Key Economic Concepts: Demand, Production, and Monetary Policy

Posted on Jan 25, 2025 in Economy

Demand and its Determinants

D = Pa, Y, Pb, GO = Pa, r, z, H

Real normal demand increases with increasing income.

  • Luxury goods: Demand increases with increasing income.
  • Necessities: Demand decreases with increasing income.

Substitute Goods: Demand increases with an increase in the price of a connected good.

Complementary Goods: The quantity demanded decreases with an increase in the price of a connected good.

Production Possibilities Frontier (PPF)

The PPF illustrates three concepts:

  • Resource Scarcity: The amounts that can be produced in a period of time are limited by technology and resources.
  • Opportunity Cost: To gain something, we must reduce the production of something else.
  • Production Potential: The maximum output that can be obtained.

Law of Diminishing Returns

The law of diminishing returns states that if, in production, one factor is fixed and variable factor units are added, there will come a time when the increases will be less.

Market Movements and Shifts

Movements are caused by alterations in price.

Shifts are caused by alterations in other factors.

Key Economic Formulas

(PML = ^PT / ^q) (PMEL = PT / q)

(CT = CF + CV) (QM = ^TC / ^q) (AFC = FC / q) (AVC = VC / q)

ATC = TC / q

Central Bank Functions

Specific Tasks:

  • Maintain foreign exchange reserves.
  • Supervise the functioning of credit institutions.
  • Promote the smooth operation of the financial system.
  • Produce and publish statistics related to their duties.
  • Act as the government’s bank and advisor.
  • Put currency into circulation.

As members of the ESCB:

  • Conduct monetary policy.
  • Control the money supply and maintain price stability.
  • Manage foreign exchange operations.
  • Issue legal tender.
  • Promote the smooth operation of payment systems.

Central Bank Balance Sheet

Assets:

Gold and Currency: The cash value was defined in terms of a quantity of gold.

Credit to the Banking System: The central bank may extend credit to banks at a reference interest rate, using financial assets as a guarantee.

Liabilities: Can be expressed as cash in the hands of the public plus bank reserves. Non-monetary liabilities include deposits from the public and the central bank’s capital.

Monetary Base

Base Money = Cash in the hands of the public + bank reserves = Total bank assets – non-monetary liabilities of the central bank.

Expansionary Monetary Policy

Expansionary monetary policy, by granting new loans to banks, will increase the amount of money and lower the interest rate. This decrease causes an increase in the investment component of aggregate demand, and therefore an increase in it. Increasing the amount of money causes a fall in interest rates, which makes lending easier and raises production, known as the monetary transmission mechanism.

Instruments of Monetary Policy

Instruments of monetary policy:

  • Open Market Operations: These are liquidity injection operations conducted by the Eurosystem, where credit institutions and central banks run auctions.
  • Standing Facilities: The marginal lending facility allows institutions to obtain overnight credit, provided they have sufficient collateral. The deposit facility allows them to make overnight deposits.
  • Required Reserves: These are the reserves that entities must hold with central banks, calculated using a ratio (e.g., 2%).