Econ 101

Would you like to learn more about economic data and how it impacts you?

You've come to the right place! EconDash™'s Econ101 will provide an easy-to-read tutorial on basic economic concepts, focusing on those that impact the entire United States region (these concepts are called macroeconomics).

There are three basic concepts that tie economics together:

1. Demand - Demand summarizes the behavior of buyers. The quantity of a product or service that buyers demand varies with its price. As the price rises, the quantity demanded falls, and vice-versa.

Example: Digital TVs initially were priced over $3,000, so the quantity demanded was low. As digital TVs have fallen in price, the quantity demanded has risen. If their prices were to fall to, say, $300, the quantity demanded would skyrocket.

2. Supply - Supply summarizes the behavior of producers and sellers. The quantity of a product or service produced and offered for sale depends on its price. As the price rises, the quantity supplied rises, and vice-versa.

Example: When oil prices are at $10 per barrel, drillers cannot make money, so they do not explore for new sources of oil. However when oil is over $30 per barrel, significant profits can be achieved so oil exploration significantly expands.

3. Equilibrium – Equilibrium summarizes the outcome of the market process. If the price of a product or service is “too high,” the quantity supplied will exceed the quantity demanded, creating a surplus of the product. That surplus leads sellers to cut prices. However, if the price of a product or service is “too low,” the quantity supplied will fall short of the quantity demanded, creating a shortage of the product. That shortage leads sellers to raise prices. In equilibrium, the price is “just right,” with no surplus or shortage, because the quantity demanded equals the quantity supplied.

Example: At any moment of time in the stock market, the equilibrium price of Microsoft shares is the price at which the quantity of shares demanded equals the quantity supplied. If, at any moment, the price of Microsoft stock were below that equilibrium price, orders to buy shares of Microsoft would exceed orders to sell, and that shortage would drive up the price. If, on the other hand, the price of Microsoft stock were above the equilibrium price, orders to sell shares of Microsoft would exceed orders to buy, and that surplus would drive down the price.

From day to day – and minute to minute - the equilibrium price of Microsoft stock changes as new information arrives and changes demand or supply. When investors want to buy more shares of Microsoft, they bid up the equilibrium price, and the market booms. On the other hand, the equilibrium price falls when investors decide to sell more of their shares.

The familiar integration of Demand, Supply and Price looks similar to the following chart.

What is "the economy"?

First: a look at the dictionary: Economy is defined as "the structure of economic life in a country, area or period". Economic is defined as: of, relating to, or based on the production, distribution and consumption of goods and services

From MSN Encarta Dictionary: the production and consumption of goods and services of a community regarded as a whole

Our major concern is the links to production, distribution, consumption, and pricing of goods and services. All indicators in the Dashboards are linked to these in one way or another. What we will see is how they relate to the production, distribution, consumption, and pricing of goods and services, and more importantly, how these are related one to another.

Production, distribution, consumption, and pricing are not natural phenomena. People are doing them. They invest, and start firms, which produce and distribute goods and services. People consume goods and services. What we observe and measure with the indicators is the result of the interaction of a huge number of individuals and firms. All these "agents" make decisions along a large number of dimensions. Understanding how the economy works, and trying to predict it, involves studying an extremely complex object, which is not an easy task.

In what follows, we will try to be as simple as possible, and we will try to stay as practical as we can: the point is to teach you how to use some economic reasoning in order to better understand news and better grasp economic data and its implications.

If you want to take a few minutes to try and understand how economists do their job, you can make a detour through our what do economists do section.

What do economists do?

We have seen that the economy is extremely complex; the result of the interaction of a lot of agents, either individuals, or people grouped into firms making decisions along a large number of dimensions.

How can we try to understand what is going on? First we need to evaluate what is happening, by gathering data. It is the data that we want to understand. Economists do this by constructing models, or mathematical equations, that they hope will be able to demonstrate patterns in the data. The purpose of the exercise is to understand what has happened and predict what is going to happen to the economy in the future. This is important in several respects. For instance, when governmental policies are changed, what happens to the economy? Knowing this for sure would allow us to evaluate policies. Unfortunately, there are not enough certainties. The more we understand the economy, the better we can predict what will happen. Also, when a firm is looking whether to invest, knowing how the economy will fare is crucial. Of course, experiments would make it a lot easier to understand how things work. This, of course, is not a possibility when studying the economy: we can't ask a state to tax at 90% income, and observe if what happens corresponds to the prediction in our model. So, we are left with models that we constantly compare against actual data.

Models are logical constructs, built on numerous assumptions. But the economy is very complex, so what economists do is simplify as much as possible. Using stringent assumptions, they try to understand as much as possible with simple models, and then increase the complexity of the models.

