Output And Prices in the ShortRun

1
Chapter 25

• Output And Prices in the Short-Run

2
What Happens to the equilibrium national income
when the price level changes ?

• There is a negative relationship between the
  price level and the Aggregate Expenditure .
• A change in the price level have an effect on
  consumption , C and on net exports which in turn
  affect Aggregate Expenditure.

3
I. Change in Consumption, C

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

4
II. Change in Net Exports ( X- M)

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

5
Change in Equilibrium National Income

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

6
The Aggregate Demand

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

7
Equilibrium National Income and The Price Level

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

8
The Aggregate Supply Curve

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

9
Short-Run Aggregate Supply

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

10
Shift in SRAS Curve or Aggregate Supply Shock

• There are two reasons for SRAS curve to shift
• 1. Change in prices of inputs or cost of
  production .
• 2. Increase in productivity .

11
I. Change in Prices of Inputs

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

12
II. Increase in Productivity

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

13
Macroeconomic Equilibrium

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

14
Aggregate Demand Shock

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

15
Aggregate Supply Shock

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

16
Stagflation

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

17
The Multiplier when the price level is held
constant Simple multiplier

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

18
Keynesian SRAS Curve

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

19
What happens in the case in which SRAS curve
slope upward ?

• In this case, a rise in national income caused by
  an increase in AD will be associated with a rise
  in the price level .
• The multiplier effect when the price level is
  allowed to vary would be smaller than the simple
  multiplier .

20
The Importance of the Shape of SRAS curve

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

21
The Effect of Demand Shock when the SRAS curve is
Vertical

• When the SRAS curve is vertical, then any change
  in AD will change the price level only , and no
  change in equilibrium national income.
• The multiplier in this case is zero .

22
Chapter 26

• Output and Prices in the Long Run

23
Potential VS. Actual National Income

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

24
The Output Gap

• Is the difference between the potential and
  actual output .
• Output Gap Y - Y
• When Y gt Y we have Recessionary gap
• When Y lt Y we have an Inflationary gap

25
Factor Prices and Output gap

• Recessionary gap ( Y gt Y ) causes downward
  pressure on wages to fall .
• Inflationary gap ( Y lt Y ) causes upward
  pressure on wages to rise .
• When Y Y , so the GDP gap 0 , there is
  neither downward nor upward pressure on wages to
  go up or down .

26
Long-Run Consequences of AD Shock

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

27
2. Contractionary AD shock

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

28
Long-Run Equilibrium

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

29
Basic Theory of Fiscal Stabilization

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

30
1. Expansionary Fiscal Policy

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

31
2. Contractionary Fiscal Policy

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

32
How a Recessionary gap can be eliminated ?

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

33
Advantages VS Disadvantages of Fiscal Policy

• Advantage The use of fiscal policy will shorten
  the period of recession .
• Disadvantage the use of fiscal policy may cause
  the economy to overshoot its potential output .

34
How an Inflationary gap can be eliminated ?

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

35
Built in Stabilizers

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

36
The effect of Fiscal Policy that is not revesed

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

37
Chapter 27

• The Nature of Money and Monetary Institutions

38
Definition of Money

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

39
Wealth and Money

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

40
Income VS. Money

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

41
Functions of Money

• 1. Act as a medium of exchange .
• 2. Act as a unit of account .
• 3. Act as store of value .

42
1. Money act as a medium of exchange

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

43
Barter Economy

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

44
2. Money act as a unit of account

• We measure the value of goods and services in
  terms of money .
• In money economy , the number of prices needed
  equal to the number of goods and services to be
  exchanged .
• In barter economy, the number of prices needed
  equal to n ( n-1 )
• 2
• where n number of goods to exchanged

45
3. Money act as a store of value

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

46
Money Supply

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

47
Definitions of Money Supply

• 1. Narrow definition of money supply or M1
• Broader definition of money supply or M2 and M3

48
Narrow definition of money supply

• M1 currency in deposits that can be
• circulation used as a medium
  of
• exchange
• Therefore
• M1 C DD NOW D ATS D any
• checkable deposits .
• NOW D Negotiable Order of Withdrawal
• ATS D Automatic Transfer Service

49
Broader Definition of Money Supply or M2 and M3

• M2 M1 SD Small TD
• M3 M2 Large denomination of TD
• Where
• SD Saving deposits
• TD Time deposits

50
Near Money Money substitutes

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

51
Money Substitutes

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

52
Inter-Bank Activities

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

53
Banking System

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

54
Basic Functions of Central Bank

• 1. Act as banker of commercial banks .
• 2. Act as banker of the government .
• 3. Act as controller of the nations money
• supply .
• 4. Act as regulator of money market .

