Markets · Policy · Open Economy
Managerial Economics
From invisible hands to exchange rate crises – every concept, formula, framework, and simulator for the final exam. Navigate by session. Use the cheat sheet. Run the numbers.
12 Sessions
6 Simulators
Inline Graphs
Formulas & Tables
MRU Video Links
Part I – Microeconomics
Sessions 1–5Session 01
Free Market & Its Limits
Price signals, externalities, asymmetric information, market failures
1Session 02
Supply & Demand
Curves, equilibrium, consumer & producer surplus, DWL
2Session 03
Elasticity & Equilibrium
PED, PES, revenue test, causal inference, crude oil case
3Session 04
Price Controls
Ceilings, floors, rent control, minimum wage, DWL
4Session 05
Taxation & Efficiency
Tax incidence, Laffer curve, DWL, carbon tax + simulators
5Part II – Macroeconomics
Sessions 6–8.2Session 06
GDP & CPI
National accounts, real vs nominal, price indices, elephant graph
6Session 07
Inflation & QTM
MV=PY, Fisher equation, costs of inflation, seigniorage
7Session 08
Business Fluctuations
AD–AS model, 4 scenarios, sticky wages, Great Depression
8Session 8.1
Monetary Policy & Fed
Fed tools pre/post-2008, money multiplier simulator, QE, ZLB
•Session 8.2
Fiscal Policy
Multipliers, crowding out, debt sustainability simulator, Japan
•Part III – Open Economy
Sessions 9–12Session 09
International Trade
Comparative advantage, tariff welfare analysis, China Shock
9Session 10
Industrial Policy
ISI vs EOI, CHIPS Act, YOZMA, China shipbuilding
10Session 11
Exchange Rate Policy
PPP, REER simulator, BoP, impossible trinity
11Session 12
Country Case: Genovia
IMF diagnostics, shock typology, full policy synthesis
12
Session 01 · Microeconomics
The Free Market & Its Limits
Why do markets work so well most of the time – and when exactly do they fail? Price signals, the invisible hand, externalities, and the two faces of asymmetric information.
Page:
1. The Invisible Hand & Price Signals
▼
Adam Smith's insight: individuals pursuing self-interest are guided by prices as if by an invisible hand to produce outcomes beneficial to society – with no central coordinator needed. The “I, Rose” example shows that no single person knows how to make even a simple product; markets coordinate dispersed knowledge through prices alone.
The Dual Role of Prices
Signal: conveys information about scarcity to all market participants without any central authority.
Incentive: motivates producers and consumers to act on that information.
“A price is a signal wrapped in an incentive.” – Tabarrok (MRU)
Incentive: motivates producers and consumers to act on that information.
“A price is a signal wrapped in an incentive.” – Tabarrok (MRU)
This is precisely why price controls are so distortionary: they sever the signal while scrambling the incentive. A gas price cap in a hurricane tells producers not to bring more supply exactly when scarcity is highest.
2. Market Failures – The Full Taxonomy
▼
Markets fail to achieve efficiency when private costs/benefits diverge from social costs/benefits, or when information is imperfect. These are the only legitimate economic justifications for government intervention.
| Failure Type | Mechanism | Market Result | Policy Fix |
|---|---|---|---|
| Negative Externality | Private cost < Social cost | Overproduction + DWL | Pigouvian tax, cap & trade |
| Positive Externality | Private benefit < Social benefit | Underproduction + DWL | Subsidy, public provision |
| Public Good | Non-rival, non-excludable | Free-rider → underprovision | Government provision |
| Adverse Selection | Pre-contract info asymmetry | Market unravelling (lemons) | Signalling, screening, mandates |
| Moral Hazard | Post-contract behaviour change | Excessive risk-taking | Deductibles, monitoring, co-pays |
| Market Power | Price-setter, not price-taker | Under-Q, over-P, DWL | Antitrust, regulation |
3. Externalities in Depth
▼
Negative Externality
A cost imposed on third parties not involved in the transaction. The firm ignores it, so output exceeds the social optimum and DWL is created.
Social Cost = Private Cost + External Cost
Efficient Q = where P = Marginal Social Cost (MSC)
Market Q = where P = Marginal Private Cost (MPC)
Overproduction = Market Q − Efficient Q
→ DWL = triangle between Q_eff and Q_market
Policy Responses Compared
| Tool | Mechanism | Key Drawback |
|---|---|---|
| Pigouvian Tax | Tax = external cost → internalises externality | Requires knowing exact external cost |
| Cap & Trade | Set quantity limit; firms trade permits | Permit price volatility |
| Regulation | Command-and-control emission limits | Ignores cost differences across firms |
| Coase Theorem | Clear property rights + low transaction costs → private bargaining reaches efficient outcome | Breaks down with many parties or high transaction costs |
4. Asymmetric Information: Adverse Selection vs Moral Hazard
▼
| Adverse Selection | Moral Hazard | |
|---|---|---|
| Timing | Pre-contract | Post-contract |
| Who holds info | Seller knows quality; buyer does not | Insured party hides future actions |
| Classic example | Akerlof used car market – lemons drive out good cars | Car owner drives recklessly after full insurance |
| Market outcome | Bad quality drives out good; market collapse | Excessive risk-taking; overconsumption |
| Fix | Signalling (warranties, credentials), screening, mandates | Deductibles, co-pays, monitoring, vesting |
Exam Trap
Adverse selection = pre-contract info problem. Moral hazard = post-contract behaviour problem. Mix these up and you will lose marks on any question about insurance, banking, or hiring.
5. MRU Videos & Key Links
▼
Session 02 · Microeconomics
Markets, Supply & Demand
How prices and quantities are determined by the interaction of buyers and sellers. The welfare geometry of markets: consumer surplus, producer surplus, and deadweight loss.
Page:
1. The Demand Curve & Its Shifters
▼
The demand curve shows the inverse relationship between price and quantity demanded, holding all else constant (ceteris paribus). It slopes downward due to the substitution effect and diminishing marginal utility.
Critical Distinction
Change in quantity demanded = movement along the curve (caused only by a price change).
Change in demand = shift of the entire curve (caused by any non-price factor).
Change in demand = shift of the entire curve (caused by any non-price factor).
| Demand Shifter | Demand Increases If… | Demand Decreases If… |
|---|---|---|
| Income (normal good) | Income rises | Income falls |
| Income (inferior good) | Income falls | Income rises |
| Price of substitutes | Substitute price rises | Substitute price falls |
| Price of complements | Complement price falls | Complement price rises |
| Tastes & preferences | Good becomes fashionable | Good becomes unfashionable |
| Expected future price | Price expected to rise (buy now) | Price expected to fall (wait) |
| Number of buyers | Population / market grows | Population / market shrinks |
2. The Supply Curve & Its Shifters
▼
The supply curve shows the positive relationship between price and quantity supplied. It slopes upward because higher prices justify higher opportunity costs and attract more producers.
| Supply Shifter | Supply Increases If… | Supply Decreases If… |
|---|---|---|
| Input costs | Input prices fall (e.g. oil, labour) | Input prices rise |
| Technology | Productivity improves | Tech regresses (rare) |
| Number of sellers | New firms enter the market | Firms exit the market |
| Expectations | Future price expected lower (sell now) | Future price expected higher (hold back) |
| Government policy | Subsidy granted | Tax imposed |
| Natural conditions | Good harvest / weather | Drought / disaster |
3. Equilibrium, Surplus & Deadweight Loss
▼
Equilibrium: Qd = Qs at price P*
Consumer Surplus (CS) = area below demand, above P*
= value buyers place on good minus what they pay
Producer Surplus (PS) = area above supply, below P*
= revenue minus opportunity cost of production
Total Surplus (TS) = CS + PS ← maximised at P*, Q* (efficiency)
Deadweight Loss (DWL) = TS lost when Q ≠ Q*
= triangle between old Q* and new Q
Supply & Demand – Equilibrium, CS and PS
At P*, Q*: Total Surplus = CS (gold) + PS (crimson) is maximised. Any deviation creates DWL.
Uber Consumer Surplus – Course Example
Uber's estimated consumer surplus was $7bn against total revenues of only $4bn. This means consumers valued Uber rides at nearly 3× what they paid – a massive welfare gain invisible to revenue figures. CS is the better welfare measure.
Session 03 · Microeconomics
Crude Oil – Elasticity Case
Elasticity & Equilibrium
How responsive are buyers and sellers to price changes? Elasticity determines tax burden distribution, revenue effects of price changes, and how to extract demand curves from real data without bias.
Page:
1. Price Elasticity of Demand (PED)
▼
PED = % change in Qd / % change in P = (ΔQ/Q) / (ΔP/P)
Always negative (downward sloping demand) – use absolute value for comparisons
|PED| > 1 → Elastic – consumers very responsive (many substitutes)
|PED| < 1 → Inelastic – consumers not very responsive (necessities)
|PED| = 1 → Unit elastic – revenue is maximised here
|PED| = 0 → Perfectly inelastic (vertical demand – e.g. insulin)
|PED| = ∞ → Perfectly elastic (horizontal demand – perfectly competitive firm)
Total Revenue Test
Elastic demand (|PED| > 1): P↑ → TR↓ | P↓ → TR↑
Inelastic demand (|PED| < 1): P↑ → TR↑ | P↓ → TR↓
Unit elastic (|PED| = 1): Price change → TR unchanged
Determinants of PED
| Factor | More Elastic If… | More Inelastic If… |
|---|---|---|
| Substitutes | Many close substitutes available | Few or no substitutes |
| Necessity vs Luxury | Luxury good (holiday, jewellery) | Necessity (food, medicine, fuel) |
| Time horizon | Long run (more time to adjust) | Short run (habits / contracts lock in) |
| Share of budget | Large share of income | Small (trivial) share of income |
| Market definition | Narrowly defined (e.g., Coke Zero) | Broadly defined (e.g., beverages) |
2. PES, Cross-Price & Income Elasticities
▼
PES = % change in Qs / % change in P (always positive)
Cross-Price Elasticity = % ΔQd good A / % ΔP good B
Positive → substitutes (coffee & tea)
Negative → complements (cars & petrol)
Income Elasticity = % ΔQd / % ΔIncome
> 0 → normal good
> 1 → luxury good (income-elastic)
< 0 → inferior good (bus rides, instant noodles)
PES determinants: production flexibility, input availability, time horizon (long run always more elastic as capacity adjusts), and whether the good is storable (storable goods have more elastic supply as inventory acts as a buffer).
