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m ookboo com E2 1 Animaasam 7 Memem shimts AD t we mightmugingam Prim mammary I I E rms arid milham um m quotENE ma mural quot3 g g E i l had up mm 1 I r e mu m mu a le gin EH31 3 Heal EDP qiiiutrnum m1 GP 31 mini 3 with a ownload free books at b Sanjay Rode Advanced Macroeconomics Download free ebooks at bookbooncom N Advanced Macroeconomics 2012 Sanjay Rode ampVentus Publishing ApS ISBN 978 87 403 01 56 4 Download free ebooks at bookbooncom co Please click the advert Advanced Macroeconomics Contents 11 12 13 21 22 23 24 25 26 31 32 Preface Acknowledgement Introduction to Macroeconomics Close to open economy ISLM Framework Aggregate demand and supply Consumption Function Introduction The Ando Modigliani Approach The life cycle hypothesis The Friedman approach Permanent income Friedman consumption function Cyclical movement The Duesenberry Approach Relative income Money De nition and function Aggregate supply wages prices and employment Philips Curve The aggregate supply curve Dynamic Contents 10 11 11 25 35 44 44 48 53 56 57 60 74 74 78 The next step for top performing graduates Masters in Management This 12month fulltime programme is a business qualification with impact In 2010 our MiM employment rate was 95 within 3 months of graduation the majority of graduates choosing to work in consulting or financial services Designed for high achieving graduates across all disciplines London Business School s Masters in Management provides specific and tangible foundations for a successful career in business As well as a renowned qualification from a world class business school you also gain access to the School s network of more than 34000 global alumni a community that offers support and opportunities throughout your career For more information visit wwwlondonedumm email mimlondonedu or give us a call on 44 020 7000 7573 Figures taken from London Business School s Masters in Management 2010 employment report Download free ebooks at bookbooncom Please click the advert Advanced Macroeconomics 33 34 35 36 37 38 39 41 42 43 44 45 46 47 48 49 410 411 412 413 Contents The Production Function 79 The properties of aggregate supply curve 82 Long term adjustment 84 In ation expectation and aggregate supply curve 85 Aggregate supply curve 87 The Modi ed Philips Curve 91 Expected augmented Philips Curve 91 Open economy Macro economy 96 Introduction 96 Open economy and goods market 99 The Mundell Fleming model 103 Competitive depreciation 1 11 The role of prices in open economy 111 Automatic adjustment 113 Expenditure switching and reducing policies 114 Devaluation 1 15 Exchange rate and prices 115 Crawling peg exchange rate 116 I curve effect 117 The Monetary Approach to Balance of Payment MABoP 119 Exchange rate overshooting 126 1 quot 515 ll l 39 direction 39 cureoi m E aring Bus am 5 Pug 4 Teach with the Best Learn with the Best Agilent offers a wide variety of affordable industryleading electronic test equipment as well as knowledgerich online resources for professors and students Lu 6 1 quotE m v H quot i m 3 r T We have 10039s of comprehensive webbased teaching tools lab experiments application notes brochures DVDs CDs posters and more Agilent Technologies Inc 2012 us 18008294444 canada 18778944414 Anticipate Accelerate Achieve Agilent Technologies Download free ebooks at bookbooncom Please click the advert Advanced Macroeconomics Contents 5 Modern Macroeconomics 137 51 Introduction 137 52 The ef ciency wage hypothesis 137 53 The government budget constraint and debt dynamics 142 54 Rational expectation 149 55 The New Keynesian alterative 157 56 Ricardian equivalence 158 57 Search and matching model 162 73 Criticism 168 58 Implicit contracts 169 59 Insider Outsider model 172 510 Real business cycle 174 6 International adjustments Policy implications 184 61 Government budget constraints 184 62 Hyperin ation 186 63 Laffer curve 188 64 Controlling de cit 189 65 Debt management 190 66 The dynamic of de cit and debts 190 67 The Borrow Ricardo problem 193 68 Money and debt nancing 193 13 You re full of energy and ideas And that s 6 Just What we are lo okmg for Looking for a career where your ideas could really make a difference UBS s Graduate Programme and internships are a chance for you to experience for yourself what it39s like to be part of a global team that rewards your input and believes in succeeding together Wherever you are in your academic career make your future a part of ours by visiting wwwubscomgraduates wwwubscomlgraduates alsUBs Download free ebooks at bookbooncom Please click the advert Advanced Macroeconomics Contents 69 The burden of debt 193 610 Government assets 194 611 The budget de cit 194 612 The size of debt budget 195 613 Merged Bank Fund Model 196 614 Rules versus discretion 216 615 Lags in the effects of policy 218 617 Credibility 223 References 225 Glossary 228 D I 39 e o I tte DlSCOVCI the truth at WWWdClOittCCaCareers Deloitte Er Touche LLP and affiliated entities Download free ebooks at bookbooncom Advanced Macroeconomics Preface This book aims at ful lling the curriculum requirement of the Masters students of Macroeconomics Macroeconomics is one of the most practical subjects and is very useful for policy making The domestic and international economy is subjected to different variations in saving income exchange as well as interest rate and balance of payment This book attempts to explain the domestic and international factors responsible for creating the equilibrium of balance of payment interest rate and in ation The various dimensions of issues and logics form the basic core of this book This book will help the students to think analyze and apply the content of this book practically Various industry related example such as data of exchange rate in ation domestic output etc are mentioned to understand the macroeconomic