Comprehensive Study Notes: The Firm in the Macroeconomy

Introduction to Macroeconomics

Three Key Economic Ideas

• People are rational: Economists assume individuals make decisions to maximize their utility, weighing costs and benefits.

• People respond to incentives: Incentives influence choices, leading to changes in behavior.

• Optimal decisions are made at the margin: Marginal analysis involves comparing additional benefits and costs of a small change in activity.

Additional info: Marginal Cost (MC) and Marginal Benefit (MB) are central to marginal analysis.

The Economic Problem: An Economic Model

Basic Economic Questions

• What goods and services will be produced? Determined by consumer demand and resource allocation.

• How will goods and services be produced? Choices between labor-intensive and capital-intensive methods.

• Who will receive the goods and services? Distribution depends on income, government policy, and market forces.

Efficiency and Equity

• Efficiency: Achieved when resources are used to maximize output.

• Equity: Fair distribution of economic benefits.

Trade-offs, Comparative Advantage, and the Market System

Production Possibilities Frontier (PPF) and Opportunity Cost

• The PPF shows the maximum combinations of goods/services that can be produced with available resources.

• Opportunity cost is the value of the next best alternative forgone.

Formula:

$\text{Opportunity Cost of Good X} = \frac{\text{Loss of Good Y}}{\text{Gain of Good X}}$

Additional info: Increasing marginal opportunity costs create a bowed-out PPF.

Comparative Advantage and Trade

• Absolute advantage: Ability to produce more with the same resources.

• Comparative advantage: Ability to produce at a lower opportunity cost.

• Trade allows specialization, increasing overall consumption possibilities.

Supply and Demand

Demand

• Law of Demand: As price falls, quantity demanded rises (ceteris paribus).

• Determinants: Income, prices of related goods, tastes, expectations, number of buyers.

• Normal goods: Demand increases as income rises.

• Inferior goods: Demand decreases as income rises.

Supply

• Law of Supply: As price rises, quantity supplied rises (ceteris paribus).

• Determinants: Input prices, technology, expectations, number of sellers.

Market Equilibrium

• Occurs where quantity demanded equals quantity supplied.

• Changes in supply or demand shift the equilibrium price and quantity.

	Supply Curve Unchanged	Supply Curve Shifts to the Right	Supply Curve Shifts to the Left
Demand Curve Unchanged	Unchanged price/quantity	Price decreases, quantity increases	Price increases, quantity decreases
Demand Curve Shifts to the Right	Price increases, quantity increases	Price may increase or decrease, quantity increases	Price increases, quantity may increase or decrease
Demand Curve Shifts to the Left	Price decreases, quantity decreases	Price decreases, quantity may increase or decrease	Price may increase or decrease, quantity decreases

GDP: Measuring Total Production and Income

Gross Domestic Product (GDP)

• GDP: Market value of all final goods and services produced within a country in a given period.

• Expenditure approach: $Y = C + I + G + NX$

• Income approach: Sums incomes earned by factors of production.

GDP Deflator

• Measures the price level of all new, domestically produced, final goods and services.

Formula:

$\text{GDP Deflator} = \frac{\text{Nominal GDP}}{\text{Real GDP}} \times 100$

Unemployment and Inflation

Measuring Unemployment

• Unemployment rate: $\frac{\text{Number of unemployed}}{\text{Labour force}} \times 100$

• Labour force participation rate: $\frac{\text{Labour force}}{\text{Working-age population}} \times 100$

Types of Unemployment

• Frictional: Short-term, due to job search or transitions.

• Structural: Mismatch between skills and jobs.

• Cyclical: Due to economic downturns.

• Seasonal: Due to seasonal patterns.

Inflation

• Measured by the Consumer Price Index (CPI).

Formula:

$\text{Inflation Rate} = \frac{\text{CPI}_{\text{current}} - \text{CPI}_{\text{previous}}}{\text{CPI}_{\text{previous}}} \times 100$

Economic Growth, the Financial System, and Business Cycles

Long-Run Economic Growth

• Driven by increases in productivity, capital, and technological progress.

• Potential GDP is the level of output when all resources are fully employed.

The Financial System

• Facilitates the flow of funds from savers to borrowers.

• Includes banks, bond markets, and stock markets.

GDP and Savings:

$Y = C + I + G + NX$

For a closed economy: $I = Y - C - G$

Aggregate Expenditure and Aggregate Demand/Supply

Aggregate Expenditure Model

• Focuses on the short-run relationship between total spending and real GDP.

• Equilibrium occurs when planned aggregate expenditure equals output.

Multiplier Effect:

$\text{Multiplier} = \frac{1}{1 - \text{MPC}}$

where MPC is the marginal propensity to consume.

Aggregate Demand and Aggregate Supply

• AD curve: Shows the relationship between the price level and quantity of real GDP demanded.

• SRAS curve: Upward sloping; shows the relationship between the price level and quantity of real GDP supplied in the short run.

• LRAS curve: Vertical at potential GDP.

The Monetary System and Monetary Policy

What is Money?

• Medium of exchange, unit of account, store of value.

• Commodity money vs. fiat money.

How Banks Create Money

• Banks use fractional reserve banking to create money through lending.

Simple Deposit Multiplier:

$\text{Simple Deposit Multiplier} = \frac{1}{\text{Reserve Ratio}}$

The Quantity Theory of Money

$M \times V = P \times Y$

• M: Money supply

• V: Velocity of money

• P: Price level

• Y: Real output

Monetary Policy

• Actions by the central bank to manage the money supply and interest rates.

• Goals: Price stability, high employment, economic growth, stability of financial markets.

Conclusion

These notes provide a structured overview of foundational macroeconomic concepts, models, and policies, suitable for exam preparation and deeper understanding of the macroeconomy.