EDITION ECONOMICS Post-Soviet CRAM KIT Communist EDITOR ALPACA-IN-CHIEF Recovery Robb Dooling Daniel Berdichevsky the World Scholar s Cup

Transcription

1 EDITION ECONOMICS Post-Soviet Communist Recovery 18 YE AR S DO ING OU RB ECONOMICS EST, SO YO U CRAM KIT EDITOR Robb Dooling the World Scholar s Cup ALPACA-IN-CHIEF Daniel Berdichevsky CA N DO YO U RS

2 ECONOMICS CRAM KIT HOW TO THINK LIKE AN ECONOMIST... 2 CATEGORIZATION... 3 THE ORIGIN OF MARKETS (TRADE)... 4 INTRODUCTION TO MARKETS... 5 DEMAND... 6 SUPPLY... 7 ELASTICITY... 8 EQUILIBRIUM... 9 GOVERNMENT POLICIES TARIFFS AND EXPORTS BEHAVIOR OF FIRMS FAILURES OF PERFECT COMPETITION INSTITUTIONS BASICS OF MACROECONOMICS UNEMPLOYMENT GROSS DOMESTIC PRODUCT MEASURING GDP MEASURING INFLATION MONEY THE FINANCIAL SYSTEM MONETARY POLICY MORE ON SAVING AND INVESTMENT MONEY MARKET IN THE LONG RUN MODELING THE ECONOMY LIVING STANDARDS THE OUTPUT GAP AND THE SHORT RUN AGGREGATE DEMAND AGGREGATE SUPPLY EQUILIBRIUM FISCAL POLICY COMMUNIST ECONOMIC SYSTEMS BUREAUCRATIC PLANNING MIKHAIL GORBACHEV BORIS YELTSIN BORIS YELTSIN VLADIMIR PUTIN DMITRI MEDVEDEV ECONOMICS IN THREE PAGES LIST OF LISTS... 44

3 ECONOMICS CRAM KIT 2 FUNDAMENTAL ECONOMIC CONCEPTS How to Think like an Economist ADMISSION TO THE CLUB SO YOU WANT TO BE AN ECONOMIST? Repeat after me 1. There are no free lunches. 2. People have unlimited wants. 3. The cost of doing something includes its full economic cost. 4. Humans behave rationally. 5. Humans benefit from voluntary exchange---- otherwise they wouldn t trade. WHY IS THERE SCARCITY? Because wants are unlimited and resources are limited. To cope, we must make choices and face trade-offs THE RATIONAL HOMO ECONOMICUS RATIONALITY CHECKLIST Perform cost-benefit analysis Maximize utility, or happiness Think on the margin Account for all economic costs MAXIMIZING UTILITY An economic agent maximizes utility when marginal utility equals marginal cost DIMINISHING RETURNS Economists assume that marginal benefit decreases as quantity increases. Eating your 42 nd slice will not make you as happy as the first one did. MARGINAL ANALYSIS Marginal analysis involves comparing the costs and benefits of doing just a little more of something. The marginal benefit of reading one more page of this Cram Kit is one more question answered correctly at competition. Marginal utility Marginal benefit THE COST OF MAKING A CHOICE We have to pay for our choices. What's more, we give up a choice we don t make for every choice we do make. TYPES OF COSTS Type Definition Example Number of slices THE INVISIBLE HAND STRIKES BACK In 1776, Adam Smith published An Inquiry into the Nature and Causes of the Wealth of Nations, establishing the field of economics and the idea of the invisible hand (the market regulates itself). Opportunity cost (implicit cost) Accounting cost (explicit cost) Economic cost Value of the next-best choice What you tangibly pay to get something Opportunity cost + accounting cost Value of sleep you lose when you choose to cram Cost in dollars of this Cram Kit Sum of the above QUICK QUIZ QUESTIONS 1. The full cost of a decision is its. 2. If Jolly Jeremy Joe is in a hot dog competition, the fact that his 100 th hot dog gives him far less utility than his first is known as. 3. There are no free lunches in our world because of and. ANSWERS 1. economic cost 2. diminishing returns 3. limited resources, unlimited wants

4 ECONOMICS CRAM KIT 3 FUNDAMENTAL ECONOMIC CONCEPTS Categorization MODELING MICROECONOMICS VS. MACROECONOMICS ECONOMIC ANALYSIS THE PYRAMID OF ECONOMICS ` Careful observation Description Economies Economic Analysis Markets Measurement of economic theory Theory Individuals Theoretical models capture the basics of economic interactions while stripping away extra details. Most models look too simplistic. But it is this simplicity that allows us to identify what assumptions and characteristics are important. The true strength of a model is how well it captures and predicts whatever we want to understand. MODELING PARETO EFFICIENCY Something is Pareto efficient when no one can have more without someone else ending up with less. If you and your two friends split $100 so that each of you has $33 and $1 is left on the table, the situation is not pareto efficient. You could take one more dollar without hurting your friends. But if you and your two friends split $100 so that you have $100 and each of them has $0, the situation is pareto efficient. They can t get any money without taking away some of yours. MICROECONOMICS Microeconomics models individual behavior to analyze markets as a whole. Conclusions about markets are then extended to the economy as a whole. Microeconomics works up the pyramid. MACROECONOMICS Macroeconomics is concerned with the entire economy. It studies big changes and analyzes how societies----and the individuals within them----can and do grow better or worse off. Macroeconomics works down the pyramid. POSITIVE VS. NORMATIVE ECONOMICS POSITIVE What is? Falsifiable statements -- now or with future data Conclusions of a model NORMATIVE What should be? Subjective statements Judgments THREE FUNDAMENTAL QUESTIONS Every market must answer three basic questions: How much should be produced? 1 Who should produce? 2 Who should receive what is produced? 3 POSITIVE OR NORMATIVE? Academic Decathlon puts the Decathlete through 10 different events (positive) Temperatures next year will cause a 10% decline in crop yields. (positive) Economics is tough, but understanding it is useful for understanding policy (normative) Alpacas are better than llamas (normative)

5 ECONOMICS CRAM KIT 4 FUNDAMENTAL ECONOMIC CONCEPTS The Origin of Markets (Trade) WHY TRADE? PRODUCTION POSSIBILITIES FRONTIER (PPF) ABSOLUTE VS. COMPARATIVE ADVANTAGE Absolute advantage An agent has an absolute advantage for producing a good when he can produce that good more efficiently than other agents. Comparative advantage An agent has a comparative advantage for producing a good when he can produce that good at a lower opportunity cost than other agents. An agent can be terrible at producing every good and service and have no absolute advantages versus a second agent, but he must have a comparative advantage in at least one good AN EXAMPLE FROM OUTER SPACE 1. Say Laika is very good at producing both dog treats and spacesuits. She can produce 80 dog treats or 20 spacesuits in one month. 2. Neil is not very good at producing either good. He can produce 30 dog treats or 10 spacesuits in one month. 3. Laika has absolute advantages for both goods, while Neil has none. 4. Laika gives up four dog treats for each spacesuit produced, while Neil only gives up three. a. Laika gives up 1/4 of a spacesuit per dog treat, less than Neil s 1/3 of an spacesuit b. Neil gives up 3 dog treats per spacesuit, less than Laika s 4 dog treats 5. This means Laika has a comparative advantage in producing dog treats, while Neil has a comparative advantage in producing spacesuits. 6. Therefore, Laika should specialize in producing dog treats, and Neil in producing spacesuits. 7. Trade benefits both because they are able to specialize in their comparative advantages. A country s PPF represents all the combinations of output (in this case, combinations of milk and missiles) that are feasible Any combination of milk and missiles inside or on the curve is possible, but only points on the curve are efficient Points outside the curve are impossible to produce but may be obtained through the benefits of trade Producing more of one good requires a tradeoff in the form of less production of the other good The curve bows out because of diminishing returns to scale: producing more milk increases the opportunity cost in terms of missiles Different slopes (different opportunity costs) imply comparative advantages A curve that is farther out indicates higher production and an absolute advantage TRADE QUESTIONS FOR ANSWERS QUESTIONS 1. If an agent can produce more of a good than another agent with the same inputs, he has a(n). 2. Comparative advantages arise from lower of production. ANSWERS 1. absolute advantage 2. opportunity costs

6 ECONOMICS CRAM KIT 5 MICROECONOMICS Introduction to Markets PERFECT COMPETITON MARKET MODEL MARKETS ASSUMING MAKES The perfectly competitive market model relies on several key assumptions. These assumptions mark the boundary between perfect competition and other market types: All agents accept prices as given No individual has market power No producer can set prices other than the market price WE ALL COME TOGETHER Markets occur when producers and consumers exchange a certain good or service voluntarily Markets do not have to be explicitly created by a central body (like a government) Markets are not always highly organized As long as the transactions are voluntary, everyone involved will be better off One homogenous product Diminishing returns Entry and exit costs are zero All producers produce an identical product or service Consuming more of a product eventually offers less utility to consumers Inputs eventually grow less useful as production rises Entry costs are the costs of starting a certain business Exit costs are costs of shutting down a business THE PRICE IS RIGHT A market price conveys the value of a good to producers and consumers In perfect competition, the price represents the opportunity cost of a good s production Price also signals the value of the good to all producers and consumers All buyers and sellers are price takers, not makers AGGREGATION Prices are good indicators of a product s value in a competitive market. Adding up prices allows us to compare different goods. This process is called aggregation and allows firms and consumers to make good market decisions. Transaction costs are zero Perfect information Rational behavior The process of exchange does not add more costs The market price is the same for all consumers Consumers are aware of all producers and vice versa Everyone has access to the market price Firms maximize profits Consumers maximize utility MARKET MENTALITY QUESTIONS 1. What does no agent has market power mean in context of a perfectly competitive market? 2. In a competitive market, market price reflects the. 3. Aggregation is the process of. ANSWERS 1. No individual agent can affect the market price. All economic agents must accept the market price as it is determined by the market as a whole. 2. value consumers and producers place on the good 3. comparing different goods using a common measuring stick, such as market price

7 [[ ECONOMICS CRAM KIT 6 MICROECONOMICS Demand THEORY OF THE CONSUMER THE LAW OF DEMAND The quantity demanded of a good by consumers increases when market price decreases and decreases when price increases----price and quantity demanded are negatively correlated. SHIFTING ALL OVER THE PLACE CONSUMER INCOME Normal goods (computers, yachts, calculators): Increased income higher demand Inferior goods (dollar store goods, used textbooks): Increased income lower demand TERM Quantity demanded Demand Demand schedule DEFINITION The amount of a good consumers will demand at a given price; a specific value, NOT the general relationship given by demand The overall relationship given by the law of demand, relates price to quantity demanded A table that represents the law of demand, maps values of prices to quantities demanded PRICES OF RELATED GOODS Substitutes (goods that can fill each other s role in consumption----7-up and Sprite): Increased price of one higher demand for substitute Complements (goods that combine for consumption---- peanut butter and jelly): Increased price of one lower demand for complement NUMBER OF CONSUMERS Increased number of consumers higher demand CONSUMER PREFERENCES AND EXPECTATIONS Good becomes more desirable higher demand Expectation of pay cut lower demand Demand curve Curve that represents the law of demand, maps an interval of prices to quantities demanded THE DEMAND CURVE Shifts in a curve are NOT the same as changes in quantity or price Demand increased is a shift of the demand curve; quantity demanded has changed at every price A change in quantity demanded or price is a movement along the curve Price $25 $20 $15 $10 $ Quantity Demanded I DEMAND A QUIZ QUESTIONS 1. The law of demand states that when price increases, quantity demanded. 2. A change in quantity demanded for every price implies a. 3. An increase in the price of a good will lead to a(n) in the demand for its complement. THE DEMAND SCHEDULE Price $5 $10 $15 $20 $25 Quantity ANSWERS 1. decreases 2. shift of the demand curve 3. decrease

