1. Economic Theory, 3 rd Stage Prepared by Nyaz Najmadin To Accompany Principles of Macroeconomics, fifth edition, 2009 By N. Gregory Makiw

2. Slide 21-2Copyright © 2003 Pearson Education, Inc. HOW PEOPLE MAKE DECISIONS Because the behavior of an economy reflects the behavior of the individuals who make up the economy, we begin our study of economics with four principles of individual decision making. Chapter 1 The principles of economics

3. PRINCIPLE 3: RATIONAL PEOPLE THINK AT THE MARGIN  Economists use the term marginal changes to describe small incremental adjustments to an existing plan of action.  Rational people often make decisions by comparing marginal benefits and marginal costs. A rational decision maker takes an action if and only if the marginal benefit of the action exceeds the marginal cost. Slide 21-3

4. PRINCIPLE 4: PEOPLE RESPOND TO INCENTIVES  Because rational people make decisions by comparing costs and benefits, they respond to incentives. One economist went so far as to suggest that the entire field could be simply summarized: “People respond to incentives. The rest is commentary.”  When analyzing any policy, we must consider not only the direct effects but also the less obvious indirect effects that work through incentives. If the policy changes incentives, it will cause people to alter their behavior. Slide 21-4

5.  Incentives are crucial to analyzing how markets work. For example, a higher price in a market provides an incentive for buyers to consume less and an incentive for sellers to produce more. Slide 21-5

6. Key words - Opportunity cost - Marginal benefit - Marginal cost - Incentives - Standard of living - Environment - Pollution - Regulation Slide 21-6

7. Chapter 2: CONTROLS ON PRICES  When the price is not allowed to rise above the equilibrium point (level), the legislated maximum is called a price ceiling.  By contrast, when the price cannot fall below the equilibrium level, the legislated minimum is called a price floor. Slide 21-7Copyright © 2003 Pearson Education, Inc.

8. Slide 21-8  What will happen when the government imposes a binding price ceiling on a competitive market?  1- Rent control depresses rents below the equilibrium level. Thus, a shortage of the good arises (e.g. ice cream), the quantity of demanded exceeds the quantity supplied.  2- Long lines. Sellers must ration the scarce goods among the large number of potential buyers. Long lines are inefficient because they waste buyers’ time. The two outcomes?

9. Slide 21-9  One common example of a price ceiling is rent control. The goal of this policy is to help the poor by making housing more affordable. Case Study: Rent Control in the Short run and the long run

10. Slide 21-10 The short-run impacts of rent control Explain why are the short-run supply and demand for housing relatively inelastic?  The reason is landlords have a fixed number of apartments to rent, and they cannot adjust this number quickly as market conditions change.  In addition, the number of people searching for housing in a city may not be highly responsive to rents in the short run because people take time to adjust their housing arrangements.

11. The long-run effect of rent control  Explain why are the long-run supply and demand for housing relatively elastic? Time is an important variable. Over time, landlords respond to low rents by not building new apartments and by failing to maintain existing ones. On the demand side, low rents encourage people to find their own apartments (rather than living with their parents or sharing apartments with roommates) and induce more people to move into a city. Slide 21-11

12. Slide 21-12 What is “price floor”?  Price floor is an attempt by the government to maintain prices at other than (or above) equilibrium levels. Whereas a price ceiling places a legal maximum on prices, a price floor places a legal minimum. Impacts (Effects) of price floor

13. Slide 21-13 1- At this floor, the quantity of the good (e.g. ice cream) supplied exceeds the quantity demanded. Some people who want to sell ice cream at the going price are unable to. Thus, price floor causes a surplus. 2- In the case of a price floor, some sellers are unable to sell all they want at the market price. The sellers who appeal to the personal biases of the buyers, perhaps due to racial or familial ties, are better able to sell their goods than those who do not. What are the impacts of Price Floor?

14. Slide 21-14 EVALUATING PRICE CONTROLS  Indeed, price controls are often aimed at helping the poor. For instance, rent-control laws try to make housing affordable for everyone.  Yet price controls often hurt those they are trying to help. Rent control may keep rents low, but it also discourages landlords from maintaining their buildings and makes housing hard to find.  Other ways can be accomplished. For instance, the government can make housing more affordable by paying a fraction of the rent for poor families. Unlike rent control, such rent subsidies do not reduce the quantity of housing supplied and, therefore, do not lead to housing shortages.

15. Key words  Price ceiling  Price floor  Landlords  Tenants  Sellers  Buyers  Apartments  Rents  Inefficient  equilibrium level Slide 21-15

16. Chapter 3: Saving, Investment, and the Financial System

17. The Financial System financial system  The financial system consists of the group of institutions in the economy that help to match one person’s saving with another person’s investment.  It moves the economy’s scarce resources from savers to borrowers.

