Introduction to Economics PDF

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This document provides an introductory overview of economics as a field. It covers fundamental concepts such as the nature of economics as an empirical and social science and explores its methodologies, including models and approaches like induction and deduction. Further, it outlines crucial elements of economics, such as factors of production (land, labor, and capital), the importance of scarcity and choice, and distinguishes between microeconomics and macroeconomics. This document could be relevant for introductory courses in economics.

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Subscribe to DeepL Pro to translate larger documents. Visit www.DeepL.com/pro for more information. TOPIC 1: INTRODUCTION 1. ECONOMY a) Science Economics is an empirical and social science. It is a science because by employing a certain method...

Subscribe to DeepL Pro to translate larger documents. Visit www.DeepL.com/pro for more information. TOPIC 1: INTRODUCTION 1. ECONOMY a) Science Economics is an empirical and social science. It is a science because by employing a certain methodology, it establishes laws, describes cause-effect relationships and observes the interrelationships between the parts of the field that fall under its purview. Economics, as a modern science, was born in 1776, coinciding with the publication of Adam Smith's book "An Inquiry into the Nature and Causes of the Wealth of Nations". Until then, there was a lack of overall vision, which is the merit attributed to Smith. Empirical science: its knowledge is based on real-world experience. Economics does not use the experimental method. The economic scientist observes the facts, but does not intervene in them. Social science: the object of its knowledge is the investigation of certain types of human actions and relationships. The social sciences do not have the accuracy of other sciences in which, whenever a process is repeated under the same circumstances, the results are the same. Economic laws cannot be asked to be fulfilled for each case and for each individual. The laws of the social sciences, in general, and of economics, in particular, are based on large numbers and are fulfilled for the whole. b) Method It is the path followed by a science to explain the reality it studies. Economics uses models to explain reality. Models are simplified representations of reality. As an empirical science, economics builds models based on reality. It uses the methods of induction and deduction: by deductive means it proceeds to their verification. c) Definition The word economy derives from the Greek terms Oikos, meaning house, and nomos, meaning rule. Oikonomia would be the government of the house, or domestic administration. In this sense the word economy is used for a long time: set of rules to manage or govern soberly the house, the family and, by extension, the community. The definitions of economics in recent decades emphasize scarcity and choice, characteristics present in all economic activity. It was Lionel Robbins who introduced this trend in 1932, defining economics as "the science that studies human behavior as a relationship between ends and limited means that have various applications". 1 Paul Samuelson, following this line, defines economics as "the study of the way in which societies use scarce resources to produce valuable goods and distribute them among different individuals". The main drawback of these definitions is that they are based on the assumption of rationality, which is implicit in all of them. 2. MICROECONOMICS AND MACROECONOMICS Microeconomics: the part of economics that studies the behavior, from the economic point of view, of individuals, natural or legal persons, their aggregates and the relationships between them, always within the market for a given good, service or factor. Macroeconomics: studies an economy as a whole. The major macroeconomic topics are: Production Employment Prices Public Sector Relationship of the economy with the outside world It does not stop to study the markets, but the whole. The relationship between microeconomics and macroeconomics is very close, and the interrelationship between the two is constant. 3. THE FACTORS OF PRODUCTION They can also be called resources. They are the basic elements used for the production of goods or the provision of services. They are usually divided into: Land (T): In a broad sense, in addition to the surface on which the economic activity is carried out, its location, its contents and the free fruits of nature (minerals, water, sunlight, etc.). Labor (L): Comprises the physical and intellectual capacities of human beings applied to the production of goods and the provision of services (human capital). Capital (K): These are the human contributions that facilitate the productive process. A distinction must be made between physical capital (machines, buildings...) and financial capital (stocks, bonds...), and between real investment and financial investment. Capital goods are not intended to satisfy human needs directly, but their accumulation allows them to be satisfied better and more abundantly in the medium term. There are some goods that can be both consumption and capital goods. Net Investment = Gross Investment - Replacement Investment 2 4. BASIC QUESTIONS ANSWERED BY ECONOMICS. THE CIRCULAR FLOW OF INCOME The basic questions are: ⮚ What to produce? ⮚ How to produce? ⮚ For whom to produce? The question, What to produce, attempts to answer what goods the economy produces and how much of each. It is answered by the "price theory". Once it has been decided what is to be produced, it is necessary to see how it is done. This tries to answer the question How to produce? There are many possible combinations of Land, Labor and Capital to obtain the desired goods. The way to use resources efficiently is studied by the "theory of production". The last question, for whom to produce, is, in large part, the result of the answers given to the previous questions. The decision about how to produce, i.e. how land, labor and capital are used and how much of each of them is used, involves the remuneration (rent, wages and interest) obtained by the owners of these factors and, therefore, the ability of each one to access the goods that have been produced. The part of economics that studies this subject is called "distribution theory". The circular income flow model helps to understand the answers to these questions. 3 5. VARIOUS ORGANIZATIONS OF THE ECONOMIC SYSTEM An economic system is the set of basic, technical and institutional relationships that characterize the economic organization of a society and condition its fundamental decisions and the predominant channels of its activity. The different ways of answering the basic questions situate us in the different economic systems: a) Capitalist Economics: answers basic questions exclusively through the market. In each particular market the interaction of forces (supply and demand) sets the price, without state intervention. ▪ Leaves the weakest defenseless Example: there are no minimum wages or social security. b) Centralized Economy: the questions are solved by a central authority that totally controls the economy. In this case, the market has no say; it is this authority that decides what is produced, how much, the factors of production used and the price of goods and factors. ▪ It ensures the full employment of productive resources and the remuneration of each one. ▪ Its cost is the lack of freedom to decide and incentives to improve. ▪ There is no official inflation. ▪ Possible emergence of black markets due to shortage of goods. c) Market Economy: it is a mixture of the two previous ones. It is the market that that answers the basic questions, but under the tutelage of the State. ▪ The State protects the most disadvantaged. ▪ Ensures the provision of public services. ▪ Market failures → monopoly, externalities, public goods.... Establish working conditions Maximum prices for basic necessities Provision of services Promoting infrastructures Penalizing negative externalities Collect taxes 6. THE PRODUCTION POSSIBILITIES FRONTIER (PPP) Indicates the maximum amount of goods that an economy can produce by efficiently using what it owns. It has a concave shape as a consequence of the fact that the factors of production are not homogeneous and, therefore, opportunity costs are increasing: more and more of one good has to be given up to obtain the same increase in the other. Any combination above the PPF is unattainable from the production point of view, but may be attainable from the consumption point of view if the country trades with others. 