8 ECONOMICS CRAM KIT 7 MICROECONOMICS Supply THEORY OF THE FIRM THE LAW OF SUPPLY The quantity of a good supplied by producers increases when market price increases and decreases when price decreases----price and quantity supplied are positively correlated. TERM Quantity supplied Supply DEFINITION The amount of a good firms will supply at a given price; a specific value, NOT the general relationship given by supply The overall relationship given by the law of supply, relates price to quantity supplied SHIFTY SUPPLY COST OF FACTORS OF PRODUCTION Increased factor costs higher production costs Higher production costs lower supply ADVANCES IN TECHNOLOGY Technological advances lower production costs Lower production costs higher supply EXPECTATIONS OF PRICE CHANGES Expectation of lower future price Higher price now NUMBER OF PRODUCERS Increased number of firms higher supply higher price now higher supply SHIFTS VS. MOVEMENTS Supply schedule Supply curve A table that represents supply, maps values of prices to quantities supplied Curve that represents supply, maps an interval of prices to quantities supplied THE SUPPLY CURVE Price $25 $20 $15 $10 $ Quantity Supplied THE SUPPLY SCHEDULE Price $5 $10 $15 $20 $25 Quantity A HEALTHY SUPPLY OF QUIZZES QUESTIONS 1. When price increases, quantity supplied. 2. If firms expect prices to rise, supply will now. ANSWERS 1. increases 2. decrease

9 ECONOMICS CRAM KIT 8 MICROECONOMICS Elasticity ELASTICITY BASICS PRICE ELASTICITY OF DEMAND How much is quantity demanded affected by changes in the good s price? PRICE ELASTICITY OF SUPPLY How much is quantity supplied affected by changes in a good s price? ELASTICITY AND GOODS Elastic Goods with close substitutes Example: baseball caps Luxury goods that we can do without Example: Porsches Elastic In the long run, firms can reallocate resources DEMAND SUPPLY Inelastic Necessities that people must buy regardless of price Example: insulin Inelastic In the short run, firms cannot reallocate resources Extremely scarce goods FACTORS THAT AFFECT PRICE ELASTICITY Demand Supply Degree of substitution (goods with close substitutes have high elasticity of demand) Degree of necessity (necessities are more inelastic) Time frame (in the short run, goods tend to be more inelastic) Scope of the market (a larger market is more inelastic since fewer substitutes are available) Scarcity of inputs (scarcity of inputs means more inelastic supply) Time frame (in the short run, supply is inelastic) Presence of barriers to entry (lower barriers to entry means more elastic supply) CALCULATING ELASTICITY THE FORMULA % changein A E = % changeinb (AF - A I ) AI (B -B ) B E is the elasticity of A with respect to B A F is the final value of A, A I is the initial value B F is the final value of B, B I is the initial value DEFINITIONS E = 0: Perfectly inelastic, vertical line; change in variable B does not affect variable A at all 0 < E < 1: Inelastic; steep line; change in variable B causes a smaller change in variable A E = 1: Unit elastic; convex curve; change in variable B causes an equal change in variable A E > 1: Elastic; shallow line, change in variable B causes a larger change in variable A E = : Perfectly elastic; horizontal line; changing variable B infinitely affects variable A AN EXAMPLE % changeinq (qf - q I) qi E = % changeinp (p -p ) p E is the price elasticity of demand (elasticity of demand with respect to price) m is a good s price; p F and p I are final and initial price, respectively q is the quantity demanded; q F and q I are final and initial quantities, respectively REVENUE THE ELASTICITY SHORTCUT Price elastic good Increase in price decrease in revenue Revenue = price of good x quantity Price inelastic good Increase in price increase in revenue F F I I I I Unit elastic good Increase in price no change in revenue

10 ECONOMICS CRAM KIT 9 MICROECONOMICS Equilibrium MEET ME AT THE INTERSECTION MARKET SURPLUS THE INVISIBLE HAND The laws of supply and demand meet at the market equilibrium point, where their forces are equal and opposite. Price A B Quantity Triangle A is consumer surplus, or the difference between how much consumers are willing to pay and the market price Triangle B is producer surplus, or the difference between the price at which firms are willing to sell their product and the market price Market equilibrium maximizes market surplus, or the sum of producer and consumer surplus; the goal of social planners is to maximize this surplus SHIFTING SUPPLY AND DEMAND Shift Result Supply Demand Price Quantity Producer surplus Consumer surplus Total surplus N/A ambiguous N/A ambiguous N/A ambiguous N/A ambiguous ambiguous ambiguous ambiguous ambiguous ambiguous ambiguous ambiguous ambiguous ambiguous ambiguous An means an increase, not a shift upward. Likewise, means a decrease, not a shift downward.

11 ECONOMICS CRAM KIT 10 MICROECONOMICS Government Policies PRICE CONTROLS PRICE CEILINGS Price ceilings set a maximum legal price on a good. If this price is below the equilibrium price, the ceiling is binding and the market price is changed. TAXATION ONLY ON THE MARGIN Marginal taxes (taxes per unit) make consumers pay a different price than what producers receive. The government steps in between consumers and producers. Since marginal taxes distort how prices signal value, they lead to inefficiency. Price B A C Price Ceiling Price A Consumer price Tax D C Trapezoid A is the new consumer surplus Triangle B is the new producer surplus Triangle C is the deadweight loss caused by the policy because the market is not in equilibrium The width of the shaded rectangle is the difference between quantity demanded and quantity supplied, or the shortage in the market Note that A + B + C = equilibrium market surplus Price A B PRICE FLOOR C Quantity Quantity Price Floor Triangle A is the new consumer surplus Trapezoid B is the new producer surplus Triangle C is the policy s deadweight loss The width of the shaded rectangle is the difference between quantity supplied and quantity demanded---- in other words, the surplus in the market THE LESSON TO BE LEARNED Applying a price ceiling below equilibrium or a price floor above equilibrium is inefficient and leads to deadweight losses. B Quantity Producer price Triangle A is the new consumer surplus Triangle B is the new producer surplus Triangle C is the deadweight loss caused by taxation because quantity is contracted (mutually beneficial transactions are not taking place) Rectangle D is tax revenue, which is equal to market quantity times revenue Note that marginal taxation is equivalent to holding quantity at a fixed value (like a quantity ceiling) ELASTICITY AND TAXATION Flatter curves increase the size of the deadweight loss triangle and make the revenue rectangle smaller Therefore, markets with elastic demand and supply curves suffer the most from taxation and provide the least revenue The incidence of taxation determines whether consumers or producers bear the majority of the tax If supply is more inelastic than demand, demand can adjust more easily and firms bear more of the tax Similarly, if demand is more inelastic, consumers will bear the brunt of the taxation

12 ECONOMICS CRAM KIT 11 MICROECONOMICS Tariffs and Exports TRADE IN A SMALL ECONOMY OVERPOWERED BY THE WORLD We assume the domestic economy is small relative to the world economy and cannot influence the world price. Therefore, the world price is fixed for the domestic market, making international trade equivalent to a price control. The difference is that the world market either buys the surplus or supplies the shortage. DIAGRAM OF AN IMPORTING ECONOMY TRADE TAXATION TARIFFS, IMPORT DUTIES, AND OTHER NASTIES Price A tariff is a tax on imports. C A B C C World Price + Tariff World Price Price The big triangle A is consumer surplus The small triangle B is producer surplus Triangle C represents the gains from trade Rectangle D is the value of the goods imported Price B AN EXPORTING ECONOMY A A B Quantity The small triangle A is consumer surplus The big triangle B is producer surplus Triangle C represents the gains from trade Rectangle D is the value of the goods exported C D Quantity C D World Price World Price Quantity Triangle A represents the gains from trade with the import tax in place Triangle B is the revenue collected by the government from the tax The two triangles marked by C are the deadweight losses associated with the tax If the tax were removed, the gains from trade would be A + B + C Applying an import tariff increases producer surplus at the expense of consumer surplus and efficiency TRADE AND TARIFFS TRIVIA QUESTIONS 1. An export tax benefits domestic at the expense of domestic. 2. An import tax benefits international at the expense of international. 3. For a small open economy, international trade is equivalent to a binding. 4. If voluntary trade is always beneficial, why do some oppose it? ANSWERS 1. consumers; producers 2. consumers; producers 3. price control 4. While the economy as a whole benefits, not everyone does.

13 ECONOMICS CRAM KIT 12 MICROECONOMICS Behavior of Firms FIRM DECISION-MAKING COST CURVES TYPES OF COSTS Marginal cost Fixed costs: Incurred even when quantity produced is zero, independent of output Variable costs: Change with quantity produced, contribute to marginal cost Total costs: Sum of fixed costs and variable costs $ AFC Average total cost Average variable cost MARGINAL COST & MARGINAL REVENUE Average fixed cost Marginal cost Cost of producing just one more of a good Quantity Produced Marginal revenue Revenue from producing just one more of a good. For a perfectly competitive market, fixed at market price Average Fixed Cost AVERAGE COST CURVES Fixed costs divided by quantity produced Decreases as quantity increases TYPES OF PROFIT 1. Accounting profit: Total revenue minus accounting costs; producers attempt to maximize this 2. Economic profit: Total revenue minus full economic costs (including opportunity costs) 3. Normal profit: Zero economic profit; means accounting profit equals opportunity cost of production; in a competitive market firms can expect normal profits in the long run THE GOLDEN RULE: MC = MR All firms are assumed to seek to maximize profits. Profit maximization in any market occurs where marginal revenue equals marginal cost (MC=MR). All firms will produce up to this point of profitmaximization. In graphical terms, find where the marginal cost and marginal revenue curves intersect. Then, look at the quantity where that occurs. In a perfectly competitive market, the marginal revenue curve is the same as the demand curve, which is perfectly elastic at the market price. In a perfectly competitive market, therefore, profitmaximization occurs where the demand curve intersects the MC curve. Average variable cost (AVC) Average total cost (ATC) Variable costs divided by quantity produced Decreases and then increase Sum of average fixed cost and average variable cost ATC = Total fixed costs + Total variable costs Total number of units produced DIMINISHING RETURNS TO SCALE Marginal costs first decrease and then increase. This phenomenon is the result of diminishing returns to scale. Firms will spread fixed costs over multiple units of output. Variable costs, however, will drag average cost upward after a certain point. Consider a restaurant kitchen. After a certain point, adding too many cooks will cause inefficiency----they will get in one another s way, and one may faceplant into the soup. MULTIPLE INPUTS Inputs: labor and capital Prices: wage rate and price of capital Increasing the price of an input makes a firm substitute away from it

14 ECONOMICS CRAM KIT 13 MICROECONOMICS Failures of Perfect Competition IMPERFECT MARKETS: MONOPOLY FAILURES OF PERFECT COMPETITION Removing any assumptions of perfect competition creates a new market type. All of these market types are inefficient and create deadweight loss. All firms face downward sloping demand curves. MONOPOLY BASICS Only one firm supplies (example: De Beers diamonds) This firm has full market power to set prices Arise from barriers to entry or economies of scale (after a certain point, producing more of a good will increase costs due to increasing inefficiency) Faces a downward sloping demand curve (for the entire market) Deliberate scarcity Monopolies can produce less than what is demanded to increase profits This leaves some consumer demand unmet, decreasing general welfare Some consumer surplus becomes producer surplus, but part of it vanishes as deadweight loss Inefficiency Monopolists are sometimes lazy, incompetent, or just lack incentive to raise standards due to no competition This inefficiency can result in wasted resources, higher production costs, and higher prices Positive economic profit A monopoly will set price and quantity supplied where marginal revenue equals marginal cost Unlike a perfectly competitive firm, increasing supply to reach that point increases economic profits DEALING WITH MONOPOLIES The United States government has devised several methods of dealing with monopolies. Regulation Legislation (Sherman Anti-Trust Act) Public Ownership I HAVE THE POWER MARKET POWER Market power is the ability of an individual to influence market price. Perfect competitors have no market power and must accept the market price. High entry costs CAUSES OF MARKET POWER Control of natural resources PRICE DISCRIMINATION Price discrimination involves selling the same product to different consumers at different prices----such as airline seats or movie tickets. This practice increases producer surplus at the expense of consumer surplus. Monopolies price discriminate to capture new consumers without losing current ones. BARRIERS TO ENTRY Monopolies arise due to barriers that keep competitors from entering the market. Barriers include: Ownership of a key resource Government-created barriers (patents, copyrights, and other property protections) Natural monopolies: emerge when it is practical for only one seller to operate in a given market 1. Market power 2. Economies of scale 3. Sherman Anti- Trust Act 4. Barriers to entry 5. Only one supplier Policies that restrict entry Rent seeking (see later) Economies of scale YOU SHALL NOT MATCH A. After a certain point, producing more goods increases costs B. Monopoly C. Ability to influence market price D. Legislation that deals with monopolies E. Prevent more firms from entering Answers: 1. C; 2. A; 3. D; 4. E; 5. B

