ABSOLUTE ADVANTAGE

-Individual: exists when a person can produce more of a certain good/service than someone else in the same amount of time or can produce a good using the least amount of resources.
-National: exists when a country can produce more of a good/service than another country in a given time.

COMPARATIVE ADVANTAGE

-A person has a comparative advantage in the production of a product when it can produce at a lower domestic opportunity cost than a trading partner.

EXAMPLES OF OUTPUT

Tons/acres
Miles/gallon
Apples/tree
Televisions produced per hour

EXAMPLES OF INPUT

Number of hours to do a job.
Number of acres to feed a horse
Number of gallons of paint to paint a house

SPECIALIZATION AND TRADE

-Gains from trade are based on comparative advantage not absolute advantage.

Mechanisms of foreign exchange 

Foreign exchange 

-The buying and selling of currency 

-Any transaction that occurs in the balance of payment necessitates foreign exchange.

-The exchange rate is determined in the foreign currency market.

Changes in exchange rate

Exchange rates are a function of the supply and demand for currency.

-An increase in the supply of a currency will decrease the exchange rate of a currency.

-A decrease in supply of a currency will increase the exchange rate.

-An increase in demand of a currency will increase the exchange rate of a currency.

-A decrease in demand of a currency will decrease the exchange rate of a currency.

Appreciation and Depreciation 

-Appreciation of a currency occurs when the exchange rate of that currency increases.

-Depreciation of a currency occurs when the exchange rate of that currency decreases.

Exchange rate determinants 

Consumer tastes 

Relative income 

Relative price level

Speculation 

Exports and imports 

-The exchange rate is a determinant of both exports and imports.

-Appreciation of the dollar causes American goods to be relatively cheaper thus reducing exports and increasing imports.

-Depreciation of the dollar causes American goods to be relatively cheaper and foreign goods to be more expensive thus increasing exports and reducing imports.

BALANCE OF PAYMENTS

-Measure of money inflows and outflows between the U.S. and the rest of the world.

 *Inflows are referred to as CREDITS.

 *Outflows are referred to as DEBITS.

-The balance of payments is divided into 3 accounts:

 *Current account.

 *Capital/financial account.

 *Official reserves account.

CURRENT ACCOUNT

Balance of trade or net exports

-Exports of goods and services – import of goods and services.

-Exports create a debit to the balance of payments.

Net foreign income

-Income earned by U.S. owned by foreign assets – income paid to foreign held U.S. assets.

Net transfers

-Foreign aid -> a debit to the current account.

CAPITAL/FINANCIAL ACCOUNT

-The balance of capital ownership.

-Includes the purchase of both real and financial assets.

-Direct investment in the U.S. is a credit to the capital account.

-Purchase of foreign financial assets represents a debit to the capital account.

-Purchase of domestic financial assets by foreigners represents a credit to the capital account.

RELATIONSHIP BETWEEN CURRENT AND CAPITAL ACCOUNT

-The current account and the capital account should zero each other out.

-That is if the current account has a negative balance (deficit), then the capital account should have a positive balance (surplus).

OFFICIAL RESERVES

-The foreign currency holding of the U.S. Federal Reserve System.

-When there is a balance of payments surplus, the FED accumulates foreign currency and debits the balance of payment.

-When there is a balance of payment deficit, the FED depletes its reserves of foreign currency and credits the balance of payments.

-The official reserves zeros out the balance of payment.

ACTIVE VS PASSIVE OFFICIAL RESERVES

-The U.S. is passive in its use of official reserves. It does not seek to manipulate the dollar exchange rate.

THE PHILLIPS CURVE

Original SR Phillips Curve
Inflation and unemployment	Inverse relationship.
Inflation	It increases as the economy expands.
Recession	Unemployment increases as the economy slows down.
Along the curve	Cyclical change in the GDP.
Stagflation
Late 1970s to 1981	Increasing inflation and unemployment at the same time.
Data?
A New Philips Approach
New range?	The SRPC can move inward and outward.
Cost push inflation	More stress on resources, wages and input costs.
Supply shocks	Rapid loss of resources or rapid increase in resource cost.
SRPC curves moves	Outward during shocks.
SRPC moves back	Inward as the society increases productivity or regains resource.
Long Run Philips Curve
Inflation	Society adjusts for cost/wage increases with new prices.
LRPC is?	The efficient PPF.
Natural rate of unemployment	Becomes the equivalent of full employment rate.
Phillips and AD/AS curves
Change points on SRPC	If AD changes, you move the points on the curve.
Move the SRPC	You shift the curve of the SRPC.

THE LONG RUN PHILLIPS CURVE

-Because the long run Phillips curve exists at a natural rate of unemployment (Un), structural changes in the economy that affects Un will cause the LRPC to shift.

-Increases in Un will shift LRPC ->.

-Decreases in Un will shift LRPC <- (Low inflation -> high unemployment).

Relating Phillips curve to AS/AD

-Changes in the AS/AD model can also be seen in the Philips curve.

Misery index

-a combination of inflation and unemployment in any given year. Single digit misery is good.

Supply shocks

-this is the rapid and significant increase in resource cost.

Disinflation

-this is reduction in inflation from year to year or over time. It is found in the LRPC.

Deflation

-general decline in price.

SUPPLY SIDE ECONOMY

-changes in AS and not AD are the main active force in determining the level of inflation, unemployment rates and economy growth.