3. Crude Oil Case – The Identification Problem
▼
You cannot simply regress quantity on price to get the demand elasticity. Observed price-quantity combinations are the intersection of supply AND demand. If both curves are shifting simultaneously, OLS traces out neither.
Identification Problem
A scatter plot of crude oil price vs. consumption data doesn't trace a demand curve. If supply shifts right (US shale boom) while demand is stable, the observed points trace the demand curve. If demand shifts while supply is stable, they trace the supply curve. Without knowing which curve shifted, OLS estimates are biased.
Valid Strategy: Use the Shale Supply Shock
The US shale oil revolution (2014–2019) caused a large exogenous outward shift in supply while demand was relatively stable. Using price-quantity data from this period allows estimation of the demand elasticity by holding the demand curve roughly constant.
Crude oil demand PED ≈ −0.06 to −0.10 (short run, very inelastic)
→ A 42% price reduction only reduces global consumption ~5%
→ Long-run elasticity significantly higher as substitution becomes possible
Policy Implication
Very inelastic demand means carbon taxes / fuel taxes must be very large to meaningfully reduce consumption. But the tax revenue is high, which can be recycled (e.g., Canada's carbon rebate). This is why time horizon matters: short-run inelastic demand becomes more elastic as EV adoption grows.
4. MRU Videos & Key Links
▼
Elasticity of Demand
MRUCalculating the Elasticity of Demand
MRUOffice Hours: Elasticity of Demand
MRUElasticity of Supply
MRUElasticity of Supply: Why Housing is Unaffordable
MRUElasticity of Supply: Do Gun Buybacks Work?
MRU
Session 04 · Microeconomics
Rent Control · Minimum Wage · Uber CS
⚙ Tax Incidence Simulator
Price Controls & Tax Incidence
When governments override the market price. Ceilings create shortages; floors create surpluses. Both destroy total surplus. And whoever legally pays a tax is not necessarily who economically bears it.
Page:
1. Price Ceilings – Binding Below Equilibrium
▼
A price ceiling sets a maximum legal price below equilibrium (Pceil < P*). If set above P*, it is non-binding and has no effect.
At P_ceil < P*:
Qd > Qs → Shortage
CS: mixed – rises for lucky buyers (pay less), falls for rationed buyers (get nothing)
PS: always falls (lower price, fewer units sold)
DWL: triangle between Qs and Q* on the supply-demand diagram
Price Ceiling – Shortage & DWL
P₀ = price ceiling (below P*). Qs < Qd creates a shortage. DWL triangle (crimson) = foregone surplus from trades that don't happen.
Exam Trap – CS Under a Ceiling
CS does NOT automatically rise under a price ceiling. Lucky buyers gain (pay less), but rationed buyers lose entirely. Net CS effect depends on elasticities. Total surplus always falls. Never say “consumers benefit from price controls” without qualification.
Hidden Costs Beyond the DWL Triangle
- Search costs: time spent queuing or hunting for the good
- Quality deterioration: sellers cut costs since price is capped
- Misallocation: good goes to first/luckiest buyer, not highest-value buyer
- Black markets: illegal transactions emerge at market-clearing prices
Rent control: Short run → some renters pay less. Long run → housing supply shrinks (landlords convert units, defer maintenance), quality falls, black markets (“key money”) emerge. Mumbai and New York are the canonical cases of severe long-run housing shortage from rent control.
2. Price Floors – Binding Above Equilibrium
▼
A price floor sets a minimum legal price above equilibrium (Pfloor > P*). Creates a surplus (excess supply).
At P_floor > P*:
Qs > Qd → Surplus
CS: always falls (higher price, fewer units consumed)
PS: mixed – rises for sellers who still sell, falls for those priced out
DWL: triangle between Qd and Q*
Minimum Wage – Price Floor in the Labour Market
| Scenario | Effect on Employment |
|---|---|
| Min wage > market wage (binding) | Labour surplus → unemployment rises (Qs labour > Qd labour) |
| Min wage < market wage (non-binding) | No effect on employment |
| Monopsony labour market | Min wage can increase employment (market wage was below competitive level) |
US federal minimum wage = $7.25/hr (unchanged since 2009). The Raise the Wage Act (2021, proposed $15/hr) passed the House but stalled in the Senate. Many states set higher floors independently.
3. Welfare Analysis Summary
▼
| Price Ceiling | Price Floor | |
|---|---|---|
| Set at | Below P* | Above P* |
| Quantity traded | Falls (Qs < Q*) | Falls (Qd < Q*) |
| Market outcome | Shortage (Qd > Qs) | Surplus (Qs > Qd) |
| Consumer Surplus | Ambiguous (mixed) | Falls |
| Producer Surplus | Falls | Ambiguous (mixed) |
| Total Surplus | Falls (DWL created) | Falls (DWL created) |
| Example | Rent control, gas caps | Minimum wage, agricultural support |
⚙ Tax Incidence Simulator
▼
Who economically bears a tax depends on relative elasticities, not who legally pays it. Adjust the sliders to see how burden shifts.
Tax Incidence Calculator
|PED| – Demand Elasticity
0.8
PES – Supply Elasticity
1.2
Tax per unit ($)
–
Buyer bears
–
Seller bears
RuleThe more inelastic side bears a greater share. The legal payer is irrelevant – the wedge is identical whether tax is levied on buyer or seller.
5. MRU Videos & Key Links
▼
Price Ceilings: US Economy in the 1970s
MRUHow Price Ceilings Create Shortages
MRUPrice Ceilings: Deadweight Loss
MRUPrice Ceilings: Rent Controls
MRUPrice Floors: The Minimum Wage
MRUWhy Do Governments Enact Price Controls?
MRU
Session 05 · Microeconomics
Canada Carbon Tax · Trump Tax Cuts
⚙ Laffer Curve Explorer
Taxation & Market Efficiency
Taxes create wedges between buyer and seller prices, generate revenue, and destroy surplus. Who bears the burden has nothing to do with who legally pays – and raising rates doesn't always raise revenue.
Page:
1. Tax Incidence – Who Really Pays?
▼
Tax incidence is the economic burden of a tax – who actually bears the cost, regardless of legal assignment. The legal payer is irrelevant; only elasticities determine incidence.
Burden on Buyers = P_buyer − P*
Burden on Sellers = P* − P_seller
Tax wedge = P_buyer − P_seller = t
Key Rule: The more inelastic side bears MORE of the tax burden.
→ Inelastic demand: buyers pay more | Inelastic supply: sellers pay more
→ Assigning tax to buyer vs seller produces IDENTICAL outcomes
| Scenario | Who Bears the Tax? | Why |
|---|---|---|
| Perfectly inelastic demand | 100% buyers | Buyers pay any price; sellers pass on full tax |
| Perfectly elastic demand | 100% sellers | Any price rise eliminates all demand |
| Perfectly inelastic supply | 100% sellers | Fixed supply; sellers can't pass it on |
| Perfectly elastic supply | 100% buyers | Any price cut eliminates all supply |
| Equal elasticities | 50/50 split | Symmetric responsiveness |
2. Tax Revenue, DWL & the Efficiency Cost
▼
Tax Revenue = t × Q_tax
DWL = ½ × t × ΔQ
= triangle between old Q* and new Q_tax
DWL grows with the square of the tax rate:
→ Double the tax → quadruple the DWL (if elasticities constant)
→ Therefore: tax inelastic goods (small DWL per dollar of revenue)
→ This is why cigarettes, alcohol & petrol face the highest excise taxes
3. Marginal vs Average Tax Rates
▼
Average Tax Rate (ATR) = Total Tax Paid / Total Income
Marginal Tax Rate (MTR) = Tax on the next dollar of income
Progressive: MTR > ATR (rates rise with income – most income tax systems)
Flat: MTR = ATR (single rate regardless of income)
Regressive: MTR < ATR (e.g. payroll tax with cap)
Exam Trap – Tax Bracket Confusion
Moving into a higher bracket does NOT mean all income is taxed at the higher rate. Only income above the threshold faces the higher marginal rate. Your ATR is always ≤ MTR in a progressive system. This is one of the most common public misconceptions about taxation.
4. The Laffer Curve & Revenue-Maximising Tax Rate
▼
Revenue = Tax Rate × Tax Base
At t = 0%: Revenue = 0 (no tax collected)
At t = 100%: Revenue = 0 (no one works / declares income)
→ Revenue peaks at some t* between 0% and 100%
If current rate < t*: cutting taxes reduces revenue
If current rate > t*: cutting taxes increases revenue (Laffer argument)
→ Empirical evidence: most advanced economies are BELOW t*
→ Tax cuts do NOT pay for themselves in most real-world cases
The Laffer Curve – Tax Revenue vs Tax Rate
Revenue peaks at t*. The Laffer argument only holds if the economy is on the right-hand side of t*. Most empirical evidence places advanced economies on the left.
