Absolute and Comparative Advantage

Absolute Advantage

• Individual- 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- When a country can produce more a good/service than another country can in the same time period.

Comparative Advantage

• A person or a nation has a comparative advantage when it can produce the product at a lower domestic opportunity cost than can a trading partner.
• Examples of output problems
• Words per minute
• Miles per gallons
• Tons per acre
• Apples per tree
• Televisions produced per hour
• Examples of input problems
• 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.

Mechanics of the Foreign Exchange (FOREX)

• Buying and selling of currency. 
• Any transaction that occurs in the balance of payments necessitates foreign exchange.
• The exchange rate (e) is determined in the foreign currency markets.

 Changes in exchange rates

• Exchange rates (e) are a function of the supply and demand for currency. 
• Increase in the supply of a currency will decrease the exchange rate of a currency. 
• Decrease in supply of a currency will increase the exchange rate of a currency.
• Increase in demand for a currency will increase the exchange rate of a currency.
• Decrease in demand for a currency will decrease the exchange rate of a currency

Appreciation and depreciation

• Appreciation occurs when exchange rate of that currency increases. (e increases)
• Depreciation occurs when exchange rate of that currency decreases (e decreases)
• Determinants of Exchange rate:
• Consumer tastes (buyers taste)
• 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 more expensive and foreign 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 relatively more expensive, thus increasing exports and reducing imports.
• As two currencies trade:
• One supply line will change; the other demand line will change.
• They will move in the same direction.
• One currency will appreciate, the other will depreciate.
• Flexible rate - Based on the supply and demand of that currency versus the other currency. It is very sensitive to the business cycle and it provides options for investment.
• Fixed rate - Based on country's willingness to distribute currency and to control the amount.

Balance of Payments

The Balance of Payments

• Measures of money inflows and outflows between the united states and the rest of the world (ROW).
• Inflows = credits
• Outflows = debits
• The balance of payment is divided into three accounts:
• Current account
• Capital/financial account
• Official reserves account

Current account

•  Balance of trade or Net exports
• Exports of goods/services- import of goods/services.
• Exports create a credit to the balance of payments.
• Imports create a debit to the balance of payments.
•  Net foreign income
• Income earned by the U.S. owned foreign assets
• Interest payments on U.S. owned foreign assets- Interest payments on German-owned U.S treasury bonds.
•  Net transfers (tend to be Unilateral)
•  Foreign aid- a debit to the current account.
•  Ex - Mexican migrant worker sends money to family.

Capital / Financial Account

• The balance of capital ownership.
• Includes the purchase of both real and financial assets
• Direct investment in the United States is a credit to the capital account.
• For example the Toyota company in San Antonio.
• Direct investment by United States firms/individuals in a foreign country are a debit to the capital account.
• Intel factory construction in Germany
• Purchase of foreign financial assets represents a Debit to the capital account. 
• Warren buffets buys stock in Petrochina.
• Purchase of domestic financial assets by foreigners represents a credit to the capital account.
• The UAE sovereign wealth fund purchases a large stake in the NASDAQ.

 Relationship between current and capital account

• Current account and capital account zero each other out.
• If current account has a negative balance (deficit) then capital account should have a positive balance (surplus).

 Official reserves

• Foreign currency holdings of the U.S. fed.
• When there is a balance of payments surplus, fed accumulates foreign currency and debits the balance of payments.
• When there is a balance of payments deficit, fed depletes its reserves of foreign currency and credits the balance of payments.

Active v. 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 People's Republic of China is active in its use of official reserves. It actively buys and sells dollars in order to maintain a steady exchange rate w/ the United States.

Formulas

1. Balance of trade = Good exports + goods imports
2. Balance on goods & services = Goods exports + service exports + goods imports + service imports.
3. Current Account = Balance on goods and services + net investment + net transfer
4. Capital account = Foreign purchases + domestic purchases.

Unit 5

• SRAS - Wages fixed as $ fluctuates
• LRAS - Wages responsive to ∆ in PL
• Effects - SR - > PL ∆ allow firm to exceed normal outputs and labor since profits up
• LR -> Wages adjust to PL; previous output levels follow.
• Extended Model - Both SRAS and LRAS; LRAS vertical @ full employment

Inflation

• Demand-pull - Price up based on AD (Right)
• SR - $ up, Prod. up
• LR - AD increases subside
• Cost-push - Left, inc. in per unit costs (up in res. $); Cause of PL increase
• Gov. dilemma 
• Wait - Recession (Prod. and Employ. down)
• Action - Inflationary Spiral

