MARKET STRUCTURES Because a monopoly is the sole producer in its
market, it can alter the price of its good by adjusting the
I. Perfect Competition [Mankiw, Chapter 14, page 268]
• There are many buyers and many sellers in the
market.
• The goods offered by the various sellers are largely
the same.
• Firms can freely enter or exit the market.
Competitive market – a market with many buyers and
sellers trading identical products so that each buyer and
seller is a price taker. The actions of any single buyer or
seller in the market have a negligible impact on the
market price.
Shutdown Decision in Perfect Competition
• Short-Run Decision to Shut Down
Shutdown – refers to a short-run decision not to produce
anything during a specific period of time because of
current market conditions. A firm that shuts down
temporarily still has to pay its fixed costs.
Shut down if Total Revenue < Variable Cost,
or if Price < Average Variable Cost
In the short run when a firm cannot recover its fixed
costs, the firm will choose to shut down temporarily if
the price of the good is less than average variable cost.
• Long-Run Decision to Exit/Enter a Market
Exit – refers to a long-run decision to leave the market. A
firm that exits the market does not have to pay any costs
at all, fixed or variable.
Exit if Total Revenue < Total Cost,
or if Price < Average Total Cost
In the long run when the firm can recover both fixed
and variable costs, it will choose to exit if the price is less
than average total cost.
Enter if Price > Average Total Cost
The rule for entry is exactly the opposite of the rule
for exit. He will enter the market if the price of the good
exceeds the average total cost of production.
II. Monopoly [Mankiw, Chapter 15, page 290]
• a firm that is the sole seller of a product without any
close substitute. A monopoly arises when:
• a single firm owns a key resource
• when the government gives a firm the exclusive right
to produce a good
• when a single firm can supply the entire market at a
lower cost than many firms could
quantity it supplies to the market. Whereas a
competitive firm is a price taker, a monopoly firm is a
price maker.
III. Monopolistic Competition [Mankiw, Chapter 16, page 320
• a market structure in which many firms sell products
that are similar but not identical. A monopolistically
competitive market is characterized by three
attributes:
• many firms
• differentiated products
• free entry and exit
IV. Oligopoly [Mankiw, Chapter 17, page 338]
• a market structure in which only a few sellers offer
similar or identical products.
Oligopolists would be better off cooperating and
reaching the monopoly outcome. Yet because they each
pursue their own self-interest, they fail to maximize their
joint profit. Each oligopolist is tempted to raise
production and capture a larger share of the market. As
each of them tries to do this, total production rises, and
the price falls.
Nash equilibrium – a situation in which economic actors
interacting with one another each choose their best
strategy given the strategies that all the other actors
have chosen.
When firms in an oligopoly individually choose
production to maximize profit, they produce a quantity
of output greater than the level produced by monopoly
and less than the level produced by perfect competition.
Prisoners’ dilemma – a particular “game” between two
captured prisoners that illustrates why cooperation is
difficult to maintain even when it is mutually beneficial.
Self-interest makes it difficult for the oligopolists to
maintain the cooperative outcome with low production,
high prices, and monopoly profits.
 At what price does the different market structures Market Basket - a representative group of goods and
charged its product? services; basis of CPI, and includes eight major
Perfect Competition Marginal Revenue = Price categories:
Monopoly Marginal Revenue < Price 1. Food and Beverages
Monopolistic Marginal Revenue = Marginal 2. Housing
Competition Cost, then uses its demand curve 3. Apparel
to find the price at which it can sell 4. Transportation
that quantity. 5. Medical Care
Oligopoly Marginal Revenue < Price
6. Recreation
7. Education and Communication
What’s the profit maximizing quantity for each market 8. Other Goods and Services
structure?
Perfect Competition To maximize profit, a firm chooses
a quantity of output such that
[P=MR=MC] marginal revenue equals marginal Base year – the year chosen as a point of reference or
cost. Because marginal revenue basis of comparison for prices in other years; a
for a competitive firm equals the benchmark year.
market price, the firm chooses Sample Computation of CPI
quantity so that price equals
marginal cost.
Monopoly A monopoly maximizes profit by
choosing the quantity at which
[P>MR=MC] marginal revenue equals marginal
cost. It then uses the demand
curve to find the price that will
induce consumers to buy that
quantity.
Monopolistic A monopolistically competitive
Competition firm follows a monopolist’s rule
Computing the Percentage Change in Price using CPI
for profit maximization: It chooses
to produce the quantity at which
marginal revenue equals marginal
cost and then uses its demand
curve to find the price at which it Inflation – is an increase in the price level and is usually
can sell that quantity. measured on an annual basis.
Oligopoly Oligopolists maximize their total Inflation Rate – is the positive percentage change in the
profits by forming a cartel and price level on an annual basis.
producing the monopoly quantity
and charging the monopoly price. II. Real Income – nominal income adjusted for price
changes.
Nominal Income – the current dollar amount of a
PRICES AND UNEMPLOYMENT [Arnold, Chapter 6, page 129]
person’s income.
I. Price – refers to a single price
Price Level - a weighted average of the prices of all
goods and services.
Price Index – a measure of the price level. When you know the inflation rate, you can find out
Consumer Price Index (CPI) – the weighted average whether your income is:
of prices of a specific set of goods and services
purchased by a typical household; a widely cited 1. Keeping Up with Inflation: Real income stays
index number for the price level. constant
Real Income year 1 = Real Income year 2
 2. Not Keeping Up with Inflation: Real income falls
Real Income year 1 > Real Income year 2
3. More Than Keeping Up with Inflation: Real income
rises
Real Income year 1 < Real Income year 2
III. Measuring Unemployment
Total Population in the United States – categorized into:
1. People under 16 years of age in the armed forces, or
institutionalized (in a prison, mental institution, or
home for the aged)
2. Civilian Noninstitutional Population
a. Not in the labor force
b. In Labor Force/ Civilian Labor Force
i. Employed
ii. Unemployed
Unemployment Rate – is the percentage of the civilian
labor force that is unemployed.
discouraged workers. They are not counted in the
calculation for the unemployment rate.
Types of Unemployment
1. Frictional Unemployment – unemployment that is
due to the natural frictions in the economy and that
is caused by changing market conditions and
represented by qualified individuals with
transferrable skills who change jobs.
2. Structural Unemployment – unemployment due to
structural changes in the economy that eliminate
some job and create others for which the
unemployed are unqualified.

