Economics, Money, and Trade: Key Concepts and Theories
Institutions
Social arrangements created to satisfy long-term needs. Adam Smith studied various institutions, including language, morals, justice, property rights, division of labor, money, and markets. He believed that in times of commercial interdependence, a laissez-faire (let alone) policy was the most appropriate approach for governing authorities.
Economics
The social science that studies the production, distribution, and consumption of goods and services.
Money
Any object or record accepted as payment for goods and services and repayment of debts within a specific socio-economic context. Commodity money has intrinsic value, meaning it is inherently valuable, unlike tokens like banknotes.
Legal Tender
Any form of payment that must be accepted for debt settlement according to local laws.
Supply Chain
A system of organizations, people, technology, activities, information, and resources involved in moving a product or service from supplier to customer. It tracks the flow of materials from source to end customer.
Interest Rate
The price of credit, representing a fee paid on borrowed assets. While typically applied to money, interest can also be calculated on other borrowed assets like shares, consumer goods (hire purchase), or even factories (finance lease arrangements).
The cost of money depends on the interest rate and inflation.
Natural Price vs. Market Price
According to Adam Smith, the natural price represents the production cost, remaining constant over time and depending on wages, profits, and land rent. It’s the price covering production value. However, it doesn’t necessarily reflect the actual market price.
Market price is the price at which a good or service is offered or fetched in the marketplace. Classical economics posits that market price relates directly to demand and inversely to supply. The actual market price reflects a short-term equilibrium between current demand and supply.
Nominal Price vs. Real Price
Nominal price is the monetary value of a commodity, expressed in fixed terms for a specific year or period. It’s the money value that changes over time.
Real price adjusts the nominal value to remove the effects of general price level changes. It reflects changes in quantities, not just prices.
Purchasing Power Parity (Rate of Exchange)
The rate of exchange is the price of one currency in terms of another. Purchasing power parity theory, based on Fisher’s law, suggests that identical products and services should cost the same in different countries in the long run.
Consumer Price Index (CPI)
A statistical estimate of the price level of goods and services purchased by households. CPI changes measure inflation and can be used for indexation of wages, salaries, pensions, or regulated prices. CPI construction requires price data and weighting data.
Inflation
Inflation is the growth of the money supply without a corresponding increase in goods and services, causing a rise in the general price level. Various inflation measures exist due to different price indices affecting different people.
Two main causes of inflation:
- Cost-push inflation: Higher costs lead to increased prices.
- Demand-pull inflation: Increased demand allows firms to raise prices, generating profit.
Disguised Unemployment
Occurs when labor marginal productivity is zero because employed workers do not produce anything.
Mercantilism
An economic system (16th-18th centuries) aiming to increase national wealth through government regulation of commercial interests. It assumes that national prosperity depends on capital supply, global trade volume is fixed, and one party benefits at another’s expense. Mercantilists believed in maximizing exports and minimizing imports through tariffs.
Key Mercantilist Principles:
- National strength
- Zero-sum economy
- Money is wealth
- Positive balance of trade
- Industry over agriculture
- Protect infant industry
- Royal factories
- Utility of poverty
- Population policies
- Colonialism
Specie Flow Mechanism
David Hume’s argument against mercantilism’s pursuit of a positive balance of trade. It states that gold flows into a country with a trade surplus and out of a country with a trade deficit.
Growing Path (Growth)
Occurs when an economy grows, capital accumulates, consumption increases, and population grows due to welfare. Adam Smith identified three growth sources:
- Improved capital efficiency through division of labor and technological progress.
- Foreign trade promoting market expansion and reinforcing other growth sources.
- Growth in labor force and capital stock, with labor force growth depending on population growth.
Stationary State
The state reached when an economy hits its market limits, preventing further capital accumulation due to stagnant demand. It follows a growing path.
Malthusian Restriction
The concept that population growth (geometric) outpaces food production growth (arithmetic), leading to food shortages.
Malthus’s assumptions:
- Food is essential for life.
- Attraction between sexes is constant.
- Food production increases arithmetically.
- Population increases geometrically.
Enclosure Movement
The process in England where open fields and forests were enclosed, impacting workers who used them for sustenance.
Engel’s Law
The theory that as income rises, the proportion spent on food decreases.
Intensive vs. Extensive Production
In agriculture, intensive production uses high inputs (capital, labor, fertilizers, pesticides) relative to land area, while extensive production uses low inputs.
Rent of the Land
David Ricardo defined it as the portion of land produce paid to the landlord for using the land’s inherent powers. Rent increases are irrelevant when food supply exceeds demand.
Bill of Exchange vs. Promissory Note
A bill of exchange is an unconditional order to pay a fixed sum to a third party at a future date.
A promissory note is a written promise to repay a loan or debt under specific terms.