55
1. Banker of Commercial Bank

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

56
2. Banker to the Government

• The government deposits the fund in the central
  bank .
• The government write checks against its account
  in the central bank .
• The central bank sells government bonds or
  securities for the government .

57
3. Controller of Money supply

• The central bank can use the monetary policy
  changing the money supply to close the GDP gap
  and stabilize the economy at its full employment
  level or Y .

58
4. Regulator of Money Market

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

59
Financial Intermediaries

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

60
Commercial Banks

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

61
Reserves of Commercial Banks

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

62
Required VS. Actual Reserves

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

63
Money Creation by the Banking System

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

64
Creation of Deposits Money

• Having all the previous assumptions in mind ,
  assume that National Commercial bank ( NCB ) has
  the following Balance sheet ( in thousands )
• Assets Liabilities
  Equity
• Cash other SR 200 Deposits SR 1000
• Reserves Capital
  100
• Loans 900
  _____
• SR 1100
  SR 1100

65
Now Assume a foreigner , who just arrived in the
country opened an account with NCB and deposited
SR 100,000 ( New deposit) , so the balance sheet
after the deposit will be

• Assets Liabilities
  Equity
• Cash and other Reserves SR 300 Deposits
  SR 1100
• Loans 900
  Capital 100
• 
  ______
  ________
• SR 1200
  SR 1200
• Since Actual reserves SR 300,000
• Since Required reserves SR 220,000
  therefore this bank has Excess Reserves
  SR 80,000

66
Now the NCB will use the excess reserves of SR
80,000 to make new loans , so the balance sheet
after making the loan will be as follows

• Assets
  Liabilities Equity
• Cash other Reserves SR 220 Deposits
  SR 1100
• Loans 980
  Capital 100
• _______
  _______
• SR
  1200 SR 1200
• Now the new loan ( SR 80,000) made by the NCB
  either will be re-deposited in the same bank or
  it will be deposited in another bank (
  second-generation bank) where 20 will be added
  to the required reserves and the remaining
  balance will be given as a loan .

67
The sequence of loans and deposits after a single
initial deposit of SR 100,000 in NCB is as
follows

• Bank New New
  Additional
• deposits
  loans reserves
• 1st generation bank SR 100 SR 80
  SR 20
• 2nd generation bank 80 64
  16
• 3rd generation bank 64 51.2
  12.8
• 4th generation bank 51.2 40.96
  10.24
• 5th generation bank 40.96 32.77
  8.19
• 0
  0 0
• Total for banking SR 500 SR 400
  SR 100
• system

68
Creation of Deposits ( assuming 10 percent
reserve requirement and a 100 increase in
reserves )

• Bank Increase in
  Increase in Increase in
• Deposits ()
  Loans ( ) Reserves()
• _________________________________________________
  
• First National 0.00
  100.00 0.00
• A 100.00
  90.00 10.00
• B 90.00
  81.00 9.00
• C 81.00
  72.90 8.10
• D 72.90
  65.61 7.29
• . .
  . .
• . .
  . .
• Total for all banks 1000.00 1000.00
  100.00

69
Excess Reserves and Cash Drain

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

70
Excess reserves Cash drain Continue

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

71
Example

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

72
The answer

• Change in Deposits 1 . 100,000
• in banking system .20 .05.15
• SR 250,0000
  
• Change in Loans 250,000 ( 1-.20-.05-.15)
• In banking system 250,000 ( 0.60 )
• SR 150,000

73
Chapter 28

• Money, Output , and Prices

74
Chapter 28

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

75
Present Value and Interest Rates

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

76
Example

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

77
If Market interest rate is 10

• PV R1 R2 .. Rn F
• 1 2
  n n
• (1i ) (1i ) .. (1i )
  (1i)
• PV 100 100 . 100 1000
• 1 2
  5 5
• (1.10) (1.10) ( 1.10) (1.10)
• PV 999.96 1000

78
If market interest rate is 20

• PV 100 100 100 1000
• 1 2
  5 5
• (1.2 ) ( 1.2) ( 1.2 )
  ( 1.2 )
• PV 701 Therefore ,
• The higher the market interest rate, the lower is
  the present value of a bond .

