According to the table, what is the unemployment rate and what is the labor force participation rate? Unemployment = ((150-138.75)/150) x 100 Labor force participation rate = (150/200) x 100 = 75% 9. Jobless Recovery: A period in which real GDP growth rate is positive but the unemployment rate is still rising 10. Job Search: Workers who spend time looking for employment a. Frictional Unemployment: Unemployment due to the time workers spend in job search i. A certain amount of frictional unemployment is inevitable due to the constant process of economic change ii. The economy is more productive if workers take the time to find jobs that are well matched to their skills iii. When there is a low unemployment rate, periods of unemployment tend to be quite short, suggesting that much of the unemployment is frictional iv. In periods of higher unemployment, workers tend to be jobless for longer periods of time, suggesting that a smaller share of unemployment is frictional b. Structural Unemployment: Unemployment that results when there are more people seeking jobs in particular labor markets than there are jobs available at the current wage rate, even when the economy is at the peak of the business cycle Minimum Wage – each person should get an honest hours worth of work Labor Unions – Creating unemployment? Labor unions are not good if you’re not working because they have bargaining power (an organized association of workers, often in a trade or profession, formed to protect and further their rights and interests Efficiency Wages – Wages that employers set above the equilibrium rate as an incentive for better employee performance *** Frictional and Structural employment are considered long term unemployment Frictional & Structural unemployment are always present; they are NATURAL c. Short Run Unemployment – Cyclical: When workers lose their jobs during downturns in the business cycle. Cyclical unemployment results from a large drop-off in demand. When consumer demand for goods and services drops, business revenues decline, and eventually companies have to lay off workers to maintain profit margins. For example… 100 people are in the labor force 1 person was unemployed for 12 months 12 others were unemployed for 1 non-overlapping month each What is the unemployment rate?GDP % = (2/100) x 100 = 2% because 1 person contributed 50% to the unemployment rate and the others produced the other 50%. The one person that was unemployed for 12 months contributes more to unemployment. Actual Unemployment Natural 5% unemployme nt Cyclical Unemployment 11. Nominal vs. Real Wages a. Nominal: Rate of pay employees are compensated ($15/hr) b. Real: Wages adjusted for inflation or wages in terms of the amount of goods and services that can be bought 12. Okun’s Law: change in GDP % = 3% - 2(change in unemployment %) 3%1.5% Because 3% - 2(1.5) = 0% 13. Phillips Curve (unemployment % & inflation %) a. If inflation is high, then unemployment is low (and vice versa) Inflation %Unemployment %14. Costs of Inflation: (a general increase in prices and fall in the purchasing value of money) a. Shoe Leather Costs: The increased costs of transactions caused by inflation i. Since cash loses its value quickly during high inflation, people waste more time running around to spend it as fast as they can b. Menu Costs: The real cost of changing a listed price c. Unit of Account Costs (inconveniences): Costs arising from the way inflation makes money a less reliable unit of measurement i. Calculations are hard when inflation is high Expected inflation is not bad! Unexpected inflation is a big problem! Inflation rate = ((price level yr 2 – price level yr 1)/price level yr 1) x 100 15. Interest Rate: the proportion of a loan that is charged as interest to the borrower, typically expressed as a percentage of the loan outstanding a. Real interest: the rate of interest an investor, saver, or lender receives after allowing for inflation b. Nominal interest: the interest rate before taking inflation into account __________________________________________________________________ _ Chapter 9: Economic Growth and Development 1. Facts a. World income distribution is very unequal, but this is a recent phenomenon 2. The rule of 70: the magic of compounding a. Even small differences in growth rate get magnified over time b. Doubling time = (70 / percent growth rate) i. Example: If real GDP per capita is growing at an annual growth rate of 3.5%, it will double in: = 70/3.5 = 20 YEARS c. The moral? Small improvements in growth add up fast (the power of compounding) 3. Sources of Economic Growth a. Factor accumulation i. Capital ii. Human capital (health, education, experience) iii. Technology iv. Rule of law, “institutions” *** technology and rule of law are unobservable that combine to determine total productivity 4. Aggregate Production Function Y = T x F (K,H,L,N) T = total factor productivity ∙ Technology ∙ Rule of law ∙ Institutions ∙ Property rights ∙ Social contracts K = physical capital ∙ In order to have more capital, you need to invest ∙ Encourage investment ∙ Investing in a poorer country gives you more return H = human capital ∙ Health, experience, and education L = labor force N = natural resources *** all of your inputs are compliments and that is why you multiply (when you add, they are substitutes) Y = T (2K + 3H + 5L) inputs are perfect substitutes Y = T (K)^0.3 (H)^0.4(L)^0.4 inputs are perfect compliments 5. In per capita terms: (Y/L) = T ((K)^0.3(H)^0.4(L)0.4) //// L) divide everything by labor force 6. Sources of economic growth a. Factor accumulation (more k & h) b. Technological change (grow your technology) Chapter 10: Savings, Investment, and the Financial System 1. Refreshing our National Income Account Knowledge… a. Closed Economy (no trade, self sufficient) GDP = C + I + G Total Income = Total Spending Now, what can be done with income? It can either be spent on consumption – consumer spending (C) plus government spending (G) – or saved (S). SO, it must be true that… GDP = C + G + S Total spending consists of either consumption spending (C+G) or investment spending (I) GPD = C + G + I Total income = consumption spending + investment spending Putting the equations together, we get: C + G + S = C + G + I Consumption spending + savings = consumption spending + investment spending Subtract consumption spending (C+G) from both sides and we get: S = I Savings = Investment spending Budget Surplus: The difference between tax revenue and government spending when tax revenue exceeds government spending (positive contribution to national savings) Budget Deficit: The difference between tax revenue and government spending when government spending exceeds tax revenue (negative contribution to national savings) Budget Balance: The difference between tax revenue and government spending. A positive budget balance is referred to as a budget surplus; a negative budget balance is referred to as a budget deficit National Savings: The sum of private savings and the government’s budget balance; the total amount of savings generated within the economy Total income = Consumption spending + savings b. Open Economy NCI = IM – X Net capital inflow = Imports – Exports Rearranging the equation, we get: I = Y – C – G + NX Using both of the equations, we know that GDP – C – G is equal to National Savings that: (I – S) + NX = 0 Investment spending is equal to savings, where savings is equal to national savings plus net capital inflow Net Capital Inflow: The total inflow of funds into a country minus the total outflow of funds out of a country 2. The Market for Loanable Funds A hypothetical market that brings together those who want to lend money (savers) and those who want to borrow (firms with investment spending projects) We assume that the price of loans is the nominal interest rate a. The Demand for Loanable Funds i. The demand curve for loanable funds slopes downward: the lower the interest rate, the greater the quantity of loanable funds demanded. Here. Reducing the interest rate from 12% to 4% increases the quantity of loanable funds demanded from $150 billion to $450 billion. ii. The higher the interest rate, the higher the opportunity cost of investment spending iii. The higher the opportunity cost of investment spending, the lower the number of investment spending projects firms want to carry out, and therefore the lower quantity of loanable funds demanded iv. To evaluate whether a particular investment spending project iw worth undertaking, a business must compare the present value of the future payoff with