Phillips Curve

• Long Run Phillips Curve - Vert @ natural rate of unemployment
• Struc changes in Un also shifts LRPC
• Inc in Un LRPC ->
• Dec in Un LRPC <-
• No trade off b/t inflation and unemployment
• Occurs at Un; Rep by up or down
• Shifts if LRAS shifts
• Assumption - More worker benefits create higher natural rates vice versa for less
• Short Run Phillips Curve - Tradeoff b/t inflation and unemployment
• Supply Shocks - Rapid and significant increase in resource cost (SRAS left; SRPC right)
• Misery Index - Combo of inflation and unemployment in any given year. 0-9 good
• Inflation - General rise in PL
• Deflation - General decline in PL
• Disinflation - Decrease in rate of inflation over time
• Stagflation - Inflation and unemployment increase @ same time

Reaganomics

• ∆ in AS, not AD -> Determines inflation level, unemployment rates, and econ. growth
• Supply side economics support policies that promote GDP growth by arguing that high marginal tax rates along with current system of transfer payments (unemployment comp or welfare program) provide disincentives to work invest, innovate, and undertake entrepreneur ventures
• Low marginal tax rates induce more work -> AS up
• Leisure more costly, work more attractive
• Incentives to save and invest
• High marginal tax rates reduce rewards for saving and investment
• Consumption might increase; investment depends on savings
• Lower marginal rates encourage saving and investing
• Laffer Curve - Theoretical relationship b/t tax rates and gov revenue
• As tax rates increase from 0, tax revenues increase from 0 to some max point and then decline
• Criticisms
• Research suggests impact of tax rates on incentives to work, save, and invest are small
• Tax cuts increase demand -> fuel inflation and demand can exceed supply
• Economy's real location on curve difficult to determine

Monetary Policy

Conducted by the FED; comprised of 3 tools

Reserve Requirement

• Small % of deposit in bank, rest is loaned out (Fractional Reserve Banking)
• Inc. in MS -> Inc. in amt of $ held in bank deposits
• Recession - Dec. RR -> More ER; More loans; MS up, interest rates down; AD up (Easy)
• Inflation - Inc. RR -> Less ER; Less loans; MS down, interest rates up; AD down (Tight)

Discount Rate

• Interest rate FED charges to banks
• MS up needs decrease in Dis. Rate (Easy)
• MS down needs increase in Dis. Rate (Tight)

Open Market Op

• FED buys/sells bonds (securities)
• MS up needs buy bonds (easy)
• MS down needs sell bonds (tight)

Easy monetary policy: Buy Bonds; Decrease Dis. R & RR

Loans increase; AD up; GDP up; MS up; Interest rates down

Tight monetary policy: Sell Bonds; Increase Dis. R & RR

Loans decrease; AD down; GDP down; MS down; Interest rates up

• Fed Fund Rate - FDIC banks loan each other overnight funds (Opposite of Dis. Rate)
• Prime Rate - Interest rate banks give to most credit worthy customers 

Countercyclical Policies: Keynesian Fiscal Policy vs. Monetary Policy

In the early 21st century, here in the USA, an efficient, "full employment" economy will probably have:

• Annual unemployment rate 4%
• Annual inflation rate 4%

If the economy goes into a recession:

• The real GDP drops for at least 6 months
• Unemployment rate increases to 6% or more
• Inflation rate decreases to 2% or less

If Congress enacts Keynesian Fiscal Policies to attempt to slow/stop the recession, then:

• The policy will try to improve C or G (parts of AD)
• Congress will decrease federal taxes
• Congress will increase job and spending programs
• The federal budget will probably create a deficit
• Due to changes in Money Demand, interest rates will increase (Crowding out might occur, but Keynesians don't care)

If the Federal Reserve employs Monetary Policy options to slow/stop the recession, then: 

• The policy will target improvement in Ig (part of AD)
• The Fed will target a lower Fed Fund Rate
• The Fed can lower the discount rate
• The Fed can buy bonds (Open Market Operations)
• The Fed can (theoretically) lower the reserve requirement, but probably won't because it is too complex for the banks.
• These Fed policies will lower the interest rates through changes in the Money Supply
• These options should increase Ig

If the economy suffers from too much demand-pull inflation or cost-push inflation, then:

• The unemployment rate will go to 4% or less 
• The inflation rate will probably go to 4% or more

If Congress enacts Keynesian Fiscal Policies to attempt to slow/stop the inflation problems, then: 

• The policy will try to decrease C or G (parts ofAD)
• Congress will increase federal taxes
• Congress will decrease job and spending programs
• The federal budget will probably create a surplus
• Due to changes in Money Demand, interest rates will decrease

If the Federal Reserve employs Monetary Policy options to slow/stop the inflation problems, then:

• The policy will target decreases in Ig (part of AD)
• The Fed will target a higher Fed Fund Rate
• The Fed can increase the discount rate
• The Fed can sell bonds (Open Market Operations)
• The Fed can (theoretically) raise the reserve requirement, but probably won't because it is too complex for banks
• These Fed policies will raise the interest rates through changes in the Money Supply
• These options should decrease Ig

