Economics Overview for ETS Test

Adam Smith:
Division of Labor => greater productivity (Pin Factory) Laissez Faire = Government stay out of the economy Invisible Hand of the Market = what guides the economy

Supply and Demand Graph

PRICE

SUPPLY

DEMAND (down)

QUANTITY

Supply and Demand

Inelastic = steep, increase price to increase revenues

Elastic = flat, decrease price to increase revenues

Complements (Milk & cookies)

(Price of Milk increases, demand for cookies decreases (shifts left)

If price of a substitute increases, (Coke & Pepsi) D shifts right.

Price floor above market equilibrium

=> surplus and higher price

Price ceiling below market

=> shortage and lower prices

A monopoly causes price to increase and Q to decrease.

International
If dollar strengthens (appreciates)relative to the yen: 100 yen/$ => 120 yen/$ US imports more, exports less If US economy is strong => dollar gets stronger (appreciates)

 If dollar weakens (depreciates) relative to the yen:

150 yen/$ => 130 yen/$

US imports less, exports more

Theory of Comparative Advantage

says everyone wins with free trade.

Current international monetary system is managed float. Hedging is used to negate Foreign Exchange (FX) risk

 Assume exchange rate is 120 yen per $ To convert $100 to yen => 100* 120 yen/$ = 12,000 yen To convert 100 yen to $ => 100 yen/120 = $0.83

 If the population is growing faster than the economy, the standard of living is declining

Marginal costs and benefits

Economic decisions are made based on the marginal (incremental) costs and benefits: If Marginal Revenue >= Marginal Cost => do it. If MR < MC, dont do it Ignore sunk costs

 Firm profit is maximized at the Q where MR = MC, all types of industries

$ MC

MR Profit Max Q

Expected payoff based on probabilities

(use a decision tree if complicated): EXAMPLE: 20% chance you will get into the party, 60% chance you will win $100 at the party =>Expect to win 0.2 * 0.6 * $100 = $12

Federal Reserve Bank

= The Fed The US Central Bank Monetary Policy: Controls the Money Supply and the interest rate.

Fed Policy tools include:

Changing the Reserve Requirement Using Open market operations
to change the MS to change market interest rate, specifically the Fed Funds rate.

 In a Recession, the Fed will decrease interest rates to stimulate Investment by firms.

 Market rate of interest = real interest rate + expected inflation

Business cycle
= Recovery (growing real GDP)
And Recession (shrinking real GDP, usual rule of thumb = 2 consecutive quarters)

Fiscal Policy
= Congress and President, mess with taxes and government spending Recession => Decrease taxes, increase spending Inflation => Increase taxes, decrease spending

GOOD LUCK!