The US government has assembled some of the best economists to help guide US monetary policy. By evaluating economic data and models, they try to predict proper monetary policy to optimize the economy. These independant individuals lead the Federal Reserve, which controls the interest rates charged to banks by the US Federal Reserve System and the cash reserve requirements of US banks. These two factors are a large part of the US monetary policy. The Federal Reserve Open Market Committee (FOMC) evaluates monetary policy in meetings throughout the year.

Later on, you should be able to use very simple constructs, or models, to grasp some of the implications in changes in the indicators. We will not claim that the models replicate the economy, just that they allow us to understand some part of the mechanism that makes up the economy. You may want to check out what a model is in a little more detail, with simple illustrative examples.

On the use of models, an example

Let' s model the market for wine. We want to simplify things, so assume there is only one quality of wine (a stringent assumption, of course). Assume also that all trade takes place at one site.

If you are a producer of wine, and you expect prices to go up, then you will want to increase your production level. However, if prices go down, you'd rather lower your production level and produce something else that is more profitable. If you are a wine buyer, well you will buy more if the price is low, less if the price is high. Despite the producers desires, short term price is determined in large part by the buyers willingness to pay.

If there are many wine makers and many buyers, no one will be able to set prices: if you increase over the market price, all customers go to the next merchant who sells at the market price and nobody will buy from you. So how is the market price determined? Well, it is the price at which the total quantity of wine produced is equal to the total quantity of wine demanded.

In a simple example, let's say there are 10 wine buyers. They like wine, but if it's too expensive, they will buy beer instead. The buyers have the following secret profile.

Now let's take our 3 sellers of wine. In our market let's assume the sale of wine happens one day in the town center. The sellers come with 300 bottles, feeling good and start by asking for $4.00 per bottle. What happens? Then 10 Buyers offer to buy only 200 of the bottles. The sellers are stuck with 100 bottles left. Instead, they offer $3.00 per bottle, which sells all the bottles available, for $100 more in total proceeds.

Suppose there is frost in the late spring, so wine makers cannot make as much wine as they used to. They now only have 100 bottles. What is the effect on the market price and the quantity sold? If demand fundamentals do not change, then at the "no frost" price, there is more demanded than supplied, so the price has to be greater. And at a higher price, demand will be lower. So the result is an increase in price when there is a decrease in production. In our example, the sellers will get $5.00 per bottle to sell their 100 bottles, versus $3.00 the year before, when 300 bottles were available.

Cycles, Leading variables, lagging variables

Cycles, Leading variables, lagging variables

Procyclical, Acyclical and Countercyclical Variables

A data series is made by taking an indicator and saving it at regular intervals of time

When we look at the GDP growth rate, we notice that it reaches maximum and minimum points (peaks and troughs) with a certain regularity. Generally, after a boom, there is a slowdown. One cycle of the economy is defined as 'the period between two peaks'. A question we want to ask is, "Where are we in the current cycle?" Some element of an answer can be given by looking at other indicator series.

The economy is described by a series of documenting movements in variables that are related in some way to output (GDP, GNP, growth, employment, unemployment, prices, job creation, interest rates, housing, consumption, etc.) Some variables follow a cycle similar to GDP; when GDP is growing faster, they are also growing faster, and vice versa. These variables are said to be procyclical. Other variables go in the opposite direction, and are said to be countercyclical. Finally some variables are acyclical, meaning they are not moving in a way that is linked somewhat systematically to GDP.

Volatility

Another important concept is that of volatility. By volatility, we mean how big is the deviation from the mean. This is usually measured by the standard deviation. A variable is more volatile if the swings from a peak to a trough are big. GDP is relatively volatile: it does swing around. Later on, we will want to explain why it does so. By looking at the variables that compose GDP, and comparing the share of GDP they are accountable for, as well as their relative volatility, we can form an idea of which of them influences the changes in GDP the most. Consumption of non durables and services accounts for roughly 60% of our measure of GDP, with broad investment and government consumption accounting for 20% each.

Consumption it's self is not very volatile: the average swing is less than half that of GDP. Government consumption is as volatile as GDP, but, as we see in the chart above, acyclical. Investment, on the other hand, is much more volatile than GDP, so, although it doesn't account for much of the measure, it seems to be an important factor in explaining the swings in output.

The bottom line: understanding the link between investment and output will be crucial to understanding business cycles.

Leading and Lagging variables

If we want to answer the question in hand ("Where are we in the current cycle?") it is interesting to look at procyclical variables and ask whether these variables reach a peak at the same time, or before or after, the GDP. Variables that reach a peak before GDP are called leading indicators. Variables that are behind in the schedule are called lagging indicators. Those that reach a peak at the same time are called coincident indicators.

Microeconomics and macroeconomics

Microeconomics is the study of the behavior of individual agents, either households or firms. Understanding the response of a household to changes in prices and wages, or similarly, trying to understand how firms make their production and pricing decisions, all are microeconomic subjects.

