Reading 14: Demand and supply analysis

I. Demand side:

14a. Elasticities of demand (own price, cross price, income elasticities)

Market demand of products change in response to change in certain factors. Elasticity measure the product
demand sensitivities to these factors, and calculated as the ratio of percentage change in quantity demand per
percentage change in influence factors. This topic will discuss 3 main factors including: own price, cross price, and
income elasticities
14a1. Own price Elasticities
● Own price elasticity: the product demand sensitivities to change in its own prices
○ Generally price and quantities demand have an inverse relationship, the higher the price, the lower
the demand, therefore own price elasticity is often negative
○ Ratio of ΔQ/Qo (%) per ΔP/Po (%)
𝛥𝑄 𝛥𝑃 𝑃 𝛥𝑄
𝐸= / 𝑃 = 𝑄0 ∗ 𝛥𝑃 (slope)
𝑄0 0 0
○ Elasticity is NOT the slope of Demand curve
○ Slopes depend on measurement units (for prices and quantity), (absolute values)
○ Elasticity base on % change → not depend on measurement units

● Elastic: Q very responsive to P, Inelastic: Q not very responsive to P

● Perfect elastic(ε= ∞): Price↑ → demand (Q)↓ → 0
● Perfect inelastic(ε=0): Price change→ demand (Q) unchanged (e.g: electricities, water, gas)

14a2. Income Elasticities

● The product demand sensitivities to change in income level (ratio of ΔQ/Qo (%) per ΔI/Io (%)
14a3. Cross price Elasticities
● The product demand sensitivities to change in prices of related goods
● ratio of ΔQ (%) per ΔP (%) of related goods
● Substitutes: similar products of competitors (e.g: samsung vs. Iphone)
○ ε> 0: Price related goods↑, make our Quantity demand↑→ competitors
● Complements: related products that sales closely linked together (e.g: gas and vehicles)
○ ε< 0: Price related goods↑, make our Quantity demand↓→ complements
● The Higher Elasticity mean the better substitute or complement

14b. normal good vs inferior goods:

● Normal goods: I ↑→ Q ↑
○ For goods that are considered normal, the higher the consumers income, the higher their
demands for products and services
● Inferior goods: I ↑ →Q ↓
○ For low qualities, inferior goods, the higher the society wealth, the lower their demand for
inferior products, thus, their demand curve is positive slope
● Giffen goods: Price ↓ lead to Q ↓(super inferior), upward sloping demand curve
● Veblen goods: Price ↑ lead to Q ↑, (very luxuries)
○ upward sloping demand curve for a price range
○ Not an inferior goods → income elasticity > 0 → violate the axioms of theory of demand

14c. Income vs. substitute effect:

● Substitute effect: the effect on quantities demands comes from change in price in compare to substitutions
○ PX↓ → relatively cheaper than substitutes goods → lead to QX↑ (eg: vietjet vs. VNA)
● Income effect: effect on quantities demands comes from change in price in compare to consumer income
○ PX↓ → Goods X relatively cheaper vs. income (%buyers incomes↓)→ QX can ↑or↓, depend on type.
■ Normal goods: Pnormal↓→ relative cheaper vs. income → Qnormal↑
■ Inferior goods: Pinferior↓→ more inferior vs. income → Qinferior↓

● Each products will have it own income and substitute effect on prices change, so the total effects (substitute
+ income effect) can have 03 case scenario:
○ PX↓ : Substitute effect ↑, Income effect ↑→ Q↑↑
○ PX↓ : Substitute effect ↑↑, Income effect ↓ → Q↑
○ PX↓ : Substitute effect ↑, Income effect ↓↓→ Q↓→ giffen goods
II. Supply side:
14 d diminishing marginal returns:
● Factors of production: 1.land, 2.material, 3.physical capital, 4.labor
● Production function: Quantity produced (Q) are function of physical capital (K) and labor (L)

● Marginal Product (MP): additional product units (ΔQ) for an additional unit of labour (holding K constant),
MP line will have 3 phases:
1. initially, additional (L) ↑ will lead to MP↑, (teamwork, specialization) (until A, slopes increasing)
2. Diminish marginal productivity (DMP): the point when MP start to decline for each additional unit
of labour, (A to B, slope decreasing)
3. Theoretically, MP↓ as we continue to add more (L)↑↑, until a point MP decline to negative →
Additional unit of Labour will decrease output (from B onwards)

14 e break-even and shutdown point:

Basic terms:
● Short run (SR): all factors of productions are fixed, cant change scale of operation (plant, employees)
● Long run(LR): all factors of production can change (sell plant, lay off workers)

● Variable cost (VC): materials, parts, etc.

● Fix cost (FC): plants, machinery, equipments
● Total cost (TC): = Variable cost + Fix cost
● Marginal cost (MC): cost to produce an additional unit of product
○ Economy of scales: Q↑ → MC↓, until a point when MC start to increase,
○ MC curve will cut AVC and ATC at respective lowest points, then bring both curves up
● Marginal revenue (MR): additional revenue for selling 1 more unit

Example:TP, AP, MP
14e1: Perfect competition
Market characteristics:
● Price taker: Price = Marginal Revenue = Average Revenue
● Because perfect competition → producers cut price to compete → until lowest price: at lowest ATC point
 Break-even and shut down prices:
● Break even: when Total Revenue (TR) enough to cover Total Cost (=TVC +TFC)→ economic profit =0
○ (TR=TC=TVC+TFC)
○ P1= ATC: → economic profit =0
● Shutdown point: (same for both perfect and imperfect competition)
○ Short run:
■ when TVC < TR < TC, company loss, but still continue operate to minimize FC loss
■ When TR<TVC, reduce loss by shutdown
○ Long run: if TR < TC, company should shut down, regardless of TVC

2. Imperfect competition
● Price searcher: Price ≠Marginal Revenue, downward slope Demand curve
● Use total approach methods, rather than marginal methods
 ● Break-even: at QBE1 and QBE2, TC = TR → breakeven
● Maximize profit: at QMax: TR-TC = Max

14f economy of scale:

● SR: plan size is fixed, LR: firms can choose most profitable scale of operation
● LR ATC: draw for different scales of operation, each point on LR ATC is minimum ATC for the given scale
● LR ATC: is u-shape:
○ Economy of scales: ATC decrease, due to specialization, mass production, technology, bargaining
power
○ Minimum efficient scale: Lowest point in LR ATC,
■ In perfect competition market, firms have to operate at this level,
■ Market Price will also be at P*, other firms operate at different level will be loss → bankrupt
○ Diseconomy of scale: ATC increase: bureaucracy, inefficiency, lack innovation
Reading 15: Market structure
Economic profit: Total Revenue - Opportunity cost of productions
(include normal returns for all factors of productions: labor, machine, capital, opportunity cost)

15a. Characteristics of 4 markets structures

● Number of firms and size
● Demand curve elasticity
● Competition: product, pricing
● Barrier to entry

Demand
Number product Elasticity Pricing power Barrier

Perfect perfect -price taker

competition Many Identical elastic - no power very low

Monopolistic - small power

competition many differentiate Elastic -small price difference low

-High power
Identical or -firms interdependent
Oligopoly only few differentiate inelastic -pricing affect each other high

perfect -Complete price power

Monopoly one Unique inelastic -Government regulated very high

Evaluate 3 factors of the 4 markets:

15b. Relationship of Price, MR, MC, profit, and elasticity
15d. Optimal price (P) và output (Q) for firm
a. All firms maximize economic profit by producing at the Quantity where Marginal revenue equals
Marginal cost (MR = MC)
15e Long run equilibrium
b. For all competitive market: in LR Economic Profit = 0

I) Perfect competition
● P = MR = AR (= Demand curve)
○ Firm are price taker → perfectly elastic Demand curve
○ MR = P: additional sale assumed to be at market price → MR curve = D curve
● Profit maximize: for Q* at MC = MR
○ in SR, Price can be higher ATC → still have profit
● Long run equilibrium:
○ New firms enter market, Supply↑ → Price↓ (Price continue to decrease until the minimum ATC)
○ In equilibrium, Price will equal the minimum ATC, and at the point of MR cut MC
■ P = ATC = MC = MR
○ At this level economic profit = 0, only normal profit realized

● Shutdown point:
○ If P < ATC the firm will be in loss
○ If AVC < P < ATC: Revenue still enough to cover VC and part of FC
■ → operate in SR, Shut down in LR
○ If P < AVC → shutdown in both SR and LR

