macro economic theory [doyle]
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Accounting relationships
Macro Economic Theory:
Product
Income
Expenditure
National Income
The measure of money
GDP is a
flow variable- only defined for a particular time period
-the amount of money you have is a stock variable there is no
particular time period its a particular point in time
Stock variable- measured at a particular point in time
All the fi nal goods and services produced within a countries borders during a
particular calendar yearmeasured at current market prices
GDP is everything that is produced within a countries borders, so even toyota's
production in the US counts towards the US's GDP
Nominal GDP
GDP DOES NOT INCLUDE:
*Used goods are not counted as part of current GDP Except for the portion of their pricethat reflects something newly produced
Capital gains are not counted
Intermediate goods
GDP (gross domestic product)
Measures all of the output anyware in the world (labor, capital, demand)
GDP + net factor payments from abroad
= GDP+NFP=GNP
Net factor payments (US)
Payments to us - payments made by foreign
Net= something minus something else-
GNP (gross national product)
Main measure of economic activity in macro economics
Shoes Value
Cow=$200 Rancher= $200
Leather=$300 Leather guy= $100
Shoes=$500 Shoe manufacturer= $200
Retai l=$600 Retai le r=$100
Shoe GDP= $600 Income= $600
Example:
GDP- only includes goods and services for which a market transaction is recorded
Licit Market Transaction: these are not counted in GDP
GDP does include clean up costs
GDP should equal the income made by those involved
Output is income-
Measured at current market pricesi.
Price X Q= GDPn
Nominal GDP1)
2009 - $1 100=$100
2010 - $2 100=$200
National output in terms of ""constant" dollars = Y
Nominal GDP/ GDP def lator = real GDP-
GDP deflator
Per Capita GDP= Y/population
The degree of income equality/inequality= GINI Coefficient
The rate of growth in real GDP= Y2010-Y2009/ Y2009= x%
In the long run it shoul d be right around 3%-
Rate of Economic growth
GDP
Friday, September 03, 201 0
11:52 AM
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Example: 2010:3 (3rd quarter 2010)
Quarters in the year are in 3 month sets
GDP over time
y
x
Slope= %3
1960 2010
The wave= the business cycle
Expansion: the period in which the rate of GDP growth is positive
Resession: the period lasting at least 2 consecutive quarters during which
the GDP is negative
% (AxB)= %A + %B
% (A/B)= %A- %B= -3% -5%=-8%
Calculating the pErcentage change in the product of 2 varaibles:
Every child will live a better l ife than their parents
American Dream-upward mobility
Crunchy conservative
www.frontporch.com
Look at the part of national income account and who ends up with the output
-> where all the output goes (who gets what) the di vision of national output)
Y=C+I+G+NX
Ex post expenditures - after the fact spending must be the same as GDP
Consumer durables (last a long time)1-
Non durable2-
C= Consumer Expenditures
Changes in the stock of capital [K]
It has nothing to do with financial expenditures
Residential Constructiona)
Business fixed investmentb)
Inventory Investmentc)
I= Investment Expenditure
National income expenditure identity:
National Expenditure
Investment i s spending that effect GDP
No purely fi nancial transactions are effected in the national i ncome account
Does not include transfer payments (TR)
Purchases on goods and services
G= Government Purchases
Exports of goods and services -i mports of goods and services = the current account
defficit (if NX0) = trade deficit (surpl us)
Someone in hong kong buys a car from US= export-
Someone buys a porche from italy= import-
American staying at hotel in rome= import-
Shares of stock and gov bonds dont count ei ther way-
Interest is counted in net exports-
Expenditures within these categories:
NX= Net Exports
An increase in overall level of prices (which are mesured in terms of money) -> which implies adecrease in the value of money.
Deflation: Implies a decrease in the overall level of prices, -> which corresponds an increase in the
value of money
Inflation
On the way the the price of beer doubles
Now you can only get 2 bee rs for $20
-> Friday, 4 beers @ $5 per beer
Changing the value of money:
CPI
Laspeyres Index= past weighted (the quantities used to weight the different prices are fixed)
Paasche Index= present weighted (the quantities used to wei ght different prices are variable)
CPI= The Consumer Price Index
How are they measured?
Capital= produced goods that are intended to
produce other goods for sale
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GDP deflator
Suppose 2 goods: Q^a and Q^b
CPI => P^(a)v(T+1) + P^(b)v(T+1) x Q^(B)v(T)
P^avT+1 x Q^AvT+1 + P^A
GDP deflator
Generally the CPI equations overstate the rate of inflation
All multipl e choice
7 or 8 questions that specify a particular transaction
Quiz:
If the quality of the things purchased are improving in quality then the money spent is more
valuable
It doesnt take into account changes in quality-
When a goods price rises people tend to seek out substitutes-
Major Reason why the CPI tends to overstate the actual rate of inflation:
When people substitute A for B because Pb^ then they move to a leve l of subjective well being
The CPI might understate the rate of inflation because:
Labor force- employed
Labor force = = 9.5% currently
Some say it should be measured:
= the unemployment rate= the preparation of the labor force that is currently not working:
Unemployment Rate:
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Working age population-employed
Working age population = 18%
When people change or are in-between jobs (short duration)i.