issues It also aims at providing insights to the students teachers and policy makers to think about various macroeconomic issues in broader way Once the issues are known to the policy makers planners and academicians then it is easier for them to think in that direction and ultimately help them to solve some of these issues The advanced macroeconomics book provides fundamentals of the basic macroeconomic identities It will also assist the other educational stream students to understand macroeconomics who are studying it for the rst time This book is divided into two parts The rst part explains the topics related to the closed economy Second part is related to the open economy where open economy and macro economy is explained Both the parts are equally important because the rst part forms the basic crux for understanding the second part which needs higher comprehension levels Some current issues such as foreign exchange money and capital market are also explained in this book as such issues help students to understand the subject in greater depth The rst chapter explains the basic concepts of macroeconomics The ISLM model is explained with expansionary scal and monetary policy The aggregate demand curve is derived from the ISLM equilibrium The aggregate demand and supply explains the price adjustment in the short and long run Second chapter clari es in detail the consumption function The lifecycle and permanent income hypothesis form the major parts of the chapter The investment theories demand and supply of money and the money multiplier are also a part of this chapter Third chapter elucidates the aggregate supply curve in ation and Philips curve The linkage of in ation de cit and debt as well as de cit and debt nancing is also depicted in the last part Chapter four describes the open economy as well as the macroeconomy The chapter attempts to interpret the Mundell Fleming model under xed and exible exchange rate exchange rate uctuation and the reserve bank policy Chapter fth de nes the fundamentals of the modern macroeconomics Rational expectations and real business cycle theory is explained in the latter part Ef ciency wage hypothesis explains the wage bargaining of the workers in industry Download free ebooks at bookbooncom Advanced Macroeconomics Preface Insider and outsider model explains how workers perform the wage bargaining in the industry Search and match model explains the asymmetric information and moral hazard problem of selection of workers and employment issues Chapter six clari es the monetary and scal policy mix for internal stability in details Exchange rate and debt management of government is discussed in the second section Rules versus discretion and the Polak Fund model are also discussed in this chapter Download free ebooks at bookbooncom Advanced Macroeconomics Aclmowledoement 1 Acknowledgement The researchers and academicians are unique in their contribution to Macroeconomics Nobody can correspond with each other in terms of their contribution My work is just a piece of paper and is subjected to various limitations but sincere efforts are made to study the domestic and international factors affecting on macroeconomics Words fall short to express my deep sense of gratitude to my research guide Dr Neeraj Hatekar Professor Department of Economics University of Mumbai Mumbai India His continuous support in my research endeavor was a source of inspiration He taught me various principles of macroeconomics theoretically as well as practically I am lucky to work with him as a research student I am inspired by Dr Indira Hirway Professor and Director of Center for Development Alternatives CFDA Ahmedabad India Her work in labor and gender economics time use study has helped me understand the various macroeconomic issues in detail She took many efforts to teach me the theory and advanced macroeconomics topics in her of ce and in the eld work I wish to express my heartfelt gratitude to Dr Sangita Kohli Principal S K Somaiya College of Arts Science and Commerce for continuous support and encouragement starting right from the planning of the research to the eventual writing of this book I am thankful to Dr Mahadeo Deshmukh Department of Economics SKSomaiya College University of Mumbai for having provided consistent support for research work I would like to thank Dr Sindhu Sara Thomas from the Department of English for the valuable suggestions and help during the research work I owe very special gratitude to Mrs Smitha Angane Department of Statistics and Mathematics who has always lent a helping hand I would like to record my deep appreciation for the administrative staff of SK Somaiya College University of Mumbai particularly to Mr Sanam Pawar Librarian and Mr Mane for their immense help in meeting the requirements smoothly I am thankful to my friend Mr Srinivasan Iyar for some very fruitful discussions on various aspects and part of this book Mr Amit Naik and Mr Anant Phirke have been a continuous source of inspiration and help at need Their affection and encouragement has helped me throughout this research work I must also acknowledge the support of my numerous friends Mr Rajesh Patil and associates Mr Rajendra Ichale to name only a few Finally I would like to express my affectionate appreciation of my mother and father It is dif cult to explain how much efforts they have taken in order to pursue my study I am especially thankful to my uncle and aunt Without their co operation and help I would have not completed this book My brother MrShantaram Rode constantly provided moral support in dif cult times The continuous inspiration from Sushma and Rani was an advantage I am thankful to many of my friends and colleagues without their help this work would not have seen the light of day Last but not the least I would like to thank to my postgraduate and undergraduate students whom I teach