TB Link : https://drive.google.

com/file/d/1KSQlhFMGCCSV8R4bOoIsRMnMtuhVOTc4/view

CH 23

Saving & Investment are functions of income and interest rates.

Saving is positively related to interest rates (incr in one leads to incr in another) while
investment is negatively related to interest rates (incr in one leads to decr in another)

- Macroeconomics Microeconomics definition

- SLUGGISH ECONOMY – a state in which growth is slow flat or declining. Results in

lower volumes of buying and selling and an overall decrease in the levels of saving
and investments.

- Repo rate : rate at which banks borrow money

- The economy’s income & expenditure

When judging whether the economy is doing well or poorly, it is natural to look at
the total income that everyone in the economy is earning. That is the task of gross
domestic product. GDP measures the total income of everyone in the economy and
the total expenditure on the economy’s output of goods and services. An economy’s
income is the same as its expenditure. In this economy, when
households buy goods and services from firms, these expenditures flow through
the markets for goods and services. When the firms use the money they receive
from sales to pay workers’ wages, landowners’ rent, and firm owners’ profit, this
income flows through the markets for the factors of production. Money continuously
flows from households to firms and then back to households.

- Measurement of GDP

1. GDP adds together many different kinds of products into a single measure of the
value of economic activity. To do this, it uses market prices.
2. It includes all items produced in the economy and sold legally in markets.
GDP excludes most items produced and sold illicitly, such as illegal drugs. It also
excludes most items that are produced and consumed at home and,
therefore, never enter the marketplace. Vegetables you buy at the grocery store
are part of GDP; vegetables you grow in your garden are not.
3. GDP includes only the value of final goods. This is done because the value of
intermediate goods is already included in the prices of the final goods. Adding
the market value of the paper to the market value of the card would be double
counting.
4. GDP includes both tangible goods & intangible services
5. GDP includes goods and services currently produced. It does not include
transactions involving items produced in the past.
 6. GDP measures the value of production within the geographic confines of a
country.
7. GDP measures the value of production that takes place within a specific interval
of time. Usually, that interval is a year or a quarter

- The difference between the two calculations of GDP is called the statistical
discrepancy.

COMPONENTS OF GDP

Y= C+I+G+NX
C = spending by households on g/s with exception of purchases of new housing.
I = spending on capital equipment inventories structures including household
purchases of new housing.
G = spending on g/s by local state federal govt
NX = spending on domestically produced goods by foreigners minus spending on
foreign goods by domestic residents

- Real GDP = production of g/s valued at constant prices

- nominal GDP = production of g/s valued at current prices

Numerical example

IS GDP A GOOD MEASURE OF WELL BEING?

No. GDP does not directly measure things that make our lives worthwhile but it does
measure the ability to obtain many of the inputs into a worthwhile life. GDP however
is not a perfect measure of well-being. It excludes:
1. Leisure
2. Values of almost all activities that take place outside markets
3. Value of goods & services produced at home
4. Quality of environment
5. Says nothing about distribution of income
CH 24

- Consumer price index definition slide 525 – measure of overall cost of g/s bought by
a consumer
- How is CPI calculated ?
1. Fix a basket : determine which price is more important among two products. If
one product is bought more than the other, it will be given greater weight.
2. Find prices : find price of each of the goods & services
3. Compute cost of basket : By keeping content of the baskets same, we only deal
with effects of price changes & not effects of quantity changes. (4a , 2b)
4. Choose base year and compute index
CPI = ( price of g/s in current year *100)/ price of basket in base year
5. Compute Inflation rate :

Infl Rate in yr2 = [( cpi in year 2- cpi in year 1)*100]/ cpi in year 1

- PRODUCER PRICE INDEX : measure of cost of a basket of g/s bought by firms

PROBLEMS IN MEASURING COST OF LIVING

1. SUBSTITUTION BIAS : consumers shifting from one good to another , a relatively

cheaper one due to rise in prices. If price index is computed assuming a fixed basket
of goods, it ignores the possibility of consumer substitution.

2. INTRODUCTION OF NEW GOODS: it facilitates wide variety to choose from and

this reduces cost of maintaining same level of economic well-being. CPI does not
reflect the increase in value of dollar that arises from introduction of new goods .

