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-Keywords-
Positive Analysis – Describes the world how it is, based on hard facts and data.

Normative Analysis – Describes the world how it should be, based on opinions.

Comparative Advantage – A person has Comparative Advantage if he can produce something at a

lower cost than anyone else.

Opportunity costs – What it costs someone to produce something is the opportunity cost – the value
of what is given up.

Trade-offs – Best allocation of your resources in order to make better decisions.

Incentive – =~ Motivation

Model – An organized system or work plan; Representations of the economics system and simplify
reality to improve our understanding of it.

Macroeconomics – Is the study of economics in an individual, group, or company level.

Microeconomics – Is the study of a national economy as a whole.

-Questions-
Explain with a numerical example the principle of comparative advantage and why gains from
trade arise if comparative advantages exist.

- First introduced by David Ricardo (pictured) in 1817, comparative advantage exists when a
country has a 'margin of superiority' in the supply of a product i.e. the cost of production is lower.
- Countries will usually specialise in and export products, which use intensively the factors inputs,
which they are most abundantly endowed. For example the Canadian economy which is rich in
low cost land is able to exploit this by specializing in agricultural production. The dynamic Asian
economies including China has focused their resources in exporting low-cost manufactured goods
which take advantage of much lower labour costs. This is now changing as China looks to move
from a middle-income country by specializing in industries that use higher levels of knowledge and
technology.
- In the richest advanced countries, the comparative advantage is mainly in specializing in producing
and exporting high-value and high-technology goods and high-knowledge services.

Output of X Output of Y
Country A 180 90
Country B 200 150

- In this example, country B has an absolute advantage in both products. Absolute advantage
occurs when a country or region can create more of a product with the same factor inputs. But
Country A has a comparative advantage in the production of good X. It is 9/10ths as efficient at
producing good X but it is only 3/5ths as efficient at producing good Y.
- Comparative advantage exists when a country has lower opportunity cost, i.e., it gives up less of
one product to obtain more of another product. In our example above, for country A, every extra
unit of good Y produced involves an opportunity cost of 2 unit of good X. For country B, an
additional unit of good Y involves a sacrifice of only 4.3 units of good X.
- There are gains to be had from country A specializing in the supply of good X and country B
allocating more of their resources into the production of good Y.

Explain why models are used in economics and what you need to be aware of when using them.
 - Models are representations of the economics system and simplify reality to improve our
understanding of it. Depending how much your assumptions cover reality, models also
proportionate on usefulness. Thus models help us understand reality, but they don’t show
the truth.
- When using models, you have to be aware of the assumptions you make, the data you use
and implications, because all of these derive the model!

Explain briefly the 10 principles of economics

- People face trade-offs: Every decision you make includes trade-offs , if we not only take
money as a resource, but also other resources such as energy, time etc. thus the saying
“There is no such thing as a free meal”
- Opportunity costs: This means that whatever you give in order to produce something, can
be interpreted as opportunity costs. (as already mentioned in keywords)
- People think at the Margin: In economy not everything is black and white, thus people use
margins in order to analyse data, and perform small adjustments to their actions which is
also known as marginal changes.
- People respond to incentives: Our decision making changes whenever we are introduced to
new costs and benefits, thus concluding that we react accordingly with new incentives. It is
also said that Economics is at root the study of incentives; the way people get what they
want or need.
- Trade makes everybody better off: This is best described by an example of which, if you give
something you don’t need, for something you want and the same case for the other party,
then everyone is better off. The only time where this kind of trade does not happen is when
it is forced.
- Markets are good at organizing: If the markets organize, then they will be good at it. The
reason for this is that the markets the prices and self-interest guide the decisions. There is
also the phenomena described as the “Invisible hand”, which guides the market participants
and leads to desirable outcomes.
- Governmental interventions is sometimes good: Because of some difficulties that can
happen in the market, the market starts to not work as well as it is supposed to; that is when
the government should intervene. These interventions are very productive because they
form regulations in order to keep the market balanced.
- Living standards depend on productivity: (I am not sure about this one but I think it is as
simple as saying that your productivity is directly proportional to your living standards.
- Printing money causes inflation: This is another simple principle which describes that
whenever you print money you cause inflation, because of the circulation of that money into
the market. However not all inflation is caused by printing money.
- Unemployment and Inflation are linked: This shows that for a short period of time, when
inflation is introduced to a market the unemployment rate would be reduced. But as
mentioned this effect is temporary and it is a government’s duty to adjust everything when
printing money in order to not cause upheaval.

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-Keywords-

Market: a group of buyers and sellers of a particular good or service

Competitive market: In a competitive market there are many buyers and sellers.

