ECON 100.
1 NOTES
CHAPTER 1:
10 PRINCIPLES OF ECONOMICS
Scarcity
● Limited nature of society’s resources
Efficiency
● Addresses how well economic
resources are used
Economics
● Study of how society manages its
scarce resources
10 PRINCIPLES OF ECONOMICS
● How people make decisions
1. People face trade-offs.
2. The cost of something is what
you give up to get it.
3. Rational people think at the
margin.
4. People respond to incentives.
● How people interact
5. Trade can make everyone
better off.
6. Markets are usually a good
way to organize economic
activity.
7. Governments can sometimes
improve market outcomes.
● How the economy as a whole works
8. A country’s standard of living
depends on its ability to
produce goods and services.
9. Prices rise when the
government prints too much
money.
10. Society faces a short-run
trade-off between inflation
and unemployment.
PEOPLE FACE TRADE-OFFS
● Making decisions requires trading off
one goal against another
● People are likely to make good
decisions only if they understand the
options available to them
● “Guns and butter”
● Efficiency and equality
Efficiency
● Getting maximum benefits from
scarce resources in a society
● Size of the economic pie
Equality
● Benefits are distributed uniformly
among society’s members
● How the pie is divided into individual
slices
THE COST OF SOMETHING IS WHAT YOU
GIVE UP TO GET IT
Opportunity cost
● Whatever must be given to obtain
another item
RATIONAL PEOPLE THINK AT THE
MARGIN
● Economists normally assume people
are rational
○ Systematically and
purposefully doing the best
they can to achieve
objectives given the available
opportunities
● Rational people make decisions by
comparing marginal benefits &
marginal costs
○ Takes action if and only if the
marginal benefit exceeds
marginal cost
● What is the optimal amount of X or
Y?
○ Rather than choosing either X
or Y
Marginal change
● Small incremental adjustment to an
existing plan of action
● Adjustments around the edges
PEOPLE RESPOND TO INCENTIVES
● Policies can result in unintended
consequences
 ECON 100.1 NOTES
Incentive
● Something that induces a person to
act
● Prospect of punishment or reward
TRADE CAN MAKE EVERYONE BETTER
OFF
● Trade between countries is mutually
beneficial
○ Allows countries to specialize
in what they do best
○ Provides a greater variety of
goods and services
MARKETS ARE USUALLY A GOOD WAY
TO ORGANIZE ECONOMIC ACTIVITY
Central planning
● Only the government could organize
economic activity in a way that
promoted well-being for the country
as a whole
○ Lacked necessary
information about consumer
tastes & producer costs
■ Reflected in prices
Market economy
● Allocates resources through the
decentralized decisions of many
firms & households as they interact in
markets for goods & services
Invisible hand
● Adam Smith
○ An inquiry into the nature and
causes of the wealth of
nations
○ 1776
● Guides households & firms
interacting in markets to desirable
market outcomes
○ Despite the self-interest that
drives actors in a market
economy
● Prices adjust to guide buyers &
sellers to reach outcomes that mostly
maximizes the well-being of society
as a whole
○ When a government prevents
prices from adjusting
naturally to supply & demand,
it impedes the invisible
hand’s ability to coordinate
decisions
○ Taxes adversely affect the
allocation of resources
■ Distorts prices
● Individuals are usually best left to
their own devices
○ Without the heavy hand of
government directing their
actions
GOVERNMENTS CAN SOMETIMES
IMPROVE MARKET OUTCOMES
● The invisible hand can only work its
magic if the government enforces
rules & maintains institutions key to a
market economy
○ Powerful but not omnipotent
● Well-designed public policy can
enhance economic efficiency
● Aim to achieve a more equal
distribution of economic well-being
Property rights
● The ability of an individual to own
and exercise control over scarce
resources
Market failure
● The market on its own fails to
produce an efficient allocation of
market resources
Externality
● The impact of one person’s actions
on the well-being of a bystander
● Costs that the market on its own may
fail to take into account
● Justifies government intervention
Market power
 ECON 100.1 NOTES
● Ability of an individual to unduly
influence market prices
○ Monopoly
A COUNTRY’S STANDARD OF LIVING
DEPENDS ON ITS ABILITY TO PRODUCE
GOODS & SERVICES
● Growth rate of a nation’s productivity
determines the growth rate of its
average income
● If productivity is the primary
determinant of living standards, other
explanations must be less important
Productivity
● Quantity of goods & services
produces from each unit of labor
input
○ Nations with larger quantity
of goods & services
produced tend to enjoy a
higher standard of living
○ Vice versa
What can explain declining wages?
➔ Wage over productivity
➔ Numerator is the issue
◆ Denominator can be
addressed by technocrats in
the BSP
➔ Nominal wages have not been
increasing over time despite rising
productivity
➔ Very high inflation erodes real wages
PRICES RISE WHEN THE GOVERNMENT
PRINTS TOO MUCH MONEY
● Creating large quantities of money
causes its value to fall
Inflation
● An increase in the overall level of
prices in an economy
Hyperinflation
● Extreme version of inflation
Why print money?
➔ If tax revenues are low or if
borrowing money is impossible
➔ Inflation can also work against
government interests since people
are less motivated to spend
➔ Inflation also rises with supply issues
◆ Shrinkflation
SOCIETY FACES A SHORT-RUN TRADE-
OFF BETWEEN INFLATION &
UNEMPLOYMENT
● Increasing the amount of money in
the economy stimulates the overall
level of spending & demand
○ Higher demand may cause
firms to raise prices &
encourage employment
○ More hiring means lower
unemployment
● Many economic policies tend to push
inflation & unemployment in opposite
directions
○ The short-run trade-off can
be exploited through policy
○ Changing government
spending can influence
demand
○ Changes in demand can
influence the combination of
inflation & unemployment in
the short run
Business cycle
● Fluctuations in economic activity
○ Measured by the production
of goods and services &
employment
INFLATION & UNEMPLOYMENT SEQUENCE
● Government prints more money in
the short run
● Interest rates go up
● People will buy less
● Equilibrium quantity will decrease
● Firms will tend to raise prices over
time
 ECON 100.1 NOTES
○ But to produce more goods,
firms have to hire more
workers
○ More hiring means
unemployment goes down