3. UNMEASURED QUALITY CHANGE : if the quality of good deteriorates while

price remains the same , the value of dollar falls , since you are getting a lesser good
for the same amount of money. If quality of good rises , value of dollar rises

GDP DEFLATOR VS CPI

The first difference is that the GDP deflator reflects the prices of all goods and
services produced domestically, whereas the CPI reflects the prices of all goods and
services bought by consumers. The second difference between the GDP deflator and the CPI
concerns how various prices are weighted to yield a single number for the overall
level of prices. The CPI compares the price of a fixed basket of goods and services
to the price of the basket in the base year. The GDP deflator compares the price of currently
produced goods and services to the price of the same goods and services in the base
year. Sometimes the two measures diverge. Whenever they diverge, we explain the
divergence with the help of these differences.
CORRECTING ECONOMIC VARIABLES FOR EFFECTS OF INFLATION
DOLLAR FIGURES FROM DIFF TIMES

Salary in 2012 $ = salary in 1931$ * (price lvl in 2012 / price lvl in 1931)
INDEXATION : correction by law of dollar amount for effects of inflation

REAL & NOMINAL INTEREST RATES

Higher the inflation rate, lower is the purchasing power.

Nominal int rate = the interest rate as usually reported without a correction for the effects
of inflation
Real interest rate = the interest rate corrected for the effects of inflation
Real int rate = nominal – inflation rate

Deposit 1000
Interest 100
Interest rate 10%
Amount = 1000 + 100 = 1100

To buy DVDs : the cost of DVD is 10

100 dvd with 1000 but after getting interest of 100,

1. 0% inflation = 1100/10 = 110 dvd

2. 6% inflation = 1100/6 = 103.7 dvd
3. 10% inflation = 1100/11= 100 dvd
4. 2% DEFLATION = 1100/ 9.8 = 112.24 dvd
5. 12% inflation = 1100/12 = 98.21 dvd

Q4 What is the significance of nominal interest rate and real interest rate? With the help of
example explain the relationship between inflation and real interest rate? With the help of an
example explain the relationship between real interest rate and savings. [1+2+2]

Answer: Chapter 24.2C Real and Nominal interest

Definition of Real and Nominal Interest rate

Nominal interest rate: the interest rate as usually reported without a correction for the effects
of inflation.

Real interest rate: the interest rate corrected for the effects of inflation.

Relationship between inflation and real interest: Negative relationship between the two.
When inflation is higher than was expected, the real interest rate is lower than expected.
Q4 Mr. Munim was an accountant in 1984 and earned Rs. 12,000 that year. His daughter Ms.
Milli is also an accountant and she earned Rs. 2,10,000 in 2019. The price index was 17.6 in
1984 and 218.4 in 2019. What do CPI of 1984 and 2019 indicate? Given this information,
how can we conclude whether father’s income is greater or daughter’s income is more?
Explain the rational/logic behind your response. [2+1+2]

Answer: Chapter 24.2a Dollar figure from different time

Salary in 2019 = Salary in 1984 × Price index in 2019 /Price Index in 1984

Salary in 2019 = Rs. 12,000 × (218.4/ 17.6).

Salary in 2019 dollars = Rs.148909

Daughter’s income is greater than father’s income.

Various factors are responsible for this, for instance, overall economic growth and increase in
living standard along with increase in CPI over a period of time.

The salary in 1984= Salary in 2019 × Price index in 1984 /Price Index in 2019

= 210,000 * (17.6 / 218.4)

= 16923.
CH 25

Productivity is the quantity of goods and services produced from each unit of labor input.

1. living standard is tied to productivity

2. productivity is the key determinant of living standards
3. growth in productivity is the key determinant of growth and living standards
4. nation can enjoy high standard of living only if it produces large quantities of g/s

DETERMINANTS :

⁃ physical capital : the stock of equipment and structures that are used to produce goods
and services
⁃ human capital : the knowledge and skills that workers acquire through education,
training, and experience
⁃ natural resources : the inputs into the production of goods and services that are
provided by nature
- technical knowledge : society’s understanding of the best ways to produce goods and
services

It is worthwhile to distinguish between technological knowledge and human

capital. Although they are closely related, there is an important difference. Technological
knowledge refers to society’s understanding about how the
world works. Human capital refers to the resources expended transmitting this
understanding to the labour force. Technological knowledge is the quality of society’s
textbooks, whereas human capital is the amount of time that the population has devoted to
reading them.

ECONOMIC GROWTH AND PUBLIC POLICY

1. Saving & investment – People face trade-offs because resources are scarce devoting
more resources to producing capital requires devoting fewer resources to producing
goods and services for current consumption. It requires that society sacrifice
consumption of goods and services in the present to enjoy higher consumption in
the future.

