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I. Introduction
Economics is the social science that studies the production, distribution, and
consumption of goods and services. The term economics comes from the Ancient Greek for
oikos ("house") and nomos ("custom" or "law"), hence "rules of the house(hold)".
Current economic models developed out of the broader field of political economy in
the late 19th century, owing to a desire to use an empirical approach more akin to the
physical sciences A definition that captures much of modern economics is that of Lionel
Robbins in a 1932 essay: "the science which studies human behavior as a relationship
between ends and scarce means which have alternative uses.
Economics aims to explain how economies work and how economic agents interact.
Economic analysis is applied throughout society, in business and finance but also in crime,
education, the family, health, law, politics, religion, social institutions, and war. The
dominating effect of economics on the social sciences been described as economic
imperialism.
Economic imperialism, in contemporary economics, refers to economic analysis of
seemingly non-economic aspects of life, such as crime, law, irrational behavior, marriage,
prejudice, politics, religion, and war.
This paper aims to give a preview of what comprises the science of economics and
how each economic activity is seen in our daily lives.
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II. Scope of Economics
Macroeconomics
Macroeconomics is a branch of economics that deals with the performance, structure,
and behavior of a national or regional economy as a whole. Along with microeconomics,
macroeconomics is one of the two most general fields in economics. Macroeconomists study
aggregated indicators such as GDP, unemployment rates, and price indices to understand
how the whole economy functions. Macroeconomists develop models that explain the
relationship between such factors as national income, output, consumption, unemployment,
inflation, savings, investment, international trade and international finance. In contrast,
microeconomics is primarily focused on the actions of individual agents, such as firms and
consumers, and how their behavior determines prices and quantities in specific markets.
While macroeconomics is a broad field of study, there are two areas of research that
are emblematic of the discipline: the attempt to understand the causes and consequences of
short-run fluctuations in national income (the business cycle), and the attempt to understand
the determinants of long-run economic growth (increases in national income).
Macroeconomic models and their forecasts are used by both governments and large
corporations to assist in the development and evaluation of economic policy and business
strategy.
Growth
Growth economics studies factors that explain economic growth the increase in
output per capita of a country over a long period of time. The same factors are used to
explain differences in the level of output per capita between countries. Much-studied factors
include the rate of investment, population growth, and technological change. These are
represented in theoretical and empirical forms (as in the neoclassical growth model) and in
growth accounting.
Development of Macroeconomic Theory
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The first published use of the term "macroeconomics" was by the Norwegian
Economist Ragnar Frisch in 1933 and before this, there already was an effort to understand
many of the broad elements of the field.
Keynesianism
Until the 1930s, most economic analysis did not separate out individual behavior
from aggregate behavior. With the Great Depression of the 1930s and the development of the
concept of national income and product statistics, the field of macroeconomics began to
expand. Before that time, comprehensive national accounts, as we know them today, did not
exist. The ideas of the British economist John Maynard Keynes, who worked on explaining
the Great Depression, were particularly influential.
One of the challenges of economics has been a struggle to reconcile macroeconomic
and microeconomic models. Starting in the 1950s, macroeconomists developed micro-based
models of macroeconomic behavior, such as the consumption function. Dutch economist Jan
Tinbergen developed the first national macroeconomic model, which he first built for the
Netherlands and later applied to the United States and the United Kingdom after World War
II. The first global macroeconomic model, Wharton Econometric Forecasting Associates
LINK project, was initiated by Lawrence Klein and was mentioned in his citation for the
Nobel Memorial Prize in Economics in 1980.
Theorists such as Robert Lucas Jr suggested (in the 1970s) that at least some
traditional Keynesian (after John Maynard Keynes) macroeconomic models were
questionable as they were not derived from assumptions about individual behavior, but
instead based on observed past correlations between macroeconomic variables. However,
New Keynesian macroeconomics has generally presented microeconomic models to shore up
their macroeconomic theorizing, and some Keynesians have contested the idea that
microeconomic foundations are essential, if the model is analytically useful. An analogy is
the acceptance of continuous methods in physics despite our knowledge of subatomic
particles.
The various schools of thought are not always in direct competition with one another,
even though they sometimes reach differing conclusions. Macroeconomics is an ever
evolving area of research. The goal of economic research is not to be "right," but rather to be
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useful (Friedman, M. 1953). An economic model, according to Friedman, should accurately
reproduce observations beyond the data used to calibrate or fit the model.
Analytical approaches
The traditional distinction is between two different approaches to economics:
Keynesian economics, focusing on demand; and supply-side economics, focusing on supply.
Neither view is typically endorsed to the complete exclusion of the other, but most schools
do tend clearly to emphasize one or the other as a theoretical foundation.
* Keynesian economics: The first stage of macroeconomics was a period of academic
theory heavily influenced by the economist Keynes. This period focused on aggregate
demand to explain levels of unemployment and the business cycle. That is, business cycle
fluctuations should be reduced through fiscal policy (the government spends more or less
depending on the situation) and monetary policy. Early Keynesian macroeconomics was
"activist," calling for regular use of policy to stabilize the capitalist economy, while some
Keynesians called for the use of incomes policies.
* Neoclassical economics: For decades there existed a split between the Keynesians and
classical economists, the former studying macroeconomics and the latter studying
microeconomics. This schism has been resolved since the late 80s, however, and
macroeconomics has evolved well into its second phase. Keynesian models are now
considered to be outdated and new models have been designed, using the benchmark of
general equilibrium, and are more closely related to microeconomics. The main policy
difference in this second stage of macroeconomics is an increased focus on monetary policy,
such as interest rates and money supply. Mainstream macroeconomic theory today treats the
demand side as more important in the short run and the supply side as more important in the
long run.
