TOPIC 0: INTRODUCTION

Industrial revolution: It is a wave of technological advances and organizational changes which transformed
an agrarian and craft-based economy into a commercial and industrial one.

Capitalism: It is an economic system (comprises the institutions that organize production and distribution of
goods and services) based on private property, markets and firms.
Private property means that you can enjoy your possessions and exclude others from their use, or dispose
them by gift or sale (an example is the private property of the means of production).
Markets are a way to connect people who may mutually benefit by exchanging goods and services, trough a
process of buying and selling (exchanges are voluntary, reciprocated and mutually beneficial).
Firms are a way of organizing production, where one or more individuals own the capital goods used in
production, owners pay wages and salaries to the employees, and the firm’s output is the property of the
firm’s owners (and it is sold on market for profit).

Demand side: It is the side of a market where participants are offering money in return for goods or services
(employers are the demand side).

Supply side: It is the side of a market where participants are offering something in return for money
(employees are the supply side).

Economics: It is the study of how people interact with each other and with their natural surrounding in
producing their livelihoods, and how their decisions affect the behaviour of others.

Specialization: Firms employing large numbers of workers allowed specialization (division of labour).
It is like doing what you are really good at, and in the economy, when people specialize in what they are
good at, it leads to a more efficient and productive economy.
We become better at producing things when we focus on a limited range of activities.

Absolute advantage: A person has an absolute advantage in the production of some good, if produces more
of a good with the same amount of resources compared to another individual.

Comparative advantage: It is based on the opportunity cost of producing a good.

A person has a comparative advantage in the production of some good if the cost of producing an additional
unit of that good, relative to another good, is lower than another person’s cost.

- Anna has an absolute advantage in both apples and wheat.

- Anna has a comparative advantage in wheat, to produce 1 unit
of wheat she gives up only 25 units of apples (Marco 50).
- Marco has a comparative advantage in apples, to produce 1 unit
of apples Marco gives up 0.02 units of wheat (Anna 0.04).

Law of comparative advantage: It is about making the best use of resources when countries, or people trade
with each other, everyone should focus on what they are best at, and trade to get what they are not as good at.
TOPIC 1: TECHNOLOGY, PRODUCTION, COSTS, AND PROFITS
Resources: They are the factors of production (used to produce goods and services).
Primary factors → They facilitate production but do not become part of the final product (land, labour, capital).
Secondary factors → They are obtained from the primary ones, such as raw materials, energy, etc.

Technology: It is a process that takes a set of inputs (resources) and produces an output.
A change in technology that reduces the amount of resources required to produce a given amount of
output is called technological progress.

Isocost line: It is a line that joins all the possible combinations of inputs that cost the same amount.

Relative price: It is the price of one good (or factor) relative to another.
The slope of the isocost line is the relative price of labour in terms of coal.

The firm’s profit: It is equal to the revenue that it gets from selling output
minus its cost (price inversely related to cost).

Entrepreneur: Is a person who creates, or is an early adopter, of new technologies.

If an entrepreneur manages to produce output with the new least-cost technology 𝑓, then his profits would
increase: ∆𝐶 = 𝐶 − 𝑓 , these additional profits are known as innovation rents, or Schumpeterian rents.
!!! The firm’s aim is to maximize profits and minimize costs (profits and costs are inversely related).

Production function: A production function describes the relationship between the amount of output
produced and the amount of inputs used to produce it, 𝑌 =𝑓(x) .

Average product (AP): It is the average amount of output produced for every input unit, 𝑌 =𝑓(x) / x .
For a point A, the AP corresponds to the slope of a straight the line that passes trough A and the origin.

Marginal product (MP): It is the additional output produced if the inputs are increased by one unit.
The MP it is also the slope of the production function, 𝑌 =𝑓 ’(x) .

Law of diminishing marginal returns: Output increases as the inputs increases, but the marginal product
falls, the MP usually goes down when the units of inputs are increased, that means that an additional increase
in input will result in a progressive decline in output (diminishing marginal returns implies decreasing AP).

