1. Output And Prices in the Short-Run
Chapter 25
Output And Prices in the Short-Run

2. What Happens to the equilibrium national income when the price level changes ?
There is a negative relationship between the price level and the Aggregate Expenditure .
A change in the price level have an effect on consumption , C and on net exports which in turn affect Aggregate Expenditure.

3. I. Change in Consumption, C
An increase in domestic price level , lower the real value of wealth or income which in turn decrease consumption and the decrease the Aggregate Expenditure , so AE function shift downward .
So as P rises , real W falls , C decreases,and AE Function shift downward .
A fall in the price level has the opposite effect .

4. II. Change in Net Exports ( X- M)
When domestic price level rises, then domestic goods become more expensive relative to foreign goods. Therefore,
Domestic consumers will buy less of domestic goods and more of foreign goods, so imports will rise .
Foreign countries will reduce their purchases of our domestic goods so Exports will decrease and as a result Net Exports ( X- M ) will fall .

5. Change in Equilibrium National Income
Change in the price level change both Consumption and Net export .
A rise in the price level will decrease both C and ( X-M ) so AE function shift down and Y will decrease .
A fall in the price level has the opposite effect so as P falls , Y will rise .

6. The Aggregate Demand
The negative relationship between the price level and National income is called Aggregate Demand , AD .
AD curve is negatively slopped which means that :
As Price level decrease, Income will rise and as price level rises , Income will falls .
The change in price level , P, causes a movement along the AD curve .

7. Equilibrium National Income and The Price Level
So far, we have discussed how equilibrium National Income is determined using only the Aggregate Demand , AD .
To complete the picture, we need to add the Aggregate Supply to show the final market equilibrium .

8. The Aggregate Supply Curve
Shows the relationship between the quantity supplied by all firms and the price level .
Short-run Aggregate Supply, SRAS curve: relates the price level to quantity supplied by all firms with the assumption that prices of all factors of production remain constant.
Long-run aggregate supplied curve, LRAS: relates the price level to quantity supplied by all firms after the economy has fully adjusted to the change in the price level .

9. Short-Run Aggregate Supply
The SRAS curve shows a positive relationship between the price level and the total output produced by all firms in the economy.
A change in the price level causes a movement along the SRAS curve from one point to another .

10. Shift in SRAS Curve or Aggregate Supply Shock
There are two reasons for SRAS curve to shift :
1. Change in prices of inputs or cost of production .
2. Increase in productivity .

11. I. Change in Prices of Inputs
If prices of inputs rise .. Cost of production will rise .. profit will decrease, therefore, for the same output to be produced , an increase in the price level is required , otherwise the firms will cut production and that shift the SRAS curve to the left .
If prices of inputs fall … it will have the opposite effect . (shift SRAS to the right )

12. II. Increase in Productivity
If labor productivity rises .. Unit cost of production will fall as long as the wage rate does not rise sufficiently to offset the productivity rise . This will shift the SRAS curve to the right .
If labor productivity falls it will have the opposite effect which means it will shift the SRAS curve to the left .

13. Macroeconomic Equilibrium
The intersection between the AD and SRAS curves give us the macroeconomic equilibrium of national income and the price level .
Any shift in either the AD or SRAS curves leads to change in the equilibrium value of the national income and the price level .

14. Aggregate Demand Shock
An increase in AD … shift the AD curve to the right , and this increase both the equilibrium national income and the price level . This increase in AD is called Expansionary Demand Shock.
A fall in AD … shift AD curve to the left, and this decrease both equilibrium national income and the price level . This is called Contractionary Demand Shock

15. Aggregate Supply Shock
An increase in aggregate supply will shift the SRAS curve to the right or downward and this will lead to an increase in the equilibrium national income , but to a decrease in equilibrium price level .
A decrease in aggregate supply will shift the SRAS curve to the left or upward, and this decreases equilibrium national income , but increases the price level .

16. Stagflation The combination of inflation and
An increase in the price level is called Inflation .
A decrease in output is called Stagnation.
The combination of inflation and
stagnation is called Stagflation

17. The Multiplier when the price level is held constant { Simple multiplier }
The simple multiplier measures the horizontal shift in AD curve in response to the change in autonomous expenditure.
If the price level is held constant, it means that firms are willing to supply all output demanded at the existing price.This leads to horizontal SRAS curve called “ Keynesian SRAS curve “ .

18. Keynesian SRAS Curve Keynesian SRAS curve is horizontal .
Based on the Keynesian SRAS curve , firms will supply whatever they can sell at their existing price as long as they are operating below the normal capacity .
Therefore, based on the Keynesian SRAS curve, real national income is demand determined .

19. What happens in the case in which SRAS curve slope upward ?
In this case, a rise in national income caused by an increase in AD will be associated with a rise in the price level .
The multiplier effect when the price level is allowed to vary would be smaller than the simple multiplier .