Frictional unemployment1)
Long term unemployment due to changes in the empl oyment market (long duration)i.
Usually caused by changes in technology or common practicesii.
Structural Uunemployment2)
Indeterminate terminationi.
Example people layed off during a recession they wont be hi redii.
Cyclical unemployment3)
3 major types of Unemployment:
CPI
Systematically overstate the actual rate of inflation
Tends to understateboth the impactand actual rate of inflation because:
it doesnt take into account reductions in wel fare that result from changing consumption patterns
when prices rise
1)
It doesnt include i mpact prices2)
Its used to convert nominal GDP to normal gdp
GDP Deflator
What is the full employment unemployment rate?
some immutable constantThe full employmet unemployment rate0%
Unemployment rate
Or between the unemployment rate and the rate of economic growth
There is a negative rel ationship between the unemployment rate and GDP
How the economy behaves in the long run at full employment
Fresh Water Macroeconomics: (classical approach)
Micro theory- long run theory of the firm: varaible
short run : fixed
Long run=> prices are completely f lexible, and all markets clear
Short run=> prices are sticky or fixed, and some markets if not all markets don't clear
The long run vs. the short run:
Kains: short run
The entire economy is always le ading toward full employment
Y*=AF(K,L)
*in the long run the full employment level of GDP is determined by the state of
production technology (A), the shape of the production function (F), and the
amount ofcapital (K), and labor (L) employed in the production process when
the economy is at full employment
In the long run what determines the full employment, potential level of GDP? The "Natural"
full employment level of GDP:
It has entirely to do with the supply and productive capacity but nothing to do with
spending
The long run Macro Economic Theory: self regulating economy
Exogenous= determined outside the theoretical framework
Endogenous= determined within the theoretical framework
Chapter 3:
dY=Y*=AF(K,L)
dL (y)
L
y
L
y
L = MPL= Marginal product of labor
The MPL is positive1)
The marginal product of labor is decreasing2)
Each additional worker causes output to increase but
the increase in output attributable to the l ast unit of
labor is less than that attributable to the previ ous unit of
labor
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The perfectly competitive firm: maximize profits by setting output such that MPL*P=W
When a firm is maximizing profits they vary the number of employment
MPL*P= the marginal revenue product of labor
w= the nominal wage
Labor increases=> MRP is decreasing
Because MPL decreases => so I increses L as long as MRP > w=>
MPL*P=W=> MPL= W/P
When:
Y*=F(K,L)W/P
L
DL (MPL)
SL (income/leisure trade off)
Labor Market Framework
W/P
L
SLSL'
DL (MPL)
W/P*
W/P'
L*
Increase in immigration => Supply of Labor will i ncrease=> W/P decrease to W/P' and L increases to L'
L' ^Y=AF(K,L^) => L in the long run causes Y
=> K/P => %Y^
Increase in immigration increasing demand for labor drives down wages
SL
DL
L
W/P
W/P*
L' L*
^ Mortality rate among working age adults => supply of labor would
Decrease
SL'
W/P'
=> K => labor redundancy => v DL=> v W/P until workers became so "immiserated" that they would
eventual ly realize that "they had nothing to lose but their chains"
W/P
L
DL (MPL)
SL
W/P*
L* L'
^K => MPL at all leve ls of employment
K2
K1
GDP
L
^ Demand for Labor => W/P ^ to W/P' and L^ to L'
W/P'
DL' (MPL')
The amount by which output increases the income increases thus the
standard of livi ng increases
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Would el iminating ten-year drive down higher education costs?
Economics of Ten-year Professors
SL
DL
W/P
L
W/P*
L*
Eliminating Ten-year would cause a decrease in supply
SL'
DL'
W/P'
L'
Labor
All di fferent types of labor are substitutes
The real wage for labor type a to increase the demand for labor type b will increase and that will drive
the W/Pb(real wages) to increase
w/p(mi n) => DL =>w/p^
Y=A(K,L)
Arrogate Production function
SL
DL
W/P
LL* L'
W/p*
DL' (MPL)
W/P'
^ A => ^ MPL => ^ DL=> ^ W?P => ^L
r* (real interest rate)
C,I,G,T,TR,S,SPUT, SGUT
Section 3.2
Y=C+I+G
Given the l ong run output (Y*). What causes C+I+G = Y*
Consumption has an exogenous component (not dependent on income)
a(r,w) => autonomous consumption
r=money interest rate(i) - rate of inflation ()
c/disposable income=(Y+TR-T)
MPS= 1-MPC
=1-b
b= the marginal propensity to consume => 0
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payments / change in income T/Y
Proportional taxati on=> the average ta rate stays constant because the marginal tax rate is constant
from dollar "one:
Progressive taxation the average tax rate rises as income rises because of increasing marginal tax rates
Regressive taxation- the average tax rate raises when income falls
$250,000=$250,000.00 the di viding line between the top 2% of distributi on of income and
everybody else. Proposed tax increase from 35% to 39% or increase above $250,000
Progressive tax code
Y t(Marginal)
0-$23K 0%
25k-50k 25%
50k- 125k 30%
125k-250k 35%
250- 39%
Laugher curve:
T
t
t=marginal tax rate
T=tax revenues
% (tY)= %t+%Y
If tv by a smaller % then Y^, (tY)^
(TR,T,G)
Exogenous= determined outside the theoretical framework within which we're working
Government purchases: G=G
Given Y=C+I+G, what causes people to want to buy what exactly is bei ng produced?