Malthus model: This model is based on two assumptions: The law of diminish marginal returns and a
positive effect of living standards on population growth.
Before the industrial revolution: If living standards improve, population grows (more workers), income will
decrease due to diminishing marginal returns (smaller profits), then falling living standards would slow
population growth, and income would settle at the subsistence level, it is a vicious cycle.
After the industrial revolution: Technological progress became faster than demographic development,
allowing us to escape from the Malthusian trap (reverted the relationship between income and fertility).
TOPIC 2: SCARCITY, WORK AND CHOICE
Scarcity: The demand for a good or a service is greater than the availability of the good or the service.

Trade-off: It is when we have to choose between two different actions, and choosing one over the other
implies give up, or sacrifice, the other.

Utility: It is an important indicator of the value that one places on an outcome, and of course higher valued
outcomes will be preferred over lower valued outcomes.

Indifference curve: It is the geometrical locus of all the bundles that provide the same level of utility to the
individual, and all the bundles below the indifference curve are worst than the bundles above the curve.
- ICs slope downwards due to trade-off (bundles with more of one good, have less of the other one).
- Higher ICs correspond to higher utility level (moving away from the origin we have more of both goods).
- ICs curves do not cross.

The Marginal Rate of Substitution (MRS): It is the trade-off that an individual is WILLING to make
between two goods, it measures the units (of one good) that the individual is willing to give up in exchange
for a small increase for something else, keeping the same level of utility.
At any point the MRS is equal to the slope of the indifference curve.

Law of satiation of wants: The value of an additional unit of consumption declines the more is consumed,
this is known as diminishing marginal returns to consumption.
Diminishing marginal returns require the MRS to decrease as you move to the right (as you increase the
quantity of one good and decrease the other), so that ICs are depicted as strictly convex curves.

Opportunity cost: To get more of one good the individual has to forgot the opportunity of getting more of
the other good, in other words the opportunity cost is the value of the best next alternative that must be
foregone (sacrificed) when a decision is made.
The economic cost of an action is defined as its out-of-pocket cost plus its opportunity cost, for example:
doing A implies not doing B, and so not doing B becomes part of the cost of doing A.

The feasible set: It comprises all the bundles that an individual could
choose given the limitations (or constraints) he faces.

The feasible frontier: It is a curve that defines the maximum feasible

quantity of one good for a given quantity of the other, therefore any
feasible combination of inputs is on, or inside the frontier.

The Marginal Rate of Transformation (MRT): It measures the quantity of some good that MUST be
sacrificed to acquire one additional unit of another good (that is the opportunity cost).
The MRT is the slope of the feasible frontier, which is represented by the line BC.
The optimal bundle e (equilibrium): It is the point where the highest indifferent curve touches the feasible
frontier, therefore MRS = MRT holds (if MRT < MRS the individual has an incentive to increase).
Equilibrium is a situation that is self-perpetuating, meaning that something of interest does not change unless
an outside force of change is introduced (for example an expansion of the feasible set).

!!! When the real wage increases (real wage = nominal wage / price , it refers to the amount of goods and
services an employee can purchase with their nominal wage) there are two logically distinct effect:
The income effect → you receive exogenous money, so you have
an incentive to reduce the supply of labour, since keeping constant
the hours of labour you have more money (MRS higher).
The substitution effect → your wage increases, so your free time
has a greater cost, and you have the incentive to work more (MRT
higher).

Differentiated product: It is a product produced by a single firm that has some unique characteristics
compared to similar products.

Cost function: 𝑌 = 𝐶(𝑞) The cost of production depends on the quantity produced.

Average cost: A𝐶(𝑞) = 𝐶(𝑞) / 𝑞 It measures the average cost for every unit produced.

Marginal cost: M𝐶(𝑞) = 𝐶 ’(𝑞) It measures the cost of producing one additional unit of output.

Revenue: 𝑅(𝑞) = 𝑃(𝑞) * 𝑞 It corresponds to what the firm gets from selling output.

Marginal revenue: 𝑀𝑅(𝑞) = 𝑅 ′(𝑞) How much a firm earns by selling one more unit of output.

Price elasticity of demand: It measures the % change in demand in response to a % increase in price.
If the 𝜖 > 1 the demand is elastic, therefore people are more sensitive to price changes, otherwise the demand
is inelastic and people don’t care.