3. Natural Unemployment – unemployment caused by

Employment Rate (employment/population ratio) – is frictional and structural factors in the economy.
the percentage of the civilian noninstitutional population
that is employed.

Full Employment
Labor Force Participation Rate – is the percentage of the • the condition that exists when the unemployment
civilian noninstitutional population that is in the civilian rate is equal to the natural unemployment rate.
labor force; gives us the percentage of the population • this does not imply a zero-unemployment rate
that is willing to work.
Cyclical Unemployment Rate
• the difference between the unemployment rate and
Reasons for Unemployment the natural unemployment rate.
• Job Loser – this person was employed in the civilian
labor force and was either fired or laid off. Most
unemployed persons fall into this category.
• Job Leaver – this person was employed in the civilian
labor force and quit the job
• Reentrant – this person was previously employed, GDP AND REAL GDP
hasn’t worked for some time, and is currently
Gross Domestic Product (GDP) – is the market value of
reentering the labor force.
all finish goods and services produced within a country
• New Entrant – this person has never held a full-time
in a given period of time. (Refer to Mankiw p. 475)
job for two weeks or longer and is now in the civilian
• GDP excludes product that are sold illicitly such as
labor force looking for a job.
illegal drugs and items produced and consumed at
home. Ex. Vegetables in the market are part of GDP
but vegetables grown in the garden is not.
Discouraged Worker
• GDP includes only the value of final goods. The value
• When individuals are neither actively looking for of intermediate goods is already in the prices of the
work nor waiting to be called back to a job, they are final goods. Adding the market value of the paper to
not unemployed, but rather, are considered
 the market value of the cars would be double • Imports – are goods produced abroad and sold
counting. domestically.
GDP per capita = Real GDP/Total Population
To compute for GDP, use: Y = C + G + I + Nx

Expenditure Components of GDP

CONSUMPTION (C) or “personal consumption

expenditures” - The value of all goods and services
bought by households. Includes: GDP measures:
• durable goods - last a long time • total income
ex: cars, home appliances • total output
• nondurable goods - last a short time • total expenditure
ex: food, clothing • the sum of value-added at all stages
• services - work done for consumers in the production of final goods.
ex: dry cleaning, air travel.
Nominal GDP – the production of goods and services
INVESTMENTS (I)
valued at current prices.
Definition 1: Spending on [the factor of
production] capital.
Real GDP - the production of goods and services valued
Definition 2: Spending on goods bought for
at constant prices.
future use
Includes: Practice Problem 1
– Business fixed investment – spending on plant
and equipment that firms will use to produce
other goods & services.
– Residential fixed investment – spending on
housing units by consumers and landlords.
– Inventory investment – the change in the value
of all firms’ inventories. 1. Compute for the nominal GDP.
2. Compute real GDP in each year using 2006 as the
GOVERNMENT SPENDING (G) base year.
• G includes all government spending on goods ANSWERS:
and services. Examples: spending on roads,
bridges, salaries of government employees, etc.
• G excludes transfer payments because they do
not represent spending on goods and services.
– Examples of government transfers
include unemployment insurance,
veterans’ benefits, and old-age or
disability payments

NET EXPORTS (Nx) The inflation rate is the percentage increase in the overall
level of prices.
Net Exports = Exports – Imports