● SR supply curve for a firm: is it MC line (above the AVC):

○ P<P1 (AVC) → shutdown
○ P1(AVC) < P <P2(ATC) → loss but still running
○ P > P2(ATC): making profit → expand production along MC line → SR supply curve ~ MC
15c Supply curve:
● PC: Supply curve = MC (when P > AVC) và Mkt Supply = ∑𝑛𝑓=1→𝑛 𝑆𝑓𝑖𝑟𝑚𝑠
● Other mkt: no Supply function, because:
○ Q* define by MR = MC,
○ P* define following D curve
● → quantity not a function of price, (no Q = f(P),
● However: Q = f (MC, MR, D)

Change in demand and supply (SR)

● (SR) demand increase → Market Price & QM increase
● Increased Market prices will affect firms → they can have SR profit
● (LR) supply will increase (firm increase scale, new firms enter) → Supply curve move right
● Price back to normal level, no more SR profit

Market
FACTOR Shift Equilibrium SR Firm LR market

P↑ →𝑄𝑓 ↑ S↑:Firm scale↑,new firm enter

Demand ↑ D curve → 𝑄𝑀 ↑P↑ SR profit↑ → 𝑄𝑀 ↑, P↓

P↓ →𝑄𝑓 ↓ S↓:Firm scale↓,firms exits

Demand ↓ D curve ← 𝑄𝑀 ↓P↓ SR profit↓ → 𝑄𝑀 ↓, P↑

P↓ →𝑄𝑓 ↓ S↓:Firm scale↓,firms exits

Supply↑ S curve → 𝑄𝑀 ↑P↓ SR profit ↓ → 𝑄𝑀 ↓, P↑
 P↑ →𝑄𝑓 ↑ S↑:Firm scale↑,new firm enter
Supply↓ S curve ← 𝑄𝑀 ↓P↑ SR profit↑ → 𝑄𝑀 ↑, P↓

Change in demand and supply (LR)

● When Demand↑ make Q↑and P↑
○ At higher price, firms start making economic profit (P1 cut MC > ATC)
○ New firms enter → Q↑
○ Supply curve shift right→ Price go back to Po (Po = ATC)
○ No more economic profit, only higher quantity produced (Q2 > Q0)
● When Demand permanently ↑→ in LR, Supply(Q) will increase to meet higher demand
II) Monopolistic competition

● Many producers, differentiated products, with limited pricing power

● Downward slope demand (high elastic)
● D ≠ MR ≠ AR
○ MR have to be lower than Demand curve
○ (To sell an additional unit, price have to be lower)
● Profit maximization: still at MC = MR
○ SR: Economic profit: P - ATC
○ LR: SR profit → new competition enter → Economic profit back to = 0
Note:
● Price and ATC:
○ Q*: MC cut MR: and P* = ATC (cut Demand curve)
○ P* is NOT at Minimum ATC → excess capacity or inefficient scale (can attribute to differentiation)
● Price and MC:
○ Because P* lies on Demand curve (higher than MR curve)
○ And MR = MC → Price > MC → margin (even in LR, when economic profit = 0)
○ Margin = P* - MR*
○ Price (P*) will be higher than perfect competition (can attribute to differentiation)
III) Oligopoly
● Firms are Interdependent, if a firm change price → other follow→ affect the whole market, PnL depend on
how competitors react to each decision
● Long Run: Poligopoly will be in between perfect collusion and perfect competition prices
a. Pperfect collusion ~ Pmonopoly > Poligopoly > Pperfect competition (MC=MR=P)

There are 4 theories to analyze Oligopoly market, depend on different assumptions/focus:

3.1 Kinked demand curve:
1. Focus: Price vs. Elasticity
2. Assumptions:
a. If a firm increase price:
i. competitors will not follow: → sales will decline more
ii. Elastic: flatter Demand slopes: because small Δ P lead to larger Δ Q)
iii. → At Prices > PK: demand more elastic

b. If a firm decrease price:

i. Competitors will follow and cut price to compete
ii. There no substitute effect (because all firms cut price), only income effect (lower price
vs. same income)
iii. → smaller ΔQuantity demand than increase prices→ less elastic
iv. → At Prices < PK: demand less elastic
 c. Profit maximization: at the point of the kink QK
d. MR will have gap at kinked point
e. Any firms with MC curve cut through this gap, will have PK as profit maximize point
f. Weakness: how to determine market price (PK) is outside scope của model

3.2 Cournot model:

Assumption:
1. Duopoly: market only have 2 firms (with same and constant MC)
2. Each firms know their competitor quantity produced (Q) (assumed equal last period)
3. Firms use Market Demand curve - Competitor (Q) → construct their own Demand and MR curves
a. → identify profit maximizing quantity (Q*)
b. At the begin of each period, both firm will determine their Q* simultaneously
4. Firms will adjust (Q*) each period until they finally equal
5. After QA = QB → stable equilibrium, no additional profit by changing (Q)
a. PriceMonopoly > PriceOligopoly > PricePC (= MC)
b. If more firms added to the market: PriceOligopoly → MC
3.3 Nash equilibrium:

● Nash equilibrium (NE): when there no other choices that make any firm better off
● Determine: Best case for A is to cheat, either if B honors or not (200 > 150, and 100 > 50)
Assumption:
● Decision model, best choice for a firm depend on action of other firm
2. 2 firms with collusion agreement: keep price high to benefit both
3. Firms can choose to honor or cheat, neither firm know what the other choose
4. There are 4 scenario:
a. Both honor: better outcome for both but not NE, because both can cheat to improve
situations (150 → 200)
b. One honor, one cheat: If firm A cheat (cut price) → earn 200 (better)
i. But B will also have to cheat to improve situation
c. Both cheat: this is Nash Equilibrium: Because no Firm can change to improve situation

● From Collusion agreement at high price, eventually will move to Nash Equilibrium, even clearly
better outcome is both should honor

● Factors to improve Collusion agreement compliance:

a. Fewer firms, minimum outside competition,
b. Similar product, cost structure,
c. Severe retaliation for cheating
3.4 Dominant model:
Assumptions:
1. Dominant firm (DF) with largest market share và lowest cost structure (MC),
2. DF determine the price base on their cost structure
3. Competitive firm (CF) : price taker

4. Maximize profit:
a. DF identify quantity: Q*DF: MCDF cut MRDF → Q*DF
b. DF identify price: P*DF : at QDF on the DDF curve → P*DF will then be market Price

c. CF take price P* as given

d. CF identify quantity: QCF: is at P* on the MCCF curve
i. (because at higher Q, firm will loss due to MC > P)

5. If CF cut Price↓, DF will cut Price more↓↓

a. Force CF to lose sales and market share,
b. → CF quit→ DF take over and gain more market share↑

IV) Monopoly
● Demand curve:
○ Still downward sloping even if they have complete pricing power → trade off between Price and
Quantity sold
○ Price searcher: have imperfect info about market demand curve → test different prices to find P*
● Maximize profit:
○ identify Q* at MC cut MR
 ○ Identify P* at Q* on the demand curve (price searcher in practices)
○ Profit: = (P* - ATC*).Q*
● Long run:high barrier to entry → Long Run profit can exist

Monopoly vs. Perfect competition:

● PC: produce at QPC & PPC, Firms too small to affect supply (Q) and prices → total market efficiency
● Monopoly: only produce at Qmonopoly và Pmonopoly, because MC = MR
○ Consumer surplus↓because Quantity↓and Price↑
○ Dead weight loss (DWL): reduced Consumer and Producer Surplus by DWL (inefficiency)
● Rent seeking: efficiency loss for cost to maintain monopoly position

Price Discrimination
● Monopoly: complete price power→ discrimination pricing to best utilize (capture consumer surplus)
● Discriminate price: can charge different prices to different group of customers, if:
○ Have different groups of customers with different prices elasticity
○ Customers cannot resell the product
○ Single price: when price discrimination is not possible
○ E.g: electricity, airline tickets

● Simplify assumption: No FC and VC constant → MC = ATC

● Price discrimination reduce DWL inefficiency, because more customers groups increase Quantity solds
○ QMonopoly → QPC
● Perfect discrimination: charge each customers the price they willing to pay → no consumer
surplus, producer capture all
IVb) Natural monopoly:
● Industries that naturally have extremely high fix cost → need to maximize economy of scales to
reduces average fix costs: Q ↑→ AFC↓ (e.g electricity)
● Economy of scales apply through WHOLE relevant range of consumer demand
● If markets demand divided between 2 firms → ATC↑↑↑ Costs increase too high, both will loss
● VC very low compared to FC (e.g: power cables (VC) vs. power plant (FC))
○ → assume MC = constant