Macroeconomics studies the aggregate economy. It tries to understand why economies grow, and why they go through cycles, and how various economies interact. It is the sum total of microeconomic behaviour in a given geographic area. In other words, macroeconomists try to explain the patterns that can be found in time-series data, data that is the basis for the indicators used in EconDash. Hence our main concern in this site is macroeconomic.

Historically, micro and macro were studied independently, using different tools. Macroeconomists would model "an economy", just as a black box, without taking into account the agents that interact and de facto are the economy. In the 1970s, this approach was criticized, and macroeconomists have used individual agents as the starting point of their models ever since. This is the approach taken here.

Learn From the Shipwreck!

We will understand how the economy works, through a story of a shipwreck on an island. Although we want to understand aggregates (or the total impact on an economy), we will always start by looking at individuals, in order to understand how these individuals, or agents, make decisions. This allows us to derive implications for the economy as a whole. To be able to understand what happens, we need to make significant assumptions that simplify the situation to better understand basic economic concepts. As you will see, a lot can be learned by using models and stories that have unrealistic or extreme assumptions.

We will start by taking a look at the simplest possible scenario: a person, on an island, who only has the resources to make goods by himself. This situation will allow us to introduce some relatively simple concepts that will then be used in most of the subsequent analyses.

Once this island economy is established, we will allow our "poor lost friend" to be joined by more people, and progressively the features of the island will change making it resemble (though not too closely) a real economy: money, bonds, a labor market, capital equipment, a government…and another island ("the rest of the world").

At all stages, we will compare the conclusions that we get from working with our simple island world to data we have on the U.S. and other world economies.

After the shipwreck…

Imagine Robinson, the lone survivor of a shipwreck. He is stranded on an island, where he has very few alternatives. He can stay on the beach ("leisure"), or he can use his time to produce some goods. For instance, he could try catching fish in the sea or climbing a coconut tree to grab fresh coconuts. He could also construct a shelter. (We assume for now that there is a lot of driftwood, so we do not to count driftwood as capital in the production process.)

To sum up: Robinson enjoys two things: leisure, and consumption. He does not like work per se, and so would be very happy to spend all his days doing nothing but leisurely activities, like learning to surf. However, to get the goods that he enjoys, he needs to work. How is he going to choose how much time to work and how much time to spend on the beach?

Before proceding, we need to make assumptions about Robinson's preferences and his ability to produce. How much extra consumption or additional goods does he need to motivate him to work an extra hour? If he has close to no consumption, then he is more than willing to give up leisure time to work and produce more goods. Hence, he does not need to be compensated by many units of goods to work one hour more. When he has a lot of goods at disposition, such as when he had been fed and had shelter, then he doesn't feel the same need for extra goods: he'd rather keep some of his time for leisure. Hence, to remain as happy, working one extra hour, he will require a big increase in consumption.

What about his ability to produce? If he is working very few hours, then working one hour allows him to produce a lot more goods than before. If he has already been working for a long time, then one extra hour won't allow him to produce much more. Hence there is diminishing productivity in labor!

So, how much will Robinson work? Assume he is working 5 hours a day. Does he want to work one more hour? Taking into account diminishing productivity of labor, he can know how many goods he can produce by working the sixth hour, and compare this to the amount of goods he would like to be compensated for that hour of work. If he produces more goods in the last hour (the 6th) than he needs to be compensated from that extra labor, he will work more. If he gets less, then he won't. Since he can do this for every starting work effort, it seems clear that, as long as working a bit more yield more than enough product, he will increase his work load, and vice versa. So the point where he doesn't want to increase or decrease his work effort is where the last hour worked yields just enough extra goods to compensate him for his work: no more, no less. From that point, working one hour more produces less than what he needs to be compensated, hence he would be less happy by working more. And working one hour less does increase his leisure time, but the number of goods that he produces decreases, and that decrease is more important in terms of loss of well being than the gain due to the extra time off!

Production Shocks on the Island

Now that we have a simple guide to Robinson's decision making, we are ready to shock his production process and look at the changes that occur after these shocks. Notice that, since our economy only has one inhabitant, the GDP of the island is the total number of goods that Robinson produces.

In the real world, most changes in the production process combine a change in level (for any hours worked, the total production changes by a constant amount) and a change in marginal productivity (adding an hour's work adds more or less goods than it would have before the shock). It is convenient to decompose any shock into these two effects, called wealth effect and substitution effects. Notice that there are cases where only the wealth effect appears: for instance, for an individual, winning at the lottery, and for an economy, if there is a big tempest that greatly increases the quantities of fish that can be harvested. For Robinson: imagine that a crate full of goods washes onto the shore. For any effort choice he possibly has, the total production in that moment has increased by the number of goods in the crate.

A pure substitution effect is more difficult to see in the real world, as there are always wealth effects . But it is very useful to see what happens in the hypothetical case in which there is a pure substitution effect: In the wealth effect, changes in GDP are accompanied with changes in consumption and labor in a certain direction (increase in wealth), lead to more consumption and less labor. If there are changes in productivity, then there are different changes due to the substitution effect.