Supply side economists

-supports policies that promote GDP growth by arguing that high marginal tax rates along with the current system of transfer payment such as unemployment compensation or welfare programs provide disincentive to work , invest, innovate and undertake entrepreneurial ventures.

INCENTIVES TO SAVE AND INVEST

1)      High marginal taxes reduce the revenues for savings and investments.

2)      Consumption might increase but investments depend upon savings.

3)      Lower marginal tax rates encourage savings and investments.

LAFFER CURVE

-theoretical relationship between tax rates and tax revenues. As tax rates increase from zero, tax revenues increase from zero to some maximum level and then decline.

CRITICISM TO THE LAFFER CURVE

1)      Evidence suggests that the impact of tax rates on incentives to work, save and invest is small.

2)      Tax cuts increase demand which can fuel inflation and demand may exceed supply.

CROWDING OUT

What is it? 

-A critique and flaw of Keynesian policies that are applied to fight a recession (expansionary policy).

Why does it happen?

-The policy of cutting taxes and raising spending will create a budget deficit.

So?

-The budget deficit must be funded and to do this congress orders the sale of US bonds.

This money comes from?

-Money comes from US citizens and companies and investment firms.

Therefore?

-Money that could be spent on consumption or used for private savings is now being used to buy bonds.

On the money market?

-This will cause the  money demand curve to shift outward.

On the loan-able funds?

-This will cause the supply curve to shift inward because the are not saving money privately anymore.

On both graphs?

-The nominal and real interest rate will increase.

Therefore, on the investment D graph?

-The increase in nominal and real interest rates will cause Ig to decrease.

Isn't this counterproductive?

-Yes.

Why do it?

-Fiscal policy supporters insist that gains in C and G will outweigh any loss in future Ig.

Why?

-C and G are greater than Ig and they are short run improvements. Ig is longer run and Keynesian don't worry about that. In the long run we are all dead.

Anymore?

-Yes, this is summarized on the aggregate model. The AD will move outward due to the increases in C and G and then "maybe" move inward due to the loss of Ig, but not as much as the increase. Therefore the economy improves.

COUNTER-CYCLICAL POLICIES: KEYNESIAN FISCAL POLICY VS. MONETARY POLICY

MONETARY TOOLS

1) Reserve requirement

    -Only a small percent of your bank deposit is in the safe. The rest of the money has been loaned out. This      is called "Fractional Reserve Banking". The FED sets the amount that the banks must hold. The                   RR(reserve ratio) is the % of deposits that banks must hold and not loan out.
  -When the FED increases money supply(MS), it increases the amount of money held in bank deposits.

If there is a recession, the FED should decrease the RR:

1) Banks hold less money and have more excess reserves.
2) Banks create more money by loaning out excess reserves.
3) MS increases, interest rates fall, AD goes up.

If there is inflation, FED should increase the RR:

1) Banks should hold more money and have less ER.
2) Banks create less money.
3) MS decreases, interest rates up, D down.

2) Discount rate

    -This is the interest rates that FED charges commercial banks.
    -To increase the MS, the FED should decrease the discount rate (easy money policy).
    -To decrease MS, the FED should increase the discount rate (tight money supply).
    -Only member banks are entitled to the discount rate.

3) Open market operations

    -The FED buys/sells government bonds(securities),
    -This is the most important and widely used monetary policy.
    -To increase the MS, the FED buy government securities.
    -To decrease the MS, the FED sell government securities.
    -Buying bonds = bigger MS, selling bonds = smaller MS.

Federal funds rate

-This is where FDIC member banks loan each other overnight funds.

Prime rate

-This is the interest rate that banks charge their most credit worthy customer.

When a customer deposits or withdraws cash from their demand deposit account, it has no effect on money supply. It only changes:

1) The composition of money
2) Excess reserves.
3) Required reserves.

Single bank

-Loan from your excess reserves (ER).

Banking system

-ER * multiplier (total money supply).

Anytime the FED buys or sells bonds, ER is created. 

BANKS AND THE CREATION OF MONEY

How do banks create money?

*By lending out deposits(money).

Where do loans come from?

*Loans come from depositors who take cash and place it in accounts at the banks.

How are the amounts of potential loans calculated?

*They are calculated by using a T-Account that consists of assets and liabilities.

Banks liabilities(the right side of the T-Account sheet):

*Demand deposits: these are cash deposits from the public, they are a liability because they belong to             depositors and can be withdrawn by depositors.
*Owner's Equity: values of stocks held by the public ownership of bank shares.

Key Concept for AP concerning liabilities:

1) If the DD comes in from someone's cash holdings then that DD is already part of the money supply.
2) If the DD comes in from the purchase of bonds(by the FED) then it creates new cash and therefore               creates new money supply.

Bank assets(the left side of the T-Account sheet):

1) Required reserves(RR): These are the percentages of DD that must be held in the vault so that some            depositors have access to their money. it is usually 5%, 10%, 20% but in reality is 10% or below.
2) Excess reserves(ER): They are source for new loans.
3) Property.
4) Securities(bonds): Securities are bonds purchased by the bank. These could be bonds purchased by the       FED.
5) Loans: These can be amounts held by banks from previous transactions owed to the bank by prior               customers.

Money creation (using excess reserves)

*Banks want to create profits.

The money multiplier (also known as):

*The loan multiplier.
*Reserve multiplier.
*Check-able deposit multiplier.

The formula is:

*1 divided by the reserve requirement ratio (1/RR).
Excess reserves are multiplied by the multiplier to create new loans for the entire banking system and this creates new money supply.