● Monopoly produce at QU, PU (MC cut MR)

● Regulator want to improve output and efficiency → regulate price:
○ Average cost pricing:
■ Set maximum PAC at ATC cut Demand: PAC @ ATC x D
■ Firm produce until QAC → Q↑ Price↓(compare to QU, PU)
■ Monopolist Economic Profit = 0 (because Price = Average total cost)

○ Marginal cost pricing: Set maximum PMC at MC cut Demand: PMC @ MC x D

■ Achieve most efficient quantity (because Price = Marginal cost)
■ Monopolist will loss, because Price < ATC → need government subsidy

Summary:

P vs. MC,MR Profit maximize power Long run

 PMkt= S x D LR: no barrier → new
D = MR = AR no power→ firms enter
ERFECT P =MR= MC single firm cant → LR: eco profit = 0
ETITION MC = SR Supply Q* at MC = MR = P affect Price P=ATC ( = MR=MC)

LR: small barrier → new

firms enter
D ≠MR ≠AR Q* at MC=MR → LR: eco profit = 0
ONOPOLISTIC D > MR P* at Q* on D curve P=ATC > MC cut ATC
OMPETITION P > MR= MC P > MR=MC → margin (not minimum ATC)

LR: Price somewhere

between:
-Perfect collusion: Max
profit~monopoly
-Perfect competition:
LIGOPOLY Zero economic profit

MR gap at K
P>K : |e|>1 Q* (QK ): for any MC cut
nked curve P<K : |e|<1 through MR gap

Assume market demand and Qcompetitor

→ build Firm Demand and MR curve
→ Q* at MC=MROwn (given QCompetitor) QA = QB = constant
ournot model MCA =MCB No.Firms↑ → P*→ MC

Nash equilibrium:
Cheat agreement: P low
But no firm can change
Collusion Agreement: P action to improve
ash equilibrium high Q low outcome

QDF at MRDF = MCDF

MCDF < MCCF P* at QDF on D curve
ominant firm QDF >> QCF QCF at P* cut MCCF

D curve > MR Price

curve Q* at MC=MR discrimination: Perfect barrier → no
FC >> VC P* at Q* on D curve Q ↑→ QPC competition
ONOPOLY MC ~ constant P↑ and Q↓ (inefficient) inefficient↓ LR Profit is achievable
 Gov. regulate
price
ACP: QAC ↑và
PAC ↓ - Average cost price:
MCP: QMC ↑↑ zero economic benefit
atural (max) và PMC ↓↓ ACP: QAC at ATC cut D - MC pricing: loss
onopoly (min) MCP: QMC at MC cut D (government subsidy)

15f Pricing strategy for each market:

Profit maximize

PERFECT - Max PnL at MC=MR

COMPETITION - P = MR = MC

- Max PnL at MC=MR

MONOPOLY - P > MR = MC

MONOPOLISTIC - Max PnL at MC=MR

COMPETITION - P > MR = MC

OLIGOPOLY Interdependent firms → LR outcome in between Monopoly and PC:

-Pperfect collusion ~ Pmonolopy > Poligopoly > Pperfect competition (MC=MR=P)
Firm action depend on assumptions:

- Max PnL at MC=MR

Kinked curve - MR broken→ firms with different MC can have same optimal QK

- Max PnL at MC=MR (the collusion agreement level)

- Perfect Collusion = Monopoly profit
Collusion - But firms will have to share total Q

- Max PnL at MRDF = MCDF (price maker)

Dominant firm - QCF at P* cut MCCF (price taker)

15g Concentration measure:

● Government prevent M&A that make firm become too large→ super high market power
 ● Concentration measure: measures of firms market shares, indicator of market power
Measures:
● N-firm concentration ratio: sum market share of the largest N firms in the market
● HHI: sum of square of market share → very sensitive

Reading 16: GDP, Price, Growth

16 a Calculate GDP expenditure and income approach

● GDP: measure flow of outputs and incomes of the economy

Two approach to measure GDP: expenditure and income

● Aggregate output / expenditure (AO) (AE): value spent on all goods produced in the periods
● Aggregate income (AI): value of all payments received, by Household (H), Firms (F), and government (G)
○ all AI finally attribute to (H) (ultimate owner of (F) and (G) (non-profit)
● (AO) = (AI) for the whole economy, total expenditure must equal total income

GDP Calculation:
○ All goods/services produced in the period
○ Only market values of final goods are included
■ intermediate goods is excluded to avoid double counting
■ not count reselling or use in production of other goods
○ Goods & services at imputed (estimate) values:
■ own-occupy housing (~rental service)
■ (G) services, not priced → value at cost : e.g: police, hospital, education
○ Excluded items:
■ (G) transfer payments to (H) (not economic output)
■ Asset capitals gains
■ Value of labor not sold (home labor)
■ Goods produced in previous periods
■ Byproducts of production

16b Value of final output vs sum of value-added method

● Value of final output: summing the value of all final goods produced
● Sum of value-added method: sum the additional value created at each stage of production

16c Nominal vs real GDP, GDP deflator

● Nominal GDP: values of all goods and services produced, at current market prices.
○ GDPi=𝛴Pi.Qi
○ Inflation increase GDP even though physical output constant
● Real GDP: use current year Qi and price (P0) from base year to calculate
○ Real GDPi=𝛴P0.Qi
 ○ real GDP only reflect output increase, inflation effect not counted as economic growth
● GDP deflator: price index calculate from converting nominal GDP to real GDP
𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃
○ 𝐺𝐷𝑃 𝑑𝑒𝑓𝑙𝑎𝑡𝑜𝑟 =
𝑅𝑒𝑎𝑙 𝐺𝐷𝑃
↔
16d GDP, national income, personal income, disposable income

I) Expenditure approach: sum of all spendings on new produced goods and services
○ GDP = C + I + G + (X-M)
Include 4 factors: Households (C), Firms (I), Government (G), and foreign trade (X-M)

● Households:
○ (H) provide capital, labour, lands, receive incomes (factor market)
■ Income = Tax (T) + Consumption (C) + Savings (S)
○ (C) provide incomes to firms (goods market)
○ (S) provide funding to firms / government (financial market)
○ (T) provide incomes to (G)
● Firms:
○ (F) provide goods, service receive incomes (goods market)
○ (F) investment (I) flow to other firms (goods market)
● Government:
○ Collect Tax (T) from (H) and (F)
○ (G) spending create income for firms (goods market)
○ If (G-T) > 0 → budget deficit → (G) borrow throw financial market
● External factor:
○ (X-M) trade with the world throw goods market
○ If (X-M) < 0:
■ Trade deficit → economy spend more than it produce
● must be funds through borrowing financial market
II) Income approach: total all incomes earned by selling goods and services
● GDP = National income + capital consumption allowance + statistic discrepancy
○ CCA: depreciation of physical capitals from production (account for depreciations in firms financial
statements)
○ Statistical discrepancy: differences between two methods

NATIONAL INCOME PERSONAL INCOME

From National Income:

Salaries (labor capital) (+) Salaries

Small business NI (+) Small business NI

Interest income (financial capital) (+) Interests income

Rent (physical capital) (+) Rent income

Government indirect taxes (-) Government indirect taxes

Corporate profit before taxes:

● Corporate taxes (-) Corporates taxes
● Dividends (+) Keep dividend (H)
● Retain earning (-) Retain earning (F)

(+) Transfer payment

= PERSONAL INCOME

(-) Personal income taxes

= PERSONAL DISPOSABLE INCOME

● Consumptions
● Savings

16 e Saving, Investment, fiscal balance, trade balance

1. Income approach:
● Personal Disposable Income = GDP + Transfer payment - Tax - Saving (Firms) = Consumption + Saving (H)
● PDI = Y + TP - Tax - SF = C + SH
● → Y = C + (SF+SH) + (Tax - TP)
○ Net tax (T) = Tax - Transfer payment
○ Total saving (S) = S(H) + S(B)
● →Y=C+S+T
2. Expenditure approach:
→ Y = C + G + I + (X - M)
3. For AI = AE
● C + I + G + (X-M) = C + T + S
 ○ → S = I + (G-T) + (X-M)
○ → (S-I) = (G-T) + (X-M)
● (S) spent on: 1. Investment (I), 2. financing budget deficit (G-T) and 3. trade (X-M)
● Trade balance: = Export - import
○ Trade flows and capital flows must balanced: if trade deficit → capital flows must surplus
● Fiscal balance: = Gov spending - Tax
○ Budget deficits → either funded by idle capital (S - I), or trade deficit: (X-M) <0