The profit: π(𝑞) = 𝑅(𝑞) − 𝐶(𝑞) It is defined as revenue minus cost, and to maximize profit firms choose
the level of production that makes MR = MC.
The firm will raise q if and only if MR > MC, and stops as soon as MR = MC.

The markup: It's the profit margin, it corresponds to the amount by which a company increases the price of
a product, above its production cost → It is inversely related to 𝜖, indeed if 𝜖 is very low (demand is
inelastic), the company has more control over the price and can set a higher markup.

TOPIC 3: BANKS, MONEY AND CREDIT MARKETS

Money: It is a medium of exchange consisting of bank notes and bank deposits, or anything else that can be
used to buy good and services.
Money requires trust to function, which is usually provided by the government or banks, and it is accepted as
payment because other can use it for the same purpose.

Commodity money → Objects that have value in themselves.

Representative money → Any type of money that has face value greater than its value as material.
Commodity-backed money → A claim on a commodity.
Fiat money → Created and issued by the State, not convertible by law into anything other than itself.

Disposable income: It is the amount of money received as profit, interest, rent and other payments, net of
taxes, over a period of time (it is a flow variable, that means measure per unit of time).

Wealth: It is the market value of the stock of assets owned, including real assets and financial assets, net of
outstanding debts (it is a stock variable, that means measured at a point in time).
It is the largest amount that you could consume without borrowing (accumulation of past and current savings).

Depreciation: The value of real assets tends to decline either due to use or the passage of time.
Income (in this case gross income) minus depreciation is known as net income, that is the maximum amount
that you could consume and leave your wealth unchanged.

Savings: When consumption is less than net income, saving takes places, and wealth increases.

❓ Assets like shares, loans and bonds provide a stream of income in the future, how do we value them?
Break-even price: The maximum price 𝑝 that a person would be willing to pay for an IOU (financial
contract that promises to pay F in the future) is known as break-even price: 𝑝 (1+𝑖) = 𝐹 or 𝑝 = 𝐹 / (1 + 𝑖).

Borrowing and lending: They are about shifting consumption over time, borrowing allows us to buy more
now, but we buy less later (the opportunity cost of having more goods now is having less goods later).
The maximum amount we can borrow from our pay check, supposing it is equals to €100 is: (1 + 𝑟) 𝑐0 =
€100
If we borrows 𝑐0 today, then 𝑐1 ≤ €100 − (1 + 𝑟) 𝑐0 , where 𝑐1 denotes future consumption.
1+ 𝑟 is the MRT , indeed to increase 𝑐0 by one unit, the individual has to give up 1 + r units of c1.
Note that: A reduction in r (r > r’) induces both an income effect (the feasible set expands) and a substitution
effect (consumption is cheaper now), so the individual end up borrowing more.
Impatience is typically caused by: Myopia (people experience present satisfaction more strongly than their
idea of future satisfaction) and Prudence (people know that the future is uncertain).

Balance sheets: They are an essential tool for understanding how wealth changes when someone borrows or
lends, they summarize what a household or firm owns, and what it owes to other.
- What you own, including what others owe you, is called your assets.
- What you owe to others is called your liabilities.
The difference between assets and liabilities is called net worth (net worth ≡ assets – liabilities).
!!! If you borrow or lend your net worth does not change.

Banks: A bank is a firm that make profits trough its lending and borrowing activity.
Banks charge higher interest rates when they lend money to individuals or businesses (loans), compared to
what they pay when they borrow money themselves from the CB (reserves), they earn the difference between
the interest they charge on loans and the interest they pay on what they borrow.

Central Bank: This is like the boss of all the banks in a country, it's responsible for making rules and
decisions about how much money is available in the country and how it's used.
It is the authority responsible for policies that affect a country’s supply of money and credit.
By controlling the price of reserves the CB indirectly controls the supply of broad money.

Types of money:
Bank money, the money you use in your bank account (bank deposits), it’s not the same as cash but is like an
IOU from the bank, it is the liability of commercial banks.
Base money, or legal tender, it includes the cash you can hold in your hand (currencies), and commercial
bank reserves (the money that commercial banks have in their accounts at the CB, it is the liability of CBs).
Broad money, includes both cash in people’s hands and bank deposits.
It is a measure of the total money supply in an economy that includes physical currency in circulation (cash
in people’s hands) but also bank deposits, that can be quickly converted into cash or used for transactions.

