Economics fundamentals

Economics fundamentals

ECONOMY: science that deals with the way scarce resources are managed, to produce goods and services and distribute them for consumption among members of society.

The economic problem is scarcity and it arises because human needs are unlimited, while economic resources are limited.


Economics allows two types of approaches to which microeconomics and macroeconomics respond:

Microeconomics focuses its analysis on the behavior of small decision-making units (households and companies). Analyze how they make their decisions and how they interact in different markets. Example: The microeconomist studies how an increase in the tax on tobacco affects consumption, how a rise in rents affects the housing market, how a subsidy in the price of diesel influences the demand for vehicles, etc.

Macroeconomics focuses its analysis on the overall functioning of the economy (economic growth, inflation, interest rate, exchange rate, the balance of payment, etc.)An example: Macroeconomists study how a rise in the interest rate affects consumption, how a devaluation of the currency affects the balance of trade, the relationship between inflation and unemployment, etc.

circular flowchart


The circular flowchart is a model that allows us to see how households and businesses interact.

(*) The outer green arrows represent monetary flows

(*) The inner red arrows are flows of goods and services

Households own the factors of production (labor, land, capital, etc.) that they sell to companies so that they can develop their activity.

Companies manufacture goods and offer services that are demanded by households.





Households and firms interact in two types of markets:

  • In the goods and services market, households are applicants and companies are suppliers.
  • In the factors of the production market, companies are applicants while households are suppliers.

production alternatives


Given a technological level, the endowment of factors of production in an economy (labor, land, natural resources, capital, etc.) determines its production capacity.

Capital represents everything produced by the man that is used in the production of other final goods (machinery, installations, warehouses, buildings, computers, etc.).

These factors can be used in the production of different goods or the provision of different services. The production capacity of the economy is limited by this endowment of factors.

Production possibilities frontier:


It reflects the options offered to society and the need to choose between them. An economy is located on the production possibilities frontier when all the factors available to that economy are being used for the production of goods and services. No economy has infinite production capacity.


Let’s assume that a country focuses its activity on the manufacture of only two types of goods (washing machines and shoes).

The ”production possibilities frontier” represents the dilemma between manufacturing one good or another.

Point A would be the one in which the country dedicated all its productive capacity exclusively to the manufacture of washing machines, while point B would be the one in which it focused solely on the production of shoes.

All the points of said curve, from point A to point B (included) are efficient levels of production, that is, combinations of washing machines and shoes resulting from an efficient use of the available factors of production.

The points on the curve are the maximum levels of production of an economy given certain resources.

The interior points (shaded area) represent feasible production levels (the country’s economy can reach them) but inefficient ones (since with the same factors of production the economy is capable of positioning itself at some point on the curve with higher production volumes).

The points outside the curve (to its right) represent volumes of production that are not achievable from the factors of production that it has.

The production possibilities frontier has an outward curved shape due to a general principle of economics, the so-called “Law of Diminishing Returns.”

When the volume of production of a good is small, by increasing the productive factors destined for its manufacture, a strong increase in its production is achieved. But as new productive factors are allocated, the increase in production is less and less.

It was indicated at the beginning of the lesson that this curve represents the production possibilities frontier of an economy given a given level of production factors and technology.

If technology advances, the manufacturing volume will increase (given a given volume of factors of production). The production possibilities frontier would shift to the right.

An economic system is the set of basic, TECHNICAL, AND INSTITUTIONAL relationships that characterize the economic organization of a society. These relations condition the general sense of the fundamental decisions that are taken in every society and the predominant channels of its activity. (What to produce, how much? How? For whom? These are the questions that every economic system must answer)

A market is any social institution in which goods and services, as well as production factors, are freely exchanged. (Swipe flow)

Supply and demand:

They are the two forces that interact in the market, determining the amount traded for each good (or service) and the price at which it is sold.

The demand curve for a good determines the amount of that good that buyers want to buy at each price level, holding other factors constant (tastes, income, prices of related goods).

The demand is determined by a series of variables:

  1. a) Price of the good: The quantity demanded moves inversely to the price: if the price of a good goes up, less is demanded, while if it goes down, its demand increases.
  2. b) Income: Normally if the consumer’s income increases, the quantity demanded of a good also increases. This is the behavior of most goods, which are called “normal goods.”

But it is possible that when the consumer’s income increases, his consumption of a certain good decrease; They are called “inferior goods”. The greater purchasing power of the consumer allows him to replace them with others of higher quality.

For example, the coffee substitute. The consumer of this product when his income increases tends to replace it with coffee.

  1. c) Price of related goods: we will distinguish between substitute goods and complementary goods.

A substitute good can satisfy the consumer’s need in practically the same way as the good in question (for example, margarine is a good substitute for butter).

A complementary good is consumed together with the good in question (for example, a tennis racket and a tennis ball).

If the price of the substitute good rises, the demand for the good increases (and the opposite if it falls).

If the price of butter rises, it will tend to increase the demand for margarine (many consumers will substitute margarine for butter).

On the other hand, if the price of a complementary good increases, the demand for the good decreases (and the opposite if it decreases).

If the price of tennis rackets goes up, the demand for balls will decrease, since some people will stop practicing this sport.

  • you like it If a product becomes fashionable, its demand will increase, while if it loses popularity, its demand will decrease.
  • Expectations about the futureDepending on how the consumer anticipates that the scenario can change, it will positively or negatively influence the demand for a good.

If the consumer anticipates changes in technology, price increases or decreases, income increases or decreases, etc., his current demand for a good may be affected.

It has a negative slope since as the price rises the quantity demanded decreases, while if it falls the price increases.

Variations in the price of the good produce movements along the curve, while variations in the other indicated variables produce displacements of the curve.

If the consumer’s income increases, the price of substitute goods increases, the price of complementary goods decreases, the product becomes fashionable, or expectations favor current consumption, the demand curve will shift to the right.

Conversely, if the consumer’s income falls, the price of substitute goods rises, the price of complementary goods falls, the product loses popularity, or expectations hurt current consumption, the demand curve will shift downward. the left.

Demand Shift Summary:

Lower the price of a complement: right

Lower the price of a substitute: left

Increase income, normal good: right

Income increases, and inferior goods: left

Population grows: right

Change in tastes: right

Let’s see an example.

If the current average price of an all-terrain vehicle is $25,000 and its annual sales are 10,000 units, a price decrease will lead to an increase in sales.

If the price of these vehicles is maintained, but they become fashionable among young people, their sales will increase. At the same price as before (25,000 euros) sales will exceed 10,000 units.

Supply determines the amount of a good that sellers offer to the market based on the price level.

The supply is determined by the following variables:

a) Price of the goodQuantity supplied and price move in the same direction. If the price goes up, sellers will increase their offer, but if the price goes down, the offer will also decrease.

When the price of a good falls, the profitability that the seller obtains decreases, which will lead him to direct his activity toward other types of goods.

This parallel relationship of quantity supplied and price determines that the supply curve slopes upward.

b) Factor prices (resources used in their manufacture). If the price of the factors rises, the manufacturing cost increases, with which the profitability obtained by the seller is reduced. Therefore, the relationship of this variable with supply is inverse:

If the price of the factors rises, the quantity supplied decreases and if the price falls, it increases.

c) Technology: technology and quantity supplied move in parallel. A technological improvement will lead to a decrease in manufacturing costs, increasing the profitability of the product. This will prompt the seller to increase their offer.

d) Expectations: their influence on supply is similar to that seen when analyzing demand. The expectations, depending on what they are (expected rise or fall in the price of the good, changes in tastes, the upward or downward trend in the cost of factors, etc.), can favor or harm the quantity supplied.

While variations in the other three variables cause shifts in the curve.


If the price of stereo equipment falls, its supply decreases; the seller will focus his efforts on other goods that report a higher return (downward movement along the curve).

If the price of the components of the music equipment rises, its manufacturing cost will increase, decreasing its profitability for each price level. This will cause, as in the previous case, a reduction in supply (shift to the left of the curve).

Summary: Supply Shift

Technological improvement: right

Wages rise: left

Lower interest rate: right

Commodity prices rise: left

Increase in the number of companies: right

Good weather: der

The point of intersection of the supply and demand curves is called the equilibrium point, determining a quantity and a market price.

At this point, the amount that buyers want to buy matches the amount that sellers want to sell. Both groups are satisfied and there is no pressure on the price (either upward or downward).

In a competitive market, the individual decisions of thousands of buyers and sellers naturally push toward the break-even point.

If at any given time the market is not in equilibrium, this may be because the price is higher than the equilibrium price, in which case the quantity demanded will be less than the quantity supplied.

Or that the price is lower than the equilibrium price, in which case the quantity demanded will be greater than the quantity supplied.

In both cases, the price will suffer pressures that will push it until it reaches the equilibrium point.

The equilibrium price is the one for which the plans of the demanders and the suppliers coincide.