Price taker: As sellers (and buyers) have no influence on the prices they are said to be price takers

Law of demand: if, other things being equal (ceteris paribus), the price of a good rises, the quantity
demanded falls and vice versa; the quantity demanded is negatively related to the price

Normal good: a good for which, ceteris paribus, an increase in income leads to an increase in
demand.

Inferior good: is a good for which, ceteris paribus, an increase in income leads to a decrease in
demand.

Substitutes: Two goods for which an increase in the price of one leads to an increase in the demand
for the other one. (or vice versa)

Complements: Two goods for which an increase in the price of one leads to a decrease in the
demand for the other. (or vice versa)

Law of supply: The quantity supplied of a good rises, if – ceteris paribus – the price of the good rises;
the quantity supplied is positively related to the price

Individual supply curve: Shows how much of a product a firm supplies

Individual demand curve: Shows how much of a product an individual demands

Market supply curve: Shows how much of a product a lot of firms supply

Market demand curve: Shows how much of a product a lot of individual demands

Market equilibrium: The point where the demand and supply curve meet

Price elasticity of demand: A measure of how much the quantity demanded of a good responds to a
change in the price of that good, computed as the percentage change in quantity demanded divided
by the percentage change in price.

Price elasticity of supply: : How much does the quantity supplied of a good respond to a change in
the price of that good, computed as the percentage change in quantity supplied divided by the
percentage change in price.

Cross price elasticity of demand: A measure of how much the quantity demanded of one good
responds to a change in the price of another good, computed as the percentage change in quantity
demanded for the first good divided by the percentage change in the price of the second good.

Income elasticity of demand: A measure of how much the quantity demanded of a good responds
to a change in consumers’ income, computed as the percentage change in quantity demanded
divided by the percentage change in income.

Inelastic: x

Unit elastic: x

Elastic supply: x
 -Questions-

Are individual demand curves aggregated horizontally or vertically to get the market demand curve?
Illustrate your answer graphically with a numerical example.

-
- This shows that the individual demand curve aggregates horizontally to get the market
demand curve

Show graphically how an increase in income affect the demand curve for (1) a normal good, and (2)
an inferior good.

- (1) Demand increases (shift to the right)

- (2) Demand decreases (shift to the left)

Are individual supply curves aggregated horizontally or vertically to get the market supply curve?
Illustrate your answer graphically with a numerical example.

This shows that even the individual supply curves aggregate horizontaly

Explain and show graphically how an increase in input prices affect the supply curve.

- When the prices of inputs increase firms will produce less for a given price (or a given
quantity will be sold at a higher price) because they make less profit. This will lead to a shift
of the supply curve to the left.
- The graph is just simply the supply curve shifting to the left, too lazy to put it here.

Explain how the actions of buyers and sellers move competitive markets to an equilibrium!

- Buyers want to buy the product for as cheap as possible, sellers want to sell the product for
as highly margined as they can. At the point where most of the people are comfortable with
the selling and buying of that product, an equilibrium point is reached/
Explain how an increase in preferences for ice cream influences the equilibrium in the ice cream
market!

- When the demand is raised, the demand line is shifted to the right, and the equilibrium is at
a higher point.

A question that asks you to calculate the elasticity of two points on a curve applying the midpoint
method for calculating elasticities.

- X

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-Keywords-
Tax incidence: The distribution of a tax burden.
Welfare economics: Welfare economics is defined as a branch of economics that studies
how the distribution of income, resources and goods that affects the economic well-being. An
example of welfare economics is the study of how certain health services help bridge the
barrier between different classes of people.
Willingness to pay: is the maximum amount an individual is willing to sacrifice to procure a
good.
Consumer surplus: A buyer’s willingness to pay minus the amount the buyer actually pays.
Producer surplus: Producer surplus is the amount a seller is paid for a good minus the
seller’s cost.
Total surplus: The sum of consumer and producer surplus which we call total surplus.
Deadweight loss: The fall in total surplus that results when a tax (or some other policy)
distorts a market outcome is called deadweight loss
Efficiency: Through the price mechanism markets allocate goods to those who value them
most as measured by their willingness to pay (to those whose WTP is higher than the market
price). Also through the price mechanism markets allocate the production of goods to those
who can do so at least cost (to those whose production costs are below the market price).
Equity: Deals with the fair distribution of economic prosperity among members of society.
-Exam Questions-
Analyze graphically how a price ceiling impacts on equilibrium price and quantity in a competitive
market!

- There are two kinds of price ceilings above market price, and below market price. The price
ceiling above the market price does not change the equilibrium because it is not
immediately effective, price ceiling above market price is only effective if there is a huge
inflation.
- As per the ceiling below the market price there are certain changes that happen.
 -
- First and foremost the graph shows that the supply decreases, and the demand increases,
thus resulting in a shortage. That means that Less of the good is available than before, and
even more is demanded. And also uncoordinated rationing mechanisms are made such as:
queuing, personal preferences of sellers and black markets.

