Comprehensive Outline for Economic Concepts and Theory

Outlined by Lambers CPA Review

 Supply and Demand

o The market matches buyers and sellers of good and services.
o Demand is the quantity of a good or service that consumers are willing and able
to purchase at various prices.
 Law of demand - the price of a product and the quantity demanded
are inversely related.
 Substitution effect - when prices decrease, buyer will enter the market.
The product will be cheaper relative to other goods and is substituted for
them.
 Income effect - people buy more when prices are lower.
 Normal goods - commodities for which demand is
negatively related to income.
 Inferior goods - commodities for which demand is
negatively related to income.
 Substitutes - increase is price of one product will generate
an increase in demand for another.
 Complements - increase in the price for one product will
generate a decrease in demand for another. Bread prices go up,
jelly demand goes down
o Demand curves
 Elasticity of demand - the parentage change in quantity demanded
divided by the percentage change in price.
o Supply is the amount of goods or services that producers are willing to offer at a
given price.
 Law of supply - the price of a product and the quantity supplied are
positively related.
 Price elasticity of supply - percentage change in quantity supplied
divided by the percentage change in price.
 Equilibrium - the point at which the demand and supply curves intersect.
o Law of diminishing returns - a fixed amount of production resources, the
addition of increments of labor will produce diminishing returns.
o Law of diminishing marginal utility - useful will decline as consumers
acquired additional units of a product.

 GDP and Business Cycles

o National income - the measure of the output and performance of a nations’
economy.
 Gross domestic product (GDP) - the total market value of all final goods
and services produced within the US whether domestic or foreign during a
year.
  Gross national product (GNP) - value of output produced with the US
owned resources regardless of their location. GNP is GDP plus output of US
owned resources abroad minus foreign owned resources in the US.
 Measurement of GDP can use one of two approaches.
 Income approach - GDP is sum of various types of income such
as wages, interest, rents, indirect business taxes, net foreign income.
 Expenditure approach - GDP is sum of spending such as
personal consumption spending, gross private domestic investment,
government purchases, net exports.
 Net domestic product - GDP - deprecation (consumption of fixed assets)
 National income - NDP + US net income earned abroad - indirect
business taxes such as sales taxes.
 Personal income - NI - corporate taxes - social security
contributions + transfer payments
 Disposable income - PI - personal income taxes
o Business cycles
 Peak phase - economy has reached its highest level of production (GDP).
 Trough - low levels of economic activity and under use of resources.
 Recovery (expansion) - increasing economic activity.
 Recession - activity severely contracts.
 Depression - conditions are similar but longer lasting.
o Economic indicators
 Consumer price index (CPI) - based on prices of 364 goods and services
over time.
 Leading indicators such as new orders, building permits, weekly
production.
 Lagging indicators - unemployment consumer credit,
o Employment
 Natural rate of unemployment - the long-term rate that would exist even
if there were no cyclical unemployment.
 Full employment - when the real rate of unemployment is equal to the
natural rate.
 Frictional unemployment - employees are between jobs.
 Structural unemployment - includes those who have skills but do not
match the required skill levels. by employers.
 Cyclical unemployment - downturn in the business cycle.

 Fiscal Economics
o Deals with the ability of the economy to generate and maintain full employment
over the long run without government intervention. Three assumptions about this
theory.
 The difference between savings plans and investment plans is fundamental
to an understanding of changes in the level of income.
 Price flexibility cannot be relied upon to provide full employment.
 Equilibrium GDP does not necessarily provide full employment.
 o Multiplier - a change in consumption, investment, net exports or government
spending results in a multiplied change in equilibrium GDP.
 Marginal propensity to consume (MPC) - the percentage of additional
income that is consumed.
 Marginal propensity to save (MPS) - the percentage of additional income
that is saved.
 MPC + MPS = 1 or MPS = 1 - MPC

 Money and the Economy

o M1 - coins and currency, checking deposits
o M2 - M1 plus savings, small time deposits, money market accounts.
o Monetary policy by the FED is designed to control the economy through the
supply of money in the banking system. Tools to accomplish this are:
 Reserves
 Discount rates