In the first case (price higher than equilibrium) there will be an excess supply (the quantity supplied at that price will be higher than demanded). A surplus of supply is generated that remains unsold, which will lead sellers to lower the price to sell these goods. As the price falls, the demand for the good will increase while the supply decreases. This process will continue until the break-even point is reached.

In the second case (price lower than the equilibrium price) an excess demand is created (the quantity demanded will be greater than the quantity supplied). This unsatisfied demand will allow sellers to raise the price, resulting in increased supply and decreased demand. This process continues until the break-even point is reached.


The bicycle market is in equilibrium, with annual sales of 100,000 units at an average price of 100 euros.

After the victory of a national cyclist in the Tour, this sport became very popular in the country, shifting the demand curve to the right.

At the current price (100 euros) an imbalance arises: sellers continue to offer 100,000 units.


The concept of elasticity measures the amplitude of the variation of a variable when another variable on which it depends varies.

This concept is applied to demand and supply curves to measure the variation in the quantity demanded or supplied as a result of variations in the variables that determine them.

Price elasticity of demand: measures the change in the quantity demanded in response to a change in price.

It is calculated by dividing the percentage change in quantity demanded by the percentage change in price.

Price elasticity of demand = Quantity % variation / Price % variation

The demand for a good is elastic if the quantity demanded responds significantly to a change in price, and inelastic if the quantity demanded responds very slightly to a change in price.

According to the value of elasticity, we can talk about:


Elastic demand (elasticity > 1)

Demand with unit elasticity (elasticity = 1)

Inelastic demand (elasticity < 1)

Perfectly inelastic demand (elasticity < 0): WHEN THE DEMAND DOES NOT RESPOND TO PRICE VARIATIONS.

Factors that determine whether demand is elastic or inelastic

a) Necessary good versus luxury good. Necessary goods often have inelastic demand. Its demand oscillates little with price variations (people will continue buying that good because they need it). example bread

By contrast, the demand for luxury goods is often highly elastic. As they are not necessary goods, the consumer can do without them at any given time. This determines that its demand reacts intensely to price variations. example cruise pants brands

b) Existence or not of close substitute goods. If there are close substitute goods, the demand will tend to be more elastic since many consumers will buy the substitute good when faced with a price increase.

For example, olive oil has a close substitute which is sunflower oil. If the price of olive oil rises considerably, many consumers will buy sunflower oil.

When there are no close substitute goods, demand is usually more inelastic.

For example, milk has no close substitute, presenting an inelastic demand. Even if its price goes up, people will have no choice but to continue buying milk.

c) Time horizon: goods tend to have a more elastic demand when a longer time horizon is analyzed.

For example, if the price of gasoline rises (within certain limits) the consumer will have to continue filling the tank of his vehicle, so the quantity demanded will not suffer a great variation in the short term.

Income elasticity of demand

The income elasticity of demand measures the magnitude of the change in the quantity demanded in response to a change in the consumer’s income.

Income elasticity of demand = Variation % of quantity / Variation % of income

The goods are classified into:

Normal: they have positive income elasticity (an increase in income leads to an increase in the demand for the good).

Inferior: they have negative income elasticity (an increase in income causes a decrease in the demand for the good).


An inferior good can be a low-quality food product: when income increases, the consumer instead of acquiring more of that good, replaces it with another of higher quality.

Necessary goods tend to have a low income elasticity. The consumer tends to purchase the amount he needs regardless of whether his income goes up or down.

Luxury goods tend to have a high income elasticity: their demand varies significantly with variations in consumer income.

Price elasticity of supply

This elasticity measures the magnitude of the change in the quantity supplied in response to a change in price.

Price Elasticity of Supply = Quantity % Variation / Price % Variation

Its operation is similar to that of the elasticity of demand.

According to its elasticity, the supply of a market can be classified into:

Perfectly elastic supply (elasticity = infinity)

Elastic supply (elasticity > 1)

Supply with unit elasticity (elasticity = 1)

Inelastic supply (elasticity < 1)

Perfectly inelastic supply (elasticity < 0)

As can be seen, the supply is elastic when the quantity supplied is very sensitive to a price variation and it is inelastic when it hardly fluctuates.

An example of elastic supply is that of rural houses. If the price of accommodation rises, many owners will decide to condition their second homes as rural houses, while when the price falls, some rural houses are no longer offered.

On the other hand, an example of inelastic supply is that of oil since the wells are at full capacity and

it is very difficult in the short term to increase production no matter how much the price rises.

Production Costs

production function

The production function relates the number of production factors used (labor, machinery, raw materials, other supplies, etc.) with the production obtained from a certain good.

In the initial phase, the production function may present an increasing slope:

By increasing the factors of production, the amount obtained increases more than proportionally.

For example: suppose that the activity consists of fencing a farm. 2 people probably do it more than twice as fast as one since each of them can specialize in a certain task (one is placing the posts in the ground and the other is installing the metal mesh).

This increase in efficiency by increasing the factors of production can be due to multiple causes.

In the previous example, the incorporation of a second worker allows specialization.

But normally after a certain level of production, this initial increase in efficiency disappears and inefficiencies begin to appear. The slope of the production function is decreasing.

The increase in production obtained by increasing the factors of production used is less and less.

For example, there comes a certain moment in which an increase in the factors of production by 40 percent manages to increase production by only 25 percent.

This law is called the “law of diminishing marginal product .” Marginal product is the increase in production that is obtained by increasing a given factor of production by 1 unit.

In the previous example of placing the fence, there comes a time when the incorporation of new employees is achieving increasingly lower productivity (tools have to be shared, some tasks become bottlenecks, it is difficult to coordinate so many people, etc. .).

The law of diminishing marginal product not only affects the labor factor but normally affects all factors of production.

The marginal product is equal to the slope of the production curve, and in the previous graph, it can be seen how this slope decreases (the curve becomes more and more flat).

cost curves

cost curve

The total cost curve represents the costs incurred by the company based on the level of activity.

Total costs are the sum of fixed costs and variable costs.

Fixed costs are those that do not vary depending on the level of activity. The company incurs them regardless of whether it works at 100 percent of its capacity, at 50 percent, or even is stopped (for example, the rent of the central offices).

Variable costs are those that vary depending on the level of activity. (for example, the consumption of raw material depends on the volume of manufacture).

Next, we will distinguish between the short-term and the long-term.

Short run cost curve



a) Average total cost

The average total cost curve is obtained by dividing the total cost by the units produced.

This curve is U-shaped.

The average total cost is the sum of the average fixed cost and the average variable cost.

The average fixed cost will always be decreasing (within certain levels of activity). Being a fixed cost, as production increases, the cost to be attributed to each unit is less and less.

The average variable cost (variable cost per unit of product) can decrease in an initial phase (coincides with the volumes of activity in which the production function has an increasing slope). But as the law of diminishing marginal productivity begins to be fulfilled, the average variable cost begins to rise. Its slope will increase to the same extent that the slope of the production function becomes flatter.

Result of the interaction of the two types of costs, the average total cost curve initially presents a downward slope (activity level with an average fixed cost and average variable cost downwards), but as the activity increases and the variable cost average starts to rise, the average total cost curve changes slope and starts to rise.

b) Marginal cost

The marginal cost curve represents the increase in total cost by increasing production by one unit.

In the initial phase, the slope of this curve is decreasing. As was the case with the average variable cost, it corresponds to that initial level of activity where the production function has an increasing slope.

As production increases, efficiency improves and the cost of producing an additional unit decreases.

But when the law of diminishing marginal production begins to manifest itself, the slope of the marginal cost curve begins to increase.

It costs more and more to produce an additional unit.

c) Average total cost curve and marginal cost curve

The marginal cost curve intersects the average total cost curve at its lowest point.

As long as the marginal cost is below the average total cost (that is, as long as the cost of producing an additional unit is less than the average total cost) the average total cost will be decreasing.

From the moment in which the marginal cost is above the average total cost, said average total cost will begin to rise.

The lowest point of the average total cost curve corresponds to the most efficient level of activity of the company, that is, the one in which the company produces at the minimum cost per unit of product.

Once the average total cost begins to rise, further increases in the volume of activity will cause its slope to become ever steeper.

The law of diminishing marginal production explains the cost of an additional unit will be increasing.

Long-term cost curve



The fundamental difference between short-run costs and long-run costs is as follows:

In the short term, there are fixed costs, costs that the company incurs regardless of its level of activity, and costs that arise even if the company is stopped (amortization of machines, financial costs, rents, etc.). These are costs that the company cannot eliminate immediately even if it decides to end its activities.

In the long run, all costs are variable. The company can cancel the rental contracts for its offices or rent new offices, it can sell its facilities, machinery, etc., acquire new ones, cancel its loans, or request new ones, etc.

The long-run average total cost is also U-shaped (same as the short-run curve) but its shape is more open.

Joining the minimum points of the short-term curves corresponding to each level of activity, we will obtain the long-term curve. The minimum point of each short-run average total cost curve is tangent to the long-run curve.