Analyse graphically how a goods tax on buyers and sellers influences equilibrium price and
quantity in a competitive market!

- taxes discourage market activity, quantity of good sold is lower in new equilibrium and 2
buyers and sellers share the burden of taxes
- - in the new equilibrium buyers pay more for the good and sellers receive less

-
Explain graphically why a competitive market leads to an efficient allocation of resources!

- Through the price mechanism markets allocate goods to those who value them most as
measured by their willingness to pay (to those whose WTP is higher than the market price).

Also through the price mechanism markets allocate the production of goods to those who can do so
at least cost (to those whose production costs are below the market price).
 -

Explain graphically the concept of deadweight loss!

- The effect is a decline in producer surplus to A, and in producer surplus to F and an increase
in tax revenue by B+D. Total surplus is reduced by C+E. The fall in total surplus that results
when a tax (or some other policy) distorts a market outcome is called deadweight loss. C+E
measures the size of the deadweight loss.

-
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- KEYWORDS -

Regressive tax: high-income taxpayers pay a smaller fraction of their income than do low-
income tax-payers

Proportional tax: high-income and low-income taxpayers pay the same fraction of income

Progressive tax: high-income taxpayers pay a larger fraction of their income than do low-income
tax-payers

Negative externality: arises when a person engages in an activity that (directly, not through
market prices) negatively influences the well-being of another person without this person being
compensated for the harm caused by the other person.

Positive externality: arises when a person engages in an activity that positively (directly, not
through market prices) influences the well-being of another person without this other person
having to pay for the benefits received caused by the first persons activity.

Public good: Neither excludable nor rival. People cannot be prevented from using it and one
person’s use does not diminish other person’s ability of using such a good.

Common resource: Public goods and common resources are not excludable but in contrast to
public goods, common resources are rival: one person’s use of the common resource reduces
other person’s ability to use it.

Benefit principle: People should pay taxes based on the benefits they receive from
governmental services. This principle tries to make public goods similar to private goods. A
person who uses lots of a public goods should pay more for it.

Ability-to-pay principle: Taxes should be levied on people according to how well these people
can carry the burden. The idea behind is that all people should carry an equal burden when it
comes to contributing to governmental expenses. (Because of what is conceived as a burden
also depends on one’s own income / wealth the ability-to-pay principle does not imply a lump-
sum tax.)

Lump-sum tax: everybody pays the same amount.

Exam questions next page VVV

-Exam questions-

1) Explain graphically why the presence of negative externalities lead to an inefficient market
solution and how a Pigouvian tax can remedy the problem.

To understand how negative externalities lead to market ineffi- ciency consider the example of
an aluminum factory whose smoke emissions have a negative impact on the health of
neighbours.
Because of the negative externality there are additional costs. The correct cost curve to consider
is now the social cost curve which includes private costs plus costs for others

In order to compensate for the social costs, the company has to pay somehow. A method to do
this is by taxes, and these taxes should be as high as the social costs.

This is called internalizing externalities. Incentives are altered so that people take account of the
external effects of their action. If external effects are internalized through a tax it is called a
Pigouvian tax.

2) Explain what public goods are and why they will not be provided sufficiently through
markets.

Public goods are goods that everyone can use (check the keyword for a more formal definition),
and the reason why theyre not provided sufficiently through markets is because of the “free-
rider problem”. The free-rider problem is understandable through the word itself, which means
that when someone pays for a product and you benefit from it, BUT you didn’t pay for it as the
rest.

3) Explain why a lump-sum tax is the most efficient tax and why it is rarely implemented in
practice.

It is efficient because it does not alter people’s decisions. Regardless of what you decide about
labour and consumption, it has no influence on the tax that you pay. Why are lump-sum taxes
then rarely observed in practice?

The reason is that it goes against what many people perceive as fair in terms of equity
considerations because a lump-sum tax takes the same amount of money from the rich and the
poor

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Common Abbreviations: MC (Marginal Costs), ATC (Average total costs),