• Exports – goods that are produced domestically

and sold abroad.
One measure of the price level is the GDP deflator,
defined as:
Practice Problem 2
1. Use your previous answers to compute
the GDP deflator in each year.
2. Use GDP deflator to compute the inflation rate from
2006 to 2007, and from 2007 to 2008.
ANSWERS:
The overall level of prices can be measured by either:
• the Consumer Price Index (CPI),
the price of a fixed basket of goods
purchased by the typical consumer
• the GDP deflator, the ratio of nominal to real
GDP
Business cycles - are economy wide fluctuations in total
national output, income, and employment, usually
lasting for a period of 2 to 10 years, marked by
widespread expansion or contraction in most sectors of
the economy.
Phases of the Business Cycles
Economists typically divide business cycles into two
main phases: recession and expansion. Peaks and troughs
mark the turning points of the cycle.
• Recession is a recurring period of decline in total
output, income, and employment, usually lasting
from 6 to 12 months and marked by contractions
in many sectors of the economy. A recession that
is large in both scale and duration is called a
depression.
• Expansion – is the phase of the cycle when the
economy moves from trough to a peak. It is a
period where GDP expands until it reaches its
peak.
AGGREGATE DEMAND AND AGGREGATE SUPPLY
Aggregate-Demand Curve
• A curve that shows the quantity of goods and
services that households, firms, the government, and
customers abroad want to buy at each price level
Why is the AD curve downward sloping?
• There are three distinct but related reasons a fall
in the price level increases the quantity of goods
and services demanded:
1. The Wealth Effect - Consumers are wealthier,
which stimulated the demand for consumption.
2. The Interest Rate Effect - Interest rates fall,
which stimulates the demand for investment
goods.
3. The Exchange-Rate Effect - The currency
depreciates, which stimulated the demand for
net exports.
The same three effects work in reverse: When the price
level rises, decreased wealth depresses consumer
spending, higher interest rates depress investment
spending, and a currency appreciation depresses net
exports.
What shifts the AD curve?
1. Shifts Arising from Changes in Consumption: An
event that causes consumers to spend more at a
given price level (a tax cut, a stock market boom)
shifts the aggregate-demand curve to the right.
An event that causes consumers to spend less at
a given price level (a tax hike, a stock market
 decline) shifts the aggregate-demand curve to
the left.
2. Shifts Arising from Changes in Investment: An
event that causes firms to invest more at a given
price level (optimism about the future, a fall in
interest rates due to an increase in the money
supply) shifts the aggregate-demand curve to
the right. An event that causes firms to invest
less at a given price level (pessimism about the
future, a rise in interest rates due to a decrease
in the money supply) shifts the aggregate-
demand curve to the left.
3. Shifts Arising from Changes in Government
Purchases: An increase in government purchases
of goods and services (greater spending on
defense or highway construction) shifts the
aggregate-demand curve to the right. A decrease
in government purchases on goods and services
(a cutback in defense or highway spending) shifts
the aggregate demand curve to the left.
4. Shifts Arising from Changes in Net Exports: An
event that raises spending on net exports at a
given price level (a boom overseas, speculation
that causes an exchange rate depreciation) shifts
the aggregate-demand curve to the right. An
event that reduces spending on net exports at a
given price level (a recession overseas,
speculation that causes an exchange-rate
appreciation) shifts the aggregate-demand curve
to the left.
Aggregate-Supply Curve
• A curve that shows the quantity of goods and
services that firms choose to produce and sell at
each price level.
Why does the Short-Run Aggregate-Supply Curve Slope
upward?
1. The Sticky-Wage Theory:
• An unexpectedly low-price level raises the real
wage, which causes firms to hire fewer workers
and produce a smaller quantity of goods and
services.
2. The Sticky-Price Theory:
• An unexpectedly low-price level leaves some
firms with higher than-desired prices, which
depresses their sales and leads them to cut back
production.
3. The Misperceptions Theory:
• An unexpectedly low-price level leads some
suppliers to think their relative prices have
fallen, which induces a fall in production.
What shifts the Short Run Aggregate Supply curve?
1. Shifts Arising from Changes in Labor:
• An increase in the quantity of labor available
(perhaps due to a fall in the natural rate of
unemployment) shifts the aggregate-supply
curve to the right. A decrease in the quantity of