The descending section of the average total cost curve al/p corresponds to levels of activity in which there are economies of scale :

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In other words, increases in activity lead to a decrease in the average total cost. The company gains in efficiency as its activity increases. The reasons can be very varied: for example, the greater volume allows mechanizing certain phases of the production process or allows the workforce to be segmented into units specialized in specific phases of the production process, etc.

In the flat section there are constant returns to scale:

The economies of scale have already disappeared, but the company manages to maintain its level of efficiency.

In the ascending section, there are diseconomies of scale.

The high volume of activity impairs efficiency, raising the average cost per unit of product. The causes can be multiple (decision-making is complicated, the company becomes bureaucratized, functions overlap, etc.).

In short, every activity has an optimal level of activity in the long term, the one in which the total average cost is minimized.

Market Types

Competition is a way of organizing markets that allows equilibrium prices and quantities to be determined.

1) Perfect Competition

The competitive market is characterized by 3 properties:

  1. a) Many buyers and sellers are involved, the size of each of them being very small about the market as a whole: no actor dominates the market. This implies that the individual decision of each of them (buyers or sellers) does not influence the price. They are price takers.
  2. b) The products offered by the different sellers are identical, there are practically no differences between them. A buyer will be indifferent to buying the product of one company or another.
  3. c) There is freedom of entry and exit in the market for buyers and sellers. Some companies close and leave and others enter the market.
  4. d) market transparency: all participants are aware of market conditions.

The behavior of a competitive company

The competitive firm will try to maximize its profit (difference between income and expenses).

Revenue is calculated by multiplying the quantity sold by the price. The company is a price taker since the price is set by the market. At that price, the company will be able to sell everything it produces.

To analyze their costs, we represent the average total cost and marginal cost curve.

The company will decide to increase its production as long as the revenue of an additional unit (market price) exceeds the cost of an additional unit (marginal cost). This will lead him to fix his level of production at the point of intersection of the price line and the marginal cost curve.

If it were below that level (to the left of the point), it would interest him to increase his production because, for that additional unit, he would obtain an income (price) higher than its cost.

On the other hand, if it were above said level (to the right of the point) it would be in your interest to reduce your activity since the last units produced would cost you more than the income you would obtain.

This process leads him to converge at the point of intersection of the price line and the marginal cost curve.

What will the supply curve be?


For each price level, the quantity supplied would be determined by the intersection point of the price line and the marginal cost curve. Therefore, its supply curve would be identical to its marginal cost curve.

For the price P1, it would offer Q1, while for the price P2, it would offer Q2.

Where does this curve start?

In the short term, the company faces fixed expenses and variable expenses.

Fixed expenses will occur regardless of the level of activity of the company, so it is a variable that will not influence when deciding its level of activity.

Variable costs if they are based on the volume of activity. Therefore, the company will decide to produce as long as the income covers the variable costs.

It would not make sense to carry out an activity that generates income that is lower than the costs that it originates (variable costs).

Then the supply curve is similar to the marginal cost curve located above the average variable cost curve.

What benefit does the company get?

The total profit that the company obtains will be equal to the profit that it obtains for each unit multiplied by the quantity.

When talking about benefits, they must be understood as extraordinary benefits. We have already seen that the costs include the opportunity cost, equivalent to the “logical” benefit that the market demands for carrying out a certain activity and that is a function of the necessary investment and the risk assumed.

The profit per unit is equal to the difference between the price and the average total cost.

Long term

In the long term, there is mobility in and out of the market (something that in the short term is not feasible).

This implies that if an economic sector obtains (extraordinary) benefits, it will attract new companies that will shift the supply curve to the right, causing the price to fall. The entry of new companies will continue until the benefit disappears.

If, on the contrary, the sector incurs losses, some companies will begin to leave the market, shifting the supply curve to the left, which will make the price rise. This process will continue until the leaks are gone.

In short, in the long term, the sector will be at a point where the benefit is nil.

Then the market tends to a point where companies make ordinary profits but not extraordinary profits.

One difference between the short term and the long term is that in the short term, companies can obtain extraordinary benefits, while in the long term, the entry and exit of companies make these exceptional benefits disappear.

The monopoly

A monopolistic market is one controlled by a single firm that has full power to set prices.

Why do monopolies arise?

A monopoly arises when there are very strong entry barriers that protect the only participant and that prevent the entry of new competitors.

a) There is a key resource in the manufacture of the product that only that company possesses.

For example, patents for the manufacture of drugs. Only that company that owns a certain patent will be able to manufacture that specific medicine.

b) The company has the only concession granted by the State to produce a certain good.

For example, the State grants a company the exclusivity of gas distribution in a certain area.

c) The cost structure of a given industry makes a single large producer more efficient than a group of smaller companies.

For example, in the manufacture of large aircraft, a large company that can undertake the high investments required is more efficient than several smaller companies.

How do monopolies make their production and price decisions?

As in the competitive market, the monopoly tries to maximize its profit.

For this reason, it will decide to produce as long as the marginal income (that of the last unit produced) is greater than its marginal cost.

As we saw when analyzing the perfectly competitive market, the monopoly will be located at the intersection point of the marginal revenue curve with the marginal cost curve.

The cost lines (marginal cost and average total cost) of a monopoly are similar to those of a competitive firm.

But while in a perfectly competitive market, marginal revenue is equal to price and is the same for each level of activity (horizontal straight line located at the price level), in the monopolistic market this marginal revenue is a downward curve.

The monopoly faces a negatively sloping demand curve: depending on the price it sets, buyers will demand more or less.

Therefore, if the monopoly wants to increase its sales, it has to lower the price. This price decrease not only affects the last unit but also affects all of its sales (since all sales are made at the same price).

This determines that the marginal revenue curve also has a negative slope. It coincides with the demand curve at the origin but from then on it evolves below said curve and may become negative.

Marginal revenue will be equal to the price of the last unit minus the decrease in revenue caused by the price drop of all previous units.

How is the price determined?

It projects the quantity that it has decided to produce on the demand curve, thus determining the price at which the market will buy all its supply.

Therefore, although the monopoly can set the price of the good, it cannot obtain an infinite benefit since it is limited by the demand curve. If the monopoly sets a very high price, the quantity demanded would be reduced considerably.

For example, a company has a monopoly on gas stations in a certain region. If the price of gasoline rises, people will travel less and if it is exorbitantly priced, people will travel practically nothing.

What profit does a monopoly get?

Your profit will be equal to the difference between the price and the total average cost, multiplied by the quantity sold. It is equivalent to the shaded area on the graph

While in a perfectly competitive market, the benefit disappears in the long term, the monopoly is capable of obtaining long-term benefits since the game of entry and exit of companies does not occur, which is what determines this null benefit.

Does monopoly maximize the benefit of society?

The competitive market maximizes the benefit of society at the equilibrium point.

At the said point, the value given to the good by the last buyer (represented by the demand curve) is equal to the cost it has for the last seller (supply curve).

In the monopoly, at the equilibrium point (intersection point of the marginal revenue and marginal cost curve) the demand curve (represents the value for the buyer) is higher than the marginal cost curve (cost for the producer).

In other words, if the benefit obtained by the buyer is greater than the cost it has for the producer, then the benefit of society would increase if the quantity supplied by the monopoly increased up to the intersection point of the demand curve and the supply curve. marginal cost.

This is not in the interest of the monopoly since from the point of intersection of the marginal revenue and marginal cost curves, additional increases in activity reduce its particular benefit.

In short, the monopoly, trying to maximize its private benefit, is located at a level of activity below that which would maximize the overall benefit of society.

This loss of profit is precisely the cost that the existence of a monopoly has for society.

On the other hand, the price set by a monopoly is higher than the price set by a perfectly competitive market.

In a competitive market, the price is equal to the marginal cost, while in a monopolistic market, the price (determined by the demand curve) is higher.

This high price does not imply per se a lower benefit for society as a whole, what it does imply is a transfer of profits from buyers in favor of the monopoly.

The social cost of a monopoly drives governments to act to try to limit them.

  1. a) Regulating the conditions in which monopolies can act: for example, setting rates, demanding a level of quality of services, etc. The State tries in this way to protect the consumer.
  2. b) Trying to break the monopoly situation: allowing new competitors access to the market (granting licenses in regulated sectors), forcing monopolistic companies to carry out disinvestments to reduce their control of the market, setting maximum limits of market share that a company can control, prohibiting certain business concentration operations, etc.
  3. c) Nationalizing some monopolies so that it is the State that manages them under more favorable conditions for consumers.

price discrimination

Some monopolies try to apply a price discrimination policy that consists of selling the product at a different price depending on the type of consumer.

It is about selling it more expensive to that type of consumer who values ​​the good more and who is, therefore, willing to pay a higher price.

And sell it cheaper to those others who value it less or who have fewer resources and who are willing to pay less for the good.

The monopoly tries to differentiate among the potential buyer’s different subgroups based on the possible value that they can give to the good.

If the company does not perform price discrimination, it will have to sell the product to all potential buyers at the same price.