15 ECONOMICS CRAM KIT 14 MICROECONOMICS Failures of Perfect Competition IMPERFECT MARKETS CONTINUED OLIGOPOLY Only a few firms (suppliers) exist Each firm has some degree of market power Goods are either homogenous or differentiated Firms primarily face non-price competition Producers often collude and form cartels Examples: Market for mobile phone service, OPEC Collusion occurs when firms in an oligopoly cooperate to raise market prices artificially. A group of firms that colludes to control prices is a cartel, which is illegal under U.S. antitrust law. The incentive to cheat in a cartel is strong, so cartels tend to break down even without government intervention. THE BOTTOM LINE An oligopoly will be more efficient and benefit more people than a monopoly, but will be less efficient and benefit fewer people than a perfectly competitive market. MONOPOLISTIC COMPETITION Goods no longer homogenous Large number of firms, just like perfect competition Firms compete by differentiating their products, often artificially Producers often engage in non-price competition (for example, through advertising) Firms face a downward sloping demand curve Examples: Blue jeans, restaurants, toothbrushes The diversification of products in a monopolistically competitive market gives consumers more choices than in a perfectly competitive market, where all products are homogenous. However, since market price is greater than marginal cost, the markets will experience some social inefficiency. THE BOTTOM LINE You can spot a monopolistically competitive market whenever multiple companies are using ads to convince you that their products are different when they are actually pretty similar. MARKET FAILURES Market failures occur when competitive markets fail to produce socially desirable outcomes. The two main forms of market failures are linked to externalities and public goods. Externalities are costs or benefits associated with a decision not factored into the decision-making process. They do not affect the decision maker directly. Negative externalities Harm others They are the costs of an action that are not passed along to the agent taking that action Since the agent does not face the cost, he will perform more of the action than is optimal Positive externalities Benefit others They are the benefits of an action not felt by the agent taking that action Since the agent does not enjoy the benefit, he will perform less of the action than is optimal INTERNALIZE IT! One way to address externalities is to internalize them, by incorporating the cost of the externality into the market. For instance, if companies are taxed for each pound of pollution they emit----and the tax is set to equal the cost of that pollution to society----companies will make choices based on true social cost. THE COASE THEOREM As long as the parties involved in a dispute can negotiate and property rights are clearly defined, the private market can settle any disputes. PLEASE DON T FAIL THIS TRUTH TEST TRUE/FALSE 1. Oligopolies are more efficient than monopolies 2. Externalities are the only area of market failure ANSWERS 1. True 2. False; public goods are also associated with market failure

16 ECONOMICS CRAM KIT 15 MICROECONOMICS Institutions PROPERTY RIGHTS INSTITUTIONS AND ORGANIZATIONS Institutions Formal or informal rules that structure human interaction Examples: Codes of conduct, social norms, most markets, laws MINE, NOT YOURS Organizations More formal than institutions Examples: Stock exchanges, organized religions, corporations Property rights dictate who can and can t use a good. The rivalry of a good is how much one person s use of a good prevents another person from using it. The excludability of a good is the ease of preventing someone from using it. RIVAL NON- RIVAL TYPES OF GOODS EXCLUDABLE Private Goods (food, clothes, cars) Common goods (electricity, cable television) INTELLECTUAL PROPERTY NON-EXCLUDABLE Collective goods (sidewalks, fishing ponds) Public Goods (national defense, air) Copyright: protection given to the creators of literature, art, or music Patent: rights awarded to inventors so that no one else can copy their inventions for a period of time FINANCIAL INTERMEDIARIES These institutions link savers and borrowers. Banks, stock exchanges, and bond markets are financial intermediaries. ENTREPRENEURS & CREATIVE DESTRUCTION INNOVATION Entrepreneurs can earn economic profits by taking risks to be the first to sell a product or to provide a new or better service. While innovation can create new barriers to entry in the form of patents and copyrights, it also destroys existing market imperfections and therefore betters society. CREATIVE DESTRUCTION Economist Joseph Schumpeter described the impact of entrepreneurs as creative destruction---- replacing the old and inefficient with the new and improved. THE GOVERNMENT POWERS OF THE GOVERNMENT Ability to tax citizens Legitimate use of force The use of force gives power to the court system, which ensures contracts are upheld. Without the rule of law, market economies cannot function. DEMOCRATIC INEFFICIENCIES Pork barrel politics: The tendency of elected officials to steer money to their home communities to increase their chances of being reelected Logrolling: Vote trading among elected officials, usually to get support for pet projects Rent seeking: Socially unproductive activities that redirect, rather than create, economic benefits (lobbying, for example) AN EFFICIENT LITTLE QUIZ 1. Non-excludable and rival 2. Excludable and rival 3. Non-excludable and nonrival 4. Excludable and non-rival A. Private B. Public C. Common D. Collective Savings deposited Banks Loans borrowed Answers: 1. D; 2. A; 3. B; 4. C

17 ECONOMICS CRAM KIT 16 MACROECONOMICS Basics of Macroeconomics MACROECONOMICS ISSUES Macroeconomics is concerned with two main issues: Factors that affect things in the long run (the size of economies, standard of living, and price level) The causes and consequences of short-run economic fluctuations (especially unemployment and inflation) THE STATE OF THE ECONOMY THE BUSINESS CYCLE Real output fluctuates cyclically, alternating between periods of growth and decline. Note that even though the economy fluctuates, the general trend is upwards. Peak REAL GDP Real Gross Domestic Product (GDP) measures the total quantity of goods and services produced in an economy in a given year, adjusted for the effects of inflation. REAL GDP PER CAPITA Per capita is a Latin phrase meaning per head. GDP per capita is the GDP per person in the economy; it indicates what the average person is able to consume in an economy. If the population were suddenly to double, GDP per capita would be cut in half. (Technically, the same would be true if every person in the economy were to grow a second head.) AVERAGE LABOR PRODUCTIVITY Average labor productivity measures how much the typical worker can produce. Divide the economy s total output (GDP) by the total number of workers employed. Average labor productivity = Economy' s output (GDP) Total number of workers Real output TERM Downturn Expansion Downturn Recession Depression Expansion Time Trough DEFINITION Increase in real GDP; occurs until a peak Decrease in real GDP; occurs until a trough Downturn that lasts at least two quarters (six months) No official definition; a very steep and prolonged recession Greater levels of production and average labor productivity enable consumption that improves the standard of living. HUMAN HAPPINESS Human happiness depends on more than just material levels of consumption. Other important factors: A long, healthy life Access to education Clean environment Possession of alpacas A QUIZ FOR A DEPRESSION QUESTIONS 1. A period of increase in real GDP is a(n). 2. What were the years of the Great Depression? 3. When was World War II? 4. How do most nations moderate the business cycle? ANSWERS 1. expansion to to through countercyclical monetary and fiscal policy

18 ECONOMICS CRAM KIT 17 MACROECONOMICS Unemployment EMPLOYMENT TYPES OF UNEMPLOYMENT THE LABOR FORCE The labor force includes all members of the population who have a job (employed) or are actively seeking employment (unemployed). To be in the labor force, you cannot be: Younger than 16 or retired In jail, in the military, or a homemaker A discouraged worker: you must have worked in the past week or looked for work in the past four weeks TERM Employment rate Unemployment rate Participation rate Employed Unemployed Discouraged worker / out of the labor force DEFINITION Percentage of the labor force that has a job; number of persons employed divided by the labor force; never 100% Percentage of the labor force that lacks a job but is searching for one. The Bureau of Labor Statistics measures unemployment. Percentage of the population in the labor force----about 66% Worked for pay in the past week, or on vacation or sick leave Did not work during the past week but did look for paid work sometime in the past four weeks Did not work in the past week or look for work in the past four weeks THE NATURAL RATE OF UNEMPLOYMENT Key fact: Full employment is NOT 0% unemployment. There is always unemployment----some people are always between jobs, or just joining the labor force The unemployment rate of an economy at full output is the natural rate of unemployment Okun s law relates unemployment to GDP; every 1% increase in unemployment above the natural rate results in a 2% drop in real GDP No one knows exactly what the natural rate is in 21 st century America----it might be higher than it used to be d Structural Mismatch between skills demanded and skills supplied Spurred by changes in technology or consumer preferences Would be zero if retraining was instant was instant and free Factors into the natural rate of unemployment Cyclical Unemployment resulting from movement along the business cycle Increases with recessions and decreases with expansions Does not factor into the natural rate of unemployment Frictional Caused by time-lag between jobs Inevitable Factors into the natural rate of unemployment QUIZ FOR EMPLOYMENT QUESTIONS 1. Unemployed workers must be, but not have a. 2. Unemployment due to a mismatch between skills demanded and skills supplied is. 3. No one knows the rate of unemployment. 4. The percentage of the population that is in the labor force is known as the. ANSWERS 1. looking for work; job 2. structural unemployment 3. natural 4. labor participation rate

19 ECONOMICS CRAM KIT 18 MACROECONOMICS Gross Domestic Product THE BIG PART OF MACRO HISTORY OF GDP GROSS DOMESTIC PRODUCT (GDP) GDP is the market value of all final goods and services produced within a country in a given period of time. Development of GDP the market value The total value of different goods (add up dollar values) In the mid-17 th century, Sir William Petty was assigned by the British government to assess the Irish people s ability to pay taxes. of all final goods and services Only final goods are counted Capital goods (made to make other goods) are counted the year they are produced In 1932, the U.S. Department of Commerce commissioned Simon Kuznets to develop a system to measure national output. produced within a country" All goods produced within a country s borders, even if a foreigner owns the factory Kuznets presented his findings in 1934 to the U.S. Senate. in a given period of time Typically a specific quarter or year When the U.S. entered World War II (which effectively ended the Great Depression) it continued to refine techniques for measuring output. WHAT S NOT INCLUDED IN GDP Intermediate goods: goods used for the production of other goods, value is reflected in its final good Example: bolts Goods not sold on the open market: illegal black market goods, as well as goods produced for personal consumption Example: home-knit sweaters Used goods: the value of the good was already counted in GDP when the good was sold new Example: a used car Transfer payments: moving money between the government and people Example: a Social Security check For his efforts, Kuznets received the Nobel Prize in Economic Science in LIMITATIONS OF GDP HEY, YOU MISSED ME! GDP misses out on a lot of economic activity. It can be difficult to determine what is a final good GDP excludes goods and services not bought or sold in official markets (such as work done by stay-athome spouses) GDP usually ignores the fact that certain activities deplete natural resources, pollute, or have other costly externalities

20 ECONOMICS CRAM KIT 19 MACROECONOMICS Measuring GDP MEASURING GDP, PART A MEASURING GDP, PART B THREE WAYS TO MEASURE IT Calculating GDP Production Approach: Measure total value of economic output Expenditures Approach: Count everything spent on consumption CONSUMPTION/EXPENDITURES APPROACH GDP = production = expenditures = Y = C + I + G + NX Consumption (C): value of all purchases of final goods designed for consumption by consumers Consumer durables: long-lived consumer goods Consumer nondurables: used up more quickly than durable goods Services: intangible goods Investment (I): what firms spend on capital, technologies, and real estate Income Approach: Follow the money Business fixed investment: purchase of capital equipment Residential fixed investment: purchase of new homes and apartment buildings Inventories: unsold goods placed in storage for later sale Government spending (G): everything the government pays for labor, goods, and services INCOME APPROACH GDP = production = expenditures = income REAL In terms of a base period s price level Can be compared across years REAL VS. NOMINAL NOMINAL In terms of the measurement year s price level Includes inflation Real measurements like real GDP are used to measure economic growth Economists need a way to separate the effects of changes in price from changes in quantity produced (and production equals GDP) Prices do not change consistently----the price of one good may increase while the price of another decreases by a different magnitude SURPLUS AND DEFICIT NX = net exports = exports -- imports Trade surplus: Exports exceed imports; GDP increases Trade deficit: Imports exceed exports; GDP decreases In the long run, imports and exports will move in similar directions, both either decreasing or increasing. Net exports (NX): exports minus imports TRICKY BITS The value of homes purchased is considered personal investment, NOT consumption If a good does not sell in the given time period, it enters a firm s inventory and is counted as investment A good in inventory sold in a later year does NOT enter that year s GDP, as it was already counted as an investment in inventory Government transfer payments, such as Social Security, are not payments for a good or service and thus are not considered government expenditures CAUTION Don t confuse trade surpluses and deficits with budget surpluses and deficits Budget surpluses and deficits refer to the difference between how much a government takes in (mostly as tax revenue) and how much it spends Trade surpluses and deficits refer to how much an economy exports versus how much it imports