TC (Total Costs), Q (quantity)
-Keywords-
Opportunity cost: The cost of something is what you give up to get it.
Total cost: The market value of the inputs it uses for production of its outputs
Profit: Profit = total revenue - total cost, in words it would be that the profit is the subtraction of
total revenue with total costs.
Total revenue: The amount a firm receives for the sale of its output
Production function: Relationship between quantities of inputs used to make a good and the
quantity of output of that good.
Fixed costs: Costs that do not vary with the quantity of output produced
Variable costs: costs that vary with the quantity of output produced
Marginal costs: the increase in total costs that arises from an extra unit of production: MC=
∆TC/∆Q
Average fixed costs: fixed costs divided by the quantity of output
Average variable costs: variable costs divided by the quantity of output
Average total costs: total costs divided by the quantity of output: ATC(average total costs) =
TC(total costs)/Q(quantity)
Economies of scale: is an example for when the ATC starts declining and output increases,
which could be followed by an example of the increasing expertise of workers within time
which increases productivity and thus gives opportunities to buy larger quantities of
resources in a cheaper price.
Diseconomies of scale: ATC rises while output increases (The reason for saying output
increases is that we need some kind of factor in order to see whether the ATC is rising or
not, and it’s not stated as an after effect of ATC rise)
Constant returns to scale: ATC stays the same while output increases
QUESTIONS
1) Explain graphically the profit maximizing decision of a firm in a competitive market!

There are two ways of calculating the maximum profit a company can earn with their current data,
first one is to simply calculate Total revenue – Total costs, which gives us profit. And then we chose
which value is the higher and we go with that.*

There is, however, another way of finding the profit maximizing quantity which is to compare for
each additional individual unit where production is profit maximizing. What do we have to do for
that? We have to compare marginal revenue and marginal costs of each unit. As long as MR > MC
profit increases, and once MR < MC profit decreases. Hence, the firm maximizes profits when MC =
MR = P.
I think in order to understand this you must understand the difference between MC (marginal costs)
and TC (total costs).

2) What are the differences between short term and long term adjustments of a firm’s costs?

To explain this I would like to start with long term adjustments because it would be easier to
understand the difference more thoroughly.
The long term adjustments can be interpreted as “Looking at the bigger picture”, a follow-up
example for this would be that the costs of the factory in the present are more or less a fixed
number which doesn’t change, however in the future this number might actually change a lot!
Another example can be taken into consideration which would further enhance your understanding
of long term is simply the phenomena of “economies of scale” which is explained in the keywords.

As for short term adjustments we can take into consideration the employment of a new employee.
At the time we employ this person, there are of course changes that happen to this company in
terms of costs and profit, product etc. And all the different kinds of costs such as fixed costs, variable
costs etc that come with these kind of actions(ex: employing) are all short term adjustments.

3) Explain graphically firm’s long and short run supply curve!

I have no idea gotta ask the prof, I don’t quite get it

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-Keywords-
Monopoly: A firm is a monopoly if it is the sole seller of a product and if this product has no close
substitutes.
Oligopoly: a market structure in which only a few sellers offer identical or similar products.
Cartel: When oligopoly firms come into agreement to set quantities and prices is called
collusion, and the firms that do it are called cartel.
Monopolistic competition: a market structure in which many firms sell products that are similar
but not identical.
Price discrimination: a business practice of selling the same good at different prices to different
customers.
Nash equilibrium: a situation in which economic actors interacting with each other choose their
best strategy given the strategies all other actors have chosen.
Game theory: Firms in oligopolistic market frequently plan strategies, and each decision induces
direct response(s) by rivals, hence each decision made by any firm affects the whole market.
Dominant strategy: When a firm chooses a strategy to get the most payoff, no matter what the
other firm chooses, then it is called Dominant strategy.

-QUESTIONS-
1. Explain why a monopoly arises and what a government can do to mitigate its problematic
effects.

Well it depends as there are 2 kinds of monopolies, government created monopolies and natural
monopolies. In the government created monopolies the government gives the exclusive rights to
one firm to sell a product or a service. Exclusive rights means that only that company is able to do it
and if any other company does it in that state or province is punished by law. And thus there is no
competition, as a result of this the firm will rise without too many difficulties.

And a natural monopoly is when a company rises due to being able to supply goods and services at a
lower price than two or more firms. This means, that a single company could produce any quantity
at minimum average costs. And that is what enables it to rise.

Question 2,3 below

2. Explain graphically the profit-maximizing decision of a monopoly and show the profit a
monopoly makes.

Well to find the profit of a monopoly company we take the formulas and strategies from Economics
Questions 5, and we apply them here aswell. So one way to do it is to directly subtract total revenue
with total costs and that will give us the overall profit. But we can also calculate for each unit t
(which is price minus ATC) and multiply it with the number of units sold (Q).
3. Explain graphically the long-run and short-run profit maximizing decision of a firm in
monopolistic competition

idk
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-QUESTIONS-
1. How does immigration affect labor market?
So here in this chart you can see that the equilibrium in labour market works similar to any
competitive market. And so you can already see that any additional supply or demand will shift
the curve. And when immigration happens, the labour quantity rises and with that the equilibrium
will directly shift to the right.

