1. GSIAS – North American Economy Economics 101

2. 2-2 Lesson Overview Microeconomics Supply/Demand/Equilibrium  Govt. Policies Effect (Drugs/Min. Wage/Taxes) Macroeconomics Interest Rates and Inflation Open Economy Macroeconomics

3. Macro vs. Micro Economics Microeconomics is the study of how individual households and firms make decisions and how they interact with one another in markets.  Prices and selection of products Macroeconomics is the study of the economy as a whole. Its goal is to explain the economic changes that affect many households, firms, and markets at once.  Inflation  Unemployment  Economic Growth

4. THE MARKET FORCES OF SUPPLY AND DEMAND 4 Demand The quantity demanded of any good is the amount of the good that buyers are willing and able to purchase. Law of demand: the claim that the quantity demanded of a good falls when the price of the good rises, other things equal

5. THE MARKET FORCES OF SUPPLY AND DEMAND 5 P Q The Market Demand Curve for Lattes P Q d (Market) $0.0024 1.0021 2.0018 3.0015 4.0012 5.009 6.006

6. THE MARKET FORCES OF SUPPLY AND DEMAND 6 Demand Curve Shifters The demand curve shows how price affects quantity demanded, other things being equal. These “other things” are non-price determinants of demand (i.e., things that determine buyers’ demand for a good, other than the good’s price). Changes in them shift the D curve… P Q

7. THE MARKET FORCES OF SUPPLY AND DEMAND 7 Summary: Variables That Influence Buyers VariableA change in this variable… Price…causes a movement along the D curve # of buyers…shifts the D curve Income…shifts the D curve Price of related goods…shifts the D curve Tastes…shifts the D curve Expectations…shifts the D curve

8. A. The price of iPods falls B. The price of music downloads falls C. The price of CDs falls A C T I V E L E A R N I N G 1 Demand Curve 8 Draw a demand curve for music downloads. What happens to it in each of the following scenarios? Why?

9. THE MARKET FORCES OF SUPPLY AND DEMAND 9 Supply The quantity supplied of any good is the amount that sellers are willing and able to sell. Law of supply: the claim that the quantity supplied of a good rises when the price of the good rises, other things equal

10. THE MARKET FORCES OF SUPPLY AND DEMAND 10 P Q The Market Supply Curve P Q S (Market) $0.000 1.005 2.0010 3.0015 4.0020 5.0025 6.0030

11. THE MARKET FORCES OF SUPPLY AND DEMAND 11 Supply Curve Shifters The supply curve shows how price affects quantity supplied, other things being equal. These “other things” are non-price determinants of supply. Changes in them shift the S curve… P Q

12. THE MARKET FORCES OF SUPPLY AND DEMAND 12 Summary: Variables that Influence Sellers VariableA change in this variable… Price…causes a movement along the S curve Input Prices…shifts the S curve Technology…shifts the S curve # of Sellers…shifts the S curve Expectations…shifts the S curve

13. A C T I V E L E A R N I N G 2 Supply Curve 13 Draw a supply curve for tax return preparation software. What happens to it in each of the following scenarios? A. Retailers cut the price of the software. B. A technological advance allows the software to be produced at lower cost. C. Professional tax return preparers raise the price of the services they provide.

14. THE MARKET FORCES OF SUPPLY AND DEMAND 14 P Q Supply and Demand Together D S Equilibrium: P has reached the level where quantity supplied equals quantity demanded

15. THE MARKET FORCES OF SUPPLY AND DEMAND 15 P Q D S Surplus (a.k.a. excess supply): when quantity supplied is greater than quantity demanded Surplus Example: If P = $5, then Q D = 9 lattes and Q S = 25 lattes resulting in a surplus of 16 lattes

16. THE MARKET FORCES OF SUPPLY AND DEMAND 16 P Q D S Surplus (a.k.a. excess supply): when quantity supplied is greater than quantity demanded Facing a surplus, sellers try to increase sales by cutting price. This causes Q D to rise Surplus …which reduces the surplus. and Q S to fall…

17. THE MARKET FORCES OF SUPPLY AND DEMAND 17 P Q D S Surplus (a.k.a. excess supply): when quantity supplied is greater than quantity demanded Facing a surplus, sellers try to increase sales by cutting price. This causes Q D to rise and Q S to fall. Surplus Prices continue to fall until market reaches equilibrium.

18. THE MARKET FORCES OF SUPPLY AND DEMAND 18 STEP 1: S curve shifts because event affects cost of production. D curve does not shift, because production technology is not one of the factors that affect demand. STEP 2: S shifts right because event reduces cost, makes production more profitable at any given price. EXAMPLE 2: A Shift in Supply P Q D1D1 S1S1 P1P1 Q1Q1 S2S2 P2P2 Q2Q2 EVENT: New technology reduces cost of producing hybrid cars. STEP 3: The shift causes price to fall and quantity to rise.

19. THE MARKET FORCES OF SUPPLY AND DEMAND 19 EXAMPLE 3: A Shift in Both Supply and Demand P Q D1D1 S1S1 P1P1 Q1Q1 S2S2 D2D2 P2P2 Q2Q2 EVENTS: price of gas rises AND new technology reduces production costs STEP 1: Both curves shift. STEP 2: Both shift to the right. STEP 3: Q rises, but effect on P is ambiguous: If demand increases more than supply, P rises.