21 ECONOMICS CRAM KIT 20 MACROECONOMICS Measuring Inflation INFLATION AND THE CONSUMER PRICE INDEX WHAT IS INFLATION? Inflation is an increase in the aggregate price level or, equivalently, a decrease in the value of money THE CONSUMER PRICE INDEX (CPI) In the United States, the Bureau of Labor Statistics calculates the CPI each month by comparing the prices of a given basket of goods between the current year and a base year. This basket includes the sorts of goods that an average household would buy regularly (housing is the main component), and varies by income and region. The CPI in the base year is always 100. A CPI of 120 = prices are 20% higher than in the base year. A CPI of 75 = prices went down 25% since the base year. THE FORMULA: CPI YEAR T = ADVANTAGES Used to reflect changes in cost of living (so as to adjust Social Security benefits and other COLA accounts) Captures changes in price for basic consumer goods Makes inflation rate easy to calculate COST OF BASKET YEAR T COST OF BASKET BASE YEAR X 100 DISADVANTAGES New goods and services are introduced all of the time. Example: Kenya added mobile phone airtime to its CPI basket in Does not account for substitution bias (consumers may switch to a good not in the basket if one gets too expensive) Does not account for changes in quality THE BOSKIN COMMISSION In 1996, economist Michael Boskin was appointed to head a commission to evaluate CPI. His group found that the CPI overstated the rate of price inflation by 1.3% a year. GDP DEFLATOR The GDP deflator also measures inflation. The deflator corrects for price increases in nominal GDP. THE FORMULA GDP deflator= nominal GDP real GDP x 100 VOLATILITY Compared to the CPI, the GDP deflator is much less volatile. It increases less at peaks and declines less at troug DIFFERENCES The GDP deflator is different from the CPI in two main ways. The GDP deflator reflects only the prices of domestically produced goods. The CPI can include imports like oil. The GDP deflator and CPI place different weights on goods. Since the deflator weights prices by production, it adjusts to changing consumption patterns. DEFLATING THE DEFLATOR: SHORTCOMINGS Unfortunately, the GDP deflator is difficult to calculate accurately and therefore is only published once per year. That means the deflator cannot track inflation very quickly. As a result, it is not very useful for guiding government policy, despite its accuracy. Like the CPI, the GDP deflator fails to take into account changes in product quality.

22 ECONOMICS CRAM KIT 21 MACROECONOMICS Money IT S A DEFINITION Money is something accepted as payment for goods and for the settlement of debts. THE MONEY SUPPLY DEFINITION The money supply is the stock of all liquid assets in an economy that can be exchanged for goods. FUNCTIONS OF MONEY Medium of exchange: Eliminates the need to barter for goods, which requires both parties to want what the other has (double coincidence of wants) Unit of account: Establishes the value of goods relative to one another Store of value: Allows individuals to store wealth over a period of time For something to be money, it must satisfy these three functions. Commodity money Fiat money TYPES OF MONEY Money with value outside of just being money, such as gold, or cigarettes in prison Money only valuable because the government says it is and we believe it to be so MONETARY AGGREGATES Monetary aggregates classify money by its liquidity: how easily it can be converted into currency. M0 is the most liquid, M1 more liquid, M2 the most liquid. M0 Cash and coins Most liquid category M1 M0 Demand/checking deposits Other checkable deposits Nonbank travelers' checks M2 M1 Savings deposits CDs money market funds WHAT IS NOT MONEY Credit cards are NOT money. They just provide a convenient way to accumulate debt. The use of credit cards reduces the economy s need for money, since credit cards are convenient. THE QUANTITY THEORY OF MONEY MV = PQ M = the money supply V = velocity (how often a dollar is spent in a year) P = the aggregate price level Q = total output V and Q are generally held constant, meaning an increase in M (money supply) will lead to an increase in P (inflation). M2 is widely considered the most useful measure of the money supply. MONEY QUIZ (WITH A WORD BANK) medium of exchange unit of account store of value liquid commodity money fiat money 1. Currency is the most form of money. 2. Money s role as a allows people to store wealth over time. 3. is money with intrinsic value. 4. Money s role as a removes the need to barter. 5. Most money today is. 6. Money s role as a provides a way to compare the value of goods. Answers 1. liquid; 2. store of value; 3. commodity money; 4. medium of exchange; 5. fiat money; 6. unit of account

23 ECONOMICS CRAM KIT 22 MACROECONOMICS The Financial System SAVING AND INVESTMENT DEFINITIONS Saving: Difference between what is earned and spent Investment: Purchase of new capital equipment Financial institutions: Coordinate the saving and investment decisions in the economy Financial markets: Institutions in which people with money to save supply their funds to those who wish to borrow for investment BONDS AND STOCKS DEFINITION BONDS Certificate that specifies how much the borrower owes the bond holder STOCKS Share of ownership in a firm SELLING Debt finance Equity finance PROFITING The bond purchaser receives both the principal back and interest on the loan Shareholders hope to have their stock increase in value (and may receive dividends) FINANCIAL INTERMEDIARIES A financial intermediary links two other parties in a financial transaction. Banks and mutual funds are the most common. BANKS Most businesses turn to banks for the funds they need, since most small businesses do not have the resources to sell bonds or stocks. Banks draw their funds from deposits made by people who wish to save money. Banks pay their depositors a rate of interest and charge borrowers an even higher rate of interest for taking loans. MUTUAL FUNDS Mutual funds allow investors to buy into a diverse pool of stocks and bonds in a single investment vehicle. Diversification means mutual funds are less risky and volatile than individual stocks Mutual funds are managed by experts Even someone with only a small amount of savings can invest in a mutual fund and effectively have a diverse portfolio RISKS OTHER Market interest rates can fluctuate The borrower may default by declaring bankruptcy The date of maturity is the date on which the loan will be repaid Stock shares of ownership more risk more potential profit Bonds loans less risk less potential profit Riskier than bond (bondholders are paid before shareholders) but rewards are greater Often sold to the public on stock exchanges, such as the NASDAQ or New York Stock Exchange INTRODUCING THE FEDERAL RESERVE Federal Reserve Helps control money supply Money supply affects economy The Federal Reserve is often called the Fed It serves as the central bank of the United States It is a lender of last resort to other banks, to help maintain the stability of the banking system Control of the money supply falls to the Federal Open Market Committee (FOMC) The FOMC is made up of the seven governors of the Federal Reserve and five regional bank presidents The amount of money in the economy results from the interaction of the public, commercial banks, and the Federal Reserve system

24 ECONOMICS CRAM KIT 23 MACROECONOMICS Monetary Policy SHOW ME THE MONEY WHAT IS MONETARY POLICY? The Federal Reserve can use monetary policy to stimulate or slow down the economy. Monetary policy has three goals: price stability, full employment, and economic growth. Policy makers cannot achieve all three goals simultaneously WAYS TO IMPLEMENT MONETARY POLICY OPEN MARKET OPERATIONS FOMC trades securities on the open market Buying securities injects money into the economy Open market operations are performed daily Selling securities takes money out of the economy DISCOUNT RATE AND FEDERAL FUNDS RATE Discount rate Interest rate the Fed charges banks for loans Changed infrequently and by the board of governors Federal funds rate Overnight rate charged on loans between banks Not directly set by the Fed, but strongly influenced Increasing the interest rate decreases the money supply Dictates how much of its deposits a bank must hold in reserve Increasing the reserve requirement decreases the money supply Expansionary monetary policy Increases the money supply Increases aggregate demand in the short run (at the risk of inflation) Contractionary monetary policy Decreases the money supply Lower aggregate demand in the short run RESERVE REQUIREMENT Set by the board of governors 1 Money Multiplier= RR (RR = reserve requirement) THE FED IN SLIGHTLY MORE DETAIL AMERICA S CENTRAL BANK The Federal Reserve is the central banking system of the United States. Created by the Federal Reserve Act (1913) It contains 12 district banks. It sets monetary policy, manages banks, and serves as lender of last resort FEDERAL RESERVE BOARD OF GOVERNORS Located in Washington, D.C. Directed by a presidentially-appointed chairman---- as of 2012, Ben Bernanke. Members appointed by the President, approved by Senate and serve 14 year terms FEDERAL OPEN MARKET COMMITTEE (FOMC) Manages open market operations Made up of Seven rotating governors of the Fed President of the New York district bank Presidents of four other district banks Day-to-day operations run by New York bank Meets every six weeks in Washington, D.C. MONETARY POLICY: PROS AND CONS THE POSITIVE Monetary policy can be enacted immediately, unlike most fiscal policy, which must be legislated Central banks are relatively free of political interference; thus, they can pursue unpopular but important policies Central banks are staffed by professionals, not politicians THE BAD Monetary policy does not affect the economy quickly Central banks are hard to hold accountable Increasing the money supply may not boost the economy as well as traditional fiscal policy would

25 ECONOMICS CRAM KIT 24 MACROECONOMICS More on Saving and Investment SAVING AND INVESTMENT IN AGGREGATE IDENTITY An identity will always be true, just like the equality of GDP, production, income, and expenditures. CLOSED TO TRADE Assume the economy in question is closed to trade. GDP = Y = C + I + G I = Y -- C -- G = national savings = S By subtracting net taxes (T) from each side: S = (Y -- C -- T) + (T -- G) = I Savings is equal to investment and to the sum of private savings (Y -- C -- T) and government saving (T -- G). GOVERNMENT SAVINGS If government savings are positive, the government is running a budget surplus. If government savings are negative, the government is running a budget deficit. This implies that when the government runs a deficit, investment decreases. INTERNATIONAL CAPITAL FLOWS In an open economy, domestic savings do not need to equal domestic investment. There are two kinds of international capital flows. Foreign direct investment: A company or individual acquires and actively manages assets in a foreign country----such as an airport in Belgium run by the British Portfolio investment: An individual or company purchases stock or bonds issued by a foreign corporation but does not play a direct role in managing it Net capital output (NCO) equals the purchase of foreign capital or financial assets by domestic residents minus foreign purchase of domestic assets. In an open economy, NCO = NX Remember: Y = C + I + G + NX, so: Y -- C -- G = S = I + NX Therefore, S = I + NCO In an open economy, savings can differ from investment only as much as the difference is offset by net capital outflow. COORDINATING SAVING AND INVESTMENT Real Interest Rate The financial market features the supply of savings and the demand for savings (or investment). The supply and demand for savings are equalized through adjustments of the real interest rate. The real interest rate acts as the price of a loan. It is how much borrowers pay for a loan and how much savers earn for giving up their money so that it can be loaned. Supply of savings Demand for savings FINANCIAL MARKETS Quantity of Money Effect of interest rate the higher the real interest rate, the more people will save the lower the real interest, the more investing businesses will do BANK RUNS Supply of Savings Savings Demand Resulting curve the supply of savings slopes upward the demand for savings slopes downward A bank run occurs when depositors rush to a bank to withdraw their deposits before other depositors. Banks only hold reserves equal to a fraction of their liabilities----so even solvent banks will be unable to pay all of their depositors right away. The FDIC (a government institution) now insures deposits at federal banks for up to $250,000, so, even if a bank collapses in a bank run, accountholders can recover up to $250,000 of their money from the FDIC.

