Unit 7 Absolute / Comparative Advantage

Absolute/ Comparative Advantage:

Absolute Advantage:

•  Individual- exists when a person can produce more of a certain good/ service than       someone else in the same amount of time (or can produce a good using the least   amount of resources.)

·         National-exists when a country can produce more o a good/ service than another county can in the same time period.

Comparative Advantage:

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

Specialization and Trade:

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

Examples of Output Problem:

tons per acre

miles per gallon

word per minute

apple per tree

television produced per hour

Examples of Input Problems:

number of hours to do a job

number of acres to feed a horse

number of gallon of paint to paint a house

Unit 7 Foreign Exchange

Foreign Exchange

Foreign Exchange:

·         
Buying and selling of currency

·         Any transactions that occurs in the balance of payments necessitates foreign exchange

·         Exchange Rate (e) is determined in the foreign currency markets

Changes in Exchange Rates:

Exchange rates (e) are a function of supply and demand for currency

- an increase in the supply of a currency

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

- increase in demand for currency will increase the exchange rate of currency

- decrease in demand for a currency will decrease the exchange rate of currency

Appreciation and Depreciation:

·         Appreciation of currency occurs when exchange rate of that currency increases (e^)

·         Depreciation of a currency occurs when the exchange rate of that currency decreases

Exchange Rate Determinants:

Consumer tastes

Relative income

Relative price level

Speculation

Exports and Imports:

·         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

Floating/ Flexible Rates:

Depends upon supply and demand of that currency vs. other currencies

Very sensitive to business cycle / provide options for investments

Fixed Rates:

Based on a country's willingness to distribute currency and to control the amount

As two currencies trade:

1.    

One supply line will ∆, the other demand line will ∆.

2.    They will move in the same direction

3.    One currency will appreciate, the other will depreciate

Unit 7 B.O.P

Balance of Payment:

Measure of money inflows and outflows between the US and the Rest of the World

• Inflows are referred to as Credits
• Outflows are referred to as Debits

The balance of payments is divided by 3 accounts
      1. Current Account
      2. Capital/ Financial Accounts
      3. Official Reserves Accounts

Current Accounts:

·         Exports create credit and Imports create debit

• Balance of trade or net exports: Exports of Goods/ Services, Import of Goods and Services.
• Net foreign income: Income earned by US owned foreign assets and Income paid to foreign held US assets
• Net transfers (tend to be unilateral)

-       Foreign aid → a debit to current account

Capital/ Financial Accounts:

• The balance of capital ownership
•  Includes the purchase of both real and financial assets
• Direct investment in the US is a credit to the capital account
• Direct investment by US Firms/ individuals in foreign country are debits to capital accounts
• Purchase of foreign financial assets represents a debit to a capital account
• Purchase of domestic financial assets by foreigners represents a credit to the capital accounts

Relationship Between Current and Capital Accounts:

·         Current Account and Capital should zero each other out

·         That is…. If Current Account has a negative balance (deficit) then the Capital Account should have a positive balance (surplus)

Official Reserves: 

• Foreign currency holdings of US Federal Reserve System
• When there is a balance of payments surplus the FED accumulates foreign currency and debits balance of payments
• When there is a balance of payments deficit FED depletes its reserves of foreign currency and credits balance of payments
• Official Reserves 0 out the balance of payments0

Active VS Passive Official Reserves

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

Formulas:

Balance of Trade

Good Exports + Goods Imports

Balance of Goods and Services

(Goods Exports + Service Exports) + (Goods imports + Service Imports)

Current Account

Balance on goods and services + Net Investments and Net Transfers

Capital Account

Foreign Purchases + Domestic Purchases

Unit 6

Long-Run Economic Growth, Phillips Curves, and the Laffer Curve

• Focus on Real GDP per Capita
• Last 50 Years Real GDP grew by about 3.5% per year
• Last 50 Years Real GDP per Capita grew by about 2.3% per year

The Sources of Long-Run Growth:

• Productivity—output per unit of input
• Labor Productivity – output per worker
* What leads to higher productivity?
* Stock of Physical Capital – buildings, machines, robots, etc.
* Human Capital – Knowledge, skills, educations, etc.
* Technology – technical means for producing goods and services
* Improved Resource Allocation – Trade allows us to shift labor services from low-productive jobs to high productive jobs.
* Economies of Scale – reductions in per-unit cost that result from increases in the size of markets and firms.