Stagflation
● High unemployment & high inflation

Phillips Curve
● Shows the relationship between
inflation & unemployment
● High inflation leads to low
unemployment
 ECON 100.1 NOTES
CHAPTER 2:
THINKING LIKE AN ECONOMIST
ECONOMIC METHODS
● Economics utilizes the scientific
method
○ Interplay between theory and
observation
○ Deciding which assumptions
to make
● Conducting experiments is often
impractical
○ Instead pay attention to
natural experiments offered
by history
● Assumptions can simplify the
complex world & make it easier to
understand
○ Different assumptions answer
different questions
● Economic models omit many details
to see only the essentials
○ Built with certain assumptions
○ Most are built on
mathematics
ECONOMIC MODELS
● Circular-Flow Diagram
● Production Possibilities Frontier
Production Possibilities Frontier
Circular-Flow Diagram
● Shows how money flows through
markets among households and
firms
● Money left from the transactions
result in profit for firm owners
● Represents the journey of a single
unit of currency from the pockets of
consumers to firms and back to
individual consumers
● Households & firms
○ Primary decision makers
present in the model
● Factors of production
○ Inputs utilized by firms to
produce goods & services
● Markets for goods & services
○ Households are buyers
○ Firms are sellers
○ Households buy the output of
goods & services that firms
produce
● Markets for the factors of production
○ Households are sellers
○ Firms are buyers
○ Households provide the
inputs that firms use to
produce goods & services
● Graph that shows the combinations
of output that the economy can
possibly produce given the available
factors of production & the available
production technology
○ Trade-off between outputs
can change over time
○ Movement along the PPF can
occur when capacity for
 ECON 100.1 NOTES
production increases or
decreases ➔ Positive views about the world can
● The economy can produce any affect normative views about what
combination on or inside the frontier policies are desirable
○ Slope measures the ➔ Economic policies often have
opportunity cost of one good normative goals
in terms of the other
■ Rise / Run Positive correlation
○ Opportunity cost varies how ● Variables move in the same direction
much of the 2 goods the
economy is producing Negative correlation
● Both endpoints represent extreme ● Variables move in opposite
possibilities directions
○ Not every conceivable
outcome is feasible due to
scarce resources
● Outcome is efficient if the economy
can maximize resources
○ Points on the PPF
● Outcome is inefficient when
producing less than it could from the
resources available
○ Points inside the PPF