 Unemployment, Inflation, Deflation, Government

o Unemployment - types
 Frictional - caused by the normal workings of the labor market.
 Structural - aggregate demand is sufficient to provide full employment but
the distribution of demand does not relate to labor force.
 Cyclical
 Seasonal
 Regional
 Technological.
o Inflation
 Cost-push - increased production costs are passed on to the consumer.
 Demand-pull - demand for goods and services is excessive.
 Consumer price index
o Government’s role
 Taxation
 Progressive
 Regressive
 Proportional
 Direct taxes are paid by the taxpayer directly such as income taxes.
 Indirect taxes are paid by someone else even though the individual
will eventually pay the taxes.

 International Trade
o Comparative advantage - countries should produce products when they have
the competitive advantage for sale and buy when they do not.
 Production possibilities curve - represents the tradeoffs between two
alternative goods that can be produced from the same amount of resources.

 Trade Barriers
o The following items are barriers to successful trade.
  Tariffs - consumption taxes to restrict imports.
 Antidumping taxes
 Import quotas
 Embargo - total ban on some kinds of imports.

 Foreign Currency Rates and Markets

o Exchange rate determination
 Spot rate - rate paid for immediate delivery of a currency.
 Forward exchange rate - future price of currency.
o Avoiding the problem through hedging.
 Purchased or selling forward contracts.

 Balance of Payments
o Balance of trade is difference between total exports and imports of goods.

What methods can the

government use to control
inflation?
By Investopedia | Updated January 9, 2018 — 9:30 AM EST

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A:
Inflation takes place when an economy grows due to increased spending. When
this happens, prices rise and the currency within the economy is worth less than
it was before; basically the currency won’t buy as much as it would before. When
a currency is worth less, its exchange rate weakens when compared to other
currencies.

There are many methods used to control inflation, some work well,
while some may have having damaging consequences such as a recession. For
example, controlling inflation through wage and price controls can cause a
recession and hurt the people whose jobs are lost because of it.

One popular method of controlling inflation is through a contractionary monetary

policy. The goal of a contractionary policy is to reduce the money supply within
an economy by decreasing bond prices and increasing interest rates. This helps
reduce spending because when there is less money to go around, those who
have money want to keep it and save it, instead of spending it. It also means that
there is less available credit, which can also reduces spending. Reducing
spending is important during inflation, because it helps halt economic growth
and, in turn, the rate of inflation.

There are three main ways to carry out a contractionary policy. The first is to
increase interest rates through the Federal Reserve. The Federal Reserve rate is
the rate at which banks borrow money from the government, but, in order to
make money, they must lend it at higher rates. So, when the Federal Reserve
increases its interest rate, banks have no choice but to increase their rates as
well. When banks increase their rates, less people want to borrow money
because it costs more to do so while that money accrues at a higher interest. So,
spending drops, prices drop and inflation slows.

The second method is to increase reserve requirements on the amount of money

banks are legally required to keep on hand to cover withdrawals. The more
money banks are required to hold back, the less they have to lend to consumers.
If they have less to lend, consumers will borrow less, which will decrease
spending.
The third method is to directly or indirectly reduce the money supply by enacting
policies that encourage reduction of the money supply. Two examples of this
include calling in debts that are owed to the government and increasing the
interest paid on bonds so that more investors will buy them. The latter policy
raises the exchange rate of the currency due to higher demand and, in turn,
increases imports and decreases exports. Both of these policies will reduce the
amount of money in circulation because the money will be going from banks,
companies and investors pockets and into the government’s pocket where they
can control what happens to it.

Read more: What methods can the government use to control inflation? |
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Governments and central banks generally target an annual inflation rate of 2-3% in order to maintain
economic stability and growth. If inflation "overheats" and prices rise too rapidly, restrictive or
'tight' monetary and fiscal policy tools are employed. If prices begin to fall generally, as is the case with
deflation, 'loose' or expansionary monetary and fiscal policy tools are used. These sorts of tools,
however, are potentially more difficult to employ due to technical and real-world limitations.