economics Sanj ay Iayawant Rode Download free ebooks at bookbooncom l Advanced Macroeconomics introduction to Macroeconomics 1 Introduction to Macroeconomics 11 Close to open economy The productive activities have been an active part of human civilization since ancient times Modern economies have more diversion in form of production function Now skilled labors and advanced computerized machineries are used in the production process The production system at the rst instance satis es the consumption need of the people Therefore in a closed economy without government sector all income which is generated from all natural resources is consumed by people In terms of equations it is presented as follows YC 11 Where Y Production C Consumption All consumption is equal to the income or production If we assume that no external sector exists then exports and imports are not possible In case of lower consumption and more income some income can be saved the equation can be presented as YCS 12 Where Y Production C Consumption S Saving Ultimately saving can be converted in to investment S21 after some time It can be interpreted as YCI 13 Where Y Production C Consumption Download free ebooks at bookbooncom ll Advanced Macroeconomics introduction to Macroeconomics I Investment If equation 12 and 13 are combined then it can be computed as follows CI E Y E CS 14 Income which is either consumed or invested is equivalent to income consumed and saved This is because savings become investments in the long run We live in a democracy and government forms an important part in economy If we add government in the above equation then government does expenditure on various infrastructure projects and welfare schemes It imposes direct taxes on people s income Hence the total disposable income is affected by government expenditure Further the equation becomes YCI G 15 Where G Government levied taxes Government not only nances various development projects but also provides subsidies and maintains defense law and order in society Such activities require expenditure and it is regularly maintained in economy with additional expenditure The total income of the population declines after imposing direct taxes deducing the current equation to YD CS 16 Where YD Disposable income of people C Consumption S Saving In the modern world all the economies are open economies and we cannot neglect external sector Foreign trade is a must in the globalized world and it is increasing with increase in openness of a country s economy Including these factors it can be interpreted as follows YCI GXM 17 Where XM Net exports to other countries Download free ebooks at bookbooncom 12 Please click the advert Advanced Macroeconomics Introduction to Macroeconomics All governments encourage export and try to minimize imports The aim is to increase the foreign capital ow and reserves Including net exports is not enough for equilibrium in the balance of payment Capital ow is also taken into consideration It can be interpreted as YCI G TRTA 18 Where TR Total Receipts TA Total Payments A total receipt comprises the capital ow and net exports Similarly the total payments comprises of the capital out ow and payment for import If we combine the equation 16 and 17 then CS 2 YD E YTRTA 19 C E YDS E YTR TA s 19a SIE GTR TA NX 110 E E E in a E It s only an opportunity if you act on it fIlKEA EfETUDEMT Download free ebooks at bookbooncom 13 Advanced Macroeconomics introduction to Macroeconomics Where NX Net Exports Therefore saving investment government budget and foreign trade has following macroeconomic identity it is presented as CI GNXE Y 2 YD TATR E CS TATR 111 Left hand side of the equation shows the output component of economy Output supply is measured in terms of money it is the national income of the country Right hand side of the equation shows the disposal income it is equivalent to the Gross Domestic Product GDP plus transfer payment and taxes 111 Income and spending Aggregate income in the economy comprises the consumption income government expenditure and net exports It is explained as AD CIG NX 112 Where AD Aggregate Demand NX Net Exports Figure 11 Income and spending in economy E IUgtO AD AD IUlt O 45 Output Download free ebooks at bookbooncom 14 Advanced Macroeconomics introduction to Macroeconomics Figure 11 shows that the aggregate demand is a horizontal line It shows that the aggregate demand in the economy is independent Point E shows that the income is equal to the aggregate demand In the economy if output is more than income then the rms reduce production In the long run when there is less production The output remains in equilibrium Thus the output and equilibrium income is achieved In an economy goods are produced up to the point where they are adjusted to aggregate demand Therefore ADCIGNXY 113 If there is less demand for goods produced then rms will hold the stock of goods and produce less In this case unplanned inventories are working in direction to control supply It can be written as IUY AD 114 In scenarios where unplanned inventories control the aggregate demand in the economy the aggregate demand equals income It can further be deduced as YAD 115 Sometimes the producer expects more demand in future It is their regular exercise to forecast the aggregate demand Hence they invest more economic resources in their rm and nd a market for their products in the long term In such case planned spending is equal to planned output in an economy Therefore the planned spending is also equal to the planned income This is a direct relationship between the income and the spending in an economy But an opposite situation is also possible which is commonly known as recession We will discuss this issue in detail in the next section 112 The consumption function There is direct relationship between disposable income and consumption In general the higher the