4 In the long run, the factors of production may increase (and also decrease), raising the PPF and making possible production possibilities that were not possible in previous periods. If the endowment of productive factors changes, quantitatively or qualitatively, the PPF rises (if they increase) or shifts downward (if they decrease). If the factors of production were homogeneous, opportunity costs would be constant and PPF would be a straight line. a) Efficiency and inefficiency Efficient point: if production takes place at one point of the PPP and the production of one good is to be increased, the production of the other must necessarily be reduced. Unattainable point (from a production perspective): o Attainable: ⮚ From the consumption point of view, trading with other economies. ⮚ In the long run, because if productive factors increase, the PPF shifts upwards. b) FPP and economic development Gross investment → total production of capital goods. Net investment → change in the quantity of capital goods. Net Investment = Gross Investment - Replacement Investment 5 1: Gross Investment > Replacement Investment → Net Investment > 0 2: Gross Investment = Replacement Investment → Net Investment = 0 3: Gross Investment < Replacement Investment → Net Investment < 0. 7. INITIAL CONCEPTS a) Positive Economics and Normative Economics Positive Economics: seeks objective explanations about the functioning of economic phenomena, it strives to explain things "as they are", as they occur in reality, independently of value judgments. It is concerned, therefore, with formulating laws of general compliance, which do not depend on the way of thinking or on the training of one or the other. Positive economics establishes propositions of the type "if such circumstances exist, then such events will occur". Normative economics: concerned with "what should be". It locates and isolates economic problems, proposing the application of measures to achieve certain goals or objectives (full employment, price stability, etc.). Its propositions depend, to a large extent, on the value judgments of those who formulate them. b) Endogenous and exogenous variables Endogenous: those whose values are determined by the model itself. Exogenous: their values are not determined by the model, but are given to it. c) Nominal and Real Values Nominal (or Current) Value: magnitude is valued in nominal or current terms or prices when it is expressed in monetary units of the year to which it refers. Real (or Constant) Value: A magnitude is valued in terms, or at prices, real or constant when it is expressed in monetary units of a year that serves as a base or reference. Expressing magnitudes of different years in real terms means valuing all of them in the same monetary units, those of the year taken as a base, which makes it possible to compare them easily since the distortion caused by price variations has been eliminated. 6 d) Absolute Prices, Relative Prices and Opportunity Cost Absolute Prices: when a good is valued in monetary units. Relative prices: when a good is valued in terms of another good. The relative price is, at the same time, the opportunity cost: what a good costs in units of another good. e) Marginal and Medium The marginal term informs about how one variable is affected by changing another; it is a dynamic concept. The mean term indicates the relationship or correspondence between two variables at a given time; it is, therefore, a static concept. f) Ceteris Paribus Clause Economic phenomena usually depend on quite a number of variables. One way to study the influence of one of the variables on the phenomenon under study is to assume that, except for the variable of interest, all other variables remain constant. Ceteris paribus is equivalent to saying "assuming all else constant". 7 8 Subscribe to DeepL Pro to translate larger documents. Visit www.DeepL.com/pro for more information. TOPIC 2: ELEMENTARY MARKET THEORY 1. THE CLAIM A. General The demand for a good is the quantity of that good that buyers are willing to purchase in a given period of time. It depends on multiple factors: the price of the good (PX), the prices of related goods (PY, PZ), the income of buyers (M), tastes (G), etc. The demand function indicates the relationship between the quantity demanded of the good and the factors on which it depends: X = f (PX,PY,PZ,...,M, G...) The graphical representation of the demand function relates quantity and price, assuming all other factors constant. It is decreasing, it has an inverse relationship between the price of the good and the quantity demanded of that good. It indicates the quantity of good that one is willing to acquire for each price, ceteris paribus. The market demand for a good is the sum of the demands of the individuals that compose it. → The quantity demanded by the market for each price is the sum of the individual demands for that price. Two types of variations in the quantity demanded can be distinguished: a) Within the same demand function. These variations in the quantity demanded occur when (ceteris paribus) the price of the good itself changes. If the price of the good goes up, the quantity demanded goes down: displacement from point A to B of the demand function where we are. b) Shift to another demand function. They occur when a factor other than the price of the good itself changes. If consumers' income rises, the quantity demanded rises: displacement from point A to C, changing the demand function. 9 B. Demand factors and their effects on the demand function 1) Price of the good itself (PX): the price of a good is the factor that most influences its demand. The quantity demanded varies inversely with price, and the various price-quantity combinations are the different points of the demand function. 2) Prices of other goods (PY, PZ...): The variations that occur in the quantity demanded of a good when the price of others varies depend on the relationship that exists between the goods. We can distinguish three cases: a) Independent goods: two goods are independent when variations in the price of one do not affect the quantity demanded of the other. Their demands are not related. Ex: ball and hammer b) Complementary goods: two goods are complementary when the demand for one pulls in the same direction as the demand for the other: if the demand for one increases, the demand for the other increases, and if the demand for one decreases, the demand for the other decreases. There is an inverse relationship between the price of one good and the demand for the other good. Ex: paddle tennis court and racquets rental c) Substitute goods: two goods are substitutes when the demand for one pulls in the opposite direction of the demand for the other: if the demand for one increases, the demand for the other decreases, and if the demand for one decreases, the demand for the other increases. There is a direct relationship between the price of one good and the demand for the other. Ex: diesel cars and gasoline cars 3) The individual's income (M): The variations that occur in the quantity demanded of a good when the consumer's income varies depend on the type of good. We can distinguish the following cases: a) Staple goods: these are goods whose demand is hardly affected by changes in income. These goods are also very insensitive to changes in their own price. The Engel curve, which relates the quantity demanded of a good to income, is horizontal. b) Normal goods: these are goods whose demand varies in the same direction as income. The Engel curve of normal goods is increasing. c) Inferior goods: these are goods which, above a certain level of income, the consumer's demand decreases as income increases, and may stop acquiring them for high income levels. The Engel curve for inferior goods has an increasing area, corresponding to very low incomes, and after a certain level of income, it becomes decreasing, with consumption of the good decreasing as income increases. d) Luxury goods: these are goods that are only demanded at high income levels. Their demand behaves like that of a normal good. The Engel curve is increasing, like that of a normal good, the only difference being that it is shifted to the right. 