labor available (perhaps due to a rise in the
natural rate of unemployment) shifts the
aggregate-supply curve to the left.
2. Shifts Arising from Changes in Capital:
• An increase in physical or human capital shifts
the aggregate-supply curve to the right. A
decrease in physical or human capital shifts the
aggregate-supply curve to the left.
3. Shifts Arising from Changes in Natural Resources:
• An increase in the availability of natural
resources shifts the aggregate-supply curve to
the right. A decrease in the availability of natural
resources shifts the aggregate-supply curve to
the left.
4. Shifts Arising from Changes in Technology:
• An advance in technological knowledge shifts the
aggregate-supply curve to the right. A decrease
in the available technology (perhaps due to
government regulation) shifts the aggregate-
supply curve to the left.
5. Shifts Arising from Changes in the Expected Price
Level:
• A decrease in the expected price level shifts the
short-run aggregate-supply curve to the right. An
increase in the expected price level shifts the
short-run aggregate-supply curve to the left.
Long-Run Aggregate Supply and Long-Run Equilibrium
• The long-run aggregate supply (LRAS) curve is
vertical at the Natural Real GDP level.
• Graphically, long-run equilibrium exists at the
intersection of the AD and LRAS curves. It is the
condition that exists in the economy when all
economy wide adjustments have taken place and
workers do not hold any (relevant) misperceptions.
In long-run equilibrium, the quantity demanded of
Real GDP equals the quantity supplied of Real GDP,
which equals Natural Real GDP.
• An important macroeconomic question is, “Will the
level of Real GDP that the economy produces in the
long run be the same as in the short run?” Most
economists say that it will not. They argue that, in the
long run, the economy produces the full-
employment Real GDP, or the Natural Real GDP (Q
N). The aggregate supply curve that identifies the
output the economy produces in the long run, the
long-run aggregate supply (LRAS) curve, is portrayed
as the vertical line in Exhibit 14.
Natural Real GDP
The Real GDP that is produced at the natural
unemployment rate. The Real GDP that is produced
when the economy is in long-run equilibrium.
Three States of an Economy
Long-run equilibrium identifies the level of Real GDP the
economy produces when wages and prices have adjusted
to their final equilibrium levels and when workers have
no relevant misperceptions. Graphically, this occurs at
the intersection of the AD and LRAS curves. Further, the
level of Real GDP that the economy produces in long-run
equilibrium is the Natural Real GDP (Q N).
Short -Run Equilibrium
Graphically, short-run equilibrium exists at the
intersection of the AD and SRAS curves. A shift in either
or both of these curves can change the price level and
Real GDP. For example, an increase in aggregate demand
increases the price level and Real GDP, ceteris paribus.
Disequilibrium
When the economy is in neither short-run nor long-run
equilibrium, it is said to be in disequilibrium. Essentially,
disequilibrium is the state of the economy as it moves
from one short-run equilibrium to another or from short-
run equilibrium to long-run equilibrium. In
disequilibrium, the quantity supplied, and the quantity
demanded of Real GDP are not equal.
KEYNESIAN CONSUMPTION FUNCTION AND
EQUILIBRIUM
Keynes on Say’s Law
Keynes did not agree that Say’s law would necessarily
hold in a money economy. He thought it was possible for
consumption to fall (for saving to increase) by more than
investment increased. Consequently, a decrease in
consumption or increase in saving) could lower total
expenditures and aggregate demand in the economy.
Keynes disagreed. He didn’t think that added saving
would necessarily stimulate an equal amount of added
investment spending. Example, let consumption equal
$3,000, investment equal $600, government purchases
equal $1,200, and net exports equal $200. Then saving
increases by $100, lowering consumption to $2,900.
According to the classical economists, investment will
rise by $100 at the same time, going from $600 to $700.
Keynes asked, what is the guarantee that an increase in
investment will equally match an increase in saving?
What if saving rises by $100 (and consumption goes
down by $100), but investment rises by, say, only $40
(instead of $100)? Then the original equation TE= C + I +
G + (EX - IM) changes from
TE= $3,000 + $600 + $1,200 + $200 =$5,000
To TE = $2,900 + $640 + $1,200 + $200= $4,940
not to TE = $2,900 + $700 + $1,200 + $200=$5,000
MPC stands for marginal propensity to consume,
which is the ratio of the change in consumption to
the change in disposable income:
The marginal propensity to save (MPS) is the ratio
of the change in saving to the change in disposable
income:

The Multiplier
A change in autonomous spending will bring about a
multiple change in total spending. The overall change
in spending is equal to the multiplier [1/(1 - MPC )]
times the change in autonomous spending.
FISCAL POLICY
Budget Deficit, Surplus, or Balance
The government budget can be in one of three states:
• If government expenditures are greater than tax
revenues, the federal government runs a budget
deficit.
• If tax revenues are greater than government
expenditures, the federal government runs a budget
surplus.
• If government expenditures equal tax revenues, the
federal government runs a balanced budget.
Demand-Side Fiscal Policy
This section focuses on how government spending and
taxes—fiscal policy—can affect the demand side of the
economy, that is, aggregate demand.
Demand-Side Fiscal Policy: A Keynesian Perspective
In Keynesian theory, demand-side fiscal policy can be
used to rid the economy of a recessionary gap or an
inflationary gap. A recessionary gap calls for
expansionary fiscal policy, and an inflationary gap calls
for contractionary fiscal policy. Ideally, fiscal policy
changes aggregate demand by enough to rid the
economy of either a recessionary gap or an inflationary
gap.
Crowding Out
• Crowding out is the decrease in private expenditures
that occurs as a consequence of increased
government spending and/or the greater financing
needs of a budget deficit. The crowding-out effect
suggests that expansionary fiscal policy does not
work to the degree that Keynesian theory predicts.
• Complete (incomplete) crowding out occurs when
the decrease in one or more components of private
spending completely (partially) offsets the increase
in government spending.
Why Demand-Side Fiscal Policy May Be Ineffective
• Demand-side fiscal policy may be ineffective at
achieving certain macroeconomic goals because
of (1) crowding out and (2) lags.
Supply-Side Fiscal Policy
Fiscal policy effects may be felt on the supply side as well
as on the demand side of the economy. For example, a
reduction in tax rates may alter an individual’s incentive
to work and produce, thus altering aggregate supply
• When fiscal policy measures affect tax rates,
they may affect both aggregate supply and
aggregate demand. It is generally accepted that
a marginal tax rate reduction increases the
attractiveness of work relative to leisure and tax-
avoidance activities and thus leads to an increase
in aggregate supply.
• Tax revenues equal the tax base multiplied by
the (average) tax rate. Whether tax revenues
increase or decrease as a result of a tax rate
reduction depends on whether the percentage
increase in the tax base is greater or less than the
percentage reduction in the tax rate. If the
percentage increase in the tax base is greater
than the percentage reduction in the tax rate,
then tax revenues will increase. If the percentage
increase in the tax base is less than the
percentage reduction in the tax rate, then tax
revenues will decrease.
MONEY, CENTRAL BANKS, AND PRICES
Money – used to mean wealth.
• set of assets in an economy that people regularly
use to buy goods and services from other people
Wealth – used to refer to the total of all stores of
value, including both money and nonmonetary
assets.
Functions:
• Medium of exchange – an item that buyers give to
sellers when they want to purchase goods and
services
• Unit of account – the yardstick people use to post
prices and record debt
• Store of value – an item that people can use to
transfer purchasing power from the present to
future
Liquidity – the ease with which an asset can be converted
into the economy’s medium of exchange
Kinds of Money
• Commodity money – money that takes the form of a
commodity with intrinsic value
• Fiat money – money without intrinsic value that is
used as money by government decree
➢ Intrinsic value – the item would have value even
if it were not used as money
Money Supply – the quantity of money available in the
economy
➢ Monetary Policy – setting of the money supply by
policymakers in the central bank
➢ Currency – the paper bills and coins in the hands of
the public
➢ Demand deposits – balances in bank accounts that
depositors can access on demand by writing checks
Note: Credit cards are excluded from all measures of the
quantity of money. The reason is that credit cards are not
really a method of payment but rather a method of
deferring payment. When you buy a meal with a credit
card, the bank that issued the card pays the restaurant
what it is due. At a later date, you will have to repay the
bank (perhaps with interest). When the time comes to
pay your credit card bill, you will probably do so by
writing a check against your checking account. The
balance in this checking account is part of the economy’s
stock of money.
Central bank – an institution designed to oversee the
banking system and regulate the quantity of money in
the economy.
Federal Reserve (FED) – the central bank of the United
States
• was created in 1913 after a series of bank failures in
1907 convinced Congress that the United States
needed a central bank to ensure the health of the
nation’s banking system.
Roles of FED
1. Regulate banks and ensure the health of banking
system.
2. Acts as a lender of last resort – a lender to those who
cannot borrow anywhere else.
3. Control the quantity of money that is made available
in the economy.
➢ Reserves – deposits that banks have received
but have not loaned out
➢ Fractional-reserve banking – a banking system in
which banks hold only a fraction of deposits as
reserves.
➢ Reserve ratio – the fraction of deposits that
banks hold as reserves.
➢ Reserve requirement – a minimum amount of
reserves that banks must hold.
➢ Excess reserves – banks may hold reserves above
the legal minimum.
➢ Money multiplier – the amount of money the
banking system generates with each dollar of
reserves.
BANK CAPITAL, LEVERAGE
➢ Bank capital - the resources a bank’s owners
have put into the institution
➢ Leverage - the use of borrowed money to
supplement existing funds
➢ Leverage ratio – the ratio of assets to bank
capital
Capital requirement – a government regulation
specifying a minimum amount of bank capital
How Fed Influences the Quantity of Reserves
• Open-market operations – the purchase and sale of
U.S government bonds by the FED. To increase the
money supply, the Fed instructs its bond traders at
the New York Fed to buy bonds from the public in the
nation’s bond markets.
• FED lending to banks - Fed can also increase the
quantity of reserves in the economy by lending
reserves to banks. Banks borrow from the Fed when
they feel they do not have enough reserves on hand,
either to satisfy bank regulators, meet depositor
withdrawals, make new loans, or for some other
business reason.
➢ Discount rate - the interest rate on the loans
that the FED makes to banks.
How Fed Influences the Reserve Ratio
• Reserve requirements – regulations on the
minimum amount of reserves that banks must
hold against deposits
 • Paying interest on reserves - when a bank holds
reserves on deposit at the Fed, the Fed now pays
the bank interest on those deposits. This change
gives the Fed another tool with which to
influence the economy.
Equation of Exchange
• Real interest rate - takes the inflation rate into account
Real rate = nominal rate - inflation rate
INTERNATIONAL TRADE AND FINANCE
International Trade Theory
• individuals trade to make themselves better off.
How Countries Know What to Trade
Comparative Advantage – the advantage a country has
when it can produce a good at lower opportunity cost
than another country can.