the current cost of that project 1. If the present value > current cost = profitable and worth investing in 2. If the interest rate falls, then the present value of any given project rises, so more projects pass that test (and vice versa) Present Value: (of X) The amount of money needed today in order to receive X at a future date given the interest rate Ex.) A firm has two potential investment projects in mind, each of which will yield $1000 a year from now Each project has different initial costs:One requires that the firm borrow $900 right now The other requires that the firm borrow $950 Which of these projects is worth borrowing money to finance and undertake? Depends on the interest rate… A 10% interest rate means $1000 is worth $909 now, so only the first project is worth it, since its initial cost ($900) is l less that the present value b. The Supply of Loanable Funds i. The supply curve for loanable funds slopes upward: the higher the interest rate, the greater the quantity of loanable funds supplied. Here, increasing the interest rate from 4% to 12% increases the quantity of loanable funds supplied from $150 billion to $450 billion ii. Loanable funds are supplied by savers, and savers incur an opportunity cost when they lend to a business: the funds could instead be spent on consumption iii. By saving your money today and earning interest on it, you are rewarded with higher consumption in the future when the loan you made is repaid with interest iv. It is a good assumption that more people are willing to forgo current consumption and make a loan to a borrower when the interest rate is higher 3. The Equilibrium Interest Rate A situation where the interest rate at which the quantity of loanable funds supplied equals the quantity of loanable funds demanded a. At the equilibrium interest rate, the quantity of loanable funds supplied equals the quantity of loanable funds demanded. Here, the equilibrium interest rate is 8% with $300 billion of funds lent and borrowed. Lenders who demand an interest rate of 8% or lower have their offers of loans accepted; those who demand a higher interest rate do not. Projects that are profitable at an interest rate of 8% or higher are funded; those that are profitable only when the interest rate falls below 8% are not. 4. Shifts of the Demand for Loanable Funds a. Changes in perceived business opportunities b. Changes in government borrowing Crowding Out: The negative effect of budget deficits on private investment, which occurs because government borrowing drives up interest rates 5. Shifts of the Supply of Loanable Funds a. Changes in private savings behavior b. Changes in net capital inflows 6. Inflation and Interest Rates a. Anything that shifts either the supply of loanable funds curve of the demand for loanable funds curve changes the interest rate Major Changes in Interest rates due to… ∙ Changes in government policy ∙ Technological innovations that create new investment opportunities The true cost of borrowing is the real interest rate, not the nominal interest rate. Real interest rate = Nominal interest rate – Inflation rate SO, why do we use the nominal interest rate rather than the real interest rate? ∙ In the real world, neither borrowers nor lenders know what the future inflation rate will be when they make a deal ∙ Actual loan contracts specify a nominal interest rate rather than a real interest rate Fisher Effect: The principle by which an increase in expected future inflation drives up the nominal interest rate, leaving the expected real interest rate unchanged i = r + pi Real interest rate = Nominal interest rate – Inflation rate ∙ An increase in expected future inflation drives up the nominal interest rate, where each additional percentage point of expected future inflation drives up the nominal interest rate by 1 percentage point ∙ The central point is that both lenders and borrowers base their decisions on the expected real interest rate ∙ As a result, a change in the expected rate of inflation does not affect the equilibrium quantity of loanable funds or the expected real interest rate; all it affects is the equilibrium and nominal interest rate 7. The Financial System Wealth: (of a household) the value of accumulated savings Financial Asset: A paper claim that entitles the buyer to future income from the seller. Loan, stocks, bonds, and bank deposits are types of financial assets Physical Asset: A claim on a tangible object that can be used to generate future income Liability: A requirement to pay income in the future A well-functioning financial system is a critical ingredient in achieving long-run growth because it encourages greater savings and investment spending. It also ensures that savings and investment spending are undertaken efficiently. a. Three Tasks of a Financial System: ∙ Reducing Transaction Costs o Transaction Costs: The expenses of negotiating and executing a deal ∙ Reducing Risk o Financial Risk: Uncertainty about future outcomes that involved financial losses or gains o Risk-averse: a person who is more sensitive to a loss than to a gain of an equal dollar amount o Diversification: Investment in several different assets with unrelated, or independent, risks, so that the possible losses are independent events ∙ Proving Liquidity o Liquid: Describes an asset that can be quickly converted into cash with relatively little loss of value An asset is liquid if it can be quickly converted into cash with relatively little loss of value o Illiquid: Describes an asset that cannot be quickly converted into cash with relatively little loss of value b. Types of Financial Assets ∙ Loans: A lending agreement between an individual lender and an individual borrower. Loans are usually tailored to the individual borrower’s needs and ability to pay but carry relatively high transaction costs ∙ Bond: An IOU issued by the borrower ∙ Loan-Back Securities: Assets created by pooling individual loans and selling shared in that pool ∙ Stocks: A share in the ownership of a company ∙ Financial Intermediaries: An institution, such as a mutual fund, pension fund, life insurance company, or bank that transforms the funds it gathers from many individuals into financial assets ∙ Mutual Fund: A financial intermediary that creates a stock portfolio by buying and holding shared in companies then selling shares of this portfolio to individual investors ∙ Pension Fund: A type of mutual fund that holds assets in order to provide retirement income to its members ∙ Life Insurance Companies: A financial intermediary that sells policies guaranteeing a payment to a policyholder’s beneficiaries when the policyholder dies ∙ Bank: A financial intermediary that provides liquid assets in the form of bank deposits to lenders and uses those funds to finance the illiquid investments or investment spending needs of borrowers *** REMEMBER C = GDP – G – I NS = Y – C – G PS = Y – C – T BB = T – G Chapter 11: Income & Expenditure Marginal Propensity to Consume: The increase in consumer spending when disposable income rises by $1. Because consumers normal spend part but not all of an additional dollar of disposable income, MPC is between 0 and 1 MPC = (change in consumer spending) / (change in disposable income) For example, if consumer spending goes up by $6 billion when disposable income goes up by $10 billion, MPC = 6/10 = 0.6 Marginal Propensity to Save: The fraction of an additional dollar of disposable income that is saved MPS = 1 – MPC Because we assumed that there are no taxes and no international trade, each $1 increase in aggregate spending raises both real GDP and disposable income by $1. So the $100 billion increase in investment spending initially raises real GDP by $100 billion. This leads to a second-round increase in consumer spending, which raises real GDP by a further MPC × $100 billion. It is followed by a third-round increase in consumer spending of MPC × MPC × $100 billion, and so on. After an infinite number of rounds, the total effect on real GDP is: Total increase in real GDP = (1 + MPC + MPC^2 + MPC ^3 + …) x $100 billion So the $100 billion increase in investment spending sets off a chain reaction in the economy. The net result of this chain reaction is that a $100 billion increase in investment spending leads to a change in real GDP that is a multiple of the size of that initial change in spending. How large is this multiple? It’s a mathematical fact that an infinite series of the form 1 + x + x^2 + x^3+ …, where x is between 0 and 1, is equal to 1/(1 − x). So the total effect of a $100 billion increase in