10 4) Consumer tastes (G): demand also depends on factors such as consumer tastes or preferences. 5) Other factors: a) Population size. b) Population structure. c) Income distribution. 2. THE OFFER A. General The supply of a good is the quantity of that good that producers are willing to put on the market in a given period of time. The supply, in addition to the price of the good itself, depends on multiple elements: cost of productive factors, state of technology, taxes and subsidies, price of other goods, etc. The graphical representation of the supply function is increasing and indicates the quantity of good that one is willing to put on the market for each price, ceteris paribus. The market supply is the sum of the offers of the producers that compose the market. The amount of market supply, for each price, is the sum of the individual offers for that price. The quantity of a good offered may change for various reasons: a) Within the supply function itself. They occur when the price of the good itself varies. b) Shifting to another supply function. It occurs when some factor other than the price of the good itself changes, something that in the original demand function we were considering constant. B. Supply-side factors and their effect on the supply function 1) Price of the good itself (PX): Changes in the price of the good lead to other points of the original supply function. 2) Technology: A technological advance, ceteris paribus, makes it possible to put more of the good on the market with the same or fewer productive factors, or, in other words, to produce the good at a lower unit cost. As a consequence, the supply function shifts downwards. 3) Factor cost: Factor cost has a direct impact on supply. If factor costs increase, the producer will tend to pass this increase to the market, asking for more monetary units for each unit of good manufactured. This results in a shift of the supply function to the left. 4) Taxes and subsidies: The establishment of a tax on production makes the product more expensive and the bidder will tend to pass this increased cost on to demand, shifting the supply function to the left. In the case of a tax per unit of output, suppliers will try to sell each unit of the good at the previous price plus the tax. 11 5) Variations in the price of other goods: For a variation in the price of one good to affect the supply of another, the factors of production must be able to be used indistinctly to produce the two goods. If this is the case, and the price of one of the goods rises, the suppliers of the other will be attracted by this rise and will stop producing the good they were engaged in to produce the one whose price has risen. As a consequence, the supply of the good that has become relatively cheaper shifts to the left. 3. MARKET EQUILIBRIUM A market is in equilibrium for the price at which the quantity of product that buyers wish to buy coincides with the quantity that suppliers wish to sell (D=S). Equilibrium occurs, therefore, for the price of the good that brings the market forces into agreement. For price Px1 → Excess supply (shortage of demand) → ↓Px. For price Px2 → Shortage of supply (excess demand) → ↑Px. ↘↙ For price PxE → Equilibrium. 4. VARIOUS IMPACTS ON MARKET EQUILIBRIUM Equilibrium tends to be stable as long as circumstances do not change. If for any reason the demand and/or supply shifts, the initial equilibrium is altered and a process of rebalancing takes place until a new situation of stability is reached. In this section we will study how equilibrium is altered for various reasons: the establishment of a tax, the setting of maximum and minimum prices and the variation in demand in the face of an advertising campaign. a) Establishment of a T tax per product unit ✓ When the tax is established, the bidders will try to pass it on to the demanders, raising the price by the amount of the tax. ✓ The bid function is shifted to the left. ✓ For price Px2 → Excess supply (X1- X2) → ↓Px. ✓ In the final situation the bidders manage to pass on only a part of the tax to the demanders. DEMANDERS: TD = Px3 - Px1 SUPPLIERS: TS = T - (Px3 - Px1) 12 b) Maximum and minimum prices Maximum prices The competent authority establishes a price above which t h e good cannot be sold on the market. If PMAX ≥ Price set by the naturally the market → The measure produces no effect on equilibrium. 13 Establishment of maximum prices c) Other balance incidences 14 Subscribe to DeepL Pro to translate larger documents. Visit www.DeepL.com/pro for more information. TOPIC 3: ELASTICITY 1. ELASTICITY OF DEMAND The elasticity of demand, or price elasticity, tells how, ceteris paribus, the demand for a good is affected by a change in its price or, in other words, it informs about the sensitivity of demand to price. The value of the elasticity of demand is given by a coefficient -the elasticity coefficient- which is the quotient between the percentage variation of the quantity demanded and the percentage variation of the price. A very interesting information provided by the elasticity coefficient is how consumer spending reacts to changes in the price of the good. Values of the price-elasticity coefficient: 1. Elastic points: These are the points at which the elasticity of demand is greater than 1 (or less than - 1, if we consider the sign). In these points, demand is sensitive to price; the higher the value of the elasticity, the more sensitive it is. Another characteristic of the elastic points is that if the price of the good falls, consumer spending on it increases (if the price were to rise, spending would fall). The percentage change in quantity demanded is greater than in price. 2. Unit elasticity: The elasticity of demand is unitary when the value of the coefficient is unity (or - 1). In this case, variations in price do not produce changes in consumer spending. Price changes and expenditure remains constant. The percentage change in quantity demanded is the same as in price. 3. Inelastic points: These are the points at which the elasticity of demand is less than 1 (or greater than - 1). Demand is not very sensitive to price, less sensitive the closer the value of the elasticity is to zero. At the points 15 inelastic, if the price of the good falls, consumer spending on it decreases (and if it rises, it increases). The percentage change in quantity demanded is smaller than in price. 4. Rigid demand: demand is rigid, or perfectly inelastic, when it does not react to variations in price. The value of the elasticity coefficient is zero. 5. Perfectly elastic demand: demand is perfectly elastic, or of infinite elasticity, when there are variations in the quantity demanded of the good without the need for the price to vary. The value of the elasticity coefficient is infinite. Therefore, knowing the value of the elasticity, it is possible to know how consumer spending on the good will react when the price varies. Some of the factors on which demand elasticity depends are: The type of property involved, The greater or lesser ease of replacing the asset, Consumers' response time to price changes - The time it takes for consumers to respond to price changes. The importance of the price of the good in the consumer's budget. The elasticity of demand is a linear demand function and, therefore, of constant slope, we find points of different elasticities. 16 The relationship between the demand function and the expenditure function is given by the following graph. 2. CROSS-ELASTICITY The coefficient of cross-elasticity indicates, ceteris paribus, how the demand for one good reacts to a change in the price of another good; it therefore provides information on the sensitivity of the demand for one good with respect to the price of another. The value of this elasticity coefficient is given by the quotient between the percentage change in the quantity demanded of one good and the percentage change in the price of another. 1. Null cross-elasticity: There is no relationship between the two goods and, therefore, they are independent. 2. Positive cross-elasticity: The coefficient is positive as long as the two variables we are comparing move in the same direction: if PY goes up, the quantity demanded of X goes up, and if PY goes down, the quantity demanded of X goes down. A positive cross elasticity indicates that the goods are substitutes. 