disposal income then higher is the consumption We must understand that consumption of individual cannot be zero It always increases with increase in age Consumption in simple terms is de ned as C cY 116 Where C Consumption Y Income Consumption is depending up on income and average consumption remains same for a long period of time Alternatively we can rede ne consumption as YCS 117 Download free ebooks at bookbooncom 15 Advanced Macroeconomics introduction to Macroeconomics In the above equation income is equally divided in consumption and saving In a different way it is de ned as Y SC 118a In order to get the saving out of income and consumption we can reorganize the above equation as SY C 118b Some households have minimal income thus they cannot save out of their income regularly Their income is equal to their consumption If the household income increases and the consumption remain constant then the saving occurs But it is usual that income rises with the rise in consumption If we substitute equation 115 into 118b then SY C39eY 118 1cY 019 Where savings depend on the average consumption and change in income there is regular investment in the economy by the government Aggregate demand depends on the consumption and planned average investment It is explained as follows AD C 2 120 Aggregate demand is equal to aggregate consumption and average investment It is very dynamic in nature thus it can be inferred as AD 6I CY 121 As per the equation 115 we have substituted consumption with ccY We assume that autonomous investment in economy should be equivalent to average consumption Therefore the investment will take care of the aggregate consumption in the economy If the income level rises then the propensity to consume can rise Therefore there is need to increase in autonomous investment Ab 26 122 If the economy is capitalistic economy and there is no government intervention then autonomous investment takes care of rising consumption But in a welfare state government regularly invests in economy If commodities are short in supply then the government takes initiatives to supply them If overall production is less then government imports commodities from various countries Therefore government and external sector cannot be ignored YAD 123 Download free ebooks at bookbooncom 16gt Advancech Macroeconomics introduction to Macroeconomics If we minus consumption from both sides of the above equation then the above equation can be written as Y CzADC 124 Thus the equation becomes S I 125 Where the saving is almost equal to the planned investment in economy The following gure 12 shows planned saving and investment in the economy The diagram shows that consumption remains constant at 639 point But with rise in aggregate consumption inventories need to increase investment Therefore aggregate investment increases up to A Where demand increases and equilibrium aggregate gets achieved at B When inventory invests in the economy then output increases up to Y If more output is produced then there is decline in the income Therefore nal output is achieved with Y and equilibrium at E Figure 12 Change in aggregate demand Y ADAcY 21 IUlt0 C ccY 113 The Multiplier The autonomous investment A is equal to average A autonomous investment where income is at equilibrium level As the autonomous investment increases it leads to increase in the income If the income increases then expenditure also increases As the expenditure increases rstly output starts increasing and then income It can be explained by the following equation as ADAACA1C2AC3A1 126 AA1CC2C3 127 Download free ebooks at bookbooncom l7 Please click the advert Advanced Macroeconomics Introduction to Macroeconomics 2 3 AA1CC C 128 If we solve the above equation through geometric method then it is simpli ed as 1 AAD A A 1 C 129 AYO 130 Consequently the change in aggregate demand is equivalent to the change in income Therefore 11c is called the multiplier The multiplier is de ned as the amount at which equilibrium output changes when autonomous demand increases by one unit In simple equation it can be de ned as A l If we exclude government and external sector from the above equation then multiplier can be de ned as l a 1 c 132 encsson com YOUR CHANCE TO CHANGE THE WORLD Here at Ericsson we have a deep rooted 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aggregate demand M AD l 45 15 it l 439 a 4 w Hr m lr39l39 L lE I r K 111 1llf39u Y1 Y2 income In gure 13 the aggregate demand exceeds from Y0 to Y1 Therefore the rms will respond to the change and expansion resulting in production It will lead to increase in induced expenditure Such expansion in the production increases the induced expenditure hence the outcome is an increase in aggregate demand to the AG The expansion reduces the gap between aggregate demand and output to the vertical distance PG The equilibrium output and income is Y O The change in income is de ned as Y2 The PE equal to PE It exceeds the increase in autonomous demand EQ In the diagram multiplier exceeds 1 because consumption demand increases with the change in output It nally leads to change in the demand 114 The government sector During in ation and recession the role of government is important in a welfare state Government decisions directly affect disposable income of people The change in income occurs by two ways Firstly government produces or purchases goods and services from the market It provides goods to the people at lower prices It is done through the public distribution system Therefore disposable income of people increases Secondly government reduces the taxes and it leads to increase in the disposable income of people Similarly government spends on defense infrastructure facilities and law and order The expenditure in all welfare schemes is always higher The equation can be rewritten as AD CI G 135 Download free ebooks at bookbooncom 19 