When the price of a good decreases, the quantity demanded increases, holding everything else constant.
The demand curve slopes downward — showing that consumers buy more when prices drop.

Analogy:
Think of a sale on sneakers — the lower the price, the more pairs people rush to buy.

Measures how sensitive demand is to a change in its own price.

E_d = \frac{\%\ \text{Change in Quantity Demanded}}{\%\ \text{Change in Price}}

Or equivalently:

E_d = \left( \frac{P_0}{Q_0} \right) \times \frac{\Delta Q}{\Delta P}

Key Insight:
At the top of the demand curve, demand is elastic; at the bottom, it’s inelastic.
Firms can increase total revenue by lowering prices only when demand is elastic.

Analogy:
If gas prices rise, you can’t stop driving tomorrow — but in a year, you might switch to public transit or buy an EV.

Measures how demand for one good reacts to the price change of another.

E_{xy} = \frac{\%\ \text{Change in Quantity of Good X}}{\%\ \text{Change in Price of Good Y}}

or equivalently

E_{xy} = \left( \frac{P_0}{Q_0} \right) \times \frac{\Delta Q_x}{\Delta P_y}

Shows how demand changes with consumer income.

E_I = \frac{\%\ \text{Change in Quantity Demanded}}{\%\ \text{Change in Income}}

E_I = \left( \frac{I_0}{Q_0} \right) \times \frac{\Delta Q}{\Delta I}

Analogy:
When income rises, people buy fewer instant noodles and more steak.

When price changes, two forces drive behavior:

Example:
If Apple cuts iPhone prices, consumers buy more iPhones (substitution) and may also upgrade accessories (income).

Analogy:
Giffen goods: “I can’t afford better food, so I must buy more of this cheap one.”
Veblen goods: “I’ll buy it because it’s expensive.”

As one input (like labor) increases while others are fixed, output rises at a decreasing rate.

Marginal Product of Labour

MP_L = \frac{\Delta Q}{\Delta L}

Eventually, each additional worker contributes less — they crowd each other or run out of equipment.

Analogy:
Too many cooks in the kitchen = less productivity per chef.

TVC = Total Variable Costs — these are the costs associate with making the product. If you are producing shirts, it’s the cost of the fabric so the more you make, the more fabric you have to buy.

Total Cost = TVC + Total Fixed Costs

Fixed Costs are like the factories in which you make the shirts. In the short run, you cannot just increase or decrease factories.

Analogy:
A restaurant stays open if it covers ingredients and wages, even if rent isn’t yet paid — but closes forever if even the groceries cost more than revenue.

As production increases, average cost per unit decreases due to efficiency gains — until diseconomies kick in.

Short Run: At least one input fixed.
Long Run: All inputs variable → firm chooses optimal scale.

Graph Insight:
Connecting all short-run cost curves gives the long-run average cost curve, U-shaped.

Analogy:
Buying in bulk lowers cost — but managing a massive operation can become inefficient.

The lowest production level at which long-run average cost is minimized.
Beyond this, diseconomies of scale start.

Analogy:
The “sweet spot” where a factory runs efficiently without being oversized.

Demand curves slope downward; supply upward.

Elasticity measures responsiveness — essential for pricing strategy.

Income and substitution effects drive demand shifts.

DMR limits efficiency as more inputs are added.

Long-run efficiency achieved at Minimum Efficient Scale.

Characteristics

• Many sellers
• Homogeneous (identical) products
• No barriers to entry or exit
• No pricing power (price takers)

Key Conditions

Perfect Competition

Price = Marginal Revenue = Average Revenue = Demand

P = MR = AR = D

Profit-maximizing quantity: 

MR = MC

Short-run supply = portion of MC above AVC

Long-run supply = firms enter/exit until P=ATC

Analogy: Farmers selling wheat at a large market—no one can change the price.

Characteristics

• Many sellers
• Differentiated products
• Low barriers to entry
• Some pricing power

Profit Maximization

• MR=MC → gives optimal Qx
• Qx = optimal quantity
• Find P from demand curve at Qx​
• Profit per unit = P−ATC
• Long run: new entrants drive profit → P=ATC

Analogy: Think coffee shops—different flavours and vibes, but competition keeps profits in check.

Characteristics

• Few sellers dominate the market
• High barriers to entry
• Products can be homogeneous or differentiated
• Pricing is strategic (interdependent decisions)

Kinked Demand Model

• If one firm raises price, others don’t follow → demand is elastic above the kink.
• If one lowers price, others match → demand is inelastic below the kink.
• MRMR has a gap at the kink, and equilibrium occurs there.