20. The Importance of the Shape of SRAS curve
Over the horizontal range of SRAS curve any change in AD will change the equilibrium national income only.
Over the Intermediate range of SRAS : any change in AD will change both the equilibrium price level and income .
Over the steep range of the SRAS curve: any change in AD will cause large change in equilibrium price level ,but small change in equilibrium national income .

21. The Effect of Demand Shock when the SRAS curve is Vertical
When the SRAS curve is vertical, then any change in AD will change the price level only , and no change in equilibrium national income.
The multiplier in this case is zero .

22. Output and Prices in the Long Run
Chapter 26
Output and Prices in the Long Run

23. Potential VS. Actual National Income
Potential National Income, or Y*: Is the total output that can be produced when all production resources are being used at their normal rate of utilization . Therefore, the potential National income represent what should be produced by the economy.
Actual National Income , or Y: Is the output actually produced given by the intersection between AD and SRAS curves .

24. The Output Gap Output Gap = Y* - Y
Is the difference between the potential and actual output .
Output Gap = Y* - Y
When Y* > Y we have Recessionary gap
When Y* < Y we have an Inflationary gap

25. Factor Prices and Output gap
Recessionary gap ( Y* > Y ) causes downward pressure on wages to fall .
Inflationary gap ( Y* < Y ) causes upward pressure on wages to rise .
When Y = Y* , so the GDP gap = 0 , there is neither downward nor upward pressure on wages to go up or down .

26. Long-Run Consequences of AD Shock
1.Expansionary AD Shock: increase in AD
-A rise in AD .. Shift AD curve to the right.
This open an inflationary gap (Y > Y*)
The inflationary gap put pressure on wages to rise .. Increase cost of production .. Which shift SRAS curve to the left . This process will continue until the inflationary gap is eliminated.
This process is called “Self-Adjustment mechanism .

27. 2. Contractionary AD shock
Assume the economy is initially operating at full employment . Then ,
A fall in AD shift the AD curve to the left and open a recessionary gap .
This gap , put pressure on wages to fall,so cost of production will fall . This encourage more production, so SRAS curve shift to the right until the gap is eliminated . This process is called ( Self-Adjustment mechanism )

28. Long-Run Equilibrium
The intersection between AD and LRAS curves give us the equilibrium P and Y in the long-run
Any shift in AD or LRAS curves will change the equilibrium value of P and Y .
Any change (shift) in AD in long-run will change the price level only .
Any change in LRAS will change both price level and national income , P and Y

29. Basic Theory of Fiscal Stabilization
Fiscal Policy: is the use of government expenditure ( G) and/or government revenue ( T ) to stabilize the economy at full-employment . Fiscal policy can be divided into two cases :
1. Expansionary Fiscal Policy .
2. Contractionary Fiscal Policy .

30. 1. Expansionary Fiscal Policy
A fall in T and/or a rise in G will shift AE function upward and shift AD curve to the right , and this will increase the national income or GDP .
Therefore, if the government would like to increase National income or GDP it should use the expansionary fiscal policy.

31. 2. Contractionary Fiscal Policy
A rise in Taxes and /or fall in government expenditure will decrease AE , and shift AE function downward and shift AD curve to the left , and this will decrease the equilibrium national income or GDP.
Therefore, if the government would like to decrease GDP , it should use the contractionary fiscal policy .

32. How a Recessionary gap can be eliminated ?
1. SRAS curve shift to the right as a result of decrease in prices of input and the cost of production ( self-adjustment mechanism process ) .
2. AD curve shift to the right as a result of a rise in G /and or a fall in T which will restore full employment at Y* , but at a higher price level .

33. Advantages VS Disadvantages of Fiscal Policy
Advantage: The use of fiscal policy will shorten the period of recession .
Disadvantage: the use of fiscal policy may cause the economy to overshoot its potential output .

34. How an Inflationary gap can be eliminated ?
1. SRAS curve may shift to the left as a result of an increase in prices of factors of production (self-adjustment mechanism ) .
2. AD curve shift to the left as a result of fall in G and/or a rise in T (contractionary fiscal policy ) .

35. Built in Stabilizers
These policies specify that government spending or tax changes will take place automatically in response to upturn and downturn in economic activities .
Example of automatic measures are :
1. Unemployment compensation .
2.various welfare programs .
3. Progressive income tax .

36. The effect of Fiscal Policy that is not revesed
If the economy overshoot its potential level of output, it is possible to stabilize the economy at full employment if the fiscal policy can be quickly reversed.
But, if the fiscal policy can not be reversed quickly , then the output gap will exist for longer period, and eventually will be closed through the self-adjustment mechanism .