Components of GDP as function of Y:

● Y ↑, (C)↑
● Y ↑(I)↑
● Y ↑, T↑→ (G-T) ↓
● Y ↑, M↑→ (X-M) ↓
16 f IS and LM curves, combine to be AD curve
● AD curve: Represent negative relationship b/w. Price level (P) and Output (Y), satisfy 2 conditions
○ Equilibrium in goods market: Planned Expense = Actual income (AE=AI)→ IS curve
○ Equilibrium in money market → LM curve

1. Income Saving curve:

a. Equilibrium in goods market : planned expense = actual income (AE=AI)
b. IS curve represent negative relationship between (r) and (Y)
i. (r) ↑→ demand for money ↓→ (S)↑, (I) ↓→ (S-I) ↑→ reduce output (Y) ↓
ii. (r) ↓→ (I)↑, (S)↓→ (S-I) ↑→ increase output (Y) ↑

2. Liquidity Money curve:

a. Equilibrium in money market
b. LM curve represent positive relationship between (r) and (Y) (holding real money supply constant)
c. Quantity theory of money:
i. Money supply (M) . Velocity of money (V) = Price level (P) . Income (Y)
ii. M/P = 1/v * Y
iii. M/P: real money supply
d. If real money supply constant: → (Y) and (r) have positive relationship:
i. Economic activities (Y) ↑ → spending (C,I)↑→ demand for money ↑→ (r) ↑
ii. Economic activities (Y) ↓ → spending (C,I)↓→ demand for money ↓→ (r) ↓
3. LM x IS curves

● At LM x IS: equilibrium in both goods market and money market (for a given real money supply: M/P)
● Holding (M) constant: Different Price levels (P) → affect LM curve → LM x IS equilibrium
○ (P)↑→ real money supply (M / P) ↓→ higher money demand (r) ↑→ LM curve shift left → (Y) ↓
○ (P)↓→ real money supply (M / P) ↑→ lower money demand (r) ↓→ LM curve shift right→ (Y) ↑
● → each (P) level will have a correspond equilibrium point of IS & LM

4. AD curves
● AD curve represent inverse relationship between price (P) and output (Y)
 ● AD is all equilibriums points of IS & LM, for each (P) level
○ (P)↑affect (Y) in 3 channels, making (Y) ↓↓↓
■ (P)↑→ (r) ↑→ (I) ↓
■ (P)↑→ real wealth ↓→ (C) ↓
■ (P)↑→ goods expensive: (X)↓, (M)↑→ (X-M) ↓

16 g SR & LR supply curve

● Aggregate Supply curves show relationship bw. total output produced (Y) and price levels (P)

● Very Short Run AS:

○ Perfect elastic: fixed price (P) for all level of outputs (Y)
○ Input price is fixed→ to change output: Firm adjust labour/capital level but not change Prices

● Short Run AS:

○ In SR: Slope upward, increase output (Y)↑lead to increase costs (MC)↑→ raise Prices ↑
○ However, at least some input prices are sticky
● Long Run AS:
○ All input costs can vary in LR, wages, material change proportional to Price level
○ Perfect inelastic: Price change have NO EFFECT on supply (AS) (fixed)
○ This level of GDP is Full employment GDP
16 h movement along and shift in AD, AS
Movement along AS, AD
● AS/AD curve: reflect relationship bw. total output(AO) and price level (P)
● Change in (P) → movement along AS/AD curve, but they DOES NOT shifts
● Shift in curves: greater Outputs at ANY Price levels
AD curve
● 8 factors cause AD curve shift:
1. Consumer wealth: (W)↑ increase spending → (C)↑ → (AD)↑
2. High capacity utilization: produce at high capacity → invest more in replacement, expansion (I)↑
→ (AD)↑
3. Business expectation: business optimistic → invest more: (I)↑ → (AD)↑
4. Consumer expectation of future income: high expectation→ save less spend more: (S)↓(C)↑ →
(AD)↑
5. Monetary policies: expansion → money supply increase, low rate (M)↑, (r)↓→ more investment
and consumption (credits low), less saving → (S)↓,(C)↑(I)↑→ (AD)↑
6. Fiscal policies: Expansion policies → increase budget deficit, reduce tax, increase spending:
((T)↓→ (C)↑) (G)↑→ (AD)↑
7. Exchange rate: ccy rate low→ domestic goods cheaper increase exports,decrease imports:
(FX)↓→ (X)↑(M)↓→ (AD)↑
8. Global economic growth: global GDP↑→ Global (C)↑→ (X)↑→ (AD)↑
SRAS curve
● 5 factors cause SRAS curve shift:
1. Labour productivities: holding other constant, increase productivity↑, will decrease unit cost
(MC,ATC)↓→ supplier increase output (SRAS)↑
2. Input prices: decrease input prices (especially Labor)→ decrease unit cost (MC,ATC)↓→ supplier
increase output (SRAS)↑
3. Expectation of future output price: if business expect price to rise→ produce more (SRAS)↑
 4. Tax and subsidy: if tax cut (T)↓or Subsidy↑→ decrease production cost → produce more (SRAS)↑
5. Exchange rate:ccy rate high→ foreign goods cheaper→increase imports (of productive inputs)
(Mp)↑→ produce more (SRAS)↑
LRAS curve
● LRAS is vertical (perfect inelastic) at Full employment level of Real GDP
● 4 factors cause LRAS curve shift:
1. Increase labour supply/quality: because LRAS economy already at full-employment → increase
in Labour (population↑, immigrant) or labour quality → increase labour force productivity ↑→
increase output LRAS↑
2. Increase natural resources supply:→ increase productive inputs→ potential GDP↑→ LRAS↑
3. Increase physical capital stock:→ increase productive inputs→ potential GDP↑→ LRAS↑
4. Technology:→ increase technology often increase productivity→ potential GDP↑→ LRAS↑

16 m sources and sustainability of growth

Source of economic growth
1. labour supply: population growth, immigrant, labor participation rate
2. Human capital: skill level, technology knowhow, productivity of labor
3. Natural resources supply:oil, gas, land, can be divided to renewable and non renewable
4. Physical capital stock:can increase labour productivity and GDP
5. Technology:→ increase technology often increase productivity
Sustainability of economic growth: rate of increase in productive capacity (potential GDP)
● Potential GDP = Labour (hours) x Labour productivity
● Growth (Potential GDP) = Growth Labor force + Growth Labour productivity

16 n production function to analyze sources of growth

● production function: relationship bw Output (Y), Labor (L), Capital (K) and Productivity (A)
○ Y= A x f(L,K)
● A: total factor productivity: quantify amount of Y growth not explained by L and K, closely related to
technological advance
● production function per worker:
○ Y/L= A x f(K/L)
■ Y/L: output / worker : labor productivity
■ K/L: capital per worker
○ Productivity (Y/L) can be improved by technology (A) or physical capital (K/L)
● Production function: assumed diminishing marginal productivity → dont need capital
deepening investment (more physical capital/worker) to growth

16 o input grow vs. grow in total factor productivity

● Solow, neoclassical model:
● Growth (Potential GDP) = Growth (Technology)+ W L(Growth Labor) + W K(Growth Capital)
 ○ W LW K is weight % of L and K in GDP
● Per capita basis:
● Growth (Potential GDP/Capita) = Growth (Technology)+ W C(Growth Capital/Labor ratio)
● In developed countries, capital per worker already high,and DMP → growth in technology is
primary source of growth

16 i SR fluctuation in AS, AD
16 j macro equilibria: LR full employment, SR recessionary gap, SR inflation gap, SR stagflation gap
16 k SR equilibrium at above or below full employment

● Market is at LR Equilibrium: GDP*

● Some factors cause the AD or the AS to shift
Case 1:Recessionary gap: AD shift ↓ (→AS↓ CCW)

1. Cause & effect:

● AD shift ↓ make both (GDP) and (P)↓
● New Equilibrium GDP1 < full employment (GDP*): → recessionary gap
● Recessionary gap: period of low GDP, and high unemployment
2. Restore to full LR equilibrium employment:
○ Classical: Unemployment↑→ wage↓→AS↑(right): full GDP, Price↓↓(take too long, painful)
○ Keynesian: Government should intervene, expansion policies:T↓G↑,r↓MS↑→ restore AD↑
Case 2:Inflationary gap: AD shift ↑(→AS move left CCW)