Analogy: Gas stations on the same block—if one lowers prices, everyone else follows.

Nash Equilibrium

• Each firm chooses the best response considering competitors.
• No incentive to deviate once equilibrium is reached.

Analogy: Like two poker players — each plays optimally given the other’s move. 

Cournot Model

• Firms assume rivals will keep output constant from last period.
• Firms set output to maximize profit → leads to a stable equilibrium.

Analogy: Two food trucks keeping the same production week-to-week to avoid price wars.

Dominant Firm Model

• One firm (lowest cost) sets the market price.
• Smaller firms act as price takers producing the remaining demand.

Analogy: The lead airline sets ticket prices, smaller carriers follow.

Characteristics

• One seller
• Unique product
• Very high barriers to entry
• Complete pricing power

Profit Maximization

• MR=MC → determines Qx
• Price found on demand curve at that Qx
• Long-run economic profits possible

Marginal Revenue Relationship

MR = P \left( 1 - \frac{1}{E_p} \right)

MR=P(1−1Ep)MR=P(1−Ep​1​)

Where:
E_p​ = Price elasticity of demand

Analogy: A local utility company—no competitors, price set by demand elasticity and regulation.

Firms charge different prices to different customers for the same product.

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Analogy:

CR_N: How much of the pie the biggest firms share.

HHI: How unevenly the pie slices are distributed.

Spending components of GDP:

GDP = C + I + G + (X - M)

Where:
C=Consumption, I=Investment, G=Government spending, X=Exports, M=Imports.

Analogy: GDP as a pizza — consumption is your main slice, with smaller toppings of investment and trade.

Definition:
Shows the relationship between the overall price level and the total output (real GDP) demanded in the economy.
It slopes downward because higher prices reduce the quantity of goods and services demanded.

Formula:

GDP = C + I + G + (X - M)

Why AD slopes downward:

1. Wealth Effect – Higher prices reduce purchasing power, so people spend less.
2. Interest Rate Effect – Higher prices increase money demand → higher interest rates → less investment.
3. Exchange Rate Effect – Higher prices make exports less competitive → net exports fall.

Analogy: Think of the economy like a shopping cart — as prices rise, you can afford fewer items.

Short Run Aggregate Supply (SRAS):

• Upward sloping — some costs are fixed, so output rises with prices.
• Shifts when input costs or expectations change.

Long Run Aggregate Supply (LRAS):

• Vertical — reflects full employment output (potential GDP).
• Determined by resources, labor, and productivity.

Very Short Run:

• Horizontal — prices fixed, output adjusts through capacity (e.g., overtime work).

AD Shifts Right (Expansion):

• ↑ Consumer confidence
• ↑ Business optimism
• ↑ Government spending or ↓ Taxes
• ↑ Money supply
• ↑ Global growth

AD Shifts Left (Contraction):

• ↑ Taxes
• ↓ Confidence or income
• ↑ Exchange rate (reduces exports)

SRAS Shifts Left:

• ↑ Wages, ↑ Input prices, ↑ Business taxes

SRAS Shifts Right:

• ↑ Productivity, ↑ Subsidies, ↓ Input prices

LRAS Shifts Right:

• From long-term growth in technology, capital, or labor supply.

Analogy:

Economy “overheats” in inflationary gaps and “catches a cold
in recessionary gaps

Growth comes from increased:

1. Labor supply
2. Human capital (education, skills)
3. Physical capital (investment)
4. Technology
5. Natural resources

Potential GDP:

\text{Potential GDP} = \text{Aggregate Hours Worked} \times \text{Labor Productivity}

Potential GDP Growth Rate:

\tiny\text{Potential GDP Growth Rate} = \text{Growth in Hours Worked} + \text{Growth in Labor Productivity}

Growth in Potential GDP:

\tiny\text{Growth in Potential GDP} = \text{Growth in Tech} + W_L(\text{Growth in Labor}) + W_K(\text{Growth in Capital})

Where:

• WL​ = Labor’s share of GDP
• WK = Capital’s share of GDP

Analogy: Output is a recipe using labor and capital; better “technology” improves the recipe.

Y = A \cdot f(L, K)

Where:

• Y = Output
• A = Technology
• L = Labor
• K = Capital

Law of Diminishing Marginal Productivity:
As more input is added, output grows at a decreasing rate.