37. The Nature of Money and Monetary Institutions
Chapter 27
The Nature of Money and Monetary Institutions

38. Definition of Money Economists define money as :
Anything that is generally accepted in payment for goods or services or in the repayment of debts .
Barter economy is defined as:
an economy where one good is being exchanged directly for another good.

39. Wealth and Money
Wealth is all assets (including money) that are owned by an individual such as Bonds , Stocks , Land, Furniture, Cars, Houses , etc.
Money is just one asset of the total wealth of the individual .
Wealth is much broader concept than money .

40. Income VS. Money Income is f Flow of earning per period of time .
Money is a stock i.e. certain amount of at a given point in time .

41. Functions of Money 1. Act as a medium of exchange .
2. Act as a unit of account .
3. Act as store of value .

42. 1. Money act as a medium of exchange
This means that money is used to pay for goods and services .
This act promotes economic efficiency by reducing transaction cost .
It eliminates much of the time spent in exchanging goods and services in the Batter economy .

43. Barter Economy Exchanging one good for another good
In this economy, the transaction cost is very high .
In this economy people have to satisfy “ Double Coincidence of wants “

44. 2. Money act as a unit of account
We measure the value of goods and services in terms of money .
In money economy , the number of prices needed equal to the number of goods and services to be exchanged .
In barter economy, the number of prices needed equal to n ( n-1 ) 2
where n = number of goods to exchanged

45. 3. Money act as a store of value
Money is a store of purchasing power over time .
You can sell what you have for money, and then store your money until you have the time and desire to buy .
Money is not the only asset that has this function , but it is the most liquid asset .
Money losses value during inflation period .

46. Money Supply
Is the total stock of money in the economy at any moment in time .
There are different definitions for the money supply . These definitions vary in terms of what deposits are included .

47. Definitions of Money Supply
1. Narrow definition of money supply or M1
Broader definition of money supply or M2 and M3

48. Narrow definition of money supply
M1 = currency in + deposits that can be
circulation used as a medium of
exchange
Therefore :
M1 = C + DD + NOW D + ATS D + any
checkable deposits .
NOW D = Negotiable Order of Withdrawal
ATS D = Automatic Transfer Service

49. Broader Definition of Money Supply or M2 and M3
M2 = M1 + SD + Small TD
M3 = M2 + Large denomination of TD
Where :
SD = Saving deposits
TD = Time deposits

50. Near Money & Money substitutes
Are assets that satisfy the store of value function and can be converted into a medium of exchange, but they are not themselves a medium of exchange .
Example:
Treasury Bills that mature in 30 days

51. Money Substitutes
Are things that serve as temporary medium of exchange, but are not a store of value .
Example:
Credit card such as Visa or Master Card

52. Inter-Bank Activities
1. Banks often share loans . This is called “pool Loans “ .
2. The bank credit card are operated by large groups of banks .
The most important form of inter-bank cooperation is Check-Clearing & collection . Clearing House is the place where inter-bank debts are settled. This
function is performed by the central bank

53. Banking System 1. The Center Bank
2. The financial Institutions such as
commercial banks .
The Central Bank: It is the government owned and operated institution that serve to control the banking system ,and it is the sole money issuing authority .

54. Basic Functions of Central Bank
1. Act as banker of commercial banks .
2. Act as banker of the government .
3. Act as controller of the nation’s money
supply .
4. Act as regulator of money market .

55. 1. Banker of Commercial Bank
Accept deposits of commercial banks .
Transfer money from one account to another account on demand .
Act as a lender of last resort to commercial banks when they have urgent need for cash by providing temporary short-term loans .

56. 2. Banker to the Government
The government deposits the fund in the central bank .
The government write checks against its account in the central bank .
The central bank sells government bonds or securities for the government .

57. 3. Controller of Money supply
The central bank can use the monetary policy [ changing the money supply] to close the GDP gap and stabilize the economy at its full employment level or Y* .

58. 4. Regulator of Money Market
The central bank assume responsibility for supporting the financial system in the country .
Help to moderate the rapid swing in the interest rate to prevent serious disruption by wide scale panic and bank failure.
Act as lender of last resort to the commercial banks .

59. Financial Intermediaries
They are privately owned institutions that serve the general public.
They are called intermediaries because they stand between Savers and borrowers .
We will focus on the commercial banks, although the same analysis applies to other intermediaries as well .

60. Commercial Banks
Modern commercial banking system are of two main types :
1.one has small # of banks , but each bank
with a large # of branch offices .Example the banking system of UK and Canada.
2. The other type consists of a large # of independent banks .Example, the banking system of U.S.A .

61. Reserves of Commercial Banks
Commercial banks needs to keep only fractional reserves against their deposits during the normal times .
IN abnormal times, the commercial banks can borrow reserves from the central bank to meet any abnormal situation .