⚙ Laffer Curve Explorer
▼
Estimate tax revenue under a simple quadratic Laffer model. Set the revenue-maximising rate t* and the current tax rate to see where the economy sits.
Laffer Curve Revenue Calculator
Current Tax Rate (%)
45%
Revenue-Max Rate t* (%)
60%
Tax Base (GDP $bn)
–
Est. revenue ($bn)
–
Max revenue at t* ($bn)
–
% of max achieved
5. Carbon Tax – Pigouvian Policy Case
▼
A carbon tax is a Pigouvian tax set equal to the social cost of carbon (SCC), designed to internalise the negative externality of CO&sub2; emissions and restore social efficiency.
| Carbon Tax | Cap & Trade | |
|---|---|---|
| Certainty on… | Price (firms know cost) | Quantity (emissions capped) |
| Uncertainty on… | Quantity (how much reduction?) | Price (permit price volatile) |
| Revenue | Govt collects; can recycle to households | Depends on permit allocation |
| Political feasibility | Harder (explicit tax) | Easier (indirect, tradeable) |
| Canada example | Carbon price + income rebate = revenue-neutral; lower-income households net positive | Provincial cap-and-trade systems alongside |
Canada’s Design
Canada returns all federal carbon tax revenue to households via a “Climate Action Incentive” rebate. Lower-income households typically receive more than they pay (they consume fewer carbon-intensive goods), making this a progressive policy despite being a flat per-unit tax.
Session 06 · Macroeconomics
Real-Time Inequality · Elephant Graph
Measuring Economic Activity – GDP & CPI
How we measure the size of an economy, the level of prices, and whether growth reaches everyone. GDP components, real vs nominal, the CPI basket, and the distributional limits of aggregate statistics.
Page:
1. GDP – Definition, Components & Exclusions
▼
GDP is the market value of all final goods and services produced within a country in a given period of time. (Kuznets, 1934 – presented to the US Congress as “National Income, 1929–35”)
Expenditure Approach:
GDP = C + I + G + NX
C = Private consumption (households)
I = Business investment (fixed capital + inventory changes)
G = Government spending on goods & services (NOT transfers)
NX = Net exports = Exports − Imports
Income Approach: Sum of all factor incomes (wages + profits + rents + interest)
Output / Value-Added: Sum of value added at each production stage
What GDP Excludes
- Intermediate goods – only final goods (avoids double-counting)
- Transfer payments – social security, unemployment benefits (not production)
- Non-market production – household work, volunteer activity
- Underground / informal economy
- Environmental degradation – resource depletion not subtracted
- Income distribution – GDP per capita misses who gets the growth
2. Real vs Nominal GDP & Price Indices
▼
Nominal GDP = current quantities × current prices
Real GDP = current quantities × base-year prices
→ removes inflation to show true output growth
GDP Deflator = (Nominal GDP / Real GDP) × 100
→ broadest price index; covers all goods in the economy
Real GDP Growth ≈ Nominal GDP Growth − Inflation
| CPI | GDP Deflator | PCE (Fed preferred) | |
|---|---|---|---|
| Coverage | Fixed consumer basket | All goods in GDP | Household consumption, chain-weighted |
| Basket | Fixed (Laspeyres – substitution bias) | Current production weights | Chain-weighted (adjusts for substitution) |
| Includes imports? | Yes | No (domestic only) | Yes |
| Used for | COL adjustments, wage indexing | Macro analysis | Fed 2% inflation target |
| Bias | Overstates inflation (substitution) | Less bias | Lowest bias |
CPI Substitution Bias
CPI uses a fixed basket. When beef prices rise, consumers switch to chicken – but CPI still prices the original beef-heavy basket. This overstates the true cost of living. The Fed uses PCE precisely because it corrects for this substitution.
3. The Lorenz Curve & GINI Coefficient
▼
GINI Coefficient = Area A / (Area A + Area B)
= Area between Lorenz curve and line of equality
divided by total area below the equality line
Range: 0 (perfect equality) → 1 (perfect inequality)
Typical values: Nordics ~0.25 | US ~0.39 | South Africa ~0.63
Lorenz Curve – Income Distribution
GINI = A / (A + B). The more bowed the Lorenz curve, the greater the inequality and the larger the GINI coefficient.
4. The Elephant Graph – Who Got the Growth? (Milanovic)
▼
Branko Milanovic's Elephant Graph (2016) shows real income growth by global income percentile over 1988–2008. It reveals a striking distributional story that aggregate GDP masks entirely.
The Elephant Graph – Real Income Growth by Global Percentile (1988–2008)
The “elephant” shape: high growth for the global poor and middle class (trunk raised), a dip for the developed-world middle class (back of the elephant), and a surge for the global top 1% (trunk tip). Source: Milanovic (2016).
Why This Matters for Policy
Global GDP grew substantially over this period, but the gains were deeply unequal. The developed-world middle class (70th–80th global percentile) saw near-zero real income growth – this distributional outcome helps explain the political backlash against globalisation, rising populism, and trade protectionism post-2016.
Session 07 · Macroeconomics
Zimbabwe Hyperinflation · Seigniorage
Inflation & the Quantity Theory of Money
Why do prices rise? The Quantity Theory links money supply growth to inflation in the long run. The Fisher equation links nominal and real interest rates. And seigniorage explains why governments are sometimes tempted to print money.
Page:
1. The Quantity Theory of Money (QTM)
▼
M × V = P × Y
M = Money supply (stock of money in circulation)
V = Velocity of money (how often each unit is spent per period)
P = Price level (general level of prices)
Y = Real GDP (output)
Growth rate form: %ΔM + %ΔV = %ΔP + %ΔY
If V is stable (%ΔV ≈ 0) and Y grows at its natural rate (%ΔY = g):
Inflation (%ΔP) ≈ %ΔM − g
→ "Inflation is always and everywhere a monetary phenomenon" – Milton Friedman
→ In the long run, excess money supply growth causes inflation 1-for-1
Zimbabwe Case
Zimbabwe printed money to finance government spending after farmland seizures collapsed the tax base. M grew at >100,000% annually. V also rose (people spent money immediately before it lost value), amplifying inflation further. The central bank eventually printed a $100 trillion note – worth about US$0.40 at the time.
2. The Fisher Equation – Real vs Nominal Interest Rates
▼
Fisher Equation (exact):
(1 + i) = (1 + r)(1 + π)
Fisher Equation (approximate – use this one):
i ≈ r + π
i = nominal interest rate (what the bank quotes)
r = real interest rate (purchasing power gain)
π = inflation rate (expected, π³, for ex-ante; actual for ex-post)
Ex-ante real rate: r = i − π³ (expected inflation)
Ex-post real rate: r = i − π (actual inflation)
Unexpected inflation ↑: debtors gain, creditors lose (real debt burden falls)
Unexpected inflation ↓: debtors lose, creditors gain (real debt burden rises)
Exam Trap
The Fisher equation says a 1pp rise in expected inflation leads to a 1pp rise in the nominal rate (Fisher effect), leaving the real rate unchanged. But this is a long-run result. In the short run, central banks can push real rates below zero by keeping nominal rates low while inflation rises – this is exactly what happened post-2008 with QE.
3. Costs of Inflation
▼
| Cost | Mechanism | Who Is Hurt Most |
|---|---|---|
| Shoe-leather costs | People hold less cash, make more frequent bank trips to preserve value | Everyone; worse in high-inflation economies |
| Menu costs | Firms must update prices frequently (menus, catalogues, systems) | Retailers, restaurants, e-commerce |
| Price confusion | Hard to distinguish relative price changes from general inflation – distorts resource allocation | Firms making investment decisions |
| Money illusion | People mistake nominal gains for real gains; miscalculate savings adequacy | Workers, unsophisticated investors |
| Redistribution | Transfers real wealth from creditors to debtors (unexpected inflation only) | Pensioners, bondholders, savers |
| Tax distortions | Bracket creep; capital gains taxes on purely nominal gains; erodes real value of tax thresholds | Taxpayers in non-indexed systems |
| Financial disintermediation | High inflation → negative real rates → people avoid bank deposits → credit dries up | Borrowers; economic growth broadly |
4. Seigniorage – The Inflation Tax
▼
Seigniorage = Revenue from money creation
= (ΔM / P) = (%ΔM) × (M/P)
→ The government captures real resources by printing money
→ Equivalent to a tax on money holders: the real value of cash balances falls
Laffer Curve for Seigniorage:
As inflation rises → people hold LESS cash (M/P falls)
→ At very high inflation, seigniorage revenue actually falls
→ This is why hyperinflation is self-defeating: the money base collapses
When Governments Resort to Seigniorage
Governments typically print money when: (1) they face a fiscal crisis with no bond market access, (2) they are politically unable to raise taxes or cut spending, (3) the central bank is not independent. All three applied in Zimbabwe, Weimar Germany, and Venezuela. Independent central banks exist precisely to prevent this.