Schools of Macroeconomics
* Monetarism, led by Milton Friedman, holds that inflation is always and everywhere a
monetary phenomenon. It rejects fiscal policy because it leads to "crowding out" of the
private sector. Further, it does not wish to combat inflation or deflation by means of active
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taxation. Changes in the level and composition of taxation and government spending can
impact on the following variables in the economy:
Aggregate demand and the level of economic activity
The pattern of resource allocation
The distribution of income.
Fiscal policy refers to the overall effect of the budget outcome on economic activity. The
three possible stances of fiscal policy are neutral, expansionary and contractionary:
A neutral stance of fiscal policy implies a balanced budget where G = T (Government
spending = Tax revenue). Government spending is fully funded by tax revenue and overall
the budget outcome has a neutral effect on the level of economic activity.
An expansionary stance of fiscal policy involves a net increase in government
spending (G > T) through a rise in government spending or a fall in taxation revenue or a
combination of the two. This will lead to a larger budget deficit or a smaller budget surplus
than the government previously had, or a deficit if the government previously had a balanced
budget. Expansionary fiscal policy is usually associated with a budget deficit.
Contractionary fiscal policy (G < T) occurs when net government spending is reduced
either through higher taxation revenue or reduced government spending or a combination of
the two. This would lead to a lower budget deficit or a larger surplus than the government
previously had, or a surplus if the government previously had a balanced budget.
Contractionary fiscal policy is usually associated with a surplus.
Methods of funding
Governments spend money on a wide variety of things, from the military and police
to services like education and healthcare, as well as transfer payments such as welfare
benefits.
This expenditure can be funded in a number of different ways:
Taxation
Seignorage, the benefit from printing money
Borrowing money from the population, resulting in a fiscal deficit.
Consumption of fiscal reserves.
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fund a deficit with the release of government bonds, an increase in interest rates across the
market can occur. This is because government borrowing creates higher demand for credit in
the financial markets, causing a higher aggregate demand (AD) due to the lack of disposable
income, contrary to the objective of a budget deficit. This concept is called crowding out.
Alternatively, governments may increase government spending by funding major
construction projects. This can also cause crowding out because of the lost opportunity for a
private investor to undertake the same project. Another problem is the time lag between the
implementation of the policy and detectable effects in the economy. An expansionary fiscal
policy (decreased taxes or increased government spending) is usually intended to produce an
increase in aggregate demand; however, an unchecked spiral in aggregate demand will lead
to inflation. Hence, checks need to be kept in place.
ROLE OF FISCAL POLICY- ITS SIGNIFICANCE TO BUSINESS ECONOMY IN
DEVELOPING COUNTRIES
The main goal of the fiscal policy in developing countries is the promotion of the
highest possible rate of capital formation. Underdeveloped economies are in the
constant deficit of the capital in the economy and thus, in order to have balanced
growth accelerated rate of capital formation is required. For this purpose the fiscal
policy has to be designed in a way to raise the level of aggregate savings and to
reduce the actual and potential consumption of people.
To divert existing resources from unproductive to productive and socially more
desirable uses. Hence, fiscal policy must be blended with planning for development.
To create an equitable distribution of income and wealth in the society.
To protect the economy from the ills of inflation and unhealthy competition from
foreign countries.
To maintain relative price stability through fiscal measures.
The approach to fiscal policy must be aggregate as well as segmental. the sectoral
imbalances can be curbed by appropriate segmental fiscal measures.
The government expenditure on developmental planning projects must be increased.
For this deficit financing can be used. It refers to creation of additional money supply
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either by creation of new money by printing by government or by borrowing from the
central bank.
Public borrowing, loans from foreign nations etc can be used in the development of
the resources for public sector.
Fiscal policy in the developing economy has to operate within the framework of
social, cultural and political conditions which inhibit formation and implementation
of good economic policies.
In order to reduce inequalities of wealth and distribution, taxation must be
progressive and government spending must be welfare-oriented.
The hindrances in the effective implementation of fiscal policy in the developing
countries are loopholes in taxation laws, corrupt tax administration, a high population
growth, extravagant governmental spending on non-developmental items, an
orthodox society etc.
*Monetary policy is the process by which the government,central bank, or monetary
authority of a country controls (i) the supply ofmoney, (ii) availability of money, and (iii)
cost of money or rate of interest, in order to attain a set of objectives oriented towards the
growth and stability of the economy. Monetary theory provides insight into how to craft
optimal monetary policy.
Monetary policy is generally referred to as either being an expansionary policy, or a
contractionary policy, where an expansionary policy increases the total supply of money in
the economy, and a contractionary policy decreases the total money supply. Expansionary
policy is traditionally used to combat unemployment in a recession by lowering interest rates,
while contractionary policy involves raising interest rates in order to combat inflation.
Monetary policy should be contrasted with fiscal policy, which refers to government
borrowing, spending and taxation.
Monetary policy rests on the relationship between the rates of interest in an economy,
that is the price at which money can be borrowed, and the total supply of money. Monetary
policy uses a variety of tools to control one or both of these, to influence outcomes like
economic growth, inflation, exchange rates with other currencies and unemployment. Where
currency is under a monopoly of issuance, or where there is a regulated system of issuing
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currency through banks which are tied to a central bank, the monetary authority has the
ability to alter the money supply and thus influence the interest rate (in order to achieve
policy goals). The beginning of monetary policy as such comes from the late 19th century,
where it was used to maintain the gold standard.