26 ECONOMICS CRAM KIT 25 MACROECONOMICS Money Market in the Long Run PRICES AND THE LONG RUN The aggregate price level is the level of prices for the entire economy. It rises and falls over time. If P is the price level, then it also measures the cost of a basket of goods. Therefore, the amount of goods and service that can be bought with $1 is 1/P. 1/P is also the value of money measured in terms of goods and services. PRICES IN THE LONG RUN: MONEY MARKET Just like in any other market, the value of money is determined by the interaction of supply and demand. MONEY SUPPLY Depends on the decisions of the Federal Reserve and the banking system Inelastic in the shortrun since it is set by the Federal Reserve MONEY DEMAND Depends on how much wealth people want to hold as money Relates to the volume and prices of the transactions that take place If the real level of economic activity stays the same, doubling prices should double demand for money The long run is the time period it takes for the price level to equate demand for money with the money supply. THE GRAPH Money demand slopes downward. As the price level falls, people need less money to purchase goods. In other words, the value of money increases. Market for Money BACK TO THE NEUTRALITY OF MONEY The long-run neutrality of money means that changes in the money supply have no bearing on real quantities in the economy. Recall the quantity theory of money: MV = PY. M is the money supply V is the velocity of money (how often money changes hands each year) P is the average current price level Y is real output of goods and services at a given point in time This equation is also called the equation of exchange. Of the variables, P is dependent. Since V and Y are usually fixed for the long run, changes in P depend on changes in M, the money supply. This equation says that the amount of money spent equals the amount of money used. Also note that PY = nominal GDP = MV. EFFECTS OF INFLATION While in the long-run, inflation has no effect on the economy, it has powerful short-term effects. Inflation reduces the value of money, and taxes those that choose to hold it Inflation distorts prices: not all firms adjust their prices at the same time (so relative prices do not always reflect costs of production) Inflation introduces confusion about the value of goods and services in the future TRUE/FALSE FLASH QUIZ Value of money (1/P) Money Supply Quantity of Money Money Demand 1. In the quantity equation, Y is nominal output 2. Money supply is inelastic in the short-run 3. 1/price level is the value of money 4. In the quantity equation, M and Y are usually constant 5. Inflation reduces the value of money ANSWERS 1. False (real output); 2. True; 3. True; 4. False (V and Y are constant); 5. True

27 ECONOMICS CRAM KIT 26 MACROECONOMICS Modeling the Economy Land, capital labor THE CIRCULAR FLOW MODEL GOODS AND SERVICES (CLOCKWISE) Households Goods and services Income Transfers Factor Markets Government Goods and Services Markets MONEY (COUNTER-CLOCKWISE) Factor Markets Goods and services Factors of production Firms Goods and services Wages and rent FLOWS GDP AS FLOW GDP is equal to the flow around the model at any given point The expenditure approach is the sum of consumption and government purchases (since investment and exports are not counted in this model) The income approach uses the flow of income to households Totaling the flow in the money diagram yields nominal GDP Totaling the flow in the goods and services diagram yields real GDP ENTERING THE CIRCULAR FLOW MODEL New wealth enters the cycle through households. Households provide the human labor used to work. Even inputs such as land belong to individuals, which in turn belong to households. These land-owning individuals rent their land to businesses. Households Taxes Government Firms CIRCULAR FLOW FLASH QUIZ Consumption FIRMS HOUSEHOLDS GOVERNMENT Government purchases Goods and Services Markets THE ACTORS Revenue Produce goods and services using the factors of production owned by households Rent the factors of production (land, labor, capital, entrepreneurship) to firms Consume goods produced by firms Ability to tax to earn income Can borrow from financial markets to produce goods for society QUESTIONS 1. The three actors in the circular flow model are,, and. 2. The two markets in the circular flow model are the markets for and. 3. All factors of production are owned by. 4. With regard to the circular flow, nominal GDP is equal to the. 5. sits between households and the goods and services market. ANSWERS 1. households; firms; government 2. goods and services; factors of production 3. households 4. flow around the money diagram 5. government

28 ECONOMICS CRAM KIT 27 MACROECONOMICS Living Standards AVERAGE LABOR PRODUCTIVITY Five factors affect average labor productivity. Physical capital Tools, machinery, even computers and Internet access: the stuff that helps people make stuff Making capital for future poduction requires giving up current consumption GDP PER CAPITA Economy's output depends on the quantity of goods and services a firm can produce Total quantity of goods and services depends on the quantity of factor inputs households supply and the ability of firms to turn inputs into outputs Human capital Skills and experienced acquired through education, training, and on-the-job experience By spending time learning and training, we sacrifice current earning and consumption Natural resources The wealth of many nations depends on their natural resources Example: Saudi Arabia On the other hand, in a global economy, natural resources are not essential for an economy to succeed Example: Singapore Technological knowledge Transforms inputs into the goods and services households desire Single most important factor in raising average labor productivity Patents help encourage and publicize innovations Political and legal environment Broken political and legal systems stop many countries from building effective economies Investors and workers alike must feel confident in a country's stability, private property laws, and supply of an educated workforce All else equal, large economies should produce more than smaller economies. Real GDP per capita is equal to real GDP per worker multiplied by the fraction of the population employed. GDP POP = GDP N x N POP POP is the country s total population N is the labor force Most differences in GDP per capita can be explained by differences in average labor productivity, since the proportion of the population engaged in production remains remarkably consistent in the long run. SHORT-RUN FLUCTATIONS The most important correlates of fluctuations in the economy s growth are unemployment and inflation. During recessions, unemployment increases. Businesses increase hiring slowly in the early phases of an expansion. Increased employment lags behind the next stage of economic growth. When the economy expands, inflation accelerates. Recessions are linked to slowing inflation. A SHORT RUN QUIZ QUESTIONS 1. What is the most important factor in raising average labor productivity? 2. What is real GDP per capita equal to? ANSWERS 1. Technological knowledge 2. Real GDP per worker multiplied by the fraction of population employed

29 ECONOMICS CRAM KIT 28 MACROECONOMICS The Output Gap and the Short Run OUTPUT GAP TWO PART STRUCTURE Think of the actual level of GDP as having two parts. POTENTIAL OUTPUT Potential output is the quantity of goods and services that the economy could produce when using all its resources at normal rates. Over time, the level of potential output can increase over time as technology improves and the country obtains more resources. Y symbolizes actual output Y* symbolizes potential output SHORT RUN FLUCTATIONS AGAIN In the short run, the pace of economic growth is mostly due to the divergence between actual and potential output (that is, the presence of an output gap). In the long run, variations are due to changes in the growth rate of potential output. This, in turn, depends on the growth of the population, the rate at which capital stock increases, and changes in the pace of technological advances. Variations in rate of growth of output OUTPUT GAP The output gap is the difference between actual and potential output. Output gap = Y -- Y* When an output gap exists, the economy s resources are not being fully utilized. When the economy is in recession, an output gap exists. Unemployment rises beyond the natural rate of unemployment. During the presence of an output gap, Okun s Law (that for every 1% the unemployment rate differs from the natural rate of unemployment, the output gap deviates by 2%) applies. LONG RUN Changes in growth rate of potential output Growth rate of the population Rate of increase of capital stock SHORT RUN The level of actual output relative to potential output JOHN MAYNARD KEYNES British economist John Maynard Keynes ( ) developed the model to explain short-run fluctuations. His theory was first published in the 1936 book, The General Theory of Employment, Interest, and Money. Keynes believed known economic models were inadequate to account for the Great Depression. His view of the business cycle and how to manage it by adjusting taxation and government spending would become known as Keynesian economics. Changes in pace of technological advances In a world in which prices adjust immediately to balance supply and demand, the economy s actual output would never deviate from potential output. However, firms do not constantly adjust prices to respond to changes in market demand----they set prices and sell as much as is demanded. Only after a while will they change prices. Therefore, in the short run, firms respond to variations in demand by changing production rather than prices; short-run output in determined by the level of aggregate demand.

30 ECONOMICS CRAM KIT 29 MACROECONOMICS Aggregate Demand INTRODUCING THE AD/AS MODEL WHAT IS AGGREGATE DEMAND? Aggregate demand is the sum of all expenditures in an economy, or the country s output for a period. Aggregate demand describes how expenditures change in response to changes in the aggregate price level. AD = Y =C+I+ G+NX C = consumer spending I = investment G = government spending and purchases NX = net exports THE SHAPE Just like the microeconomic demand curve, the AD curve slopes downward. It slopes downward for different reasons, however. 1. Wealth effect: Decreases in the price level lead to increases in consumption because consumers real income has increased. 2. Interest effect: Decreases in the price level lead to decreases in the interest rate, which increases investment by decreasing its opportunity cost. 3. Foreign exchange effect: Decreases in the price level make domestically produced goods cheaper in the international market, increasing net exports. Price Level GRAPH IT! Real Level of Output AGGREGATE SHIFTS RESULT FROM CHANGES IN CONSUMPTION Tax cuts, transfer payments from the government Changes in consumer sentiment (such as after 9/11 and the Enron scandal) Changes in wealth due to the stock market Expectations about the price level in the future CHANGES IN INVESTMENT Changes in the interest rate Changed expectations about the future CHANGES IN GOVERNMENT SPENDING Only direct government spending Transfer payments are not included CHANGES IN NET EXPORTS Changes in the income of foreign entities Changes in the exchange rate CAUTION Just as with microeconomics, shifts are NOT changes in output or the price level Changes in the price level lead to movements along the aggregate demand curve Changes in any of the factors above cause shifts AD QUIZ QUESTIONS 1. An increase in the price level leads to a decrease in output due to the, which denotes that. 2. Expectations of a higher future price level shift the AD curve outward because. ANSWERS 1. wealth effect; consumers' real wealth has decreased 2. consumers wish to spend now, when prices are lower

31 ECONOMICS CRAM KIT 30 MACROECONOMICS Aggregate Supply LOTS OF SUPPLIES WHAT IS AGGREGATE SUPPLY? Aggregate supply is the potential supply of all the goods and services an economy can produce at different price levels. Aggregate supply behaves very differently in the short term and long term. SHORT RUN AGGREGATE SUPPLY (SRAS) Price Level Short-Run Aggregate Supply LONG RUN VS. SHORT RUN Economists define the long run as the period when the market is in equilibrium All prices have adjusted to their equilibrium values and all markets clear The short run is the period in which other effects, such as price stickiness, can prevent long run equilibrium Level of Output LONG RUN AGGREGATE SUPPLY (LRAS) Price Level LRAS Level of Output WHY DOES SRAS SLOPE UPWARDS? At the microeconomic level, the supply curve slopes upwards because higher prices attracted resources from the production of other products The aggregate supply curve slopes upward to reflect the relationship between price adjustments and the size of anticipated sales; firms fix prices for a while and only over time do they adjust prices Long run aggregate supply is a vertical line fixed at the full employment level of output LRAS is not affected by changes in the price level (monetary neutrality) Output must be the full employment level in the long run YOU RE SHIFTING ME! Changes in the expected aggregate price level are the most common cause of shifts in the position of SRAS; at the expected level SRAS is equal to Y* Aggregate supply shocks also shift the aggregate supply curve (example: the 1973 OPEC oil embargo) Over time, technological progress can cause LRAS to increase; this increase accounts for the long-run growth of real GDP SHORT-RUN CRAMMING QUESTIONS 1. Markets always clear in the. 2. What does the position of the SRAS depend on? 3. What is the short run defined as? 4. What accounts for the long-run growth of real GDP? ANSWERS 1. long run 2. The economy s long-run potential output (Y*) and expectations for the price level 3. The period when the market is in equilibrium (the economy produces at full, potential output) 4. The steady increase of the LRAS over time due to technological progress

32 ECONOMICS CRAM KIT 31 MACROECONOMICS Equilibrium BALANCING ACT EQUILIBRIUM OVER TIME The behavior of the economy in the short run is given by the intersection of SRAS and AD. This point of intersection is called short-run equilibrium. Long-run equilibrium is given by the intersection of LRAS and AD. LONG-RUN EQUILIBRIUM Long-run equilibrium is obtained when SRAS, LRAS, and all intersect at a common point Price Level LRAS SRAS FLUCTUATIONS Short term departures of the economy from equilibrium can be modeled in terms of short-run equilibriums. Inflationary gap: Short-run equilibrium output exceeds long-run output; the economy is overheated Deflationary gap: Short-run equilibrium output is less than long-run output; the economy is inefficient and perhaps in a recession EFFECTS OF SHIFTS: AN EXAMPLE In the long run, both curves shift to restore long-run equilibrium. Changes in either curve end up only affecting the price level in the long run. An increase in aggregate demand will lead to a higher price level and output in the short run Price Level LRAS AD 1 Real Level of Output In the long run, however, aggregate supply will shift inwards to restore equilibrium. This shift is caused by a realignment of perceptions and expectations Price Level SRAS SRAS AD 2 SRAS 1 New equilibrium AD 2 Y = Y* INCREASING LONG-RUN OUTPUT (GROWTH) A major conclusion of the AD/AS model is that increasing long-run output MUST involve an outward shift of the LRAS curve LRAS does NOT shift outward from changes due to monetary policy as money is neutral in the long run Simple government spending does not cause growth as spending only temporarily increases aggregate demand Growth can only result from improvements in labor, capital, natural resources, or productivity AGGREGATE QUIZ QUESTIONS 1. An economy is experiencing an inflationary gap when exceeds. 2. What adjusts to restore long-run equilibrium when the government stimulates aggregate demand by passing a stimulus? ANSWERS 3. short-run output; long-run output 4. short-run aggregate supply AD Real Level of Output LRAS AD 1 Real Level of Output