20. THE MARKET FORCES OF SUPPLY AND DEMAND 20 EXAMPLE 3: A Shift in Both Supply and Demand STEP 3, cont. P Q D1D1 S1S1 P1P1 Q1Q1 S2S2 D2D2 P2P2 Q2Q2 EVENTS: price of gas rises AND new technology reduces production costs But if supply increases more than demand, P falls.

21. THE MARKET FOR LOANABLE FUNDS Financial markets coordinate the economy’s saving and investment in the market for loanable funds. The market for loanable funds is the market in which those who want to save supply funds and those who want to borrow to invest demand funds.

22. Supply and Demand for Loanable Funds Loanable funds refers to all income that people have chosen to save and lend out, rather than use for their own consumption. The supply of loanable funds comes from people who have extra income they want to save and lend out. The demand for loanable funds comes from households and firms that wish to borrow to make investments.

23. Supply and Demand for Loanable Funds Interest rate  the price of the loan  the amount that borrowers pay for loans and the amount that lenders receive on their saving  in the market for loanable funds, the real interest rate

24. Supply and Demand for Loanable Funds Financial markets work much like other markets in the economy. The equilibrium of the supply and demand for loanable funds determines the real interest rate.

25. Figure 2 An Increase in the Supply of Loanable Funds Loanable Funds (in billions of dollars) 0 Interest Rate Supply,S1S1 S2S2 2.... which reduces the equilibrium interest rate... 3.... and raises the equilibrium quantity of loanable funds. Demand 1. Tax incentives for saving increase the supply of loanable funds... 5% $1,200 4% $1,600

26. THE FEDERAL RESERVE SYSTEM The Federal Reserve (Fed) serves as the nation’s central bank.  Three Primary Functions of the Fed Regulates banks to ensure they follow federal laws intended to promote safe and sound banking practices. Acts as a banker’s bank, making loans to banks and as a lender of last resort. Conducts monetary policy by controlling the money supply.

27. The Federal Open Market Committee Open-Market Operations  To increase the money supply, the Fed buys government bonds from the public.  To decrease the money supply, the Fed sells government bonds to the public.

28. BANKS AND THE MONEY SUPPLY Banks can influence the quantity of demand deposits in the economy and the money supply.

29. Money Creation with Fractional- Reserve Banking When a bank makes a loan from its reserves, the money supply increases. The money supply is affected by the amount deposited in banks and the amount that banks loan.  Deposits into a bank are recorded as both assets and liabilities.  The fraction of total deposits that a bank has to keep as reserves is called the reserve ratio.  Loans become an asset to the bank.

30. Money Creation with Fractional- Reserve Banking When one bank loans money, that money is generally deposited into another bank. This creates more deposits and more reserves to be lent out. When a bank makes a loan from its reserves, the money supply increases.

31. Banking Money Creation with Fractional-Reserve This T-Account shows a bank that…  accepts deposits,  keeps a portion as reserves,  and lends out the rest. It assumes a reserve ratio of 10%. AssetsLiabilities First National Bank Reserves $10.00 Loans $90.00 Deposits $100.00 Total Assets $100.00 Total Liabilities $100.00

32. The Money Multiplier Increase in the Money Supply = $190.00! AssetsLiabilities First National Bank Reserves $10.00 Loans $90.00 Deposits $100.00 Total Assets $100.00 Total Liabilities $100.00 AssetsLiabilities Second National Bank Reserves $9.00 Loans $81.00 Deposits $90.00 Total Assets $90.00 Total Liabilities $90.00

33. The Money Multiplier Original deposit = $100.00 1st Natl. Lending = 90.00 (=.9 x $100.00) 2nd Natl. Lending = 81.00 (=.9 x $ 90.00) 3rd Natl. Lending = 72.90 (=.9 x $ 81.00) … and on until there are just pennies left to lend! Total money created by this $100.00 deposit is $1000.00. (= 1/.1 x $100.00)

34. The Money Multiplier The money multiplier is the reciprocal of the reserve ratio: M = 1/R Example:  With a reserve requirement, R = 20% or.2:  The money multiplier is 1/.2 = 5.

35. THE CLASSICAL THEORY OF INFLATION Inflation is an increase in the overall level of prices. Hyperinflation is an extraordinarily high rate of inflation.

36. The Level of Prices and the Value of Money The quantity theory of money is used to explain the long-run determinants of the price level and the inflation rate. Inflation is an economy-wide phenomenon that concerns the value of the economy’s medium of exchange. When the overall price level rises, the value of money falls.

37. Money Supply, Money Demand, and Monetary Equilibrium The money supply is a policy variable that is controlled by the federal govt. Through instruments such as open-market operations, the govt. directly controls the quantity of money supplied. Money demand has several determinants, including interest rates and the average level of prices in the economy.