Production Possibilities Curve and LRAS:

• Economic Growth = Shift in Production Possibilities Curve outward
• Economic Growth = Shift in the Long-Run Aggregate Supply Curve to the RIGHT

Why Growth Rates Differ among Countries:

• Rates of Savings
• Foreign Investment
• Education
• Infrastructure – roads, power lines, ports, and information networks, etc.
• Research and Development
• Political Stability
• Protection of Property Rights
• Economic Freedom versus Excessive Government Intervention

The Phillips Curves – Short and Long Run

• Tradeoff between inflation and unemployment
• Stagflation leads to shifts in the SRPC.
* Aggregate Supply Shocks: Oil Embargo, Major Agriculture Shortfalls, Depreciating U.S. Dollar, Wage Hikes, Inflationary Expectations.
• Long-Run Phillips Curve (LRPC)
* Vertical line at the natural rate of unemployment

Supply-side Economics and the Laffer Curve

• Stress that changes in Aggregate Supply are an active force in determining the levels of inflation, employment, and economic growth.
• Concentrate on tax levels
• Lower taxes are an incentive for business to invest in our economy
• Lower taxes are an incentive for workers to work more and harder thereby becoming more productive.
• Lower taxes are incentives for people to increase savings and therefore create lower interest rates for increases in business investment
• Focus on the marginal tax rates

The Laffer Curve:
• Relationship between tax rates and tax revenues
• Used to support the supply-side argument
• Reaganomics = Supply-Side Economics
• Idea = The government could lower tax rates and actually increase tax revenues.
• Has been severely criticized.

Unit 5 Continued

Reaganomics 

Supply Side Economics and Laffer Curve

Supply Side Economics:

• Changes in AS and not AD are the main active force in determining the level of inflation, unemployment rates, and economic growth.
•   Supply side economists support policies that promote GDP growth by ongoing that high marginal tax rates along with current system of transfer payments such as unemployment of compensation or welfare programs provide disincentives to work, invest, innovate, and undertake entrepreneurial ventures.

Incentives to Save and Invest:

• High marginal tax rates reduce the rewards for savings and investment        
• Consumption might increase but investments depend upon savings
• Lower marginal tax rates encourage saving and investment

Laffer Curve:

• Theoretical relationship between tax rates and government revenues
• As tax rates increase from 0, tax revenues increase from 0 to same maximum level and then decline

3 criticisms of Laffer curve:

1. Evidence suggests that the impact of tax rates an incentive to work, save and invest are small

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

3. Where the economy is actually located on the curve is difficult to determine

Unit 5 continued

The Phillips Curve

 Natural Rate of unemployment is held constant

•     LR Phillips Curve exists at a Natural Rate of Unemployment (Un) Structural changes   in the economy that affect Un will also cause the LRPC to shift.
•      Increase in Un will shift LRPC →
•       Decrease in Un will shift LRPC ← 
•  SR Phillips Curve – tradeoff between inflation and unemployment

  (when one goes up the other goes down)

Relating Phillips Curve to AS/AD:

The changes in AS/AD model can also be seen in Phillip’s curve

LRPC: 

Occurs at natural rate of unemployment represented by vertical line·         No tradeoff between UN and inflation
·         Only shift if LRAS shifts
·         if NRU changes so does LRPC
·         NRU = frictional + structural + seasonal Un (4-5%)
·         Major LRPC assumption is that more worker benefits create higher natural rates and a 

fewer worker benefits create a lower natural rate.

Misery Index: Is the combination of inflation and unemployment in any given year
single digit misery is good

Supply ShocksRapid and significant in resource cost

DisinflationReduction in inflation from year to yearcan be seen in LRPC

Important Vocabulary Words you need to know:

Deflation - General decline in price

Inflation - General rise in price

Stagflation - unemployment and inflation rise/increase at the same time

UNIT 5

Unit 5 - Extending Analysis of Aggregate Supply


Short-Run Aggregate Supply
·         This is the period in which wages (and other input prices) remain fixed as price level increase or decrease

Long-Run Aggregate Supply
·         Period of time in which wages have become fully responsive to changes in price level

Effects over Short-Run / Long-Run
·         In the short-run, price level changes allow for companies to exceed normal out puts and hire more workers because profits are increasing while wages remain constant
·         In the long run, wages will adjust to the price level and previous output level will adjust accordingly.

Equilibrium in the Extended Model
·         The extended model means that both the short run and long run AS curves.
·         The long AS curves is represented with a vertical line at full employment level of real GDP.

Demand Pull Inflation in the AS Model
·         Demand pulls (to the right) which causes prices to increase based on increase in aggregate demand.
·         In the short run, demand pull will drive up prices, and increase production
·         In the long run, increase in aggregate demand will eventually return to previous levels.

Cost-Push and the Extended Model
·         Cost-push (to the left) arises from factors that will increase per unit costs such as increase in the price of a key resource.

Dilemma for the Government

·         In an effort to fight cost-push, the government can react in 2 different ways……
1. Action such as spending by the government could begin an inflationary spiral
2. No action however could lead to recession by keeping production and employment levels declining.