Microeconomics
● How households & firms make
decisions and interact in specific Demand curve
markets ● Traces out the effect of a good’s
price on the quantity of the good
Macroeconomics consumers want to buy
● Study of economy-wide phenomena ○ When income is held
○ Inflation, unemployment, constant
economic growth
● Impossible to understand Movement along the curve
macroeconomic developments ● When price changes
without considering underlying
microeconomic conditions Shift in the curve
● When non-price and non-quantity
Positive factors change
● Descriptive ○ Not named on either axis
● Based on objective information
● Make a claim about how the world is

Normative
● Prescriptive
● Based on principle
● Make a claim about how the world
ought to be
 ECON 100.1 NOTES
CHAPTER 4:
SUPPLY AND DEMAND DEMAND

Market Quantity Demanded

● Abstraction of a place where buyers ● The amount of a good that buyers
& sellers meet to trade goods & are willing & able to purchase
services
○ Organized by the individual
actions of buyers & sellers
○ Actions based on price
● Highly organized
○ Buyers & sellers meet at a
specific time & place
● Often highly competitive
○ Price & quantity are
determined by all buyers &
sellers as they interact in the
marketplace

Competitive market
● The quantity of buyers & sellers are
so many that each has a negligible
individual impact on market price
Perfectly competitive market
● Goods offered for sale are exactly
the same (indistinguishable)
● Buyers & sellers are so numerous
that no individual has influence over
market price
Price takers
● Buyers & sellers in perfectly
competitive markets accept the price
the market determines
Law of Demand
● Cet par. When price rises, the
quantity demanded falls
● When price falls, quantity demanded
rises
Demand schedule
● Table that shows the quantity
demanded at each price cet par.
Demand curve
● Graph relating price with quantity
● Slopes downward

➔ Not all goods & services are sold in

perfectly competitive markets
➔ Some degree of competition is
present in most markets
Market demand
Monopoly
● Other extreme end of the spectrum
● A single seller sets the price
Ceteris paribus
● “All other things being equal”
● Sum of all individual demands for a
good/service
● Individual demand curves
horizontally to obtain market demand
curve
○ Adding individual quantities
demanded
 ECON 100.1 NOTES
● Need not be stable over time

SHIFT TO LEFT = Decrease in demand

SHIFT TO RIGHT = Increase in demand

FACTORS CAUSING SHIFTS

● Income
● Prices of related goods
○ Substitutes
○ Complements
● Tastes
● Expectations
● Number of buyers
○ Market size
Law of Supply
Income ● Cet par. Quantity supplied rises
● A higher price for the good makes when price rises
people feel poorer ● Quantity supplied falls when price
○ Buy less of the good falls
● Not all phenomena observe the Law
Normal goods of Supply
● An increase in income leads to an
increase in demand Supply schedule
● Table showing the quantity supplied
Inferior goods at each price
● An increase in income leads to a
decrease in demand Supply curve
● Graph of the relationship between
Substitutes price and quantity supplied
● Similar goods that satisfy identical
needs or wants
● Increase in the price of one good
leads to an increase in demand for
the other good
○ Price of substitute goods
relatively decrease
Market supply
Complements ● Sum of different individual supplies
● Goods that are often paired together ● individual curve shifts horizontally to
● Increase in price of one good leads obtain market supply curve
to a decrease in demand of the other
SHIFT TO LEFT = Decrease in supply
SHIFT TO RIGHT = Increase in supply
SUPPLY
FACTORS CAUSING SHIFTS
Quantity Supplied ● Input prices
● Amount of a good that sellers are ● Technology
willing & able to sell ● Expectations
 ECON 100.1 NOTES
● Number of sellers ○ Quantity supplied is greater
than quantity demanded
● Sellers respond by cutting prices
SUPPLY AND DEMAND ○ Movement along curves