“Creating” money: Banks can create their own money, bank money, in the form of bank deposits, when they
lend money to people or businesses.
Bank money is like a promise from the bank that they owe you that amount of money, it's not actual cash.

Commercial banks reserves: The role of commercial banks reserves (accounts held by commercial banks at
the CB) is to make sure that, when people buy things, the money is safely transferred between their banks.
Commercial banks use their reserves at the CB to settle these transactions.
The transaction is legally settled only when base money changes hands at the end of the day.
!!! Throughout the day, banks make many transactions to one another, most cancelling each other out,
therefore, instead of making a bunch of small payments, they simply settle the difference at the end of the
day (they will receive the net amount of their transactions).
Note that: If a group of people have accounts at the same bank, when they make transactions the bank can
simply adjust the numbers in their accounts, without moving money around.

Fractional-Reserve banking: Banks don't need to have available the legal tender to cover all the transactions.
They only need to keep a portion of the money as a safety net (reserves) and can use the rest to make loans or
investments (when you deposit money, they can lend it to others and make money from the interest).
Banks make sure everyone gets their money when they need it, even if they don't have all the legal tender.
Maturity of transformation: Banks play a special role by taking in people's deposits, which people can
withdraw at any time, and using that money to make loans, which are paid back over many years.
Therefore they transform risky (for the banks) illiquid long-maturity assets, into safe (for depositors) liquid
short-maturity liabilities: that is turning long-term investments into short-term funds.
Credit risk, it is the risk that people who borrow money from the bank might not be able to pay it back,
if this happens, the bank loses money (the bank has to reduce the value of loans on the asset side and the
value of capital on the liability side).
Liquidity risk, it is the risk that many depositors or investors might suddenly want to take their money
out of the bank all at once (like in a bank run). If this happens, the bank might not have enough cash on
hand to give everyone their money right away.
!!! Moreover banks need to have enough money (reserves) to cover the everyday transactions they have to
make, but it's hard to predict exactly how much they'll need, so banks keep some reserves on CB accounts
just in case, precautionary reasons (typically 10% reserve ratio).

Banks getting more reserves: When a bank needs more reserves (money), it can borrow from other banks,
and they do this on a special market called the "interbank market", where banks lend money to each other.
The interest rate at which they borrow this money is called the "short-term interest rate" (most interbank
loans are for overnight maturity) or "interbank rate."
Note that: Transactions among banks in the interbank market may affect the distribution of reserves, but not
their overall amount, the supply of reserves (and base money) is only in the hands of the CB.

Central Bank’s role: The central bank controls the overall amount of money and reserves in many ways.
Open market operations (OMO), The CB buys or sells securities (share, bonds, ecc.) from or to banks: when
they buy, they give more reserves to banks, instead when they sell, they take reserves from banks.
Standing facilities, Instruments available to banks: Banks can use standing facilities to borrow money quickly
from the CB when they face temporary shortages of funds.
- The "marginal lending facility" it's the facility where banks can borrow money from the CB at a higher
interest rate, but these loans have to be collateralized.
- The "deposit facility" it’s the facility where banks deposit excess funds with the CB and earn some interest.

How banks end up creating broad money: When customers deposit money in the bank, it doesn't create
new money right away, money just moves from one place (people's wallets) to another (bank's deposits).
New money creation typically happens when:
- Bank lending increases the supply of broad money (only temporarily)→ When a bank approves a loan,
it essentially creates new money by extending credit to borrowers.
However, as soon as the loan is paid back, that money disappears.
- Buying (or selling) securities from the non-bank private sector affects money supply and creates new money.
Buying securities increases broad money, selling decreases broad money.

The banks act as a financial intermediary between people who want to save money and people who need to
borrow money, by using their money efficiently.

!!! The ability to borrow allows an individual to reduce the income shock's impact on current consumption.
TOPIC 4: NATIONAL ACCOUNTING AND BUSINESS CYCLE
Whole economy: A system where different agents interact: households, firms, government, foreign sector

National income accounts: A logically and coherent system of statistics that summarizes the aggregate
economic activity at the national level.