Nominal GDP:

GDP_N = \text{Quantity}_{\text{current}} \times \text{Price}_{\text{current}}

Real GDP:

GDP_R = \text{Quantity}_{\text{current}} \times \text{Price}_{\text{base year}}

GDP Deflator:

\text{GDP Deflator} = \frac{GDP_N}{GDP_R} \times 100

Inflation:

\text{Inflation} = \frac{\text{Deflator}_t}{\text{Deflator}_{t-1}} - 1

Personal Income:

PI = EC + NMI + NPI

Disposable Income:

HDI = PI - \text{Transfers Paid} + \text{Transfers Received}

Household Net Savings:

S = HDI - C + \Delta \text{Pension Entitlements}

S = I + (G - T) + (X - M)

Where:

• G−T= Fiscal balance
• X−M= Trade balance

If G>T: budget deficit
If X>M: Trade surplus

Analogy:
An economy’s savings must equal its investment plus any government and trade imbalances.

Definition:
Business cycles are recurring fluctuations in economic activity — expansions and contractions — around the long-term growth trend.
They are recurrent but not periodic, meaning the timing and duration vary.

Phases:

Trend GDP represents the long-term growth path around which actual GDP fluctuates.

Credit availability expands and contracts with the economy, often amplifying business cycles.

• Loose credit → during booms, lending increases
• Tight credit → during recessions, lending declines

Credit cycles can be longer and deeper than business cycles.

Why Investors Care:

• Predicts housing & corporate investment shifts
• Affects monetary policy response
• Signals risk and valuation trends

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Analogy:
Think of a concert:

• Leading = stage crew setting up
• Coincident = band playing
• Lagging = cleanup crew after show ends

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Measures:

• Labor Force = Employed + Unemployed
• Participation Rate:

\text{Participation Rate} = \frac{\text{Labor Force}}{\text{Working Age Population}}

• Unemployment Rate:

\text{Unemployment Rate} = \frac{\text{Unemployed}}{\text{Labor Force}}

• Discouraged Workers not included in labor force

Price Index: average price level of a “basket” of goods.

Consumer Price Index (CPI) measures overall cost of living.

• Headline Inflation: all goods (including food & energy)
• Core Inflation: excludes volatile items

🔸 Laspeyres Index

I_L = \frac{\sum P_t Q_0}{\sum P_0 Q_0} \times 100

Tends to overstate inflation (no substitution adjustment).

🔸 Paasche Index

I_P = \frac{\sum P_t Q_t}{\sum P_0 Q_t} \times 100

🔸 Fisher Index

I_F = \sqrt{I_L \times I_P}

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NAIRU (Non-Accelerating Inflation Rate of Unemployment):

U^* = \text{Natural Rate of Unemployment}

If unemployment < U∗, inflation rises.

What It Is

Government decisions about spending (G) and taxation (T) to influence the economy.

Tools

• Government spending (G)
• Taxes (T)

Expansionary Fiscal Policy

• G ↑, T ↓
• Increases aggregate demand → boosts GDP
  Analogy: Government pressing the “gas pedal.”

Contractionary Fiscal Policy

• G ↓, T ↑
• Slows down an overheating economy
  Analogy: Government tapping the “brakes.”

Budget Balance

• G > T → Budget deficit
• T > G → Budget surplus
  Analogy: More money flowing out than in = financial diet needed.

What It Is

Central Bank actions that influence the money supply (MS) and interest rates (r).

Tools

• Policy Rate (interest rate)
• Reserve Requirements
• Open Market Operations (OMO)

Expansionary Monetary Policy

• MS ↑ → r ↓
• Boosts consumption (C), investment (I), AD, inflation
  Analogy: Making money cheaper — like stores putting borrowing “on sale.”

Contractionary Monetary Policy

• MS ↓ → r ↑
• Cools demand and inflation
  Analogy: Turning down the thermostat

Definition

Money = medium of exchange

5 Characteristics

1. Widely accepted
2. Known value
3. High value relative to weight
4. Easily divisible
5. Hard to counterfeit
   Analogy: Good money is like a good tool — durable, reliable, and versatile.

3 Functions

• Medium of exchange
• Store of value
• Unit of account
  Analogy: Money is the “language” all goods speak.

Types of Money

• Narrow money = cash + checking deposits
• Broad money = narrow money + liquid assets
  Analogy: Narrow = backpack; Broad = full luggage set.

Fractional Reserve Banking

Banks keep a fraction of deposits and lend out the rest.

Money Multiplier

Money Created=Initial DepositReserve RequirementMoney Created=Reserve RequirementInitial Deposit​

Analogy: One dollar is “cloned” into many through lending.