So, what is the pure wealth effect? Robinson has all those extra goods. At his current labor choice, he can therefore consume more. However, leisure is relatively more attractive to him, so he decides to work a little less. There is then an increase in consumption and a decrease in labor. What is the pure substitution effect? Now, working a bit more increases his production by more than before… So Robinson has extra incentives to work. The pure substitution effect is thus an increase in labor, and an increase in consumption (Robinson can use all the extra goods he produces, like a sturdier shelter, in addition to the ones he had!).

Now, let's imagine a shock that combines both effects: for some reasons, there are a lot more fish in the sea, more coconuts on the trees, but Robinson also has refined his technique to prepare his shelter. Hence GDP on the island will go up. Since both effects allow Robinson to consume more, consumption goes up (it is procyclical). But the total effect on labor is unclear: since food is easy to get, Robinson can decrease the number of hours he puts in getting it. But since he is more productive at preparing a nice shelter, he also wants to work more on the shelter. In total, we don't know which effect dominates. In economics, we can go to the later data and see, based on the end result, which factor is more important by noting whether it increased or decreased. A labor increase would dictate that the substitution effect is stronger, for example.

Cyclicality

A Second Survivor...

After some time living alone on the island, Robinson awakens one day to find another human being on the island. Nick survived a few weeks barely holding on to a piece of wood…to finally reach Robinson's island. Once Nick is back in shape, the two men discover that Nick has a similar production capacity as Robinson, but for a different set of goods: he is very good at catching rabbits. Hence the two men can now engage in trade. There is one problem to this: there aren't always fishes to exchange for rabbits or at least not the right amount. And the men don't know each other well so they are not confident enough to exchange goods now for goods in the future…(They don't have paper, and have no confidence in their ability to remember who owes what when). Exchanges are hard to come by on this island until a few boxes of golf balls are found (it seems that the boat that was carrying Nick was carrying a huge number of golf balls). The two men have no use for the golf balls until they have the idea of using these balls as medium of exchange. So now when Robinson does not catch fish, he pays nick a golf ball to eat some rabbit, and vice versa. Nick and Robinson are happy. Nick and Ribinson fine tune their system over time. For example, if Robinson catches a lot of fish, he may sell two fish to Nicks for a golf ball. Robinson my hunger for a rabbit other days and offer two golf balls for a rabbit dinner.

How does the island's economy respond to change in production shocks? The main difference now is when there is a shock to one sector, say, fishes are relatively tough to catch due to a storm. Then the price of fish will increase relative to that of rabbits.

But effects of a general change in production opportunities on labor and consumption will be the same as before. We thus need another shipwreck to make the analysis more interesting! It is important to notice at this stage that what matters are relative prices (the price of one good relative to another). If all prices go up by the same proportion, then this should not motivate any change in consumption.

...And More

To make the situation more interesting, we now need 2 women to survive a wreck and to let some time pass. Imagine now that a second generation has reached adulthood. There are 10 individuals, each specializing in some activities (fishing, rabbit hunting, shelter repairing, etc.). Golf balls are still used as currency, but now there is a possibility to save: a crate with paper has reached the island, and all of the inhabitants have decided to keep the paper for the purpose of writing bonds. Some people have more golf balls in some periods while others have less, and bonds are going to allow them to lend and borrow. Bonds have a one period (say, a month) maturity. Selling a bond for 1golf ball amounts to borrowing 1 golf ball today, and requires a repayment of (1+R) golf balls in the following period, where R is the nominal interest rate.

We thus have on this island two markets: one for commodities and one for bonds. Looking at the market for bonds is not very instructive, however, since for every golf ball that is lent, a golf ball has to be borrowed. If Robinson sells a bond with a 1 golf ball face value to Nick, Robinson holds -1 worth of bonds and Nick holds 1 worth of bond. Hence at the aggregate, the sum is zero. We assume that there is a possibility to hold interest-bearing bonds. So why would anyone want to hold money (golf balls, in this economy), which doesn't pay any interest? For this to happen, we must assume first that no one will exchange goods for bonds. The only mean of buying commodities is using golf balls. But we also need to assume that there is a cost of transforming bonds in liquidity. If we do not assume this, then people would just transform some bonds for the exact amount of money they need to buy their desired goods. There are two opposing effects on the demand for money: first, if the interest rate R increases, it is relatively better to hold bonds, even though you incur the cost of transforming back into money, so an increase in R will decrease the demand for money. But to consume more goods, one needs relatively more money; hence an increase in consumption entails an increase in the demand for money. (Notice that the money supply on our island is fixed: there is a fixed number of golf balls) An increase in the demand for money will tend to make the general worth (or buying power) of money higher, decreasing the price level. A decrease in the demand for money will tend to bring up the prices. If there is little demand for money, people want to get rid of their extra golf balls (the value of money has decreased), and the only way to do this is to buy more goods, which is going to make the price level go up - this is inflation.