Advanced Macroeconomics introduction to Macroeconomics Consumption depends on disposable income Therefore C can be replaced with YD Similarly net income to households is transfer payment of taxes Therefore consumption function can be rewritten as follows c 5 cYD 5 cYTR TA 136 Where YDYTRTA If we assume that government spends in the economy at an average rate there is average transfer from the government to the public Government collects average taxes from people then G 5 TR 2 TR TA tY 137 Now TA is replaced with tY Therefore above equation can be rewritten as C C CYTR tYC C 138 C CCTR C1 tY 139 The above equation shows that taxes reduce the disposable income and thereby affecting consumption Net transfer also affects consumption The higher the net transfer from the government then consumption expenditure of people is also higher Marginal propensity to consume is related to C 1t It means people consume income after paying taxes If we combine above equations then AD 2 6 TR T c1 ty 21c1 1Y 140 Now aggregate demand is related to the autonomous investment in the economy consumption and disposal income 115 Government and aggregate demand In gure 14 aggregate demand curve is shown as the consumption average consumption and income The new AD is Download free ebooks at bookbooncom 2 Advanced Macroeconomics introduction to Macroeconomics denoted as at slope The slope is at because government put taxes on income and whatever is income left after disposable income is used for consumption Therefore propensity to consume out of income is now c 1t instead of c If we de ne income as follows YAD We can substitute AD in the above equation as follows Y 21c1 tY 141 Government purchases goods and services from private sector It spends G and the transfer payment is denoted as TR The taxes are assumed constant In this case government expenditure shifts the intercept of the aggregate demand curve up and attens the curve Figure 14 Aggregate demand and equilibrium ADGTCY ADGTCY V A A Income Y Now aggregate demand is equal to as follows Y1 c1 t21 Y0 ch l cl t Y0 2 l cl t 141 Government expenditure substantially makes the difference in economy Government expenditure purchase and net Download free ebooks at bookbooncom 21 Please click the advert Advanced Macroeconomics Introduction to Macroeconomics transfer affect the income of people in the economy The government spending taxes government purchase is explained in detail in the next part 116 The Budget The good balanced budget is one that takes care of receipts and payments Balanced budget manage government expenditure and increases income Budget surplus consists of more revenue and less expenditure Government budget consists of total expenditure of goods and services as well as transfer payments STAGTR 142 The budget is surplus if the total government payments are less than government receipts Alternatively if expenditure exceeds the total taxes the budget is in de cit Now we can substitute the TA as Ty then STyGTR 143 The aim of each government is to maximize the tax collection and increase tax base The tax rate is not given much importance But it depends on the tax efforts and collection of each government Each government has different capacity and efforts but it tries to minimize the expenditure But increase in government purchase is equal to AYO GAG The increase in income is in the form of taxes Tax revenue increases by TaGAG The change in budget surplus is de ned as The Graduate Programme for Engineers and Geoscientists MaerskcomMitas Ijoined MITAS because Iwas a construction supervisor in the North Sea advising and WE helping foreman a solve problems MAERSK Download free ebooks at bookbooncom 22 Advanced Macroeconomics Introduction to Macroeconomics ASzATA AE ASztaGA AE t l cl t 1AG l cl tA 1 6904 144 The above equation shows that increase in government purchase will reduce the budget surplus It is further explained in the following Table 11 Download free ebooks at bookbooncom 23 Advanced Macroeconomics introduction Macroeconomics Table 11 Budget of Government of India at a Glance In crore ofRupees 20092010 20102011 20102011 20112012 No Details Actuals Budget Revised Budget Estimates Estimates Estimates 1 Revenue Receipts 572811 682212 783833 789892 2 Tax Revenue net to centre 456536 534094 563685 664457 3 NonTax Revenue 116275 148118 220148 125435 4 capital Receipts 451676 426537 432743 467837 567 5 Recoveries of Loans 8613 5129 9001 15020 6 Other Receipts 24581 40000 22744 40000 7 BorrOWlngS and Other 418482 381408 400998 412817 iabiities 8 Total Receipts 14 1024487 1 108749 1216576 1257729 9 NonPlan Expenditure 721096 735657 821552 816182 10 on Revenue Account Of 657925 643599 726749 733558 which 11 Interest Payments 213093 248664 240757 267986 12 On Capital Account 63171 92058 94803 82624 13 Plan Expenditure 303391 373092 395024 441547 14 On Revenue Account 253884 315125 326928 363604 15 On Capital Account 49507 57967 68096 77943 16 TOtal Expenditure 1024487 1108749 1216576 1257729 913 17 Revenue EXpendlture 911809 958724 1053677 1097162 1014 18 Of which grants for creation of Capital Assets 31317 90792 146853 19 Capital Expenditure 1215 1 12678 150025 162899 160567 20 Revenue De cit 171 338998 276512 269844 307270 52 4 34 34 21 Effective Revenue De cit 1718 245195 179052 160417 35 23 18 22 Fiscal De cit 418482 381408 400998 412817 16156 64 55 51 46 23 Primary De cit 2011 205389 132744 160241 144831 31 19 2 16 Source Budget 2011 G01 Download free ebooks at bookbooncom Please click the advert Advanced Macroeconomics Introduction to Macroeconomics 12 lSLM Framework Introduction In an economy the production of goods depends on a number of factors But the average supply of goods in the economy is considered as aggregate supply Such average supply keeps the prices at a constant level The aggregate supply of goods decides the equilibrium of price The average price