Production Possibilities Frontier of US & Japan

How Money Supply Affects

• Interest rates and aggregate demands

All else being equal, a larger money supply lowers
market interest rates. Conversely, smaller money
supplies tend to raise market interest rates. The current
level of liquid money (supply) coordinates with the total
demand for liquid money (demand) to help determine US
interest rates. Opportunity cost:
The increase in the money supply is mirrored by an 1C = 3F, or 1F =1/3C
equal increase in nominal output, or Gross Domestic
JAPAN
Product (GDP). In addition, the increase in the money
Opportunity cost:
supply will lead to an increase in consumer spending.
1C = 1F, or 1F = 1C.
This increase will shift the aggregate demand curve to
the right. US has a comparative advantage in food, and Japan has
a comparative advantage in clothing.
• Price Level –inflation
Increasing the money supply faster than the growth No-specialization–No-trade (NS –NT)
in real output will cause inflation. The reason is that there • neither of the two countries is specializing in the
is more money chasing the same number of goods. production of one of the two goods, nor are the two
Therefore, the increase in monetary demand causes countries trading with each other.
firms to put up prices. If the money supply increases at
Specialization–trade (S –T) case
the same rate as real output, then prices will stay the
Two countries decide to specialize in the production of a
same.
specific good and to trade with each other.
A country gains by specializing in producing and trading
Nominal and Real Interest Rates
the good in which it has a comparative advantage.
• Nominal interest rate - refers to the interest rate before
Terms of trade: US & Japan
taking inflation into account.
2F = 1C or
Nominal rate = real interest rate + inflation rate 20 units of food for 10 units of clothing
A Common Misconception About How Much We Can
Consume
No country can consume beyond its PPF if it doesn’t
specialize and trade with other countries. But it can do so
when there is specialization and trade.
How Countries Know When They Have a Comparative
Advantage
Government officials of a country do not:
• analyze pages of cost data plot production
• possibilities frontiers on graph paper
• calculate opportunity costs.
Instead, the individual’s desire to earn a dollar, a peso, or
a euro determines the pattern of international trade.
Price differences for beef and perfume between US and
France:
• buy perfumes in France low price (sell in US at High
price)
• buy some beef in US (sell in France at High Price)
” Buying low and selling high”
The International Flow of Goods and Capital
Open-Economy Macroeconomics: Basic Concepts
closed economy – an economy that does not interact
with other economies in the world
open economy – an economy that interacts freely with
other economies around the world
The International Flows of Goods and Capital:
Exports – goods and services that are produced
domestically and sold abroad
Imports – goods and services that are produced abroad
and sold domestically
net exports – the value of a nation’s exports minus the
value of its imports; also called the trade balance
trade balance – the value of a nation’s exports minus the
value of its imports; also called net exports
trade surplus – an excess of exports over imports
trade deficit – an excess of imports over exports
Net exports = Value of country’s exports - Value of
country’s imports.
The Internationalization of the U.S. Economy
Factors that might influence a country’s exports,
imports, and net exports:
• The tastes of consumers for domestic and foreign
goods
• The prices of goods at home and abroad
• The exchange rates at which people can use domestic
currency to
buy foreign currencies
• The incomes of consumers at home and abroad
• The cost of transporting goods from country to
country
• Government policies toward international trade
Net capital outflow (net foreign investment) – the
purchase of foreign assets by domestic residents minus
the purchase of domestic assets by foreigners.
Net capital outflow = Purchase of foreign assets by
domestic residents - Purchase of domestic assets by
foreigners.
Important variables that influence net capital outflow:
• The real interest rates paid on foreign assets
• The real interest rates paid on domestic assets
• The perceived economic and political risks of
holding assets abroad
• The government policies that affect foreign
ownership of domestic assets
The Equality of Net Exports and Net Capital Outflow
• an important but subtle fact of accounting states
that, for an economy as a whole, net capital outflow
(NCO) must always equal net exports (NX): NCO = NX
Conclusions for the economy as a whole
• When a nation is running a trade surplus (NX > 0),
it is selling more goods and services to foreigners
than it is buying from them. What is it doing with the
foreign currency it receives from the net sale of
goods and services abroad? It must be using it to buy
foreign assets. Capital is flowing out of the country
(NCO > 0).
• When a nation is running a trade deficit (NX < 0),
it is buying more goods
and services from foreigners than it is selling to
them. How is it financing the net purchase of these
goods and services in world markets? It must be
selling assets abroad. Capital is flowing into the
country (NCO < 0).
Saving, Investment, and Their Relationship to the
International Flows
The economy’s GDP (denoted Y) is divided among four
components: consumption (C), investment (I),
government purchases (G), and net exports (NX).
Y = C + I + G + NX
National Saving
It is the income of the nation that is left after paying for
current consumption and government purchases.
National saving (S) equals Y - C - G.
Y - C - G = I + NX or S = I + NX
NOTE: Net exports (NX) also equal net capital outflow
(NCO)
S = I – NCO or Savings = Domestic Capital Investment +
Net Capital Outflow
International Flows of Goods and Capital:
Trade Restrictions
If countries gain from international trade, why are there
trade restrictions?
The answer requires an analysis of costs and benefits;
specifically, we need to determine who benefits and who
loses when trade is restricted.
Distributional effects of International Trade
Specialization and international trade benefit individuals
in different countries, but this is a net benefit. Not every
individual person may gain.
• The entrance of a foreign producer that has the
comparative advantage is a threat to domestic
producer of goods.
Benefits and Costs of Trade Restrictions
• Tariff is a tax on imports. The primary effect of a tariff
is to raise the price of the imported good for the
domestic consumer.
Effects:
• Raises the price
• Decrease consumers’ surplus, (and demand)
• Increase producers’ surplus, (and supply)
• Generates tariff revenue
• Reduces imports
• Moves closer to its equilibrium w/o trade
• There is a net loss (deadweight loss)
• Quota is a legal limit imposed on the amount of a
good that may be imported.
Effects:
• Reduces the supply
• Raises the price
• Decreases consumers’ surplus
• Increases producers’ surplus
• Increase the total revenue importers earn
• Because consumers lose more than producers
and importers gain, there is a net loss to the
quota.