investment spending, I, taking into account all the subsequent increases in consumer spending (and assuming no taxes and no international trade), is given by: Total increase in real GDP from $100 billion rise in I = (1/1 – MPC) x $100 billion Autonomous change in Aggregate Spending: An initial rise or fall in aggregate spending at a given level of real GDP. It’s autonomous – which means “self governing” – because it’s the cause, not the result, of the chain reaction we just described Multiplier: The ratio of total change in real GDP caused by an autonomous change in aggregate spending to the size of that autonomous change Assuming no taxes and no trade, the change in real GDP caused by an autonomous change in spending is: Change in GDP = (1 / 1 – MPC) x change in AAS So the multiplier is: Multiplier = (change in GDP / change in AAS) = (1 / 1 – MPC) Notice that the size of the multiplier depends on MPC. If the MPC is high, so is the multiplier. This is true because the size of the MPC determines how large each round of expansions is compared with the previous round. The higher the MPC is, the less disposable income “leaks out” into savings at each round of expansion. Consumption Function: An equation showing how an individual household’s consumer spending varies with the households current disposable income c = a + MPC x yd lower case letters indicate variables measured for individual household c = individual household consumer spending yd = individual household current disposable income a = constant term – individual household autonomous consumer spending, the amount of spending a household would do if it had zero disposable income Aggregate Consumption Function: The relationship for the economy as a whole between aggregate current disposable income and aggregate consumer spending C = A + MPC x YD C = consumer spending YD = disposable income A = aggregate autonomous consumer spending, the amount of consumer spending when YD equals zero Shifts in the Aggregate Consumption Function: Changes in Expected Future Disposable Income: consumers will now spend more at any given level of current disposable income, YD, corresponding to an increase in A Changes in Aggregate Wealth: A rise in aggregate wealth increases the vertical intercept A, which shifts the aggregate consumption function up Investment Spending: Although consumer spending is much larger than investment spending, booms and busts in investment spending tend to drive the business cycle Planned Investment Spending: The investment spending that firms intend to undertake during a given period. Planned investment spending may differ from actual investment spending due to unplanned inventory investment Planned investment spending is negatively related to the interest rate A higher interest rate leads to a lower level of planned investment spending What drives planned investment? ∙ Interest rate ∙ Expected future real GDP ∙ Current level of production capacity Accelerator Principle: The proposition that a higher rate of growth in real GDP results in higher level of planned investment spending, and a lower growth rate in real GDP leads to lower planned investment spending Inventories: Stocks of goods and raw materials held to facilitate business operations Inventory Investment: The value of the change in total inventories held in the economy during a given period. Unlike other types of investment spending, inventory investment can be negative if inventories fall Unplanned Inventory Investment: Unplanned changes in inventories, which occur when actual sales are more or less than businesses expected Actual Investment Spending: The sum of planned investment spending and unplanned inventory investment I = I unplanned + I planned Planned Aggregate Spending: The total amount of planned spending in the economy; includes consumer spending and planned investment spending AE planned = C + I planned Planned aggregate spending = total amount of planned spending in the economy The general relationship among real GDP, planned aggregate spending, and unplanned inventory investment follows: GDP = C + I = C + I planned + I unplanned = AE panned + I unplanned SO, whenever real GDP exceeds AE planned, I unplanned is positive; whenever real GDP is less that AE planned, I unplanned is negative Income expenditure: A situation in which aggregate output, measured by real GDP, is equal to planned aggregate spending and firms have no incentive to change output Income expenditure equilibrium GDP: The level of real GDP at which real GDP equals planned aggregate spending Keynesian Cross: A diagram that identifies income expenditure equilibrium as the point where the planned aggregate spending line crosses the 45-degree line Chapter 12: Aggregate Demand and Aggregate Supply In chapter 3, we explained that when economists talk about a fall in the demand for a particular good or service, they’re referring to a leftward shift of the demand curve. SIMILARLY, when economists talk about a negative demand shock to the economy as a whole, they’re referring to a leftward shift of the aggregate demand curve. Aggregate Demand Curve: A graphical representation that shows the relationships between the aggregate price level and the quantity of aggregate output demanded by households, firms, the government, and the rest of the world. The aggregate demand curve has a negative slope due to the wealth effect of a change in the aggregate price level and the interest rate effect of a change in the aggregate price level. A higher aggregate price level, other things equal, reduces the quantity of aggregate output demanded; a lower aggregate price level, other things equal, increases the quantity of aggregate output demanded. Why is the Aggregate Demand Curve Downward Sloping? Wealth Effect: The effect on consumer spending caused by the change in the purchasing power of consumers’ assets when the aggregate price level changes. A rise in the aggregate price level decreases the purchasing power of consumers’ assets, so consumers decrease their consumption; a fall in the aggregate price level increases the purchasing power of consumers’ assets, so consumers increase their consumption. Consumer spending falls when the aggregate price level rises, leading to a downward sloping aggregate demand curve. Interest Rate Effect: The effect on consumer spending and investment spending caused by a change in the purchasing power of consumers’ money holdings when the aggregate price level changes. A rise (fall) in the aggregate price level decreases (increases) the purchasing power of consumers’ money holdings. In response, consumers try to increase (decrease) their money holdings, which drives up (down) interest rates, thereby decreasing (increasing) consumption and investment. A higher interest rate indirectly tends to reduce exports and increase imports The Aggregate Demand Curve and the Income Expenditure Model: In the last chapter, we introduced the income expenditure model: Consumption is largely determined by income. The more money people make, the more money they will use to purchase goods and services How does the aggregate demand curve and the income expenditure model fit together? The aggregate demand curve is derived from the income expenditure model Planned aggregate spending (C + I planned) rises with real GDP. This is illustrated by the upward-sloping lines AEplanned 1 and AEplanned 2. Income expenditure equilibrium is at the point where the line representing planned aggregate spending crosses the 45-degree line. A fall in the aggregate price level caused the AE planned curve to shift from AEplanned 1 to AEplanned 2, leading to a rise in income-expenditure equilibrium GDP from Y1 to Y2. Shifts of the Aggregate Demand Curve: A rightward shift occurs when the quantity of aggregate output demanded increases at any given aggregate price level A decrease in aggregate demand means that the AD curve shifts to the left. A leftward shift implies that the quantity of aggregate output demanded falls at any given aggregate price level Panel (a) shows the effect of events that increase the quantity of aggregate output demanded at any given aggregate price level, such as improvements in business and consumer expectations or increased government spending. Such changes shift the aggregate demand curve to the right, from AD1 to AD2. Panel (b) shows the effect of events that decrease the quantity of aggregate output demanded at any given aggregate price level, such as a fall in wealth caused by a stock market decline. This shifts the aggregate demand curve leftward from AD1 to AD2.