However since the equilibrium will shift to the right, the wage equilibrium will decrease or go
down. And also as the graph shows it will also raise employment. The amount of employment
increase and wage reduction is based upon the elasticity of the workers.

2. Discuss policies to reduce inequality

This is based on my opinion, and should be disregarded from the reader

I think the best policy in regard to reduce inequality would be negative income tax, especially in
countries like Brazil where the ratio between the lowest 10% and the highest 10% is extremely high.
The policy works really well, however there are complaints from the top 10% as they think that lazy
people receive money just by being lazy. However my counter argument would be that first of all
they have a lot more money then they need, not only for essential goods but also some luxuries. If
we compare some of the top ceo of some companies, and a regular worker (ex: builder), the regular
worker uses a lot more time and energy however they receive less money. This is completely unfair
in my opinion, and it reflects back the argument of being lazy, in this case to the top 10%.

3. State three reasons for a shift in labour demand, three reasons for a shift in labour supply.

A) Labour demand

1. Changes in availability of inputs can increase the labour demand

2. If the value of a product is increased in a company, it would lead to shift to the right of labour
demand. That Is possible as long as the value of the marginal product of labour IS marginal product
times the price of the firms output.

3. Technological change is also a factor of this, with the same argument that as long as the value of
the marginal product of labour is marginal product times the price of the firms output, then
technological progress increases the efficiency and more products are being output, in this case
theres a shift to the right in the labour demand.

B) Labour supply

1. Immigration

2. Changes in preferences, for example companies take gay people into their jobs now cause they
don’t care anymore

3. The labour supply could also be thought as in specific areas instead of general ones only. So in that
case we can compare apple companies and pear companies. If the demand for apples is higher, then
the labour supply would shift in apple companies, but vice cersa in pear companies.

4. Explain two reasons how above-equilibrium wages arise at the market.

The first reason for an above equilibrium wages would be if a company is looking for employees that
are well qualified for the position, and in order for that employee to join their company instead of
another mediocre company or that it would increase the productivity of current workers.

The other reason is that if the minimum wage is higher than the market equilibrium, it leads to
higher wages.

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-Keywords-
Frictional unemployment- this occurs when there is hypothetically 0% unemployment, and that is
considered as bad because of the normal turnover. So when there is 0% unemployment people
cannot be versatile with their jobs and they cannot change them.

Structural unemployment - structural unemployment refers to workers who have lost their jobs
because they have been displaced by automation, because their skills are no longer in demand or for
similar reasons.

Labour productivity- the amount of output a typical worker turns out in an hour

Potential GDP - potential gdp is the real gdp that the economy would produce if its labour and other
resources were fully employed

Cyclical unemployment - the portion of unemployment that is attributable to a decline in the

economy‘s total production.

-Questions-
What is GDP and explain its limitations?

Gdp is used in order to estimate the total output of an economy. The GDP is the sum of the money
values of all final goods and services produced in the domestic economy and sold on organised
markets within a specific period of time, usually a year.

The limitation of gdp is that it cannot include anything and it cannot perfectly display the wellbeing
of an economy or a country, the reason for this is that it cannot include off market activities, for
example a small farm which provides the needs for a family, without the need to purchase of the
market.

The second limitation is that it has no value what so ever on leisure (free time), and so when a
country uses leisure for some reasons which may be positive, it doesn’t show in the gdp and would
look as stagnation in gdp.

Another reason is that it doesn’t count the ecological costs, so if a company produces a lot but also
does a lot of environmental damage, it only takes into count the production. ( I think here we can
include all the social costs)

Explain briefly the difference between GDP and potential GDP.

So the potential gdp, is imaginary GDP where it is calculated as the GDP if all the resources could be
used, this is usually not the case, hence the real gdp is almost always below the potential GDP.

The only time where the real gdp can be higher then the potential GDP is when more resources then
available are used, or when a lot more time is put into work. So the best distinction between real
gdp and potential gdp is the amount of resources used out of total available resources.