62. Required VS. Actual Reserves
Required Reserves is the reserves required by the central bank and it is calculated as a percentage of the total deposits .
Excess Reserves is the reserves above the required reserves .
Actual Reserves is the sum of required reserves plus excess reserves .

63. Money Creation by the Banking System
Assume that banks can invest in only one asset ( Loans ) .
Assume that there is only one kind of deposit ( Demand Deposit ) .
Assume the required reserve ratio is fixed for all banks at 20% .
Assume no excess reserves , so banks keep only the required reserves .
Assume no cash drain from the system .

64. Creation of Deposits Money
Having all the previous assumptions in mind , assume that National Commercial bank ( NCB ) has the following Balance sheet ( in thousands ) :
Assets Liabilities & Equity
Cash & other SR Deposits SR 1000
Reserves Capital
Loans _____
SR SR 1100

65. Assets Liabilities & Equity
Now Assume a foreigner , who just arrived in the country opened an account with NCB and deposited SR 100,000 ( New deposit) , so the balance sheet after the deposit will be :
Assets Liabilities & Equity
Cash and other Reserves SR Deposits SR 1100
Loans Capital
______ ________
SR SR 1200
Since Actual reserves = SR 300,000
Since Required reserves = SR 220,000 therefore this bank has Excess Reserves = SR 80,000

66. Now the NCB will use the excess reserves of SR 80,000 to make new loans , so the balance sheet after making the loan will be as follows :
Assets Liabilities & Equity
Cash & other Reserves SR Deposits SR 1100
Loans Capital
_______ _______
SR SR 1200
Now the new loan ( SR 80,000) made by the NCB either will be re-deposited in the same bank or it will be deposited in another bank ( second-generation bank) where 20% will be added to the required reserves and the remaining balance will be given as a loan .

67. The sequence of loans and deposits after a single initial deposit of SR 100,000 in NCB is as follows :
Bank New New Additional
deposits loans reserves
1st generation bank SR SR SR 20
2nd generation bank
3rd generation bank
4th generation bank
5th generation bank
Total for banking SR SR SR 100
system

68. Creation of Deposits ( assuming 10 percent reserve requirement and a $ 100 increase in reserves )
Bank Increase in Increase in Increase in
Deposits ($) Loans ( $ ) Reserves($)
_________________________________________________
First National A B C D
Total for all banks

69. Excess Reserves and Cash Drain
If we relax the two assumptions related to excess reserves and cash drain, what happens to the change in deposit and the change in loans for the banking system ?
If banks do not choose to use their excess reserves to expand their loans, then there would be no expansion of loans and change in deposit will equal to change in reserves.

70. Excess reserves & Cash drain Continue
But, if banks decided to hold part of its excess reserves and use the remaining reserves to make new loans , then the multiplier will be smaller, and in turn, the change in loans and deposits for the banking system will be smaller as well .

71. Example Assume the following : Change in reserves = SR 100,000
Required reserve ratio = 20%
Excess reserve ratio = 5%
Cash drain ratio = 15%
Find the change in deposits and change in loans for the banking system ?

72. The answer Change in Deposits = 1 . 100,000
in banking system
= SR 250,0000
Change in Loans = 250,000 ( )
In banking system = 250,000 ( 0.60 )
= SR 150,000

73. Money, Output , and Prices
Chapter 28
Money, Output , and Prices

74. Chapter 28 In this chapter , we will focus on
How money affect the economy ?
The interaction between money supply and money demand .
How household divide their total wealth between money & interest earning bonds.

75. Present Value and Interest Rates
Present value of an asset is the value now of the future payments that the asset offers .
The present value depends on the interest rate , because we use the interest rate to discount the future payments .

76. Example Given the following data :
Par value or face value of a bond = $ 1000
Coupon rate of interest = 10 %
Maturity = 5 years
Required : What is the present value of this bond a. If market interest rate is 10% ? b. If the market interest rate is 20% ?

77. If Market interest rate is 10%
PV =[ R R2 + ….. + Rn ] + F
n n
(1+i ) (1+i ) ….. (1+i ) (1+i)
PV = [ … ]
(1.10) (1.10) …… ( 1.10) (1.10)
PV = $ = $ 1000

78. If market interest rate is 20%
PV = [ … ]
(1.2 ) ( 1.2) ( 1.2 ) ( 1.2 )
PV = $ Therefore ,
The higher the market interest rate, the lower is the present value of a bond .

79. Supply and Demand for Money
Supply of Money: is the total stock of money in the economy at any moment in time . The money supply is controlled by the central bank .
Demand for Money: is the amount of wealth that every one in the economy wish to hold in the form of money balances .