Gross domestic product (GDP): (gross because it does not take into account depreciation of capital)
It is a statistic that measures the value of the aggregate production of a country in a given period of time.
From the production side it is the market value (what people are willing to pay) of all the final goods and
services produced within an economy during a given period of time.
From the income side it is the sum of all incomes (profits, wages, rents, taxes, ecc.) generated and distributed
in the economy during a given period of time.

💡 Intuition: For every seller there is a buyer, or one person’s expenditure is another’s income.

Flow of money: Households pay moneys for goods and services, and this
money flows to the firms. Then the firms will spend money in wages,
rents, etc. that flows back to households.
Flow of goods and services: Households sell labour, land, and capital to
the firms. Then firms produce goods and services (using those inputs),
that are sold to households.
Income of Households = Value of finales sales

Value added (VA): It is defined as the value of production minus the value of the intermediate goods used in
production, therefore GDP is the sum of value added in the economy during a given period of time.

(some VA goes to worker as wages)

Limitations of GDP: It is not a direct measure of social welfare.

- It mainly looks at things that are bought and sold in the market, it doesn't count household production.
- It doesn't consider the value of free time, if people work more, GDP goes up, but people are happier?
- It doesn't take into account externalities, like pollution, that can harm the environment or people's health.

Nominal GDP: The sum of the quantities of final goods and services produced times their current market
price (market prices are used as weights to homogenize quantities expressed in different measurement units).
Nominal GDP may change over time because the production of most goods and services varies over time,
and also the prices can change over time.
Real GDP (RGDP): It is the sum of the quantities of final goods and services times constant prices, that are
the prices prevailed in some specific base year.
To make real GDP even better, we use a technique called chain-linked volumes, where we use relative prices
that change slowly over time (you filter out the effect of a rapidly changing overall price level that can
happen between different years).

GDP deflator: Denoted P, it’s a price index, defined as the ratio of nominal GDP to real GDP.
It tracks the change in prices of all the goods and services produced in a country, but not necessarily of those
goods that are consumed (many goods are imported from abroad, while many local goods are exported).

The Consumer Prince Index (CPI): It measures the general level of prices that consumers have to pay for
goods and services, including consumption taxes.
The CPI is based on a carefully constructed representative basket (i.e. the behaviour of a large sample of
households) of consumption goods, whose prices are sampled at regular intervals.
The CPI is a better way to see how the cost of living for the average person is changing because it's focused
on the stuff people actually consume.

Working-age population: It conventionally comprises all people aged between 15 and 64 years.

Employment: It is the number of people who actually have a job, or who have performed at least one hour of
work, paid or unpaid (family business), in the last two weeks.

Unemployment: It is the number of people who do not have a job but are actively looking for one (at least
three times in the last week), those who are not looking for a job are counting as not in the labour force (such
as discouraged workers).

Labour force: It is the sum of employment and unemployment.

Recession: It is a period characterized with a significant decline in economic activity, that spreads across the
economy, and can last from few months to more than a year; the movement from boom, to recession, and
back to boom is called business cycle (consumption and investments co-move with the GDP, but investments
are more volatile, that means unstable).

Okun’s law: Changes in rate of the growth of GDP are negatively correlated with the rate of unemployment,
indeed as an economy grows more rapidly, the demand for labor increases → lower unemployment rates.
TOPIC 5: THE MULTIPLIER MODEL AND FISCAL POLICY
Consumption (C): Goods and services purchased by final consumers.

Investment (I): The purchase of an asset to make profit in the future.

Fixed investment: Non-residential investment (the purchase by firms of machines) + residential investment
(the purchase by people of new dwellings).

Inventories: Inventories are goods held by a firm before sale or use them, including raw materials and
partially-finished or finished goods intended for sale.

Government spending (G): The purchases of goods and services by the government.
Government consumption is the purchase of what is used for the direct satisfaction of the individual or
the collective needs of the community.
Government investments are purchases intended to create future benefits (as research spending).

Imports (M): The purchases of foreign goods and services by local consumers, firms and the government.

Exports (X): The purchases of local goods and services by foreigners.