A policy is referred to as contractionary if it reduces the size of the money supply or
raises the interest rate. An expansionary policy increases the size of the money supply, or
decreases the interest rate. Furthermore, monetary policies are described as accommodative
in the following cases: if the interest rate set by the central monetary authority is intended to
create economic growth; neutral if it is intended to neither create growth nor combat
inflation; or tight if intended to reduce inflation.
There are several monetary policy tools available to achieve these ends: increasing
interest rates by fiat; reducing the monetary base; and increasing reserve requirements. All
have the effect of contracting the money supply; and, if reversed, expand the money supply.
Since the 1970s, monetary policy has generally been formed separately from fiscal policy.
Even prior to the 1970s, the Bretton Woods system still ensured that most nations would
form the two policies separately.
Within almost all modern nations, special institutions (such as the Bank of England,
the European Central Bank, the Federal Reserve System in the United States, the Bank of
Japan orNippon Gink, the Bank of Canada or the Reserve Bank of Australia) exist which
have the task of executing the monetary policy and often independently of the executive. In
general, these institutions are called central banks and often have other responsibilities such
as supervising the smooth operation of the financial system.
The primary tool of monetary policy is open market operations. This entails
managing the quantity of money in circulation through the buying and selling of various
credit instruments, foreign currencies or commodities. All of these purchases or sales result
in more or less base currency entering or leaving market circulation.
Usually, the short term goal of open market operations is to achieve a specific short
term interest rate target. In other instances, monetary policy might instead entail the targeting
of a specific exchange rate relative to some foreign currency or else relative to gold. For
example, in the case of the USA the Federal Reserve targets the federal funds rate, the rate at
which member banks lend to one another overnight; however, the monetary policy of China
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is to target the exchange rate between the Chinese renminbi and a basket of foreign
currencies.
The other primary means of conducting monetary policy include: (i) Discount
window lending (i.e. lender of last resort); (ii) Fractional deposit lending (i.e. changes in the
reserve requirement); (iii) Moral suasion (i.e. cajoling certain market players to achieve
specified outcomes); (iv) "Open mouth operations" (i.e. talking monetary policy with the
market).
Types of monetary policy
In practice, all types of monetary policy involve modifying the amount of base
currency (M0) in circulation. This process of changing the liquidity of base currency through
the open sales and purchases of (government-issued) debt and credit instruments is called
open market operations.
Constant market transactions by the monetary authority modify the supply of
currency and this impacts other market variables such as short term interest rates and the
exchange rate.
The distinction between the various types of monetary policy lies primarily with the
set of instruments and target variables that are used by the monetary authority to achieve
their goals.
Monetary Policy: Target Market Variable: Long Term Objective:
Inflation TargetingInterest rate on overnight
debtA given rate of change in the CPI
Price Level TargetingInterest rate on overnight
debtA specific CPI number
Monetary AggregatesThe growth in money
supply
A given rate of change in the CPI
Fixed Exchange RateThe spot price of the
currencyThe spot price of the currency
Gold Standard The spot price of goldLow inflation as measured by the gold
price
Mixed Policy Usually interest rates Usually unemployment + CPI change
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The different types of policy are also called monetary regimes, in parallel to exchange
rate regimes. A fixed exchange rate is also an exchange rate regime; The Gold standard
results in a relatively fixed regime towards the currency of other countries on the gold
standard and a floating regime towards those that are not. Targeting inflation, the price level
or other monetary aggregates implies floating exchange rate unless the management of the
relevant foreign currencies is tracking the exact same variables (such as a harmonized
consumer price index).
Inflation targeting
Under this policy approach the target is to keep inflation, under a particular definition
such as Consumer Price Index, within a desired range.The inflation target is achieved through periodic adjustments to the Central Bank
interest rate target. The interest rate used is generally the interbank rate at which banks lend
to each other overnight for cash flow purposes. Depending on the country this particular
interest rate might be called the cash rate or something similar.
The interest rate target is maintained for a specific duration using open market
operations. Typically the duration that the interest rate target is kept constant will vary
between months and years. This interest rate target is usually reviewed on a monthly or
quarterly basis by a policy committee.
Changes to the interest rate target are made in response to various market indicators
in an attempt to forecast economic trends and in so doing keep the market on track towards
achieving the defined inflation target. For example, one simple method of inflation targeting
called the Taylor rule adjusts the interest rate in response to changes in the inflation rate and
the output gap. The rule was proposed by John B. TaylorofStanford University.
The inflation targeting approach to monetary policy approach was pioneered in New
Zealand. It is currently used in Australia, Canada, Chile, the Euro zone, New Zealand,
Norway, Poland, Sweden, South Africa, Turkey, and the United Kingdom.
Price level targeting
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Price level targeting is similar to inflation targeting except that CPI growth in one
year is offset in subsequent years such that over time the price level on aggregate does not
move.
Something similar to price level targeting was tried by Sweden in the 1930s, and
seems to have contributed to the relatively good performance of the Swedish economy during
the Great Depression. As of 2004, no country operates monetary policy based on a price level
target.
Monetary aggregates
In the 1980s, several countries used an approach based on a constant growth in the
money supply. This approach was refined to include different classes of money and credit
(M0, M1 etc). In the USA this approach to monetary policy was discontinued with the
selection of Alan Greenspan as Fed Chairman. This approach is also sometimes called
monetarism.
While most monetary policy focuses on a price signal of one form or another, this
approach is focused on monetary quantities.