3. Negative cross-elasticity: The coefficient is negative when the compared variables move in opposite directions: if PY goes up, the quantity demanded of X goes down, and if PY goes down, the demand for X goes up. A negative cross- elasticity indicates that the goods are complementary. 17 3. INCOME ELASTICITY Income elasticity indicates the sensitivity of the demand for a good to changes in income. The income elasticity coefficient is the quotient between the percentage change in the quantity demanded of a good and the percentage change in income. The following cases may occur, depending on the value of the elasticity: 1. Zero income elasticity: The quantity demanded of the good does not change as income varies. This is a staple good. 2. Negative income elasticity: The compared variables move in opposite directions. This is what happens in the decreasing zone of the Engel curve of inferior goods. 3. Positive income elasticity, but less than unity: It is positive when income and demand vary in the same direction. And if it is less than unity, the percentage variations in quantity are less than the percentage variations in income that give rise to them. If this occurs, we are dealing with a normal good. 4. Positive income elasticity, greater than unity: This indicates a direct relationship between the variables being compared, but, on this occasion, the percentage variations in quantity are greater than the percentage variations produced in income. For this reason, we would be dealing with a luxury good. SUMMARY TABLE 18 4. ELASTICITY OF SUPPLY The elasticity of supply indicates the sensitivity of supply to the price of the good. The expression of the elasticity coefficient is the same as that of demand, the only difference being that price and quantity refer to supply. Supply elasticity values: 1. Elastic supply: When a percentage change in price causes a higher percentage change in the quantity offered. The elasticity coefficient takes a value greater than 1. Bidders respond significantly to price variations: supply is sensitive to price; the higher the value of the elasticity, the more sensitive it is. 2. Inelastic supply: Percentage variations in price produce smaller percentage variations in quantity. When this occurs the value of the coefficient is less than unity. Supply is not very sensitive to price; the closer the value of the elasticity is to zero, the less sensitive it becomes. 3. Unitary elasticity: When the value of the coefficient of elasticity is unity. 4. Rigid supply (perfectly inelastic): When it does not react to variations in price. The value of the elasticity coefficient is zero. 5. Perfectly elastic supply (infinite elasticity): When there are variations in the quantity offered of the good without the need for its price to vary. The value of the elasticity coefficient is infinite. 5. ELASTICITY AND TIME The passage of time has an important impact on elasticity; the possibilities for suppliers and demanders to adapt to the new situation increase, and the reaction of one or the other to variations in price is greater. For this reason, in the long run the elasticity of the equilibrium points of the different functions tends to be higher than in the short run. 19 20 TOPIC 4: CONSUMER THEORY 1. UTILITY AND CONSUMER SURPLUS Utility: satisfaction that an individual obtains or finds from the consumption or possession of a good, or from receiving a service. Total Utility: is that obtained by an individual for the set of units that he consumes of a good X: U = f (X). Marginal Utility (of a given good): is the increase in utility that this unit provides to the individual. The Law of Decreasing Marginal Utility states that, from the consumption of a certain number of units of a good, if new units are consumed, marginal utility decreases, and may reach saturation, which occurs when marginal utility is zero and the maximum total utility has been reached. In very many cases (in fact, it is the norm), the law of diminishing marginal utility starts to apply from the first unit of the good. Consumer surplus: is the difference between the utility that an individual finds in the consumption of a good and the market value of that good. If the surplus of a unit of a good is negative, the consumer does not purchase it. The consumer purchases the units of good that the marginal utility function indicates, in the decreasing part, for the price of the good. Therefore, the decreasing area of the marginal utility function makes the individual's demand curve function for that good. The marginal utility function of an individual for a good serves as the demand function for that good. 21 In the particular case that the law of diminishing marginal utility is not fulfilled from the beginning, the demand function would be the diminishing part of the marginal utility function. 2. THE INDIFFERENCE CURVE The set of consumption combinations in which the individual finds the same utility is called the indifference curve. The properties of indifference curves are as follows: ⮚ Indifference curves have a negative slope. ⮚ Faced with successive and equal increases in the quantity consumed of one of the goods, the consumer is willing to give less and less of the other. well, in order to maintain constant utility ⮚ The farther away they are from the origin of coordinates, the more useful they are to the consumer. ⮚ They do not cut each other. The rate or Marginal Substitution Ratio (MSR) indicates how much of one good the consumer is willing to give up in exchange for a quantity of the other, in order to keep utility constant. 3. THE BALANCE LINE It can also be called a budget constraint. It shows the consumption possibilities to which an individual has access, taking into account his income (M) and the prices of the goods he acquires (PX,PY). Its expression is: M = X - PX + Y - PY 4. THE CONSUMER'S EQUILIBRIUM Combining the consumer's preferences - what he would like to do - with the budget constraint - what he can do - yields the equilibrium situation: the possible consumption combination that most satisfies him. 22 This situation occurs at the point on the balance line at which it is tangent to an indifference curve. At that point it is fulfilled: The consumer is in equilibrium when the marginal utility of the last monetary unit he spends on good X is equal to the marginal utility of the last monetary unit he spends on good Y. 5. EFFECTS ON EQUILIBRIUM The union of the successive consumer equilibria as income changes is called the income-consumption function. The union of the successive equilibria of the consumer when changing the price of one of the goods he purchases is called the price-consumption function. 23 6. SUBSTITUTION EFFECT AND INCOME EFFECT When the price of a good varies, its demand is altered. This alteration has two components, one is due to the substitution effect and the other to the income effect. Substitution effect: this is the change in the demand for the good as a consequence of the variation in the relative prices of the goods. If the price of X is reduced, this good becomes cheaper with respect to Y, and the consumer tends to substitute Y for X, reducing the consumption of Y and increasing that of X. It is always of opposite sign to the variation in price: if the price of a good falls, its demand, as a consequence of this effect, rises, and if the price rises, demand falls. In the graph, lowering X in price would move from point A to C, increasing consumption XC - XA. Income effect: this is the variation in the demand for the good as a consequence of the variation in the individual's real income. As the price of X decreases, the individual's real income increases, so that he/she can purchase more of all goods, particularly X. It depends on the type of good. Keeping the assumption that the price of the good falls, and representing the different cases in the same graph to facilitate their comparison, we would have: ✓ If X is normal: lowering the price increases the real income of the subject and, therefore, increases the demand for the good due to the income effect; it goes from C to B1. The effect income would be (XB1 - XC) and the total (XB1 - XA). ✓ If X were a staple: demand does not change as real income changes; we would go from C to B2 and the income effect would be zero. For these goods the total effect coincides with the substitution effect (XC - XA). ✓ If good X is inferior: its demand moves in the opposite direction to income. Therefore, as the price falls and real income rises, the demand for the good falls. The 24 The substitution effect is of one sign and the income effect of another, but the substitution effect wins, since, in absolute value, it is greater than the income effect. Because of the income effect we would go from C to B3. In this case, the income effect is negative (XC - XB3) and the total effect would be (XB3 - XA). ✓ Finally, it may be the case that the income effect exceeds, in absolute value, the substitution effect. In this case, as a consequence of the income effect, we would pass from C to B4, reducing consumption by this effect (XC - XB4) and by the total effect (XA - XB4). In this situation, a decrease in the price of the good would cause a reduction in demand and vice versa, contradicting the law of demand. 