What causes long run equil ibrium in the goods and services market?
What determines the real interest rate in the long run?
What determines the level of national saving in the long run?
*Y=C+I+G (when the goods are in equil ibrium)
Private Saving: Sp=T+TR-T-C
Public Saving: SG=T-TR-G (when positive > government is running a surplus, when negative
the gov is running a budget deficit)
S=Sp+ SG= Y+TR-T-C+T-TR-G
=Y-C-G
Proof:-
*Y-C-G=I (National Saving)
**S=I (in the long run if saving= the goods market is in equi librium)
S>I => Y-C-G>I => Y>C+I+G
=>then spending is lower than GDP
S Y-C-G < I => Yspending is higher than GDP
Bear in mind:
Loan able Funds Framework
SV
S,I
I
V*
(S,I)*
Anything that causes a change in saving at all real interest rates wil l shift the
saving function.
Anything that causes a change in investment at all interest rates will shi ft the I
function.
i=r+
So if
r=iIf r ^ => PbV => DsV => PsV
^T => Gov budget Deficit V
(Sgov but Spriv V) => V C bc disposable income V => S => S=Y-C-G
EX. Congress decides to increase taxes:
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Fiscal Policy => undertaken by the executive and legislative brands of Gov. =>G,TR, and/orT
Monetary Policy is uncertain by the central bank (FED) => M
SV
S,I
I
V*
(S,I)*
S'
V'
In the very long run => ^T => ^S => Vr => ^I =>K^ => Y^ b.c. Y=AF(K,L)
10 multi choice
1 labor market
Taxes
Transfer payments
Government spending
Fiscal policy
1 saving investment
2 short answer
Quiz on Monday:
r
S,I
S
*Y= C+I+G
Y-C-G=I
S=I
r*
(S,I)*
Saving wil l increase as people's wealth goes
down.
vW=> Cv => S^ => S shi fts to S' => (S, I)'
How will a decrease in the housing market effect this
graph?S'
I
(S,I)'
Means a decrease in private spending, especially investment, That results from highe r real interest
rates following a fiscal expansion.
Crowding out:
S
I
r
(S,I)(S,I)*
r*
^G=> example of expansionary fiscal policy since,
everything else held constant it will cause gov budget
defici t to => Sv=> r^ to r', (S
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$20=$20.00 $.01 oz gol d
$2000=$2000.00 1 oz gold
This would lead people to buy gold and sell it to the treasury which would
increase the money supply and lead to inflation
Price of gold falls to $1000 oz
The value of money is what it is able to buy
Money that derives its value because of government proclamationi.
Fiat Money2)
Checkable deposits1)
Monetary system in which the l iabil ities of financial institutions function as the main
medium of exchange
i.
Credit Money3)
.
FOMC- centered in New York
Whenever the Fed engages in an open market purchase of anything it
causes the money supply to increase
Whenever the Fed engages in an open market sale of anything it
causes the money supply to decrease
Fed purchases or sales of short term US government debt securities (t -bills)
Open market operations
The main tool the FED uses in monetary policy- changes in the money supply caused by
the central bank action
Money stock is totally determined by the Federal Reserve (the fed)
-role of the central bank
MV=PY
(M*V=P*Y)
Equation of Exchange:
Money Supply
M1= Currency in the hand of the public + checkable deposits at banks + nonbank issued travelers
checks
M2= M1+ other less li quid forms of money (savings deposits in banksetc)
M3= M2 + other even less liquid forms of money (large CD's etc)
3 Major Monetary arrogates:
Y= real GDP
P*Y= nominal GDP
P=The price le vel
M= the money supply
A number that reflects the amount of time s on average that each dollar in the
money stock changes hands during the course of the year in the income
determination process [the number of times the money stock changes hands]
PY (1 billi on)/ m(100 million)
v=10
v= PY/m
V= velocity (the velocity of money)
Increasing money supply
Quantitative Easing:
Increasing money supply
Expansionary Monetary Policy:
Decreasing money supply
Contractionary Monetary Policy:
What changes in velocity signify?
The quantity theory of money.
Veloci ty can be used as a "proxy" variable that impl ies changes in the demand for money
V= PY/M
M= 1/v PY
= kPY where k=1/v= the Cambridge "K"
When the money market is i n equil ibrium: Qs= Qd => S=D
The nominal demand for money= kPY
1/V=k= the proportion of peoples income that they choose to hold in the form of
money on average.