level decides the aggregate demand If the prices change then aggregate demand is affected Aggregate demand is related to the average price and supply If the aggregate demand rises it re ects on the aggregate supply 121 Goods and Money market The economy is divided into goods and money market The money and goods market have different equilibriums Graph 11 Equilibrium of goods and money market in economy Goods market Money market DgSgz3 939 Dmsmi DggtSg P DmgtSmI DgltDgP i lt DmltsmP SIMPLY CLEVER SKDDA We will turn your CV into an opportunity of a lifetime quotii uquot h 1 p423 quot r i r I t 5 Jr 25 3 r39r quotWM u I i quot if h P r Kg 7 a Do you like cars Would you like to be a part ofa successful brand Send US your CV on We will appreciate and reward both your enthusiasm and talent WWW39eleoverforlifelcom Send us your CV You will be surprised where it can take you 39 39 Rm Mi Download free ebooks at bookbooncom 25 Advanced Macroeconomics Introduction to Macroeconomics Goods market is in equilibrium when the demand for goods is equal to the supply of goods The price level remains equilibrium The prices of commodities can change if the demand for goods rises faster and supply remains constant resulting in price rise of the commodities The rise in price will have effect on demand of the commodity It is inversely related when the supply of goods rises and demand remains constant Therefore prices of commodities declines or falls If we consider money market equilibrium then the demand for money is equal to the supply of money The interest rate remains constant in the long run If the demand for money increases fast due to number of reasons and the supply remains constant then the interest rate start rising It is opposite when the supply of money rise and demand for money declines The interest rate declines but it is a short term adjustment Figure 15 Flowchart of goods and money market Income Goods market Asset market Aggregate output demand Money Market Bonds market Demand Demand I gt Supply Supply Interest rate Monetary policy Fiscal policy Source Dornbusch and Fischer 1994 In the long run demand and supply of money remains e qual to the supply of money and interest rate remains unchanged At the same time the demand for goods is also equal to the supply of goods The prices remain constant and the goods and money market remain in equilibrium with stable prices and stagnant interest rate Such equilibrium in goods and money market may change after expansion or contraction monetary and scal policy in the short run In the long run both markets remain in equilibrium The detail of each market is explained as follows Download free ebooks at bookbooncom 26 Advanced Macroeconomics introduction to Macroeconomics 122 Goods market equilibrium The goods market is in equilibrium when desired investment and desired national saving are equal or equivalent when the aggregate quantity of goods supplied equals the aggregate quantity of goods demanded Bernanke 2003 Alternatively in the goods market the demand for goods and supply of goods remains at equilibrium Prices of goods remain in equilibrium In other words prices of goods remain constant The aggregate demand curve is related to the interest rate and income level As the aggregate demand shifts upward the interest rate falls and the aggregate income increases The planned investment increases in the economy with increase in output and income In a closed economy the output is equal to expenditure Y CIG 145 Now we will classify each variable in to different categories C cY r 146 Consumption is related to income and interest rate As the level of income rises the consumption expenditure increases It is a positive relation between consumption and income The income is negatively corelated to the interest rate As the interest rate starts rising the consumption expenditure start declining The income is further categorized as Y YD T 147 Now consumption function can be written as follows CZCIT i7re 148 The linear version of consumption function is written as CcOclY T Czl 7Te 149 Where CO is the autonomous consumption and it is independent of income C1 is the responsiveness of consumption to a change in disposal income The C2 is the responsiveness to a change in the exante real rate of interest Now investment function is de ned as IabiTte 150 Where a is shorthand for business con dence and the productivity of investment The b is the parameter that explains how much investment declines in response to an increment in the exante real interest rate The government expenditure is de ned as Download free ebooks at bookbooncom 27 Advanced Macroeconomics introduction to Macroeconomics GG mu Government expenditure in the economy is considered as the average expenditure The IS curve is derived as follows Figure 16 Derivation of IS curve AD1 AD 1 ADCIG Am Interest 1 Rate h A V Income Figure 16 shows that the aggregate demand of investment is equal to the aggregate supply The interest rate is constant The interest rate is related to the aggregate demand At point E the aggregate demand curve shows interest rate and income Aggregate demand curve remains equilibrium with income and interest rate In the long run consumption expenditure increases due to increase in disposable income Fall in interest rate leads to rise in the investments and it also leads to rise in income and investment by the government and private sector The government expenditure infrastructure projects defense law and order increases in the economy due to the concept of welfare state every year Such developmental and social welfare expenditures increase the aggregate demand in the economy In gure 16 the rise in aggregate demand leads to shift in equilibrium from E to E Therefore the interest rate falls from i to i1 The fall in interest rate leads to rise in income If we join point a and b it results in the downward