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Keywords
Production function – Shows how much output an economy can produce
depending on a varying input (e.g. labour) for given other factors (e.g. capital,
technology).
Growth policy – Policies that increase the growth of the GDP (e.g. increasing
the limit of work hours)
An economy’s human capital – Human capital is the knowledge, education,
training etc, possessed by an individual or population.
Research and development (R & D) - activities aimed at inventing new
products or processes, or improving existing ones
Invention - is the act of discovering new products or new ways of making
products
Innovation- is the act of putting new ideas into effect
Formal and informal institutions - Formal institutions are all the legal rules
that restrict (or allow) economic and other type of development. This also
includes rules and regulations to ensure legal compliance. Informal institutions
are norms, and other “unwritten” rules that determine human behaviour.
Marginal propensity to consume - is the ratio of changes in consumption
relative to changes in disposable income that lead to the change in
consumption. The MPC tells us how much more consumers will spend if
disposable income increases by €1.
Aggregate demand - Aggregated demand is the total amount that all
consumers, firms, government agencies and foreigners wish to spend on a
country’s final goods and services (C+I+G+(X-IM)). C= Consumer expenditure; I=
Investment spending; G= government purchases; X-IM net exports
Consumer expenditure - is the total amount spent by consumers on newly
produced goods and services.
Investment spending - is the amount that firms spend on factories, machinery,
software etc. plus the amount that households spend on new houses.
Government purchases – government purchases of goods and services
Net exports – shortly is export minus import
- Questions -
Discuss policies to stimulate economic growth in the long run!
I really don’t get these types of questions how can I discuss something with
myself on an exam, maybe I’m just supposed to write my opinion or
something.
Well then in my opinion the most efficient way to increase the growth in
the long run is by capital investment. And even though subsidies/tax
changes or political stability and property rights, all may help in this growth,
I think that they do not have as much impact as the other factors.
The factors which I think help in this regard the most are the interest rates,
which have a negative correlation with level of investment, so the higher
the interest rates the lower the investment. Another factor is the technical
change, which is also listed as a separate factor that drives growth and
influences capital formation. (Capital formation is how much firms decide to
spend on investment)
As per labour quality/human capital even though it is really important to
improve the education and training, I still think that it’s very complicated to
invest in education and that the only investment necessary for human
 capital is to make sure that every child has to go at least through high
school, until they are more aware of their choices.
Spurring technological change is yet again important, however I feel that it
shouldn’t be considered any more than just a sub factor in capital
formation, since a focus in research and development should exist, however
not of great quantity.
What leads to a shift of the consumption function?
The before-tax income is called national income, the after-tax income is called disposable
income (DI).

Consumer wealth: If an increase in share or house prices occurs share and

house owners are wealthier and are also likely to feel wealthier. This
implies that for given DI they spend more money on consumption goods,
the consumption function moves upwards.
Price level: People hold much wealth in forms that are fixed in monetary
terms (e.g. cash, bank accounts, corporate and government bonds). If the
price level rises this wealth has a lower value in real terms, i.e. people are
less wealthy. This implies that for given DI they spend less money on
consumption goods, the consumption function moves downwards.
Real interest rates: rising real interest rates increase incentives to save,
hence the consumption function moves downwards. However,
Baumol/Blinder state that there is no empirical evidence for this plausible
assumption.
Future income expectations: if expectations rise consumption may also
increase hence the consumption function moves upwards.
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Key words:
Recessionary gap – In a situation where equilibrium gdp is lower than potential
gdp, then the difference between real and potential GDP is called recessionary
gap
inflationary gap – In a situation where equilibrium gdp is higher than potential
gdp, then the difference between real and potential gdp is called inflationary
gap.
income-expenditure diagram - comparing the potential equilibrium points
with the actual combinations of spending and output which is described by the
C+I+G+(X-M) line. Bringing these two aspects together implies that the
equilibrium point of the economy is at the intersection of the 45° line with the
C+I+G+(X-M) line.
Such diagrams are called income-expenditure diagrams or 45° line diagrams.
stagflation - inflation while the economy is growing slowly or is in a recession
(oversimplified) multiplier – change in C, I, G or (X-IM) may lead to higher (!)
change in GDP. This effect is called the multiplier effect.
The multiplier is defined as the ratio of the change in equilibrium GDP (Y)
divided by the original change in spending that causes the change in GDP
Questions
Explain what a multiplier is and how it is being calculated!
Change in C, I, G or (X-IM) may lead to higher (!) change in GDP. This effect is
called the multiplier effect.
The multiplier is defined as the ratio of the change in equilibrium GDP (Y)
divided by the original change in spending that causes the change in GDP
Assume a company makes an investment of € 1,000,000. This money goes to
other firms owners and workers as their income. However, they will not spend
all this money on consumption but save some (depending on MPC). Assume
that they spend €750,000. This in turn again generates income etc. (see for
more the table on the next side). Finally, it tapers off and “in infinity” an
increase in spending led to an increase in GDP of €4,000,000.
How do we calculate the multiplier?
The multiplier has the form of 1+0.75+0.752+0.753+0.754+ …. Which is an
infinite geometric progression.
More generally for a geometric progression 1+R+R2+R3+R4+ …. = 1/1-R
Applying this formula we find the multiplier to be Multiplier=1/1-0.75=4 Taking
into account that 0.75 is the MPC we can generalise Multiplier = 1/1-MPC
Explain graphically how an economy might adjust to an inflationary and a
recessionary gap through changes in wages!
So whenever a recessionary gap happens, there would be a cyclical
unemployment. This puts pressure on wages and if the wages decrease then
the price level decreases as shown in the graph, and this makes it so the real
gdp and the potential gdp are equal.