How does one individual decide how much to consume today, and how much to save in bonds (and to consume tomorrow)? Well, if the interest rate is high, then the agent has incentives to save more today (thus consuming less and working more today), because he will get relatively more tomorrow. Hence, an increase in the interest rate R will increase production (by increasing work effort) and decrease consumption demand.

We now need to examine what will happen when there are shocks to the production function. An important distinction will be whether the shocks are permanent (they last forever, as a change in technology) or temporary (lasting only one period, as a natural cataclysm). Once again, we will try to decompose the effects into wealth and substitution effects.

After doing this, we will see what changes if we let people on the island organize a labor market.

	Econ 101
Shifts in Production Temporary shift in the production function Imagine that, due to a weather front, goods are a lot easier to produce in general on the island. Fish, for example, become more plentiful for a time. What happens if we only consider this wealth effect? With supply increases price will decrease and quantity purchased and consumed will increase. Also, since the shock is temporary, people will tend to not change their behavior too much. They will tend to spread the benefits of the positive shock over future periods. (Imagine if you won at the lottery. You know this happens only once. Of course you do change your consumption pattern, but you will also spread the benefits over many years) Thus, people will tend to save more, driving down the interest rate. This reduction of the interest rate induces consumption to be higher since additional income is not needed as much, and people will tend to work less. Now there is also a change in marginal productivity: not only has the weather made the level of production increase, but for every level of effort, increasing effort a bit has now a bigger incidence on production (the same net catches more fish). We saw above that this would trigger a substitution effect: people will find it more attractive to work a bit more, because each hour gets you more production. The wealth effect above, however, makes work less attractive because you already have more to consume and would prefer more leisure time. Hence, as before, we have the prediction that an increase in GDP has a positive effect on consumption and a negative effect on the interest rate, but we can't be sure about the impact on labor in the economy. However, since the wealth effect is rather small (people prefer to spread the shock), we can suspect that the substitution effect dominates, so we should have a slight increase in the total number of hours worked. Notice that the extra consumption will tend to make the demand for money increase, and since the supply of money is fixed, the general level of prices will move slightly upwards. But apart from that, changes on the commodity market do not affect the price level. This is one side of a phenomenon usually called "Neutrality of Money," and follows the view of Monetarists like Milton Friedman. Permanent Shift Now, imagine that the change in the production possibilities is permanent: people have improved at what they are doing, and there are lots of plants and animals, and it is only getting better. Again, there is a wealth and a substitution effect. The first one implies an increase in consumption demand and a decrease in labor supply, while the second one implies an increase in labor supplied. So aggregate demand and aggregate supply increase. So, what is different from a temporary change? The fact it is permanent makes it neutral to savings. Think of the lottery example once more: if you know that you will win at the lottery every month from now on, you will just increase your spending. Why save, since the extra income is coming every month? It is the same for the case of the production shock on the island: the fact the shock is permanent implies no change in the interest rate. Consumption and GDP increase, since total spending increases, and so money demand will increase. These factors will again lead to an inflationary economy.

	Econ 101
Impacts Increase in Money supply There is no Central Bank on our island. The only way for more money to show up is the unlikely arrival of another few boxes of golf balls. Let's assume that this happens (a ship carrying the balls to the US Open was lost at sea) Let's assume further that the inhabitants of the island decide to share the balls equally. What happens? The supply of Money increases, but demand for money doesn't. Initially, this may look like a temporary wealth effect - but it is not, since everyone has same impact and it does not change real products or production, only money (golf balls). Imagine the market for fish the day after these US Open golf balls wash up on shore. Consumers are smiling, having more golf balls than ever before. When two consumers approach the fish seller, prices may start where they were yesterday, but the fish buyers soon will find they are willing to pay more because they have more golf balls. These same buyers may also be sellers of thatch for housing, and they find that they get more for thatch in the same way. So all prices will rise so as to increase the need for golf balls, and thus equate supply and demand for money. So a change in the monetary base of an economy, under our assumptions, will increase the prices, but not affect any quantities (goods, hours, etc.). This is, once again, the neutrality of money in action. Labor market After a while, people have decided to specialize a lot in their production. And some have good ideas for making more complex goods. Instead of working individually, they find they can create more value by working together - one cutting and another assembling and yet another selling, for example. Owners start these organizations and pay an hourly wage to the workers. This is also great for some people who did not like how their income fluctuated before, when they were selling each day. We assume that the wages are very flexible, and that an hour worked is worth the same for everyone, so there is only one wage level in the economy. The wage will act as a market clearing device: if there is too much labor supplied, compared to the demand, wages will go down, making some people opt for more leisure, and vice versa. It is very important to realize that what matters is the real wage (wage divided by general price level). What the workers look at is how many goods they can buy if they work one more hour, not how many golf balls they get. Hence, the neutrality of money will hold on the labor market as well as on the commodity market: only changes on the money market (money demand and money supply) will change the general level of prices. Furthermore, given that there are no changes in labor supplied or labor demanded, nominal wages will change in proportion to the change in the level in prices. Changes in labor supplied or labor demanded will have an effect on the real wage, since the change on the labor market will not affect the price level but will affect the wage level. What would happen if there were a temporary increase in productivity? For example, four people used to fish, clean, and sell fish, averaging 100 fish a day. Then they join forces, with two fishing exclusively, one cleaning, and one selling, and they find they can average 150 fish a day. With the wealth effect, consumption demand increases and labor hours (supply) decreases (can work less and still have more consumption). This remains exactly the same here. The change is the substitution part. Workers only respond to changes in wealth (including changes in real wages), but an increase in productivity makes it more attractive for the entrepreneurs to hire laborers, increasing labor demand. The overall effect is that the real wage increases, but once more the total effect on hours worked on the island is unclear. When the shock is temporary, we can safely assume that the demand effect will be stronger, thus increasing total hours worked in the economy. In the case of a permanent shift, it is less clear.