33 ECONOMICS CRAM KIT 32 MACROECONOMICS Fiscal Policy SPEND, SPEND, SPEND ADVANTAGES OF FISCAL POLICY WHAT IS FISCAL POLICY? Fiscal policy is the use of government spending and taxation to intervene in the economy. Government spending directly and indirectly increases aggregate demand and, consequently, GDP. A government stimulus package----hiring workers to build dams, reducing taxes on small businesses, and offering more student loans----is an example of fiscal policy. Contractionary Expansionary FLAVORS OF FISCAL POLICY Contractionary fiscal policy aims to decrease aggregate demand to curb inflation. Methods include increasing taxes and decreasing government spending. Expansionary fiscal policy aims to increase aggregate demand during a recession. Expansionary fiscal policy includes tax cuts and government spending increases The government can employ fiscal policy either directly, by direct spending (or spending less) or indirectly, through changes in taxes and subsidies. MODERATES THE BUSINESS CYCLE The economy will not always return quickly to longrun equilibrium With changes in spending, the government can make up for some of the failings of the free market in the short-term PROBLEMS WITH FISCAL POLICY CROWDING OUT When the government most needs to spend more to improve the economy is when the economy is generating the least tax revenues for the government. The government has to finance expansionary fiscal policy by borrowing money or increasing taxes Increasing taxes decreases consumer wealth, directly decreasing consumption Borrowing money drives interest rates up, making investment less desirable Such spending thus crowds out private investment DEBTS AND DEFICITS The government s debt is all the money it owes; it is the accumulation of all its annual deficits Since the government must pay interest on its debt, more debt means less future spending and less investment The United States has not run a surplus since the Clinton administration + - Deviations from potential output are costly Hard to identify potential output and the best interventions PROS AND CONS: GOVERNMENT INTERVENTION When resources are not fully employed, the economy forever loses what it could have produced even if it recovers on its own later Unemployment imposes hardships on those who lose their jobs Inflation results from overemploying resources GDP estimates can take about three months to calculate and are imprecise Almost all information about the economy lags, so policy makers must act on incomplete information - Against: Impractical and imprecise Effects of policy take time to be felt businesses will not invest right away When Congress approves spending on new projects, it can take many months until the projects are undertaken The economy may overshoot full employment, resulting in inflation

34 ECONOMICS CRAM KIT 33 ECONOMICS OF RUSSIA Communist Economic Systems THREE ORGANIZATION TYPES SOCIALISM State-owned firms Mostly heavy industrial plants Operated on a giant scale Consisted of national and regional firms Included housing and other social services on site PUTTING THE SOVIET IN SOVIET RUSSIA The Bolsheviks, led by Vladimir Lenin ( ), began transforming Russia into a planned economy after the end of the Russian Civil War in In the late 1920s and 1930s, Joseph Stalin ( ) collectivized agriculture. NO CAPITALISTS ALLOWED Budgetary institutions Universities, research institutions, training centers, trade schools, hospitals, and museums Funded by national and regional governments Not obligated to make income cover expenditures UNDER A SOCIALIST ECONOMIC SYSTEM Property belongs collectively to all workers No one owns property without contributing labor In practice, the government owns all property and means of production The state bureaucracy plans the allocation of resources BUREAUCRATIC RESPONSIBILITIES In Soviet Russia, resources were allocated for production through a series of five-year plans, which were then broken up into annual plans. Cooperatives Mostly agricultural farms Operated on a massive scale Included housing and other social services on site Also known as kolkhoz State Committee/Ministry of Planning (Gosplan) devises plans Central Committee of the Communist Party approves plans FLASH QUIZ Council of Ministers and its respective ministries enact plans Who does what? 1. devises. 2. approves. 3. enacts. A. Central Committee of the Communist Party B. Council of Ministers C. Gosplan Answers: 1. C, 2. A, 3. B I CAN T MOVE! To simplify planning, the state greatly limited worker mobility. Workers had to pre-acquire a new job, a residence, and a housing permit (called a propiska) in order to move to a new city within the Soviet Union. SUPER SIZE ME, INC. Gosplan favored creating giant firms throughout the economy so as to maximize economies of scale.

35 ECONOMICS CRAM KIT 34 ECONOMICS OF RUSSIA Bureaucratic Planning THE ROLE OF MANAGERS PLANNING PROCESS Bureaucratic planners (at Gosplan) determined inputs and estimated outputs for each individual factory. Number of cars to produce REWARDS Firm managers were asked to meet plan targets exactly. Possible rewards: Awards Steel required for cars Privileges Possible punishments for missing targets: Removal from office Sentence to labor camp Accusations of sabotage The death sentence Iron required for steel Machines required to mine iron ore Labor required to work machines Since punishments for deviation outweighed the possible rewards from risk-taking, managers had little incentive to innovate. PLANNING STRATEGIES DISAGGREGATION OF PLANS During the plan drafting process, lower levels of the economy sent recommendations about target outputs to higher levels through an upward flow of information. Gosplan then broke the resulting plans into more manageable parts and distributed them to economic actors through a downward flow of information. Underreporting Gosplan Individual ministries Directorates/sectors Individual firms PROBLEMS AND SOLUTIONS Managers underreported production so future plans would not exceed their abilities Otherwise, one good year could lead to unrealistic future goals Managers MOTIVATIONS Bureaucracy Shortage Misestimation in planning caused shortage in almost every sector Consumer goods suffered most duty to Communist Party fear of punishment duty to socialist system political powermaterial benefit fear of punishment WHAT WOULD YOU DO? Waste Target plans did not always require managers to use all their assigned inputs Excess inputs existed in some sectors while shortage existed in others Suppose I gave you enough flour to bake 100 loaves of bread, but your target plan only asked for 50. If you were a manager in the communist Soviet Union, you d probably sell the extra 50 loaves on the black market and claim you made 100% of the target. BLACK MARKET Many Russians broke the law to work around the imperfections of the planned economy. They traded excess inputs and outputs on the black market----the so-called shadow economy.

36 ECONOMICS CRAM KIT 35 ECONOMICS OF RUSSIA Mikhail Gorbachev MIKHAIL GORBACHEV: VITAL FACTS Born in 1931 Became General Secretary of the Communist Party in March 1985 Ousted from office in 1991 PROBLEMS Upon entering office, Gorbachev faced a stagnating economy an obsolete planning system increasingly complex economic needs faltering values and motivation SOLUTION Gorbachev intended to reform the existing communist system, not establish a market-based liberal system. He called his goal perestroika, which literally means reconstruction. PHASE II Phase II took place during 1987 and It consisted of glasnost and demokratizatsiia. These policies introduced some aspects of property rights and democratic practice but created complications because of their vagueness. Glasnost in particular allowed politicians and media to discuss openly----without fear of punishment----the important issues around the upcoming election in 1989 for a new Soviet super parliament. Glasnost allowed more public dicussion of communism and capitalism introduced some quasi-private property rights Demokratizatsiia gave interest groups political representation made politicians more accountable for their actions PHASE I Phase I took place during 1985 and It consisted of the anti-alcohol campaign and uskorenie: Antialcohol campaign Uskorenie aimed to improve worker productivity shut down some alcohol factories spurred creation of bootleg liquor caused sugar shortages aimed to accelerate investment in old infrastructure lacked funds because of decreased revenue from closed alcohol factories The two programs were fundamentally incompatible, because one reduced government revenue and the other demanded more government spending. BABY STEPS I CAN T BELIEVE IT S NOT PRIVATE! Gorbachev introduced limited property rights through cooperative enterprises. These firms operated in commercial and service sectors lacked clear governance and ownership gave some entrepreneurs business initiative MANAGERS JUST WANT TO HAVE FUN Gorbachev gave managers more freedom from bureaucratic control. As a result, managers privatized firms behind planners backs increased activity on the black market acquired money that they later used to participate in privatization HALF-MEASURES These partial reforms worsened the economic situation. Gorbachev passed up his chance to implement sweeping reforms before the onset of stagflation in 1989.

37 ECONOMICS CRAM KIT 36 ECONOMICS OF RUSSIA Mikhail Gorbachev In 1989 AN EVENTFUL YEAR The Berlin Wall fell in November Several communist Eastern European governments fell The Soviet Union lost its guaranteed markets PHASE III Mikhail Gorbachev tried to please both reformers and conservatives but ended up worsening the economic situation with his indecision. In 1989, the Soviet Union experienced stagflation: high inflation and economic decline. Inflation high wages subsidies to industry inability to collect taxes Economic decline major budget deficit widespread food shortage vast decrease in production PHASE IV In the summer of 1990, a group of young Russian economists wrote the Five Hundred Day Plan, based on the shock therapy method implemented by Poland. The idea: a rapid transformation of the economy. Mikhail Gorbachev rejected the plan in the fall of Elimination of price controls Convertibility of the ruble Privatization of property Stabilization of economy Liberalization of trade Sincerely, Stanislav Shatalin and Grigori Yavlinsky A CHALLENGER APPEARS The 15 republics of the Soviet Union began electing new leaders. Boris Yeltsin became Russia s first elected president in June His background: Member of Politburo Provincial Communist Party boss Elected speaker of 1990 Russian parliament THE COLLAPSE OF THE SOVIET UNION NO MORE HALF-MEASURES! Gorbachev s half-measures had worsened the economic crisis. In August 1991, Soviet hard-liners attempted a coup to remove Gorbachev from power. It failed, with Boris Yeltsin stepping in (or on----a tank) to save the day, but the writing was on the wall. MERRY CHRISTMAS The Soviet Union collapsed on December 25, It dissolved into 15 new republics, including the Russian Federation----which effectively succeeded the Soviet Union in the global economy. SOVIET COMMUNIST LEGACY Successes industrialized in 70 years maintained a 99% literacy rate became a global super power rivaled the United States in land, air, sea, and space NUMBER QUIZ Failures experienced chronic shortage used meaningless money dominated by monopolies manufactured uncompetitive goods 1. Between 1989 and 1991, Soviet production fell by % per year. 2. The Soviet Union faced % inflation in Growth rates were about % by the time of the collapse. Answers: %

38 ECONOMICS CRAM KIT 37 ECONOMICS OF RUSSIA Boris Yeltsin THE RETURN OF SHOCK THERAPY In the fall of 1991, Boris Yeltsin settled on a shock therapy plan outlined by Yegor Gaidar. The plan intended to convert the Russian economy to a market system very quickly---- down three different paths. Stabilization cut subsidies control budget deficit SAVING PRIVATE RUSSIA Boris Yeltsin s privatization efforts aimed to fulfill 3 main goals: 1. Creation of socioeconomic stratification 2. Transition to market economy 3. Separation of ownership from management June 1992 Passed privatization legislation July 1992 Initiated program Liberalization eliminate price controls introduce market competition establish convertibility of ruble August 1992 Initiated voucher program December 1992 Initiated share auctions Privatization THE SHOCK BEGINS On January 2, 1992, Boris Yeltsin eliminated price controls, setting shock therapy in motion. Prices shot up overnight Inflation reached high levels Production dropped Unprofitable industries failed Unemployment rose Foreign goods flooded the market By April 1992, most industrial managers opposed shock therapy----in large part because they had stopped receiving subsidies. To address their concerns, Yeltsin ordered the issuance of Central Bank credits to firms. The brief era of shock therapy was over. QUICK QUIZ 1. Socioeconomic stratification created a new. 2. What is corporatization? separate ownership from management introduce profit-motivated practice 3. said that of an efficient market economy s employment must be private. Answers: 1. middle class 2. managerial accountability to a board of directors 3. Anders Aslund, 2/3 STATE COMMITTEE ON PROPERTY Yeltsin created the State Committee on Property (Goskomimushchestvo), which classified and oversaw firms eligible for privatization. Size Large (over 1,000 employees) Medium (200-1,000 employees) Small (less than 200 employees) PRIVATIZATION BEGINS STAGE 1: THE VOUCHER PROGRAM As of August 1992, firms could sell shares in two ways: Auctioning them off Trading them for vouchers Yeltsin required firms to sell at least 29% of their shares. Every Russian citizen received vouchers. They could sell them, give them away, or use them to buy shares of privatizing firms directly through mutual funds in a voucher fund Jursidiction Federal Provincial Municipal