Therefore, if the monopoly could discriminate in price, it would be able to increase its profit.

In a competitive market, price discrimination is not possible since it is set by the market.

If the company raises its prices to a certain group of buyers, it will acquire the good of the competition.

The Oligopoly

They are markets in which firms are not simply “price-takers” (as in perfect competition), but neither are “price-setters” (as in monopoly), but rather have some market power and therefore some ability to influence the price.

In this type of market, few companies sell the same product, so the production decisions adopted by each of them have an impact on the others.

This differentiates it from the perfectly competitive market where a large number of participants means that none of them have market power, so their individual decisions do not affect the rest.

In an oligopolistic market, there will always be a choice between collaboration or competition among the participants.

If they collaborate, coordinating their actions (regulating the amount offered), this market will function as a monopoly. In this case, the profit obtained by these companies increases to the detriment of the buyers.

If, on the contrary, they decide to compete, their operation will be close to that of a competitive market (although it will not be the same). It will decrease the benefit of these companies in favor of consumers.

Collaboration vs. Competition

The collaboration between these companies is called “collusion” and the set of companies that collaborate form a “cartel”.

An example of a cartel is OPEC (organization of oil-producing countries). The countries that are part of this cartel (a large part of the main oil producers) coordinate their production volume trying to influence the price of oil.

Although the collaboration between these companies benefits all of them as a whole, it does not always occur since each of them individually could improve their situation by breaching the agreement.

There is the paradox that individually they all benefit from “cheating”, but if they all “cheat” the final result for all of them is worse than if they comply with what was agreed.

This is a situation similar to that described by the prisoner’s theorem:

It can be observed how any of the convicted see their sentence decrease if they accuse their partner, and this is regardless of the decision adopted by the partner to accuse him or not.

This situation leads the two prisoners to accuse each other with the result that the final sentence for each of them is greater than if both had collaborated and not confessed.

In short, whatever the others do (comply with the agreement or not), each company individually is interested in breaching the agreement.

It can be seen how sometimes it is difficult for there to be a collaboration between the companies that are members of the oligopoly. However, in some cases there is collaboration. The agreement usually works when:

  • It is possible to detect who fails to comply and can be penalized.
  • It is not a question of a specific collaboration at a given moment, but that the collaboration is repetitive over time. For this reason, after the first episode of lack of collaboration and once its results are known, companies will be more inclined to collaborate.
  • The smaller the number of companies present in the market, the easier the collaboration between them will be, and the larger the number, the more difficult it will be.

With few companies, the oligopoly will approach a monopoly, while with a large number, it will be closer to the competitive model.

If there is no collaboration between companies, does the oligopoly work as a competitive market?

Its operation will be close to that of a competitive market but it will not be the same.

Their level of production will be higher than if they acted in coordination, while the price will be lower. However, the same level of activity will not be achieved in a competitive market.

If there is no agreement, each participant will act thinking exclusively of their interests but will be aware that their actions will have repercussions on the other participants who could retaliate if they feel harmed.

It knows that if it significantly increases its production, the others would probably react in the same way, sinking the price, so it will act with some caution, anticipating the possible reaction of the other companies.

This will lead to a level of output higher than that of a monopolistic market but lower than that of a competitive market.

The total benefit that society obtains in an oligopolistic market is less than that generated by a competitive market since its level of activity is lower.

Instead, the price will be higher than in a competitive market, which implies that the oligopoly benefits at the expense of consumers.

MACROECONOMICS:  is the branch of economics that studies the operation of it as a whole. That is to say, it studies the global economy of a country, although to carry out said study what it does is pay attention to the individual functioning of a series of markets and the interrelationships that occur between them.

We will mainly distinguish the following markets :

  • Goods and services market: where all kinds of goods (food, electrical appliances, computers, bricks, etc.) and services (professional services of lawyers, doctors, shows, sports competitions, hairdressers, etc.) are bought and sold.
  • Money market: where the demand for money (interest of families, companies, public bodies, etc. to have money) and the money supply (amount of money that the Central Bank of the country maintains in circulation) converge.
  • Labor market: where the supply of labor (desire of the country’s inhabitants to work) and the demand for labor (interest of companies to hire workers) converge.

Among the variables studied by macroeconomics, we can mention: employment, inflation (price changes), interest rates, national income, investment, etc.

Economic policy is the responsibility of the Government, although there is an increasing tendency, as is the case in more developed countries, to give autonomy to the Central Bank to conduct monetary policy (a component of economic policy aimed at the money market).

Economic policy objectives

  • A high rate of sustainable growth in the medium-long term.
  • A low unemployment rate.
  • Price stability. (inflation)

Other objectives of economic policy are:

  • Balanced public accounts (a high deficit pushes interest rates up, negatively affecting investment).
  • Equilibrium in the balance of payments (a prolonged imbalance ends up affecting the exchange rate and therefore exports and imports).

The measures used in economic policy are grouped into:

Monetary policy measures: actions that affect the amount of money in the system, which affects the interest rate and, through it, investment. It also affects the behavior of prices and the exchange rate.

Fiscal policy measures: actions on public spending and taxes. Public spending is a component of GDP, while taxes affect the disposable income of individuals and, therefore, consumption, they also affect new investments (companies will have more or less resources to finance them) and prices.

Supply policy measures: include various actions that try to encourage work and production, technological innovation, worker training, etc.

Exchange rate: decisively influences the country’s international trade position (exports and imports), as well as the price level (for example, if the exchange rate devalues, imports become more expensive).

Foreign trade measures: tariffs, import quotas, etc. As in the previous case, they will affect the commercial position of the country concerning the exterior.

GDP:  represents the sum of all final goods and services produced in a country during a year, either by nationals or by resident foreigners.

GDP is an indicator that is used to compare the level of well-being of different countries:

In principle, the one with the highest GDP is the one with the greatest well-being.

However, to more accurately measure the well-being of a country, GDP must be related to its population.

For this reason, to compare the level of well-being of the two countries, the ratio «GDP per capita» (GDP / number of inhabitants) must be used.

How is GDP measured?

GDP can be measured from two different approaches, obtaining the same result in both cases.

  1. a) As a flow of expenses (or final products): that is, what has been the destination of the different goods and services produced during the year?
  2. b) As a flow of income: how the income generated during the production of these goods and services is distributed.

Why do both approaches coincide?

Every production process has a result (the production of goods or the provision of services). But in this process, income is generated that the company has to pay (salaries, rents, capital interest, etc.). The difference between the value of what is produced and these incomes is the profit of the company (which is nothing more than the income received by the owner of the company).

Therefore, the sum of all income (including business profit) must be equal to the value of production.

We are going to analyze the composition of GDP according to the two previous approaches :

  1. As the flow of expenditures (aggregate demand)

Aggregate demand refers to the level of overall spending in the economy.

GDP = consumption + investment + public spending + exports – imports

In abbreviations:

GDP = C + I + G + X – M

Consumption: includes those goods and services produced in the year that are purchased by families and companies for final consumption. For example a book, a bar of chocolate, a washing machine, a car, a lawyer’s fees, a haircut, a car wash, etc.

Investment: includes those assets acquired mainly by companies to incorporate them into their production structures. For example a computer, machinery, a ship, a tractor, etc.

The same good can be destined for consumption or investment, depending on the use that is going to be given to it: for example, if a family buys a car for its use, it is a consumer good, but if it is a company that buys it buy for your sales team, then it is an investment.

Public spending: includes those goods and services acquired by the Public Administration, either for consumption (office supplies, security, and cleaning services…) or as an investment element (computers, road construction, hospitals…). It also includes the payment of salaries to officials.

The net balance of foreign trade (exports – imports): it is the difference between what the country exports abroad (goods and services) and what it imports.

  1. b) As income distribution

Another way of measuring GDP is by adding the income that has been generated in the year derived from economic activity.

GDP will be equal to the sum of:

  • Wages (income received by workers).
  • Interest, income, or rentals (income received by the owners of assets that they have rented to companies).
  • Indirect taxes: VAT, taxes… (income received by the State).
  • Depreciation or amortization (income that the company itself receives to compensate it for the wear and tear suffered by its fixed assets).
  • Benefits (compensation of business owners).

nominal GDP vs. real GDP

If the GDP of a country from two different years is compared, the difference may be due to:

On the one hand, there has been a growth (or decrease) of the same.

On the other hand, because prices have changed.

The advantage of real GDP is that it eliminates the distortion produced by price changes and tells us how much the economy is growing or shrinking.

See also  Marketing Service

How is real GDP calculated? The following formula is applied:

Real GDP = Nominal GDP / GDP deflator

The “GDP deflator” is a price index that reflects the variation that has occurred in the price level of a country during a given period. It is an indicator similar to the CPI (Consumer Price Index), although the latter only takes into account those goods and services intended for consumption, while the “GDP deflator” considers all goods and services produced in the country.

Other indicators of a country’s income

GNP (Gross National Product): measures what is produced by the nationals of a country, whether they reside in it or reside abroad.