Fixed exchange rate
This policy is based on maintaining a fixed exchange rate with a foreign currency.
There are varying degrees of fixed exchange rates, which can be ranked in relation to how
rigid the fixed exchange rate is with the anchor nation.
Under a system of fiat fixed rates, the local government or monetary authority
declares a fixed exchange rate but does not actively buy or sell currency to maintain the rate.
Instead, the rate is enforced by non-convertibility measures (e.g. capital controls,
import/export licenses, etc.). In this case there is a black market exchange rate where the
currency trades at its market/unofficial rate.
Under a system of fixed-convertibility, currency is bought and sold by the central
bank or monetary authority on a daily basis to achieve the target exchange rate. This target
rate may be a fixed level or a fixed band within which the exchange rate may fluctuate until
the monetary authority intervenes to buy or sell as necessary to maintain the exchange rate
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Mixed policy
In practice, a mixed policy approach is most like "inflation targeting". However some
consideration is also given to other goals such as economic growth, unemployment and asset
bubbles. This type of policy was used by the Federal Reserve in 1998.
Monetary base
Monetary policy can be implemented by changing the size of the monetary base. This
directly changes the total amount of money circulating in the economy. A central bank can
use open market operations to change the monetary base. The central bank would buy/sell
bonds in exchange for hard currency. When the central bank disburses/collects this hard
currency payment, it alters the amount of currency in the economy, thus altering the
monetary base.
Reserve requirements
The monetary authority exerts regulatory control over banks. Monetary policy can be
implemented by changing the proportion of total assets that banks must hold in reserve with
the central bank. Banks only maintain a small portion of their assets as cash available for
immediate withdrawal; the rest is invested in illiquid assets like mortgages and loans. By
changing the proportion of total assets to be held as liquid cash, the Federal Reserve changes
the availability of loanable funds. This acts as a change in the money supply.
Discount window lending
Many central banks or finance ministries have the authority to lend funds to financial
institutions within their country. By calling in existing loans or extending new loans, the
monetary authority can directly change the size of the money supply.
Interest rates
The contraction of the monetary supply can be achieved indirectly by increasing the
nominal interest rates. Monetary authorities in different nations have differing levels of
control of economy-wide interest rates. In the United States, the Federal Reserve can set the
discount rate, as well as achieve the desired Federal funds rate by open market operations.
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This rate has significant effect on other market interest rates, but there is no perfect
relationship. In the United States open market operations are a relatively small part of the
total volume in the bond market.
In other nations, the monetary authority may be able to mandate specific interest rates
on loans, savings accounts or other financial assets. By raising the interest rate(s) under its
control, a monetary authority can contract the money supply, because higher interest rates
encourage savings and discourage borrowing. Both of these effects reduce the size of the
money supply.
Currency board
A currency board is a monetary arrangement which pegs the monetary base of a
country to that of an anchor nation. As such, it essentially operates as a hard fixed exchange
rate, whereby local currency in circulation is backed by foreign currency from the anchor
nation at a fixed rate. Thus, to grow the local monetary base an equivalent amount of foreign
currency must be held in reserves with the currency board. This limits the possibility for the
local monetary authority to inflate or pursue other objectives. The principal rationales behind
a currency board are three-fold: (i) To import monetary credibility of the anchor nation; (ii)
To maintain a fixed exchange rate with the anchor nation; (iii) To establish credibility with
the exchange rate (the currency board arrangement is the hardest form of fixed exchange
rates outside of dollarisation).
In theory, it is possible that a country may peg the local currency to more than one
foreign currency; although, in practice this has never happened (and it would be a more
complicated to run than a simple single-currency currency board).
The currency board in question will no longer issue fiat money but instead will only issue a
set number of units of local currency for each unit of foreign currency it has in its vault. The
surplus on thebalance of payments of that country is reflected by higherdeposits local banks
hold at the central bank as well as (initially) higher deposits of the (net) exporting firms at
their local banks. The growth of the domestic money supply can now be coupled to the
additional deposits of the banks at the central bank that equals additional hard foreign
exchange reserves in the hands of the central bank. The virtue of this system is that questions
of currency stability no longer apply. The drawbacks are that the country no longer has the
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ability to set monetary policy according to other domestic considerations, and that the fixed
exchange rate will, to a large extent, also fix a country's terms of trade, irrespective of
economic differences between it and its trading partners.
Hong Kong operates a currency board, as does Bulgaria. Estonia established a
currency board pegged to the Deutschmark in 1992 after gaining independence, and this
policy is seen as a mainstay of that country's subsequent economic success (see Economy of
Estonia for a detailed description of the Estonian currency board). Argentina abandoned its
currency board in January 2002 after a severe recession. This emphasised the fact that
currency boards are not irrevocable, and hence may be abandoned in the face ofspeculation
by foreign exchange traders.
Currency boards have advantages for small, open economies which would find independent
monetary policy difficult to sustain. They can also form a credible commitment to low
inflation.
A gold standard is a special case of a currency board where the value of the national
currency is linked to the value of gold instead of a foreign currency.
Monetary policy theory
It is important for policymakers to make credible announcements and degrade interest
rates as they are non- important and irrelevant in regarding to monetary policies. If private
agents (consumers and firms) believe that policymakers are committed to lowering inflation,
they will anticipate future prices to be lower than otherwise (how those expectations are
formed is an entirely different matter; compare for instance rational expectations with
adaptive expectations). If an employee expects prices to be high in the future, he or she will
draw up a wage contract with a high wage to match these prices. Hence, the expectation of
lower wages is reflected in wage-setting Behavior between employees and employers (lower
wages since prices are expected to be lower) and since wages are in fact lower there is no
demand pull inflation because employees are receiving a smaller wage and there is no cost
push inflation because employers are paying out less in wages.