1. Cause & effect:

● AD shift ↑make both (GDP) and (P)↑
● New Equilibrium GDP1 > full employment (GDP*) : → inflationary gap
○ Short run: overtime to meet new demand
2. Restore to full LR equilibrium employment:
● LR: limited resources→ input price↑→ AS↓(move left) Back to full GDP, but Price↑↑
● Or Government can reduce AD ↓to avoid high inflation
Case 3:Stagflation AS↓ shift left (→AD↑CW)

1. Cause & effect:

● AS↓ shift left, make (GDP) ↓and (P)↑ → stagflation
2. Restore to full LR equilibrium employment:
● Unemployment↑→ wage↓→AS↑(shift right): back to full GDP(may take very long)
 ● Central banks dilemma:
○ ↑AD to recover full employment, but risk push inflation Price ↑↑
○ ↓AD to fight inflation, sacrifice, push unemployment ↑↑

Case 4: AS↑ shift right

1. Cause & effect:

● AS↑ shift right, make (GDP)↑ and (P)↓ → very goods
2. Restore to full LR equilibrium employment:
● LR:
○ If AS↑ not permanent → AS curve move back, output↓back to → GDP*
○ If AS↑ permanent → no change, GDP1 become new GDP*

16 l combined change in AS and AD

● AD↑ AS↑: GDP↑, Price unclear due to effect in both direction
● AD↓AS↓: GDP↓, Price unclear due to effect in both direction
● AD↑ AS↓: Price↑ GDP unclear due to effect in both direction
● AD↓ AS↑: Price↓, GDP unclear due to effect in both direction
READING 17 BUSINESS CYCLE
17 a Business cycle, phases

Phase Expansion Peak Recession Trough

GDP growth Exponential↑↑ Slow down, peaking Decrease (< 0) (-) → (+)
(>0)

Employment Employment↑↑ Employment high Bgn:reduced hours Low employment

Firm start hiring↑ Firm hire slower>0 Later: ↓lay off End: overtime↑,
part-time↑

Inflation C↑I↑→ inflation ↑ Inflation peak↑↑ inflation↓ lag Moderate ↓inflation

Inventory/ Sale Late: ↑sale slow, Late: ↓:sale up,
Invent accumulate Invent deplete

Spending Firm I↑ C↑M↑ C&I slower I↓ C↓Housing↓ End:C↑ housing↑

● Business cycle recur not at regular interval, from 1 year to > 10 years,
○ Common rule of thumb: 2 consecutive quarter ↑: expansion
17 b Indicators: Inventories/Sales, employment, housing, trade during cycles
● Inventories/Sales: Firm want to keep inventory to meet sales demand, but not too much capital tied
up in inventory→ inventory / sale ratio is an indicator
○ Late expand: sales slow, invent accumulate → I/S > normal→ firm reduce production →
recession
○ Late trough: sales growth, invent deplete→ I/S <normal→ firm increase output → I/S→
normal
○ Inventory counted in GDP, analyst only see GDP↑ →see strength rather than begin of
weakness
● Employees: firm response slower, dont hire/fire w. each step of cycle, costly, affect moral, legal
○ → they will change how to utilize current worker first
○ Adjust production capacity: by adjusting overtime/ part time
○ Only hire or layoff worker after the expansion/recession persist

● Housing: indicator affected by cyclical swing, 4 factors affecting housing market

○ Mortgate rate: interest rate↓ → home loan ↑
○ % of income: when income high vs. housing price → demand ↑
■ If Income↑, but house price ↑↑→ housing activities↓
○ Speculation
○ Demographic: young 25-40 population: household formation age, close relate to housing demand

● External trade:
 ○ Import depend on domestic economy, while export depend on world demand
○ FX can affect both Import and Export,
○ FX depend on many variables, can go against GDP cycles

17 c Theories of Business cycle

● Neoclassical:
○ Business cycle result from temporary deviation from LR Equilibrium
○ Technology is main shifter of AS, AD
○ Economy have strong tendency toward full employment equilibrium
○ However: Great depression: more severe and prolongs than the model suggest, stay below
full employments for many years
● Keynes:
○ Business cycle result from shift in AD, due to expectations (Firms/consumer) about
future GDP
○ Optimistic: overproduce, Pessimistic: underproduce
○ Recommend Government to move economy toward full employment, reduce severity of
recession
○ Wages are downward sticky→ hard to ↓wage fast, ↑AS → recover from recession
○ Suggest Gov increase AD directly, through M.Policy (MP↑, r↓), Fiscal (T↓G↑)
● New Keynesian: add price of other Input material are downward sticky: more barriers
● Monetarist:
○ Business cycle result mainly from shift in AD, due to rate of grow of MS
○ Recession cause by external shock, or inappropriate MP↓by central bank
○ To keep AD stable & growing, central bank should follow policy stable and predictable
MP↑
● Austrian:
○ Business cycle result mainly from Government intervention
○ When r↓ forced down to artificial low level, firm invest capital in speculative/long
run/high profit business/product (e.g: real estate), other than actual consumer demand →
if turn out poorly → firm shut down → contraction
● New classic:
○ Real Business cycle (RBC) theory: Real economic variables, utility theory: i.e technology,
external shock → drive Business cycle, rather than monetary variables
○ result mainly from Government intervention
○ Government shouldnt intervene to counteract, because expansion and contraction are
efficient market response
17 d type, and measure of unemployment
● Three categories
○ Friction unemployment: necessary time lag for employees to move b/w works.
○ Structural unemployment: LR change in economy, eliminate old jobs, generate new jobs, of which
unemployed workers dont have the skills to do the available jobs
 ○ Cyclical unemployment: due to level of economic activities, increase when economy less than full
employment
● Term:
○ Labor participation rate: labor force / working age population, increase with expansion cycle
○ Labor force: all who either employed or unemployed active seeking job
○ unemployment rate: % of labor force unemployed
■ Unemployed: Not working and actively searching for work
■ LT Unemployed: unsuccessful seeking for work several months
○ Voluntary unemployment: choose not to be in the labor force → not include in unemploy rate
■ Discourage worker: avail for work but not employed or looking for job
○ Underemployment: qualified for significantly higher job, subjective, hard to identify
● Unemployment rate is lagging indicators:
○ Early expansion, discourage workers re-enter market more than amount hired immediately → UR up
(even though jobs increasing) → therefore actual number of employment is more important
○ Firm often response slower in hiring and lay off workers at cycle turning point → further lag
○ Productivity/ output: firm try to keep employee, reduce outputs in early recession, while early
expansion increase overtime, but not ready to hire yet

17 e Inflations, disinflation, deflation

● Inflations is persistent increase in price over time, of almost all goods and service
○ Erode purchasing power
○ Favor borrower at expense of lender
○ 1 jump in price level then not continue rising isnt inflation
○ Increase price of single goods is not inflation
● Hyperinflation: can destroy monetary system, cause social political upheaval
● Disinflation: inflation rate reduce over time, but > 0
● Deflation: negative inflation, associate with recession, consumer delay purchase, firm fix cost
increase
● Inflation rate: % change in price level, compare to previous years, this is the indicators to anticipate change
on central bank Monetary Policies
17 f inflation index
● GDP Deflator: increase in price level of whole economy
● CPI: basket of household consumers, similar to GDP :
○ Basket cost at current price / Basket cost at base price
○ Different composition across countries, reflect purchasing behavior
○ Also different in data collection and statistical methods
● PPI/WPI: can watch PPI at stages of production → identify emerging trend in price of goods in
process → larger full economy inflation
● Core inflation: exclude volatile foods and energy → more useful than headline in measure trend
in price
17 g compare inflation measure, their limitation
● Laspeyres index: Pn Qo / Po Qo
○ Base period basket, commonly used: three factors of bias:
 ○ New goods: added to replace old good, but initially more expensive → bias upward
○ Quality change: if price of good reflect higher quality, it not inflation, still reflect in index
○ Substitute: C switch b/w substitute goods → affect price of basket, even no actual inflation
● Hedonic: adjust for product quality
● Paasche index: Pn Qn / Po Qn
○ use current consumption basket weight rather than base year → measure only price
change
● Fisher index: chain weight, adjust for substitution bias, geometric mean of Laspeyres and
Paasche
17 h Cost push vs. demand pull inflation
● Cost push: AS↓(Stagflation), caused by input price ↑(wage, energy)
○ Wage increase are not inflation if productivity increase → measure unit labor cost
○ NAIRU
● Demand pull:AD↑(inflation gap), can be caused by M,G↑
17 i Economic indicator:
● Leading indicators: ISM, bond spread, S&P500, new orders, building permits, expectations
● Coincident indicators: NFP
● Lagging indicators: unemployment, unit labor cost, inventories / sales, CPI, GDP
READING 18 FISCAL, MONETARY POLICIES