NNP (Net National Product): it is the same as the GNP but deducting, as in the previous case, the loss of value experienced by the fixed assets.

Relationship between savings and investment

The savings that a country makes are essential to be able to finance the new investments that it wants to undertake, which will result in greater growth of its economy and, in the long term, a higher standard of living.

In any economy, it is always true:

Saving = Investment

Therefore, for a country to invest more, it must consume less and save a greater part of its income.

goods market

The goods market is one in which goods and services are bought and sold. This market will allow us to analyze how the equilibrium production level in the short term is determined in an economy.

In this short term we will assume that the equilibrium production level is determined by demand: that is, companies will produce everything that is demanded of them (this is the hypothesis used by one of the main schools of economics, the Keynesian school).

Aggregate demand (equivalent to GDP) is defined as:

Y = C + I + G + MN

We are now going to analyze how the different components behave:

  1. Consumption

Consumption depends on different factors, but its main dependence is on the level of income:

If income increases consumption increases and if income decreases consumption decreases.

  1. Investment

The investment includes both the purchase of new elements to incorporate into the productive structure of the company (machinery, computers, automobiles, installations…), as well as increases in stocks in the warehouse stock investments).

Investment is fundamentally related to two variables:

The income levelIf income increases, investment increases (there is a greater capacity to finance new projects), and if income decreases, investment also decreases.

The interest rateThe relationship is inverse: if interest rates increase, investment decreases (it is more expensive to finance new projects, so those that offer lower returns will be discarded); that is to say, the number of investment projects whose profitability is attractive enough to carry them out will decrease. And if the rates decrease, investment increases (it is cheaper to borrow to undertake new projects).

The curve has a negative slope (inverse relationship between investment and interest rates).

  1. Public spending and net foreign trade (exports – imports)

If income increases, taxes increase, so the State collects more and can spend more.

Equilibrium in the goods market

Once the different components of the demand for goods and services have been analyzed, we are going to draw their curve. It relates the demand for goods with the products offered by companies.

The slope is positive since we have seen that several of its components (consumption, investment, and public spending) are positively related to the level of income.

The point at which both lines intersect (“A”) is the equilibrium point of the economy:

The quantity demanded is equal to the quantity supplied: there is nothing left to buy, and nothing left to sell.

If the economy were at a point (“B”) in which the quantity demanded was greater than the quantity supplied, there would be unsatisfied demand (people who could not buy what they want) which would lead companies to increase their production until OA = AD

If, on the other hand, the quantity demanded were less than the quantity supplied (point “C”), there would be products that would remain unsold, which would lead companies to reduce their production until once again OA = DA


Suppose the economy is in equilibrium and suddenly there is an increase in investment (for example, a foreign investor arrives and invests heavily) or in public spending (for example, the government decides to invest heavily in roads). What happens to equilibrium output?

Initially, it increases, since both investment and public spending are components of aggregate demand, then if they increase, it increases by the same amount.

But by increasing aggregate demand, and therefore the country’s income, consumption will also increase (there is more money and people consume more ), which leads to a new increase in demand.

In short, a process begins that makes the final growth of equilibrium production higher than the initial increases experienced by investment or public spending which served to trigger this process.

  1. Investment multiplier

The easiest way to see how it works is with an example:

Suppose that the economy is in equilibrium and suddenly the investment increases by 100,000 euros. We are also going to assume that the marginal propensity to consume is 0.6 (ie, if income increases by 1 euro, people will dedicate 0.6 euros to consumption and 0.4 euros to savings).

The investment of 100,000 euros entails from the outset an increase in equilibrium production for that amount. This is the 1st impact.

This increase in production (and therefore in income) leads to an increase in consumption of 60,000 euros (=100,000 * 0.6). 2nd impact.

But this increase in consumption increases income again by 60,000 euros, which in turn causes consumption to increase again by 36,000 euros (=60,000 * 0.6). 3rd impact.

And so on.

If the various impacts are added up, we will see how much equilibrium production has increased. To do this we will use the following formula:

Equilibrium output change = (1 / (1 – MPC)) * Investment change

Applying this formula to the example, we would have that an increase in investment of 100,000 euros leads to an increase in equilibrium production of 250,000 euros.

The coefficient (1 / (1 – PMC)) is called the “investment multiplier” and measures how much income increases for each euro that investment increases. This multiplier is always greater than unity.

The greater the marginal propensity to consume (MPC) the greater the multiplier. To verify this, they can repeat the previous example assuming a PMC of 0.8 and another of 0.5.

  1. Public spending multiplier

It works in the same way as that of investment: the increase in production is greater than the increase in public spending. The multiplier is:

(1 / (1 – PMC))

The multiplier (both for investment and for public spending) is modified if we consider that there is an income taxes.

What if interest rates fall?

The opposite will happen, investment increases and therefore demand. The demand curve will shift up and the new equilibrium point will be “C”.

Therefore, it can be observed that increases in the interest rate move the equilibrium point downwards in the goods and services market, while decreases in the interest rate move it upwards.

If we represent this relationship between the equilibrium quantity demanded and the interest rate in a curve, we will obtain the IS curve.

monetary aggregates

Money is everything that serves as a means of exchange (payment)

Functions of money: medium of exchange, unit of account, store of value.

The amount of money or money supply is equal to the sum of cash in the hands of the public (bills and coins) plus deposits. It is usually represented by the letter M.

The most used aggregates, classified from smallest to largest amplitude, are:

Cash in the hands of the public (Lm): coins and bills of legal tender in the hands of the public.

M1: cash in the hands of the public + sight deposits in credit institutions. M1 is also called Monetary Supply.

M2: M1 + savings deposits in credit institutions.

M3: M2 + term deposits and other bank liabilities.

Liquid assets in the hands of the public (ALP): M3 + other components, including Treasury Bills in the hands of the public, company promissory notes, etc.

Bank money: it is made up of deposits in banks, savings banks, financial companies, or credit banks.

Financial entities (banks, savings banks, and cooperatives) receive deposits from their clients in the form of checking accounts (which we call bank money). These entities use these deposits to grant credits.

Part of the amount of these loans returns to financial institutions in the form of new bank deposits.

In short, the operations of financial institutions lead to multiplying the value of deposits (they create bank money).

How much bank money can be created?

To answer this question, we will begin by defining the concept of «bank reserve»:

Financial institutions when they receive a deposit have to leave a percentage in cash to attend cash withdrawals. This percentage is precisely the “bank reserve ” or “reserve ratio”.

The Central Bank determines this percentage, that is, the proportion of public deposits that financial institutions have to keep in the form of liquid assets (cash on hand or reserves at the Central Banktoto meet cash withdrawals.

The total amount of bank money generated by financial institutions is determined by the “Bank money multiplier”:

This would be the maximum potential amount of bank money that could be generated, which does not mean that it is generated: the bank may not use all the available amount in the granting of credits, the credits granted may not return in full as deposits to financial institutions, etc.

Legally required liquid reserves are the reserves that banks and other financial institutions are legally required to maintain. It is held in the form of cash or deposits at the central bank

central bank

  1. a) Functions
  • Issuance and circulation (or withdrawal) of legal tender. (cash provider)
  • State Banker: makes the collections and payments corresponding to the Public Administration.
  • Bank of banks: in charge of supervising the banking system, custody of commercial bank reserves (cash ratio), lender of last resort (when an entity is experiencing liquidity stress), liquidation of means of payment (centralizes collections and payments between credit entities).
  • Administrator and custodian of gold and foreign currency. Centralization and management of the country’s foreign currency reserves.

Monetary policy: determines the amount of money in the system to try to control the evolution of the interest rate in the short term.

The ultimate objective of the Central Bank is to achieve price and exchange rate stability, which should allow sustained growth in production and employment.

  1. b) Balance sheet

The assets of a Central Bank include the following items:

  • Gold and currencies.
  • Loans to commercial banks.
  • Loans to the public sector.
  • Portfolio of fixed-income securities (Public Debt): these are securities that are acquired temporarily within an operation designed to control the liquidity of the system.
  • Fixed assets (buildings, facilities, computer systems, etc.).

The following items appear in your liabilities:

  • Monetary liabilities (also called monetary base ): made up of cash in the hands of the public and bank reserves (cash in the hands of financial institutions and deposits that they have in the Central Bank).
  • Non-monetary liabilities: Own funds and public sector deposits.

Monetary base

The monetary base is the sum of cash in the hands of the public (Lm) + bank reserves (cash in the hands of credit institutions and their deposits in the Central Bank).

Monetary base = cash in the hands of the public + bank reserves

The Central Bank determines the monetary base and from there the financial intermediaries generate bank money.

If we look at the composition of the balance sheet of a Central Bank, the monetary base is equal to total assets minus non-monetary liabilities.

If the monetary base increases: money creation

If non-monetary liabilities decrease, with no change in assets, the monetary liability will necessarily have to increase.

If the monetary base is reduced: the destruction of money

If the assets of the Central Bank decrease without reducing non-monetary liabilities, it will lead to a decrease in the monetary base.