Graphs and Banking Systems

Demand Graph

• Demand for money increase inverse w/nominal interest rate and quantity of money (Q decreases, I increases and vice versa)
• Shifters: Change in
• PL
• Income
• in taxation after investment

Money Supply

• Affects AD when increased: -> r down, Ig up, AD up (Vertical)
• Decreases - Goes Left: MS down, r up, Ig down, AD down

Financial Sector

• Fin. Assets - Stocks and bonds provide expected future benefits
• Benefits owner from issuer of asset meeting certain obligations
• Fin. Liabilities - Incurred by issuer of fin. asset to stand behind issued asset
• Interest Rate - $ paid to use fin. asset
• Stocks - Fin. asset that represent ownership in a company
• Bonds - Promise to pay $ and interest in the future

Banks

• Fin. Intermediary - use liquid assets to fund investments of borrowers -> Fractional Reserve Banking
• Liquid assets include currency in bank vaults and bank reserves
• Banks create money by lending out deposits that are used multiple times
• When a customer deposits cash or withdraws cash from their demand deposit account, it has NO EFFECT ON THE MONEY SUPPLY
• It only changes...
• The composition of money
• Excess Reserves
• Required Reserves
• Changes in Money Supply for....
• Single Bank
• Loan money from ER
• Banking System
• ER x Money multiplier (1/RR) -> Total Money Supply
• When the FED buys or sells bonds, ER is created

Basic Accounting Review

• T-Account (Balance Sheet) - Lists assets and liabilities
• Assets (Amounts owned) - Items claimed legally by bank; use of funds by fin. intermediary
• Included in assets
• Required Reserves - % of DD in vault
• Excess Reserves - Remaining % of DD used for loans
• Property - Statement of a bank's property values
• Securities or Bonds - Previously purchased bonds held by the banks as investments
• Loans - Previously loaned funds now owed back to the bank
• Liabilities (Amounts owed) - Legal claims against a bank; sources of funds.
• Included in liabilities
• Demand Deposits - Cash deposits from the public to the bank
• Part of MS if from person's cash holdings
• Becomes new $ if from a bond -> MS up
• Owner's equity or stock shares - Values of the bank stocks as held by the public
• DD = RR + ER

Federal Reserve Banks

• Functions
1. Uses paper $
2. Set reserve requirement and holds bank reserves
3. Lends $ to banks and charges interest
4. Check-clear service for banks
5. Personal bank for government
6. Supervises member banks
7. Controls money supply in the  economy
• Reserve Requirement - Fed needs banks to always have $ to meet demand
• Amount = Reserve Ratio - % of DD locked to bank

Scenario 1

A private citizen takes cash that they possess and put it into a bank account

• The cash placed into the bank is already part of the money supply
• The deposit is counted as a bank liability
• A % must be placed into required reserve
• The remainder is placed into excess reserve
• The bank will want to lend all of the ER, if possible
• The amount in ER is multiplied by the monetary multiplier
• This will be assumed to become new loans in the banking system
• This will be counted as the change in money supply

Scenario 2

• The Fed buys bonds back from the public
• The public now has new cash
• This new cash is new loans
• Assume that the public puts the cash into demand deposits
• A set percentage is placed into required reserve
• The remainder becomes excess reserve
• Excess reserve is multiplied by the money multiplier (1/RR)
• This amount becomes new loans and is new money supply
• The total change in money supply is the amount of demand deposits plus the new loan amounts

Scenario 3

• The Fed buys bonds back from the member banks
• The banks now have new ER
• No money is needed to be placed in RR, since this is not owed to the public
• All of these ER are multiplied by the monetary multiplier
• This amount becomes new loans
• This amount is the change in the money supply

Unit 4 - Money

Uses of Money

• Medium of Exchange - Trade or barter
• Unit of Account - Estimate economic worth in exchange process
• Store of Money - Money holds value over period of time; products do not.

Types of Money

• Commodity Money - Value from material type from which it was made.
• Ex: Gold coins, silver
• Representative Money - Paper money that represents tangible things which gives value
• Ex: IOU
• Fiat Money - Value declared by government 
• Ex: U.S.  Money

Characteristics of Money 

• Portable
• Durable
• Uniform
• Scarce
• Acceptable
• Divisible

Money Supply

• M1 Money = Currency (Cash and coins); Checkable deposits/accounts; traveler's checks
• 75% of money; most liquid (convertible to cash)
• M2 Money = M1 money + Savings Account; deposits held by foreign banks
• Not as liquid
• M3 Money = M2 money + Certificate of Deposit (CD) 
• Early Penalty if drawn

Time Value

Is $ worth more today or tomorrow? TOMORROW

• Because opportunity cost and inflation -> charge and pay interest
• Simple Interest Formula = V = (1+P)^n x P
• Compound Interest Fornula = V = (1+(r/k))^(nk) x P
• V=Future value of $
• P = Present value of $
• r = Real interest rate as decimal
• n = years
• k = # of times interest is credited per year.