2. Diminishing returns : the property whereby the benefit from an extra unit of an
input declines as the quantity of the input increases. In other words, when workers
already have a large quantity of capital to use in producing goods and services, giving
them an additional unit of capital increases their productivity only slightly. an increase in the
saving rate leads to higher growth only for a while. As the higher saving rate allows more
capital to be accumulated, the benefits from additional capital become smaller over time,
and so growth slows down. In the long run, the higher saving rate leads to a higher level of
productivity and income but not to higher growth in these variables.
Catch up effect : the property whereby countries that start off poor tend to grow more
rapidly than countries that start off rich.
3. Investment from abroad (txb page 535) - takes several forms :
Foreign Direct Investment– capital investment owned & operated by foreign entity
Foreign Portfolio Investment – investment financed with foreign money but operated by
domestic residents
GDP - income earned by residents and non-residents within a country
GNP – income earned by residents both at home and abroad

4. Education : investment in human capital. In less developed countries the gap

between the wages of educated and un-educated workers is large. Investment in
human capital, like investment in physical capital, has an opportunity cost. When
students are in school, they forgo the wages they could have earned as members of
the labour force. An externality is the effect of one person’s actions on the well-
being of a bystander. Brain drain—the emigration of many of the most highly
educated workers to rich countries, where these workers can enjoy a higher
standard of living.

5. Health & Nutrition : expenditures that lead to a healthier population. Other things
being equal, healthier workers are more productive. Improved health from better
nutrition has been a significant factor in long-run economic growth. An insufficient
caloric intake can reduce the work effort the workers put forth. As nutrition
improves, so does their productivity. Height is also an indicator of productivity. Taller
the workers, better the productivity. Poor countries are poor because of unhealthy
population and the population isn’t healthy because the countries cant afford
adequate healthcare and nutrition. It is a vicious cycle.

6. Property Rights and Political Stability (slide 559) : market prices are the instrument
with which the invisible hand of the marketplace brings supply and demand into
balance in each of the many thousands of markets that make up the economy. An
important prerequisite for the price system to work is an economy-wide respect for
property rights. Property rights refer to the ability of people to exercise authority
over the resources they own. Economic prosperity depends in part on political
prosperity. A country with an efficient court system, honest government officials,
and a stable constitution will enjoy a higher economic standard of living than a
country with a poor court system, corrupt officials, and frequent revolutions and
coups.

(for point 7,8,9 refer slides after 559)

7. Free Trade : poor countries adopted inward oriented policies to achieve rapid
growth. Inward oriented policies attempt to increase productivity and living
standards within the country by avoiding interaction with the rest of the world. Most
economists today believe that poor countries are better off pursuing outward-
oriented policies that integrate these countries into the world economy.

8. Research & Development

9. Population growth : stretching natural resources , diluting capital stock , promoting

technological progress
 Q3 The total production function of an economy slopes upward. However, the
curve becomes flatter while moving from left to right. Give economic interpretations
of this properties. How do you relate this to that of developed and developing
countries? [3+2]

Answer: Diminishing returns and Catch-up Effect. (Chapter 25.3b)

Meaning of Production function: The production function of an economy describes the

relationship between the quantity of inputs used in production and the quantity of output from
production.
Diminishing returns: The property whereby the benefits from an extra unit of an input
declines as the quantity of the input increases.
The total production function of an economy slopes upward. However, the curve becomes
flatter while moving from left to right because of the Diminishing Returns.
Relate this with developed and developing countries: Catch-up effect.
Catch-up effect: the property whereby countries that start off poor tend to grow more rapidly
than countries that start off rich.

CH 26 (slide 571)

Financial System : the group of institution in the economy that help to match one person’s
saving with another person’s investment

financial markets : financial institutions through which savers can directly provide funds to
borrowers

Bond : is a certificate of indebtedness. It is an IOU that identifies the date of maturity, time
at which loan will be repaid and rate of interest. Sale of Bonds is called Debt Finance. 3
characteristics are –
1. BOND TERM : length of time until it matures. Can be for a few months or can have
long terms such as 30 years. Long term bonds are riskier because the holders have to
wait longer for the repayment of the principal amount.
2. CREDIT RISK – probability that the borrower will fail to pay some of the money be it
interest or principal. Such a failure is called default. Borrowers even default on their
loans by declaring bankruptcy.
3. TAX TREATMENT – the way in which tax laws treat the interest earned on the bond.
The interest is taxable so the bond owner will have to pay a portion of interest in
income taxes. Municipal bond owners are not required to pay federal income tax on
the interest income.
Stock : stock is a claim to partial ownership of firm. Sale of stock to raise money is called
Equity Finance. Stock index is average of group of stock prices. After a corporation issues
stock by selling shares to the public, these shares trade among stockholders on organized
stock exchanges. In these transactions, the corporation itself receives no money when its
stock changes hands.
When people become optimistic about a company’s future, they raise their demand for its
stock and thereby bid up the price of a share of stock.
Conversely, when people’s expectations of a company’s prospects decline, the price of a
share falls.