Quantity Theory of Money

M×V=P×YM×V=P×Y

• If M increases, and V and Y are constant → P increases (inflation)

Money Neutrality:
In the long run, more money → higher prices, not more output.
Analogy: Pouring more water into the same container raises the water level

People hold money for:

1. Transactions – everyday use
2. Precautionary – emergencies
3. Speculative – waiting to invest

Speculative Demand

• Inverse to returns
• Positive with market risk

Analogy: When markets are scary, people hold cash like life jackets.

rnominal​=rreal​+E(inflation)

r_{nominal​}=r_{real​}+E[inflation]

• Nominal rate rises one-for-one with expected inflation
  Analogy: Your salary rises with inflation, but your real purchasing power doesn’t change.

6 Main Roles

1. Currency supplier
2. Banker to government/banks
3. Lender of last resort
4. Regulator of payment systems
5. Conductor of monetary policy
6. Supervisor of banking system

Main Objective: Control inflation

Others: stable rates, full employment, sustainable growth

Qualities of Effective Central Banks: Interdependence, Credibility, Transparency

Expected

• Wages & prices adjust
• Costs of holding money increase
  Analogy: Everyone knows the weather report.

Unexpected

• Good for borrowers, bad for lenders
• Higher volatility → higher interest rates
  Analogy: A surprise storm — harder to plan.

Inflation Targeting Approaches:

• Interest Rate Targeting
• Inflation Targeting
• Exchange Rate Targeting

Neutral Interest Rate:

Growth rate of money supply that will not effect economic growth

r^* = Trend Growth Rate + Inflation

• Policy < neutral → expansionary
• Policy > neutral → contractionary

Analogy: Neutral rate is the treadmill speed where the economy neither speeds up nor slows down

Tools:

1. Government Spending
   • Transfer payments
   • Current spending
   • Capital spending
2. Taxes
   • Direct taxes
   • Indirect taxes

Advantages

• Indirect taxes quick
• Social policy support (e.g., tobacco tax)

Disadvantages

• Direct taxes + transfers slow
• May take effect after recovery

Limitations

• Recognition lag
• Action lag
• Impact lag

(G − T) > 0 → deficit

But expansion depends on changes, not level:

• Surplus ↓ or deficit ↑ → expansionary
• Surplus ↑ or deficit ↓ → contractionary

Fiscal policy uses G and T; monetary policy uses MS and r.

Money supply changes influence inflation more than real output (money neutrality).

Central banks aim to control inflation while supporting growth.

Inflation expectations drive nominal interest rates (Fisher effect).

Fiscal policy is slower due to lags, monetary policy is quicker.

The neutral rate determines whether policy is contractionary or expansionary.

Combining monetary & fiscal tools explains public vs private sector growth.

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State Actors drive cooperation and policy

Non-State Actors drive globalization and trade.

Each country ranks its priorities from top (national security) to bottom (cultural exchange).
Influenced by:

• Power of decision makers
• Political cycle length
• Level of conflict

Analogy: A budget of attention — governments spend it where they care most.

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Globalization = openness and integration

Nationalism = protection and independence

When countries depend too heavily on each other, conflict or disruption in one can ripple through many.
Analogy: A global power grid — if one link fails, the whole network dims.

Geopolitics links geography + power + economics.

Cooperation enhances efficiency; non-cooperation breeds fragmentation.

Standardization & soft power underpin long-term stability.

Globalization boosts profits but widens inequality and environmental gaps.

Interdependence = efficiency + fragility — balance is key.

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ToT=Price of ImportsPrice of Exports​

• Improving ToT → exports buy more imports (good for trade balance)
• Deteriorating ToT → exports buy fewer imports (bad for trade balance)

Analogy:
Trade is like teamwork — efficiency rises, but not everyone gets equal rewards.

Ricardian Model:

• Only labor matters.
• Differences in technology explain productivity differences.

Heckscher–Ohlin Model:

• Advantage comes from factor endowments (labor & capital).
• A country exports goods using its abundant factor.

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Analogy:
Think of it as layers of friendship — from handshake (FTA) to joint bank account (Monetary Union).

Tracks all financial transactions between a country and the rest of the world.

\text{Current Account} = \text{Capital Account} + \text{Financial Account}

Balance Identity:

Current Account+Capital Account+Financial Account=0

Current Account=(X−M)+Net Income+Transfers

Current Account=Sp+Sg−I

Where:

Where:

• Sp​ = Private Savings
• Sg = Government Savings
• I = Investment

Interpretation:
A current account deficit = savings < investment.