7. DEDUCTION OF THE CONSUMER DEMAND FUNCTION The successive equilibrium points of the consumer when varying the price of one of the goods allow us to know the consumer's demand function for that good. These equilibria provide points of that demand function: the quantity of the good that the consumer wants for each price. 25 26 TOPIC 5: MACROECONOMICS AND MAGNITUDES 1. MACROECONOMICS It is concerned with the study of an economy as a whole. It has five main objectives: ▪ Production. The analysis of the evolution of the production of goods and the provision of services of an economy is a primary objective, since it is a index of the performance of this economy. ▪ Employment. It studies and deals with the use of the resources that the economy possesses, especially the labor factor. The objective is to achieve a high level of employment of the resources. ▪ Pricing. The objective is to achieve an evolution that favors economic growth. Both an excessive growth in prices and a fall in the price of goods and services. destabilizes the economy. ▪ External equilibrium. Economies are open, they have relations with other economies: they import and export goods and services, capital enters and leaves, etc. The objective is that there is an adequate balance between the economy under study and the rest. ▪ Balance of the public sector. Pursues the proper balance between public sector revenues and expenditures, which does not mean that the public sector budget should be balanced. each fiscal year has a zero balance. Fiscal policy. It is structured around two major components: Public spending. Taxes, which finance this expenditure by deducting part of the income of households and companies. Monetary policy. It groups a series of instruments that facilitate or hinder the access of economic agents to money. Some of them: Legal coefficients Loans to the banking sector Open market operations Interest rates Supply-side policy. These are instruments aimed at encouraging work and production. Foreign policy. The instruments available to this policy can be divided into two categories: Exchange rate actions Trade policy instrument The latter include: tariffs, quotas, export subsidies, non-tariff barriers. 27 MACROMAGNITUDES These are the big numbers of an economy. They can be observed from 3 points of view: Production (Supply) Expenditure (Demand) Rentals It is like looking at a mountain from three different angles, the landscape seen from each point is different, but the height of the mountain is the same. GDP PRODUCTION APPROACH Value of final goods and services generated by an economy during a given period of time, generally one year, within its territory. It is the most widely used macro-magnitude to know the evolution and development of an economy. It is a flow, not a stock. It refers to what the economy has produced, not to wealth it possesses. 28 It only considers final goods and services. If the intermediate ones were taken into account, we would fall into double counting. For this reason, it can be calculated by adding up the values added at each stage of the production process. It is a territorial concept. It looks at the "where", not the "who". AN INDICATOR WITH MANY GAPS Some goods are difficult to value and are included in GDP according to their cost. For example, the contribution to GDP of civil servants is valued according to the salaries they earn. This means, for example, that a mission abroad is worth more than a mission in the country itself; if the number of civil servants increases, GDP increases, even though the work is the same. GDP does not take into account the underground economy. It does not consider what is not the object of the market game. For example, a cook, a gardener... contribute to the GDP, but if those same functions are done by a person for himself, they contribute nothing. Polluting creates wealth. A company's production adds value to GDP. If the company pollutes while producing, not only does it not subtract value from its output, but the services of the cleaning company also add value to GDP. FROM GDP TO DISPOSABLE PERSONAL INCOME (DPI) GDP measures a country's production. From it, other macro-magnitudes related to the creation of wealth and its distribution among citizens can be calculated: Gross Domestic Product at market price (GDP pm): Market value of all final goods produced in the territory of an economy during a given period of time. - Income of foreign residents obtained in the national territory (RRE) + Income of domestic residents obtained abroad (RRN) Gross National Product at market price (GNP pm): Value of the final production of a country's nationals. - Depreciation (D): is the loss in value of a country's capital assets. It calculates the annual wear and tear suffered by infrastructure and the cost of repair or replacement. Net National Product at market price (NNP pm): Value of production that can be distributed among the country's nationals, net of resources destined to depreciation. - Indirect Taxes (T): levied on production and consumption + State subsidies to companies (Sb) Net National Product at factor cost (NNP cf) = National Income (NI): Total sum of income obtained by the factors of production (wages, interest, rents, profits, land rents...). + Net transfers with the rest of the world (received minus delivered) 29 National Disposable Income. - Undistributed earnings - Taxes on profits - Social Security contributions paid by companies + State transfers to families + Interest on the State's Public Debt Personal Income (PR): Income actually received by individuals. - Direct taxes - Social security contributions paid by employees Disposable Personal Income (DPR): This is the income that households can actually use for consumption or savings. THE APPROACH TO SPENDING The components of GDP, from the point of view of spending by economic agents, are as follows: 1. Private consumption (C) It is the consumption of household economies: perishable goods, services and durable goods. 2. Investment or Gross Capital Formation (I) 2.1. F.B. Fixed capital: Expenditure on capital goods. 2.2. Changes in inventories: increases/decreases in company inventories of raw materials, semi-finished products and finished products. 3. Public expenditure (G) This is public sector spending: salaries, spending on goods and services and investment goods. Transfers are not included because they are not linked to a counterpart. 30 4. Net exports or net foreign exchange balance (Exports - Imports) 4.1. Exports (X): foreign demand for domestic goods and services. 4.2.Imports (M): domestic demand for foreign goods and services. THE INCOME APPROACH The components of GDP, from an income perspective, are as follows: 1. Compensation of employees: Payments made as remuneration for the labor factor: wages and salaries, remuneration in kind, bonuses and commissions, social security contributions 2. Gross operating surplus: These are the income from property and business. The surplus is used for various purposes: interest on loans, land and rental income, distributed dividends, savings of the companies themselves, etc. 31 INFLATION AND UNEMPLOYMENT INFLATION The evolution of prices is measured by means of various indexes, the best known of which is the consumer price index (CPI), which is a statistical measure of the evolution of the prices of goods and services consumed by the population residing in family dwellings. The change in prices is called inflation and reflects the increase or decrease in the prices of that basket of goods from one period to another. The inflation rate of one year with respect to the previous year is given by the expression: UNEMPLOYMENT Unemployment is measured by the unemployment rate, which is the percentage of the labor force that is unemployed. The active population is made up of all employed and unemployed persons looking for work. There are two basic statistical sources for determining unemployment figures: the registers of the unemployed (Registered Unemployment, prepared by the INEM) and labor market surveys (Active Population Survey, prepared by the INE). 