There are variations in the balance of the Central Bank, which therefore affect the monetary base, which it cannot control, and are autonomous:

For example, a deficit (or surplus) in the balance of payment is not controllable by the Central Bank, however, it will influence its level of foreign exchange reserves (asset item).

Other variations in the Central Bank’s balance are controllable and this is what will allow it to determine (with a certain approximation) the amount of the monetary base.

For example, credits granted to the banking system: if credits increase, your assets increase and therefore your liabilities will increase. If the non-monetary liability does not change, the monetary liability will necessarily have to increase (increase in the monetary base).

How does the central bank act in practice to modify the monetary base?

The rediscount rate: is the rate at which the central bank is willing to lend money to financial institutions:

If the rediscount rate rises, the credits that the Central Bank lends to the entities will be more expensive, then the financial entities will demand less (contraction of the monetary base).

If the rediscount rate falls, these credits will be cheaper, so financial institutions will request larger amounts (expansion of the monetary base).

Another way that the Central Bank has to act on the monetary base is through open market operations: buying and selling Public Debt securities from financial entities.

If the Central Bank buys Public Debt, it is increasing the liquidity of the system. Financial institutions will be substituting fixed-income securities for liquidity that they can allocate to granting loans.

On the contrary, if the Central Bank sells Public Debt to financial institutions, it replaces these liquid positions on the balance sheet with securities. In the liabilities of the Central Bank, the deposits of the financial entities will decrease since part will have been destined to the payment of the purchase of these titles.

money supply

We have seen that the aggregate M1 is also called Money Supply:

M1 = cash in the hands of the public + demand deposits (bank money)

Central banks try to control the money supply in the system since this, together with the demand for money, determines the interest rate in the short term.

The interest rate influences the volume of investment, which affects the equilibrium level of production and therefore the level of employment.

When central banks try to influence interest rates, they seek to achieve price and exchange rate stability, requirements for sustained growth in production, and employment over time.

In short, central banks have the possibility of acting on the money supply but they do not have absolute control.

demand for money

People want to hold a portion of their cash (demand for money) for a variety of reasons, including:

To be able to carry out transactions, that is, to be able to pay for the purchases they make.

The amount demanded for this reason depends mainly on the level of income: the higher the income, the higher the consumption, and therefore the higher the demand for money (and the lower the income, the opposite).

Demand as a Financial Asset: Money has a value and the public may prefer to hold some of their wealth in the form of money, especially in times of uncertainty.

Instead of having money in a bank that can fail, or in stocks that can sink, in times of crisis people may prefer to have money at home.

The demand for money, for one reason or another, has a negative relationship with the interest rate:

If rates rise, the opportunity cost of having liquid money increases and not having it deposited in a bank where it produces interest. Therefore, people will try to keep liquid to the minimum necessary.

If, on the other hand, interest rates fall, this opportunity cost is reduced, which means that people will not mind keeping a greater proportion of their savings in cash.

This inverse relationship between interest rates and the demand for money can be represented on a graph.

Variations in the interest rate cause movements along the curve:

While variations in the level of income cause shifts in the curve:

If income increases, consumption will increase, leading people to keep more cash to pay for purchases: the money demand curve shifts to the right (for the same interest rate more money will be demanded).

If income falls, consumption will fall, and therefore people’s need to hold money in cash will fall: the money demand curve shifts to the left.

Money Market Breakeven Point

We are going to assume that in the short term, the money supply is fixed, it is a certain amount, so we will represent it as a vertical line.

The equilibrium in this market is determined by the crossing point between the money demand and the money supply. This equilibrium point determines the short-term interest rate.

What would happen if the interest rate were not equilibrium?

Suppose that the interest rate is higher than the equilibrium rate (i 1 > i 0). In this case, the demand for money by citizens is less than the supply. People want to hold less liquid money (cash or low-yield demand accounts) as the opportunity cost is high, so they will invest excess liquidity in higher-yield products.

The strong demand for these alternative products (term deposits, fixed income, etc.) will lower their interest rates (the issuers of these products will not have to offer high rates to attract money since it will come by itself).

If the interest rate is lower than the equilibrium rate (i 2 < i 0), citizens will tend to have more liquid money since the opportunity cost is comparatively low. The issuing entities of alternative products will have to raise the interest rates offered to be able to place their products.

LM curve


We have seen that the demand for money depends to a large extent on the level of income (or demand for goods):

Variations in the income level determine shifts in the money demand curve, which implies a new equilibrium point and, therefore, a new interest rate (we are considering that the money supply is fixed in the short term).

Therefore, each level of income will correspond to an equilibrium interest rate.

If we represent the different pairs of points (income level and corresponding interest rate) on a graph, we will obtain a curve with a positive slope called the «LM Curve».

Monetary politics

The fundamental objective of any central bank is to maintain price and exchange rate stability, which should allow the economy to maintain a high growth rate.

Central banks will act when the economy deviates from its growth path:

If the economy slows down they will try to relaunch it by lowering interest rates to boost investment and with it growth.

If the economy grows at an excessively high rate, they will try to slow it down a bit to avoid inflationary tensions that end up affecting it very negatively. To do this they will try to increase interest rates to reduce investment and cool growth.

The interest rate is the key variable that connects the money market with the goods market.

Until now we had considered that the money supply was fixed in the short run, but this was a simplification. Central banks will increase or decrease the amount of money in the system as a means of acting on interest rates.

Central banks can influence the money supply:

  • Through the monetary base (open market operations and rediscount rate).
  • Through the fit coefficient.
  • Monetary policy can be expansive (increasing the money supply):
  • Lowering the rediscount rate
  • Purchase of public debt from financial institutions
  • Reduction of legal reserves (this measure is no longer used)
  • restrictive (decrease in the money supply):
  • Increase in the rediscount rate
  • Sale of public debt to financial institutions
  • Increase in reserve requirements (this measure is no longer used)

How do changes in the money supply affect the LM Curve?

If the money supply increases, its curve shifts to the right, which lowers the equilibrium interest rate.

At the level of the LM Curve, this implies that for a certain level of income, the interest rate is lower: this curve moves downwards.

If the money supply decreases, its curve shifts to the left, which increases the equilibrium interest rate.

At the level of the LM Curve, this implies that for a certain level of income, the interest rate is higher: this curve moves upwards.

The central banks, through monetary policy, can control the evolution of the short-term interest rate with some efficiency. But in the long term, it is the market (law of supply and demand) that determines them.

In the long term, interest rates depend to a large extent on inflation expectations:

If the country has historically been characterized by an effective fight against inflation (as can be the case in Germany), due to its orthodox economic policy, long-term interest rates will tend to remain low.

If, on the other hand, the inflationary history of the country is to shake us (we prefer not to give examples), the long-term rates will tend to be very high.

IS-LM relationship

1200px-Islm.svg (1)

The IS curve represents the different levels of income and interest rates for which the market for goods and services is in equilibrium.

The LM curve represents the various levels of income and interest rates for which the money market is in equilibrium.

We already know (at least I hope so) that the interest rate is the one that interrelates both markets:

The interest rate is set in the money market and directly affects the volume of investment and therefore the demand for goods.

If we represent both curves, the cutoff point determines the income and the interest rate for which both the goods and services market and the money market are in equilibrium.

aggregate demand function

The aggregate demand curve represents the quantity of goods and services that the inhabitants, companies, and public entities of a country want to buy for each price level.


The aggregate demand curve slopes downward: if prices go up people will want to buy less and if they go down they will want to buy more.

When we studied the IS and LM curves before, we were considering that we were moving in the short term, with fixed prices.

However, now, when studying aggregate demand, we are going to consider that we are moving in a longer term where prices do vary this demand curve is a relationship between income levels and price levels for which the different markets analyzed (goods and services market and money market) are in equilibrium.

Let’s see how the aggregate demand curve is determined:

We have seen that in the short term (with fixed prices) the crossing point of the IS-LM curves assumes an equilibrium situation in the goods and services and money markets.

Summary: fiscal policy vs. monetary politics

First of all, it should be noted that the main objective of the Government, when it tries to act on the economy, is to maintain a stable growth rate in the long term:

It is just as bad that the economy grows little, that it does so in an uncontrolled way, since this causes serious imbalances (first of all, a strong rise in inflation), which are difficult to correct and usually end with a recession.

The measures that can be adopted, as we have already seen, are diverse: on the demand side (that is, those aimed at trying to shift the aggregate demand curve) we can point out fiscal policy and monetary policy:

The fiscal policy encompasses actions that affect public spending and taxes and that have an impact primarily on the market for goods and services (shift of the IS curve).

Monetary policy, which is usually implemented by the central bank, includes measures that affect the Money Supply and that act primarily on the money market (shift of the LM curve).

See also  Who was John Stuart Mill and what were his contributions to the economy?

Let’s see an example of restrictive fiscal policy:

A tax increase lowers people’s disposable income, which lowers consumption (and also investment). The demand curve for goods shifts downward.