financial intermediaries - financial institutions through which savers can indirectly provide
funds to borrowers

Banks : primary job of banks is to take deposits and grant loans. Banks pay
depositors interest on their deposits and charge borrowers slightly higher interest
on their loans. The difference between these rates of interest covers the banks’
costs and returns some profit to the owners of the banks. They facilitate purchases of goods
and services by allowing people to write checks against their deposits and to access those
deposits with debit cards.

Mutual Funds : A mutual fund is an institution that sells shares to the

public and uses the proceeds to buy a selection, or portfolio, of various types of stocks,
bonds, or both stocks and bonds. The shareholder of the mutual fund accepts all the
risk and return associated with the portfolio. The primary advantage of mutual funds is that
they allow people with small amounts of money to diversify their holdings. Don’t put all
your eggs in one basket.
People who hold a diverse portfolio of stocks and bonds face less risk because they have
only a small stake in each company. Mutual funds make this diversification easy.

The mutual fund charges shareholders a fee, usually between 0.25 and 2.0 percent of assets
each year. Mutual funds give ordinary people access to the skills of professional money
managers. The managers of most mutual funds pay close attention to the developments and
prospects of the companies in which they buy stock. Mutual funds called index funds, which
buy all the stocks in a given stock index, perform somewhat better on average
than mutual funds that take advantage of active trading by professional money
managers.

Saving and Investment in Nation Income Accounting

Accounting refers to how various numbers are defined and added up. The rules of national
income accounting include several important identities. An identity is an equation that must
be true because of the way the variables in the equation are defined.

Y= c + i + g+ nx
A closed economy is one that does not interact with other economies. In particular, a closed
economy does not engage in international trade in goods and services, nor does it engage in
international borrowing and lending. Actual economies are open economies—that is, they
interact with other economies around the world. Because a closed economy does not
engage in international trade, imports and exports are exactly zero. Therefore, net exports
(NX) are also zero. We can now simplify the identity as

NX =0
Y = C + I + G.

Y–C–G=I
S=I
S= Y – C – G
S= ( Y-T-C) + (T-G)

Types of saving ^

Budget surplus :
Tax Rev > Govt
Spending
Budget deficit :
shortfall of TR < GS

What is a
government budget
deficit? How does it
affect (i) market
interest rates, (ii)
private investment
of an economy? Why? [2+2+1]

Government budget deficit is the excess of government expenditure over its income which
mainly come from tax and non-tax revenue. The government relies on borrowing from the
financial market, to meet the budget deficit and hence the demand for loanable funds
increases. While the supply of loanable funds being constant, increase in demand of loanable
funds leads to increase in market interest rate. Thus an increase in budget deficit results in an
increase in market interest rate.

The higher interest rates in markets increases the cost of borrowing for private investors and
hence private investments will be discouraged. Thus increase in government deficit results in
crowding out of the private investment.

Supply of loanable funds : The supply of loanable funds comes from people who have extra
income that they want to lend out and the demand comes from households and firms who wish to
borrow to make investments. Saving is the source of supply of loanable funds, investment is the
source of demand and interest rate is the price of the loan. A high amount of interest rate makes
borrowing more expensive, the quantity of loanable funds demanded falls as the interest rate rises.
Similarly, because a high interest rate makes saving more attractive, the quantity of loanable funds
supplied rises as the interest rate rises. Therefore, the supply and demand for loanable funds depend
on the real (rather than nominal) interest rate.

POLICIES THAT MAY IMPROVE THE SITUATION :

1. Saving incentives : it increases the supply of loanable funds. Lower the interest rate, greater the
investments. Thus, if a reform of the tax laws encouraged greater saving, the result would be lower
interest rates and greater investment.

2. Investment Incentives : it increases the demand for loanable funds. If the passage of an investment
tax credit encouraged firms to invest more, the demand for loanable funds would increase. As a
result, the equilibrium interest rate would rise, and the higher interest rate would stimulate saving.