5. MRU Videos & Key Links
▼
Quantity Theory of Money
MRUZimbabwe and Hyperinflation
MRUUnderstanding Inflation and CPI
MRUCosts of Inflation: Price Confusion & Money Illusion
MRUCosts of Inflation: Financial Intermediation Failure
MRUWhy Governments Create Inflation
MRUHow Money Supply Drives Inflation
MRU
Session 08 · Macroeconomics
Great Depression · Japan Lost Decades
Business Fluctuations – The AD–AS Model
The central diagnostic framework for macroeconomics. Four scenarios tell you whether to stimulate or contract, and in which direction. Sticky wages explain why recessions persist. The Great Depression is the stress test.
Page:
1. The AD–AS Framework
▼
| Curve | Slope | Represents | Key Shifters |
|---|---|---|---|
| AD | Downward | Total spending (C+I+G+NX) at each price level | Fiscal policy, monetary policy, confidence, exchange rates |
| SRAS | Upward | Output firms supply at each price (short run) | Input costs (wages, oil), supply shocks, technology |
| LRAS | Vertical at Y* | Potential output at full employment | Population, capital stock, technology, institutions |
AD–AS – Long-Run Equilibrium at Y*
At long-run equilibrium E: AD = SRAS = LRAS at price level P* and potential output Y*. Any deviation from Y* creates an output gap.
2. The Four Diagnostic Scenarios
▼
| Scenario | Cause | Symptoms | Policy Recipe |
|---|---|---|---|
| Recessionary Gap | AD shifts left (negative demand shock) | Y < Y*, unemployment ↑, prices fall or stagnate | Expansionary fiscal or monetary policy |
| Inflationary Gap | AD shifts right (positive demand shock) | Y > Y*, unemployment ↓, prices rise | Contractionary fiscal or monetary policy |
| Stagflation | SRAS shifts left (negative supply shock) | Y < Y* AND prices rise simultaneously | Policy dilemma: fight inflation OR recession, not both |
| Steady-State | AD = SRAS = LRAS | Y = Y*, stable inflation, full employment | No intervention needed |
Stagflation is the Hard Case
In stagflation (1970s oil shock), stimulating AD fights the recession but worsens inflation. Contracting AD fights inflation but deepens the recession. Policy must pick the lesser evil, or wait for the supply shock to reverse. This is why the 1979 Volcker shock (aggressive rate hikes) was so painful in the short run.
3. Sticky Wages – Why SRAS Slopes Upward
▼
Wages are sticky downward: workers resist nominal wage cuts, and contracts lock in wages for months or years. This is the mechanism that makes short-run analysis different from long-run analysis.
Real Wage = Nominal Wage (W) / Price Level (P)
If P falls (recession) and W is sticky:
Real wage (W/P) rises → labour becomes more expensive
→ Firms hire fewer workers → output falls below Y*
→ Economy stays in recessionary gap until W eventually adjusts down
If P rises (boom) and W is sticky:
Real wage (W/P) falls → labour becomes cheaper
→ Firms hire more workers → output rises above Y*
→ This is exactly why SRAS slopes upward: P↑ → real wage↓ → Q↑
Long-run self-correction: Eventually wages adjust down in a recession → SRAS shifts right until Y = Y* again. But as Keynes noted: “In the long run we are all dead.” – the case for active stabilisation policy.
4. The Business Cycle – Output Gap Over Time
▼
Business Cycle – Actual vs Potential GDP
The economy oscillates around potential GDP (Y*). Inflationary gaps (actual above Y*) call for contraction; recessionary gaps call for stimulus.
5. The Great Depression as AD–AS Case Study
▼
The Great Depression (1929–1939) resulted from three simultaneous AD-collapsing mechanisms – a perfect storm of demand destruction.
Three Mechanisms
- Consumer pessimism: 1929 stock market crash destroyed wealth and confidence → C collapsed sharply
- Banking crisis: 9,000+ bank failures dried up credit → I collapsed; Hoover's balanced-budget doctrine worsened it
- Fed policy error: Fed allowed M to fall 30% (gold standard constraint) instead of expanding – the definitive lesson of Friedman & Schwartz (1963)
Policy Lesson
Large, coordinated demand shocks can keep economies below Y* for a decade when sticky wages slow self-correction. The New Deal and ultimately WWII spending (massive G expansion) restored demand. Modern central banks now expand aggressively in crises precisely because of this lesson.
6. MRU Videos & Key Links
▼
Intro to Business Fluctuations
MRUThe Aggregate Demand Curve
MRUThe Long-Run Aggregate Supply Curve
MRUSticky Wages
MRUThe Short-Run Aggregate Supply Curve
MRUUnderstanding the Great Depression
MRUOffice Hours: Using the AD-AS Model
MRUOffice Hours: Multiple Shocks
MRU
Session 8.1 · Macroeconomics
Fed Pre & Post 2008 · QE
⚙ Money Multiplier Simulator
Monetary Policy & the Federal Reserve
How central banks expand or contract the money supply to stabilise the economy. The Fed's toolkit changed fundamentally after 2008. The zero lower bound problem forced unconventional tools: QE, forward guidance, IOER.
Page:
1. Money Creation & the Money Multiplier
▼
Money Multiplier = 1 / Reserve Requirement Ratio (rr)
→ A $100 deposit with rr = 10% creates up to $1,000 in total deposits
M1 = Currency in circulation + Demand deposits
M2 = M1 + savings deposits + money market funds
Monetary Base = Currency + Bank reserves held at the Fed
= The Fed directly controls the monetary base
Money Supply = Money Multiplier × Monetary Base
Note: Since March 2020, reserve requirements = 0%. The multiplier
mechanism is now driven by bank lending decisions, not a legal floor.
⚙ Money Multiplier Simulator
▼
See how fractional reserve banking creates money from an initial deposit. Adjust the reserve ratio to observe the multiplier effect.
Money Multiplier Calculator
Reserve Ratio (%)
10
Initial Deposit ($)
–
Money multiplier
–
Total deposits created
–
New money created
2. Fed Tools – Before vs After 2008
▼
| Tool | Pre-2008 Use | Post-2008 Change |
|---|---|---|
| Fed Funds Rate (FFR) | Primary target; set via open market operations in T-bills | Still primary target; now managed with IOER/ON-RRP corridor system |
| Open Market Ops | Buy/sell short-term T-bills to add/drain reserves | Expanded to MBS and long-term Treasuries (QE programmes) |
| Discount Rate | Rate on emergency loans at Fed window; acts as ceiling | Unchanged structure; used more actively during crises |
| Reserve Requirements | Key mechanism for money multiplier | Set to 0% in March 2020 – now essentially irrelevant |
| IOER / ON-RRP | Did not exist | IOER = effective floor for FFR; ON-RRP = lower bound for non-banks |
| Quantitative Easing (QE) | Did not exist | Balance sheet expanded from $900bn (2008) to ~$9tn (2022) |
| Forward Guidance | Minimal; Fed rarely committed to future rates | Major tool: committing to rate path shapes expectations directly |
3. Monetary Policy Best-Case vs Dilemma
▼
| Scenario | Diagnosis | Monetary Response | Outcome |
|---|---|---|---|
| Recessionary gap (demand shock) | Y < Y*, inflation falling | Cut FFR → expand M → AD shifts right | Best case: restore Y* without inflation trade-off |
| Inflationary gap (demand shock) | Y > Y*, inflation rising | Raise FFR → contract M → AD shifts left | Best case: reduce inflation without deep recession |
| Stagflation (supply shock) | Y < Y* AND inflation rising | Dilemma: cut rates → more inflation; hike rates → deeper recession | No good option; accept one or wait for shock to reverse |
The Zero Lower Bound (ZLB) Problem
When FFR hits 0%, conventional monetary policy loses traction – you can't cut rates further. Negative interest rate policy (NIRP) is possible but limited (cash hoarding). This is why the 2008 recession required QE, forward guidance, and ultimately fiscal stimulus. The ZLB is why the Keynesian case for fiscal policy is strongest in deep recessions.
4. MRU Videos & Key Links
▼
Monetary Policy and the Federal Reserve
MRUWhat Is Money?
MRUFractional Reserve Banking & Money Multiplier
MRUHow the Fed Worked: Before the Great Recession
MRUHow the Fed Works: After the Great Recession
MRUThe Fed as Lender of Last Resort
MRUMonetary Policy: Negative Real Shock Dilemma
MRU
Session 8.2 · Macroeconomics
Japan Lost Decades · Debt Dynamics
⚙ Multiplier & Debt Simulators
Fiscal Policy
Government spending and taxes as tools of economic stabilisation. How multipliers amplify fiscal decisions. Why crowding out limits their power. And when debt becomes unsustainable – the r vs g equation.