There is, however, strong empirical evidence that (nominal) wages do not
decrease even in times of recession. Reasons may be that workers and unions
successfully object such decreases, but also that firms do not decrease their
wages because they are afraid that their best workers might leave the firm.
However, real wages may fall. Furthermore, firms tend to cut costs in times of
recession and dismiss workers.

As per inflationary gap, when the economy is booming, the labour market
would be tight. This means that firms have to increase the wages in order to
maintain their current employees, and to attract new ones.
Whenever you want to increase the wages, then your business cost rises.
Consequently the supply curve shifts inward (the supply decreases), which
leads to higher price level, and that lowers the real gdp and makes it equal to
the potential gdp.
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Keywords

Commodity money- In former times money often used to be commodity money. This is an object in
use as a medium of exchange but which also has a substantial value in alternative (nonmonetary)
uses. What are examples? Cattle, cigarettes, silver, gold, etc.

Fiat money- Fiat money is money that is decreed as such by the government. It is of little value by
itself but maintains its value because people have faith that the issuer will stand behind the pieces of
printed paper and limit their production. Example : Dollars

Fractional reserve banking- Fractional reserve banking is a system under which bankers keep as
reserves only a fraction of the funds they hold on deposit. So basically a portion of what you deposit
can be used to give loans to other people etc.

Bank run- A bank run occurs if more people want their money back than what the bank holds as
reserves

Central bank- In order to control monetary policy we have central banks

Expansionary/contractionary monetary policy- Expansionary (contractionary) policy leads to higher
(lower) overall output.

Exam questions

Explain how a central bank can influence the money supply!

First, through changing the reserve requirements. The CB can increase the required reserve ratio
which means that the banks cannot lend out so much of the money deposited with them. It also can
lower the required reserve ratio which means that the banks can lend out more money.

Second, the CB can lend money to the banks. The CB can influence the amounts banks borrow by
changing the interest rate charged on these loans which is known as the discount rate or prime rate.
An increase in this interest rate is likely to lead to less borrowing from the banks and a decrease to
more borrowing.

Third, open market operations. The CB purchases government bonds from the banks which
increases their reserves. These additional reserves lead to multiple expansion of the money supply
as shown above.

Next question blow V V V

Explain graphically how an expansionary and contractionary monetary policy influences inflation
and output!

-Inflation

As per inflation we have to remember that as we see from the diagram below an expansionary
(contractionary) policy causes an increase (decrease) in the price level.

- Output
 - Higher interest rates are likely to decrease investment because borrowing money is more
expensive. Furthermore, they may reduce private consumption because borrowing money is
more expensive and household expenditure for interest on credits is higher.

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Keywords

Automatic stabilisers- More generally, an automatic stabiliser is a feature of the economy that
reduces its sensitivity to shocks such as sharp increases or decreases in spending.

National debt- The national debt is the government’s total indebtedness at a moment in time

Budget surplus- If receipts exceed expenditure, this is called a budget surplus.

Budget deficit- is the amount by which the government’s expenditure exceed its receipts during a
specified period of time, usually a year

Structural budget deficit/surplus- To seek a better measure of deficit or surplus, the concept of
structural budget deficit or surplus has been developed. This hypothetical measure replaces both
spending and taxes in the actual budget by estimates of how much the government would be
spending and receiving (given current tax rates and expenditure rules) if the economy were
operating at some fixed, high-employment level.

Questions

Discuss governmental policies to stimulate an economy through an increase in aggregate demand!

In principle, the government has three possibilities to stimulate an economy through an increase in
aggregate demand: decrease taxes, increase transfer payments and increase government spending
(e.g. on infrastructure).

More or less for taxes and transfers the first round of the multiplier effect is missing in which all
money is spend. This implies, that a governmental policy where taxes are raised and the money is
directly spend on governmental consumption/investment has a positive overall effect on aggregate
demand.

Discuss the policy approach of “supply side economics”!

In contrast to Keynesian motivated tax cuts (which focus on the demand side) the idea of supply-side
tax cuts is to set incentives for more work, savings and investment and thus increase aggregate
supply. In our well-known graphical analysis this leads to a shift of the supply curve to the right with
a decrease in price level and an increase in GDP.

Lower personal income tax rates to increase the supply of labour, reduce taxes on income from
savings (to make saving more attractive), reduce taxes on capital gains (to encourage more
investment), reduce the corporate income tax (to provide companies with more funds to invest),
incentives for energy saving investments (with a positive effect on the environment!). Compared to
a demand stimulating tax reduction, a supply-side motivated tax shifts both the supply and demand
curve outwards, leading to a higher GDP with only little inflation

Discuss the problem of the national debt!