In order to achieve this low level of inflation, policymakers must have credible
announcements; that is, private agents must believe that these announcements will reflect
actual future policy. If an announcement about low-level inflation targets is made but not
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believed by private agents, wage-setting will anticipate high-level inflation and so wages will
be higher and inflation will rise. A high wage will increase a consumer's demand ( demand
pull inflation) and a firm's costs (cost push inflation), so inflation rises. Hence, if a
policymaker's announcements regarding monetary policy are not credible, policy will not
have the desired effect.
If policymakers believe that private agents anticipate low inflation, they have an
incentive to adopt an expansionist monetary policy (where the marginal benefit of increasing
economic output outweighs the marginal cost of inflation); however, assuming private agents
have rational expectations, they know that policymakers have this incentive. Hence, private
agents know that if they anticipate low inflation, an expansionist policy will be adopted that
causes a rise in inflation. Consequently, (unless policymakers can make their announcement
of low inflation credible), private agents expect high inflation. This anticipation is fulfilled
through adaptive expectation (wage-setting Behavior);so, there is higher inflation (without
the benefit of increased output). Hence, unless credible announcements can be made,
expansionary monetary policy will fail.
Announcements can be made credible in various ways. One is to establish an
independent central bank with low inflation targets (but no output targets). Hence, private
agents know that inflation will be low because it is set by an independent body. Central
banks can be given incentives to meet their targets (for example, larger budgets, a wage
bonus for the head of the bank) in order to increase their reputation and signal a strong
commitment to a policy goal. Reputation is an important element in monetary policy
implementation. But the idea of reputation should not be confused with commitment. While a
central bank might have a favorable reputation due to good performance in conducting
monetary policy, the same central bank might not have chosen any particular form of
commitment (such as targeting a certain range for inflation). Reputation plays a crucial role
in determining how much would markets believe the announcement of a particular
commitment to a policy goal but both concepts should not be assimilated. Also, note that
under rational expectations, it is not necessary for the policymaker to have established its
reputation through past policy actions; as an example, the reputation of the head of the
central bank might be derived entirely from her or his ideology, professional background,
public statements, etc. In fact it has been argued (add citation to Kenneth Rogoff, 1985. "The
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Optimal Commitment to an Intermediate Monetary Target" in 'Quarterly Journal of
Economics' #100, pp. 1169-1189) that in order to prevent some pathologies related to the
time-inconsistency of monetary policy implementation (in particular excessive inflation), the
head of a central bank should have a larger distaste for inflation than the rest of the economy
on average. Hence the reputation of a particular central bank is not necessary tied to past
performance, but rather to particular institutional arrangements that the markets can use to
form inflation expectations.
Microeconomics
Microeconomics is a branch of economics that studies how individuals, households
and firms make decisions to allocate limited resources, typically in markets where goods or
services are being bought and sold. Microeconomics examines how these decisions and
behaviors affect the supply and demand for goods and services, which determines prices; and
how prices, in turn, determine the supply and demand of goods and services.
Macroeconomics, on the other hand, involves the "sum total of economic activity,
dealing with the issues of growth, inflation and unemployment, and with national economic
policies relating to these issues and the effects of government actions (such as changing
taxation levels) on them. Particularly in the wake of the Lucas critique, much of modernmacroeconomic theory has been built upon 'microfoundations' i.e. based upon basic
assumptions about micro-level behavior.
One of the goals of microeconomics is to analyze market mechanisms that establish
relative prices amongst goods and services and allocation of limited resources amongst many
alternative uses. Microeconomics analyzes market failure, where markets fail to produce
efficient results, as well as describing the theoretical conditions needed for perfect
competition. Significant fields of study in microeconomics include general equilibrium,
markets under asymmetric information, choice under uncertainty and economic applications
of game theory. Also considered is the elasticity of products
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Markets
In microeconomics, production is the conversion of inputs into outputs. It is an
economic process that uses resources to create a commodity that is suitable for exchange.
This can include manufacturing, storing, shipping, and packaging. Some economists define
production broadly as all economic activity other than consumption. They see every
commercial activity other than the final purchase as some form of production.
Production is a process, and as such it occurs through time and space. Because it is a
flow concept, production is measured as a "rate of output per period of time". There are three
aspects to production processes, including the quantity of the commodity produced, the form
of the good created and the temporal and spatial distribution of the commodity produced.
Opportunity cost expresses the idea that for every choice, the true economic cost is
the next best opportunity. Choices must be made between desirable yet mutually exclusive
actions. It has been described as expressing "the basic relationship between scarcity and
choice. The notion of opportunity cost plays a crucial part in ensuring that scarce resources
are used efficiently. Thus, opportunity costs are not restricted to monetary or financial costs:
the real cost of output forgone, lost time, pleasure or any other benefit that provides utility
should also be considered.
In economic theory, factors of production (or productive inputs) are the resources
employed to produce goods and services. Here the rate of output is modeled as a function of
the rate of use of each input employed.
The first factor of production is the time of the entrepreneur, which, when combined
with other factors, determines the rate of output for a particular good or service and the cost
to the entrepreneur of various rates of supply.
