Price elasticity of demand = percent change in quantity demanded / percent change in price Elasticity of labour will be greater for

firms with production processes that are more labour-intensive Percent change = change in value / average value Factors that influence elasticity of demand 1. Availability and closeness of substitute goods 2. Relative amount of income spent on the good 3. The time that has passed since the price change of the good Natural monopoly: Industry in which economics of scale are so pronounced that the ATC of total industry production is minimized when there is only one firm. Average cost pricing: most common form of regulations. Forces monopolists to reduce price to where the firms ATC intersects the market demand curve. Marginal cost pricing: efficient regulation forces monopolist to reduce price to the point where the firms MC curve intersects the market demand curve. Price discrimination: increase both output and monopoly profits only if there are at least two identifiable groups of customers with different price elasticities of demand, and the monopolist can prevent lower-price-paying customers from reselling to higher-price-paying customers

Monopolistic competition: downward-sloping demand curves (highly elastic many substitute products) A large number of independent sellers Differentiated products Firms compete on price, quality, and marketing quality Low barriers to entry

Produces quantity Q where MC=MR and D=ATC Perfect Competition produces quantity Q where MC=ATC=D Kinked demand curve model based on assumption that an increase in a firms product price will not be followed by its competitors, but a decrease in price will Economic rent: amount by which a persons earnings exceed his opportunity cost. Employees opportunity cost of employment: amount the employee could earn in his next-highest valued alternative employment

Unemployment rate = (number of unemployed)/(number in the labor force) Aggregate supply and demand Aggregate supply amount of goods and services produced by an economy Aggregate demand = Consumption + Investment + Government spending + Net exports =C+I+G+X Intertemporal substitution consumers substitute consumption later for consumption now because the cost of consuming goods now instead of later (interest rate) has increased. What effects aggregate demand? 1. Expectations about future incomes, inflation, and profits 2. Fiscal and monetary policy 3. World economy Excess aggregate supply over demand means a recession. Excess aggregate demand over supply is sometimes referred to as an inflationary gap. Recessionary gap = output gap = Full-employment GDP real GDP Classical economists believe shifts in both aggregate demand and aggregate supply were primarily driven by changes in technology over time. Monetarists believe that monetary policy is the main factor leading to business cycles and deviations from full-employment equilibrium.

Money, the Price Level, and inflation Money: 1. Medium of exchange or means of payment 2. Unit of account 3. Store of value Two measures of money supply in the US M1: includes all currency not held at banks, travelers checks, and checking account deposits of individuals and firms (excluding government checking accounts) M2: includes all the components of M1, plus time deposits, savings deposits, and money market mutual fund balances

Three primary depository institutions: 1. Commercial Banks operate as intermediaries between savers and borrowers 2. Thrift institutions savings banks, credit unions, and savings and loans associations. 3. Money market mutual fund technically investment company Four main economic functions: 1. 2. 3. 4. Create Liquidity Act as financial intermediaries Monitor the risk of loans Pool the default risks of individual loans by holding a portfolio of loans

Three Policy tools of the FED 1. The discount rate rate at which banks can borrow reserves from the fed 2. Bank reserve requirements 3. Open market operations buying or selling of Treasury securities by the Fed in the open market Money multiplier = (1 + c) / (r + c) C is currency as a percentage of deposits and r is the required reserve ratio. Change in quantity of money = change in monetary base x money multiplier If interest rate > equilibrium rate: there is excess supply of real money If interest rate < equilibrium rate: there is excess demand for real money

US Inflation, Unemployment, and Business Cycles Rising real wages result in a decrease in short-run aggregate supply (curve shifts left) High inflation, even when anticipated, reduces economic output and the growth rate of GDP because it: 1. Diverts resources from other productive activities to deal with inflations effects and uncertainty 2. Decreases the value of currency in transactions and as a store of value 3. Reduces real after-tax returns from investment and savings (since nominal increases in value purely from inflation are taxed), which reduces savings and capital investment in the economy Nominal risk-free interest rates: the sum of the real risk-free rate and the expected inflation rate. If aggregate demand increased at a steady rate as well, we would not observe business cycles of the magnitude that we do. However, aggregate demand sometimes grows more rapidly, and sometimes more slowly, than LRAS (potential GDP)

Keynesian economists believe that these fluctuations are primarily due to swings in the level of optimism of those who run businesses. Inflation = persistent increase in price level, not a one-time increase. Fiscal Policy Federal governments use of spending and taxation to meet macroeconomics goals. Balanced when tax revenue = federal expenditure Supply-side effects influence that taxation has on long-term aggregate supply (potential real GDP) As income tax rises, supply of labor falls, reducing potential GDP Laffer Curve Beyond a certain point, the increase in taxes per dollar earned will be more than offset by the decrease in the total number of dollars earned Sources of financing for investments: 1. National savings 2. Borrowing from foreigners 3. Government savings Crowding out effect larger budget deficits decrease savings, which increase real interest rate, leading firms to reduce borrowing of financial capital and investment in physical capital. Ricardo-Barro effect increases in current deficit mean greater taxes in future. Claims that in order to maintain their preferred pattern of consumption over time, rational taxpayers will increase current savings and reduce current consumption in order to offset the effect of higher future taxes Discretionary fiscal policy spending and tax decisions meant to stabilize economy Automatic fiscal policy government spending changes that occur when economic growth slows or accelerates, but do not require action by policy makers Government expenditure multiplier magnitude of the eventual impact on aggregate demand per dollar of change in government spending. Applies equally to increases and decreases in government spending. Autonomous tax multiplier smaller than the government expenditure multiplier. An increase in taxes will decrease both consumption and savings and will have a magnified effect on aggregate demand as well Balanced budget multiplier is positive. For an increase in government spending that is accompanied by an equal increase in taxes, the increase in aggregate demand from the spending increase is greater than the decrease in aggregate demand from the tax increase, once their different multiplier effects are

considered. The result is that an increase in government spending coupled with an equal increase in taxes will tend to increase aggregate demand. Limitations of discretionary fiscal policy: 1. Recognition delay 2. Administrative or law-making delay 3. Impact delay Automatic stabilizers are built in fiscal devices triggered by the state of the economy. Two categories: 1. Induced taxes amount of taxes collected as a percentage of income 2. Needs-tested spending government expenditures fo programs that pass a needs test, such as unemployment Monetary Policy Federal Reserve Bank goals: 1. Maximum employment 2. Stable prices 3. Moderate long-term interest rates Output gap is positive (actual real GDP growth rate > potential real GDP growth rate) = inflationary pressures Output gap is negative (actual < potential) = recessionary gap Federal funds rate (FFR) interest rate that banks charge each other for overnight loans Four alternative rules to Taylor rule: 1. McCallum rule An inflation targeting rule would call for the fed to base its decisions on a forecast rate of inflation and to set its federal funds rate target at a level that makes the forecast inflation rate equal its target. With an instrument rule, policy decision are based on the performance of the economy. The taylor rule is an example of an instrument rule. An Overview of Central Banks Function: control a countrys money supply Goal: price level stability and maximum sustainable growth of real GDP. That is, a low, stable and predictable rate of price inflation supports maximum economic growth.

Federal Reserve (USs central bank) has three policy tools 1. Discount rate: banks can borrow from the Fed if they have a temp shortfall in reserves. Rate at which banks can borrow reserves from the Fed 2. Bank reserve requirements: percentage of deposits that banks must retain. This tool only works well if banks are willing to lend, and their customers are willing to borrow, the additional funds made available by reducing the reserve requirement. 3. Open market operations: buying and selling Treasury securities by the Fed in the open market.