18. FINANCIAL INSTITUTIONS IN THE U.S. ECONOMY  Financial institutions can be grouped into two different categories:  Financial Markets Stock Market Bond Market  Financial Intermediaries Banks Mutual Funds

19. FINANCIAL INSTITUTIONS IN THE U.S. ECONOMY  Financial markets are the institutions through which savers can directly provide funds to borrowers.  Financial intermediaries are financial institutions through which savers can indirectly provide funds to borrowers.

20. Financial Markets  The Bond Market A bond is a certificate of indebtedness that specifies obligations of the borrower to the holder of the bond. Characteristics of a Bond –Term. The length of time until the bond matures. –Credit Risk: The probability that the borrower will fail to pay some of the interest or principal. –Tax Treatment: The way in which the tax laws treat the interest on the bond. –Municipal bonds are federal tax exempt. IOU

21. Financial Markets  The Stock Market Stock represents a claim to partial ownership in a firm and is therefore, a claim to the profits that the firm makes. The sale of stock to raise money is called equity financing. Compared to bonds, stocks offer both higher risk and potentially higher returns. The most important stock exchanges in the United States are the New York Stock Exchange, the American Stock Exchange, and NASDAQ.

22. Financial Markets  The Stock Market Most newspaper stock tables provide the following information: –Price (of a share) –Volume (number of shares sold) –Dividend (profits paid to stockholders) –Price-earnings ratio

23. Financial Intermediaries  Banks take deposits from people who want to save and use the deposits to make loans to people who want to borrow. They also pay depositors interest on their deposits and charge borrowers slightly higher interest on their loans. Banks help create a medium of exchange by allowing people to write checks against their deposits.

24. Financial Intermediaries  Mutual Funds A mutual fund is an institution that sells shares to the public and uses the proceeds (profits) to buy a portfolio, of various types of stocks, bonds, or both. –They allow people with small amounts of money to easily diversify.

25. THE MARKET FOR LOANABLE FUNDS  Loanable funds  Loanable funds refers to all income that people have chosen to save and lend out, rather than use for their own consumption.  The market for loanable funds is the market in which those who want to save supply funds and those who want to borrow to invest demand funds.

26. Supply and Demand for Loanable Funds  The interest rate is the price of the loan.  It represents the amount that borrowers pay for loans and the amount that lenders receive on their saving.  The interest rate in the market for loanable funds is the real interest rate. The equilibrium of the supply and demand for loanable funds determines the real interest rate.

27. Figure 1 The Market for Loanable Funds Loanable Funds (in billions of dollars) 0 Interest Rate Supply Demand 5% $1,200 Copyright©2004 South-Western

28. Supply and Demand for Loanable Funds  Government Policies That Affect Saving and Investment Taxes and saving Taxes and investment Government budget deficits

29. Policy 1: Saving Incentives  Taxes on interest income substantially reduce the future payoff from current saving and, as a result, reduce the incentive to save.

30. Policy 1: Saving Incentives  A tax decrease increases the incentive for households to save at any given interest rate. The supply of loanable funds curve shifts to the right. The equilibrium interest rate decreases. The quantity demanded for loanable funds increases.

31. Figure 2 An Increase in the Supply of Loanable Funds Loanable Funds (in billions of dollars) 0 Interest Rate Supply,S1S1S2S2 2.... which reduces the equilibrium interest rate... 3.... and raises the equilibrium quantity of loanable funds. Demand 1. Tax incentives for saving increase the supply of loanable funds... 5% $1,200 4% $1,600 Copyright©2004 South-Western

32. Chapter 4: Economic Fluctuations Chapter 4: Economic Fluctuations  Shifts in Aggregate Demand Case Study 1: THE GREAT DEPRESSION  The economic calamity (disaster) of the early 1930s is called the Great Depression, and it is by far the largest economic downturn in U.S. history. Real GDP fell by 27 percent from 1929 to 1933, and unemployment rose from 3 percent to 25 percent. At the same time, the price level fell by 22 percent over these 4 years. Many other countries experienced similar declines in output and prices during this period. Slide 21-32

33.  In 1930, depositors lost confidence in their banks and as they withdrew their money, they created a wave of bank failures. These bank failures meant that people lost their money, again diminishing aggregate demand. Moreover, people became suspicious of every other bank and rushed to withdrew their money even from banks that were otherwise sound. By 1933, more than 40 percent of all American banks had failed. Slide 21-33

34.  The fear and uncertainty created by bank failures, rising unemployment rates, failing consumer confidence, and inconsistent policy making in Washington also reduced investment spending. Between 1929 and 1933, for example, investment spending fell by nearly 75 percent. Slide 21-34