The choice by the entrepreneur of the rate and volume of the good or service to
supply is determined by the extent of the market. [Adam Smith] When producing in autarky,
the extent of the market is the demand by the entrepreneur himself. As additional individuals
enter the economy, the market may widen. But, in addition, competitive suppliers might also
enter. It is this dynamic system that determines the production of the good or service, and the
returns to the relevant factors of production.
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Classification of factors can include such broad aggregates as labor, land, capital, the
overall state of technology, and entrepreneurship. The number and definition of factors can
vary, depending on theoretical purpose, empirical emphasis, or school of economics.
The inputs or resources used in the production process are called factors of
production. Possible inputs are typically grouped into six categories. These factors are:
* Raw materials
* Machinery
* Labor services
* Capital goods
* Land
* Entrepreneur
In the short-run, as opposed to the long-run, at least one of these factors of production
is fixed. Examples include major pieces of equipment, suitable factory space, and key
managerial personnel. A variable factor of production is one whose usage rate can be
changed easily. Examples include electrical power consumption, transportation services, and
most raw material inputs. In the "long-run", all of these factors of production can be adjusted
by management. In the short run, a firm's "scale of operations" determines the maximum
number of outputs that can be produced, but in the long run, there are no scale limitations.
Long-run and short-run changes play an important part in economic models.
Economic efficiency
Economic efficiency describes how well a system generates the maximum desired
output a with a given set of inputs and available technology. Efficiency is improved if more
output is generated without changing inputs, or in other words, the amount of "friction" or
"waste" is reduced. Economists look for Pareto efficiency, which is reached when a change
can make someone better off without making anyone worse off.
Economic efficiency is used to refer to a number of related concepts. A system can be
called economically efficient if:
* No one can be made better off without making someone else worse off.
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In more general terms, it is theorized that market incentives, including prices of
outputs and productive inputs, select the allocation of factors of production by comparative
advantage, that is, so that (relatively) low-cost inputs are employed to keep down the
opportunity cost of a given type of output. In the process, aggregate output increases as a by
product or by design. Such specialization of production creates opportunities for gains from
trade whereby resource owners benefit from trade in the sale of one type of output for other,
more highly-valued goods. A measure of gains from trade is the increased output (formally,
the sum of increased consumer surplus and producer profits) from specialization in
production and resulting trade.
Supply and demand, prices and quantities
The supply and demand model describes how prices vary as a result of a balance
between product availability and demand. The graph depicts an increase (that is, right-shift)
in demand from D1 to D2 along with the consequent increase in price and quantity required
to reach a new equilibrium point on the supply curve (S).
The supply and demand model describes how prices vary as a result of a balance
between product availability and demand. The graph depicts an increase (that is, right-shift)
in demand from D1 to D2 along with the consequent increase in price and quantity required
to reach a new equilibrium point on the supply curve (S).
The theory of demand and supply is an organizing principle to explain prices and
quantities of goods sold and changes thereof in a market economy. In microeconomic theory,
it refers to price and output determination in a perfectly competitive market. This has served
as a building block for modeling other market structures and for other theoretical approaches.
For a given market of a commodity, demand shows the quantity that all prospective
buyers would be prepared to purchase at each unit price of the good. Demand is often
represented using a table or a graph relating price and quantity demanded (see boxed figure).
Demand theory describes individual consumers as rationally choosing the most preferred
quantity of each good, given income, prices, tastes, etc. A term for this is 'constrained utility
maximization' (with income as the constraint on demand). Here, utility refers to the
(hypothesized) preference relation for individual consumers. Utility and income are then used
to model hypothesized properties about the effect of a price change on the quantity
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demanded. The law of demand states that, in general, price and quantity demanded in a given
market are inversely related. In other words, the higher the price of a product, the less of it
people would be able and willing to buy of it (other things unchanged). As the price of a
commodity rises, overall purchasing power decreases (the income effect) and consumers
move toward relatively less expensive goods (the substitution effect). Other factors can also
affect demand; for example an increase in income will shift the demand curve outward
relative to the origin, as in the figure.
Supply is the relation between the price of a good and the quantity available for sale
from suppliers (such as producers) at that price. Supply is often represented using a table or
graph relating price and quantity supplied. Producers are hypothesized to be profit-
maximizers, meaning that they attempt to produce the amount of goods that will bring them
the highest profit. Supply is typically represented as a directly proportional relation between
price and quantity supplied (other things unchanged). In other words, the higher the price at
which the good can be sold, the more of it producers will supply. The higher price makes it
profitable to increase production. At a price below equilibrium, there is a shortage of quantity
supplied compared to quantity demanded. This pulls the price up. At a price above
equilibrium, there is a surplus of quantity supplied compared to quantity demanded. This
pushes the price down. The model of supply and demand predicts that for given supply and
demand curves, price and quantity will stabilize at the price that makes quantity supplied
equal to quantity demanded. This is at the intersection of the two curves in the graph above,
market equilibrium.
For a given quantity of a good, the price point on the demand curve indicates the
value, or marginal utility to consumers for that unit of output. It measures what the consumer
would be prepared to pay for the corresponding unit of the good. The price point on the
supply curve measures marginal cost, the increase in total cost to the supplier for the
corresponding unit of the good. The price in equilibrium is determined by supply and
demand. In a perfectly competitive market, supply and demand equate cost and value at
equilibrium.
Demand and supply can also be used to model the distribution of income to the
factors of production, including labor and capital, through factor markets. In a labor market
for example, the quantity of labor employed and the price of labor (the wage rate) are
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modeled as set by the demand for labor (from business firms etc. for production) and supply
of labor (from workers).
Demand and supply are used to explain the behavior of perfectly competitive
markets, but their usefulness as a standard of performance extends to any type of market.