80. Motives for holding Money
1. Transactions Motive
2. Precautionary Motive
3. Speculative Motive

81. 1. Transactions Motive
People need money to pay for goods and services . And firms need money to pay for factors of productions .
Money held to finance such flows are called “ Transactions balances “ .
What determines the size of the transactions balances ?
The size of transactions balances is positively related to the value of transaction

82. Transactions Motive d
M = f ( T )
T = f ( Y )
Therefore d
M = f ( Y )

83. 2. The Precautionary Motive
Precautionary balances provide protection against uncertainty about timing of cash flows . Therefore, the greater such balances, the greater is the protection against running out of money.
Precautionary balances provide protection for the unexpected events such as sickness or car accidence etc.
Precautionary motive causes the demand for money to vary positively income .

84. 3. The Speculative Motive
Firms and Households hold some money against uncertainty resulting from the fluctuation in the prices of other financial assets .
Money balances held for the above purpose is called “ Speculative balances “ .
Speculative motive implies that demand for money vary positively with wealth, but it vary negatively with interest rate .

85. Monetary Equilibrium & Aggregate Demand
Monetary equilibrium occurs at the point where demand for money equals the supply of money . Therefore, at monetary equilibrium we have :
d s
M = M

86. The Transmission Mechanism
This is the process by which changes in the demand for money or change in supply of money affect the aggregate demand .
The Transmission Mechanism operates through three stages or links. These are :
1.Link between monetary equilibrium & interest rate .
2.Link between interest rate and investment .
3.Link between investment and aggregate demand .

87. I. Link between Monetary equilibrium and Interest Rate
Any change in either the Demand for money or the Supply of money will change the interest rate . Example:
An increase in Demand for money will increase the market interest rate .
An increase in Supply of Money will lower the market interest rate .

88. II. Link between Interest Rate and Investment Expenditure
Other things being equal, a fall in interest rate decreases the cost of borrowing and that encourage more borrowing to finance more investments. Therefore, there is a negative relationship between interest rate and investment expenditure.
This relationship is called “ Marginal Efficiency of Investment or MEI .

89. III. Link between Investment and Aggregate Demand
An increase in money supply decreases interest rate, which encourage more investment and hence increase AE and that shift the AE function upward and shift AD curve to the right and that increases national income or the aggregate demand ( Y ) .

90. Strength of Monetary Forces
By how much will a given change in money supply causes national income to change ?
Here, we need to distinguish between two cases :
1. Long-run effect on national income .
2. Short-run effect on national income .

91. Long-run Effect on National Income
An increase in money supply shifts the
AD curve to the right, but that has no effect on the level of national income (Y) in the long-run, because in the long-run the LRAS curve is vertical . Therefore,
In the long-run, any change in AD will change the price level only .

92. Short-run effect on National Income
Change in AD depends on :
1. How much interest rate will fall in response to a given increase in money supply ?
2. How much investment expenditure will change in response to a change in the interest rate ?

93. 1. The change in interest rate in response to a change in money supply
The flatter the demand for money function ( the more sensitive the demand for money to interest rate) the less that interest rate will fall as a result of an increase in money supply.

94. 2. The change in investment in response to a change in interest rate
The more interest-sensitive is the investment function ( the flatter the investment function ) , the more it will increase in response to a given fall in interest rate . Therefore,
The size of the shift in AD in response to change in money supply depends on the shape of demand for money function and the marginal efficiency of investment .

95. Effective Monetary Policy
The steeper the demand for money function or ( the less interest-sensitive the demand for money function ) , because that leads to greater effect on the market interest rate .
And the flatter ( or more interest-sensitive) is the Marginal Efficiency of Investment , MEI , because that will cause greater effect on investment level .

96. Chapter 29
Monetary Policy

97. Control of the Money Supply
There are four ways in which the central bank affect the money supply . These are
1. Open market operations .
2. Reserve required ratio .
3. Discount rate .
4. Selective credit control .

98. 1. Open Market Operations
The Process of buying and selling government bonds in the financial market is called “ Open market operations “. This process can be divided into to cases :
A. Open Market Purchase .
B. Open Market Sale .

99. Open Market Purchase
Central bank buy government bonds from firms and/or households .
The central bank pay for these bonds with check.
The seller deposits the check in its own bank account .
The commercial bank present the check to the central bank for payment .
Central bank make a book entry .

100. The effect of purchasing bonds by the central bank
1. Create excess reserves at commercial banks .
2. This enable the commercial banks to create more loans .
3. The increase in loans will create more deposits by the banking system , and that will increase the money supply.

101. Open Market Sale
The central bank sells government bonds and receive a check drawn on commercial bank .The value of the check will be
deducted from the deposit at that bank.
This decrease the reserves available to commercial banks which will decrease the loans made by commercial banks.
This decrease the deposit created by banks which in turn decrease the money supply .