32 TOPIC 6: THE BASIC KEYNISIAN MODEL 1. INTRODUCTION. CHARACTERISTICS OF THE MODEL It is a very simple model, which explains in an acceptable way how the economic system works and how fiscal policy acts to try to achieve the macroeconomic objectives (that the economy tends to the desired production and full capacity). The most outstanding simplification of the model is that it considers constant prices; adjustments between supply and demand are made via production. Income and output are, in the model, synonymous concepts. We will study the model in several phases: Closed economy and no public sector Introduction of the public sector Opening of the economy to the exterior. 2. CLOSED ECONOMY AND NO PUBLIC SECTOR a) Consumption, savings and investment functions The consumption function Household consumption is the most important and stable component of an economy. Household consumption depends on the following factors: 1. Perceived income: as perceived income increases, consumption increases in absolute terms and the percentage of income consumed decreases. 2. Expected income: consumption also depends on the expected evolution of income in the short and medium term. 3. Taxes: as taxes increase, disposable income decreases and consumption decreases. 4. Interest rate: high interest rates encourage household savings and reduce consumption (due to the higher savings it generates and the higher cost of financing consumption through loans or credit). 33 The model considers it a linear function dependent only on income (Y). Its expression is C = Co + bY. Graphically it is an increasing function of slope b that cuts the ordinate axis at C0. The marginal propensity to consume (PMaC) indicates how much consumption 𝒅𝑪 varies as income varies. When the increase in income tends to zero it is: 𝑷𝑴𝒂𝑪 = = 𝒃. Match 𝒅𝒀. with the slope of the function, b. Its value moves between zero and one. The average propensity to consume (PMeC) indicates consumption per unit of income: 𝑪 𝑷𝑴𝒆𝑪 =. It coincides with the slope of the ray joining the origin of coordinates to the 𝒀 point of the consumption function corresponding to each income level. Saving function In a simple economy with no public sector, all the income received by households is devoted to consumption (C) and savings (S): Y = C + S. The savings function is: S = Y - C = Y - (Co + bY) = -Co + (1- b)Y = So + sY The marginal propensity to save (PMaS) indicates how much saving varies as 𝒅𝑺 income varies. When the ∆Y tends to zero: 𝑷𝑴𝒂𝑺 = = 𝒔. The marginal propensity to save 𝒅𝒀 𝒅𝒀 𝒅𝒀 is constant and its value moves between zero and one. 34 The average propensity to save (PMeS) indicates savings per unit of disposable 𝑺 income: 𝑷𝑴𝒆𝑺 =. Its value, for each income, coincides with the slope of the ray that 𝒀 joins the origin of coordinates with the point of the savings function corresponding to that income. The investment function The second component of private spending is investment (business spending). Investment is very sensitive to a variety of factors such as: 1. The interest rate on loans and credits → if the interest rate falls, the cost of investment is reduced, a return rises and investment projects increase. 2. Tax → tax incentives stimulate investments. 3. Level of capacity utilization → if, due to demand pressure, the installed capacity of companies is fully utilized, entrepreneurs have a clear incentive to invest in increasing this productive capacity. 4. Expectations → if expectations are positive, investments will increase. The Keynesian model greatly simplifies the investment function, considering investment as an exogenous variable independent of income. Moreover, it does not consider depreciation, so it does not distinguish between gross and net magnitudes. Graphically, the investment function in the basic Keynesian model is horizontal, indicating constant investment, which does not depend on production. 35 b) Equilibrium in the closed model without public sector and multiplier Equilibrium income or production must meet two conditions: expenditure must be equal to production and outputs must balance inputs. In the current state of the model the only two components of aggregate expenditure are household consumption (C) and investment (I). Aggregate demand is the sum of these macro magnitudes: DA = C + I. Graphically it is the consumption function shifted upwards by the amount of investment. Equilibrium is reached for the production (income) that exactly satisfies total expenditure. The production YE, corresponding to the cut of the total expenditure function with the bisector, satisfies exactly the domestic consumption corresponding to that income [C (YE)] plus investment (I). In that situation exactly what is demanded is produced. 36 From the perspective of the inputs = outputs approach, in the present case we have a single output of the circular flow of income, which is savings, and a single input, investment. The equilibrium income is the one corresponding to the cut-off point of these two functions. It is, therefore, the income (YE) for which savings [S (YE)] exactly finances the investment (I) that firms wish to make. 37 The multiplier A multiplier indicates the relationship between two economic variables and shows how one is affected by a change in the other. In the present case, the investment multiplier indicates how much income changes with a change in investment. Δ𝑌 𝑑𝑌 𝑚 ∙ Δ𝐼 - Δ𝑌 ⇒ 𝑚 =. ; 𝑒𝑛 𝑒𝑙 𝑙í𝑚𝑖𝑡𝑒, 𝑐𝑢𝑎𝑛𝑑𝑜 Δ𝐼 𝑡𝑖𝑒𝑛𝑑𝑒 𝑎 𝑐𝑒𝑟𝑜, 𝑚 Δ𝐼 𝑑𝐼 =. Then: Δ𝐼 𝑑𝑌 1 1 1 𝑚= = = = 𝑑𝐼 1-𝑏 1- 𝑃𝑀𝑎𝑆. 𝑃𝑃𝑎𝑀𝑎𝐶 The investment multiplier indicates how much income varies with a change i n investment. An increase in investment: 1. It generates a chain of secondary expenses that production (supply) must also meet. 2. To reach the new equilibrium savings must increase by the same amount as investment, and since not all of the increase in income goes to savings (some of it goes to consumption), income must grow sufficiently so that the part of it that is saved is equal to the increase in investment that has generated the change. c) The paradox of frugality The paradox of frugality indicates that if, starting from a situation of equilibrium in an economy, the willingness to save of the individuals that compose it increases, ceteris paribus, the final equilibrium is reached for a lower level of income (and, therefore, of production and employment) than the initial one and for an overall saving equal to the initial one. 38 To be frugal is to consume in moderation → a frugal person consumes what he/she needs and, therefore, saves a higher percentage of his/her income than the average. Saving is usually good for a family, but it need not be good for the entire economic system → paradox of frugality. 3. INTRODUCTION TO THE PUBLIC SECTOR MODEL. FISCAL POLICY The incorporation of the public sector into the model makes it possible to introduce fiscal policy instruments (public spending and taxes), which the economic authority uses to try to achieve the major macroeconomic objectives. a) Public spending The basic Keynesian model considers public expenditure (G) an exogenous variable. It is a new component of aggregate demand, which is added to the two initial ones: private consumption (C) and investment (I). Its graphical representation is a horizontal line. Public expenditure is the expenditure of the public sector or public administration. The basic Keynesian model considers it an exogenous variable → horizontal line that does not depend on the level of income and raises in value the DA function. 