ECONOMICS QUICK REVISION NOTES CFA level 1 Edited By Sam
Economics Keynes: Sticky prices, so if Demand falls, Supply will fall, and employment falls Expenditures GDP: Consumer Spending, Private Investment, Government expenditures Real GDP = Planned C + I + G + NX Planned consumption is determined primarily by disposable income. Rise in income allocated to consumption by MPC. NX, net exports, decrease as income rises because imports rise. If Actual Expenditures < Planned Expenditures, then inventory exists, employees will be laid off, output will fall. Thus, investment is the primary source of instability. If the economy is at less than full employment, then increase spending. If I get an additional $1,000, I spend MPC*$1000 with a group of vendors. This group then spends (MPC*$1000)*MPC and so on. The expenditures multiplier is thus expressed: M = 1 Aggregate spending increases by M*1000 (1 MPC) LRAS AD2 SRAS AD1 AD3
GDPf At AD1, increased expenditures increase output. At AD2, increased expenditure increases prices. Multiplier shows why small changes in C, I, G have such huge effects. If expansionary fiscal policy is used to thwart recessions, some argue that budget deficits lead to higher interest rates and crowd out private investments. Keynesians argue that there are excess loanable funds. Then again, this excess could be from foreign sources which causes the dollar to rise and then raises the value of imports and decrease the value of exports. Classical / Supply-Side: Demand falls then Wages fall, Supply is constant, and Employment is constant Resource Cost-Income Approach: Employee Compensation, Proprietor s Income, Rents, Corporate Profits, Interest Income, Indirect Business taxes, Depreciation, Net income of foreigners Expansionary fiscal policy such as a tax cut will be saved by consumers in anticipation of a future tax hike. This savings increases the supply of loanable funds leaving interest rates unchanged.
Automatic stabilizers ensure deficits in a recession and surpluses during booms and, thus, mitigate policy lags. The three main are Unemployment Compensation, Corporate Profit Taxes, Progressive Personal Income Taxes. Supply-siders say that taxes should be cut to stimulate investment and savings, more working, and a reduction in the use of tax shelters. Money & Banking 3 Fed Tools: Fractional Reserve System, Open Market Operations (Buy & Sell Treasury Instruments), Discount Rate M1 currency in circulation, checkable deposits, traveler s checks M2 M1 + saving deposits + time deposits (<$100k) + money market mutual fund Commercial Banks, S&L s, Credit Unions. Bank reserves vault cash and deposits held at the Fed. Potential Deposit Expansion Multiplier = 1 Required Reserve Ratio Actual DEM < potential if some decide to hold currency and if banks fail to loan out excess reserves. Expansionary monetary policy: Fed buys T- bonds which raises bond prices and drives down yields (rates). Lower real rates cause more investments to be profitable, hence raising investment spending. AD shifts to the right. In the short run, investment, output, and prices increase. Lower real rates depreciate the dollar which increases exports. Lower rates cause stocks, bonds, and houses to rise in price, thus increasing personal wealth. (Money Supply) * (Velocity) = GDP = (Price) * (Real Output) Thus, if money supply increases while velocity and quantity is fixed, prices must rise. P = MV/Y In the long run, nominal rates rise because expected inflation rises. N = I + R If a policy change is fully anticipated, contracts reflect higher prices. Thus, prices and rates increase, causing no gain in output. Individuals who use adaptive expectations will tend not to anticipate policy changes, thus leading to a change in output over the short-run but only a change in prices over the long-run. Inviduals using rational expectations will tend to anticipate policy changes, thus affecting prices over both the short- and long-run. Problems with monetary or fiscal activism: Recognition Lag, Implementation lag, Impact Lag
Implementation lag is shorter for monetary than it is for fiscal policy. Tax policy has shortest impact lag. Real Wage = Nominal Wage / Price Level Reduction in real wages occurs if higher prices are unexpected. If higher prices are fully anticipated, individuals demand a higher nominal wage, leaving the real wage unchanged. When actual inflation exceeds expected inflation, unemployment drops below the natural rate and vice versa. Stagflation. Producer Surplus = Σ (Actual Price minimum acceptable price) Supply curves are elastic when producers can add resources inexpensively. Changes in resource prices: higher costs shift supply curve left (reduce supply and increase prices) Changes in technology: lower cost techniques increase supply (shift curve right) Short run shifts along the supply curve only Long run supply curve itself shifts Price Elasticity = Percentage Change in Q / Percentage Change in P Percentage Change = Change in Value / Average Value Perfectly elastic = horizontal demand curve Perfectly inelastic = vertical demand curve Slope of demand curve is not the price elasticity. Price elasticity is higher at higher prices. Demand generally more elastic in the long run. Unitary price elasticity total expenditures on a good are constant because a change in price equals the change in quantity demanded at all price levels. For an individual firm, revenue is maximized at UPE. Monopolistic (differentiated, branded commodities) competition differs from pure competition (un-branded commodity markets) in that the monopolistic competitor faces a downward sloping demand curve. Also, in long-run equilibrium, the monopolistic competitor does not produce at the quantity where ATC is minimized. Monopolistic competitors (price searchers) maximize profits by producing where Marginal Revenue equals Marginal Cost and charges price from the demand curve. In the short run, P>ATC. In the long-run, P = ATC because of low barriers to entry.
Monopolists also set MR=MC but due to high entry barriers, positive economic profits can exist in the long-run. Demand curve must lie above the ATC curve at the optimal quantity point. Monopolists are price searchers with imperfect information about demand and must experiment with prices. Oligopoly is a small # of sellers. Interdependence among competitors (decisions made by one firm, affects D, P, Profits of others). Large economies of scale. Significant barriers to entry. Products may be similar or differentiated. Collusion Price increases, output decreases Competition P = LRATC Demand curve facing oligopolist is very elastic or flat so a small decrease in P, leads to a large change in Q. Game Theory: Prisoner s dilemma Natural Monopoly Economies of scale are so pronounced that Government imposes the price ceiling of Average Cost to ensure normal (zero) economic profit. But this gives the monopolist no incentive to reduce costs and maintain quality. Demand for productive resources is a derived demand since demand for the final good it produces determines demand for the resource. In the short run, if there are no good substitutes for a resource and demand for the final good is inelastic, then demand for the resource is inelastic. If a resource has few other uses, then it has low resources mobility and a low elasticity of supply in the short-run. Demand for a resource also increases as its productivity increases. Marginal Product = MPL = Change in Output / 1 extra unit of labor Marginal Revenue Product = MRPL = Change in Revenue / 1 extra unit of labor If the firm is a price taker: MRPL = MPL * P, where w = Price of Labor, and P = Price of the final good The profit maximizing firm will increase the use of each resource until the MRPL = W of last resource unit. MP A= MPB PA PB = MPC cost-minimization PC For a given firm that holds all other resource inputs constant, a curve depicting the marginal revenue product will be identical to the firm s demand curve for the resource. Comparative advantage is the ability to produce a good at a lower opportunity cost than others can produce it. Absolute advantage refers to using the fewest resources to produce a product.