, so income of

borrowers - companies have higher sales, employees have higher wages. But debtors repay same
nominal amount for which creditor buys less; iR = iN - in ation

Increase of paid income tax - if employer raises nominal wages more than in ation - may be
worse o - progressive rate of taxation, higher wage higher band with higher tax rate

Other costs:
• Menu cost – connected with new prices: print of new price lists, info about new prices etc.
• Costs associated with more frequent collection of cash – time, re lling of ATMs etc.

De ation – decline in price level, demand false:

• If prices decrease, companies has got lower revenues, reduce wages and employment
• If prices decrease, debtors has got lower incomes, pay in nominal terms same - bankruptcy
• If it becomes mass phenomenon, banks have problems, whole banking
system has problem
• If prices decrease, customers can delay their purchases, expecting further
price cuts
• Economy can fall into deep and prolonged recession, di cult to get out of it
• Disin ation – rate of in ation declines

Phillips curve - higher wage in ation, lower UR - when D for goods, services
increases, P of product increases, higher wages. If LD increases, U decreases

Wage in ation vs. price in ation:

• P in ation % change = Wage in ation % change - Labour productivity % change
• Wages - main part of TC or prices set as charge to wages; Nominal Unit LC = Wages / GDP / L
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 • Formation of prices through wage surcharge: P = (1+mp) * W / GDP / L

Non-accelerating in ation rate of unemployment - level of U that does not cause in ation to
increase consistent

Friedman - PC only in ST, added e ect of expectation:

• Adaptive expectations - subjects form expectations based past = P_t = P_t^e
• Rational expectations - subjects use all information, do not make systematic errors when
predicting future, deviations from perfect foresight are only random

Money illusion - tendency to perceive nominal value of money, rather than real, expressed in PP.
• People perceive increase in wages, at the same time, they don’t consider in ation

Explanation - Phillips curve with in ation expectation - UR is 4.5% - same as nature rate. Blue
SPC created for expected in ation of 0%. Actual in ation 0. If G increases G - CB MS we move up
along blue SPC. UR lower but actual in ation higher. Households have monetary illusion - think
in ation is still 0%. Over time, households will adjust their expectations - they will expect 1.5%
was in adaptive expectations. SPC right red and intersects LPC curve at 1.5% in ation.
Government intervention leads to acceleration of in ation

PC and cost supply shocks - actual rate of in ation a ected by:

• Expected rate of in ation / Deviation of actual UR from NUR
• Cost shocks / If supply shock - such as rising oil prices - SPC up

PC and rational expectations - companies / employees form expectations according to in ation

in next period - quickly re ected in actual in ation. Actual UR will equal to NUR - so 0. If no S
shocks - actual/ expected rate of in ation same - vertical PC

Lecture 11
In ation targeting - monetary policy, CB change interest in order to in uence real in ation:
• If CB expects in ation exceed in ation target in monetary policy horizon, it raises interest
• If CB expects in ation to be lower in ation target in monetary policy horizon - lowers interest

Taylor rule - interest forecasting model, determines how much nominal interest rate should
change in event of changes in GDP, in ation, other economic conditions:
• In all other things equal, 1% increase in in ation must followed by least 1% increase in interest
• Determine which monetary policy should meet goal of maximum employment and price stability
• Economy on potential output, real in ation same as in ation target
• Target Rate = Neutral Rate + 0.5 * (GDPe – GDPt) + 0.5 * (Ie – It)
• Target Rate - ST interest rate after change
• Neutral Rate - ST interest rate that currently prevail
• GDPe - expected GDP growth rate
• GDPt - LT GDP growth rate
• Ie - expected in ation rate
• It - target in ation rate

Taylor Rule and exchange rate - if nominal exchange rate appreciates, prices xed in ST, then
real exchange rate appreciates - reduces net exports, real output falls in ST - negative D shock.
CB responds lowering interest rates. Currency appreciation lowers in ation - positive S shock -
lowers prices of imported products, services. Slowdown in in ation - reason why CB responding
by lowering real interest rates

Reaction function - CB's reaction to existence of in ation / production gap

Explanation - relationship between real interest and in ation - start from Fisher: real
interest = nominal interest - eP. CB must change real interest, has impact on
expenditures - on I, C, etc. If rate of in ation increases, CB raise real interest in
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 order to weaken economy - reduce in ation. If CB tightens its in ation target - MP
upwards - CB must hold higher real interest for each level of in ation

Explanation - relationship between real interest and product gap - if economy on

potential product Y = Y *, in ation is in line with in ation target, CB maintains stable
real interest - e.g. 1% if in ation is 3%, then nominal is 4%. If positive product gap
due increased expenditures - CB raise real interest in order to dampen economy

AD - level of total economic expenditure Y at certain size of in ation

Explanation - start at A, if in ationary pressures increase, CB raise interest r1 - MP

up. Higher real interest lead to decrease in expenditures - shift along IS up, so B.