𝐷𝐴 = 𝐶 + 𝐼 + 𝐺 Balancing the model with public spending The equilibrium after the introduction of public spending must meet the same conditions we saw in the previous phase: Production must satisfy the global demand corresponding to that income: YE = C (YE) + I + G PRODUCTION = DEMAND Savings (which remain the only output) must finance investment and public spending (which are the inputs): S (YE) = I + G OUTFLOWS = INFLOWS 39 Public spending as an instrument of fiscal policy Equilibrium production is that which satisfies existing demand and full employment production is that which corresponds to an economy that has employed all its resources. It is possible to be in an equilibrium situation without being in full employment. The difference between full employment output and equilibrium output is called the output gap. Government spending, as a component of aggregate demand that affects equilibrium income, is an instrument that can be used to move the economy towards macroeconomic objectives: If equilibrium output is lower than full employment (YE < Ype) and there are unemployed resources, the government can carry out an expansionary economic policy: an increase in spending, demand rises and the new equilibrium will be given for output and employment higher than the starting ones. If equilibrium output is higher than full employment (YE > Ype), it is because demand asks more from supply than it can give. In this case, a contractionary economic policy leads to a reduction in public spending, demand falls and the new equilibrium occurs for output and employment below the initial level. 40 b) Taxes The public sector finances its spending basically through taxes. In the basic Keynesian model they influence aggregate demand through private consumption. So far we have not distinguished between income (Y) and disposable income (Yd), because if there are no taxes, households can dispose of all the income they receive. By incorporating taxes the situation changes as they can only dispose of the income t h e y have left after paying taxes. Thus: Yd = Y - T (where T is tax revenue) The model assumes that taxes are a percentage of income: T = t - Y (where t is the tax rate) The incorporation of taxes changes the consumption function which reduces its slope, turning downward around its cut-off point with the ordinate axis: C = Co + b Yd = Co + b (Y - T) = Co + b (Y - t Y) = Co + b (1 - t) Y The balance of the model The equilibrium conditions after the introduction of taxes are those already known: Production must satisfy the total expenditure corresponding to that income: YE = C (YE) + I + G. Taxes are a new outflow of the circular flow of income, which join savings. Savings and taxes must finance investment and public spending (which are the inputs): S (YE) + T (YE) = I + G 41 Taxes as an instrument of fiscal policy To achieve macroeconomic objectives, the economic authority can use taxes to influence aggregate demand through private consumption: If the equilibrium income is lower than that of full employment (YE < Ype), an expansionary fiscal policy could be implemented by reducing taxes which, by increasing disposable income, would increase private consumption and, with it, aggregate demand (C + I + G). The new equilibrium would be for higher output and employment than at the outset. If the equilibrium income is higher than that of full employment (YE > Ype), the government could implement a contractionary fiscal policy: increase the tax burden to reduce disposable income; households spend less, total expenditure is reduced, and the new equilibrium would occur for output and employment below the starting ones. Automatic stabilizers Stabilizers are tools whose purpose is to smooth economic cycles and prevent fluctuations from having extreme peaks and valleys. An instrument is an automatic stabilizer when it "by itself" adjusts to the fluctuations of the economy, smoothing them out. This is what happens with taxes. When demand grows, taxes, being proportional to income, grow automatically, reducing disposable income and slowing down consumption, which is thus lower than it could be if taxes did not act in this way. If, for 42 On the contrary, demand is reduced, taxes are curbed with income pulling up disposable income and consumption, so that consumption is higher than it would be if taxes were held constant. The automatic adjustment of some stabilizers, precisely because they smooth economic swings, may sometimes be negative. For example, increasing tax revenues associated with a recovery phase after a recession can cause demand not to grow sufficiently and make it more difficult to exit the crisis. In such cases, the automatic effect of taxes is detrimental and is known as "fiscal drag". If, in addition, real economic growth goes hand in hand with an increase in prices, a "double fiscal brake" is produced, since higher monetary incomes cause tax collection, which is progressive, to grow even more, thus acting as a real brake on economic recovery. Automatic stabilizers do not dispense economic authorities to intervene directly whenever necessary, taking active measures → active stabilizers. Examples include: public works programs, employment promotion programs, social spending, tax rate changes, etc. c) Multiplier of the exogenous variables in the closed model with public sector The incorporation of the public sector into the model, and in particular the consideration of taxes, by affecting the slope of aggregate demand, causes the expression of the multiplier of the exogenous variables to change. The new expression of the multiplier (which serves for public expenditure and for investment) is as follows: 𝑑𝑌 1 𝑚= = = 𝑑𝐺 1 - 𝑑𝐺 1 - 𝑏 (1 - 𝑡) The effectiveness of fiscal policy instruments is different. Public spending, because it has a direct impact on aggregate demand, is more effective than taxes, which have a greater impact on aggregate demand. 43 The effect of these factors on aggregate demand through private consumption and, therefore, their effectiveness is hindered by the marginal propensity to consume. d) The public sector budget It includes the revenues and expenditures of public administrations. Like any other budget, it can be balanced, in deficit or in surplus. It is desirable that the state's accounts maintain a certain balance, since a continued imbalance has a perverse effect on the economy. Therefore, one of the major macroeconomic objectives is to ensure that there is an appropriate relationship between revenues and expenditures, with a medium- to long-term vision. The implementation of fiscal policy, through public spending and taxes, to ensure that the economy tends towards its major objectives, has an impact on the budgetary situation of the public sector. 44 4. INTRODUCTION TO THE EXTERNAL SECTOR MODEL a) Imports and exports A country's foreign trade depends on multiple factors: 1. Relationship between the prices of traded goods. 2. Price of coins. 3. International trade barriers or incentives. 4. Etc. The basic Keynesian model assumes that a country's imports (M) are directly related to its income. Exports (X) are included in the model as an exogenous variable. Net exports are the difference between exports and imports. b) The balance 45 c) The new multiplier 46 By way of summary: 47 48 TOPIC 7: MONEY, BANKS AND MONETARY POLICY 1. THE MONEY The different forms of holding wealth are called assets. We can distinguish: Real assets: these are physical assets. They are not a liability for anyone. Financial assets: are a liability for the economic unit that generates them. Assets embodying a claim. They are a right for the holder and an obligation (liability) for others (the issuer). Money is a financial asset with special characteristics: Medium of exchange: the only financial asset accepted as a means of payment by most individuals. Unit of account: measure of value to express how much goods and services are worth. Deferred payment pattern: the future value of an asset is expressed in money. Other characteristics of money are: Maximum security: An asset is all the more secure when there is less possibility of losing wealth if it is to be transformed into money. For this reason, the security of money is total. Total liquidity: When you want to dispose of an asset, you have to convert it into cash, and sometimes this is not easy. Liquidity, referring to an asset, is the ease with which it can be converted into money. Money is the most liquid asset, since it is not necessary to sell it to convert it into money. Zero return: People acquire assets not only to maintain wealth, but also to increase it. One of the disadvantages of money is that it has no return. Depreciation: it loses value in the face of price increases. Types of money: Commodity money: The material value of the good coincides with its exchange value. For a good to serve as commodity money it has to fulfill a series of characteristics: divisible, uniform, easily identifiable, easily transferable, durable. Fiduciary money: exchange value is superior to material value. Stages: 1. "Full content money" → its value was fully backed by precious metals and could be exchanged for them. 2. "Nominally convertible money" → in theory it could be converted, but not in practice. 