Demand and supply can also be generalized to explain variables applying to the whole
economy, for example, quantity of total output and the general price level, studied in
macroeconomics.
Diminishing marginal utility, given quantification
Diminishing marginal utility, given quantification
In supply-and-demand analysis, the price of a good coordinates production and
consumption quantities. Price and quantity have been described as the most directly
observable characteristics of a good produced for the market. Supply, demand, and market
equilibrium are theoretical constructs linking price and quantity. But tracing the effects of
factors predicted to change supply and demandand through them, price and quantityis a
standard exercise in applied microeconomics and macroeconomics. Economic theory can
specify under what circumstances price serves as an efficient communication device to
regulate quantity. A real-world application might attempt to measure how much variables
that increase supply or demand change price and quantity.
Marginalism is the use of marginal concepts within economics. Marginal concepts are
associated with a specific change in the quantity used of a good or of a service, as opposed to
some notion of the over-all significance of that class of good or service, or of some total
quantity thereof. The central concept of marginalism proper is that of marginal utility, but
marginalists following the lead of Alfred Marshall were further heavily dependent upon the
concept of marginal physical productivity in their explanation of cost; and the neoclassical
tradition that emerged from British marginalism generally abandoned the concept of utility
and gave marginal rates of substitution a more fundamental role in analysis.
Market failure
Pollution can be a simple example of market failure. If costs of production are not
borne by producers but are by the environment, accident victims or others, then prices are
distorted.
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for changes of equilibrium due to a shift in demand or supply. In many areas, some form of
price stickiness is postulated to account for quantities, rather than prices, adjusting in the
short run to changes on the demand side or the supply side. This includes standard analysis of
the business cycle in macroeconomics. Analysis often revolves around causes of such price
stickiness and their implications for reaching a hypothesized long-run equilibrium. Examples
of such price stickiness in particular markets include wage rates in labor markets and posted
prices in markets deviating from perfect competition.
* Macroeconomic instability, addressed below, is a prime source of market failure,
whereby a general loss of business confidence or external shock can grind production and
distribution to a halt, undermining ordinary markets that are otherwise sound.
Some specialized fields of economics deal in market failure more than others. The
economics of the public sector is one example, since where markets fail, some kind of
regulatory or government program is the remedy. Much environmental economics concerns
externalities or "public bads". Policy options include regulations that reflect cost-benefit
analysis or market solutions that change incentives, such as emission fees or redefinition of
property rights. Environmental economics is related to ecological economics but there are
differences.
Most environmental economists have been trained as economists. They apply the
tools of economics to address environmental problems, many of which are related to so-
called market failurescircumstances wherein the "invisible hand" of economics is
unreliable. Most ecological economists have been trained as ecologists, but have expanded
the scope of their work to consider the impacts of humans and their economic activity on
ecological systems and services, and vice-versa. This field takes as its premise that
economics is a strict subfield of ecology. Ecological economics is sometimes described as
taking a more pluralistic approach to environmental problems and focuses more explicitly on
long-term environmental sustainability and issues of scale. Agricultural economics is one the
oldest and most established fields of economics. It is the study of the economic forces that
affect the agricultural sector and the agricultural sector's impact on the rest of the economy. It
is an area of economics that, thanks to the necessity of applying microeconomic theories to
complex real world situations, has given rise to many important advances of more general
applicability; the role of risk and uncertainty, the Behavior of households and links between
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property rights and incentives. More recently policy areas such as international commodity
trade and the environment have been stressed.
Firms
One of the assumptions of perfectly competitive markets is that there are many
producers, none of whom can influence prices or act independently of market forces. In
reality, however, people do not simply trade on markets, they work and produce through
firms. The most obvious kinds of firms are corporations, partnerships and trusts. According
to Ronald Coase people begin to organize their production in firms when the costs of doing
business becomes lower than doing it on the market. Firms combine labor and capital, and
can achieve far greater economies of scale (when producing two or more things is cheaper
than one thing) than individual market trading.
Labor economics seeks to understand the functioning of the market and dynamics for
labor. Labor markets function through the interaction of workers and employers. Labor
economics looks at the suppliers of labor services (workers), the demanders of labor services
(employers), and attempts to understand the resulting patterns of wages and other labor
income and of employment and unemployment, Practical uses include assisting the
formulation of full employment of policies.
Industrial organization studies the strategic behavior of firms, the structure of markets
and their interactions. The common market structures studied include perfect competition,
monopolistic competition, various forms of oligopoly, and monopoly.
Financial economics, often simply referred to as finance, is concerned with the
allocation of financial resources in an uncertain (or risky) environment. Thus, its focus is on
the operation of financial markets, the pricing of financial instruments, and the financial
structure of companies.
Managerial economics applies microeconomic analysis to specific decisions in
business firms or other management units. It draws heavily from quantitative methods such
as operations research and programming and from statistical methods such as regression
analysis in the absence of certainty and perfect knowledge. A unifying theme is the attempt
to optimize business decisions, including unit-cost minimization and profit maximization,
given the firm's objectives and constraints imposed by technology and market conditions.
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Public sector
Public finance is the field of economics that deals with budgeting the revenues and
expenditures of a public sector entity, usually government. The subject addresses such
matters as tax incidence (who really pays a particular tax), cost-benefit analysis of
government programs, effects on economic efficiency and income distribution of different
kinds of spending and taxes, and fiscal politics. The latter, an aspect of public choice theory,
models public-sector behavior analogously to microeconomics, involving interactions of self-
interested voters, politicians, and bureaucrats.