When this happens …
Aggregat e Demand INCREASE S
But when this happens…
Changes in Expectati ons
When consumers and firms become more
Shift to the right
When consumers and firms come more
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Aggregate demand DECREASES Shift to the left
Changes in Wealth
When the real value of household assets rises
Shift to the right
When the real value of household assets fall
Size of the existing stock of physical capital
When the existing stock of physical capital is small
Shift to the right
When the existing sock of physical capital is large
When the government increases spending or cuts taxes
Shift to the right
When the government reduces spending or raises taxes
When the central bank increase the quantity of money
Shift to the right
When the central bank reduces the quantity of money
Don't forget about the age old question of Identify the critical components of economis.
Shift to the left Shift to the left Shift to the left Shift to the left Changes in Expectations: Consumers base their spending not only on the income they have now but also on the income they expect to have in the future. Firms base their planned investment spending not only on current conditions but also on the sales they expect to make in the future Changes in Wealth: When the value of household assets rises, the purchasing power they embody also rises, leading to an increase in aggregate spending Size of the Existing Stock of Physical Capital: Firms engage in planned investment spending to add to their stock of physical capital. Their incentive to spend depends in part on how much physical capital they already have: the more they have, the less they will feel a need to add more Fiscal Policy: The use of either government spending or tax policy to stabilize the economy. An increase in government purchases shifts the aggregate demand curve to the right and a decreases shifts it to the left Monetary Policy: The use of changes in the quantity of money or the interest rate to stabilize the economy. When the central bank increases the quantity of money in circulation, households and firms have more money, which they are willing to lend out. Increasing the quantity of money shifts the aggregate curve to the right (and vice versa) __________________________________________________________________ _ Aggregate Supply Curve: A graphical representation that shows the relationship between the aggregate price level and the total quantity of aggregate output supplied The Short Run Aggregate Supply Curve: There is a positive relationship in the short run between the aggregate price level and the quantity of aggregate output supplied. A rise in the aggregate price level is associated with a rise in the quantity of aggregate output supplied. A fall in the aggregate price level is associated with a fall in the quantity of aggregate output supplied. A graphical representation that shows the positive relationship between the aggregate price level and the quantity of aggregate output supplied that exists in the short run, the time period when many production costs, particularly nominal wages, can be taken as fixed. The short-run aggregate supply curve has a positive slope because a rise in the aggregate price level leads to a rise in profits, and therefore output, when production costs are fixed. Wages are typically an inflexible production cost because the dollar amount of any given wage paid, called the nominal wage, is often determined by contracts that were signed some time ago. As a result of both formal and informal agreements, then, the economy is characterized by sticky wages: nominal wages that are slow to fall even in the face of high unemployment and slow to rise even in the face of labor shortages Shifts of the Short-Run Aggregate Supply Curve Panel (a) shows a decrease in short-run aggregate supply: the short-run aggregate supply curve shifts leftward from SRAS1 to SRAS2, and the quantity of aggregate output supplied at any given aggregate price level falls. Panel (b) shows an increase in short-run aggregate supply: the short run aggregate supply curve shifts rightward from SRAS1 to SRAS2, and the quantity of aggregate output supplied at any given aggregate price level rises. Changes in Commodity Prices: An increase in the price of a commodity (oil) raised production costs across the economy and reduced the quantity of aggregate output supplied at any given aggregate price level, shifting the curve to the left and vice versa Changes in Nominal Wages: A rise in nominal wages increases production costs and shifts the short-run aggregate supply curve to the left Changes in Productivity: An increase in productivity means that a worker can product more units of output with the same quantity of inputs. So a rise in productivity increases producers’ profits and shifts the short-run aggregate supply curve to the right The Long-Run Aggregate Supply Curve In the long run, nominal wages are flexible, not sticky A graphical representation that shows the relationship between the aggregate price level and the quantity of aggregate output supplied that would exist if all prices, including nominal wages, were fully flexible. The long-run aggregate supply curve is vertical because the aggregate price level has no effect on aggregate output in the long run – in the long run, aggregate output is determined by the economy’s potential output Potential Output: The level of real GDP the economy would produce if all prices, including nominal wages, were fully flexible This is where the LRAS touches the horizontal axis We generally think of the long-run aggregate supply curve as shifting to the right over time as an economy experiences long run growth From the Short Run to the Long Run In panel (a), the initial short run aggregate supply curve is SRAS1. At the aggregate price level P1, the quantity of aggregate output supplied Y1 exceeds potential output, Yp. Eventually, low unemployment will cause nominal wages to rise, leading to a leftward shift of the short run aggregate supply curve from SRAS1 to SRAS2. In panel (b), the reverse happens: at the aggregate price level P1, the quantity of aggregate output supplied is less than potential output. High unemployment eventually leads to a fall in nominal wages over time and a rightward shift of the short run aggregate supply curve The AD – AS Model: The basic model used to understand fluctuations in aggregate output and the aggregate price level. It uses the aggregate supply curve and the aggregate demand curve together to analyze behavior of the economy in response to shocks or government policy This model is good for: ∙ Understanding macro fluctuations in the short run ∙ Transitions from short run to longer run ∙ Roles of monetary and fiscal policies in the short run Transactions velocity of money VT = P * T / M T = 60 laptops produced P = $1000 M = $10000VT = 6 Income velocity of money V = P * Y / M “T” is not observable Y = $16,000,000 P = 100 M = 320,000,000 P*Y = 1,600,000,000 V = 5 The money that is in circulation Rearrange to write quantity equation: V = P*Y / M P*Y = M*V Side note: if M,V,P,Y don’t change too fast then %change in P + % change in Y = %change in M + %change in V Deriving the AD curve: If V is constant an if M (money supplied) is fixed, then aggregate demand is downward sloping If price goes down, then real GDP goes up Short Run Macroeconomic Equilibrium: The point at which the quantity of aggregate output supplied is equal to the quantity demanded Short Run Equilibrium Aggregate Price Level: The aggregate price level in short-run macroeconomic equilibrium Short Run Equilibrium Aggregate Output: The quantity of aggregate output produced in short-run macroeconomic equilibrium The AD-AS model combines the aggregate demand curve and the short-run aggregate supply curve. Their point of intersection, Esr, is the point of short-run macroeconomic equilibrium where the quantity of aggregate output demanded is equal to the quantity of aggregate output supplied. Pe is the short-run equilibrium aggregate price level. And Ye is the short-run equilibrium level of aggregate output. Shifts of Aggregate