38. Money Supply, Money Demand, and Monetary Equilibrium People hold money because it is the medium of exchange.  The amount of money people choose to hold depends on the prices of goods and services. In the long run, the overall level of prices adjusts to the level at which the demand for money equals the supply.

39. Figure 2 An Increase in the Money Supply Quantity of Money Value of Money, 1/ P Price Level, P Money demand 0 1 (Low) (High) (Low) 1 / 2 1 / 4 3 / 4 1 1.33 2 4 M1M1 MS 1 M2M2 MS 2 2.... decreases the value of money... 3.... and increases the price level. 1. An increase in the money supply... A B

40. Open-Economy Macroeconomics: Basic Concepts An open economy interacts with other countries in two ways.  It buys and sells goods and services in world product markets.  It buys and sells capital assets in world financial markets.

41. The Flow of Goods: Exports, Imports, Net Exports Net exports (NX) are the value of a nation’s exports minus the value of its imports. Net exports are also called the trade balance.

42. The Flow of Goods: Exports, Imports, Net Exports Factors That Affect Net Exports  The tastes of consumers for domestic and foreign goods.  The prices of goods at home and abroad.  The exchange rates at which people can use domestic currency to buy foreign currencies.

43. The Flow of Goods: Exports, Imports, Net Exports Factors That Affect Net Exports  The incomes of consumers at home and abroad.  The costs of transporting goods from country to country.  The policies of the government toward international trade.

44. The Flow of Financial Resources: Net Capital Outflow Net capital outflow refers to the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners. A U.S. resident buys stock in the Toyota corporation and a Mexican buys stock in the Ford Motor corporation.

45. The Flow of Financial Resources: Net Capital Outflow When a U.S. resident buys stock in Telmex, the Mexican phone company, the purchase raises U.S. net capital outflow. When a Japanese residents buys a bond issued by the U.S. government, the purchase reduces the U.S. net capital outflow.

46. The Flow of Financial Resources: Net Capital Outflow Variables that Influence Net Capital Outflow  The real interest rates being paid on foreign assets.  The real interest rates being paid on domestic assets.  The perceived economic and political risks of holding assets abroad.  The government policies that affect foreign ownership of domestic assets.

47. The Equality of Net Exports and Net Capital Outflow For an economy as a whole, NX and NCO must balance each other so that: NCO = NX Why?  When a nation is running a trade surplus (NX>0), it is selling more goods/services to foreigners than it is buying. What is it doing with the foreign currency received? Must be buying foreign assets. Capital is flowing out of the country (NCO>0).  When a nation is running a trade deficit (NX<0), it is buying more goods and services from foreigners than it is selling. How is it financing the purchase? It must be selling assets abroad. Capital is flowing into the country (NCO<0).

48. Saving, Investment, and Their Relationship to the International Flows National saving (S) equals Y – C – G so: S = I + NX or Saving Domestic Investment Net Capital Outflow =+ SI NCO =+

49. THE PRICES FOR INTERNATIONAL TRANSACTIONS: REAL AND NOMINAL EXCHANGE RATES International transactions are influenced by international prices. The two most important international prices are the nominal exchange rate and the real exchange rate.

50. The nominal exchange rate is the rate at which a person can trade the currency of one country for the currency of another. Nominal Exchange Rates

51. Real Exchange Rates The real exchange rate is the rate at which a person can trade the goods and services of one country for the goods and services of another.

52. Figure 1 The Market for Loanable Funds Quantity of Loanable Funds Real Interest Rate Supply of loanable funds (from national saving) Demand for loanable funds (for domestic investment and net capital outflow) Equilibrium quantity Equilibrium real interest rate

53. Figure 3 How Net Capital Outflow Depends on the Interest Rate 0 Net Capital Outflow Net capital outflow is negative. Net capital outflow is positive. Real Interest Rate

54. The Market for Foreign-Currency Exchange Quantity of Dollars Exchanged into Foreign Currency Real Exchange Rate Supply of dollars (from net capital outflow) Demand for dollars (for net exports) Equilibrium quantity Equilibrium real exchange rate Why does demand slope downward? Why is the Equil. Qty vertical?

55. The Effects of Government Budget Deficit (a) The Market for Loanable Funds(b) Net Capital Outflow Real Interest Rate Real Interest Rate (c) The Market for Foreign-Currency Exchange Quantity of Dollars Quantity of Loanable Funds Net Capital Outflow Real Exchange Rate Demand r2r2 NCO SS S S r2r2 B E1E1 rr A 1. A budget deficit reduces the supply of loanable funds... 2.... which increases the real interest rate... 4. The decrease in net capital outflow reduces the supply of dollars to be exchanged into foreign currency... 5.... which causes the real exchange rate to appreciate. 3.... which in turn reduces net capital outflow. E2E2

56. The Effects of an Import Quota (a) The Market for Loanable Funds(b) Net Capital Outflow Real Interest Rate Real Interest Rate (c) The Market for Foreign-Currency Exchange Quantity of Dollars Quantity of Loanable Funds Net Capital Outflow Real Exchange Rate rr Supply Demand NCO D D 3. Net exports, however, remain the same. 2.... and causes the real exchange rate to appreciate. E E2E2 1. An import quota increases the demand for dollars...