79
Supply and Demand for Money

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

80
Motives for holding Money

• 1. Transactions Motive
• 2. Precautionary Motive
• 3. Speculative Motive

81
1. Transactions Motive

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

82
Transactions Motive

• d
• M f ( T )
• T f ( Y )
• Therefore d
• M f ( Y )

83
2. The Precautionary Motive

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

84
3. The Speculative Motive

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

85
Monetary Equilibrium Aggregate Demand

• Monetary equilibrium occurs at the point where
  demand for money equals the supply of money .
  Therefore, at monetary equilibrium we have
• d s
• M M

86
The Transmission Mechanism

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

87
I. Link between Monetary equilibrium and Interest
Rate

• Any change in either the Demand for money or the
  Supply of money will change the interest rate .
  Example
• An increase in Demand for money will increase the
  market interest rate .
• An increase in Supply of Money will lower the
  market interest rate .

88
II. Link between Interest Rate and Investment
Expenditure

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

89
III. Link between Investment and Aggregate Demand

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

90
Strength of Monetary Forces

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

91
Long-run Effect on National Income

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

92
Short-run effect on National Income

• Change in AD depends on
• 1. How much interest rate will fall in response
  to a given increase in money supply ?
• 2. How much investment expenditure will change in
  response to a change in the interest rate ?

93
1. The change in interest rate in response to a
change in money supply

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

94
2. The change in investment in response to a
change in interest rate

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

95
Effective Monetary Policy

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

96
Chapter 29

• Monetary Policy

97
Control of the Money Supply

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

98
1. Open Market Operations

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

99
Open Market Purchase

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

100
The effect of purchasing bonds by the central
bank

• 1. Create excess reserves at commercial banks .
• 2. This enable the commercial banks to create
  more loans .
• 3. The increase in loans will create more
  deposits by the banking system , and that will
  increase the money supply.

101
Open Market Sale

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

102
2. Reserve Requirement

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

103
3. Discount Rate

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

104
Net Un-borrowed Reserves or Free Reserves

• It is the Total reserves minus both the required
  reserves as well as the borrowed reserves .
  Therefore
• Free Total Required
  Borrowed
• reserves reserves reserves
  reserves
• Example

105
Example

• Given the following Balance Sheet for NBC find
  the Free Reserves or Net Un-borrowed Reserves.
  Assume r 20 .
• Cash other reserves SR 20,000
• Loans SR 23,000 Deposits SR 40,000
• Borrowed Reserves SR 2,500
• Capital SR 500 Therefore,
• Free Reserves 20,000 8000 - 2500
• SR 9500

106
4. Selective Credit Control

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

107
Instruments Objectives of Monetary Policy

• The central bank conduct the monetary policy to
  influence the real national income and the price
  level .
• The ultimate objective of the central bank ( Y
  , P ) are called Policy Variables

T
108
Policy Instruments

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

109
Intermediate Targets

• There are two Intermediate targets available for
  the central bank . These are
• 1. Money supply 2. Interest rate
• The central bank can not control both of these
  targets independently if the demand function is
  unstable . Therefore, the central bank need to
  choose to control either the money supply or the
  interest rate.

110
Case 1 controlling Money Supply

• If the central bank chooses money supply as the
  intermediate target, then it must accept the
  fluctuation in the interest rate .

111
Case 2 controlling the interest rate

• If the central bank would like to control
  interest rate , then it must accept the
  fluctuation in the money supply .

112
Chapter 30

• Inflation

113
Definition

• Inflation is defined as
• The General Increase in the price level .

114
Causes of Inflation

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

115
Demand Shock

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

116
Supply Shock

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

117
Isolated Supply Shock

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

118
Repeated Supply Shock

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

119
Chapter 33

• Economic Growth

120
Definition

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

121
The Nature of Economic Growth

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

122
Economic Growth - Continue

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

123
Example

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

124
Economic Growth
125
Example 2
126
Benefit of Growth

• Over the Long-term economic growth is the primary
  engine for raising general standards
• Economic growth reduces income inequalities
  without actually having to lower anyones income.
• Economic growth may change the whole societys
  consumption patterns.

127
Cost of Growth

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

128
Inputs, Technological Progress and Economic Growth

• To increase average income, a country has to
  increase its output.
• The countrys output depends on its resources or
  inputs and on the techniques it employs for
  transforming inputs into output.
• The relationship between inputs and outputs is
  called Production Function .

129
Factors of Production

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

130
Economic Growth

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

131
Capital Growth

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

132
Physical Capital

• Includes such things as highways, railways, dams,
  tractors, factories, trucks , cars , and
  buildings .