Demand: Short Run Effects Demand Shock: An event that shifts the aggregate demand curve. A positive demand shock is associated with higher demand for aggregate output at any price level and shifts the curve to the right. A negative demand shock is associated with lower demand for aggregate output at any price level and shifts the curve to the left. A demand shock shifts the aggregate demand curve, moving the aggregate price level and aggregate output in the same direction. In panel (a), a negative demand shock shifts the aggregate demand curve leftward fro AD1 to AD2, reducing the aggregate price level from P1 to P2 and aggregate output from Y1 to Y2. In panel (b), a positive demand shock shifts the aggregate demand curve rightward, increasing the aggregate price level from P1 to P2 and aggregate output from Y1 to Y2. Shifts of the SRAS Curve Supply Shock: An event that shifts the short-run aggregate supply curve. A negative supply shock raises production costs and reduces the quantity supplied at any aggregate price level, shifting the curve leftward. A positive supply shock decreases production costs and increases the quantity supplied at any aggregate price level, shifting the curve rightward.A supply shock shifts the short-run aggregate supply curve, moving the aggregate price level and aggregate output in opposite directions. Panel (a) shows a negative supply shock, which shifts the short-run aggregate supply curve leftward and causes stagflation—lower aggregate output and a higher aggregate price level. Here the short-run aggregate supply curve shifts from SRAS1 to SRAS2 , and the economy moves from E1 to E2 . The aggregate price level rises from P1 to P2 , and aggregate output falls from Y1 to Y2. Panel (b) shows a positive supply shock, which shifts the short-run aggregate supply curve rightward, generating higher aggregate output and a lower aggregate price level. The short-run aggregate supply curve shifts from SRAS1 to SRAS2, and the economy moves from E1 to E2. The aggregate price level falls from P1 to P2, and aggregate output rises from Y1 to Y2. Long Run Macroeconomic Equilibrium: The point at which the short-run macroeconomic equilibrium is on the long-run aggregate supply curve; so short-run equilibrium aggregate output is equal to potential output. __________________________________________________________________ _ Chapter 13: Fiscal Policy 1. Central question for chapters 13-15… “can government policies stabilize an economy?” ie.) fighting, unemployment, inflation, or both a. Expansionary fiscal policy can close a recessionary gap: instead of waiting for the long run correction mechanism, policy makers could choose to stimulate AD and move the economy back towards long-run equilibrium 2. Fiscal Policy: Changing taxes or government spending in order to stabilize the economy a. Only moves the AD curve b. Expansionary Fiscal Policy: Increased government spending, decreased taxation in order to stabilize the economy c. Contractionary Fiscal Policy: Decreased government spending, increased taxation in order to stabilize the economy 3. Lags in Fiscal Policy a. Inside Lags: The amount of time it takes for a government or central bank to respond to a shock in the economy b. Outside Lags: The amount of time it takes for a government or central banks actions to have a noticeable effect on the economy 4. Fiscal Multipliers a. Autonomous Spending Multiplier (G) 1 / (1 – MPC) b. Tax Multiplier (T) MPC / (1 – MPC) Higher T is going to shrink your demand Lump-sum Taxes: A tax that is the same for everyone, regardless of any actions people take Automatic Stabilizers: Government spending and taxation rules that cause fiscal policy to be automatically expansionary when the economy contracts and automatically contractionary when the economy expands Discretionary Fiscal Policy: Fiscal policy that is the direct result of deliberate actions by policy makers rather than automatic adjustments or rules Cyclically Adjusted Budget Balance: An estimate of what the budget balance would be if real GDP were exactly equal to potential output Public Debt: Government debt held by individuals and institutions outside the government Implicit Liabilities: Spending promises made by governments that are effectively a debt despite the fact that they are not included in the usual debt statistics. In the United States, the largest implicit liabilities arise from Social Security and Medicare, which promise transfer payments to current and future retirees and to the elderly. __________________________________________________________________ _ Chapter 14: Money, Banking, and the FED 1. Functions of Money ∙ Medium of exchange: an asset that individuals acquire for the purpose of trading for goods and services rather than for their own consumption ∙ Store of value: An asset that is a means of holding purchasing power over time ∙ Unit of account: A measure used to set prices and make economic calculations 2. Types of Money ∙ Commodity Money: A medium of exchange that is a good, normally gold or silver, that has intrinsic values in other uses ∙ Commodity-backed Money: A medium of exchange that has no intrinsic value whose ultimate value is guaranteed by a promise that it can be converted into valuable goods on demand ∙ Fiat Money: A medium of exchange whose value derives entirely from its official status as a means of payment 3. Measuring the Money Supply ∙ Monetary Aggregates: An overall measure of the money supply. The most common monetary aggregates in the US are: ∙ M1, which involves currency in circulation, traveler’s checks, and checkable banks deposits ∙ M2, which includes M1 as well as near moneys ∙ Near Moneys: Financial assets that can’t be directly used as a medium of exchange but can be readily converted into cash or checkable bank deposits 4. What do Banks do? ∙ A bank is a financial intermediary that uses liquid assets in the form of bank deposits to finance the illiquid investments of borrowers ∙ Banks can create liquidity because it isn’t necessary for a bank to keep all of the funds deposited with it in the form of highly liquid assets ∙ Banks can’t lend out all the funds placed in their hands by depositors because they have to satisfy any depositor who wants to withdraw his or her funds, and in order to meet these demands, a bank must keep substantial quantities of liquid assets on hand ∙ Bank Reserves: Currency held by banks in their vaults plus their deposits at the Federal Reserve ∙ T-account: A simple too that summarizes a business’s financial position by showing, in a single table, the business’s assets and liabilities, with assets on the left and liabilities on the right ∙ Reserve Ratio: The fraction of bank deposits that a bank holds as reserves. In the US, the minimum required reserve ratio is set by the FED ∙ Bank Run: A phenomenon in which many of a bank’s depositors try to withdraw their funds because of fears of bank failure 5. Bank Regulation ∙ Deposit Insurance: A guarantee that a bank’s depositors will be paid even if the bank can’t come up with the funds, up to a maximum amount per account ∙ Capital Requirements: To reduce the incentive for excessive risk taking, regulators require that the owners of banks hold substantially more assets that the value of bank deposits ∙ Reserve Requirements: Rules set by the FED that set the minimum reserve ratio for banks (US 10%) ∙ Discount Window: A protection against bank runs in which the FED stands ready to lend money to banks in trouble 6. Reserves, Bank Deposits, and the Money Multiplier ∙ Excess Reserves: A bank’s reserves over and above the reserves required by law or regulation ∙ Money Multiplier = 1/reserved requirement ∙ or (money supply / money base) ∙ The ratio of money supply to the monetary base ∙ Monetary Base: the sum of currency in circulation and bank reserves ∙ Monetary Supply: money available for spending (checkable bank deposits) 7. Structure of the FED ∙ Board of Governors: oversees the entire system from its offices in D.C. o Constituted like a government agency: its seven members are appointed by the president and must be approved by the senate o Appointed for 14 year