Shortage
● Excess demand
○ Quantity demanded is greater
than quantity supplied
● Sellers respond by raising prices

ANALYZING CHANGES IN EQUILIBRIUM

Qs = Qd
Equilibrium
● Market price reaches a point where
quantity supplied is equal to quantity
demanded
● Market equilibrium determines price
1. Determine if event shifts supply
curve, demand curve, or both.
2. Decide whether curve shifts to right
or left
3. Use Supply-Demand diagram to
compare initial equilibrium.
SUPPLY = Position of supply curve
QUANTITY SUPPLIED = Amount producers
wish to sell

Equilibrium price
● Price that balances quantity supplied
& demanded
● Market-clearing price

Equilibrium quantity
● Quantity supplied & demanded at
equilibrium price

Elasticity
● How responsive the supply &
Law of Supply & Demand
demand curves are to a price change
● The price of any good adjusts to
○ If unresponsive, inelastic
bring the quantity supplied and
○ If prices go down, by how
quantity demanded of a good into
much does quantity
balance
demanded go up/quantity
supplied go down?
Surplus
● Can vary along the same demand
● Excess supply
curve
 ECON 100.1 NOTES
● Unitless measure

E = 1 = UNIT ELASTIC
E > 1 = ELASTIC
E < 1 = INELASTIC
0 or infinity = PERFECTLY ELASTIC

FACTORS AFFECTING DEMAND

ELASTICITY
● Availability of substitutes
● Necessities vs. luxuries
● Broad vs. narrow markets
● Time horizon

FACTORS AFFECTING SUPPLY ELASTICITY

● Producer flexibility
● Availability of inputs
● Inventory
● Time horizon

Rationing
● Resorting to extraneous criteria
besides willingness to pay
● Official & unofficial schemes

Prohibitions
● Possess 0 quota/restrictions
● Black markets arise from penalizing
some voluntary exchanges

Price controls
● Can yield unintended consequences
● May lead to shortages, rations, black
markets

➔ Determine first if price ceiling/floor is

binding before computing
◆ Price floor above equilibrium
◆ Price ceiling below
equilibrium

Ex. Minimum wage & labor surplus

 ECON 100.1 NOTES
CHAPTER 23:
MEASURING A NATION’S INCOME
KEY MACROECONOMIC DATA
● GDP & GDP growth
● Inflation rate
● Unemployment rate
Gross domestic product (GDP)
● Measures the total income of a
everyone in an economy
● Measures the total expenditure on
the economy’s output of goods &
services
● Income must equal expenditure
○ Adding up total expenditure
by households
○ Adding up total income paid
by firms
● Measure well-being but not
necessarily prosperity
● Measured annually quarterly in the
PH
GROSS DOMESTIC PRODUCT
Market value of all final goods & services
produced within a country in a given amount
of time
Market value
● Market prices of goods & services
are used to compute for GDP
● If a good is worth twice as much as
another, then it contributes twice as
much to the GDP
All
● Includes all items produced in the
economy & sold legally in markets
● Includes market value of housing
services
● Excludes items produced &
consumed athome
○ Did not enter the marketplace
Intermediate good
● Used to produce final goods
● Prices are already included in the
prices of final goods
○ Only included in GDP if
added to a firm’s inventory for
use/sale at a later date
○ Taken as final for the time
being
Final good
● Prices are included in GDP
Produced
● Must have been produced within the
given time period
● Dos not include transactions
involvind previously made items
○ Transfer of ownership or
resale
Within a country
● Measures the value of production
within geographical confines
○ Includes foreign
nationals/businesses who
operate in a certain country
In a given period of time
● Within a specific interval
○ Yearly or quarterly
Seasonally-adjusted GDP
● Removes the effects of regular
events on total output
● Harvest season, Christmas shopping
Gross domestic income (GDI)
● Total income in an economy
○ Aside from total expenditures
as accounted for in GDP
● Statistical discrepancy
○ Difference between GDP &
GDI
Gross national product (GNP)
● Total income earned by a nation’s
permanent residents
○ Includes citizens abroad
 ECON 100.1 NOTES
Net national product (NNP) Gross value added
○
● Total income of a nation’s residents ■ Agriculture
minus losses from depreciation ■ Industry
■ Services
National income ● Income approach
● Total income earned by a nation’s ○ Employee compensation
residents in the production of goods ○ Proprietor’s income
& services ○ Rental income
● Almost identical to NNP ○ Net interest
○ Corporate profits
Personal income ○ Depreciation
● Income that households & ○ Production taxes, statistical
noncorporate businesses receive discrepancies, etc.
● Excludes retained earnings
○ Unlike national income Y = C + I + G + NX
● Subtracts business taxes, corporat
income taxes, social insurance COMPONENTS OF GDP
contributions ● Consumption (C)
● Investment (I)
Disposable personal income ● Government expenditures (G)
● Income left after satisfying ● Net Exports (NX)
obligations to the government
● Personal income minus personal Consumption
taxes & nontax payments ● Spending by households on goods &
○ Also removes depreciation services
○ Add transfer payments ○ Excludes new housing
● Durable goods, nondurable goods,
Human development index (HDI) services
● Composite score of socioeconomic
well-being of a population Investment
○ Life expectancy, mean years ● Spending on capital goods
of schooling, purchasing ○ Used to produce more goods
power parity & services
● Business capital, residential capital,
Stock inventories
● Total amount ○ Financial investments are not
● Ex. capital included in GDP