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Analogy:

• IMF = financial paramedic
• World Bank = development architect
• WTO = trade referee

Trade enhances efficiency but creates distributional tension.

Comparative advantage drives specialization and trade gains.

Balance of Payments always balances, even if current account doesn’t.

Integration levels define how open economies are to cooperation.

IMF, World Bank, WTO each tackle a unique part of the global system.

Price Currency vs Base Currency

• Price Currency = numerator
• Base Currency = denominator

Example:
USD/EUR = 1.10 → USD is price (numerator), EUR is base (denominator)

Analogy:
Think of exchange rates like a price tag — the price currency is what’s written on the tag.

Direct vs Indirect Quotes

• Direct quote: Price of foreign currency in terms of domestic currency
• Indirect quote: Price of domestic currency in terms of foreign currency

Analogy:
Direct = “How many dollars per euro?”
Indirect = “How many euros per dollar?”

Nominal vs Real Exchange Rate

• Nominal rate: Spot FX rate today
• Real rate: Adjusts for inflation differences

​​

RER = S \times \frac{CPI_{base}}{CPI_{price}}

Analogy:
Nominal = sticker price
Real = sticker price adjusted for inflation

Spot vs Forward Rate

• Spot = FX rate today
• Forward = FX rate agreed upon for future settlement

Analogy:
Spot is “buy it today,” forward is “reserve it for later.”

Percentage Change in Exchange Rate

• If exchange rate increases, the base currency appreciates, the price currency depreciates.
• % change refers only to the base currency.

\%\Delta = \frac{Final}{Initial} - 1

Sell Side

• Banks and dealers that create and quote FX contracts

Buy Side

• Corporations (risk hedging)
• Investment accounts (hedging or speculating)
• Government entities
• Smaller investors

Analogy:
Sell side = store owners
Buy side = customers

To compute cross exchange rates:

CR = \left(\frac{PC_1}{BC}\right)\left(\frac{BC}{PC_2}\right)

Analogy:
If you know apples → oranges and oranges → bananas, you can convert apples → bananas.

• Forward points reflect difference between forward and spot.
• 1 point = same number of decimals as spot rate
  Example: Spot = 1.234 → 1 point = 0.001

Analogy:
Like a small adjustment on a price — a “decimal-sized tweak.”

Determines the forward rate based on interest rate differences:

F_{p/b} = S_{p/b} \times \frac{1+r_p}{1+r_b}

If:

• Forward > spot → forward premium
• Forward < spot → forward discount

1. Formal Dollarization

• Country adopts another nation’s currency
• No independent monetary policy
  Analogy: Giving up driving and becoming a passenger.**

2. Monetary Union

• Multiple countries share the same currency
• More integration
  Analogy: Roommates sharing one bank account.**

3. Currency Board

• Legal commitment to fixed exchange rate
• Very credible, strict
  Analogy: Currency handcuffed to another currency.**

4. Fixed Parity

• Peg within ±1% band
• No legal commitment
  Analogy: Soft promise.**

5. Target Zone

• Wider band than fixed parity

6. Crawling Peg

• Peg adjusted periodically for inflation

7. Crawling Bands

• Target zone with widening bands over time

8. Managed Float

• No target, central bank intervenes for internal goals (inflation, unemployment)

9. Independently Floating

• Market determines rate; government sets policy independently

Trade Balance=X−M

• Depreciation: Exports ↑, Imports ↓ → Trade balance improves
  Analogy: A sale in your currency makes your products look cheaper abroad.

Currency depreciation improves trade balance if:

(W_x)(E_x) + (W_m)(E_m - 1) > 0

Where:

• Wx​ = export share
• Ex= export elasticity
• Wm​ = import share
• Em= import elasticity

If holds → depreciation helps
If fails → depreciation does not help

Immediately after depreciation:

• Trade balance worsens (contracts already signed)
• Later, export volumes adjust → balance improves

Analogy: Like fixing a leak — gets messy before it gets better.

X - M = Y - (C + I + G)

To improve trade balance:

• Increase Y (output), or
• Reduce absorption (C + I + G)

Analogy: To save money, either earn more or spend less.

Exchange rates express price currency / base currency.

Percentage changes refer to the base currency.

Cross rates require multiplying a rate by another’s reciprocal.

Forward rates come from the interest rate parity condition.

9 exchange rate regimes exist — from strict (currency board) to free (independent float).

Depreciation improves trade balance if Marshall–Lerner condition holds.

The J-curve explains why depreciation helps later, not immediately.

Absorption approach shows trade balance improves by

• increasing GDP, or
• reducing domestic consumption/investment/government spending.