3. Government Budget Deficits and Surpluses : When the government spends more than it receives in
tax revenue, the resulting budget deficit lowers national saving. The supply of loanable funds
decreases, and the equilibrium interest rate rises. Thus, when the government borrows to finance its
budget deficit, it crowds out households and firms that otherwise would borrow to finance investment.
 CH 28

- How is unemployment measured?

1. Employed : This category includes those who worked as paid employees,
worked in their own business, or worked as unpaid workers in a family member’s
business. Both full-time and part-time workers are counted. This category also
includes those who were not working but who had jobs from which they were
temporarily absent because of, for example, vacation, illness, or bad weather.

2. Unemployed: This category includes those who were not employed, were
available for work, and had tried to find employment during the previous four
weeks. It also includes those waiting to be recalled to a job from which they had
been laid off.

3. Not in the labour force: This category includes those who fit neither of the first
two categories, such as full-time students, homemakers, and retirees.

LF = no. of employed + no. of unemployed

Unemployment rate = (no of employed * 100 ) / labour force

Labour force participation = (labour force * 100) / adult population

- Definitions on slide 608 – labour force, unemployment rate, labour force

participation rate

Natural rate of unemployment : the normal rate of unemployment around which the
unemployment rate fluctuates

Cyclical unemployment : the deviation of unemployment from its natural rate

- Does the Unemployment Rate Measure What We Want It To?

People move into and out of the labor force so often, statistics on
unemployment are difficult to interpret. On the one hand, some of those who
report being unemployed may not, in fact, be trying hard to find a job. They may
be calling themselves unemployed because they want to qualify for a government
program that gives financial assistance to the unemployed or because they are
working but paid “under the table” to avoid taxes on their earnings. On the other
hand, some of those who report being out of the labor force may want to work.
These individuals may have tried to find a job and may have given up after an
 unsuccessful search. Such individuals, called discouraged workers, do not show up in
unemployment statistics, even though they are truly workers without jobs.
Because of these and other problems, the BLS calculates several other measures
of labor underutilization, in addition to the official unemployment rate.

- How Long Are the Unemployed without Work?

If unemployment is short-term, one might conclude that it is not a big problem.
Workers may require a few weeks between jobs to find the openings that best suit
their tastes and skills. Most spells of unemployment are short, but most unemployment
observed at any given time is long-term. Economists and policymakers must be careful
when interpreting data on unemployment and when designing policies to help the
unemployed. Most people who become unemployed will soon find jobs.
Yet most of the economy’s unemployment problem is attributable to the relatively
few workers who are jobless for long periods of time.

- Why Are There Always Some People Unemployed?

In most markets in the economy, prices adjust to bring quantity supplied and quantity
demanded into balance. In an ideal labor market, wages would adjust
to balance the quantity of labor supplied and the quantity of labor demanded. This
adjustment of wages would ensure that all workers are always fully employed. The
unemployment rate never falls to zero; instead, it fluctuates around the natural rate of
unemployment. It takes time for workers to search for the jobs that are best suited for
them. (Explain the concept of frictional & structural unemployment)
frictional unemployment - unemployment that results because it takes time for workers to
search for the jobs that best suit their tastes and skills

structural unemployment : unemployment that results because the number of jobs available
in some labor markets is insufficient to provide a job for everyone who
wants one

job search the process by which workers find appropriate jobs given their tastes
and skills

- Why Some Frictional Unemployment Is Inevitable

different regions of the country produce different goods, employment can rise in one region
while it falls in another. Changes in the composition of demand among industries or regions
are called sectoral shifts. Frictional unemployment is inevitable simply because the
economy is always changing. As the transition takes place, jobs are created in some firms
and destroyed in others. The result of this process is higher productivity and living
standards. But along the way workers in declining industries find themselves out of work
and in search of new jobs.

- Public policy & job search

Facilitated through – internet, public policy and government programs
The Internet, for instance, may help facilitate job search and reduce frictional
unemployment. In addition, public policy may play a role. If policy can reduce the
time it takes unemployed workers to find new jobs, it can reduce the economy’s
natural rate of unemployment. Government programs try to facilitate job search in
various ways. One way is through government-run employment agencies, which give
out information about job vacancies. Another way is through public training
programs, which aim to ease workers’ transition from declining to growing industries
and to help disadvantaged groups escape poverty.