	Econ 101
Capital Until now, on this island, most goods were perishable goods: if you did not eat them or use them right away, then they would spoil. We even assumed that shelters were very basic, and counted them as consumption goods. Imagine that, after a while, inhabitants found ways to build goods that are useful in the production processes of their consumption goods. For instance, they managed to build a rowboat which they could use to fish, ladders which help pick fruit, and "machines" which turn the soil, flatten it and to build better shelters. All these goods are used as physical capital in the production process. Hence now, when deciding how much to produce, and individual must not only decide how much to work, but also how much capital to buy for the next period. People will now have to make an investment decision. If you remember, we assumed that the marginal productivity of labor (the increase in production from working an extra hour) typically decreases. It seems natural to have a similar assumption regarding the marginal productivity of capital. We also assume that capital goods depreciate at a fixed rate: each period, because of usage, part of the capital breaks down. Hence, part of the investment serves just the purpose of replacing capital that no longer works, such as when a rowboat sinks. This is called depreciated capital. We usually call gross investment the total quantity of capital purchased. If we take away from gross investment the quantity that just replaces capital that no longer works (depreciated capital), then we have net investment. How much will a person living on the island invest in capital? Well we now that the inhabitants of the island can always buy bonds, on which they have a return of R, the interest rate. It seems clear that when people decide where to place their money, they will compare the return on bonds to the return on capital investment. So what is the return on capital? Buying an extra unit of capital increases production by the marginal productivity of capital (which is diminishing, remember). Buying a ladder allows the orange grower to generate 10 more golf balls a month. This is the return on the golf balls she paid for the ladder. If she paid 500 golf balls for the ladder, she gets 2% back each month (10), or a 24% annual return on capital. Pretty good. Diminishing returns means the second ladder may only generate a 10% return, for example. If the orange grower is confidant she can get a 10 golf ball return, she would be willing to borrow money at a rate close to the 24% rate, leaving some difference to make it worthwhile. If she thinks it could be a broader range, say 6-14 golf balls of benefit, she will also want to ensure there is enough profit to take the risk if the return is only 6 golf balls. So producers will continue to invest in new capital projects until the returns approach the bond returns. If bond returns are high, fewer capital projects will be invested in, and vice versa. If capital project risks decrease, more projects will be invested in as well. What affects the demand for capital? It is clear that an increase in the interest rate will decrease the demand for capital goods, as more people buy bonds. But there are other factors that affect capital demand. Of course, if productivity of capital increases, then demand for capital will increase (this is similar to the effect of a change in labor productivity on labor demand). If depreciation increases, then the return on capital decreases (less money is made selling the capital after its use) and so this lowers the demand for capital. Finally, if a disaster (such as a typhoon) destroys a lot of the old stock of capital, then at the return on capital suddenly increases and the demand for capital increases as well.