18 a Money vs. fiscal policies:

● Fiscal policies (FP): Government taxes and spendings policies to influence the economy
○ Fiscal balance: balanced: G - T = 0, deficit: G - T > 0, surplus: G - T < 0
○ Fiscal easing/stimulus: cut tax (T)↓, increase spending (G)↑→ budget deficit
○ Fiscal tightening: cut spending (G)↓, increase tax (T)↑→ budget surplus

● Monetary policies (MP): central bank action, affecting money supply and interest
○ MP expansionary: cut interest rate (r)↓, increase money base (M)↑→ easing
■ Easing: stimulate for GDP↑, employment↑ and Inflation↑
○ MP Contractionary: raise interest rate (r)↑, decrease money base (M)↓→ tightening
■ Tighten: control inflation↓, buy also affect employment, Inflation↓

● Goals: economic growth (GDP), price stability (inflation), and wealth redistribution

I) MONETARY POLICIES: (MP)

18 b Function and definition of money:

● Function: 1. Medium of exchange, 2. Unit of accounts, 3. Storage of values
● Definition:
○ narrow money (M1): most liquid: circulated money in the economy, check bank deposit
○ Broad money (M2): = M1 + saving account/time deposit (3m up to 2 yr)

18 c Money creation process:

● Promissory note: issued by early banks to depositors → the notes later become medium of exchange
● Fraction reserve banking: bank hold a portion of deposit in reserve → the remaining available for
lending
● The money loaned out will be spent, and deposited in another bank → this money can be loan
again (after reserve requirement) → the loop continues
● Money multiplier: = 1/ Reserve requirement
● Money created = new deposit / Reserve requirement = new deposit * money multiplier

● Quantity theory of money: Money vs. Price level

○ Money supply * Velocity of money = Price * real output (Y)

○ Velocity = average number of time / year each unit of money used to purchase
goods/services
○ Assumption: V and Y constant → M↑→ P↑
○ Money neutrality: real variables (Y) and (V) are not affected by money variables

18 d Demand vs. Supply of money:

Demand of money:
● Three reasons of demand for holding money:
○ Transaction: more GDP → more transaction: positive relationship w. GDP
○ Precaution: money held for unforeseen future needs, increase with size of economy
○ Speculative: cash on hand for future investment opportunities
■ Negative relationship w.market returns (higher return →lower speculative demand)
■ Positive relationship w.market risk (high risk → higher demand for cash on hand)
● Demand of money vs. interest rate:
○ Demand negative relationship w. interest rate
○ High interest → lower demand for money (high opportunity cost compare to invest)
○ Low interest → higher demand for money (very similar to demand vs price of goods)

Supply of money:
● Control by central banks, independent of interest rate → perfect inelastic (vertical)
● Interest rate depend on equilibrium between (S) and (D)
○ At (ihigh): SupplyM > DemandM → excess cash in economy → purchase securities → push (i)↓
○ At (ilow): SupplyM < DemandM → shortage cash in economy → liquidify securities → push (i)↑
● Central bank can control money supply → affect interest rate
○ Supply negative relationship w. interest rate
○ Increase money supply: M↑→ excess cash in economy → push (i)↓
○ Decrease money supply: M↓→ shortage cash in economy → push (i)↑
18 e Fisher effect:
● Nominal interest = real interest + expected inflation
● RNominal =RReal + E(Inflation) + Risk Premium (for inflation uncertainty)

18 f Role of central bank:

● Role:
○ 1. Supplier of Ccy, 2. FX, gold reserve
○ 3. Banks of government, 4. Lender of last resort
○ 5. Monetary policies 6. Payment system,
○ 7. Regulate banking system
● Objective:
○ 1. Inflation: main objective to maintain 2% inflation
■ Menu cost: cost of company changing prices
■ Shoe leather cost: cost of minimize cash holding (depreciated by inflation)
○ 2. GDP growth and full Employment,
○ 3. Moderate LT interest rates,
○ 4. FX stabilities: e.g: developing countries pegging against USD (fix rate against USD)
■ Using FX reserve to manage FX rate stability
■ → affect Money supply and Interest rate
■ → effectively “import” inflation, and monetary policies
● e.g: Fed tighten: rUSD ↑→ USD/VND ↑→ SBV sell FX reserve
● → VND: Money supply↓,rVND↑ → “import” monetary policies
18 g cost of expected and unexpected inflation
● Menu cost vs shoe leather cost
● Cost of expected inflation:
○ Gradual decrease purchasing power → cost of holding money vs. interest bearing securities
○ Cost of moving from interest bearing securities to cash to facilitate transactions
● Cost of unanticipated inflation:
○ High unexpected inflation → borrowers gain at expense of lenders
Volatile inflation → require higher rate for additional risk → high borrowing rate
→ slow business investment (I)↓, reduce economic activities (Y)↓
○ Uncertain information about price change:
■ Price↑→ firms assume Demand↑→ increase production (Y)↑,
■ In fact, demand unchanged, Price ↑due to inflation→ excess production, inventory →
increase magnitude of business cycles

18 h monetary policies tool

● Policy rate: rates that banks can borrow from central banks
○ Policies rate↓→ banks’ cost of fund ↓→ overall interest ↓
○ Policies rate: Fed’s discount rate, ECB refinancing rate, BOE 2w repo rate
○ Fed funds rate: is the interbank overnight rates on reserves loan
■ Fed set a target for this rate and use OMO to adjust it

● Reserve requirement: percent of deposit, banks required to retain as reserves, directly affect the
available funds for lending → money supply, and interest rate. reserve↓→ MS↑and r↓
○ Only work, if bank willing to lends, and market willing to borrow

● OMO: central banks buy/sell securities to adjust money supply, the most common used tool to
achieve fed fund rate
○ Buy securities = increase money supply: MS↑and r↓
○ Sell securities = decrease money supply: MS↓and r↑

18 h monetary transmission mechanism

● There are 4 channels for monetary policies to affect inflation:
● E.g: MP tightening: central bank hike rate to control inflation:
○ Bank lending rate:
■ r↑→ lending rate(ST&LT)↑→firms(I)↓households (C)↓(S)↑
○ Asset price:
■ r↑→ discount rate↑→ value of bonds,equity↓→ households wealth↓→(C)↓
○ Market expectation:
■ r↑→ tightening→ expectation of GDP growth↓→(C)↓(I)↓
○ FX rate:
■ r↑→ FDI↑→FX rate↑→ (X)↓
 ● → all 4 channels effect: AD↓→ P↓
18 k monetary policies vs. GDP, inflation, interest, and FX rate
● In LR: Money neutrality → monetary policy only affect Price, no effect on real output (Y),
● In SR, monetary policies can affect GDP, interest, FX rate and inflation
○ Central bank:
■ OMO: buy securities, pump money to market: MS↑
■ Policy rate: cut discount rate: r↓
○ Banking system:
■ Interbank: Fed fund rate ↓
■ Primary market: more funds available → ST & LT loan rate ↓
○ Domestic market:
■ rate ↓ → firm investment up (I)↑
■ rate ↓ → consumers, reduce saving, increase credits, housing, auto (S)↓(C)↑
○ The world:
■ rate ↓ → capital outflow → FX rate ↓
■ FX rate↓ →(X)↑(M)↓
○ Aggregate demand:
■ (C)↑, (I)↑, (X-M)↑→ (AD)↑→ (GDP)↑employment ↑Price (inflation)↑

18 j qualities of effective central banks

● Independence: from political influence
○ Hike rate: r↑MS↓to fight inflation often make Y↓and employment↓
■ politician want to boost employment and GDP for election
■ → interfere w. central bank → compromise ability to manage inflation

○ Operational independence: independently determine policy rates

○ Target independence: also set inflation target and horizon to achieve, define how inflation
computed.