39 ECONOMICS CRAM KIT 38 ECONOMICS OF RUSSIA Boris Yeltsin PRIVATIZATION: STAGE II In July 1994, the voucher program ended, and Boris Yeltsin auctioned off remaining state holdings for cash. The state s goals: to fund the budget deficit to purchase capital for restructuring firms to increase foreign investment The second stage failed in large part because Vladimir Polevanov, the Minister of Privatization, interfered with the privatization process. LOANS FOR SHARES SCHEME In 1995, the Russian government, desperately needing revenue, effectively gave away shares of 12 reputable companies as collateral for loans from some of Russia s wealthiest oligarchs. Everyone knew Russia would default on the loans, and it did----meaning the oligarchs kept ownership of the companies. The Russian government defaulted on its loans. A small group of people, the "oligarchs", gained control of a huge portion of the economy The public viewed privatization in a bad light because of the apparent corruption. LIGHTNING QUIZ PRIVATIZATION EFFORTS did not provoke major social revolt redistributed assets were associated with negative changes 75% 90% large and mid-sized firms privatized industrial output privatized THE 1998 ECONOMIC CRISIS IN 1996 AND 1997 inflation stabilized the ruble reached a semi-convertible state To finance the budget deficit, the government issued treasury bills received loans from the International Monetary Fund reduced spending withheld wages from public employees IN 1998 AND 1999 State borrows $18.5 million of foreign currency to finance short-term domestic debt Reduced foreign currency reserves cause ruble to depreciate in value 1. The devaluation of the ruble boosted. 2. On, the offered Russia a package that they used, unsuccessfully, to support the ruble s value. 3. The 1998 financial crisis occurred on. Answers: 1. domestic industry 2. July 20, 1998, International Monetary Fund 3. August 17, 1998 Russia devalues the ruble and defaults on all debts In 1999, the Russian economy started to grow again. This growth was thanks to: The recovery of domestic manufacturing (since people could no longer afford foreign goods!) Increases in prices of raw materials and resources (such as oil) on the world market

40 ECONOMICS CRAM KIT 39 ECONOMICS OF RUSSIA Vladimir Putin Vladimir Putin became Russia s president in In his first term, he carried out a series of reforms originally drafted by Boris Yeltsin. flat income tax regime for liberalizing currency new legal code reduction in taxes on profits GDP GROWTH Between 1999 and the summer of 2008, Russia experienced budget surpluses eliminated foreign debt gathered large hard-currency reserves experienced modest inflation This coincided with a rise in prices for Urals crude oil blend, Russia s chief export. Year % growth GDP % % % % % % % % system to prevent money laundering new land code RESOURCE CURSE The resource curse describes negative effects associated with abundant natural resources. Increasing debt Nationalization of resources Government corruption Decay of other industries Negative growth Putin allowed oil companies to take on debt Government control of oil rose from 19% in 2004 to over 50% in 2008 Between 2003 and 2007, the state pressured firms to invest DUTCH DISEASE Dutch disease describes the negative effects of sharp inflows of foreign currency into an economy----as occurred in Russia due to its overreliance on exporting natural resources. Discover natural resources Consumers demand fewer domestic goods The manufacturing sector declined Russian GDP plummeted when oil prices fell in 2008 Export natural resources Domestic goods become too expensive Increase quantity of foreign currency Increase value of domestic currency QUICK QUIZ: THE STABILIZATION FUND WAS 1. established in the year to store. 2. used to fight and defend the. 3. divided into the and in the year. Imported goods replace domestic goods Domestic manufacturing worsens Answers: , resource extraction tax revenues 2. inflation, ruble 3. Reserve Fund, National Prosperity Fund, 2008 By the time oil prices crashed in 2008, Russia had few other profitable industries to which to turn----it was all in on exporting natural resources as its economic mainstay.

41 ECONOMICS CRAM KIT 40 ECONOMICS OF RUSSIA Dmitri Medvedev PRESENT CALM BEFORE THE STORM Dmitri Medvedev assumed the presidency in the spring of 2008 during a period of unprecedented prosperity. J Stock market thriving J Real disposable income increasing J Unemployment and poverty falling DEJA VU By the first quarter of 2009, Russia was experiencing the same ailments as it had in the 1990s. negative growth high unemployment high inflation BRIC The four rapidly emerging markets prior to 2008 consisted of BRIC: Brazil, Russia, India, and China. low oil export prices weak manufacturing THE 2008 GLOBAL FINANCIAL CRISIS The global financial crisis began in September It dramatically affected Russia. 70% 16% % drop in stock market value between June 2008 and January 2009 drop in industrial output between October 2008 and February 2009 inflation rate in February 2009 drop in government revenue in the first quarter of 2009 STUNTED RECOVERY Prudent fiscal policy and rising oil prices pulled Russia out of the 1998 crisis. To overcome the more global 2008 crisis, the state would both need to implement prudent fiscal policy and hope for: Increased domestic consumer demand Increase in world oil prices Unfortunately, high unemployment and inflation made increased domestic consumer demand unlikely----and the worldwide recession kept oil prices low. People simply weren t demanding as much oil. Russia still fails to compete in the global marketplace in most areas except raw materials exports. MODERNIZATION -0.2% GDP growth in 2009 QUIZ: GOOD TIMES IN RUSSIA Between 1999 and 2008: 1. Real disposable income rose about % a year. 2. Unemployment fell from % to %. 3. And poverty fell from % to %. 4. Between June 2008 and January 2009, the ruble lost of its value against the dollar. Answers: 1. 10, 2. 12, , /3 Dmitri Medvedev realized the need to diversify Russia s economy. He implemented a policy of modernization and launched the construction of a Russian Silicon Valley named Skol kovo. Medvedev also promised to stabilize the legal regime state s approach to property

42 ECONOMICS CRAM KIT 41 CRUNCH KIT Economics in Three Pages (Page 1) BASICS OF ECONOMICS Human wants are unlimited, but goods are scarce There are no free lunches; you can never get something truly free (due to the cost of time, and other costs) To get one thing, we must give up another Humans behave rationally in economics The full cost of an action includes its opportunity cost Opportunity cost: value of the next-best alternative RATIONALITY Marginal cost: cost of producing/consuming one more Marginal benefit: benefit of producing/consuming one more Rational agents will produce or consume a good until marginal cost = marginal benefit/revenue (MC = MR) Rational consumers maximize their utility, or satisfaction; rational firms maximize their profits POSITIVE VS. NORMATIVE Positive: What is (taxes are 20%) Normative: What should be (taxes should be lower) MICRO VS. MACRO Microeconomics: focuses on individual decision making; works its way up from individuals to markets to economies Macroeconomics: focuses on the economy as a whole; tracks economy wide variables; takes a top-down approach COMPARATIVE ADVANTAGE Comparative advantage: being able to produce a good at a lower opportunity cost than anyone else Absolute advantage: being able to produce a good more efficiently than everyone else An individual can have an absolute advantage in everything, but NOT a comparative advantage in everything Agents should specialize in what they have a comparative advantage for, and then everyone will benefit from trade THE PRODUCTION POSSIBILITIES FRONTIER (PPF) A PPF shows all of the ways an economy can produce goods Each axis features a good; the PPF measure trade-offs between these two goods All points outside the curve are impossible to produce at Points inside the curve are possible but inefficient and do not use all available resources PARETO EFFICIENCY Something is Pareto efficient if it is impossible to improve well-being without hurting someone else Pareto efficiency provides no way to judge the superiority of one distribution versus another PERFECTLY COMPETITIVE MARKETS The good being sold must be highly standardized Large number of buyers and sellers Everyone is well informed about the market price No barriers to entry exist; new firms enter easily Everyone is a price taker DEMAND Law of demand: the quantity demanded of a good decreases when the price increases and vice versa Demand: this relationship between prices and quantities for a particular market Quantity demanded: the amount demanded at a given price Demand can shift due to consumer income, substitutes and complements, the number of consumers, and consumer preferences and expectations SUPPLY Law of supply: the quantity supplied of a good increases when the price increases and vice versa Supply: relationship between prices and quantities for a particular market Quantity supplied: the amount supplied at a given price Supply can shift due to changes in factor costs, technology, expectations of future prices, number of producers, and government regulations ELASTICITY Percent change in quantity over percentage change in price Price elastic demand: goods with close substitutes, luxuries Price inelastic demand: necessities Price elastic supply: long run Price inelastic supply: short run, scarce good Factors affecting demand elasticity: substitutes, necessities, scope of market, time horizon Factors affecting supply elasticity: scarcity of inputs, presence of barriers to entry, time horizon MICROECONOMIC EQUILIBRIUM Equilibrium: intersection of supply and demand Consumer surplus: difference between how much consumers are willing to pay and the market price Producer surplus: difference between the price at which firms are willing to sell and the market price Market equilibrium maximizes consumer and producer surplus

43 ECONOMICS CRAM KIT 42 CRUNCH KIT Economics in Three Pages (Page 2) THREE FUNDAMENTAL QUESTIONS OF ECONOMICS How much should be produced? Who should produce the good? Who should receive the good? ECONOMIC AND ACCOUNTING PROFIT Total revenue: amount a firm receives from selling its goods Total cost: costs of a firm supplying its goods Accounting cost: actual monetary cost Accounting profit: straight monetary profit earned Economic cost: both monetary (accounting) cost and the opportunity cost of the resources used Economic profit: monetary profit minus opportunity cost; always equal to zero in the long run FIRMS AND COSTS Fixed costs: costs that a firm must pay regardless of how much it produces (rent, utilities); only fixed in short run Variable costs: costs that change with the amount produced Average cost: the sum of fixed costs and total variable costs, divided by the total number of units produced After a certain point, marginal costs stop decreasing and begin increasing----this is called diminishing returns to scale In the long run, all costs are variable PRICE CONTROLS Price ceilings set a maximum; price floors set a minimum Deadweight loss: lost efficiency due the market not being in equilibrium Binding price controls ALWAYS have deadweight losses Price controls transfer surplus from consumers to producers or vice versa Taxes distort the market, transferring surplus from the market to the government at the expense of efficiency The more inelastic party always bears more of the tax Revenue equals price times quantity MARKET FAILURES A market failure is when competitive markets fail to produce socially desirable outcomes Two types discussed here are externalities and public goods EXTERNALITIES Externalities are costs or benefits that affect a third party uninvolved in the activity or transaction in question Individuals do not factor externalities into their decisions since they do not pay the costs or reap the rewards Negative externalities harm third parties; the tendency is to overproduce them Positive externalities benefit third parties; there are not enough of them PROPERTY Coase Theorem: private parties can resolve the inefficiencies created by externalities as long as property rights are clearly defined and all parties can negotiate with each other A rival good, when it is consumed, can no longer be consumed by anyone else People have limited access to excludable goods Private goods are both rival and excludable Public goods are neither Collective goods are non-rival and excludable Common resources are non-excludable and rival The tragedy of the commons occurs when people overuse a resource because no one owns it MARKET POWER A firm with a downward sloping demand curve has market power; they can choose their price The combinations of price and quantity available to choose from are determined by the market demand MONOPOLY Market with only one firm Produce less than what consumers demand, and sell it at higher than the market price Arise due to the presence of barriers to entry Price discrimination: charging different customers different prices; a monopoly can capture more of the consumer surplus for the firm OLIGOPOLY Market with only a few firms Collusion: when firms cooperate to artificially raise market prices by restricting supply Cartel: group of firms that collude Cartels often break up due to an incentive to cheat MONOPOLISTIC COMPETITION Firms compete through product differentiation, not price competition Few barriers to entry exist INSTITUTIONS, ORGANIZATIONS, AND GOVERNMENT Institutions: formal or informal rules that guide human interactions Organizations are like institutions but more formal Governments can tax their citizens and use force Pork barrel politics: elected officials tend to steer money to their constituents by introducing projects Logrolling: vote trading among elected officials Rent seeking: socially unproductive activities that simply direct economic benefits