The nominal money suppl y= M
V=3
Thus, 1/v=k=1/3
Suppose:
Equation of Exchange: MV=PY
The demand for money= the demand to hold money not
have money
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So, people are holding 1/3 of their income in the form of money
An increase in V is synonymous with a decrease in demand for money(md)
A Decrease in V is synonymous wi th an increase in the demand for money (md)
-Suppose V^ to 5 => the de mand for money goes down =Kv to 1/5
Oct 12 you predict a huge financial panic=> a huge v demand for securities=> P to
decrease=> a flight to liquidity => k increases => v to decrease
MV=PY
The nominal version:
M/P= real money suppl yY=real GDP
(M/P)V=Y
MV=PY
V=exogenous (constant)
Y= depends on 3 things
*the price level is proportionate to the money supply. And a certain proportionate change in the
money supply wi ll cause an equiproportionate change in the price leve l
The real version:
M= $1t
V=4
P=1
Y=$4t
$1t * 4=1*$4t
Suppose M by 100%
$2t * 4=?*$4t
?=P=2
Money determines the level of prices
The money supply relative to velocity and real GDP determines the price level
M=kPY
But if M ^ to $2t => $2t>1/4*1*$4t=> Ms/Md =>
The thing that causes the money market to get back into equi libri um in the long run is to increase prices
$1t= 1/4*1*$4t
Proponents of money neutrality believe: the changes in M only effect nominal variables (like the price le vels)
Opponents of mone y neutrality believe the changes in money can effect real aggregates, like GPD, real
exchange rate, the equilibrium real investment rate, real usages etc.
The neutrality of Money hypothesis:
%M+%V =%P+ %Y
=Rate of money growth + rate of change in vel ocity= The rate of inflation/deflation + rate of growth of real gdp
This is to show you what determines the rate of i nflation in the l ong run
The rate of economic growth is determined by the supply side factor
%M=20%
%V =3% 20%+0%-3%=17%
%P=17%
Inflation is always a monetary phenomena
Whenever you see inflation or deflation, in the long run its always up to one thing
Decrease government purchases, decrease transfer payments, increase taxes => lower deficit1)
Borrow from public => potential problem is very high interest rates to compensate for default risk2)
Borrowing from the central bank => central bank buys government bonds => M => debt moneti zation3)
There are three ways that government can deal with a budget deficit:
The dynamic terms:
During periods of inflation, borrowers tend to benefit and lenders suffer because the value of money borrowed
is higher than the value of money repaid
The nominal interest rate= r+=I
Real interest rate= nominal interest rate - rate of inflation (r=i-)Test ch. 2-5
Open economy= international trade, capital flows
Y=C+I+G+NX
Y-C-G=I+NX
S=I+NX
The Key difference between open and closed economy
NX=net exports(exports-imports)
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*S-I=NX NX CA de ficit or a trade deficit, i.e . imports are
greater than exports => net international borrowing (a
trade deficit country is always a net international
debter-capital inflows)
NX>0 => CA surplus or a trade surplus, ie. Exports are
greater than imports => net international lending (a
trade surplus country is always a net international
creditor- net capital outflows)
Perfect capital mobil ity => any country can engage in as much international borrowing or lending as it
wishes at rw=the world real interest rate
S global
I global
rw
S,IS,I*
rw*
rw
Every country is a "small open economy"
=> no country by i tself can affect rw
If a countries net exports is greater than zero then Y> C+I+G => a countries GDP or income is greaterthan domestic spending =>it exports the difference => a country is liv ing well within its means => it is
earning more than its spending
If NX Y a countries GDP is le ss than domestic spending => its imports the difference => a country is l iving
beyond its means
What one of the major things that started the US to have trade deficit to the rest of the world?
Ex.
S
I
rw
(S-I),NXS=I*
rw*
At rw, S=I, NX=0
=> decrease in taxes => saving to go down
=>A->B = (S-I) S => NXnet intl
borrowing
S'
A B
S
I
r
yL*
r*
This country is running a trade deficit
Rw bs i
S-I=NX at rw
S-I>0 => NX>0 => CA surplus
S-I NX CA deficit
T, TR and G that will increase NX
^T => v C=> ^ S => now S' => at rw, S=I=> NX=0 => CA=0
S'
Borrowing => capital inflows => a trade deficit country is a net debter
When we were running a trade deficit, we re we engaged in net international borrowing or lending?
S v T => v S => Sv relative to I => S-Iv =>-
What was Bush trying to persuade the Japanese to do with respect to fiscal poli cy?
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NX v => the trade surplus goes down
-> foreigners were saving too much
Ben Bernanky blamed the US deficit on "Foreign Savings glut"
S
I
r
S-I
Rw~*
rw
As rw decreases, S- I gets more negative => NX
decreases => CA deficit grows
S I
I'
Theory of Purchasing Power Paridy (PPP)
In theory a unit of countries money should be worth the same in terms of goods and
services evry ware in the world.