Explanation - Changes in AD - shift in AD represents demand shock - negative or

positive. AD to right if C, I, G, NX increase for reasons other than change in in ation,
shift along - associated with change in real interest rate, IS to right. AD right when
CB increases MS or lowering in ation target

AS - in ST = production can be above potential level - positive production gap or

below level of potential product - negative production gap. In LR:
• If economy at level of potential output, in ation stable, determined by in ation
expectations previously. Actual in ation same as expected in ation. Economy is
moving at level of potential output
• Growth of real output above level of potential output will increase in ation, its
expectations, but decline in real output below level of potential output will be
associated with decline in in ation
• In ation can be a ected by supply cost shocks - raw material prices, nominal
wage growth compared to productivity growth. If market economy is not exposed
to these shocks, rate of in ation will be relatively stable and ST growth in D will
have little e ect on P of companies and consequently in ation throughout
economy

Causes of small price changes in ST - in ST, prices change little:

• Menu cost - sometimes cost of changing prices - e.g. price tags is higher than bene t
• Coordination failure - companies don’t know what competitors do, they sell their products and
services at current prices - cannot coordinate decisions in ST, afraid to be rst to raise price
• Implicit pricing contract - unwritten agreement between company and customer about prices
• Con dence lose - frequent price changes, consequences for existence of company and D size
• Collective wage agreements - they can be for year - nominal wages don’t change during period

SRAS - in ation is rising in ST, rms increasing production:

Explanation - in ST companies change volume of production under in uence of

changes in AD - provided there are no cost shocks. Change in expected in ation rate
leads to shift SRAS. If economy is at level of potential product and natural rate of
unemployment, deviation of actual product from potential product is 0

SRAS expected in ation - if there are no negative supply cost shocks in economy,
in ation rate is stable and at level of expected in ation rate

Explanation - in ation expectations change based on development of actual in ation

- adaptive expectations, same time agents considering further developments -
rational expectations. Change in in ation expectations change of SRAS up, lower
expected in ation rate pushes SRAS down

SRAS shocks:
• Permanent LT supply shocks change size of potential product - shifts in LRAS
• Temporary supply shocks - changes in raw material, energy prices or changes exchange rate
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 • If SRAS to left upwards - negative supply shock by rising commodity and energy prices,
depreciation of exchange rate or rapidly rising wage rate, output decrease
• SRAS to right downwards - positive supply shock caused by falling commodity and energy
prices, exchange rate appreciation or slow growth in nominal wage rates, output increase

SRAS output gap:

• If actual product > potential, factors of production overloaded, their prices rise, become less
a ordable. Pressures on in ation increase - in ation expectations will increase in future. Firms
raise prices more than in ation expectations in previous period - along SRAS right
• If economy gets > potential output - positive output gap, in ation rate tends to rise, pressure to
increase in ation expectations. With LT positive production gap, there would be SRAS up

Explanation - AD and AS negative D shock. Reduction G, AD to AD1. In ST,

in ation determined by expectations - expected in ation does not change, so no
SRAS movement. Actual rate of in ation declining, so nally negative output gap.
Companies’ production reduced, lay o employees, U is rising, C decreasing - will
cause reaction CB, lowers real interest rates in e ort to close negative output gap. It
lead to recovery in I and consumer spending, or to increase in NX. Negative output
gap close, economy will return to level of potential output with lower in ation.
SRAS0 to SRAS1 due to lower in ation expectations.