44 ECONOMICS CRAM KIT 43 CRUNCH KIT Economics in Three Pages (Page 3) GROSS DOMESTIC PRODUCT (GDP) Market value of all final goods and services produced within a country in a given period of time; four components GDP = Y = C + I + G + NX Consumption: consumer spending on final goods Investment: value of all money spent on capital or technology Government expenditures Net exports: exports minus imports Business cycle: fluctuations in GDP over recessions and expansions Average labor productivity: GDP divided by the total number of workers employed MACROECONOMIC MODELLING Circular flow model: households own factors of production; firms rent factors and produce goods, which households buy; two markets: goods market and factor market Aggregate demand (AD): quantity of goods demanded by an economy at different price levels, slopes downward Aggregate supply (AS): potential supply of goods and services in an economy at different price levels Short run aggregate supply (SRAS): slopes upwards Long run aggregate supply (LRAS); fixed at full employment output; vertical line; independent of price level Short run equilibrium: intersection of SRAS and AD; long run equilibrium is at the intersection of all three curves UNEMPLOYMENT Labor force: all individuals 16 or over, not in prison or armed forces, and actively looking for work or has a job Employment rate: percentage of labor force with a job Participation rate: percentage of population in the labor force Structural unemployment: unemployment due to large shifts in economy; mismatch between skills demanded and skills supplied Cyclical unemployment: caused by the business cycle Frictional unemployment: natural unemployment due to timelag between jobs Unemployment rate calculated every month by the BLS Natural rate of unemployment: never 100%; structural + frictional unemployment Okun s Law: for every 1% increase in unemployment, GDP drops by 2% MONEY A medium of exchange, unit of account, and store of value Commodity money: money with intrinsic value Fiat money: intrinsically worthless; declared valuable by gov t Inflation: rise in price level; decrease in purchasing power of money; measured by the CPI and GDP deflator Liquidity: how easily an asset can be converted into currency THE FINANCIAL SYSTEM Savings: income that is not spent Investment: purchase of new capital equipment Bond: a certificate of indebtedness Stock: ownership of a portion of a company Net capital outflow: domestic purchase of foreign capital minus foreign purchase of domestic assets FISCAL POLICY Government spending or taxes to influence AD Contractionary: increasing taxes, decreasing spending Expansionary: decreasing taxes, increasing spending MONETARY POLICY Open market operations: buying or selling securities, done by the FOMC Reserve ratio: fraction of deposits banks must keep in reserve; adjusted by Board of Governors Discount rate: interest rate the Fed charges to member banks; adjusted by Board of Governors Contractionary: selling securities, increasing reserve ratio, increasing discount rate Expansionary: buying securities, decreasing reserve ratio, decreasing discount rate Quantity theory of money: MV = PY THE ECONOMICS OF RUSSIA Russia transformed into a planned economy after the Russian Civil War The Soviet Union, an economic union of 15 nations, operated under strict bureaucratic planning Flawed planning mechanisms caused chronic shortage Mikhail Gorbachev launched perestroika, restructuring of the communist system, but worsened the economy Gorbachev was ousted and the Soviet Union collapsed in 1991 Boris Yeltsin, Russia s first elected president, successfully privatized most of the economy Vladimir Putin entered office as global oil prices rose and the Russian economy prospered Dmitri Medvedev entered office shortly before the 2008 global financial crisis He pursued modernization efforts

45 ECONOMICS CRAM KIT 44 CRUNCH KIT List of Lists (1 of 3) Michael Boskin Michael Edelstein ECONOMISTS In 1996, assigned to head a committee to review the methods used to calculate CPI Constructed the marginal and strong set of standards to gauge the effect of empire ion the British economy Stanley Engerman Estimated profitability of the slave trade Milton Friedman John Maynard Keynes Simon Kuznets Joseph Schumpeter Adam Smith Most famous advocate of monetary policy (instead of Kenyesian policy) Proposed fiscal policy as a way to smooth out the business cycle; his theories put to the test in the Great Depression; wrote 1936 book The General Theory of Employment, Interest, and Money Commissioned by the U.S. Department of Commerce to develop a system to measure national output Described the impact of entrepreneurs as creative destruction Father of classical economics; wrote the 1776 book An Inquiry into the Nature and Causes of the Wealth of Nations Aslund, Anders Colton, Tim Gontmakher, Evgeny Hanson, Philip Kornai, Janos COMMENTARY Two-thirds of national employment must be private Bureaucratic planners were unable to anticipate the need for computerization Russia s economic woes are a result of incorrect economy policy, oil dependence, and rampant corruption. Noted that rising global prices of oil and gas indirectly fueled Russian economic growth (with negative consequences) The distinction between national and regional firms in the Soviet Union was meaningless: Servility and a heads down mentality prevailed Collapse of the Soviet Union Great Depression Industrial Revolution Russian Civil War World War I World War II Five year plans EVENTS Occurred in 1991; the country dissolved into 15 new republics, most prominently the Russian Federation Lasted from August 1929 to 1933; real GDP declined by nearly 25% Emerged in Great Britain in the 1760s; featured accelerated technological development, population growth, and improved living standards Fought between the Bolsheviks and anti- Bolsheviks, Bolsheviks gained control of Russia Ended in 1914; transferred the colonies of Germany and the Ottoman Empire to Britain and France; discontent with World War I helped power the Russian Revolution Lasted from 1941 to 1945; the Soviet Union shifted allegiances and ultimately obtained a sphere of influence in Eastern Europe Read more about the individual plans in the Social Science Resource; the Soviet Union organized its economy through Five Year Plans from the 1920s to the 1980s. FISCAL AND MONETARY POLICY TERMS Contractionary policy Discount rate Expansionary policy Policy meant to fight inflation and decrease aggregate demand Interest rate the Federal Reserve charges for loans to its member banks Policy meant to fight recession and increase aggregate demand Federal funds rate Interest rates banks charge on loans to each other; based on the discount rate but not set by the Federal Reserve Fiscal policy Monetary policy Open market operations Reserve ratio Government taxation and spending policy choices meant to influence the economy Policies set by a central bank (for us, the Federal Reserve) to accelerate or slow down the economy by increasing or decreasing the money supply, respectively The trading of government securities by the Federal Reserve to adjust the size of the money supply The amount of each deposit banks must hold in reserve

46 ECONOMICS CRAM KIT 45 CRUNCH KIT List of Lists (2 of 2) Average total cost EQUATIONS TotalFixedCosts + Total Variable Costs ATC = TotalNumber of Units Produced Basket price in year t CPI CPI= 100 Basket price inbase year Elasticity E = GDP deflator Gross domestic product General profit maximizing condition Money multiplier Quantity equation %Δquantity %Δprice Nominal GDP GDP deflator = 100 Real GDP Y = C + I + G + NX Marginal revenue = marginal cost 1 MM = RR MV = PY Chairman of the Board of Governors Federal Reserve (the Fed) THE FEDERAL RESERVE Head of the Federal Reserve; appointed every four years; current chairman is Ben Bernanke The central bank of the United States; sets monetary policy to help determine the money supply Federal Open Trades government securities, or debt, on Market Committee the open market in order to alter the money supply and conduct day-to-day monetary policy; consists of the Federal Reserve Board plus the President of the New York District Bank and the presidents of four other district banks Federal Reserve Board of Governors Federal Advisory Council Governing body of the Federal Reserve; consists of seven governors appointed by Congress to 14-year terms with one term expiring every two years Consists of up to 13 bankers, with one commercial banker representing each district in the Federal Reserve system; purely advisory body with no policymaking power UNEMPLOYMENT ECONOMICS OF RUSSIA Frictional unemployment Labor force Okun s law Participation rate Structural unemployment Results from the time lag between when workers leave one job and they whenfind a new job; exists even in the healthiest and wealthiest of economies The total number of persons aged 16 and over either working or actively seeking employment (excluding those in prison or in the military) Sugests that every 1% increase in unemployment above the natural rate of unemployment results in a 2% drop in GDP Percentage of the total population eligible for the labor force that is currently in the labor force (employed or actively seeking employment) Results from fundamental changes in the economy, such as improving technology or shifting consumer preferences---- leading to a mismatch of skills offered by labor and skills desired by firms Corporatization Gazprom Perestroika Loans for shares Perestroika Resource curse Shock therapy Practice of holding managers accountable to a board of directors, separation of ownership and management State-controlled Russian natural gas firm, world s largest natural gas extractor Measures the cost to the British empire of freeing all imperial possessions at the date being analyzed Auction of 12 blue-chip companies to a group of commercial banks, transferred much of the Russian economy to a small group of oligarchs and tainted the image of privatization for the public Mikhail Gorbachev s effort to restructure the communist economy Negative effects of finding abundant natural resources Reform plan championed by Yegor Gaidar, adopted by Boris Yeltsin, emphasized stabilization, liberalization, and privatization Socialism A theoretical state between the overthrow of capitalism and establishment of communism, advocates public ownership of property and social welfare

47 ECONOMICS CRAM KIT 46 CRUNCH KIT List of Lists (3 of 3) price elasticity of demand complements substitutes normal good inferior good firm monopoly COMPETITION a measurement of the sensitivity of quantity demanded to a change in market price related goods, such that when the price of one good falls, demand for the other rises related goods, such that when the price of one good falls, demand for the other falls a good the demand for which increases as the income of its consumers increases a good the demand for which decreases as the income of its consumers increases an organization that produces a good or service for sale to the market a market that has only one producer, with high barriers to entry natural monopoly a special monopoly that arises when two producers cannot both exist and be profitable; often regulated or run by the government oligopoly monopolistic competition perfect competition a market with only a few producers and high barriers to entry; firms in an oligopoly sometimes collude a market structure with many producers each aiming to differentiate its product, hoping to obtain a small amount of monopoly power a market with many producers and consumers, perfect information, and no barriers benefit-cost analysis margin marginal benefit marginal cost utility marginal utility total utility optimization free market economy command economy laissez-faire absolute advantage comparative advantage MARGINS & ADVANTAGE rational decision-making process, weighing pros and cons a small incremental change the benefit of an incremental change the cost of an incremental change satisfaction gained from doing or consuming something satisfaction gained from an incremental change the total satisfaction (or dissatisfaction!) gained from doing or consuming something act of maximizing total utility an economic system in which market forces allocate goods and services economic system in which a central authority makes all economic decisions the notion that government should not interfere with the economy when one country is able to produce more of a good than another country when one country has a lower opportunity cost of producing a good than another country MICROVOCABULARY FUNDAMENTALS price quantity supplied quantity demanded supply demand law of supply law of demand demand schedule supply schedule the amount in exchange for which sellers give buyers a good or service the total of a good or service that, at a given price level, producers will be willing to sell the total of a good or service that, at a given price level, consumers will be willing to buy the relationship between price quantity supplied by producers the relationship between price and quantity demanded by consumers as price increases, producers will supply greater quantities of goods and services as price increases, consumers will demand smaller quantities of goods and services a table showing quantity demanded at various prices a table showing quantity supplied at various prices economics microeconomics the study of decision-making study of economics on the micro-scale: households, firms, specific regions of an economy macroeconomics study of economics at a broad level: national and international issues and policies scarcity opportunity cost trade-off factors of production land capital labor not having the resources to satisfy all wants the value of the next-best alternative to a choice the act of giving something up to get something else resources used to produce goods and services factor of production----includes all natural resources factor of production; includes buildings and equipment factor of production; includes workers

48 ECONOMICS CRAM KIT 47 FINAL TIPS AND ABOUT THE AUTHOR FINAL TIPS Don t just learn definitions by rote; rephrase them in ways that make sense to you Repeat after me: shifts in demand are not the same as shifts in quantiy demanded Come prepared to draw out supply and demand diagrams The marginal utility of eliminating wrong answers before answering is very high When running short on time, memorize key facts from Section IV by leader, reform, and year Make a study playlist that gets you pumped for brain workouts ABOUT THE AUTHOR Catherine Tran is a student of philosophy and religious studies at the University of Texas who hopes to attend law school. She competed as an Honor on the 2011 Seven Lakes Academic Decathlon team. When she isn t studying, her next-best alternatives include writing about morality, attending live concerts, and shopping for second-hand clothing. The previous sentence makes her appear a lot hipper than she actually is. ABOUT THE EDITORS ROBB DOOLING DANIEL BERDICHEVSKY SOPHY LEE Robb Dooling first became a DemiDec factor of production in namely, a beta tester. In addition to beta testers, DemiDec factors of production include writers, editors, and frequently-misplaced laptops. Daniel Berdichevsky is conducting a lifelong experiment to determine whether the law of diminishing marginal utility applies to the consumption of tea. He is pictured here speaking at a school in India after drinking four cups. Sophy Lee rides her bike the way she pursues everything else in life, from Academic Decathlon to her Harvard education: with determination, focus, and a proper diet of berries, yogurt, and self-appraisal.