F/$1 or foreign price of one unit of domestic money
$1/F or the domestic price of one unit of foreign money
The nominal exchange rate:
Long run:
When F/$1 => e^ => domestic money has appreciated (increased in value relative to foreign
exchange)
-
Flex ible or floating Exchange rates
When F/$1 v => e v=> domestic money has depreciated (decreased in value relative to foreign
exchange)
-
Id e changes E1.3/$1 to e1.4/$1 => the dollar has appreciated to one euro has appreciated-
Real exchange rate= e^x PD/PF roughly measures how e xpensive domestic goods are
relative to foreign goods
E=real exchange rate => E^ => a real appreciation => domestic goods have be come relatively
more expensive to foreigners
The real echnage rate is always tending towards the value of 1 at which point purchasing
power parody holds
%e=f-d
Real Exchange Rate
v T=> C^ => Sv => at rw 1 I >S => (s-I) v => NX v => the current account defici t increases
CA deficit => (S-I) net capital inflow => not intl borrowing, so when (S -I) v => borrowing from
abroad
%De=f -d
Quiz review:
E is constantly changing to cause the balance of payments to equal zero (BOP=0):
If a country is running a current account deficit that means its citizens are trying to make more
payments to foreigners than foreigners are trying to make to them
-
=>e v (domestic money depreciates )
If a country is runni ng a trade surplus (NX>0)
Foreigners are trying to make more payments to it then they are trying to make to foreigners
=> domestic money should appreciate
Flexible Exchange rates:
Test:
Short answer
Output in the long run
Saving investment
Long run monetary framework
Ricardian Equivalence:
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Changes in taxes wil l have no effect on saving because they wi ll have no affect on
consumption
If taxes are increased=> gov saving , but private saving goes down by the exact same amount. So
only if consumpti on decreases will saving increase
Tax rate
Laugher Curve :
Its possible that a decrease in taxes can cause an increase in tax revenues
Taxes
If tv => ^ Ls => ^ L* and v w/p => since Y* = AF(K,L) => ^ Y* => ^ t* Y=taxes
One of the things not able to e xplain in the long run is the business cycle
In the short run, assume that prices are fixed
The key feature of short run:
Short Run
P
y
Y*=AF(K,C)
Y*
LRAS
ADC (M*)
Arrogate demand (AD) is drawn for a particular money
supply(m) and therfore for a particular real money
supply(m.p), given P=> at P*, M/P= M*/P*
=>vP =>(M*/P)^=> "real balance
effect"=>^spending => for goods market to be
in equi librium if ( C+I+G)^ =>Y^ =>B => C
P* SRAS
A
B C
In the short run aggregate demand determines GDP
If Y prices will begi n to fall => Short run aggregate shift (SRAS) shif ts down until Y=Y*If output rises above full empl oyment level prices will begin to rise and SRAS shifts up until output
equals full employment level
Resession:
PLRAS
SRAS
AD
Y*
AD'
Y' Y
P1P2P3
vAD in roughl y 2007=> Yv to Y' => Y' a recession => P should fall =>delation
=>P1 to P2 to P3 =>Y ^ back to Y*
The use of fiscal and/or monetary poli cy to "manage" AD
Stabilization Policy
Favorable supply shock:
Supply Shocks:
'
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P
Q
SRAS
AD
SRAS'
Y* Y**
Ch 10: Aggregate Demand (determines the level of GDP in the short run)
ISLM
Keynesian Cross Theory:how planned spending determines/causes the level of GDPP
P B A
C AD
AD*
Y' Y*
LRAS
SRAS
Planned SpendingCp=a+b(Y-T+TR)
Ip=I
Gp=G
Ep=planned spending
E=actual spending
Ep>E => Ip>I =>unplanned
inventory dissimulations =>Ep>y
EpIp unplanned
inventory accumulations => Ep B>A =>
Ep unplanned
invantory decumulations
= (Ip-I) Y^ until
Y=Y* where Y=Ep at C
c
F
D
Suppose YB => D (Ip-I)>0
=> Yv until Y=Y* whereY=Ep at c
Y= E but when Ep >E, the di fference is that Ip>I => an unplanned decrease in I
If people don't want to buy all of the output that is being produced
what happens to it? It's added to inventories
I>Ip
Ip [1/1-b] is the basic Keynesian
spending multiplier
Even small changes in planned spending
can cause large changes on the equal levelof GDP
-
b=.8 1/1-b = 1/1-.8 =1/.2 =5
b=.9 1/1-b = 1/1-.9 =1/.1 =10 Gv by $100b and b=.9
=> multipl ier = 10 so
whenG=-$100b, in
the short run, y=-$1
trillion
In theory a unit of countries money should be worth the same in terms of goods and
Long Run:
Theory of Purchasing Power Parody
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services every ware in the world.