sloping IS curve Download free ebooks at bookbooncom Please click the advert Advanced Macroeconomics introduction to Macroeconomics Properties and shift of IS curve 1 IS curve is downward sloping from left to right 2 The IS curve shows the interaction between interest rate and income output 3 Change in aggregate demand curve leads to shift of IS curve from left to right 4 IS curve is steep when there is small change of interest rate and large change of income Shift of the IS curve Figure 17 Shift of IS curve A AD1 E AD AD gm 45 Interest rate I b IS 181 O Y Income Y1 Y The Agilent InfiniiVision X Series and 1000 Series offer affordable oscilloscopes for your labs Plus resources such as lab guides experiments and more to help enrich your curriculum and make your job easier BEIJIEIJH E u39l n 39 39luk am for All 00300 MILhurrlue T ira rm Agilent Technologies Inc 2012 us 18008294444 canada 18778944414 Anticipate Accelerate Achieve Agilent Technologies Download free ebooks at bookbooncom 29 Advanced Macroeconomics introduction to Macroeconomics As the investment starts rising in the economy the output also increases It leads to rising in the aggregate demand which is observed at point E But rise in aggregate demand shifts the AD curve to ADI The new equilibrium is achieved at E1 At new equilibrium the income rises from Y to Y1 If we derive points a and b then a shift occurs from IS to IS1 curve The new IS1 curve does not get affected by the interest rate Interest rate does not change but the income changes The slope of the IS curve remains same 123 Derivation of LM curve LM curve shows the relationship with money demand and supply Interest rate remains constant when there is no change in demand and supply of money In the short run the demand for money changes very fast but supply of money doesn t Therefore the interest rate rises fast It is also possible that the demand does not rise and supply remains high In this case interest rate declines The demand for real balances increases with the level of real income and decreases with the interest rate The demand for real balances is written as LkY hi khgt0 152 The parameters k and h re ect the sensitivity of the demand for real balances to the level of income and the interest rate For money market equilibrium the demand for money should equal to supply of money Download free ebooks at bookbooncom 3 Advanced Macroeconomics gzkY hi P If we solve it for interest rate then it can be written as iikY h P Untroduct on to Macroeconomics 153 154 The above equation is for the LM curve In the following gure 18 the LM curve is derived Figure 18 Derivation of LM curve 11 LM P1 Mdl Md Ms 7 Y1 Figure 18 shows that the money demand and money supply are at equilibrium at E The interest rate is constant at income level Y As the money demand shifts from Md to Mdl then the interest rate also rises from I to 11 At the same time income rises from Y to Y1 As there is more and more demand for money it further increases the income But at the same time interest rate also rises It means the LM curve shows the link between the interest rate and the income It is a positive relationship between the two variables 31 Download free ebooks at bookbooncom Advanced Macroeconomics introduction to Macroeconomics 124 Shift of LM curve Figure 19 Shift of LM curve LM1 incomeoutput Figure 19 shows that money demand in the short run shifts from M d to Mdl The supply of money also shifts from MS to M81 The new demand and supply of money E1 point increases the income in the economy It is shown as Y to Y1 At point A and at point B two separate LM curves are drawn The expansionary monetary policy leads to increase in income The interest rate remains constant at I The LM curve shifts to LMI Properties of LM curve 1 LM curve is upward sloping 2 LM curve shows the relationship between income and interest rate 3 At same level of interest rate demand for money shift IS curve to right 125 Equilibrium of the IS LM model In the long term ISLM model intersect each other and they remain in equilibrium The downward sloping IS curve and upward sloping LM curve always interact with each other with different possibilities of equilibriums Figure 110 Equilibrium of the ISLM model IS Interest Rate I v Y Income LM L V A Download free ebooks at bookbooncom 32 Advanced Macroeconomics Introduction to Macroeconomics Figure 110 presents the intersection point of IS and LM curves at point E It is always at long term equilibrium It means the rate of interest and income remains constant It is possible that in the short run due to expansionary and contractionary scal and monetary policy The shift is either backward or forward It reduces or increases interest rate and income The arrows in the diagram show the movements to the original equilibrium The following adjustments are shown in the table 12 Table 12 Adjustments in the ISLM model Quadrants Income Interest rate Increase Decrease Increase Increase Decrease Increase IV Decrease Decrease It is not advisable to follow the particular monetary or scal policy This is because following one policy has effect on the income and interest rate In the long run both policies are ineffective 126 Effect of scal policy If government has the expansionary scal policy then such policy leads to the rise in income and interest rate Here the government s objective is to increase the disposable income of people Figure 111 Effect of scal policy on ISLM model t I LM Interest Rate E2 11 I E E1 181 ISO gt 4L 0 i Y Y2 Y1 Output Effects of scal policy on ISLM model Government helps to improve income of people through expansionary scal policy Government reduces the direct and indirect taxes Here an attempt is made to increase the disposable income of people After reduction of direct taxes disposable income of people increases The direct taxes are also reduced on the various commodities resulting in increase