terms to insulate them from political pressure ∙ 12 Federal Reserve Banks: each serve a region of the country, providing various banking and supervisory services ∙ Federal Open Market Committee: make decisions about monetary policy o Consists of the Board of Governors plus 5 of the regional bank presidents 8. What the FED does: A central bank that oversees and regulates the banking system ad controls the monetary base ∙ Federal Funds Market: a financial market that allows banks that fall short of reserve requirements to borrow funds from banks with excess reserves ∙ Federal Funds Rate: The interest rate at which funds are borrowed and lent in the federal funds market ∙ Discount Rate: the rate of interest the FED charges on loans to banks that fall short of reserve requirements 9. Open Market Operations ∙ Like the banks it oversees, the FED has assets and liabilities. The FED’s assets normally consist of holdings of debt issued by the US government, mainly short term US government bonds with a maturity of less than one year, known as US Treasury bills. The Fed isn’t exactly part of the US government, so the US Treasury bills held by the FED are a liability of the government but an asset of the FED ∙ The FEDS liabilities consist of currency in circulation and bank reserves ∙ Open Market Operation: A purchase or sale of US Treasury bills by the FED, normally through a transaction with a commercial bank 10. Respond the the Banking Crisis: The Creation of the Fed ∙ In 1913, the national banking system was eliminated and the Fed was created as a way to compel all deposit taking instituions to hold adequate reserves and to open their accounts to inspection by regulators ∙ But, this did not eliminate the potential for bank runs so the potential for more bank runs became a reality during the Great Depression ∙ After of a failure of a large bank in 1930, federal official realized that the economy-wide effects compelled them to take a less hands-off approach and to intervene more vigorously ∙ In 1932, the Reconstruction Finance Corporation (RFC) was established and given the authority to make loans to banks in order to stabilize the banking sector ∙ In 1933, FDR immediately declared a “bank holiday” closing all banks until regulators could get a handle on the problem ∙ Although the RFC stabilized the banking industry, they still needed to do more, so the Glass-Steagall Act of 1933 separated banks into two categories: ∙ Commercial banks: a bank that accepts deposits and is covered by deposit insurance ∙ Investment banks: A bank that trades in financial assets and is not covered by deposit insurance Leverage: The degree to which a financial institution is financing its investments with borrowed funds Balance Sheet Effect: The reduction in a firm’s net worth from falling asset prices Vicious Cycle of Deleveraging: Describes the sequence of events that takes place when a firm’s asset sales to cover losses produce negative balance sheet effects on other firms and force creditors to call in their loans, forcing sales of more assets and causing further declines in asset prices Subprime Lending: Lending to home-buyers who don’t meet the usual criteria for borrowing Securitization: The pooling of loans and mortgages made by a financial institution and the sale of shares in such a pool to other investors Open market operations are the principal tool of monetary policy: The Fed can increase or reduce the monetary base by buying or selling government debts to banks If the Fed wants to increase the money supply, it will buy T-bills If the Fed wants to decrease the money supply, it will sell T-bills __________________________________________________________________ _ Chapter 15: Monetary Policy 1. Demand for money What determines how much M the public holds? ∙ Price of things we buy (P) M goes up ∙ Wealth and income (Y) M goes up ∙ Opportunity cost of M (r) M goes down 2. The Money Demand Curve ∙ A graphical representation of the relationship between the interest rate and the quantity of money demanded ∙ The money demanded curve slopes downward because, other things equal, a higher interest rate increases the opportunity cost of holding money ∙ By contrast, if the interest rate is high, the opportunity cost of holding money is high people will respond by keeping only small amounts in cash and deposits, converting assets into money only when needed ∙ When prices increase, you’ll want to hold more money ∙ If prices grow or if income grows, shift to the right 3. Shifts in the Money Demand Curve The demand curve for money shifts when non-interest rate factors that affect the demand for money change. An increase in money demand shifts money demand curve to the right, from MD1 to MD2, and the quantity of money demanded rises at any given interest rate. A decrease in money demand shifts the money demand curve to the left, from MD1 to MD3, and the quantity of money demanded falls at any given interest rate. Shifts: ∙ Changes in the Aggregate Price Level: Higher prices increase the demand for money (right) and lower prices decrease the demand for money (left) o The demand for money is proportional to the price level If the aggregate price level rises by 20% the quantity of money demanded at any given interest rate also rises by 20% ∙ Changes in Real GDP: The large the quantity of goods and services they buy, the larger the quantity of money they will want to hold at any given interest rate o An increase in real GDP rightward o A decrease in real GPD leftward ∙ Changes in Credit Market and Banking Technology: The invention of a revolving-balance credit card allowed people to hold less money in order to fund their purchases and decreased the demand for money 4. The Equilibrium Interest Rate ∙ Liquidity Preference Model of the Interest Rate: A model of the market for money in which the interest rate is determined by the supply and demand for money The money supply curve, MS, is vertical at the money supply chosen by the Fed, M. The money market is in equilibrium at the interest rate rE: the quantity of money demanded by the public is equal to M, the quantity of money supplied. At a point such as L, the interest rate, rL, s below rE and the corresponding quantity of money demanded, ML, exceeds the money supply, M. In an attempt to shift their wealth out of non-money interest-bearing financial assets and raise their money holdings, investors drive the interest rate up to rE. At a point such as H, the interest rate rH exceeds rE and the corresponding quantity of money demanded, MH, is less than the money supply, M. In an attempt to shift out of money holdings into non money interest-bearing financial assets, investors drive the interest rate down to rE. 5. Monetary Policy and the Interest Rate The Fed can lower the interest rate by increasing the money supply. Here, the equilibrium interest rate falls from r1 to r2 in response to an increase in the money supply from M1 to M2. In order to induce people to hold the large quantity of money, the interest rate must fall from r1 to r2. So an increase in the money supply drives the interest rate down. Similarly, a reduction in the money supply drives the interest rate up. By adjusting the money supply up or down, the Fed can set the interest rate. Target Federal Funds Rate: The Fed’s desired level for the federal funds rate. The Fed adjusts the money supply through the purchase and sale of Treasury bills until the actual rate equals the desired rate. The Federal Reserve sets a target for the federal funds rate and uses open market operations to achieve that target. In both panels the target rate is rT. In panel (a) the initial equilibrium interest rate, r1, is above the target rate. The Fed increases the money supply by making an open-market purchase of Treasury bills, pushing the money supply curve rightward, from MS1 to MS2, and driving the interest rate down to rT. In panel (b) the initial equilibrium interest rate, r1, is below the target rate. The Fed reduces the money supply by making an open-market sale of Treasury bills, pushing the money supply curve leftward, from MS1 to MS2, and driving the interest rate up to rT.Panel (b) shows the opposite case. Again, the initial money supply curve is MS1 with money supply M1. But this time the equilibrium interest rate, r1, is below the target federal funds rate, rT. In this case, the Fed will make an open-market sale of Treasury bills, leading to a fall in the money supply to M2 via the money multiplier. The money supply curve shifts leftward from MS1 to MS2, driving the equilibrium interest rate up to the target federal funds rate, rT. 6. Expansionary and Contractionary Monetary Policy ∙ In chapter 12, we learned that monetary policy shifts the aggregate demand curve. We can now explain how that works: through the effect of monetary policy on the interest rate ∙ Expansionary Monetary Policy: Monetary policy, that, through the lowering of the interest rate, increases aggregate demand and therefore output (shift to the right) ∙ Contractionary Monetary Policy: Monetary policy, that through the raising of the interest rate, reduces aggregate demand and therefore output 7. Taylor Rule Method of Setting Monetary Policy: a rule that sets the federal funds rate according to the level of the inflation rate and either the output gap or the unemployment rate 8. Inflation Targeting: An approach to monetary policy that require that the central bank try to keep the inflation rate near a predetermined target rate ∙ One major difference between inflation targeting and the Taylor rule method is that inflation targeting is forward looking rather than backward-looking. o The Taylor rule method adjusts monetary policy in response to past inflation o Inflation targeting is based on a forecast of future inflation ∙ Advocates of inflation targeting argue that it has two key advantages over the Taylor Rule: o Economic uncertainty is reduced because the central bank’s plan is transparent: the public knows the objective of an inflation-targeting central bank o The central bank’s success can be judged by seeing how closely actual inflation rates have matched the inflation target, making central banks accountable 9. Zero Lower Bound for Interest Rates: statement of the fact that interest rates cannot fall below zero 10. Short-Run and Long-Run Effects of an Increase in the Money Supply When the economy is already at potential output, an increase in the money supply generates a positive short-run effect, but no long-run effect, on real GDP. Here, the economy begins at E1, a point of short-run and long-run macroeconomic equilibrium. An increase in the money supply shifts the AD curve rightward, and the economy moves to a new short-run macroeconomic equilibrium at E2 and a new real GDP of Y2. But E2 is not a long-run equilibrium: Y2 exceeds potential output, Y1, leading over time to an increase in nominal wages. In the long run, the increase in nominal wages shifts the short-run aggregate supply curve leftward, to a new position at SRAS2. The economy reaches a new short-run and long-run macroeconomic equilibrium at E3 on the LRAS curve, and output falls back to potential output, Y1. When the economy is already at potential output, the only long-run effect of an increase in the money supply is an increase in the aggregate price level from P1 to P3.11. Monetary Neutrality: The concept that changes in the money supply have no real effects on the economy in the long run and only result in a proportional change in the price level 12. The Long-Run Determination of the Interest Rate In the short run, an increase in the money supply from M1 to M2 pushes the interest rate down from r1 to r2 and the economy moves to E2, a short-run equilibrium. In the long run, however, the aggregate price level rises in proportion to the increase in the money supply, leading to an increase in money demand at any given interest rate in proportion to the increase in the aggregate price level, as shown by the shift from MD1 to MD2. The result is that the quantity of money demanded at any given interest rate rises by the same amount as the quantity of money supplied. The economy moves to long-run equilibrium at E3 and the interest rate returns to r1.Now suppose the money supply increases from M1 to M2. In the short run, the economy moves from E1 to E2 and the interest rate falls from r1 to r2. Over time, however, the aggregate price level rises, and this raises money demand, shifting the money demand curve rightward from MD1 to MD2. The economy moves to a new long-run equilibrium at E3, and the interest rate rises to its original level at r1. __________________________________________________________________ _ Chapter 19: The Open Economy 1. Balance of Payments Accounts: Summary of the country’s transactions with other countries for a give year ∙ Balance of Payments on Current Account: Transactions that don’t create liabilities; a country’s balance of payments on goods and services plus net international transfer payments and factor income ∙ Current Account: Transactions that don’t create liabilities; a country’s balance of payments on goods and services plus net international transfer payments and factor income ∙ Balance of Payments on Goods and Services: The difference between the value of exports and the value of imports during a given period ∙ Merchandise Trade Balance/Trade Balance: The difference between a country’s exports and imports of goods alone – not including services ∙ Balance of Payments on Financial Account/Financial Account: International transactions that involved the sale or purchase of assets, and therefore create future liabilities The yellow arrow represents payments that are counted in the current account. The green arrow represents payments that are counted in the financial account. Because the total flow into the US must equal the total flow out of the US, the sum of the current account plus the financial account is zero. 2. Modeling the Financial Account ∙ A country’s financial account measures its net sales of assets to foreigners. There is, however, another way to think about the financial account: it’s a measure of capital inflows, of foreign savings that are available to finance domestic investment spendingThe Loanable Funds Model According to the loanable funds model of the interest rate, the equilibrium interest rate is determined by the intersection of the supply of loanable funds curve, S, and the demand for loanable funds curve, D. At point E, the equilibrium interest rate is 4%. Loanable Funds Markets in a Two-Country World Here we show two countries, the US and Britain, each with its own loanable funds market. The equilibrium interest rate is 6% in the US but only 2% in the British market. This creates an incentive for capital to flow from Britain to the US. Panel a shows the loanable funds market in the US, where the equilibrium in the absence of international capital flows is at point Eus with an interest rate of 6%. Panel b shows the loanable funds market in Britain, where the equilibrium in the absence of international capital flows is at point Eb with an interest rate of 2%. Will the actual interest rate in the US remain at 6% and that in Britain at 2%? No… not if it is easy for British residents to make loans to Americans. In that case, British lenders, attracted by high US interest rates, will send some of their loanable funds to the US. This capital inflow will increase the quantity of loanable funds supplied to American borrowers, pushing the US interest rate down. At the same time, it will reduce the quantity of loanable funds supplied to British borrowers, pushing the British interest rate up. SO, international capital flows will narrow the gap between US and British interest rates. This figure shows an international equilibrium in the loanable funds markets where the equilibrium interest rate is 4% in both the US and Britain. At this interest rate, the quantity of loanable funds exceeds the quantity of loanable funds supplied by American lenders. This gap is filled by “imported” funds – a capital inflow from Britain. At the same time, the quantity of loanable funds supplied by British lenders is greater than the quantity of loanable funds demanded by British borrowers. This excess is “exported” in the form of a capital outflow to the US. And the two markets are in equilibrium at a common interest rate of 4% -- at that interest rate, the total quantity of loans demanded by borrowers across the two markets is equal to the total quantity of loans supplied by lenders across the two markets. In short, international flows of capital are like international flows of goods and services. Capital moves from places where it would be cheap in the absence of international capital flows to places where it would be expensive in the absence of such flows. 