Why Nations Sometimes Restrict Trade
The National Defense Argument
✓ Argument Certain industries—such as aircraft,
petroleum, chemicals, and weapons—are necessary
to the national defense
✓ These goods must be produced domestically
whether the comparative advantage or not.
One reason: Leaving weapons production to another
country, they maintain, is too dangerous.
Critics: “Valid arguments may be abused”
The Infant Indus try Argument
Alexander Hamilton, the first U.S. secretary of the
treasury.
✓ infant, or new industries should be protected from
foreign competitors until they are mature enough to
compete on an equal basis
✓ Argument for temporary protection
Downside: “protection is almost impossible”
The Antidumping Argument
Dumping is the sale of goods abroad at a price below
their cost and below the price charged in the domestic
market.
According to critics of dumping:
• unfair trade practice that puts domestic producers of
substitute goods at a disadvantage.
• seek only to penetrate a market and drive out
domestic competitors
• some economists point to the infeasibility of this
strategy.
• After the dumpers have driven out their competition
and raised prices, their competition is likely to
return.
• Dumpers incurred only a string of losses (owing to
their selling below cost).
The Foreign Export Subsidies Argument
• Some governments subsidize firms that export
goods. If a country offers a below-market
(interest rate) loan to a company
• the complainers are the domestic producers
who can’t sell their goods at as high a price
because of the so-called gift domestic
consumers are receiving from foreign
governments.
Unfair advantage for Foreign Producers: Cheaper
Products
The Low Foreign Wages Argument
• A country’s high-wage disadvantage may be
offset by its productivity advantage, and a
country’s low-wage advantage may be offset by
its productivity d is advantage.
• High wages do not necessarily mean high costs
when productivity and the costs of nonlabor
resources are included.
The Saving Domestic Jobs Argument
• LOW FOREIGN WAGE:
If domestic producers cannot compete with foreign
producers because foreign producers pay low wages
and domestic producers pay high wages, domestic
producers will go out of business and domestic jobs will
be lost.
• SUBSIDIES ARGUMENT:
If foreign government subsidies give a competitive edge
to foreign producers, not only will domestic producers
fail, but as a result of their failure, domestic jobs will be
lost.
Counter argue:
If a domestic producer is being outcompeted by foreign
producers and if domestic jobs in an industry are being
lost as a result, the world market is signaling that those
labor resources could be put to better use in an industry
in which the country holds a comparative advantage.
The Protection- As-A- Bargaining-Chip Argument
Threatening to restrict trade can help remove trade
restrictions by foreign governments.
TWO BADS OPTION:
1. It can carry out its threat and implement the trade The price of one currency in terms of another currency.
restriction, which would reduce its own economic
welfare.
2. It can back down from its threats, which would
cause its. lose prestige in international affair

CONCLUSION
“Economist support free international trade. They view
trade as a way of allocating production efficiently and
raising living standards both at home and abroad”