Page:
1. Fiscal Multipliers
▼
Spending Multiplier = 1 / (1 − MPC) = 1 / MPS
Tax Multiplier = −MPC / (1 − MPC) = −MPC / MPS
Balanced Budget Multiplier = 1 (equal ΔG and ΔT → net ΔY = ΔG)
MPC = Marginal Propensity to Consume (e.g. 0.8)
MPS = Marginal Propensity to Save = 1 − MPC
Example with MPC = 0.8:
Spending multiplier = 1 / 0.2 = 5
Tax multiplier = −0.8 / 0.2 = −4
→ Government spending is more potent than a tax cut of the same size
→ Because spending directly adds to AD; tax cuts depend on MPC to kick in
⚙ Fiscal Multiplier Calculator
▼
Fiscal Multiplier Calculator
MPC (0–0.99)
0.8
Policy Size ($bn)
Policy Type
Crowding Out (%)
20
–
Raw multiplier
–
After crowding out
–
ΔGDP
2. Crowding Out & Limits of Fiscal Policy
▼
Crowding out: deficit-financed government spending raises demand for loanable funds → interest rates rise → private investment falls. The fiscal stimulus partially offsets itself.
| Limit | Mechanism | Severity |
|---|---|---|
| Crowding out | Higher interest rates reduce private investment | Moderate (worse at full employment, less at ZLB) |
| Time lags | Recognition → legislation → implementation → effect: 12–24 months | Stimulus often arrives post-recovery; destabilising |
| Ricardian equivalence | Rational agents save tax cuts to pay future taxes → MPC ≈ 0 on lump-sum transfers | Partially true; weakens tax cut multiplier |
| Open economy leakage | Stimulus partly spent on imports → multiplier smaller in open economy | Higher for closed economies |
| Debt sustainability | High debt → higher rates → more debt → potential spiral | Critical at debt/GDP > 90–100% |
Automatic Stabilisers
These operate without legislation, dampening cycles automatically:
- Progressive income tax: tax revenue falls in recessions (automatic cut) and rises in booms (automatic drag)
- Unemployment insurance: payouts rise in recessions, supporting consumer spending without any vote
- Welfare programmes: enrollment rises automatically as incomes fall
3. Debt Dynamics – The r vs g Equation
▼
Debt Dynamics Equation:
Δ(Debt/GDP) = Primary Deficit/GDP + (r − g) × (Debt/GDP)
r = real interest rate on government debt
g = real GDP growth rate
Primary Deficit = spending (ex-interest) minus tax revenue
Debt is sustainable if: r < g (growth outpaces borrowing cost)
Debt is snowballing if: r > g (interest compounds faster than economy grows)
Japan: Debt/GDP > 260% BUT r ≈ 0% and g ≈ 1% → historically stable
Japan is the outlier: domestically held debt, currency sovereignty, strong institutions
Risk: rising global rates (2022–) now threatening Japan’s unique position
⚙ Debt Sustainability & Required Growth Calculator
▼
Using the course framework: given a country’s debt, interest rate, and fiscal position – what nominal and real GDP growth is needed to stabilise the debt ratio?
Debt stabilises when: g_n* = (1+r_n) × b/(b+s) − 1
Required real growth: g_r* = g_n* − π
r_n = nominal interest rate | b = debt/GDP | s = primary surplus/GDP | π = inflation
Required Growth Rate Calculator
Nominal Interest Rate on Debt (%)
Inflation Rate π (%)
Current Debt/GDP (%)
Primary Deficit/GDP (+ = deficit)
Actual Nominal Growth g (%)
–
Required nominal growth g_n*
–
Required real growth g_r*
–
Actual vs required gap
–
ΔDebt/GDP this year
📌 Try Japan: r=1.0, π=2.5, Debt=260, PD=3.0, g=1.5 • Spain 2025: r=3.8, π=2.5, Debt=105, PD=3.0, g=2.8
4. Japan – Fiscal Policy at Its Limits
▼
Japan has run near-continuous fiscal deficits since its asset bubble collapsed in 1990. The “Lost Decades” involved repeated stimulus packages that supported demand but failed to restore sustained growth. Japan's debt sustainability relied on three exceptional conditions: (1) near-zero domestic interest rates, (2) high domestic savings willing to hold JGBs at low yields, (3) no external funding requirement. As the Bank of Japan raised rates in 2024 for the first time in 17 years, the sustainability arithmetic is finally being tested.
The Japan Lesson for Fiscal Policy
Fiscal stimulus can prevent deflation spirals and support demand, but it cannot by itself restore trend growth if the underlying problem is structural (demographic decline, productivity stagnation, zombie firms). Japan's case shows that fiscal policy has limits – and that accumulating debt is a bet on keeping r < g indefinitely.
5. MRU Videos & Key Links
▼
Session 09 · Open Economy
China Shock · Autor et al.
International Trade
Why countries trade, who gains and who loses, and when protectionism might be justified. Comparative advantage, the tariff welfare decomposition, and the distributional reality the China Shock exposed.
Page:
1. Comparative Advantage & Gains from Trade
▼
Absolute Advantage: produce more output with the same inputs
Comparative Advantage: lower opportunity cost of production
Key insight: trade based on COMPARATIVE advantage, not absolute advantage
→ Both parties gain even if one is absolutely better at everything
Opportunity Cost of Good A = units of Good B forgone per unit of A
Specialise where your opportunity cost is lowest
Terms of Trade (ToT) = Export Price Index / Import Price Index
ToT improve: exports buy more imports → welfare gain
ToT deteriorate: exports buy fewer imports → welfare loss
Lucy & Bob Example (from slides)
Even if Bob is faster at both hunting and root-gathering, if his opportunity cost of hunting is lower, he should specialise in hunting and Lucy in gathering. Both end up with more of both goods through trade than in autarky. The gains from specialisation are always mutual when opportunity costs differ.
Two Models of Trade
| Comparative Advantage Model | Economies of Scale Model | |
|---|---|---|
| Driver | Different opportunity costs across countries | Scale economies; first-mover lock-in |
| Prediction | Countries specialise in different goods | Similar countries trade same goods (intra-industry) |
| Example | Kenya exports flowers; UK exports financial services | Germany and France trade cars with each other |
| Policy implication | Free trade always welfare-improving | Industrial policy may lock in advantageous position |
2. Tariff Welfare Decomposition – Areas A, B, C, D
▼
A tariff raises the domestic price from Pworld to Ptariff = Pworld + t, reducing imports and creating welfare effects across four areas on the supply-demand diagram.
Effects of a tariff on a small open economy:
Area A: CS lost → PS gained (transfer from consumers to producers)
Area B: CS lost → DWL (production inefficiency triangle)
Area C: CS lost → Govt revenue (transfer from consumers to government)
Area D: CS lost → DWL (consumption distortion triangle)
Net welfare change = −A − B − C − D + A + C = −B − D
→ Net DWL always negative for small country imposing tariff
→ Producers gain (A); government gains (C); consumers lose (A+B+C+D)
→ Large country: may improve ToT, partially offsetting B+D (optimal tariff)
Exam Trap
The domestic producer surplus gain (area A) is a transfer from consumers, not a net welfare gain. Only the government revenue (C) represents a potentially recaptured transfer. Areas B and D are pure DWL – destroyed surplus with no offsetting gain anywhere.
3. The China Shock – Trade Theory Meets Reality
▼
Autor, Dorn & Hanson (2013, 2016, 2021): China's WTO accession (2001) and manufacturing surge created concentrated, persistent labour market damage in US regions. Standard trade models predicted workers would transition smoothly; the data showed they largely didn't – for 20+ years.
Why Standard Trade Theory Failed to Predict This
- Geographic concentration: losses fell on specific regions (Ohio, Michigan, the Rust Belt) not diffused across the whole economy
- Retraining failure: displaced workers didn't retrain or relocate as smoothly as models assumed; social costs (opioids, mortality) were severe
- Trade adjustment assistance failed: US TAA programmes were underfunded and poorly designed
- Political consequence: concentrated losers organised; diffuse winners didn't. This drove the post-2016 trade policy backlash
Policy Takeaway
Trade creates aggregate gains but concentrated losses. The economics of trade are sound; the politics depend on whether the winners credibly compensate the losers. When they don't, the political system eventually responds – Brexit, Trump tariffs, and rising protectionism are the results.
4. Arguments For & Against Protectionism
▼
| Argument | Economic Validity | Counter |
|---|---|---|
| Infant industry | Valid if scale economies exist and protection is temporary | Hard to remove once established; political capture risk |
| National security | Valid for genuinely strategic sectors | Often abused to protect uncompetitive industries |
| Dumping protection | Valid if foreign firm genuinely pricing below cost to destroy competition | Difficult to prove; may just be comparative advantage |
| Save jobs | Saves jobs in protected sector; destroys jobs elsewhere via retaliation and higher costs | Net job effect typically negative or zero |
| Optimal tariff | Valid for large countries with market power in ToT | Invites retaliation; rarely optimal in practice |
| Distributional | Valid concern; but tariffs are blunt redistributive tools | Direct transfers more efficient than trade barriers |
5. MRU Videos & Key Links
▼
Trade: Engine of Specialisation & Growth
MRUComparative Advantage
MRUAnother Look at Comparative Advantage
MRUComparative Advantage Homework
MRUTariffs and Protectionism
MRUArguments Against International Trade
MRUAvengers: The Story of Globalisation
MRU
Session 10 · Open Economy
CHIPS Act · YOZMA · China Shipbuilding
Industrial Policy
When and how governments deliberately shift resources toward specific industries beyond what free markets produce. The market failure justifications, ISI vs EOI strategies, and three live case studies from the course.
Page:
1. Market Failure Justifications for Industrial Policy
▼
Industrial policy = government actions that deliberately shift resources toward targeted industries, firms, or technologies beyond what free markets would produce. It requires a market failure to justify intervention economically.
| Market Failure | Mechanism | Policy Response | Example |
|---|---|---|---|
| Economies of Scale | Natural monopoly or first-mover advantage; private market too small to reach efficient scale | Infant industry protection; subsidies to reach scale | Korea’s POSCO steel; Boeing vs Airbus |
| Positive Externalities | R&D spillovers; knowledge creation underinvested by private sector | R&D subsidies, patent system, public research | Bell Labs; DARPA → internet |
| Coordination Failure | No single firm invests without others (“big push” needed for cluster) | Government coordinates simultaneous investment | Semiconductor supply chains |
| Strategic / Security | Dependence on foreign supply chains creates vulnerability | National security-motivated subsidies | CHIPS Act – semiconductor reshoring |
| Capital Market Failure | Long-horizon, high-risk projects not financed by private capital | State development banks, government VC funds | YOZMA (Israel); KfW (Germany) |
The Political Economy Problem
Even when economically justified, industrial policy risks interest group capture, supporting losers instead of winners, and creating permanent dependency. The key question is not just “is there a market failure?” but “is the government capable of correcting it better than the market?” – a question of government failure risk.