	Econ 101
Business Cycles We are now ready to take a look at what happens to the island during both permanent and temporary shifts in production (which is the GDP for the island) and look at the behavior of variables like investment, labor, consumption, and interest rates. We will be able to compare the prediction of the model with the data: more precisely, we will compare the cyclicality of various variables in the model to that in the data. (Cyclicality) Let's first take a look at what happens when there is a temporary change in the production possibilities. Because the weather was nice (ie. new, lower branches grew for the oranges), it is a lot easier to initially produce goods, but marginal productivity of both labor and capital is unaffected. Hence there is no substitution effect. What happens? Because of increases in production, the quantity of goods sold increases and prices drop. The increased wealth in this economy incites people to consume more and work less, hence demand for goods increases and labor hours (supply) decreases. On the labor market, since there is no change in productivity, labor demand is unchanged, thus real wages will increase to reconcile demand and supply of labor. On the goods market, since the change is temporary, the change in demand is relatively small compared to the change in supply. People want to save part of the wealth for future periods. Hence the interest rate decreases, thus increasing a bit the incentives to consume. Let's assume the shock is now permanent: technology on the island has improved, and will stay at a higher level. There is both a change in levels of production and in the marginal productivity of labor. However (and unrealistically), let's keep the marginal productivity of capital constant for a while. Since the shock is permanent, there is no incentives to increase saving in this economy, so in this case the interest rate is going to remain the same. Output and consumption will increase by similar amounts. As in the temporary case, labor supply decreases but labor demand increases, increasing the real wage and increasing labor slightly. By introducing a change in the marginal productivity of capital, which is more realistic, we can reintroduce an increase in investment. This of course increases demand on capital, increasing interest rates slightly (interest rates are slightly procyclical as well). Since machines are more productive, they yield higher returns, thus giving incentives to invest more. This, of course increases demand on capital, increasing interest rates slightly (interest rates are slightly procyclical as well). In the discussion about volatility, we saw that investment is a lot more volatile than consumption. Changes in output are absorbed by changes in capital investment, due to a mix of temporary and permanent shocks. Many the temporary shocks have some persistence: they affect not only the current period, but also future ones, although by a different magnitudes. These persistent shocks support the fact that changes in output are absorbed by capital investment changes.

	Econ 101
Government After some time, residents on the island decide to organize their society in a more formal way, and elect a government. The government decides to spend some resources to provide public services. Government spending mixes two roles: first, it affects people's happiness directly, as any other form of consumption. Perhaps the government organizes a big gathering with free food, gives kids nutritious lunches, or organizes a nice plaza with plants and fountains. Second, government spending also improves production. We assume that a unit of government spending increases the supply of goods in the economy by a small positive amount. For example, the government may help build a nursery for plants and a factory for fountains needed for the plaza. How does the government get the money it spends? By taxing residents, of course. At first, we assume that the tax is of the same amount for every inhabitant, no matter the income. This type of taxes is called a lump-sum tax, and it does not create distortions in economic incentives: individual behavior cannot affect it, so leisure/labor choices are unaffected. Obviously, this is not the most realistic tax we can introduce. Later, we will introduce an income tax. But by concentrating on this lump-sum tax, we can isolate the effects of changes in government spending on individual spending. What happens when government spending increases temporarily? Individuals see their level of happiness go up, due to this increase. They will decide that some of their private consumption is superfluous, and substitute public services for private consumption (For instance, if the government provides a free lunch, people won't spend for that lunch. Also, remember that consumption's extra benefits decrease as the level of consumption increases.) An increase in government spending thus reduces private consumption. Based on US macroeconomic data, an increase in government spending by 10 units decreases private consumption by 2 to 4 units. Overall consumption demand increases, but not by the full amount of government consumption. What happens then with interest rates? The increase in total consumption reduces savings. With fewer savings, the supply of money drops and interest rates rise. This is especially true when governments spend more than they tax, or deficit spending. In this deficit spending the government borrows money, increasing money demand and also increasing interest rates. These effects are often referred to as the crowding out of private spending. Now, it is time to get more realistic in the type of tax imposed. Let us assume an income tax with a flat rate. The government takes a certain percentage of the income of all individuals on the island, including savings. When choosing how much to work and how much to invest, individuals now look at the after tax wage and the after tax return on investment. Changes in the tax rate will then affect the labor-leisure choice of individuals, as well as the savings behavior. Let's assume that there is an increase in the tax rate, but not the government spending or the transfer, to isolate the effects of the increase in taxation. A higher tax rate lowers the incentives to work, lowering the after-tax return on investment, and so reducing investment. Consumption and investment decrease, and labor decreases. Thus both supply and demand of goods decrease (demand decreasing by more). We conclude that the permanent increase in the tax rate decreases output and decreases consumption, work effort and investment. Since investment translates into capital in the future, there are long run effects of the change in the tax rate: less investment means less capital in the future (or a lesser increase in the capital stock), so it decreases long term growth. The Laffer Curve, named after it's creator Art Laffer, an advisor to US President Reagan in the 1980s, shows that for very high and very low tax rates, the tax revenue will be lower, while for more median tax rates, the tax revenue is higher. Of course, there are no reasons for the government to tax if it is not spending. Let's assume now an increase in government spending financed by an increase in the tax rate. The permanent increase in government spending, we saw earlier, translates in lower wealth. Hence private consumption decreases and work effort increases. However, the change in the tax rate distorts the incentives to work, and decreases work effort. It also decreases private consumption and investment (recall that investment is not affected by the permanent change in government spending). We are thus unclear whether labor effort increases or decreases. Also, the overall demand for goods increases (since the government increases its demands). The long-run capital stock is reduced, however, since investment is reduced.