*$/F or the domestic price of one unit of foreign money
The nominal echange rate=* F/$1 or the foreign price of one unit of domestic money
When F/$1 => e^ => domestic money has appreciated (increased in value relative to
foreign exchange)
Flex ible or floating exchange rates
When F/$1 v => ev => domestic money has depreciated (decreased oin value relative to
foreign exchange)
If e changes 1.3/$1 to 1.4/$1 => the dol lar has appreciated to euro has appreciated
e=nominal exchange rate
Real exchange rate= ex PD/PF roughly measures how ex pensive domestic goods are relative
to foreign goods
=real exchange rate => ^ => a real appreciation => domestic goods have become relatively
more expensive
If e^ => domestic goods are more expensive to fore igners
The real exchange rate is always tending towards the value of 1 at which point purchasing
power parody holds
%e=F-D
Real Exchange Rate
Advantages to QE2
QE2 could signifi cantly decrease borrowing costs => spending1)
QE2 could boost other asset prices => w => consumption spendi ng2)
QE2 could cause the dollar to depreciate => D relative toF => ev => doll ar depreciates => NX3)
IS-LM curve
r
Y
IS
A
B
CE>Y=>y^
Anything direct spending
disturbances that causes
Ep^ at all r's and Y's shift
IS out (vS =>IS out)
Any direct spending
disturbance that causes
Epv at all r's and Y's shift
IS in. (S^ => IS in)
[IS']: T =>(v gov budget deficit) => v (Y-T+TR)= disposable income => Ep(vC) =>IS in
C-> A = 1/1-b * A = 1/1-b*-bT
[IS'']: optimism within the business community= MPKF => I at all r's => IS out
IS'
IS''
LM Curve
r
IS
YY2 Y1
r2
r1
L=money demand
M=money supply
Money Market:
open mkt. sales => vM)
M=M~ (open mkt. purchases => ^M
Md=Md ( I , Y +) i=r with
+
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(i.e. if P~)
=a measure of the perceived riskiness of non monetary assets
i
m
m
Md(I,y,)
i*
m~
m
m'
I'
Debt instruments (IOU's)
Most bonds are associated with a fixed stream of payment(s) in the future=> those payments
represent interest
**Bond prices and interest rates are negatively related
Pc= coupon payment/nominal interest rate
10%=$10/$100
i=coupon payment/ Pc
Consider a consol= a bond that pays interest forever but which never matures(the principle value
is never paid off)
-suppose interest on newly issued bonds decrease to 5% if you purchase a $100 consol, it wi ll pay
$5/year forever
-demand increases for 10% bonds -> PB increase until i t is no longer more desireable than a newly
issued %5 bond, i.e. PB increase unti l = $200
PB=$50 = 10/I => $50(i)=$10 => i=20%
^DB at $50 => PB^ to $100 => $100 = $10/I => I => 10%
Suppose only 2 Financial assets:
Money & Bonds (M and B)
Supply of financial wealth= MS+BSDemand of financial wealth=Md+Bd
Ms+Bs=Md+Bd =>
**Ms-Md=Bd-Bs
When the financial system is in equilibrium:
Bonds:
Ms=Md then Bd=Bs
Ms-Md=Bd-Bs
Ms>Md=Bd>Bs
Ms at i *, Ms>Md (excess suppl y in the money market) => this suggests
Bd>Bs => PB^ => I decreases until Bd=Bs => in the money market the interest rate falls to I*
until the de mand for money = the supply of money (Md=Ms)
A ----> B
^PB what wil l happen to the demand for corporate stock? => Ds^ => Ps^
^Ps, PB=> D real estate => P^ real estate
All securi ties are more or less substitutes for one another:
When the fed monetary poli cy becomes expansionary:
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i
Time1800 1915
Financial Panics
A financial Panic=> a flight to liquidi ty => decrease in (V)velocity => Md =>Md> Ms= Bs>Bd =>PBv => i^
by enough to cause Bs=Bd=Md=Ms
MS
Md
i
5% = i*
m/p
Md'
15%=I"
In this case, Buy securities=> Ms as a result of Fed open market
purchases => Iv to I"
MS
Md
i
i*
m/p
vMs=>i^=>PBv I"
=> Dsv =>Psv
=>D houses v
=>Phouses v
Bond Market
Money Market
(Md>Ms) => ^ Ms s.t. Md=Ms (by buying bonds)=>
then, interest rates don't have to change
vT=> gov. budget deficit => borrowing => Bs => Bs>Dd => PBv => i^
vPB => ^I =>vDs=> vPsBc stocks are a substitute for bonds-
Big players dont like it bc:
Liquidity preference framework:
LM Curve:
I Ms
m/p
IS-LM
The LM curve shares all
combinations of r and Y at
which the money market is
in equil ibrium, everything
else held constant
Md=Md(i*Y*)
Md (Y0)
Md(Y2)
Md(Y1)
i2
i1
i0
LMr
R2R1R0
Y0 Y1 Y0 Y
Ms Ms'
Strange cases:
LM
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Assume perfect capital mobility => balance of payments is in equill ibrium at the world real
interest rate
BP=0 at Vw.
Balance of Payments is a way of keeping track of all international transactions
BoP must = 0
Under flexible exchange rates,e will occur until BoP=0
Under fixed exchange rates, official reserve transactions (ORT) occur until BoP=0
What causes this?
CA (current account)= NX= net sales of domestic goods and services to foreigners =>
Domestic payment to foreigners (-) , If it involves a foreign payment to domestic
residents (+)
-
KFA (capital and financial account)= Net sales of securit ies to foreigners by domestic
residents= sales of domestic securities abroad (domestic borrowing) - purchases of
foreign securi ties by domestic residents (domestic lending abroad).