In small countries :

1) Our children will be burdened by heavy interest payments which will necessitate higher
taxes.
2) Repaying the enormous debt will ruin the nation.
3) Like an individual a nation has a limited capacity to borrow. If it exceeds this limit it is in
danger of being unable to pay its creditors and may go bankrupt.

In bigger countries :

1) Budget deficits may contribute to higher demand which leads to high inflation (in times of a
booming economy) and higher interest rates and thus a reduction in growth!
2) On the bond market government bonds compete with corporate bonds for the available
funds and hence crowd out private investment.
3) The volume of investment today will determine the capital stock tomorrow – and thus
influence the size of future potential GDP. This is an important reason why a large national
debt may burden future generations.

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Key words

Law of comparative advantage- Some countries have comparative advantage regarding a certain
product because they are more efficient, better conditions etc.

Infant industry argument- If we expose promising new industries to fierce international competition
too soon they may never develop to the point where they can survive on their own in the
international marketplace.

Tariff- A tariff is simply a tax on imports

Quota- is a legal limit on the amount of a good that may be imported

Export subsidy- Is a payment by the government to exporters to permit them to reduce the selling
prices of their goods so that they can compete more effectively in foreign markets.

Questions

Explain (partly graphically) similarities and differences of quotas and tariffs!

The general result is that an import quota on a product normally reduces the volume of that product
traded, raises the price in the importing country, and reduces the price in the exporting.

Equilibrium must now fulfill the conditions that the quantity of wheat imported by one country must
equal the quantity of wheat exported by another. And the price that consumers in the importing
country pay must exceed the price that suppliers from the exporting country receive by the amount
of the tariff.

So we can derive the general conclusion that tariffs and quotas can lead to the same reduction in
international trade and the same domestic prices.

So we can derive the general conclusion that tariffs and quotas can lead to the same reduction in
international trade and the same domestic prices.

Another argument in favour of tariffs is that of productive efficiency. A tariff handicaps all foreign
suppliers equally and thus awards the sales to those suppliers who can provide the goods at least
cost. In contrast, a quota may be based on historical sales or on political favourism and thus may
lead to corruption.

Should the government protect its own industry? Discuss!

Yes because:

1) Gaining a price advantage: A tariff forces exporters to sell their goods at lower prices and
enables domestic producers to sell at higher prices.
2) Protecting particular industries: Whenever a particular industry is threatened by foreign
competition domestic industry and unions call for protection.
3) National defense: Some industries are important for national defense (e.g. aircraft industry),
and such industries need to be protected.
4) Strategic trade policy: A rather strong argument for temporary (!) protection is that we life in
an imperfect world where not all nations play by the rules of the free trade game.
Therefore, it makes sense to threaten to protect ones own markets unless other nations
agree to open theirs.

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Key words

Currency appreciation- Its opposite, an increase of value of a currency, is currency appreciation.

Currency depreciation- The depreciation of a country's currency refers to a decrease in the value of
that country's currency

Devaluation- devaluation (if a unit of a nation’s currency can buy fewer units of foreign currency)

Revaluation- revaluation (if a unit of a nation’s currency can buy more units of foreign currency).
Balance of payments deficit- The balance of payments deficit is the amount by which the quantity
supplied of a country’s currency (per year) exceeds the quantity demanded

Balance of payments surplus- The balance of payments surplus is the amount by which the quantity
demanded of a country’s currency (per year) exceeds the quantity supplied.

Foreign reserves- assets held by a central bank or other monetary authority, usually in
various reserve currencies, mostly the United States dollar

Fixed exchange rates- when a government sets its own exchange rate

Flexible exchange rates- also known as floating exchange rates is when the equilibrium is set by
supply and demand

Questions

Explain what determines exchange rate movements in the short, medium and long run!

Short run: most economists agree that interest rates and financial flows are the major determinants
of exchange rates in the short run. In particular, interest rate differentials determine where a huge
amount of “money travelling around the globe” is being invested

In the medium run the theory of exchange rates is most unsettled. Economists once reasoned that
because consumer spending increases in a booming economy the same thing is likely to happen to
imported goods. This, in turn, means that the demand for foreign currency rises and that this leads
to a depreciation of the national currency.

For a long time economists believed that in the long run the purchasing-power parity (PPP) theory is
relevant. It holds that the exchange rate between any two national currencies adjusts to reflect
differences in the price level in the two countries.

Explain how (1) a boom in another country B and (2) an appreciation of country A’s currency affect
the economy of country A!

I do not know this