Net Exports (NX): Or trade balance, it is exports X minus imports M (trade surplus if >0, trade deficit <0).

Aggregate demand (AD): It is the sum of all components of spending for domestic goods.

By construction the aggregate demand (AD) is equal to GDP (Y).

Aggregate consumption function:

Now suppose that aggregate consumption expenditure depends on disposable income only.
Disposable income YD is income minus taxes (YD = Y – T),
and we have the following aggregate consumption function:
The parameter c1 represents the Marginal Propensity to Consume, that is the effect that an additional unit of
disposable income has on consumption (typically is less than 1).
The parameter c0 represents the Autonomous Consumption Level, that captures all the other influences on
consumption not related to disposable income.

By imposing some strong assumption, such as T = 0, G = 0 and NX = 0, the national accounting identity
collapses to: Y = C + I = AD.

Keynesian approach: Firms do not operate at full capacity utilization, so there are underutilized resources,
but they are capable to supply any amount of goods and services demanded (demand creates its own supply).
The equilibrium condition: Y = AD can be rewritten as Y = C + I = Co + C1Y + I .
We can solve for the unique output level that guarantees equilibrium:

Let c0 + I denotes the autonomous demand A, that is the component of

aggregate demand that is not affected by income, indeed AD = A + c1Y .

Multiplier of aggregate demand: The ratio 1 / 1 – c1 is known as the multiplier of AD.

The equilibrium output level is equal to the multiplier times the autonomous demand A,
therefore an eventual increase in A, will generate an increase in output.
Direct effect, it causes an increase in AD, and therefore in output Y.
Indirect effect, it causes an increase in Y, that creates a less than proportional increase in C, and so on.
Each additional increase in Y is smaller than the previous one, so that the indirect effect vanishes in the limit.

Savings: Consider the national accounting identity Y = C + I + G ,

and subtract taxes from both sides and rearrange terms:
Savings = Sp (private savings) + Sg (public savings)

And therefore we can show the IS relation, investments is identically equal to savings.
!!! If consumers decide to increase private savings by decreasing autonomous consumption c0, the
equilibrium output level drops, and private savings is not affected recall the IS relation, S cannot change.

Paradox of thrift: Consumers try to save more by reducing aggregate demand, this induce a drop in income
(AD = Y), and they end up saving the same amount as before.
“What is true for the parts, must be true of the whole”: The paradox of thrift happens because a decrease
in demand for goods and services can lead to lower income for individuals.
So, individual efforts to save more, have consequences for the economy as a whole.

Fiscal policy: The government can directly intervene to stabilize aggregate demand, indeed the government
can cut taxes or increase government spending during a recession (a decline in economic activity), and that’s
what is called fiscal stimulus, aimed to increase the AD via the multiplier.

Aggregate investment: Firms invest to improve their productive capacity.

The return of investment in productive capacity is the expected profit rate on investment π.
The interest rate r is the opportunity cost of investment.
A profit-maximizing firm will invest as longs as the expected profit rate exceeds the interest rate.
- A higher interest rate reduces aggregate investment.
- A higher expected rate of profit raises aggregate investment.
The aggregate investment function is:
National accounting identity: Taking into account proportional taxes on income and foreign trade.

Note that: Imports depend on domestic income so that M = mY ,

where 0 < m < 1 is the marginal propensity to import.

Again we can easily resolve for the equilibrium output level:

!!! And we can notice that taxation and opening up the economy reduces the size of the multiplier (inversely
related to taxation and the marginal propensity to import).
The multiplier effect is a key concept, it's the idea that a change in one of the components of AD, like
government spending, can have a huge impact on the overall output.
Remember that: With fully employed resources, an increase in government spending would displace, or
crowd out, some private spending (reduction), reducing possibly to zero the multiplier effect.
The size of the multiplier will also depend on the expectations about the future of households, firms, etc.
TOPIC 6: INFLATION, UNEMPLOYMENT, MONETARY POLICE

The wage-setting curve determines the real wage necessary at

each level of economy-wide employment.
On the horizontal axis we have the working-age population (WAP),
and the vertical axis measures the economy-wide real wage W / P.
For each level of employment denoted N the wage-setting curve
determines the optimal real wage w.
The level of unemployment denoted U is obtained as the difference
between the labour force LF and employment N.