● Credibility: central banks that keep promise and follow their stated purpose
○ credible central bank → market believe → target can be self-fulfilling
○ Low credit central bank: e.g. government w. large debt → incentive to let inflation rise
● Transparency:
○ Periodically disclose economic environments in inflation/economic reports.
○ Clearly state the economic indicators, that they base on to set policies rates, and how → a.
more credible, b. Easier to anticipate & implement policies change

18 l central banks targets: inflation, interest, and FX rate

Central banks use different economic indicators as target for policy decision:
● Interest rate targeting:
○ if interest rate out of target band → adjust MS or growth of MS to control interest rate
 ● Inflation targeting:
○ Most central banks currently target this, some are required by law
○ Target often is 2% with +/- 1% band
● Exchange rate targeting:
○ Many developing countries that depend on trades or large debt use to peg ccy ag USD
○ If domestic ccy↓→ sell reserve, buy domestic ccy → policies effect: MSdomestic↓rdomestic↑
○ → great volatile MS to adapt & maintain stable FX rate
○ Targeting countries effectively follow monetary policies and interest rate consistent w this
goal → may have the same inflation rate as the targeted ccy

○ buy/sell reserve to affect FX rate is only SR, FX reserve is limited → sometimes peg falls

18 m expansion or contraction?
● Real trend rate (or trend rate): an economy long term sustainable real growth rate
○ Not observable → estimated
○ Change over time as structure of the economy change (from spending → saving behaviors)
● Neutral interest rate = real trend rate + inflation target
○ If MS growth at neutral interest rate → trend rate will not be affected
○ Compare policies rate vs. neutral interest rate → determine contraction vs expansion policy

● Contraction vs expansion:
○ Policies rate > neutral interest rate → contraction
○ Policies rate < neutral interest rate → expansion

● MP need to target the sources of inflation (core), if economy still below full employment, but high
inflation due to energy price, but, central bank contraction→ make it worse

18 n monetary policies limitation

1. Bond market vigilantes: central bank cut ST rate but LT rate increase, or vice versa

● Central bank hike: Tightening (control inflation)

○ MS↓r↑→ market expect LR inflation↓ LR GDP↓→ LT yield↓(due to inflation premium↓)
○ Monetary tighten viewed as too extreme → recession LR GDP↓→ LT bond more
attractive→ P↑yield↓

● Central bank cut: expansion (stimulus)

○ MS↑r↓→ market expect LR inflation↑LR GDP↑→ LT yield↑(due to inflation premium↑)
○ Monetary stimulus→ inflationary boom→ LT bond not attractive→ P↓yield↑
If central bank is credible → mkt trust that inflation target will be maintain over time→ this effect small
 2. Liquidity trap: money supply (MS) increase but interest not down, thus Investment and
Consumption not increase → policies not effective
○ When the economy willing to hold excessive cash rather than invest → interest not down
○ money demand very elastic → MS (Q) need to increase a lot ↑↑↑↑, for (r) (P)↓a bit
○ MS↑but rate NOT ↓→ (I), (C) NOT ↑,
○ If a country running MS expansion policy, but still deflation (low inflation, GDP)→ liquidity trap

3. Bank not willing to lend:

○ Financial crisis: Bank lost equity capital, want to rebuild → decrease lending
○ → policies: rate cut, increase MS not effective
○ Uncertainty about future economy→ bank conservative, hold excess reserve rather than
loan
○ Quantitative easing (QE): buy large amount of securities: government bond, mortgages
■ Even purchase securities w. Credit risk → improve banks balance sheet
■ shift risk from private to public sector

4. Developing countries
○ No liquid market for government debt interest rate → difficult for OMO
○ Rapid developing economy → difficult to find neutral rate
○ Central bank lack credibility/no independence, past failure to maintain inflation rate

II) FISCAL POLICIES: (FP)

18 o. Role, objective of fiscal policy

● Easing: Budget deficit: → response to recession, stimulus (spend more tax less)
● Tighten: Budget surplus → fight inflation (tax more spend less)
● Economic theory:
○ Keynes: fiscal policies is important to impact AD,
○ Monetarist:
■ fiscal stimulus only temporary,
■ monetary policies should be use to adjust inflation

● Discretionary fiscal policies: policies (spending and taxing) with intention to stable the economy
● Automatic stabilizers: stabilizers built in to the system and triggered by state of economy,
○ e.g. recession:
■ GDP Y↓ → taxable income↓, (T)↓
■ Unemployment ↑ → government transfer payment ↑ (G)↑ → auto budget easing
18 p. Fiscal tools, pros. and cons.
● Spending tool:
○ transfer payment: wealth redistribution
○ Current spending: government routine on an ongoing basis
○ Capital spending: infrastructure, school, hospital → boost future economy productivity
 ● Revenue:
○ Direct tax: income tax, corporate tax, capital gain tax, social securities
○ Indirect tax: on goods: VAT, excise (tobacco, alcohol)
● Pros & Cons:
○ indirect tax quick to implement without significant cost
○ Direct tax, transfer payment, capital spending, take time to implement
○ Spending tool more effective than tax tools, because people not spend all of the tax saving
○ Tax tool more effect on low incomes class, because they save less, higher MPC → boost
AD

● Financial multiplier
○ Change in Government spending have multiplier effect,
■ People with increased income will continues to spend → infinite loop
■ How much of the increased income they spent, depend on Tax rate and MPC

○ Fiscal multiplier = 1/ (1 - MPC (1-t))

○ Money created = new spending * fiscal multiplier
■ E.g: with tax rate 25%, MPC 80%:
■ 100m increase in Government spending
■ → Private sector: Revenue 100m ↑ Tax (25m) ↑ = Income: 75m↑
■ Income: 75m↑ → Spend 80% = 60m↑, Saving 20% = 15m↑
■ Individual who receive 60m↑, continue to spend 80% (48m↑) and save 20% (12m↑)
■ Final total money created = 100m / (1 - 80% (1-25%)) = 250m

● Balanced budget multiplier:

○ Government can increase tax to offset increase in spending, also have magnified effect.
Tax↑→ disposable incomes and consumption↓→ AD ↓

AD ↓= Amount taxed * MPC * fiscal multiplier

○ Because MPC < 1 → tax multiplier always smaller than fiscal multiplier

○ Balanced budget multiplier: increase both (G) and (T) → net budget unchanged, but AD
still increase
○ Balance ↑= Amount * (1-MPC) fiscal multiplier
● Ricardian equivalence:
○ Government deficit will be offset by taxpayer saving↑, due to higher expected future tax
○ Deficit ↑→ greater future tax → Saving ↑Consumption ↓
○ Taxpayer S↑C↓just enough to repay government debt → no net effect on AD (debate)

18 q argument about fiscal deficit

● Debt ratio: if interest on government debt > real growth rate → debt ratio will increase overtime
 ● Concern w. Fiscal deficit:
○ 1. High deficit → high future tax → discourage economic growth and start up
○ 2. Market lose confident → not refinancing the debt → government defaults
○ 3. Crowding out effect: government borrow↑ → rates ↑→ private sector harder to borrow
● Argument for fiscal deficits:
○ 1. Debts primarily held onshore → overstated problems
○ 2. If finance capital investment → future economic grow
○ 4. Ricardian may hold → deficit not too bad

18 r difficult in implementation of fiscal

● Discretionary fiscal policies: 1. Recognition lag, 2. Action lag, 3. Impact lag
● Other issue:
○ misreading of statistic: e.g. government use expansion policies at full employment → only drive inflation↑
○ limit to deficit: debt/GDP level too high → unable to raise fund (bonds) to fund deficit
○ Multiple targets: e.g. high inflation & high unemployment → cant target both