2. ISI vs EOI – Two Strategies
▼
| Import Substitution Industrialisation (ISI) | Export-Oriented Industrialisation (EOI) | |
|---|---|---|
| Goal | Replace imports with domestic production | Build competitive export industries |
| Trade orientation | Inward-looking; protectionist | Outward-looking; open to competition |
| Competitive discipline | Low – firms shielded from global competition | High – firms must compete in global markets |
| Tools | High tariffs, quotas, state enterprises | Subsidies, undervalued currency, targeted clusters |
| Examples | Latin America 1950s–80s; India pre-1991 | East Asian Tigers; China post-1978 |
| Historical outcome | Generally failed – inefficiency, debt crises, reversal | Mixed but dramatically successful in East Asia |
EOI Sub-Types
- Encouraging Winners: broad export support without picking specific firms (South Korea’s general export subsidies)
- Picking Winners: government selects specific firms or sectors to champion – higher risk, higher return potential (TSMC in Taiwan; POSCO in Korea)
3. Case Study: CHIPS Act (US, 2022)
▼
Justification: COVID-19 chip shortage revealed deep strategic vulnerability (national security externality). Positive externalities from domestic R&D clusters. Economies of scale in fab construction require patient capital beyond private market horizons.
Critique: Subsidising firms (TSMC, Intel) already capable of self-financing. Risk of political capture. Taiwan and South Korea already produce cutting-edge chips efficiently – reshoring at scale may be economically inefficient even if strategically rational.
4. Case Study: YOZMA (Israel, 1993)
▼
YOZMA (“initiative” in Hebrew) was a government VC fund-of-funds: the state contributed 40% of capital to each of 10 private VC funds, with private investors providing the remainder. The government took equity but gave private funds full management control.
Why it worked: Capital market failure was the genuine barrier (no domestic VC culture, risk capital not available). Government catalysed market formation rather than replacing it. Private management incentives remained intact. Exit was planned from the start.
The TemplateYOZMA is widely cited as the model for government VC intervention: address a genuine capital market failure, leverage rather than replace private capital, preserve management incentives, and plan your exit. Israel became a global startup hub – “Startup Nation” – partly as a result.
5. Case Study: China Shipbuilding
▼
China went from near-zero to the world’s largest shipbuilder (over 50% global share by 2023) through sustained state support: subsidised land, state bank financing at below-market rates, preferential domestic procurement, and strategic underpricing.
| Aspect | Detail |
|---|---|
| Justification used | Economies of scale at industry level; strategic sector; employment |
| Tools deployed | State bank loans, subsidised inputs, land grants, domestic preference rules |
| Result | Global overcapacity; Korean and European shipbuilders decimated; ship prices fell ~40% |
| WTO status | Multiple disputes; subsidies likely violate WTO rules but enforcement is slow |
| Strategic lesson | Picking winners at scale can distort entire global industries; benefits concentrated in China, costs distributed globally |
Session 11 · Open Economy
PPP · USD Reserve Status
⚙ REER Simulator
Exchange Rate Policy
How currencies are valued, what moves them, and the constraints governments face. PPP, the balance of payments identity, the Impossible Trinity, and why depreciation doesn't always fix a trade deficit immediately.
Page:
1. Exchange Rate Basics & PPP
▼
Nominal Exchange Rate (e) = units of foreign currency per 1 unit of domestic
Appreciation: domestic currency buys MORE foreign currency
Depreciation: domestic currency buys LESS foreign currency
Fixed rate terms: revaluation (up) / devaluation (down)
Real Exchange Rate (RER) = e × (P_domestic / P_foreign)
= relative price of domestic goods vs foreign goods
RER appreciation → domestic exports more expensive → competitiveness falls
REER = trade-weighted average RER across all trading partners
Purchasing Power Parity (PPP):
Absolute: e = P_domestic / P_foreign (Big Mac index)
Relative: %Δe ≈ π_domestic − π_foreign
→ If domestic inflation exceeds foreign, currency should depreciate to compensate
→ PPP holds as a long-run tendency, not a short-run fact
2. Balance of Payments – Current & Financial Accounts
▼
Current Account (CA) = Trade Balance + Services + Income + Transfers
Trade Balance = Merchandise exports − imports
Financial Account (FA) = Net capital flows (FDI + portfolio investment + other)
BoP Identity: CA + FA + ΔReserves ≈ 0
→ CA deficit must be financed by FA surplus OR reserve drawdown
→ A country can’t run a CA deficit forever without attracting foreign capital
| CA Position | Financing | Sustainability |
|---|---|---|
| CA Surplus | Country lends to world; accumulates foreign assets | Generally sustainable; risk of protectionist backlash |
| CA Deficit + FA Surplus (FDI-driven) | Borrowing via productive investment | Sustainable if investment generates future export growth |
| CA Deficit + FA Surplus (portfolio-driven) | Borrowing via volatile short-term flows (“hot money”) | Risky; sudden stops possible |
| CA Deficit + Reserve drawdown | Depleting the buffer stock of FX reserves | Unsustainable; currency crisis risk |
3. Fixed vs Floating & The Impossible Trinity
▼
The Impossible Trinity (Mundell-Fleming Trilemma)
A country can have at most two of these three simultaneously:
1. Fixed exchange rate
2. Free capital mobility
3. Independent monetary policy
Eurozone: Fixed rate + free capital → gave up monetary policy
China: Fixed rate + monetary policy → capital controls
US/UK/EU: Floating + free capital + monetary policy → give up fixed rate
1. Fixed exchange rate
2. Free capital mobility
3. Independent monetary policy
Eurozone: Fixed rate + free capital → gave up monetary policy
China: Fixed rate + monetary policy → capital controls
US/UK/EU: Floating + free capital + monetary policy → give up fixed rate
| Fixed Rate | Floating Rate | |
|---|---|---|
| Advantage | Price stability, credibility, eliminates FX transaction risk | Automatic external adjustment, monetary policy freedom |
| Disadvantage | Surrenders monetary policy; vulnerable to speculative attack | Volatility; uncertainty for trade and investment planning |
| Best for | Small open economy with dominant trade partner; low inflation credibility needed | Large economy with asymmetric shocks; robust institutions |
| Examples | HKD pegged to USD; Denmark pegged to EUR; Gulf states pegged to USD | USD, EUR, GBP, JPY, CHF |
4. The J-Curve – Why Depreciation Takes Time to Work
▼
After a currency depreciation, the trade balance often worsens before it improves. This is the J-curve effect: import/export volumes take time to adjust because contracts are pre-set and habits are slow to change.
The J-Curve – Trade Balance Response to Depreciation
Short run: import prices rise (denominated in foreign currency) before volumes fall → trade balance deteriorates. Long run: volumes adjust as consumers and firms respond to new relative prices → trade balance improves.
Marshall-Lerner Condition:
Depreciation improves trade balance only if:
|PED_exports| + |PED_imports| > 1
→ If both demand elasticities sum to >1, depreciation works long-run
→ In the short run, elasticities are low (J-curve); long run they rise
⚙ REER Calculator
▼
Calculate the Real Effective Exchange Rate and see whether a currency is over- or under-valued relative to a base period (set at 100).
REER Calculator
Nominal Exchange Rate (e)
Domestic Price Level (P_d)
Foreign Price Level (P_f)
–
REER index
–
vs base (100)
5. USD Reserve Status & FDI Currency Effects
▼
USD Reserve Currency: “Exorbitant Privilege”
~58% of global FX reserves held in USD (2024, down from 71% in 2000)
→ US can borrow more cheaply (safe-haven demand for Treasuries)
→ US dollar gets seigniorage benefit at global scale
→ But: structural CA deficit partly a consequence (world demands USD assets)
FDI & Currency Effects:
FDI inflow → demand for domestic currency → appreciation pressure
FDI outflow / capital flight → depreciation pressure
Carry trade unwinding → sharp, sudden moves in both directions
Session 12 · Synthesis
Genovia Report · Spain IMF 2025 · Shock Playbook
Country Case – Macro Policy in Practice
Applying the full toolkit: diagnose a country’s macroeconomic condition, identify the binding constraints, and prescribe a coherent policy mix. The Genovia case and Spain IMF 2025 report as live diagnostics.