133
Human Capital

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

134
Technological Change

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

135
Determinant of Growth of Total Output

• 1. Growth in the Labor Force
• 2. Growth in Human capital
• 3.Growth in Physical capital
• 4. Technological improvement

136
1. Growth in the Labor Force

• This may be caused by growth in the population or
  increase in the fraction of the population that
  chooses to participate in the labor force .

137
2. Growth in Human Capital

• This is the increase in skills that workers have
  either through formal education or on-the-job
  experience .

138
3. Growth in Physical Capital

• Such as factories, machines, transportation, and
  communications facilities. These are increase
  only through process of investment

139
4. Technological Improvement

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

140
Note

• Chapter 33 up to page 728

141
Chapter 35

• Gain From International Trade

142
In this chapter we will discuss

• Sources of the gain from trade .
• Absolute advantage from trade.
• Comparative advantage of trade.
• Opportunity cost .
• Gain from trade with variable cost .
• Sources of comparative advantage .
• The Terms of trade .

143
Sources of the Gain from Trade

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

144
This same basic principle also applies to nations

• With trade , each nation is able to concentrate
  on producing goods and services that it produce
  efficiently while trading to obtain goods and
  services that it does not produce efficiently .
• The gain from trade is clear when there is an
  absolute advantage .

145
Absolute Advantage

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

146
Comparative Advantage

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

147
Example

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

148
The Answer

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

149
The Answer - Continue

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

150
Case 1 World output before trade or No
Specialization

• U.S. A. France
  World
• Product workers output workers
  output output
• X 100 100 100 100
  200
• Y 100 100 100 50
  150

151
Case 2 World output with trade ( after
specialization )

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

152
Example Gains from specialization with Absolute
Advantage

• Amount of wheat and cloth that can be produced
  with 1 unit of resources in U.S.A. and England.
• Wheat (bushels)
  Cloth (yards)
• U.S.A. 10
  6
• England 5
  10
• Therefore, U.S.A. has absolute advantage in
  producing wheat, and England has absolute
  advantage in producing cloth .

153
Gain from specialization with Absolute Advantage

• If U.S.A specialized in wheat and England in
  cloth
• Wheat (bushels)
  Cloth (yards )
• U.S.A. 20
  0
• England 0
  20
• _______
  ________
• 20
  20
• We see that total world production of both wheat
  and cloth increases when each country produces
  more of the good in which it has absolute
  advantage.

154
Changes resulting from the transfer of 1 unit of
U.S. resources into wheat and 1 unit of English
resources into cloth

• Wheat ( bushels) Cloth
  (Yards)
• U.S.A. 10
  - 6
• England - 5
  10
• ________
  ________
• 5
  4
• Therefore, specialization of each country in the
  product in which it has absolute advantage will
  increase total production of both commodities .

155
Gain from specialization with comparative
advantage

• Amount of wheat and cloth that can be produced
  with 1 unit of resources in U.S.A and England
• Wheat (bushels)
  Cloth ( Yards )
• U.S.A. 100
  60
• England 5
  10
• Here , U.S.A has absolute advantage in both
  goods.
• So, it seems that U.S.A has nothing to gain by
  trading with England, But by looking at the
  comparative advantage , we see that is wrong .

156
Gain from specialization with comparative
advantage

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

157
Changes resulting from the transfer of one-tenth
of 1 unit of U.S. resources into wheat and 1 unit
of English resources into cloth

• Wheat (bushels)
  Cloth ( yards )
• U.S.A. 10
  - 6
• England - 5
  10
• _______
  ________
• world 5
  4
• Therefore, when there is comparative advantage,
  specialization make it possible to produce more
  of both commodities .

158
Conclusion

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

159
The Opportunity Cost

• The Opportunity cost is defined as
• The best alternative given up . Example
• Given the following Table below , find the
  opportunity cost of producing each unit of wheat
  and cloth ?
• Wheat (bushels) Cloth(
  Yards )
• U.S.A. 10
  6
• England 5 10

160
The Opportunity cost of wheat cloth

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

161
Conclusion

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

162
The Terms of Trade

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

163
Example

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

164
Example - Continue

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

165
Example 2

• Assume the following
• Index of export prices rises from 100 to 120
• Index of import prices rises from 100 to 110
• Therefore
• The old Term of Trade 100 X 100 100
• 100
  
• The new term of trade 120 X 100 109
• 110

166
Example - Continue

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