Note that: The wage-setting curve is upward sloping because an increase in unemployment will reduce the
employees individual bargaining power and increase the employers one.

If w = wWS then employers are paying and employees are earning a real wage that both consider optimal
given the current labour market conditions.
If w > wWS then employers are paying a real wage higher than their optimal one: they will use their
bargaining power to reduce the nominal wage so that w = W / P will decrease.
If w < wWS then employees are earning a real wage lower than their optimal one: they will bargain for a
higher nominal wage so that w = W / P will increase.

Consider a firm employing only labour to produce some differentiated good, on average a worker produces λ
units of output, and is paid a nominal wage W.
The unit labor cost W / λ reflects the cost associated with labor for producing each unit of output.
Since labour is the only input we have W / λ = MC (additional cost incurred by producing one more unit).
But also W / λ = AC (the total cost incurred during the production divided by the quantity produced).
Profit-maximizing firm will set its price according to:
That can be easily rewritten as:

We define P as the aggregate price level (average price of goods produced and purchased in the economy),
W / P = w represents the economy-wide real wage, and it is equal to the average output per worker λ minus
the real profit per worker λμ .
Note that: since λ and μ are constant by assumption, the real wage implied by the price-setting behaviour of
firms (how firms set prices for their goods or services impact the real wage) is constant too.

The price-setting curve identifies the real wage when firms choose
their profit-maximizing price.
The wage-setting curve and the price-setting curve jointly identify
the unique equilibrium employment level.
There’s no incentive to change the nominal wage or the price level.
If w > WPS firms will increase P and decrease employment, this will induce a reduction in w.
If w < WPS firms will decrease P and increase employment, this will induce an increase in w.

The multiplier model: Explains how spending decisions generate demand for goods and services and, as a
result, employment and output → With an increase in spending (for example, increase in consumer spending),
businesses experience higher demand for goods and services, and to meet this demand, businesses increase
production and hire more workers.

The labour market model: Focuses on how labour is employed to produce goods and services, and how
wages and prices react to changes → Increased labor demand can contribute to higher wages.

If aggregate demand (AD) is higher, it means that overall spending in the economy is raised, and businesses
may experience an increase in demand for their goods and services.

Wage-price spiral:
When workers receive higher wages, they have more purchasing power.
Increased income often leads to higher consumer spending.
The increased consumer spending creates higher demand for goods and services.
Businesses respond to this increased demand by increasing production and hiring more workers.
To maintain their profit margins, businesses may raise prices for their products or services.
Conclusion: higher wages lead to higher prices, and higher prices lead to demands for further wage increases.

Positive inflation refers to a situation where the general price level in the economy is rising over time (as
long as output and employment are above the natural level).

* bargaining gap: w > WPS .

Wage-price spirals can become particularly pernicious when nominal wages are at least partially
indexed to inflation, and therefore do automatically respond to the latter.
The automatic adjustment of wages to inflation, known as indexing, can intensify and prolong a wage-price
spiral, it creates a self-reinforcing cycle where inflation and wages continuously feed into each other.

If aggregate demand (AD) is lower, it means that overall spending in the economy is reduced, and businesses
may experience a decrease in demand for their goods and services.
In this case the wage-price spiral generates deflation.

On the Phillips Curve, an increase in nominal wages, if not matched by an equivalent increase in
productivity, can lead to higher production costs for businesses. This increase in costs may be passed on to
consumers in the form of higher prices, contributing to inflation.
The Philips Curve (PC) identifies the negative relationship between unemployment and inflation rate (as the
inflation rate increases, the unemployment rate tends to decrease).
Policymakers, who have the ability to adjust the level of Aggregate Demand (AD) through monetary and
fiscal policies, could pick any combinations of inflation and unemployment along the Phillips Curve.

Agents are forward looking: People take actions now in anticipation of things that may happen in the future.
Workers might negotiate wages based on their expectations of future inflation (even if the bargaining gap is 0).
People consider changes in prices as messages about what will happen in the future, and expectations
influence consumer spending, investment, and other economic activities.

If the gap is positive (negative) → upward pressure on W (nominal wage) will be stronger (weaker).