Page:
1. The IMF Diagnostic Framework – Describe, Diagnose, Prescribe
▼
The IMF Article IV consultation applies a consistent three-step diagnostic. Think of it as the macro equivalent of a doctor’s physical: check vitals, identify pathology, prescribe treatment.
| Step | What to Look At | Key Indicators |
|---|---|---|
| 1. Describe | Current macroeconomic state | GDP growth, unemployment rate, inflation, CA balance, debt/GDP, FX reserves |
| 2. Diagnose | What shock? What gap? | AD-AS position, output gap sign & size, demand vs supply shock, external balance sustainability |
| 3. Prescribe | Policy levers available | Fiscal space (r vs g), monetary room (at ZLB?), exchange rate regime, structural reform capacity |
Before Prescribing – Always Check:
1. Fiscal space: Is r < g? Is debt/GDP sustainable?
2. Monetary room: Fixed or floating rate? At ZLB?
3. External constraint: CA deficit? Reserve adequacy? Currency regime?
4. Institutional quality: Can the government actually implement the policy?
5. Political economy: What is politically feasible vs economically optimal?
2. Monetary room: Fixed or floating rate? At ZLB?
3. External constraint: CA deficit? Reserve adequacy? Currency regime?
4. Institutional quality: Can the government actually implement the policy?
5. Political economy: What is politically feasible vs economically optimal?
2. The Shock Playbook – Policy Recipes by Scenario
▼
| Shock Type | AD-AS Effect | Fiscal Response | Monetary Response | External |
|---|---|---|---|---|
| Negative Demand Shock | AD ↓ → recessionary gap | Expansionary (if fiscal space) | Rate cuts / QE | Let currency depreciate if floating |
| Positive Demand Shock | AD ↑ → inflationary gap | Contractionary (reduce deficit) | Rate hikes | Allow appreciation to cool demand |
| Negative Supply Shock | SRAS ↓ → stagflation | Dilemma; structural reforms to restore supply | Dilemma; accept inflation or recession | Depreciation makes import shock worse |
| Positive Supply Shock | SRAS ↑ → growth + low inflation | No action or use opportunity to consolidate | Can cut rates without inflation risk | May attract capital inflows |
| BoP / Currency Crisis | Capital flight → depreciation spiral | Austerity (IMF conditionality) | Rate hikes to defend currency | FX intervention; capital controls (temporary) |
3. Exam-Style Scenario Structure
▼
For any country case question, follow this structure to maximise marks:
- Identify the shock type from the data provided – demand or supply? Domestic or external? Permanent or temporary?
- Place the economy on the AD-AS diagram → name the gap explicitly (recessionary / inflationary / stagflation)
- Check fiscal space: run the debt dynamics equation – is r < g? What is primary deficit/surplus?
- Check monetary room: Is the central bank independent? Fixed or floating? Inflation target credible?
- Check external constraint: CA balance, FX reserve adequacy (rule of thumb: 3 months of imports), exchange rate regime
- Recommend a policy mix with explicit trade-offs – never just say “expand” or “contract”
- Address distribution: who wins and who loses from the policy? Are the losses politically sustainable?
Common Exam Mistakes
(1) Recommending fiscal expansion without checking debt sustainability. (2) Recommending rate cuts in a fixed-rate regime country (impossible under the Impossible Trinity). (3) Ignoring the external constraint entirely. (4) Describing the problem without prescribing a policy. (5) Prescribing a policy without naming its costs and trade-offs.
4. Spain IMF 2025 – Applied Diagnostic
▼
| Diagnostic Dimension | Spain 2025 Assessment |
|---|---|
| Output gap | Narrowing; near potential GDP or slight inflationary gap |
| Monetary policy | ECB-determined (Impossible Trinity: no independent monetary policy in Eurozone); rate cuts from 2024 as EA inflation fell |
| Fiscal space | Debt/GDP ~105%; primary deficit; r vs g borderline; IMF recommends consolidation |
| External | CA roughly balanced; tourism-driven services surplus offsets goods deficit |
| IMF prescription | Fiscal consolidation to reduce debt; structural reforms (labour market, housing); growth-friendly composition of adjustment |
5. Cross-Concept Synthesis – The Full Toolkit at a Glance
▼
| Concept | Session | Key Formula / Rule |
|---|---|---|
| Consumer Surplus | S02 | Area below demand, above P* |
| Tax Incidence | S04/S05 | Burden on inelastic side; buyer share = PES/(PED+PES) |
| DWL from tax | S05 | ½ × t × ΔQ; grows with square of tax rate |
| GDP identity | S06 | C + I + G + NX; real = nominal ÷ deflator |
| Quantity Theory | S07 | MV = PY; π ≈ %ΔM − g |
| Fisher Equation | S07 | i = r + π³ |
| AD-AS scenarios | S08 | 4 cases: recessionary / inflationary / stagflation / steady-state |
| Fiscal multiplier | S8.2 | 1/(1−MPC); tax multiplier = −MPC/(1−MPC) |
| Debt dynamics | S8.2 | Δ(D/Y) = PD/Y + (r−g)×D/Y; sustainable if r < g |
| Comparative advantage | S09 | Specialise where opportunity cost is lowest |
| Tariff welfare | S09 | Net loss = −B − D (always negative for small country) |
| PPP / REER | S11 | REER = e × (P_d/P_f); depreciation improves CA if M-L holds |
| Impossible Trinity | S11 | Can’t have fixed rate + free capital + monetary policy simultaneously |
6. Key Links & Case Materials
▼
✎ Concept Cheat Sheet – Sessions 1–12
Reference
Glossary
All key terms from Sessions 1–12, organised by course part. Definitions are concise and exam-ready – not encyclopaedic.
Part I – Microeconomics
Sessions 1–5Adverse Selection
Pre-contract information asymmetry where one party knows quality the other does not. Classic example: Akerlof’s market for lemons, where bad quality drives out good quality because buyers offer only the average price.
Average Tax Rate (ATR)
Total tax paid divided by total income. Always ≤ the marginal tax rate in a progressive system. Moving into a higher bracket does not mean all income is taxed at that rate – only income above the threshold.
Cap and Trade
A market-based environmental policy that sets a ceiling on total emissions (the cap) and lets firms buy and sell emission permits (the trade). Provides certainty on quantity but not on price, unlike a carbon tax.
Carbon Tax (Pigouvian Tax)
A tax set equal to the external cost of carbon emissions, designed to internalise a negative externality and restore social efficiency. Canada’s revenue-neutral design returns all revenue to households via rebates.
Ceteris Paribus
“All else equal” – the assumption that all other variables are held constant when examining the relationship between two variables. Fundamental to isolating supply and demand curve movements.
Coase Theorem
If property rights are clearly defined and transaction costs are low, private parties will bargain to an efficient outcome regardless of who holds the rights. Breaks down with many parties or high transaction costs.
Consumer Surplus (CS)
The area below the demand curve and above the market price. Measures the value buyers receive above and beyond what they pay. Uber’s estimated CS of $7bn far exceeded its $4bn revenue, illustrating how CS outstrips market value.
Cross-Price Elasticity
% change in quantity demanded of good A divided by % change in price of good B. Positive = substitutes (coffee and tea); negative = complements (cars and petrol).
Deadweight Loss (DWL)
The loss of total surplus when a market does not operate at the competitive equilibrium (P*, Q*). Arises from taxes, price controls, monopoly, or externalities. Represented as a triangle on the supply-demand diagram.
Elasticity of Supply (PES)
% change in quantity supplied divided by % change in price. Always positive. Higher in the long run as firms adjust capacity. Key determinants: production flexibility, input availability, time horizon, storability.
Externality
A cost or benefit imposed on a third party not involved in a transaction. Negative externalities cause overproduction (private cost < social cost); positive externalities cause underproduction (private benefit < social benefit).
Income Elasticity
% change in quantity demanded divided by % change in income. Positive = normal good; negative = inferior good; >1 = luxury good (income-elastic).
Invisible Hand
Adam Smith’s insight that individuals pursuing self-interest are guided by prices to produce socially beneficial outcomes without central coordination. Prices act as both a signal of scarcity and an incentive to respond to it.
Laffer Curve
The relationship between tax rates and tax revenue. Revenue is zero at both 0% and 100%; it peaks at some intermediate rate t*. Cutting taxes increases revenue only if the current rate is above t*. Empirical evidence places most advanced economies below t*.
Marginal Tax Rate (MTR)
The tax levied on the next dollar of income. In a progressive system, MTR > ATR. Moving into a higher bracket raises only the marginal rate on income above the threshold, not on all income.
Market Failure
A situation in which markets fail to allocate resources efficiently. The main types are: externalities, public goods, asymmetric information, and market power. Each represents a legitimate economic justification for government intervention.
Moral Hazard
Post-contract behaviour change when one party is insulated from the full consequences of their actions. E.g., a fully insured driver taking more risks; a bank guaranteed by government taking on excessive leverage (“too big to fail”).
Price Ceiling
A legal maximum price set below equilibrium. Creates a shortage (Qd > Qs), reduces total surplus, and generates DWL. Additional costs include search costs, quality deterioration, misallocation, and black markets. Classic example: rent control.
Price Elasticity of Demand (PED)
% change in quantity demanded divided by % change in price. Always negative; use absolute value. |PED| > 1 = elastic; <1 = inelastic; =1 = unit elastic (revenue maximised). Crude oil PED ≈ −0.06 to −0.10 short-run.
Price Floor
A legal minimum price set above equilibrium. Creates a surplus (Qs > Qd) and reduces total surplus. Consumer surplus always falls. Classic examples: minimum wage (labour market), agricultural support prices.
Producer Surplus (PS)
The area above the supply curve and below the market price. Represents revenue minus the opportunity cost of production. Related to but not identical to profit (which also subtracts fixed costs).
Tax Incidence
The economic burden of a tax – who actually bears the cost. Determined entirely by elasticities, not by who legally pays. The more inelastic side bears more of the burden. Assigning tax to buyer vs seller produces identical outcomes.
Total Revenue Test
Method for determining elasticity from price-quantity data. Elastic demand: price cut raises revenue. Inelastic demand: price cut reduces revenue. Unit elastic: price changes leave revenue unchanged.
Part II – Macroeconomics
Sessions 6–8.2Aggregate Demand (AD)
Total spending in the economy at each price level: C + I + G + NX. Shifts right with expansionary fiscal/monetary policy, rising confidence, or weaker currency. Shifts left with contractionary policy, financial crises, or falling confidence.