-
Capital inflows-capital outflows
ORT(offi cial reserve transactions) = Sales of foreign exchange reserves by the domestic
central bank- purchases of foreign exchange reserves by the domestic central bank
-
BoP= CA + KFA + ORT => under fixed exchange rates
Mondell Flemming Model:
Open Economy IS-LM
KFA surplus (ne t borrowing from abroad)
If CA+KFA0
ORT must be negative
From Chinas Persective :
US is running a, CA deficit=
BoP>0=> excess demand for domestic money in fore ign exchange markets=> exchange rate
money appreciates=> exports go down and imports go up=> net exports decrease unti l BoP=0
BoPexcess supply of domestic money in fore ign exchange markets =>exchange rateis
going to go down => domestic money depreciates=> exports increase and imports decrease=>
NX^ until BoP=0
e=F/$1
BoP=0=CA+KFA+ORT
C=a(r,w) + b(Y+TR-T)
I=I(r[-], MPKf[+])
G=G
NX=NX(e,y)
Y=C+I+G+NX
Open economy:
Good Market equi librium condition
Inflation, deflation= value of money for goods and services Appreciation, depreciation= value of money compared to other currencies
E>1=> foreign goods inexpensive
E foreign goods expensive
^ E => real appreciation => v net exports
v E=> real depreciation => NX
E= F/$ * PD/ PF = the price of one unit of domestic goods in terms of foreign goods:
Perfect Capitol Mobility:
NX= NX(e)
rw
BP=0
r
y
BP surplus bc KFA surplus (forei gners buying higher yielding domestic
securitie s => e^ ($ appreciates)
BP deficit bc KFA deficit (domestic residents buying higher foreign
securities) => e v (domesti c money will depreciate)
Under flexible exchange rates
changes in the nominal ex change
rate occur that cause the balance of
payments (BP) to equal zero
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Example: monetary
policy >>> LM
IS
r
Y* Y' y''
r*=rwBP=0
^Ms=> LM shifts down and to the
right=> A->B (rV and y^) => BP def icit
because KFA deficit (more foreign
lending) =>eV (domestic money
depreciates) => NX^ => IS curve shif tsout=> Y sti l further until C at Y''
LM'
A
B
IS'
C
Y
Fiscal Policy >>>
LM
IS
r
Y*
r=rw*
Y
BP=0
^T => IS shifts down and to the left =>r'
BP deficit bc a KFA def icit => eV (domestic
money depreciates) => NX^ => IS up=>
eventually returns to initial position A
IS'
B
A
Under flexible exchange rates changes in fiscal policy will not permanently change anything
>>^T, eV
Fixed Exchange Rates: the central bank pegs the value of money compared to foreign
Gov sets a fixed exchange and whenever there is pressure on it to change the central bank must
intervene in order to maintain the fixed exchange
They require central bank intervention in order to maintain a fixed rate
Pressure to; ^e=>CA^ or KFA^ => ORTV=> more central bank purchases of foreign exchange=> Ms
Pressure to; Ve=> CAV or KFAV so ORT => central bank sales of foreign exchange =>MsV
Flex ible: e (exchange rate) actually does increase
Fixed: buy foreign currency and sell domestic money => Ms until pressure on e^ ceases
BP surplus => pressure on e to appreciate b.c. excess demand for domestic money =>foreigners trying to
make more payments to us then we to them:
Flexible: e actually does decrease
Fixed: Sel l foreign currency => vMs until pressure to e v ceases=> (+ORT)
BP deficit=> pressure on e to depreciate b.c. excess (-ORT) supply of domestic money =>Domestic
residents are trying to make more payments to foreigners than foreigners making to domestic residents
Gold content of =.02oz/
Fixed exchange rates cause a necessity to fi x a price of a key commodity(gold)
Gold content of $=.01/$
e= 1/gold content of =.5/1$
gold content of $
It does not require of imply the value of money will be stableSetting up a gold standard requires fixed exchange rates
^ the value of gold in the commodity market => the value of domestic money => deflation
V the value of gold in the commodity market=> v the value of domestic money => inflation
When you fix the value of money in the terms of a commodity doesnt make the value of money
stable. If the value of money in fluctuating bc of the central bank moving then the gold standard
can be a more stable type of way to use money
Suspension: closed the doors and changed the exchange rate
Gold Standard: Requires Fixed exchange rate.
Fixed exchange in IS-LM framework
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LM
IS
r
YY*
r*
r'
^Ms => rv to r', Y^ to Y' => Capital inflow (KFA defi cit) =>
pressure on e to V => the Fed sells foreign currency =>
MsV => LM shifts back up until pressure on eV is
eliminated i.e. until LM returns to its former position
LM' BP=0
y'
How fiscal policy is Potent and Monetary policy is Not Potent
LMr
YY*
r*
IS
BP=0
IS'
^G=> IS out =>r^ and Y^ but now r>rw, BP surplus
=> Pressure on e^ => buy foreign exchange MS=>
until LM=IS=BP => so A->B->C
a
B
cr'
Y'
IS-LM, Kansian Cross, Multipli er, Understand self adjusting tendencies at work in the economy
^e => appreciation
Ve=> depreciation
Flexible exchange rates:
-> exchange rates are aloud to fl oat but the central bank can effect the exchange rate when
it wants
"Dirty" Float
^e=> reduction
Ve=>devaluation
Fixed:
Fixed Exchange Rate
BP=0
LM
IS
r=rw
r
y
Y* Y
Y=full employment
ODP
Devaluation involves increasing the money supply until the exchange rate
falls to the new desired level and them maintaining the exchange rate at
that level
Fixed=> Flex ible => Fixed
LM
^Ms=> A->B => BP def icit => Pressure on eV, but the central bank lets it fall
(devaluation) => NX^ => IS out => Y^ to Y
Devaluation enables a country to use expansionary monetary policy under fixed
exchange rates
IS'
A
B
C
Why is China so resistant to revaluing its money?