Deflation is a serious economic issue that can exacerbate a crisis and turn a recession into a full-blown
depression. When prices fall and are expected to drop in the future, businesses and individuals choose
to hold on to money rather than spend or invest. This leads to a drop in demand, which in turn forces
businesses to cut production and sell off inventories at even lower prices.

Businesses layoff workers and the unemployed have more difficulty finding work. Eventually,
they default on debts, causing bankruptcies and credit and liquidity shortages known as a deflationary
spiral. This scenario is scary, and policymakers will do whatever is necessary to avoid falling into such an
economic hole. Here are some ways that governments fight deflation.

Monetary Policy Tools

Lowering bank reserve limits

In a fractional reserve banking system, as in the U.S. and the rest of the developed world, banks use
deposits to create new loans. By regulation, they are only allowed to do so to the extent of the reserve
limit. That limit is currently 10% in the U.S., meaning that for every $100 deposited with a bank, it can
loan out $90 and keep $10 as reserves. Of that new $90, $81 can be turned into new loans and $9 kept
as reserves, and so on, until the original deposit creates $1000 worth of new credit money: $100 / 0.10
multiplier. If the reserve limit is relaxed to 5%, twice as much credit would be generated, incentivizing
new loans for investment and consumption.

Open market operations

Central banks buy treasury securities in the open market and, in return, issue newly created money to
the seller. This increases the money supply and encourages people to spend those dollars. The quantity
theory of money states that like any other good, the price of money is determined by its supply and
demand. If the supply of money is increased, it should become less expensive: each dollar would buy
less stuff and so prices would go up instead of down.

Lowering the target interest rate

Central banks can lower the target interest rate on the short-term funds that are lent to and among
the financial sector. If this rate is high, it will cost the financial sector more to borrow the funds needed
to meet day-to-day operations and obligations. Short-term interest rates also influence longer-term
rates, so if the target rate is raised, long-term money, such as mortgage loans, also becomes more
expensive. Lowering rates makes it cheaper to borrow money and encourages new investment using
borrowed money. It also encourages individuals to buy a home by reducing monthly costs.

Quantitative easing

When nominal interest rates are lowered all the way to zero, central banks must resort to
unconventional monetary tools. Quantitative easing (QE) is when private securities are purchased on
the open market, beyond just treasuries. Not only does this pump more money into the financial
system, but it also bids up the price of financial assets, keeping them from declining further. (See
also: Why Didn't Quantitative Easing Lead to Hyperinflation.)

Negative interest rates

Another unconventional tool is to set a negative nominal interest rate. A negative interest rate
policy (NIRP) effectively means that depositors must pay, rather than receive interest on deposits. If it
becomes costly to hold on to money, it should encourage spending of that money on consumption, or
investment in assets or projects that earn a positive return. (For more, see: How Unconventional
Monetary Policy Works.)

Fiscal Policy Tools

Increase government spending

Keynesian economists advocate using fiscal policy to spur aggregate demand and pull an economy out of
a deflationary period. If individuals and businesses stop spending, there is no incentive for firms to
produce and employ people. The government can step in as spender of last resort with hopes of keeping
production going along with employment. The government can even borrow money to spend by
incurring a fiscal deficit. Businesses and their employees will use that government money to spend and
invest until prices begin to rise again with demand.

Cut tax rates

If governments cut taxes, more income will stay in the pockets of businesses and their employees, who
will feel a wealth effect and spend money that was previously earmarked for taxes. One risk of lowering
taxes during a recessionary period is that overall tax revenues will drop, which may force the
government to curtail spending and even cease operations of basic services. There has been conflicting
evidence as to whether or not general and specific tax cuts actually stimulate the real economy. (For
more, see: Do Tax Cuts Stimulate The Economy?)

The Bottom Line

While fighting deflation is a bit more difficult that containing inflation, governments and central banks
have an array of tools they can use to stimulate demand and economic growth. The risk of a deflationary
spiral can lead to a cascade of negative outcomes that hurt everyone. By using expansionary fiscal and
monetary tools, including some unconventional methods, falling prices can be reversed and aggregate
demand restored.

Read more: The Top 6 Ways Governments Fight Deflation |

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