102. 2. Reserve Requirement
An increase in the required reserve ratio forces the banks with no excess reserves to decrease its loans, which in turn, decreases the deposits and that will decrease the money supply .
Example:

103. 3. Discount Rate
This is the interest rate charged by the central bank on loans borrowed by the commercial banks .
A fall in discount rate may encourage more borrowing by commercial banks and that increases the reserves of the banks , which in turn, increases loans and deposits in the banking system and that finally will increase the money supply.

104. Net Un-borrowed Reserves or Free Reserves
It is the Total reserves minus both the required reserves as well as the borrowed reserves . Therefore :
Free = Total – Required – Borrowed
reserves reserves reserves reserves
Example:

105. Example
Given the following Balance Sheet for NBC find the Free Reserves or Net Un-borrowed Reserves. Assume r = 20% .
Cash & other reserves = SR 20,000
Loans = SR 23,000 ; Deposits = SR 40,000
Borrowed Reserves = SR 2,500
Capital = SR Therefore,
Free Reserves = 20,000 –
= SR 9500

106. 4. Selective Credit Control
Margin Requirement:
It is the fraction of the price of stock that must be put in cash by the purchaser and the balance can be borrowed from the brokerage firm .
If the C.B would like to increase the money supply , it will reduce the margin requirement and the opposite is also true.

107. Instruments & Objectives of Monetary Policy
The central bank conduct the monetary policy to influence the real national income and the price level .
The ultimate objective of the central bank ( Y , P ) are called “ Policy Variables “ T

108. Policy Instruments
To achieve its objective, the central bank uses certain variables or tools . These variables are called Policy Instruments.
Variables that are neither policy variables nor policy instruments, but play a key role in the execution of monetary policy are called Intermediate Targets.

109. Intermediate Targets
There are two Intermediate targets available for the central bank . These are :
1. Money supply Interest rate
The central bank can not control both of these targets independently if the demand function is unstable . Therefore, the central bank need to choose to control either the money supply or the interest rate.

110. Case 1 : controlling Money Supply
If the central bank chooses money supply as the intermediate target, then it must accept the fluctuation in the interest rate .

111. Case 2 : controlling the interest rate
If the central bank would like to control interest rate , then it must accept the fluctuation in the money supply .

112. Chapter 30
Inflation

113. Definition
Inflation is defined as :
“ The General Increase in the price level “ .

114. Causes of Inflation
1. Shift in AD curve to the right. This is called “ Demand Shock Inflation “ or Demand –Side Inflation or Just Demand Inflation.
2. Shift in SRAS curve to the left. This is called “ Supply Shock Inflation “ or Supply- Side Inflation or Cost- Push Inflation .

115. Demand Shock
1. Isolated Demand Shock: Shift in AD curve to the right without monetary validation ( which means with money supply held constant .
2. Sustained Demand Shock: shift in AD curve to the right accompanied by a monetary validation . This will lead to sustained inflation .

116. Supply Shock
1. Isolated Supply Shock: Once and for all increase in the cost of production .
2. Repeated Supply Shock

117. Isolated Supply Shock A. If No Monetary Validation:
An Isolated supply shock without monetary validation will have a period of inflation followed by a period of deflation
B. Supply Shock inflation with monetary Validation: This cause the initial increase in the price level to be followed by further increase in the price level .

118. Repeated Supply Shock
This means continuous shift in SRAS curve to the left resulting from continuous rise in wage or price of raw materials . Here also we need to distinguish between two cases :
A. IF No Monetary Validation .
B. If there is a monetary validation.

119. Chapter 33
Economic Growth

120. Definition
Economic Growth is defined as the long-run increase in per capita real output of a society .
Real per capita output = Total real GDP
Or real per capita GDP Population
The growth in real per capita GDP means that the average standard of living is higher.

121. The Nature of Economic Growth
There are 3 ways of increasing the GDP :
1. Policies that increase Aggregate Demand.
2. Policies that reduce structural or frictional unemployment which can increase the employed labor force and thus increase potential output.
3. Over the long-run, the main cause of rising national income is economic growth

122. Economic Growth - Continue
Growth is much more powerful method of raising the living standards than the removal of a recessionary gap or structural unemployment .
A small differences in growth rate make big differences in the level of potential national income over few decades .

123. Example
If two countries ( A and B ) start with the same level of income or GDP say $100 million . And if country A grows at 3% per year while country B grows at 2% per year than A’s income will be twice B’s income in 72 years as shown in the next table :

124. Economic Growth Year growth rate of 2% growth rate of 3% $ 100 10 122
$ 100 10
122
135 30
181
244 70
400
796 72
416
845

125. Example 2 Year Growth rate of 1% Growth rate of 2% $ 100 10 111 122 30
$ 100 10
111
122 30
135
181 35
142
200 70
201
400

126. Benefit of Growth
Over the Long-term economic growth is the primary engine for raising general standards
Economic growth reduces income inequalities without actually having to lower anyone’s income.
Economic growth may change the whole society’s consumption patterns.