The Prices for International Transactions

nominal exchange rate - the rate at which a person can
trade the currency of one country for the currency of
another
appreciation - an increase in the value of a currency as
measured by the amount of foreign currency it can buy The Demand for and Supply of Currencies
depreciation - a decrease in the value of a currency as Thus, the demand for pesos and the supply of dollars are
measured by the amount of foreign currency it can buy linked and vice versa:
real exchange rate - the rate at which a person can Demand for pesos ↔ Supply of dollars
trade the goods and services of one country for the Demand for dollars ↔ Supply of pesos
goods and services of another
i. Flexible exchange rates
Real exchange rate = Nominal exchange rate x Domestic Flexible Exchange Rate System
Price Foreign price The system whereby exchange rates are
determined by the forces of supply and demand
Real exchange rate = (e x P)/P*
for a currency.
Where, Appreciation
P- domestic market An increase in the value of one currency relative
P*- foreign market to other currencies.
e- nominal exchange rate Depreciation
A decrease in the value of one currency relative
International Finance (Chapter 35- Arnold) to other currencies.
Net export
The difference between the value of its exports and the
value of its imports is called net exports.
Trade Balance
The value of a country’s exports minus the value of its
imports; sometimes referred to as net exports.
Trade Surplus
The condition that exists when the value of a country’s
exports is greater than the value of its imports.
Trade Deficit
The condition that exists when the value of a country’s
imports is greater than the value of its exports.
Foreign Exchange Market
The market in which currencies of different countries are Factors That Affect the Equilibrium Exchange Rate
exchanged. A Difference in Income Growth Rates
Exchange Rate An increase in a country’s income will usually cause the
nation’s residents to buy more of both domestic and
foreign goods. The increased demand for imports will
result in an increased demand for foreign currency.
A currency is overvalued if its price in terms of other
currencies is above the equilibrium price.
Undervalued
A currency is undervalued if its price in terms of other
currencies is below the equilibrium price.

If the peso is undervalued, the dollar must be overvalued.

Overvalued peso ↔ Undervalued dollar

Undervalued peso ↔ Overvalued dollar

Differences in Relative Inflation Rates

Purchasing Power Parity (PPP) Theory
Theory stating that exchange rates between any two
currencies will adjust to reflect changes in the relative
price levels of the two countries.

The PPP theory predicts that changes in the relative price

levels of two countries will affect the exchange rate in
such a way that 1 unit of a country’s currency will
continue to buy the same amount of foreign goods as it
did before the change in the relative price levels.

Changes in Real Interest Rates
Financial capital also moves between countries. The flow
of financial capital depends on different countries’ real
interest rates—interest rates adjusted for inflation.
Fixed exchange rates
Fixed Exchange Rate System
The system whereby a nation’s currency is set at a fixed
rate relative to all other currencies, and central banks
intervene in the foreign exchange market to maintain the
fixed rate.
Overvalued
Options Under a Fixed Exchange Rate System
Devaluation and Revaluation
Devaluation – a government action that changes
the exchange rate by lowering the official price
of a currency.
Revaluation – government act that changes the
exchange rate by raising the official price of a
currency.
Protectionist Trade Policy (Quotas and Tariffs)
Ex: The United States can impose quotas and tariffs on
Chinese goods in order to reduce American consumption
of them.
Changes in Monetary Policy
• A country can use monetary policy to support the • Countries in such an area can either fix their
exchange rate or the official price of its currency currencies or adopt the same currency and thus keep
• Some economists argue against fixed exchange rates all the benefits of flexible exchange rates without
because they think it unwise for a nation to adopt a incurring any of the costs.
particular monetary policy simply to maintain an
international exchange rate.
• Domestic monetary policies should be used to meet
domestic economic goals, such as price stability, low
unemployment, low and stable interest rates, and so Submitted by:
forth. Alonzo, Alieto Mae
Baba, Faith Krystal
Fixed Exchange Rate Flexible Exchange Rate
Celocia, Grix Jonard
System System
Mayol, Lee Nielle
Promotes Adopts policies to meet
Villester, Kyra Flocel
International Trade domestic economic goals
Group 2 Block A1
Managed Float
A managed flexible exchange rate system, under which
nations now and then intervene to adjust their official
reserve holdings to moderate major swings in exchange
rates.
Optimal Currency Area
A geographic area in which exchange rates can be fixed
or a common currency used without sacrificing domestic
economic goals, such as low unemployment.

Trade and Labor Mobility

Ex: The movement of labor will reduce some of the
unemployment problems in Canada, and with more
workers in the United States, more output will be
produced, thus dampening upward.

Trade and Lab or Immobility

• If people cannot move, what happens in the
economies of the two countries depends largely on
whether exchange rates are fixed or flexible.
• If labor is immobile, changes in relative demand may
pose major economic problems when exchange
rates are fixed, but not when they are flexible.

Costs, Benefits, and Optimal Currency Areas

• Exchanging one currency for another (say, U.S.
dollars for Canadian dollars or U.S. dollars for
Japanese yen) incurs a charge, and the risk is greater
of not knowing what the value of one’s currency will
be on the foreign exchange market on any given day.
• When labor in countries within a geographic area is
mobile enough to move easily and quickly in
response to changes in relative demand, the
countries are said to constitute an optimal currency
area.