3. Understanding Exchange Rates ∙ Foreign Exchange Market: The market in which currencies can be exchanged for each other ∙ Exchange Rates: The price at which currencies trade, determined by the foreign exchange market ∙ Appreciates: A rise in the value of one currency in terms of other currencies ∙ Depreciates: A fall in the value of one currency in terms of other currencies Movements in exchange rates, other things equal, affect the relative prices of goods, services, and assets in different countries. 4. Equilibrium Exchange Rate: the exchange rate at which the quantity of a currency demanded in the foreign exchange market is equal to the quantity supplied The Foreign Exchange Market The foreign exchange market matches up the demand for a currency from foreigners who want to buy domestic goods, services, and assets with the supply of a currency from domestic residents who want to buy foreign goods, services, and assets. The figure shows two curves, the demand curve for US dollars and the supply curve for US dollars. The key to understanding the slopes of these curves is that the level of the exchange rate affects exports and imports. When a country’s currency appreciates (becomes more valuable), exports fall and imports rise. When a country’s currency depreciates (becomes less valuable) exports rise and imports fall. If the US dollar rises against the euro (the dollar appreciates), America products will become more expensive to Europeans relative to European produces. SO, Europeans will buy less from the US and will acquire fewer dollars in the foreign exchange market: the quantity of US dollars demanded falls as the number of euros needed to buy a US dollar rises. If the US dollar falls against the euro (the dollar depreciates), American products will become relatively cheaper for Europeans. Europeans will respond buy buying ore from the US and acquiring more dollars in the foreign exchange market: the quantity of US dollars demanded rises as the number of euros needed to buy a US dollar falls. An Increase in the Demand for US Dollars Suppose that for some reason capital flows from Europe to the US increase. The demand for US dollars in the foreign exchange market increases as European investors convert euros into dollars to fund their new investments in the US. This is shown by the shift of the demand curve from D1 to D2. As a result, the US dollar appreciates against the euro: the number of euros per US dollar at the equilibrium exchange rate rises from XR1 to XR2. 5. Inflation and Real Exchange Rates ∙ To take account of the effect of difference in inflation rates, economists calculate real exchange rates: (sigma) the ratio of the price level abroad and the domestic price level, where the foreign price level is converted into domestic currency units via the current nominal exchange rate o As the exchange rate falls, they should be able to sell more Real exchange rate = Mexican pesos per US dollar x (Pus / Pmex) ∙ Nominal Exchange Rate: (e) the number of units of the domestic currency that can purchase a unit of a given foreign currency (Foreign Currency / Home Currency) ie.) euro / $ , pesos / $ ∙ Purchasing Power Parity: A theory that states that exchange rates between currencies are in equilibrium when their purchasing power is the same in each of the two countries when real exchange rates = 1 o Lose the incentive to have foreign trade o Goods would cost the same amount of money in each country 6. Exchange Rate Regimes ∙ Exchange Rate Regime: A rule governing policy toward the exchange rate ∙ Fixed Exchange Rate: An exchange rate regime in which the government keeps the exchange rate against some other currency at or near a particular target. ∙ Floating Exchange Rate: An exchange rate regime in which the government lets market forces determine the exchange rates 7. Exchange Market Intervention Panel a shows the case in which the equilibrium value of the geno is below the target exchange rate. Panel b shows the case in which the equilibrium value of the geno above the target exchange rate In both panels, the imaginary country of Genovia is trying to keep the exchange rate of the geno fixed at US$1.50 per geno. In panel (a), the equilibrium exchange rate is below $1.50, leading to a surplus of genos on the foreign exchange market. To keep the geno from falling below $1.50, the Genovian government can buy genos and sell U.S. dollars. In panel (b), the equilibrium exchange rate is above $1.50, leading to a shortage of genos on the foreign exchange market. To keep the geno from rising above $1.50, the Genovian government can sell genos and buy U.S. dollars.As panel a shows, at the target exchange rate of $1.50 per geno, there is a surplus of genos in the foreign exchange market, which would normally push the value of the geno down. One way the Genovian government can support the geno is to “soak up” the surplus of genos by buying its own currency in the foreign exchange market. ∙ A government purchase or sale of currency in the foreign exchange market is called an exchange market intervention ∙ To buy genos in the foreign exchange market, the Genovian government must have US dollar to exchange for genos. In fact, most countries maintain foreign exchange reserves: stocks of foreign currency that they can use to buy their own currency to support its price They can also raise the interest rate, which will increase capital flows, increasing the demand for genos an increase in a country’s interest rate will increase the value of its currency They can also reduce the supply of genos to the foreign exchange market by requiring domestic residents who want to buy foreign currency to get a license foreign exchange controls: licensing systems that limit the right of individuals to buy foreign currency 8. Devaluation and Revaluation ∙ Devaluation: A reduction in the value of a currency that is set under a fixed exchange rate regime o Makes domestic goods cheaper in terms of foreign currency which leads to higher exports o Also makes foreign goods more expensive in terms of domestic currency which reduces imports ∙ Revaluation: An increase in the value of a currency that is set under a fixed exchange rate regime o Makes domestic goods more expensive in terms of foreign currency which reduces exports o Makes foreign goods more cheaper in domestic currency, which increases imports 9. Monetary Policy and the Exchange Rate This shows the effect of an interest rate reduction on the foreign exchange market. The demand curve for genos shifts leftward, from D1 to D2, and the supply curve shifts rightward, from S1 to S2. The equilibrium exchange rate, as measured in U.S. dollars per geno, falls from XR1 to XR2. That is, a reduction in the Genovian interest rate causes the geno to depreciate. Here we show what happens in the foreign exchange market if Genovia cuts its interest rate. Residents of Genovia have a reduced incentive to keep their funds at home, so they invest more abroad. As a result, the supply of genos shifts rightward, from S1 to S2. Meanwhile, foreigners have less incentive to put funds into Genovia, so the demand for genos shifts leftward, from D1 to D2. The geno depreciates: the equilibrium exchange rate falls from XR1 to XR2. The depreciation of the geno affects aggregate demand. A depreciation that is the result of a change in a fixed exchange rate increases exports and reduces imports, thereby increasing aggregate demand. A depreciation that results from an interest rate cut has the same effect: it increases exports and reduces imports, increasing aggregate demand.
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