127. Cost of Growth
Growth requires heavy investment of resources in capital goods as well as in activities such as education.
Growth which promises more goods tomorrow, is achieved by consuming fewer goods today. Therefore, for the economy as a whole this sacrifice of current consumption is the primary cost of growth.

128. Inputs, Technological Progress and Economic Growth
To increase average income, a country has to increase its output.
The country’s output depends on its resources or inputs and on the techniques it employs for transforming inputs into output.
The relationship between inputs and outputs is called “ Production Function “ .

129. Factors of Production 1. Land or Natural Resources . 2. Labor
3. Capital
Countries can not achieve rapid and sustained economic growth by increasing their stock of natural resources .
But, countries can and do experience fluctuations in income as a result of fluctuations in the prices of their natural resources .

130. Economic Growth
At the time at which prices of inputs are rising quickly that bring temporary income growth .
But to achieve long-term sustained income growth, countries have to look beyond their natural resources .
sustained increase in labor input . A country can produce more output if its population of workers grows .

131. Capital Growth
Population growth on its own does not lead to higher per capita output.
The input that is most responsible for rapid and sustained economic growth is the capital .
There are two broad types of capital :
1. Physical capital .
2. Human capital .

132. Physical Capital
Includes such things as highways, railways, dams, tractors, factories, trucks , cars , and buildings .

133. Human Capital
Is the accumulated knowledge and skills of the working population that enable them to increase their output .
As individuals accumulate more capital their income grow .
As nations accumulate more capital per worker, labor productivity and output per capita grow .

134. Technological Change
Although rich countries have much more capital than the poor countries, that is not the only difference between them .
Typically, rich countries uses more productive technologies than do poor countries. AS a result, even if both countries have the same per capita capital, the rich countries produce more output than the poor

135. Determinant of Growth of Total Output
1. Growth in the Labor Force
2. Growth in Human capital
3.Growth in Physical capital
4. Technological improvement

136. 1. Growth in the Labor Force
This may be caused by growth in the population or increase in the fraction of the population that chooses to participate in the labor force .

137. 2. Growth in Human Capital
This is the increase in skills that workers have either through formal education or on-the-job experience .

138. 3. Growth in Physical Capital
Such as factories, machines, transportation, and communications facilities. These are increase only through process of investment

139. 4. Technological Improvement
This may be brought about by innovation that introduces new product, new ways of producing existing product and new forms of business organization .

140. Note
Chapter 33 up to page 728

141. Gain From International Trade
Chapter 35
Gain From International Trade

142. In this chapter we will discuss :
Sources of the gain from trade .
Absolute advantage from trade.
Comparative advantage of trade.
Opportunity cost .
Gain from trade with variable cost .
Sources of comparative advantage .
The Terms of trade .

143. Sources of the Gain from Trade
Without Trade: , each person would have to be self-sufficient , i.e. each would have to produce all goods and services that he or she consumed.
Trade among individuals allows people to specialize in activities they can do well and to buy from others the goods and services they can not easily produce .

144. This same basic principle also applies to nations
With trade , each nation is able to concentrate on producing goods and services that it produce efficiently while trading to obtain goods and services that it does not produce efficiently .
The gain from trade is clear when there is an absolute advantage .

145. Absolute Advantage
Is the ability to produce a good with fewer inputs or to produce more output with the same quantity of inputs .
One country is said to have an absolute advantage over another in production o x when an equal quantity of resources can produce more X in the first country than in the second country .

146. Comparative Advantage
Is the ability to produce a good or a service at a lower opportunity cost than other producers .
If countries ( Nations ) specialize in their areas of comparative advantage then the world output will increase . To see this let us compare two cases :
1. When there is no trade (no specialization )
2. When there is trade ( after specialization )

147. Example 1. Assume we have two countries ( U.S.A & France)
2. Assume Labor is the only factor of production .
3. You are given the following table :
Comparative cost of production
Product U.S.A (worker/day) France(worker/day)
1 unit of X
1 unit of Y
4. Assume that the workforce in each country consist of 200 workers divided equally in production of X and Y .

148. The Answer
From the table, we see that the U.S.A is just as good at producing X as France .
But, U.S.A has absolute advantage in producing Y .
Now, looking at the comparative cost of production expressed in worker per unit , we see that :

149. The Answer - Continue U.S.A. France Relative price
of X to Y / 1 = / 2 = ½
of Y to X /1 = / 1 = 2
Since , in France the opportunity cost of producing X is lower than in U.S.A , So France has a comparative cost of producing X, so France will specialize in the production of X.