The way china keeps a fixe d exchange rate is by pegging the value of the Yuon to the dollar
If the Chinese revalue its currency the Chinese goods will become more expensive
LM'
IS
r
YY*
r=r*BP=0
For the Chinese to revalue the Yuon,VMs until their e($/1Y)^ to the new "desired" leve l => LM up => but
as e^ => NX V => IS in until YV to Y'
BP is horizontal at rw + (risk premium on borrowing from abroad)
LM
IS'
A
B
C
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LM
IS
r
YY*
r*BP=0
BP=0 =0 and to 5%=> BP shifts
up=> At A1 new BP defi cit=>
eV massive depreciation as a
result of capital flight, which
should NX, but VMs in orderto keep e from falling to
practically "0"
Using Supply and demand analysis to understand e
e=f/$1
Q=$in the foreign
exchange market
S (imports of goods and services, foreign lending)
D (exports, foreign borrowing)
Q*
e*
QD QS
Suppose e fixed at e=>Qs>
QD (of domestic may in the
foreign exchange market:
excess supply) => over
valued =>VMs => S shifts,
or QS-QD=ORT
e
S'
Capital inf lows=> foreigners are paying us for IOU's
KFA=capital inflows-capital outflows
CA=$200b
KFA=$200b
BP=Payments to us-payments by US
Foreign lending= purchases of foreign IOU's by US residents
Refers to the decrease in private spendi ng especially investment that results from an increase in
the interest rate when expansionary fiscal policy is adopted( ^G, TR,VT)
i.e. if b=.9
then change in Y=10* change in G
If interest rate is constant if g the n Y= 1/1-b * ^G
IS-LM
Crowding out:
LM
IS
IS'
^G=>IS out=> A->B= (1/1-b*^G)=>but at B1Were "off" LM (excess demand in money market i.e
Md>Ms=Bs>Bd
PBv and r^ => so Y only to Y'
a c b
Prevent crowding out?
=>debt monetization =>the fed buys the
government bonds that were issued in connection
with G=>Ms^=>LM out=> if r, no crowding out
LM'r'
r*
Self adjusting tendencies
If output is greater than full employment output
If out falls below the sras down
Tying together the ISLM and the economy sel f adjusting theory
LM(M/P) Y>YF=>since MP^
IS
FE
But when the price level increases the real money supply decreases (Pigu effect)
What happens when the fed increases the real money supply?
=>LM curve shi fts out bc. (M/P)^ => r V and Y^ =>
y>Yf=>w^=>P^=>(M/P)v=>usP^, LM shifts back to where i t was befoee IS=LM=FE
r
r*
Y*
LM'
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The economy is in the midst of a recession:
LM
LM'
IS
r
YY*
r*
r'
FE Vw=>IS in=>Y to Y' and rV to r'
=>yM>MF=> wv =>Pv
=>m/p^ =>LM graduall y out unti l Y=Yf)
IS'
y'
STagflation:
LM
IS
r
YY*
r*BP=0
FE
FE' Adverse supply shock temporarily reduces Yf
=>Yv to y' => but y>y', so p^=> m/pV=> lm back =>yV
**Anything that y in IS-LM AD by the same amount
Expectations Adjusted Philips curve
5%
4%
= 5.5% 6%
=e+(M-)
=(-)
%(w/p)=%w-%P so if %p=3% and w, then %(w/p)=-3%
If M= then=e
=e+(M-)
In order to get to Mt+1, ^ tot+1 => assuming adoptive expectationseT+n=T+N-1
If=T+1 this period, then next period eT+2=T+1, soT+1 is associated with a higher rate of inflation
that before (T+2)
Policy:Mt+1=Mt+1+
In order to get rid of inflationary expectations, has to rise above M(recession)
T+2
T+1
e=T
T+1 T
What would happen with a private sector spendi ng disturbance effect the fixed exchange rate.
Would it have been worse and how and why?
Test question: Return to the gold standard:
Fed's hands tied under fixed ex change:
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LM
IS
r
YY*
r=rw*BP=0
In the short run they buy bonds to increase the money supply=> lm out=> rV and Y^
Under fixed exchange since r capitol outf lows (KFA deficit=BP deficit)=> pressure on exchange rate to fall (on domestic money to depreciate
below the fixed nominal exchange rate)
The money supply is too high and r is to l ow there is pressure to decrease the exchange rate=> v MS and continue to do so until LM returned to its
former position
Net result is no change
Screen clipping taken: 1/17/2011, 10:29 PM
Suppose the central bank wants to stimulate the economy:
LM'