Much of economics is positive, seeking to describe and predict economic phenomena.
Normative economics seeks to identify what is economically good and bad.
Welfare economics is a normative branch of economics that uses microeconomic
techniques to simultaneously determine the allocative efficiency within an economy and the
income distribution associated with it. It attempts to measure social welfare by examining the
economic activities of the individuals that comprise society.
III. Review Of Related Literature
Foreign Literature
Alfred Marshall's Principles of Economics was the most influential textbook in
economics. Marshall defined economics as
"a study of mankind in the ordinary business of life; it examines that part of
individual and social action which is most closely connected with the attainment and with the
use of the material requisites of wellbeing. Thus it is on one side a study of wealth; and onthe other, and more important side, a part of the study of man."
Many other books of the period included in their definitions something about the "study of
exchange and production." Definitions of this sort emphasize that the topics with which
economics is most closely identified concern those processes involved in meeting man's
material needs. Economists today do not use these definitions because the boundaries of
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economics have expanded since Marshall. Economists do more than study exchange and
production, though exchange remains at the heart of economics.
Most contemporary definitions of economics involve the notions of choice and
scarcity. Perhaps the earliest of these is by Lionell Robbins in 1935: "Economics is a science
which studies human behavior as a relationship between ends and scarce means which have
alternative uses." Virtually all textbooks have definitions that are derived from this
definition.
The state, according to Keynesian economics, can help maintain economic growth
and stability in a mixed economy, in which both the public and private sectorsplay important
roles. Keynesian economics seeks to provide solutions to what some consider failures of
laissez-faireeconomic liberalism, which advocates that markets and the private sector
operate best without state intervention. The theories forming the basis of Keynesian
economics were first presented in The General Theory of Employment, Interest and Money,
published in 1936.
In Keynes's theory, some micro-level actions of individuals and firms can lead to
aggregate macroeconomic outcomes in which the economy operates below itspotential
output and growth. Many classical economists had believed in Say's Law, that supply creates
its own demand, so that a "general glut" would therefore be impossible. Keynes contended
that aggregate demand forgoods might be insufficient during economic downturns, leading
to unnecessarily high unemployment and losses of potential output. Keynes argued that
government policies could be used to increase aggregate demand, thus increasing economic
activity and reducing high unemployment and deflation. Keynes's macroeconomic theories
were a response to mass unemployment in 1920s Britain and in 1930s America.
Keynes argued that the solution to depression was to stimulate the economy
("inducement to invest") through some combination of two approaches :
a reduction in interest rates.
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Government investment in infrastructure - the injection of income results in more
spending in the general economy, which in turn stimulates more production and
investment involving still more income and spending and so forth. The initial
stimulation starts a cascade of events, whose total increase in economic activity is a
multiple of the original investment.[1]
A central conclusion of Keynesian economics is that in some situations, no strong
automatic mechanism moves output and employment towards full employment levels. This
conclusion conflicts with economic approaches that assume a general tendency towards an
equilibrium. In the 'neoclassical synthesis', which combines Keynesian macro concepts with
a micro foundation, the conditions ofGeneral equilibrium allow for price adjustment to
achieve this goal.
The New Classical Macroeconomics movement, which began in the late 1960s and early
1970s, criticized Keynesian theories, while "New Keynesian" economics have sought to base
Keynes's idea on more rigorous theoretical foundations.
More broadly, Keynes saw his as ageneraltheory, in which utilization of resources could be
high or low, whereas previous economics focused on theparticularcase of full utilization.
Local Literature
No available resources.
http://en.wikipedia.org/wiki/Keynesian_economics#cite_note-0http://en.wikipedia.org/wiki/Full_employmenthttp://en.wikipedia.org/wiki/Economic_equilibriumhttp://en.wikipedia.org/wiki/Neoclassical_synthesishttp://en.wikipedia.org/wiki/General_equilibriumhttp://en.wikipedia.org/wiki/Keynesian_economics#cite_note-0http://en.wikipedia.org/wiki/Full_employmenthttp://en.wikipedia.org/wiki/Economic_equilibriumhttp://en.wikipedia.org/wiki/Neoclassical_synthesishttp://en.wikipedia.org/wiki/General_equilibrium8/6/2019 (2) Eco Term Paper
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IV. Conclusion:
We therefore conclude, that the understanding of how our government our economy
works is a good way of exercising our citizenship membership to a political society of
whatever race that we belong to. Knowledge in economic systems allows us to be more
aware and be more cautious in taking care of our business transactions in a way that it also
allows us to be more sensitive of what our actions may bring to our neighbors. Being
members of a Christian society, we should exercise a healthy and friendly competence when
it comes to the developing of our nations economy. A nation should work as one to reach
economic success.
V. Recommendation
We highly recommend this paper to all students of any levels who want to have an
overview of what Economics is. We really hope that this paper will help them broaden their
knowledge of some governmental functions as such, in a way that it will develop their critical
minds to think of some measures that can possibly resolve our nations economic crisis.
VI. Problems Encountered
The problems in making this research paper are as follows:
Conflict of schedules
Unavailable resources(information)
Other projects
Procrastination
Late release of the Term Paper title, thus it became a conflict for us. Cramming.
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INTRODUCTION TO ECONOMICS
ECONOMICS 11B16
MWF 4:30 5:30
Members
Mariel Galanao
Mc Christian Mano
Ronald Barnillo
Rian Paul NoblezaClark Vincent Lacsamana
Christi Anne Pamela Ledesma