3. At present, money has no precious metal backing. 49 Legal money: It is the one issued by the institution that has that function in each country. The legal money was the commodity money (gold, silver,...) minted by the kingdom, and t h e fiat money issued by the central banks is legal money. Bank money: Consists of indirect financial assets, issued by certain financial intermediaries, which are generally accepted as means of payment. Demand deposits held in banks that are mobilized by means of checks or credit cards. 2. the financial system It is made up of the set of institutions that serve as intermediaries between demanders and suppliers of financial resources. It comprises all financial flows between subjects and economic sectors. The reasons for the existence of financial intermediaries are: security, formation and aggregation of funds. The indirect financial asset has lower profitability than the primary asset but is safer and more liquid. Net interest margin: the difference between the interest rate at which financial intermediaries remunerate the funds they receive and the interest rate at which they charge for the funds they lend. 50 Not all financial flows are originated by the financing needs of the spending units → a significant portion seeks liquidity, profitability, etc. In order to meet the financing needs of companies and individuals, financial intermediaries must raise funds from savers, recognizing the debt they acquire from them through "indirect financial assets" (e.g., deposits). Financial assets created by companies directly in need of financing are called "primary financial assets" (e.g., stocks). When investing in financial assets, money providers have to consider and balance several factors: Liquidity: ease and certainty of converting the asset into cash in the short term. Profitability: capacity to generate interest. Risk: probability that the issuer will meet its commitments within the maturity of the asset. Financial intermediaries can be divided into two categories, depending on whether or not they can issue assets that are accepted as a means of payment. There are several classifications of financial asset markets, which are not mutually exclusive: 51 3. BANKS AND MONEY CREATION The purpose of banks, like that of any other company, is to achieve maximum profit. The purpose of banks, like that of any other business, is to maximize profit. ⎫ If we look at purely banking activity, the banking financial intermediary would maximize profit, in theory, if: Banking operations must comply with three characteristics to ensure the proper functioning of the system: Liquidity: the bank must be able to convert customer deposits into cash on demand. Profitability: the bank must achieve the profitability required by its shareholders. Solvency: the bank must have a set of assets and rights superior to its debts and obligations. Diagram of the balance sheet of a commercial bank: Banks must maintain as reserves part of the funds they raise for the purpose of To be able to handle the withdrawal of deposits from customers upon request Comply with the requirements of the monetary authority, which requires the maintenance of minimum reserves - legal or compulsory reserves - for security reasons and as a means of controlling the amount of money in the system. These reserves play an essential role in the money creation process and are determined by the cash ratio. 52 In a system with n banks, which adjust their reserves to the legal reserves and in which the public (individuals and firms) do not hold money in their hands, the creation of money as a consequence of an initial variation is given by the expression: Where the multiplier is: 4. THE CENTRAL BANK Central banks are the monetary authority in each country and are in charge of this economic policy. They are autonomous bodies and, therefore, do not answer to the government. In the particular case of the Eurozone, the Treaty on European Union (TEU) assigns to the European System of Central Banks (ESCB) the functions of designing and implementing monetary policy. The ESCB is composed of the European Central Bank (ECB) and the national central banks of the member states. The Banco de España, as a member of the ESCB, has, among others, the following functions: Define and conduct monetary policy for the euro area with the primary objective of maintaining price stability in the euro area as a whole → monetary policy decisions are taken in the ECB Council, which includes the governors of the national central banks. Carry out foreign exchange operations, in line with the provisions of the TUE. Promote the proper functioning of the payment system in the euro zone and at the national level. The Banco de España, as the national central bank, performs the following functions, among others: Custody and management of foreign exchange reserves and precious metals not transferred to the ECB. Issue and put into circulation banknotes and coins, subject to prior authorization by the ECB. It is the state bank, as such, it performs treasury functions, collections and payments on behalf of the state and is the financial agent of the public debt. Promote the proper functioning of the financial system. It is the bank of banks → safeguards the reserves of private banks, supervises their solvency and the compliance of credit institutions with the rules. 53 Although its main objectives are monetary, it also deals with other economic objectives (production, employment, etc.). Elaborate and publish statistics. Advise the government and prepare reports and studies. Represent Spain in international institutions. The balance sheet of a central bank records its banking operations: 5. THE MONETARY BASE AND THE MONEY SUPPLY Changes in the monetary base are at the origin of the money creation process. The monetary base (B) is the sum of cash held by the public and in banks' vaults plus banks' deposits at the central bank. Or, in other words, it is equal to the cash in the hands of the public plus the reserves of the banking system. The factors that cause the monetary base to vary are divided into autonomous or controllable, depending on whether or not the monetary authority can use them to influence the monetary base. The quantity of money or money supply (M) is the sum of cash in the hands of the public plus deposits in banks. It is usually represented by the letter M. The money supply multiplier shows the relationship between the monetary base and the money supply. It indicates the amount of money (money supply) created by a change in the monetary base. Where "e" is the ratio of cash held by the public to deposits, and "l" is the banking system's reserve ratio (reserves to deposits). 54 6. MONETARY POLICY. OBJECTIVES AND INSTRUMENTS 55 Although the objectives of monetary policy are the general objectives of the economy, the decisions taken in this area affect prices and the exchange rate more directly, through changes in the money supply. The instruments of monetary policy are the following: a) Legal ratios. This is a percentage of the liabilities that financial institutions must cover. It obliges institutions to maintain liquid funds above what the financial management of their treasury would require. b) Loans to the banking sector. They are monitored by means of their frequency, lending volume and interest rate. c) Open market operations. The central bank buys and sells government securities in the financial markets in order to regulate the liquidity of the system. d) Other instruments. Mandatory investment ratio: obliges financial institutions to allocate a percentage of their resources to certain investments → "privileged financing circuits". Rediscounting: granting of credits to banks with the guarantee of bills of exchange that they, in turn, have discounted to companies and individuals. The rediscount interest rate makes the rediscount attractive or not. 56

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