Flow Government expenditures

● Extra amount per unit of time ● Spending on goods & services by
● Ex. income national & local governments
○ Excludes government
APPROACHES TO COMPUTING GDP transfers
● Expenditure approach
○ Y = C + I + G + NX Net exports
○ NX = X - M ● Foreign purchases of domestically
● Production approach produced goods minus domestic
○ Y=A+I+S purchases of foreign goods
 ECON 100.1 NOTES
○ Exports minus imports

Nominal GDP
● Production of goods & services
valued at current prices

Real GDP Inflation

● Production of goods & services ● Steady increase in price levels over
valued at constant prices time
○ Adjusted for inflation
Rising inflation
● Accelerating prices

Deflation
● Decreasing prices

GDP deflator
● Measure of the price level relative to
a base year
● Ratio of nominal GDP to real GDP
times 100 Purchasing power of the peso (PPP)
● Measure of the real value of the peso
in a given period relative to a chosen
reference periodic

CAUSES OF INFLATION
● Cost push
● Demand pull
● Inflation expectations
● Monetary policy

Cost push
● When aggregate supply falls, leads
to an increase in equilibrium price
● Factors affecting production

Demand pull
● Changes in aggregate demand can
affect price levels
○ Consumption, Government
expenses, Investment, Net
exports
COMPOUND ANNUAL GROWTH RATE
Inflation expectations
● Expectations about future reduction
INFLATION
in purchasing power
 ECON 100.1 NOTES
● Firms demand higher wages/prices
to compensate

TYPES OF INFLATION
● Headline inflation
○ Changes in price levels of all
goods in CPI basket
● Core inflation
○ Similar to headline inflation
○ Excludes food & energy
prices in CPI basket
 ECON 100.1 NOTES
CHAPTER 24:
MEASURING THE COST OF LIVING
Consumer price index (CPI)
● Measure of the overall cost of goods
& services bought by a typical
consumer
○ Computation uses the same
quantity of goods in the fixed
basket
COMPUTING THE CPI
1. Fix the basket
2. Find the prices
3. Compute the basket’s cost
4. Choose a base year and compute
the index
5. Compute the inflation rate
● Percentage change in price index
from the preceding period
Core CPI
● Measure of the overall cost of
consumer goods & services
○ Excludes food & energy bc of
substantial short-run volatility
● Better reflects underlying inflation
trends
Producer price index (PPI)
● Measure of the cost of a basket of
goods & services bought by firms
PROBLEMS IN MEASURING CPI
● Substitution bias
○Change in prices is not
consistent or proportionate
○ Consumers respond by
buying different amounts of
certain goods
■ Buying less expensive
goods
● Introduction of new goods
○ Increased variety reduces the
cost of maintaining the same
level of economic well-being
○ Increased value of prices is
not reflected in CPI
● Unmeasured quality change
GDP DEFLATOR vs. CPI
● Inclusion of goods
○ GDP deflator reflects prices
of goods produced
domestically
○ CPI reflects prices of goods
bought by consumers
■ Includes imports
○ Oil price hike
■ CPI rises much more
than GDP
● Weight of values
○ CPI compares price of fixed
basket against a base year
○ GDP deflator compares the
price of currently produced
goods
■ Price of goods stay
relatively unchanged
○ Single yield number for the
overall level of prices
➔ When capacity to buy more
increases, greater purchasing power
➔ Vice versa for less purchasing power
● Smaller rate of inflation,
smalle increase in purchasing
power
Nominal interest rate
 ECON 100.1 NOTES
● Indicates how fast the amount of
money in personal savings rises over
time