150. Case # 1 : World output before trade or No Specialization
U.S. A France World
Product workers output workers output output X Y

151. Case # 2 : World output with trade ( after specialization )
U.S. A France World
Product Workers output workers output output X Y
You see that world production has increased from
( 200 X and 150 Y ) to ( 200 X and 200 Y ) after specialization without any increase in the resources.
Therefore, world output is greater when countries specialize in producing the goods in which they have a comparative advantage and then engage in trade.

152. Example: Gains from specialization with Absolute Advantage
Amount of wheat and cloth that can be produced with 1 unit of resources in U.S.A. and England.
Wheat (bushels) Cloth (yards)
U.S.A
England
Therefore, U.S.A. has absolute advantage in producing wheat, and England has absolute advantage in producing cloth .

153. Gain from specialization with Absolute Advantage
If U.S.A specialized in wheat and England in cloth :
Wheat (bushels) Cloth (yards )
U.S.A
England
_______ ________
We see that total world production of both wheat and cloth increases when each country produces more of the good in which it has absolute advantage.

154. Changes resulting from the transfer of 1 unit of U. S
Changes resulting from the transfer of 1 unit of U.S. resources into wheat and 1 unit of English resources into cloth
Wheat ( bushels) Cloth (Yards)
U.S.A
England
________ ________
Therefore, specialization of each country in the product in which it has absolute advantage will increase total production of both commodities .

155. Gain from specialization with comparative advantage
Amount of wheat and cloth that can be produced with 1 unit of resources in U.S.A and England :
Wheat (bushels) Cloth ( Yards )
U.S.A
England
Here , U.S.A has absolute advantage in both goods.
So, it seems that U.S.A has nothing to gain by trading with England, But by looking at the comparative advantage , we see that is wrong .

156. Gain from specialization with comparative advantage
U.S.A can produce 20 times as much as wheat as England ( 100/5 = 20 ) by using same quantity of resources .
But, it can produce only 6 times as much cloth ( 60/10 = 6 ) as England .
Therefore, U.S.A. said to have comparative advantage in the production of wheat , and a comparative disadvantage in production of cloth. While England has the opposite case .

157. Changes resulting from the transfer of one-tenth of 1 unit of U. S
Changes resulting from the transfer of one-tenth of 1 unit of U.S. resources into wheat and 1 unit of English resources into cloth
Wheat (bushels) Cloth ( yards )
U.S.A
England
_______ ________
world
Therefore, when there is comparative advantage, specialization make it possible to produce more of both commodities .

158. Conclusion
The gain from specialization depends on the pattern of comparative not on absolute advantage . Therefore,
If there is comparative advantage , then there are gains from trade .
If there is No comparative advantage, then there are no gains from trade.
Therefore, absolute advantage without comparative advantage does not lead to gains from trade.

159. The Opportunity Cost The Opportunity cost is defined as :
The best alternative given up . Example:
Given the following Table below , find the opportunity cost of producing each unit of wheat and cloth ?
Wheat (bushels) Cloth( Yards )
U.S.A
England

160. The Opportunity cost of wheat & cloth
Cloth Wheat
U.S.A /10 = 0.6 yard /6 = 1.67 bushels
England /5 = 2 yards /10 = 0.5 bushels
Therefore, U.S.A. has lower opportunity cost of producing wheat 0.6 yard relative to 2 yards .
While, England has lower opportunity cost in producing cloth 0.5 bushels relative to 1.67

161. Conclusion
The gain from trade arises from differing opportunity costs in the two countries .
The country which has lower opportunity cost will have a comparative advantage over the other country in the production of the product.
The opportunity costs depends on the relative cost of producing two products not on the absolute cost .
When opportunity costs are the same in all countries, there is no gain from specialization .

162. The Terms of Trade
The terms of trade refer to the ratio of the prices of goods exported to the prices of those imported
Terms of trade = index of export prices X100
index of import prices
A rise in the price of exported goods, with the price of imports unchanged, indicates a rise in the term of trade, so it will take fewer exports to buy the same quantity of imports .

163. Example Assume the following : Export price index = 100
Import price index = 100
The Term of Trade = X 100 = 100
100
Which means that a unit of export will buy one unit of import .

164. Example - Continue
Now, if export price index rises from 100 to 120 while import price index remain constant at 100
Then Term of trade = X 100 = 120
100
Which means that a unit of exports will buy 20 % more imports than at the old term .
Therefore, a rise in the term of trade is referred to as “favorable change in the country’s term of trade “ . A fall in the term is unfavorable change

165. Example 2 Assume the following :
Index of export prices rises from 100 to 120
Index of import prices rises from 100 to 110
Therefore :
The old Term of Trade = X 100 = 100
100
The new term of trade = X 100 = 109
110

166. Example - Continue
This means that with the new terms of trade a unit of exports will buy 9% more imports than at the old terms .
Therefore, a favorable change in the term of trade ( a rise in export prices relative to import prices ) means that a country can acquire more imports per unit of exports and vice versa .