UNEMPLOYMENT INSURANCE
a government program that partially protects workers’ incomes when they become
unemployed. People respond to incentives. Because
unemployment benefits stop when a worker takes a new job, the unemployed
devote less effort to job search and are more likely to turn down unattractive
job offers. In addition, because unemployment insurance makes unemployment
less onerous, workers are less likely to seek guarantees of job security when they
negotiate with employers over the terms of employment. When unemployed
workers applied to collect unemployment insurance benefits, the state randomly
selected some of them and offered each a $500 bonus if they found new jobs within
11 weeks. The design of the unemployment insurance system
influences the effort that the unemployed devote to job search. Unemployment
insurance benefits, run out after 6 months or 1 year. Unemployment rate is
an imperfect measure of a nation’s overall level of economic well-being. Most
economists agree that eliminating unemployment insurance would reduce the
amount of unemployment in the economy.
MINIMUM WAGE LAWS
The number of jobs is insufficient for the number of workers. Minimum wage law
enforces minimum wage to remain above the level that balances the demand and
supply. This raises quantity supplied of labour and reduces the quantity demanded
of labour. There is a Surplus of labour because there are more workers willing to
work than there are jobs so some workers are unemployed.

Unions : a worker association that bargains with employers over wages, benefits,
and working conditions

Collective bargaining : the process by which unions and firms agree on the
terms of employment

Strike : the organized withdrawal of labor from a firm by a union

When unions raise wages above the level that would prevail in competitive markets,
they reduce the quantity of labor demanded, cause some workers to be
unemployed, and reduce the wages in the rest of the economy. The resulting
allocation of labor is, critics argue, both inefficient and inequitable. It is inefficient
because high union wages reduce employment in unionized firms below the
efficient, competitive level. It is inequitable because some workers benefit at the
expense of other workers. Advocates of unions also claim that unions are important
for helping firms respond efficiently to workers’ concerns. In the end, there is no
consensus among economists about whether unions are good or bad for the
economy. Like many institutions, their influence is probably beneficial in some
circumstances and adverse in others.

THEORY OF EFFICIENCY WAGES :

According to this theory, firms operate more efficiently if wages
are above the equilibrium level. Therefore, it may be profitable for firms to keep
wages high even in the presence of a surplus of labor. efficiency wages are above-
equilibrium wages paid by firms to increase worker productivity. There are several
types of efficiency-wage theory. Each type suggests a different explanation for why
firms may want to pay high wages.

1. Worker Health : Better-paid workers eat a more nutritious diet, and workers who
eat a better diet are healthier and more productive.
2. Worker turnover : Workers quit jobs for many reasons: to take jobs at other
firms, to move to other parts of the country, to leave the labor force, and so on.
The frequency with which they quit depends on the entire set of incentives they
 face, including the benefits of leaving and the benefits of staying. The more a
firm pays its workers, the less often its workers will choose to leave. Thus, a firm
can reduce turnover among its workers by paying them a high wage.

3. Worker Quality : All firms want workers who are talented, and they strive to pick
the best applicants to fill job openings. But because firms cannot perfectly gauge
the quality of applicants, hiring has a degree of randomness to it. When a firm
pays a high wage, it attracts a better pool of workers to apply for its jobs and
thereby increases the quality of its workforce.

4. Worker Effort : In many jobs, workers have some discretion over how hard to
work. As a result, firms monitor the efforts of their workers, and workers caught
shirking their responsibilities are fired. paying wages above the equilibrium level.
High wages make workers more eager to keep their jobs and thus motivate them
to put forward their best effort.
Ch 29

Money : set of assets that people use to buy g/s from other people
Example – cash in your wallet

Functions of money :
1. Medium of exchange – the item buyers give to sellers when they want to purchase
g/s
2. Unit of account – yardstick people use to post prices and record debts. When we
want to measure and record economic value we use money as unit of account
3. Store of value – item that people use to transfer purchasing power from present to
future

Wealth is total of all stores of value including both money and non-monetary assets.

Liquidity is the ease with which an asset can be converted into the economy’s medium of
exchange

Kinds of money :
1. Commodity money – takes the form of a commodity with intrinsic value
Intrinsic value : item will have a value even when it is not used as money (jewellery- gold
because earlier gold coins were used as money as it was easy to carry measure and verify
for impurities)
Another example is cigarettes.

Gold standard is when economy uses gold as money or uses paper money that is convertible
into gold on demand.

2. Fiat money – money without intrinsic value used as money because of govt decree.
Example is comparing the paper money in your wallet ( USD or rupee) and
monopoly paper dollar money. US government has decreed the dollars to be valid
money.