Real interest rate

● How fast the purchasing power of
personal savings rises over time
 ECON 100.1 NOTES
CHAPTER 25: ● Quantity of goods & services
PRODUCTION AND GROWTH produced from each unit of labor
input

DETERMINANTS OF PRODUCTIVITY
● Physical capital
● Human capital
● Natural resources
● Technical knowledge

Capital
● Produced factor of production

Physical capital per worker

● Stock of equipment & structures
GENERAL EQUILIBRIUM MODEL used to produce goods & services

Total production Human capital per worker

● Depends on how much inputs there
are
● How such inputs are converte into
outputs
○ K = Capital
○ L = Labor
○ Often equated to an overbar
to denote fixed/given
amounts
__
Y = F (K , L) = Y
Production function
● Denotes technology
● Relates inputs & outputs
● Constant returns to scale (CRTS) is
assumed for simplicity
○ zY = F (zK , zL)
○ If all inputs increase by X%,
output increases by X%
● Increase in any one of the variables
(L,K) leads to a proportional increase
in Y
Productivity
● Knowledge & skills that workers
acquire through education, training,
experience
● Confers positive externalities
Natural resources per worker
● Inputs into production that are
provided by nature
○ Renewable & nonrenewable
Technological knowledge
● Society’s understanding of the best
ways to produce goods & services
○ Can be common or
proprietary
➔ Saving and investment are key
ingredients to long-run economic
growth
➔ When a country saves a large portion
of its GDP, more resources are
available for investment in capital
➔ Higher capital raises productivity &
living standards
Diminishing returns
● Diminishing marginal product of
capital
○ Marginal productivity of labor
 ECON 100.1 NOTES
■ To raise MPL, provide
more capital
■ A firm hires labor only
to the extent that
marginal profits are 0
○ Marginal productivity of
capital
● The benefit from an extra unit of
input declines as the quality of input
increases
○ As the stock of capital rises,
extra output produced from
an additional unit of capital
falls Catch-up effect
○ Giving workers additional ● Cet par. It is easier for a country to
capital only raises grow fast if it starts out relatively
productivity slightly poor
● Increase in saving rate leads ot ○ Small amounts of capital
higher growth only for a while investment can substantially
○ In the long run, higher saving raise productivity
rate leads to higher ○ Workers in rich countries
productivity & income have high productivity partly
○ But not higher growth in because of large amounts of
these variables capital
● World Bank encourages the flow of
capital to poor countries
○ International Monetary Fund

Foreign direct investment

● Capital investment that is owned &
opeated by a foreign entity

Foreign portfolio investment

SOLOW GROWTH MODEL ● Investment financed with
foreignmoney but operated by
domestic residents

Inward-oriented policies
● Aim to increase productivity & living
standards within the country by
avoiding interaction with the rest of
the world

Outward-oriented policies
● Integrating countries into the world
economy
ECON 100.1 NOTES
 ECON 100.1 NOTES
CHAPTER 26:
SAVING, INVESTMENT, THE
FINANCIAL SYSTEM

Consumption
● A micro choice that affects the
economy’s behavior in both th elong
& short runs
○ Long run = saving is key
determinant of economic
growth
○ Short run = consumption
determines aggregate
demand
■ Moves the needle of ● P = income
GDP
● Understanding consumption is Consumption function
important in explaining business ● C = Consumption
fluctuations ● Yd = disposable income
○ Income after taxes & transfers
● Consumption increases with
disposable income