18 s determine expansion vs. contraction

● The Change in surplus or deficit level is used to classify policies as expansion or contraction
○ Fiscal surplus↑→ contraction Fiscal surplus↓→ expansion
○ Fiscal deficit↑→ expansion Fiscal deficit↓→ contraction
● Structural budget deficit (cyclical adjusted):normal deficit level that would occur base on current policies
○ Use to gauge fiscal policies→ actual deficit differ from this level → measure at expansion/contraction
18 t monetary vs. fiscal
MP and FP can each be either expansion or contraction:
1. Expansion FP and MP: high expansion effect, lower interest, both private and public sector expand
2. Contraction FP and MP:high contraction effect, high interest, both private and public sector contract
3. Expansion FP and Contraction MP:
a. Higher demand (G↑), higher interest (r↑) → higher public sector as % of GDP
4. Contraction FP and Expansion MP:
a. Lower demand (G↓), lower interest (r↓) → higher private sector as % of GDP
Effect: different FP tool have different effect:
Fiscal spending effect > transfer payment (to the poor) > tax cut
READING 19 Trade
19 a GDP vs GNP
● GDP: total value of goods produced w/in the country
● GNP: total value produced by the labour and capital of the country citizen, regardless where the
production take place
19 b benefit vs cost of trade
● Benefit of specialize, economy of scales, more competition → more efficient allocation of resources
○ Export: increase profit, GDP, employment, Import: increase consumer surplus, lower cost
● Cost: loss business + job to foreign competitors, but overall gain from free trade > cost → winner
can compensate the loser and still better off
19 c comparative vs absolute advantages
● Absolute advantage: can produce goods at lower term of resources
● Comparative advantage: can produce goods at lower opportunities cost in term of other goods
● David Ricardo:
○ UK vs Spain, produce cloth and wine,
○ Cost express in term of labour hours → each country have comparative advantage of a
goods
○ → trade make both country better off, even Spain may have absolute advantages in both
goods
● Production possibilities frontier PPF:
○ plot 2 goods: foods and machines, on 2 axis of a frontier,
○ slope at each point is opportunities cost of food in term of machine
○ Countries should produce more of the goods that they have comp.adv. (lower opp. cost)

19 d Ricardian vs Heckscher-Ohlin model of trade, Comparative advantages.

● Ricardian model:
○ 1 factor of production labor,
○ Source of comparative advantages: technology differences
● H-O:
○ 2 factors: capital and labors,
○ Source of comparative advantages: difference b/w 2 factors relative amount
○ Redistribution of wealth within each countries
○ Price of less scarce factors will increase (due to export), at the expense of the other factors
(due to import)
19 e Type of trade and capital restriction
● Reasons for trade restriction:
○ Supported theory:
■ protect infant industry → grow and compete, learning curve
■ national securities → protect producer of crucial defense goods/services
○ Not supported: protect domestic jobs and industry: at the expense of consumers and other
new jobs
 ○ Other: retaliation, countering foreign export subsidy, anti-dumping
● Type of restriction:
○ Minimum domestic content, Voluntary export restraint (VER)
○ Export subsidies: benefit the exporter and foreign consumers at expense of consumer surplus
of exporting country, and detriment of foreign producers
■ Large exporter ctry → subsidy = world price cũng giảm
○ Tariff: tax on imported goods
○ Quota: limit amounts of imports,
■ if charge quota rents → result same w. Tariff
■ Not charge → foreign exporter gain the quota rents
○ Effect: higher price, lower imported Quantities
○ Domestic producer surplus gain
○ DWL = losses in consumers surplus - producer gain - government tariff/quotas
○ Only exception: quota in large import country → reduce the world price

19 f trading union
● 1. FTA: remove all barriers to import/exports
● 2. Custom union: common trade rules w. outside parties
● 3. Common market: free movement of capital and labours
● 4. Economic union: common economic policies
● 5. Monetary union: common ccy
19 g capital restriction
● Prohibit/restrict foreign investment, FDI in certain industries or capital withdrawal
● Reduce volatility of domestic asset: avoid impact of large capital flows on market→ panic
● Maintain fix FX rates → frees on policies → keep domestic rate low
● Protect strategic industry
19 h Balance of payment
● Current account:
○ trade balance: machine/goods/services flows
○ Income receipt: include foreign income, dividends
○ Unilateral transfer/ aids/ gifts
● Capital account:
○ Capital transfer: invest fix assets, funds
○ debt forgive, migrants assets flows (in/out)
○ Non financial assets: intangible assets (patents), right to natural resources
● Financial account:
○ Asset abroad: gold, ccy, securities, others assets, claims against foreign
○ Foreign claim of country asset: ccys, securities, FDI, other claims in domestic
● X-M < 0 → trade deficit → net cash outflow → foreign claims ↑ or asset abroad ↓→ offset by sales
of assets or debt incur to foreigners
● X-M > 0 → current account surplus offset by purchase of foreign financial or physical assets
 ● Sum all 3 accounts = 0 → CA deficit is made up by net surplus in capital and financial accounts
19 i BOP vs Gov, Firms, Consumers
● X-M = (S - I) - (G - T) : trade balance = private excess savings and (T-G) government savings
● Trade deficit : net saving (private & gov) < investment → must be funded by foreign borrowing
● Lower private saving, or government saving, or higher investment → all make CA deficit
● If deficit (increase borrow) to finance high consumption → not good, but to finance capital
investment → future ability to pay back
19 j function, objective: IMF, WB, WTO
● IMF: exchange stability, multilateral payment system, support members w BOP difficulties
● WB: financial assistant for developing countries, fight poverties, provide low interest loans for
education, health, infrastructure, public admin, agriculture, environments
● WTO: promote international trades, multilateral trades agreements
READING 20 FX
20 a Nominal vs Real rate, Spot vs Fwd
● 1.18 term (price) ccy / 1 Base ccy: 1.18 Usd/Eur
● 1.18 domestic ccy / 1 foreign ccy
● Rate ↓ = C1↑C2↓
● Real exchange rate (d/f) = spot (d/f) * CPIforeign/ CPIdomestic (~ remove domestic inflation and
consider foreign inflation)
20 b Function, mkt participant
● Hedger vs speculators
● Sell side: large interbanks,
● Buy side: government, corporates, investors (individual, funds, both speculate and trades)
20 c % change vs another ccy
● Can only calculate % change of base ccy (ccy2) : = (Rate 2 / Rate 1)
● For term ccy → reciprocal: % change of term ccy (ccy1) : = (1/Rate 2 / 1/Rate 1)
𝑈/𝐸
20 d Cross ccy: = 𝐴/𝐸, J/U * U/E = J/E
𝑈/𝐴

20 f interest rate parity, calculate fwd rate

𝐹𝑊𝐷 1+ 𝑅𝑑
● = → Fwd = Spot (1 + Rd) / (1+Rf)
𝑆𝑃𝑂𝑇 1+𝑅𝑓
20 e,g Forward discount premium
● Quote pips
● Quote % (not annualized): e.g: U/E spot: 1.14 and U/E 3m +1.787% : → U/E 3m = 1.14
(1+1.787%)
● Fwd premium/discount (of base ccy) = fwd > spot → premium

20 i exchange rate regime

● No own ccy:
○ Formal dollarization: → use other countries money, no monetary policies
○ Monetary union
● Have own ccy:
○ Ccy board arrangement: commit fix FX rate, ccys is only issued if fully backed by USD
reserve
■ Give up independent policies, import inflation
○ Conventional fixed peg: fix peg +/- 1%, can direct/indirect intervene to maintain rate
○ Peg with horizontal bands, target zone: peg basket +/- 2%: more policies discretion
○ Crawling peg: peg adjusted periodically, for inflation changes
○ FX rate management within crawling band: width of the bands increase overtime
○ Managed float: occasionally influence rate, responding to inflation, employment, but no
specific target rate zone
○ Independent float: market determined
20 j FX vs international trades, capital flows
How FX rate change affect trade balance?
● Elasticity approach:
○ FX rate ↓→ X↑ M ↓→ Trade deficit ↓, but how?
○ Marshall Lenner condition:
■ Wxex + WM(eM - 1) > 0
■ WX , WM : weight X, M over total trades
○ → FX rate↓ only efficient if M or X elastic
○ Luxuries, goods w close substitute → high elasticity
○ Necessity goods are inelastic
○ J curve: due to pre-orders → trade balance relatively insensitive in short-run → J-curve
● Absorption approach: analyze FX rate effect, focus on capital flows
○ X - M = (S-I) + (T-G): trade balance = private + government saving - domestic investment
■ Government deficit, funded by excess domestic saving, or net inflow of foreign capital
■ Investment, funded by total saving (private and public), and foreign capital
○ Trade balance = Y - E
■ Y: national income, domestic production
■ E: domestic absorption of goods service
○ For TB to improve, ccy depreciation need to have the following effects:
■ → Income (Y) - Expenditure (E) must ↑
■ → Domestic Saving - Investment (E) must ↑
○ Effectiveness depend on level of capital utilization
■ Less than full employment: FX rate ↓→ X↑ demand increase → both Y, E↑, but Y ↑
more, because only part of income is saved → TB improve
■ Full employment: increase demand → higher price → reverse FX effect → not
improve TB
■ But lower FX rate → lower asset value → Saving ↑ to rebuild wealth → improve TB in
ST