This policy could be appropriate when the government wants to curb excessive growth in the economy.

Let us now see an example of expansionary monetary policy :

An increase in the monetary base will determine an increase in the money supply, which will cause a drop in interest rates in the money market.

This policy could be appropriate when the government wants to revitalize a stagnant economy.

Therefore, and for summary purposes:

If the economy is growing at an excessively high rate, with the risk of triggering inflation, the Government will adopt restrictive fiscal or monetary policies:

  • tax increase
  • Reduction of public spending
  • Reduction of the monetary base

If the economy is stagnant, the Government will try to relaunch it with expansionary fiscal or monetary policies:

  • lower taxes
  • Increase in public spending
  • Increase in the monetary base

Effects of monetary policy:

  • On aggregate demand: the increase in the money supply will lower the interest rate and will have a positive impact on aggregate demand since it will increase consumer spending. the investment will also increase because companies find it cheaper to finance themselves. This reduces unemployment and increases the growth of the economy.
  • Effects on inflation: inflation is caused by an excessive increase in the money supply.
  • Effects on the price of the peso: High-interest rates will encourage the entry of foreign capital into the country.

Work Market

The labor demand function (job requests by companies) has a negative slope  concerning wages:

The lower real wages are, the more labor companies will demand.

While the job offer has a positive slope concerning the salary:

The higher the wages, the more people will want to work.

The equilibrium in the labor market is determined by the crossing point of the two previous curves:

Two of the main schools of economic thought, the classical school and the Keynesian school, disagree on what is the situation in which this market is usually found:

According to the classical school, the labor market is always in a situation of full employment. This is because wages are downward sensitive: if there is unemployment, wages tend to fall (the unemployed will be willing to work for less money). This decrease in salaries leads companies to hire more labor, causing unemployment to disappear.

According to Keynesians, the labor market is not always in a situation of full employment, but there may be unemployment. This is explained by the fact that short-term wages are downwardly rigid: even if there is unemployment, the unions will not accept a drop in wages, which will prevent the demand for labor from increasing.

In any case, the equilibrium point in the labor market, the one where supply and demand intersect (whether at full employment or not), will determine the number of people who will participate in the production process.

Phillips curve

phillip curve

The Phillips curve was formulated from a study carried out in England in the 19th century in which a negative correlation was found between the increase in wages and the unemployment rate.

If wages rose, unemployment decreased and if wages fell, it increased.

Given the strong relationship between wages and prices, this curve is often used to represent the relationship between inflation and unemployment.

The explanation lies in the fact that as aggregate demand increases, the pressure on prices is greater and they begin to rise, while unemployment decreases.

In the short run, when prices rise, real wages fall (nominal wages tend to rise less than prices). This drop in real wages lowers the cost of labor and companies demand more work.

This curve seems to pose a dilemma for the country’s economic authorities: choose between low inflation with high unemployment or higher inflation but with lower unemployment.

In short, by fighting inflation (cooling the economy) unemployment increases, while if you want to fight unemployment by relaunching the economy, you will have to accept a growth in inflation.

The relationship described by the Phillips curve loses validity in the long run.

In the long run, nominal wages end up collecting all the price increases, so the initial drop in real wages disappears and companies get rid of the workers they had initially hired.

Therefore, there is no inverse relationship between inflation and employment.

production function

The production function determines the amount that companies are going to produce, that is, the amount of goods and services that they are going to offer to the market.

In all production processes, companies use:

  • Productive resources or capital stock (machinery, computers, facilities, vehicles, etc.).
  • Human resources (workers).


We can represent the production function by the formula y = F (L, K), which tells us that the country’s production (Y) depends on the amount of labor (L) and the amount of capital (K).

The amount of work is determined in the labor market, while the productive resources are considered fixed in the short term.

With these two premises, we can already draw the curve of the production function:

The slope of the curve is positive but decreasing: the greater the volume of work, the more production will increase, but by an ever smaller percentage (law of diminishing returns).

For example, work will be carried out faster with 2 masons than with one, and with 4 than with 2, but there comes a time when it does not contribute anything to continue incorporating workers.

A change in the volume of employment (given a given amount of productive resources) causes a shift along the curve.

While the variations that can be produced punctually in the volume of productive resources cause a displacement of the curve:

If productive resources increase for a given level of work, the level of output will increase: the output curve shifts upward.

If productive resources decrease, the production curve shifts downward.

The productive resources available to an economy are determined by its level of savings:

The higher the level of savings, the country’s investment will be, which will increase its productive resources and, therefore, its level of production in the long term.

In short, the labor market determines the level of employment in the economy, and once this is defined, the production function will determine the volume of production (aggregate supply).

The production function that we have analyzed can be complicated if we introduce more factors of production:

Natural resources (N) available to the country: minerals, fishing, forests, energy, etc.

Human capital (H): level of education and training of the population.

The production function would now be Y = f (L, K, N, H), working in a very similar way as we have explained:

Aggregate offer function

This curve reflects the relationship between the level of production offered by companies and the price level.

The slope of this curve is positive: if prices increase, companies offer more (they will increase production).

This positive slope is considered to occur when analyzing the behavior of the economy in the short-medium term, being the position defended by an economic school called the “Synthesis Model” (this name comes from the fact that it serves as a link between the analysis of the short, Keynesian school, and the long term, classical school).

This positive slope can be explained by the operation of the Phillips curve: if production increases (decrease in unemployment), prices rise.

According to the Keynesian school, the slope of aggregate supply in the short term is horizontal, while according to the classical school, in the long term this slope is vertical:

  1. a) Keynesian school

In the very short run, the slope of the supply curve is horizontal. In the short term, wages are rigid, they do not vary, which means that the prices of the products do not either (companies are supposed to set their prices by adding a margin to their production costs, whereas those coming from labor have decisive weight).

Companies will be willing to offer everything that is demanded at the existing price level, they will not try to raise prices.

However, this school admits that when the term is no longer so short (we move to the short-medium term) wages can vary upwards: if companies want to produce more, they will need more labor and this greater demand for labor will push prices up. rising wages, which will end up being reflected in a rise in the prices of their products and will cause the Aggregate Supply curve to begin to present a positive slope.

  1. b) Classical school

He focuses his analysis on the long term and defends that the supply curve has a completely vertical slope. According to this school, any economy will always be at its full employment level, so the volume of products offered to the market will be the maximum that the installed capacity allows, regardless of the price level.

According to this school, the equilibrium production level of an economy is determined by the supply side (it is the one that the production function allows given a level of full employment) and not by the demand side.

Aggregate supply-demand scheme

The intersection of the supply and demand curves determines the level of production and prices at which the economy is in equilibrium. It also determines the level of employment.

What happens if the economy is not at that equilibrium point?

Suppose that the supply is greater than the demand (point B). This implies that part of the production of the companies does not find a seller, so to avoid keeping part of the production in the warehouse, the companies will lower prices (which will increase demand), while reducing production.

This process continues until the economy returns to the equilibrium point:

Quantity supplied = Quantity demanded

economic theories

The two great lines of thought in the study of macroeconomics have been the classical school and the Keynesian school. From these two great currents, new trends have subsequently emerged.

The main difference between the two schools revolves around their aggregate supply curve model:

For the classics, who look at the long term as we have already seen, this curve is vertical since the production of the companies is determined by the level of full employment (it is always produced at full capacity).

For Keynesians, who pay more attention to the behavior of the economy in the short term, the supply curve is horizontal. At a given price level, what people demand is produced.

  1. a) Classical school
  • Perfect competition in all markets.
  • Flexible upward and downward prices, including wages, will allow all markets (for goods and services, money, labor, etc.) to always be in equilibrium (if there is unsatisfied demand or supply, the adjustment of prices will ensure that the market regains equilibrium).
  • The labor market is always in a situation of full employment. There is no unemployment, the unemployment that may exist is fractional (due to the time it takes people to find a job according to their training) or voluntary (people who do not want to accept the salary offered by the market).
  • Therefore, the supply dominates the demand. The supply curve is vertical and is what determines the equilibrium production level: variations in demand only produce variations in prices.
  • Monetary policy is ineffective (money neutrality): variations in the money supply only affect the price level, without having any effect on the real variables (quantity demanded, equilibrium production, wages, etc., once the effect has been filtered out). Of the prices).
  • Fiscal policy is also useless since the economy is always in a situation of full employment, so these measures in the end only translate into price increases. In short, the State should not interfere in the progress of the economy.

This model is especially suitable for explaining the long run.

  1. ) Keynesian school
  • Perfect competition in the goods market, on the other hand, does not always occur in the labor market due to the power of unions (which prevent wages from falling when there is unemployment).
  • The rigidity of downward wages in the short term can cause the labor market to be out of equilibrium and cause involuntary unemployment (in the classical model when this situation occurred, wages fell and unemployment disappeared, in the model Keynesian this does not occur).
  • The production offered by the companies tries to cover the demanded quantity, being, therefore, the latter the one that determines the level of activity of the economy and, with it, the level of employment.
  • Short-term money can affect the level of production since the economy is not always at full employment. Monetary policy can have positive effects.
  • Fiscal policy can also be effective in the short term to try to relaunch a stagnant economy. In short, the role of the State is sometimes necessary.