Currency refers to the paper bills and coins in the hands of public. Most widely accepted
medium of exchange and is a part of money stock.

Demand Deposits (DD) – balances in bank accounts that depositors can access on demand
by writing a cheque / check or swiping debit card at a store.

M1 : demand dep , traveller’s checks, other checkable deposits, currency

M2 : saving dep, small time dep, money market mutual funds, few minor categories ,
everything in M1.
FEDERAL RESERVE SYSTEM
Federal reserve (fed) is the central bank of US
Central bank : institution that supervises the banking system and regulates the quantity of
money in an economy.

Jobs of the FED

1. Regulate banks and ensure the health of banking system. It acts as a bank’s bank and
lender of the last resort.
2. Controls quantity of money that is made available in the economy – money supply.
Monetary policy is settling of money supply by policy makers in central bank.
Monetary policy is made by FOMC (federal open market committee)
Money supply is the quantity of money available in the economy.

How fomc works :

Made up of 7 members of the board of governors and 5 of the 12 regional bank presidents.
They all attend the meeting but only 5 get to vote. The 5 with voting rights rotate among the
12 regional presidents over time. The president of New York Fed always gets a vote.
Through the decisions of the FOMC the Fed has the power to increase or decrease the
number of dollars in an economy. Fed’s primary tool is open market operations – purchase
and sale of US govt bonds. If fomc decides to increase the money supply, Fed creates dollars
and uses them to buy govt bonds from public in the nation’s bond markets. Next, these
bonds are in the hands of the public. Conversely if fomc decides to decrease the money
supply, Fed sells govt bonds from its portfolio to the public in the nation’s bond markets.
After the sale, the bonds are out of the hands of the public so fed decreases money supply.

BANKS & MONEY SUPPLY (pg 617 – 619)

Reserves are deposits that banks have received but they haven’t loaned them out.

1. 100% reserve : deposits that banks have received but haven’t loaned out are called
reserves. In this economy, all deposits are held as reserves so its called 100 percent
reserve banking.
2. Fractional reserve banking system : banks hold only a fraction of deposits as
reserves. The fraction of total deposits that banks hold as reserve is called reserve
ratio. When banks hold only a fraction of deposits in reserve, the banking system
creates money.
3. The money multiplier : amount of money the banking system generates with each
dollar of reserves. Money multiplier is the reciprocal of reserve ratio. If R is the ratio
of reserves to deposits at each bank then the ratio of deposits to reserves in the
banking system must be 1/R. Thus, the higher the reserve ratio, the less of each
deposit banks loan out, and the smaller the money multiplier.

Original deposit – 100

First – ( 100 * 0.9) = 90 // Second – (90 * 0.9) = 81 // Third – (81 * 0.9) = 72

Pg 620
Bank capital leverage and the financial crisis
CH 30

30-1-a
Level of prices & value of money
When cpi and other measures of price lvl rise, commentators often look at many individual
price s that make up these price indexes.
Inflation is an economy wide phenomenon that concerns the value of the economy’s
medium of exchange. Price level is the measure of value of money. Rise in price level implies
that the value of money has decreased because now each dollar buys smaller quantity of
goods and services. If P is the price of g/s measured in terms of money, 1/P is the value of
money measured in terms of g/s.
When the overall price level rises, value of money falls.

30-1-b
Money Supply, Money Demand, Monetary equilibrium
Supply and demand determine the value of money.
1. Money supply – when Fed sells bonds in open market operations, it receives dollars
in exchange and contracts money supply. Similarly when fed buys govt bonds, it
expands money supply. If the dollars are deposited into bank, holding some as
reserves and loaning out the rest, the money multiplier swings into action and the
OMO has a greater effect on money supply.
2. Money demand – demand for money shows how much wealth people want to hold
in liquid form. The quantity of money demanded depends on the interest rate that a
person could earn by using the money to buy an interest bearing bond rather than
leaving it in a wallet or low interest checking account.

In the long run, money supply and money demand are brought into equilibrium by overall
level of prices. If price level is below equilibrium, people will want to hold less money than
the fed has created and if it is above equilibrium, people will want to hold more money than
the fed has created. Consequently, the price level must rise or fall to balance the money
demand and money supply. At equilibrium price level, quantity of money people want to
hold balances the quantity of money fed has created and supplied.