	Econ 101
Another Island Now imagine the people on the island discover that there is another island not so far away. The other island is also populated, and produces the same set of goods. On this island, goods are exchanged against tennis balls. Let's assume for a moment that people on both islands decide to consider tennis balls and golf balls as worth the same. If we assume, in addition, that there are no transportation costs for goods, it is the case that prices of goods are the same on both islands. If the price of a certain good differs from one island to the other, then all who desire the good will buy from the cheapest location, bringing that price up and the other down. Under these assumptions, then, we get a very simplified version of the law of one price. In our bi-island world, there is now possibility to have excess savings or borrowing: it is possible to lend to foreigners, or to borrow from foreigners. The difference between income and spending in a country is called the current-account balance. It has to be equal to net-foreign investment. If the current-account is in deficit, then the country is spending more than its income, and is a net borrower from abroad. (This is the case with the United States) So what happens when there are changes in the production function? Well, the existence of an international credit market allows savings and borrowing in the economy to be different. Hence, if we assume that the economy we are looking at is small relative to the rest of the world (which clearly is not the case in our world), then wherever we had changes in the interest rates for the closed (single) economy analysis, now the interest rate doesn't change, but the current-account balance changes. For instance, in the case of a temporary negative shock in our first island, say a harvest failure, at the given interest rate, people want to borrow more, to spread the negative effects of the shock. In our previous analysis, this would push the interest rate upwards, thus making it more costly to borrow, and more attractive to lend, and reconciling borrowing and lending. Now, however, borrowing is going to increase, and the interest rate is going to stay at its level. But the island is going to borrow from the other island, hence pushing its current account balance towards higher deficits. Basically, the island is using foreign funds to finance part of its consumption. Similarly, if instead of a supply shock we consider a demand shock, say because capital got a lot more productive, inducing an increase in investment demand, in our previous analysis, this would have resulted in an increase of the interest rate. But now, the other island will finance part of the increase in home investment, and the current-account is going to be pushed towards higher deficits. The analysis above assumes that the country is relatively small, and doesn't weight enough in world borrowing markets. This is the case for countries like Belgium, Austria, Portugal, and Ireland. But it is not the case for each of our islands in our two island world (since each island accounts roughly for half of the influence), and it is not the case for the U.S. If we consider the case in which each island weights a lot in the world borrowing market, then we get a situation that is a mix between the case of a closed economy and the case of a small open economy. The interest rate is going to increase, but by less as in the closed economy case, and current accounts are pushed towards deficits. This is how one significant country can have an impact on the world economy. Until now, we have assumed that golf balls and tennis balls are exchanged on a one to one basis. Let's relax that assumption in order to introduce exchange rates. The exchange rate expresses the number of foreign currency units needed to buy one unit of home currency. For instance, it is possible that 2 tennis balls are required to get a golf ball. The exchange rate is then 2. Each island has now a central bank of some sorts, and the central bank's only role is to hold some of the other island's currency in reserve. These reserves will be used to defend the currency is some cases: for instance, if demand for golf balls is going down, so that the value of golf balls relative to tennis balls dips, Robinson's central bank might want to buy golf balls in exchange for tennis balls to keep the exchange rate at a reasonable level. Before we take a look at fixed and flexible exchange rates, let's take a look at the two main propositions in international economics. An often used example of Purchasing-Power Parity is the Big Mac Index. You can read more on the Big Mac Index at The Economist's website First, there is the purchasing-power parity, or PPP. This is a generalization of the law of one price: if there are no transportation costs, the prices, corrected for the level of the exchange rate, should be the same across countries. Second, a similar proposition holds for interest rates: if people can freely borrow and save on both islands, then the interest rates corrected for the level of the exchange rate, should be the same on both islands. This is called the interest-rate parity. Let's take a look at fixed exchange rate systems. Basically, our two islands decide that the exchange rate is going to remain fixed at 2 tennis balls for a golf ball. The respective central banks commit to exchanging tennis balls for golf balls at that rate and vice-versa, whenever someone requests it. Why would such a system break down? Imagine that because of government policies, people feel that golf balls are worth relatively less than 2 tennis balls…then they will all go and request from Robinson's central bank tennis balls in exchange for their excess golf balls. Although the central bank holds a lot of tennis balls, eventually, it is going to run out of them. Hence if this keeps on for long enough, the system will break, and the exchange rate will have to fluctuate freely. Will it break when the central bank holds zero tennis ball or before? The answer is before: at some point, people will realize that the central bank can't keep giving out tennis balls. If suddenly it runs out of them, then people holding golf balls will have lost, since golf balls will be worth a lot less than 2 tennis balls. Hence many people will go exchange their golf balls, accelerating the process. When the exchange rate is allowed to float, then the exchange rate level is determined by the demand for the currency in the world economy. In this case, the exchange rate just varies whenever people want more or less of the currency relative to other currencies. This allows the 2 tennis balls to a golf ball to change to 2.2, 2.5, 1.8, or whatever, depending on the demand on tennis and golf ball exchanges.