The Keynesian model is especially suitable for the short run.

Balance of payments: accounting record of the set of transactions of a country with the rest of the world in a given period.

Exchange rate

The exchange rate defines the exchange relationship between two currencies (the price at which they can be bought or sold). This rate is determined in the foreign exchange market.

The curve that represents the demand for foreign exchange has a negative slope concerning the exchange rate: the lower it is, the cheaper the currency will be and therefore more will be demanded.

The curve that represents the supply of currency has a positive slope: the higher the exchange rate is, the more expensive the currency will be and therefore those who have this currency will want to sell it.

The equilibrium exchange rate is determined by the intersection point of these two curves.

If the exchange rate $/euro is 0.90, it means that with each euro you can buy 0.90 dollars.

What happens if this market is not in equilibrium?

Suppose that the equilibrium point $/euros is 0.90 but that the exchange rate applied by the central bank is $1/euro. In this case, the euro will be expensive (with one euro you can buy a dollar when in equilibrium you can only buy 0.9 dollars).

An expensive euro will hinder European exports (they will be expensive abroad) and will favor imports (they will be cheap), tourism to Europe will decrease, some investment projects in Europe will be rejected, etc. In short, the demand for euros will decrease, while the demand for dollars will increase: this will cause the euro to lose value until the equilibrium point is reached again.

Let us now suppose that the exchange rate applied was 0.8 $/euro.

In this case, the euro will be cheap, which will favor exports and hinder imports, tourism to Europe will increase and foreign investment in this region will be boosted. In short, the demand for euros will increase (and that of the dollar will weaken), which will cause its value to appreciate until it reaches the equilibrium point again.

Exchange rate policies

  1. a) Flexible exchange rate

The Central Bank of the country does not intervene in setting the exchange rate, leaving it to the market, through the Supply and Demand Law, which determines the exchange rate, which will fluctuate over time.

If the central bank does not intervene at any time, it is called a “clean float” and if it does so occasionally, it is called a “dirty float”.

  1. b) Fixed exchange rate

The Central Bank sets a certain exchange rate and is in charge of defending it, intervening in the market buying and selling currencies, for which it will use its reserves.

If the exchange rate tends to appreciate, it will sell its currency (buy currency), trying to increase the supply of its currency and prevent the exchange rate from increasing.

If the exchange rate tends to devalue, it will buy its currency (selling currencies) to try to strengthen its demand and prevent the exchange rate from falling.

It may happen that in defending a fixed exchange rate the Central Bank ends up exhausting all its reserves, running out of resources to be able to continue defending it, for which reason it will be forced to let it fluctuate freely.

  1. c) Mixed exchange rate

The Central Bank can establish some bands within which it will allow its currency to fluctuate freely, but if at any time the exchange rate gets dangerously close to the established limits, it will intervene to prevent it from going outside the established bands.

In general, central banks look for the exchange rates of their currencies to be as stable as possible:

If it appreciates a lot, it will make exports difficult, which will translate into a deficit in the trade balance and unemployment.

If it depreciates a lot, imports will become more expensive, which will translate into a strong rebound in inflation.

Inflation (I): is the general and continuous growth of the prices of goods and services in an economy.

Inflation is a reflection that money loses value, so to acquire a good, an increasing amount of money will have to be delivered.

Inflation is measured by indicators that reflect the increase in prices. The two most used are:

The Consumer Price Index (CPI ): measures the price level of those goods and services that consumers purchase.

The GDP deflator: measures the price level of all the goods and services that make up the GDP of an economy.

When the rise in prices is very high, it is said that the country suffers from hyperinflation (rates above 100%). How do you get to this situation?

The country has very high expenses (military, bureaucracy, inefficiency, corruption, etc.) and its income is very low (tax fraud). To meet its expenses, the central bank begins to issue large amounts of money, which makes it lose value and inflation soars.

Factors that favor inflation:

The strong growth rate of the economy, with a supply that is not capable of satisfying the demand, causes upward pressure on prices.

Pressure on costs: the sharp rise in wages due to pressure from unions, rise in the price of oil, increase in the cost of imports due to deterioration in the exchange rate, etc. All this translates into price increases.

Although the two previous factors would explain a rise in prices, for this to become an inflationary spiral, there must be a sharp increase in the quantity of money, so that it loses value and prices skyrocket.

The Quantity Theory holds that when the central bank rapidly increases the money supply the result is a high rate of inflation.

effects of inflation

  • It hurts those people whose incomes tend to grow less than inflation, as is the case of retirees, the unemployed, etc.
  • It benefits debtors (the amount of their debts loses value) and harms creditors.
  • It generates uncertainty, making investments difficult: it is very difficult to make long-term forecasts of income and expenses with a minimum guarantee since the variation in prices can destroy all hypotheses.
  • Products, by increasing their prices, lose competitiveness in the foreign market.
  • It usually has a negative fiscal impact: inflation tends to increase the tax burden.

Policies against inflation

In the fight against inflation, policies are usually applied to cool demand, whether fiscal or monetary, to try to slow down its growth rate and reduce upward pressure on prices.

It is also important to control the growth of the quantity of money since we have seen that it has a decisive impact on the increase in prices.

It will also be essential to convince unions and employers to moderate wage increases.

For this reason, the credibility of the government is fundamental in the fight against inflation:

If the government has a good anti-inflationary record, the estimates it makes on the expected growth in prices will enjoy credibility and the different economic actors (businessmen, workers, unions, etc.) will try to adjust their requests for increases to these estimates.

economic cycles:


If the evolution of the GDP growth rate is observed over a long period, it can be seen how it describes waves with a certain regularity. Each wave corresponds to an economic cycle.

Four phases can be distinguished in the long-term evolution of GDP:

Trend: It is the direction that is presented in the long term.

Economic cycles: deviations that occur from the trend and that are repeated with a certain periodicity. They usually last several years.

Seasonal variations: recurring movements that occur each year.

Random variations: variations of an irregular nature.

If we focus on the analysis of the cycle we can distinguish four stages:

Valley: it is the lowest point of the cycle and it is characterized by the fact that productive capacity is underutilized, there is unemployment, a drop in company profits, investments are stagnant, etc.

Recovery: sales and profits begin to rise, unemployment falls, new investments are undertaken again, and prices slowly begin to rise.

Peak: high point of the cycle. The productive capacity is fully used, which makes it difficult to maintain the growth rate; the tensions on the prices begin to be very strong; there are difficulties in finding qualified labor; business expectations begin to deteriorate given the rise in inflation, hurting planned investments.

Contraction: the government, in its fight against inflation, adopts measures to cool down the economy, which translates into a drop in sales and profits; unemployment begins to pick up; In this environment of discouragement, investments suffer. suspensions of payment and bankruptcies are triggered, etc.

It should be noted that in an economic cycle, the upswing does not have to have the same duration as the downswing, in fact lately the upswings have tended to be significantly longer than the downs.

Economic cycles and stabilizing policies

The government’s economic policy is aimed at mitigating the fluctuations produced by cycles, to achieve a stable growth rate in the long term, which requires keeping prices under control:

A low phase of the cycle with unemployment is just as bad as a high phase with inflationary tensions (it ends up generating a series of imbalances that ultimately lead the economy to a phase of stagnation).

Among the various stabilizing measures that the government can adopt, are fiscal policy and monetary policy.

In times of recession: reduction of taxes, increase in public spending, increase in the money supply, etc. These measures can be taken individually or jointly.

In times of expansion: the government will adopt measures contrary to the previous ones, that is, reduction of public spending, contraction of the money supply, etc.

Taxes already work as stabilizers by themselves :

If income falls, tax collection decreases (which contributes to reducing the negative impact of the decrease) and when it rises, collection increases (it moderates the growth of the economy).

Economic growth and development

When analyzing economic growth, a distinction must be made between the short-term and the long-term:

In the short term, this growth responds mainly to variations in aggregate demand, while in the long term, the main role corresponds to aggregate supply.

Long-term growth is the consequence of an increase in productive resources (while in the short term, these tend to be more or less fixed), in addition, the increase in population and, especially, technological improvements also have an influence.

Among the conditions that must exist in a country to favor this long-term growth, the following can be highlighted:

Internal and external competition contributes to accelerating technological innovations, increasing product quality, and lowering costs. Monopoly regimes hinder this progress.

An effective legal system that is capable of resolving disputes quickly.

A developed capital market is capable of promoting savings and channeling it towards investment.

The macroeconomic balance: situations of imbalances such as a trade deficit or an excessive public deficit, end up negatively affecting economic growth.

A moderate inflation rate: creates a more favorable climate for investment, favors international competitiveness, avoids price escalation that hinders economic growth, etc.


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