Graph and explanation on page 637

30-1-c
Effects of monetary injection
fed could inject money into the economy by buying some govt bonds from the public in
OMO. The monetary injection shifts the supply curve to the right and the equilibrium point
also moves. As a result the equilibrium price level increases. When an increase in money
supply makes dollars more plentiful , the result is an increase in the price level that makes
each dollar less valuable. According to the quantity theory of money, the quantity of money
available in the economy determines the price level and the growth rate in the quantity of
money available determines inflation rate.

30-1-d
adjustment process
before the injection , the economy was in equilibrium. But after the injection , people have
more dollars in their wallets than they want. at prevailing price level the quantity of money
supplied exceeds the quantity of money demanded. People try to get rid of this excess supply
of money by either buying new goods and services or make loans to others by buying bonds
or by depositing the money in the banks in savings account. The economy’s output of goods
and services is determined by physical capital , human capital , available labor , natural
resources and technological knowledge but these remain unchanged during the injection of
money. Thus the greater demand for goods increases prices which in turn increases quantity
of money demanded.

30-1-e
Classical dichotomy and money neutrality – David Hume
economic variables are divided into nominal variables and real variables.
nominal - measured in monetary units (income of corn farmers)
real - measured in physical units (quantity of corn they produce)
Nominal GDP is a nominal variable because it measures dollar value of the economy’s output
of goods and services while
real GDP is a real variable because it measures the total quantity of goods and services
produced and it isn’t influenced by The current prices of goods and services.
the separation of these two variables is called classical dichotomy - theoretical separation of
nominal and real variables.
Money neutrality means that changes in the money supply will not affect real variables

Is monetary neutrality realistic? not completely because a change in the length of yardstick
would not matter in the long run. over short periods of time, monetary changes do affect real
variables. Over the course of a decade , monetary changes have significant effects on nominal
variables but only negligible impact on the real variables.

30-1-f
velocity and quantity equation
velocity of money is the rate at which money changes hands.
V = (P x Y) / M
economy produces 100 pizzas in a year and it sells for $10 and the quantity of money id $50
then velocity is
V = (10*100) / 50
= 20

MxV=PxY
relates the quantity of money, the velocity of money and the dollar value of the economy’s
output of goods and services.

1. velocity of money is stable over time

2. central bank changes the quantity of money and it causes proportionate changes in the
nominal value of output
3. Y is determine by factor supplies and technology and so money is neutral and it does
not affect output
4. with output (Y) determined by factor supplies and technology when the central bank
alters money supply (M) and induces proportional changes in the nominal value of output (P
x Y) these changes are reflected in changes in the price level (P)
5. when central bank increases money supply rapidly it results in high rate of inflation

30-1-g
inflation tax
govt use money creation as a way to pat for their spending. For this it has to raise necessary
funds. The govt does this by levying taxes such as income tax sales tax, borrowing from the
public by selling bonds etc. When govt raises revenue by printing money it is said to levy an
inflation tax. when govt prints money, price level increases and the dollars become less
valuable. inflation tax is a tax on everyone who holds money.

30-1-h
fisher effect
nominal interest rate is the interest rate you hear about at your bank while real interest rate
corrects the nominal interest rate for the effect of inflation to tell you hoe fast the purchasing
power of your savings account will rise over time.
real int rate = nominal int rate - inflation rate
nominal int rate = real int rate + inflation rate

supply and demand for loanable funds determine the real interest rate and growth in money
supply determines the inflation rate. In the long run when money is neutral, change in money
growth shouldn’t affect the real interest rate. For real interest rate to be unaffected , nominal
interest rate must adjust one for one to changes in the inflation rate. When Fed increases the
rate of money growth , in the long run the inflation rate and nominal interest rate both are
high.
This adjustment is called fisher effect
It however need not hold in the short run because inflation may be unanticipated.

COSTS OF INFLATION
1. fall in purchasing power
2. shoeleather costs - tax isnt a cost to the society. it gives an incentive to the people to
not avoid paying taxes and this distortion of incentive itself is known as deadweight
losses. Shoeleather cost refers to the resources wasted when inflation encourages
people to reduces their money holdings.
3. menu costs - the cost of changing prices.
4. relative price variability and misallocation of resources- consumers decide what to
buy after comparing quality and prices of various goods. Prices only change once in a
while and inflation causes relative prices to vary more than they otherwise would.
When inflation distorts relative prices , consumer decisions are also distorted and
markets are less able to allocate resources to their best use
5. inflation induced tax distortion
6. confusion and inconvenience
7. special cost of unexpected inflation - arbitrary redistribution of wealth
8. inflation is bad but deflation is worse