Financial system
● Consists of all the institutions in the
economy that match one person’s
savings with another person’s
investment
● Distributes resources from savers to
borrowers
○ Financial markets
○ Financial intermediaries

Savers
● Supply their money to the financial
system
● Expect to get back their money with
interest at a later date

Borrowers
● Demand money from the financial
system
● Required to pay back with interest at
a later date

Financial markets
● Institutions through which a person
can borrow or directly supply funds
 ECON 100.1 NOTES
● Allow savers to directly interact with
borrowers
●
Bond
● Certificate of indebtedness
● Date of maturity
○ When the loan will be repaid
● Principal
○ Amount borrowed
● Term
○ Length of time until bond
matures
● Perpetuity
○ Bond thtat never matures
○ Pays interest forever but
principal is never repaid
● Credit risk
○ Probability that the borrower
will fail to pay some or the
interest or principal
○ Default = failure to pay
○ Borrowers can default on
their loans by declaring
bankruptcy
○ Higher risk, higher interest
rate
■ Vice versa
● Junk bonds
○ Pay very high interest rates
● Tax treatment
○ The way tax laws treat the
interest earned on the bond
○ Interest on most bonds is
taxable income
● Municipal bonds
○ Bonds issued by the
government
● Inflation protection
○ Most bonds are written in
nominal terms
○ Some bonds list terms
proportionately with respect
to inflation
Stock
● A claim to partial ownership in a firm
● Carry greater risk than bonds but
offer potentially higher returns
Stock index
● Computed as an average of a group
of stock prices
Equity finance
● Sale of stock to raise money
Debt finance
● Sale of bonds to raise money for new
investments
Financial intermediaries
● Financial institutions through which
savers can indirectly provide funds to
borrowers
FINANCIAL INTERMEDIARIES
● Banks
● Mutual Funds
Banks
● Takes in deposits from savers
○ Interest is earned on deposits
● Uses deposits to provide loans for
borrowers
○ Slightly higher interest is
charged
● Facilitate the purchase of goods &
services
○ Create a special asset that
people can use as a medium
of exchange
Medium of exchange
● Item that people can use to engage
in transactions
Mutual funds
● Sells shares to the public
● Uses proceeds to buy a portfolio of
various stocks, bonds, or both
○ Shareholder accepts all risks
& returns associated wih the
portfolio
 ECON 100.1 NOTES
● Allows people with small amounts of ○ For the economy as a whole
money to diversify their holdings
● Gives ordinary people access to the Private saving
skills of professional money ● Amount of income households have
managers left after paying for taxes &
consumption
Index funds
● Buy all the stocks in a given stock Public saving
index ● Amount of tax revenue the
● Perform somewhat better on average government has left after paying for
than mutual funds spending
● Keep costs low by buying & selling ● Budget surplus
rarely and not having to pay for ○ Excess of tax revenue
professional managers ○ (T - G) = +
● Budget deficit
○ Shortfall of tax revenue
○ (T - G) = -

SUPPLY = National savings

DEMAND = Investment demand

Closed economy
● Does not interact with other
economies
● No exports & imports

Open economies
● Interact with other global economies

Market for loanable funds

● Assumed to be the only financial
market in an economy
I=Y-C-G ● Market in which those who want to
S=I save supply & those who want to
S = (Y - T - C) + (T - G) borrow to invest demand funds
● Direct lending
National saving (S) ○ Buying a bond from a firm
● Total of private and public savings in ● Indirect lending
an economy ○ Making a bank deposit
● Saving = investment
 ECON 100.1 NOTES

Loanable funds
● All income that people have chosen
to save & lend out
● Sourced from savings & investments

➔ Interest rate takes on the price

function in supply & demand graphs
➔ If a reform of tax laws encouraged
greater saving, the result would be
lower interest rates & greater
investment
➔ If tax reform encouraged greater
investment, the result would be
higher interest rates & greater saving

Crowding out effect

● Rising public sector spending drives
down private sector spending

Present value
● Amount of money needed at present
to produce a future amount given
prevailing interest rates

Future value
● Amount of money in the future
produced by today’s money given
prevailing interest rates