One of the objectives of Central Banks is to maintain price stability, i.e. to keep inflation at low and
predictable levels, but how do they try to control the inflation rate?
1. Short-term interest rate: Control over the policy rate to influence borrowing costs and economic activity.
Lowering interest rates encourages borrowing and spending, stimulating economic activity and
potentially raising inflation. Conversely, raising interest rates cool down economic activity and inflation.
2. Expectations: Communicating clear inflation targets and policy intentions to shape the expectations.

3. Long-term interest rate: Indirectly influencing long-term rates, for example trough the purchase of long-
term bonds → This increases the demand for these assets, leading to an increase in their prices, and a drop in
long-term interest rates (since there is an inverse relationship between bond prices and interest rates).
!!! The drop in long-term interest rates is designed to stimulate economic activity

💡 All these policies that CBs can implement in the pursuit of their goals in known as monetary policy.

Flexible inflation targeting is a monetary policy adopted by central banks to achieve their primary objective
of price stability → Central banks aim to keep inflation at a target level over the medium term (achieving the
exact target at all times might be challenging due to various economic factors).
TOPIC 7: PUBLIC FINANCE
Consider the national accounting identity:
In an open economy some relevant incomes
originate from abroad, so we define Net Income From Abroad (NIFA) as the net primary income from
abroad (i.e. net factor incomes from abroad plus net transfers from abroad).
Net factor incomes from abroad → Includes net earnings from factors of production, such as profits,
earned by residents from their investments abroad, minus the corresponding earnings that foreign
investors receive from their investments in the domestic country.
Net transfers from abroad → Includes net transfers, such as remittances (money that is sent or
transferred by migrants or foreign workers to their home countries), received from abroad minus the
transfers sent abroad by residents.
Now we add NIFA to both sides of our identity:
The sum GDP + NIFA is known as Gross
National Disposable Income (GNDI).
Now we subtract from both sides taxes net of transfers (T) and rearrange the terms to highlight
the so-called sectoral balances:

Each sector can only trade with the remaining two, its surplus (deficit) implies an accumulation
(decumulation) of financial claims on one of the other sector, or on both.
1. If disposable income exceeds the private sector’s spending on consumption and investment,
the private sector’s net worth increases (assets - liabilities), either trough purchases of additional
assets or repayment of existing debt.
2. If the public sector’s total expenditure exceeds taxes and other revenues (remember that taxes
are revenue for the government), the public sector’s net worth decreases.
3. If the value of exports, plus net income from abroad, is less than the value of imports, then
the foreign sector’s net worth decreases (what we import is less then what we export to foreigns).

💡 The financial imbalances of all sectors must sum to zero.

The domestic economy’s net worth (the net worth of all the sectors combined) reduces to the value
of its stock of real assets plus its net foreign assets.
A primary budget deficit (government spending > revenue) will decrease the government’s net
worth but will increase that of the private or foreign sector.
Moreover, if the government issues sovereign bonds (it’s a type of security issued by the
government) to finance its deficit, then either the private sector or the foreign sector will acquire
them, and increase their financial claims.
Define the Current Account (CA) surplus (deficit if negative) as CA = NX + NIFA .
It records the difference between the sum of exports and income received from non-
residents and the sum of imports and income payed to non-residents.
We define private savings as SP = GNDI – T – C , and public savings as SG = T – G, and savings as S
= SP + SG , in this way the national accounting identity can be rewritten as S – I = CA .
Remember that: In a closed economy CA = 0 , and total savings are equal to gross capital formation
(it is basically investment in the economy, I).

- The left-hand side represents the joint surplus of the domestic private and public sectors,
i.e. the surplus of domestic economy.
- The right-hand side instead represents the deficit of the foreign sector.
The surplus of the domestic economy is always equal to the deficit of the rest of the world, and vice versa.

However, there are mainly three ways for a government to financing its deficit, and all of them will
decrease the public sector’s net worth:
Borrow domestically → The government can issue sovereign debt and sell it to the private sector.
Borrow abroad → The government can issue debt (in domestic or foreign currencies) and sell it
to the foreign sector.
Print money → The government can issue sovereign debt and sell it directly to the CB, in
exchange for CB reserves (liability of the CB).