Explanation - AD and AS positive D shock. Government increase G, AD right, so E to E1,

increase in actual product above potential - positive output gap, rising in ation. Higher in ation
re ected in in ation expectations - higher nominal wages, higher raw material P. Change in
in ation - SRAS0 to SRAS1. Higher in ation expectations result in CB’s reaction of rising interest,
which weak planned expenditures - close production gap. Economy to level of potential output E2,
at higher level of real, but especially expected stable in ation

Explanation - AD and AS temporary negative supply shock - start at E0, E at potential output
level and NUR, output gap 0. Oil P rise, acceleration in in ation rate, at same time rising in ation
expectations, so SRAS0 to SRAS1. Output falls below potential output, economy in negative
output gap - market return economy to level of potential output and NUR. ST S shock will
disappear over time, companies can adapt to it, for example, by introducing new technologies. CB
does not intervene in event of temporary S shock - assumes e ect temporary S shock will
gradually disappear

Lecture 12
Response to demand in ation:

Cold Turkey Method - СB increase signi cantly real interest - deep decline in
production and increase in U, but rate of in ation will fall rapidly. Recession is
deeper, but shorter

Explanation - start at E0, potential output at stable and expected in ation rate 8%.
If CB decides to reduce in ation to 3%, must raise real interest rates signi cantly at
each level of current in ation rate, MP up. Increase in real interest will reduce PAE at each level of
in ation rate, which will be re ected by AD0 to AD1, so E1. In ST, real output < potential output,
CB gets economy into negative output gap, increases U. If policy strong in form of rising interest -
faster return to potential levels. CB a ect in ation expectations, which falling, SRAS to to E2

Gradualistic method - CB gradually changes real interest to reduce AD with small

e ects on UR and decline in output. Decline in product with gradualist method is
lower, but longer

Explanation - start at E0, potential level product, stable in ation 8%. In ation high
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 for CB - smaller increases in real interest. Gradual reduction is important if adaptive expectations
prevail. Smaller rise in real interest leads to small decline in AD, so E0 to E1. Processes return
economy back to potential output to E2, so actual in ation and in ation expectations lower -
SRAS0 to SRAS1. New in ation is 6% - continue. ST - will deviate economy from potential output
through changes in real interest and decline in AD, so E3. Economy return through adjustment
processes to required level of actual and current expected in ation rates, so E4

Response to demand in ation and expectation - in ation expectations, which linked to agents'
perceptions of CB's e orts to reduce in ation, have decisive in uence on how individual policies
will translate into declining real output and rising unemployment
• Adaptive expectations - largely, in ation rate has higher inertia, in ation will decline gradually -
associated with LT, which is characterised by slower adjustment of wages and prices
• Rational expectations - announced disin ationary policy, increase in real interest will quickly be
re ected in decisions of households and companies on amount of wages and prices - decline

Sacri ce ratio - e ect of rising and falling in ation on total production and output, measures loss
in output per each 1% change in in ation
• Sacri ce ratio = Cost of lost production / Percentage change in in ation

Response to S side in ation - CB's response to S shock depends on whether it is temporary or

permanent. Economy enter recession under in uence of supply shock, in ation rise:

Explanation - suppressive restrictive policy - prices increase signi cantly, in ation to 6%,
in ation expectations have changed - SRAS0 to SRAS1, so E1, decline in real output below
potential output Yg1. PAE lower with higher in ation - sales di culties and U is rising,
so stag ation. So, CB tighten policy - raise real interest - at each level in ation rate,
reaction function move up to eliminate higher in ation, so AD0 to AD1, further widen
product gap, so E2. To reduce in ation, CB widened output gap, deepened recession
in ST, ful lled in ation target, kept in ation rate at previous level. Policy costly because
large loss production

Neutral policy - CB doesn’t raise real interest, doesn’t react to negative supply shock
- temporary supply shock. Growth of in ation, so in ation expectations - SRAS0 to
SRAS1. Real output falls below potential output and economy is in negative output
gap. Market return economy potential output and NUR. ST supply shock disappear
over time - can adapted toby introducing new technologies

Accommodative policy - negative supply shock will increase in ation and in ation
expectations - SRAS0 to SRAS1, so E1, decline in real output, increase in UR - above
NUR. To stabilise product, return real product to potential, CB lower interest to
support growth AD, so E2. Situation accompanied by higher in ation rate, same time
higher expected in ation rate, so SRAS0 to SRAS1. Economy has returned to level of
potential output, but at higher rate of actual and expected in ation. Level of potential
output thus corresponds to higher in ation expectations, which may be in con ict with
current central monetary policy rule
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