Automatic Stabilisers
Fiscal mechanisms that automatically expand in recessions and contract in booms without legislation. Include progressive income taxes, unemployment insurance, and welfare programmes. Dampen business cycle fluctuations passively.
CPI (Consumer Price Index)
A fixed-basket price index measuring the cost of living for a typical consumer. Used for wage indexing and inflation measurement. Suffers from substitution bias (overstates inflation ~1%/year). The Fed prefers PCE over CPI.
Crowding Out
Deficit-financed government spending raises demand for loanable funds, pushing up interest rates and reducing private investment. Partially offsets fiscal stimulus. Weaker at the zero lower bound when private investment is already depressed.
Debt Dynamics
Δ(Debt/GDP) = Primary Deficit/GDP + (r−g) × Debt/GDP. Debt is sustainable when r < g (growth outpaces borrowing cost). The snowball effect occurs when r > g, causing debt to grow faster than the economy.
Fiscal Multiplier
The ratio of change in GDP to change in government spending: 1/(1−MPC). The tax multiplier is −MPC/(1−MPC), smaller in absolute value because tax cuts depend on MPC to feed into spending. Both are reduced by crowding out and import leakage.
Fisher Equation
i ≈ r + π³. Nominal interest rate = real interest rate + expected inflation. A 1pp rise in expected inflation should raise nominal rates 1:1, leaving real rates unchanged (Fisher effect). Holds in the long run; can be violated short-term by central bank policy.
GDP (Gross Domestic Product)
Market value of all final goods and services produced within a country in a given period. Measured as C + I + G + NX (expenditure approach) or as sum of all factor incomes (income approach). Excludes transfers, intermediate goods, and non-market production.
GDP Deflator
Nominal GDP divided by Real GDP, times 100. A broad price index covering all goods and services in the economy, unlike CPI which covers only a fixed consumer basket. Does not include imported goods.
GINI Coefficient
A measure of income inequality ranging from 0 (perfect equality) to 1 (perfect inequality). Derived from the Lorenz curve: the larger the area between the Lorenz curve and the 45° line of equality, the higher the GINI.
Inflationary Gap
When actual GDP exceeds potential GDP (Y > Y*). Caused by a positive AD shock. Results in rising prices and below-natural unemployment. Requires contractionary fiscal or monetary policy to close.
LRAS (Long-Run Aggregate Supply)
A vertical line at potential GDP (Y*). Represents output at full employment when all prices and wages have fully adjusted. Shifts right with productivity growth, labour force expansion, or capital accumulation. Unaffected by demand-side policies in the long run.
Money Multiplier
1 / reserve requirement ratio. Determines how much money a banking system creates from an initial deposit. Since March 2020, US reserve requirements = 0%; the multiplier is now driven by bank lending decisions rather than regulatory floors.
Output Gap
Actual GDP minus Potential GDP (Y*). A negative output gap (actual < potential) = recessionary gap. A positive output gap (actual > potential) = inflationary gap. Determines the direction of appropriate stabilisation policy.
PCE (Personal Consumption Expenditures)
The Fed’s preferred inflation measure. Chain-weighted (adjusts for substitution), includes employer/government-paid items, and shows lower bias than CPI. The Fed targets 2% PCE inflation.
Quantitative Easing (QE)
Central bank purchases of long-term assets (MBS, Treasuries) to lower long-term interest rates when the policy rate is at the zero lower bound. Expanded the Fed’s balance sheet from ~$900bn (2008) to ~$9tn (2022 peak).
Quantity Theory of Money (QTM)
MV = PY. In the long run, with stable velocity (V) and natural output growth (g), inflation ≈ %ΔM − g. Friedman: “Inflation is always and everywhere a monetary phenomenon.” Explains hyperinflation (Zimbabwe, Weimar Germany) through excessive money printing.
Recessionary Gap
When actual GDP falls below potential GDP (Y < Y*). Caused by a negative AD shock. Results in rising unemployment and falling or stagnant prices. Requires expansionary fiscal or monetary policy to close.
Real GDP
GDP measured in constant base-year prices, removing the effect of inflation. Allows true comparison of output across time periods. Real GDP growth = Nominal GDP growth − Inflation.
Ricardian Equivalence
Forward-looking consumers anticipate that tax cuts today imply higher taxes tomorrow (to repay debt), so they save the tax cut rather than spend it. If fully operative, fiscal stimulus has no effect on AD. Mainly applies to transitory, lump-sum tax cuts.
Seigniorage
Revenue earned by a government from creating money. Equivalent to an inflation tax on money holders, whose real cash balances fall as prices rise. Governments resort to seigniorage when unable to raise taxes or borrow. Self-defeating at very high rates (money demand collapses).
SRAS (Short-Run Aggregate Supply)
Upward-sloping because of sticky wages. Higher prices reduce real wages, making labour cheaper and inducing firms to hire more and produce more. Shifts left with input cost increases (oil shock) or negative supply shocks; right with lower input costs or positive productivity shocks.
Stagflation
Simultaneous increase in prices and unemployment, caused by a negative supply shock (SRAS shifts left). Creates a policy dilemma: stimulating AD fights the recession but worsens inflation; contracting AD fights inflation but deepens the recession. The 1970s oil shocks are the canonical case.
Sticky Wages
Nominal wages resist downward adjustment due to contracts, efficiency wage considerations, and worker resistance. When price levels fall in a recession, real wages rise, labour becomes more expensive, and employment falls. Explains why recessions persist and why the SRAS slopes upward.
Zero Lower Bound (ZLB)
The practical floor of ~0% for nominal interest rates. When the policy rate hits zero, conventional monetary policy loses effectiveness. Forces central banks toward unconventional tools: QE, forward guidance, negative interest rate policy (NIRP).
Part III – Open Economy
Sessions 9–12Balance of Payments (BoP)
A record of all economic transactions between a country and the rest of the world. Composed of the Current Account (CA), Financial Account (FA), and reserve changes. The BoP identity: CA + FA + ΔReserves ≈ 0.
China Shock
Autor, Dorn & Hanson (2013, 2016): China’s WTO accession (2001) caused concentrated, persistent labour market damage in US manufacturing regions. Local labour markets had not fully recovered 20+ years later. Exposed the failure of standard trade adjustment mechanisms.
Comparative Advantage
The ability to produce a good at a lower opportunity cost than a trading partner. Forms the basis for mutually beneficial trade even if one country has an absolute advantage in everything. Countries specialise where their opportunity cost is lowest.
Current Account (CA)
The broadest measure of trade: merchandise trade balance + services + income + transfers. A CA deficit means a country spends more abroad than it earns, requiring a FA surplus or reserve drawdown to finance it. Sustainable if financed by productive FDI.
Export-Oriented Industrialisation (EOI)
Industrial policy strategy that builds competitive export industries exposed to global competition. Sub-types: encouraging winners (broad export support) vs picking winners (targeting specific firms). Associated with the East Asian Tigers’ dramatic development success.
Financial Account (FA)
Records net capital flows into and out of a country: FDI + portfolio investment + other capital flows. A FA surplus (capital inflow) tends to appreciate the currency; a FA deficit (capital outflow) tends to depreciate it.
Import Substitution Industrialisation (ISI)
Industrial policy strategy that replaces imports with domestically produced goods using high tariffs, quotas, and state enterprises. Inward-looking and protectionist. Generally failed in Latin America (1950s–80s) due to inefficiency, lack of competitive discipline, and political capture.
Impossible Trinity (Mundell-Fleming Trilemma)
A country cannot simultaneously maintain: (1) a fixed exchange rate, (2) free capital mobility, and (3) independent monetary policy. Must sacrifice one. Eurozone: gave up monetary policy. China: uses capital controls. US/UK: floating rate.
Industrial Policy
Government actions that deliberately shift resources toward targeted industries beyond what free markets would produce. Economically justified only by genuine market failures: economies of scale, positive externalities, coordination failure, strategic security, or capital market failure.
J-Curve
The pattern where a currency depreciation initially worsens the trade balance before improving it. Short run: import prices rise before volumes fall (contracts pre-set, habits slow). Long run: volumes adjust as consumers and firms respond to relative price changes. Requires Marshall-Lerner condition to hold long-run.
Marshall-Lerner Condition
Depreciation improves the trade balance in the long run only if |PED_exports| + |PED_imports| > 1. If the sum of demand elasticities exceeds 1, the volume improvement eventually outweighs the price deterioration.
Purchasing Power Parity (PPP)
Absolute PPP: the exchange rate equals the ratio of price levels (e = P_domestic / P_foreign). Relative PPP: the exchange rate change approximates the inflation differential. Holds as a long-run tendency. Used to compare GDP across countries at comparable living standards.
Real Effective Exchange Rate (REER)
Trade-weighted average of nominal exchange rates adjusted for relative inflation. REER = e × (P_domestic / P_foreign). REER appreciation = domestic goods become relatively more expensive → export competitiveness falls. Better measure of competitiveness than the nominal exchange rate.
Tariff
A tax on imports. Raises domestic price from P_world to P_world + t. For a small country: net welfare loss = −B −D (DWL from production and consumption distortions). Domestic producers gain area A; government gains area C; consumers lose A+B+C+D. Large countries may gain terms-of-trade benefits.
Terms of Trade (ToT)
Export price index divided by import price index. Improvement: exports buy more imports → welfare gain. Deterioration: exports buy fewer imports → welfare loss. Large countries imposing tariffs can improve ToT by depressing world prices (area “e” in the tariff diagram).