in the income of people Download free ebooks at bookbooncom Advanced Macroeconomics introduction to Macroeconomics The gure shows that the expansionary scal policy leads to increase in income Government s expansionary scal policy will increase in income from Y to Y1 Due to expansionary scal policy the income of the people increases very fast But increase in income leads to more saving and people keep money in bank to keep the advantage of increase in interest rate In the gure interest rate increases from I to II The increase in income was expected Y1 but income increases up to Y2 The crowding out occurs in the expansionary scal policy It is shown as Y1 to Y2 The increase in interest rate wipes out the increase in total income Therefore again at higher level of income and higher interest rate industrialists do not nd it easy to invest money and their investment in rms starts declining As the investment declines the employment generation in the economy also starts declining Workers do not nd jobs and the levels of income decline Therefore the increase in interest rate reduces the investment employment and level of income in the economy Therefore again in the long run economy is in equilibrium at point E Short term expansionary scal policy has no effect on the income and interest rate 127 Effect on monetary policy on ISLM model The objective of each monetary authority is to have economic growth in the country Therefore it always increases the money supply and reduces the interest rate At lower interest rate more investment is possible Figure112 Effect of monetary policy on ISLM model LM1 E I E1 11 R W0 Y1 T LM 1s A Monetary policy always improves the income of people through reducing the interest rate The reduction in interest rate helps for investment in the economy Figure 112 shows that the monetary authority reduces the interest rate therefore I decline to II The level of income increases from Y to Y1 But in the long run the reduction in the interest rate and increase in income leads to more investment The production in the economy increases due to high capital investment But the high production leads to lower demand and the prices declines This is because every rm tries to sell their products in national and international markets They may sell at lower prices to cover the xed cost of production The decline in prices due to competition reduces the pro t margin The investment and pro t does not match each other Therefore investment in the future period is affected Thus a recession stage is observed in the economy Decline in the investment reduces the employment opportunities and the level of income declines in the economy The income declines further and it comes again at the original level In the long run expansionary monetary policy is ineffective The interest rate I and income Y remains unaffected in long run Download free ebooks at bookbooncom Advanced Macroeconomics introduction to Macroeconomics 128 Conclusion The goods market is in equilibrium with demand for goods equal to supply of goods The prices are constant The money market is in equilibrium with demand for money equal supply of money Both goods and money market are in equilibrium with interest rate and income It is long run equilibrium with income and interest rate The expansionary scal and monetary policy leads to increase and decrease in the interest rate and income But such changes are short term changes in the economy In the long term both monetary and scal policies are ineffective Therefore the equilibrium interest rate and income is achieved in the long run in the economy 13 Aggregate demand and supply Aggregate demand depends on the goods and money market Goods market shows the equilibrium of income and price level The money market equilibrium shows the relationship between interest rate and income If both markets are in equilibrium with interest rate and income then the aggregate demand is also in equilibrium It shows the relationship between the interest rate and income Figure 113 shows the aggregate demand curve and ISLM curve equilibrium Figure 113 Derivation of aggregate demand T LM Price P pi i 3 IS Vl 3 A g 3 Interest i i b 11 A AD L v Y Y1 Income Download free ebooks at bookbooncom 35 Advanced Macroeconomics introduction to Macroeconomics Figure 113 exhibits that the ISLM curves are intersecting at Point E At point E IS curve shifts to IS1 then the new equilibrium is observed at E1 The IS curve shifts to right because expansionary scal policy Government increases the investment on infrastructure facilities and social services At the same time reduction in the direct and indirect taxes improve the income of people In second diagram if a and b points are joined then the aggregate demand curve can be derived 131 Effects of monetary expansion on AD The aggregate demand curve is affected by the expansionary monetary policy The rise in the money supply and decline in interest rate has the effect on income and output Therefore there is increase in output and income Figure 114 presents the expansionary monetary policy and its effects on aggregate demand Figure 114 Effect of monetary policy on aggregate demand Interest I 11 A Prices Y Income Figure 114 indicates that the expansionary monetary policy will have a positive effect on the income and output The interest rate will fall from i to i1 The LM curve shifts from LM to LMI The expansionary monetary policy will have no effect on the price level The prices will remain at equilibrium at P If we join the two points a and b separately then AD curve can be derived 132 Shifts of aggregate demand curve Aggregate demand curve shifts towards the right if there is expansionary scal policy Download free ebooks at bookbooncom 36gt Please click the advert Advanced Macroeconomics Hntrodmct on to Macroeconomics Figure 115 Fiscal policy and shift of aggregate demand 11 Interest 1 gt 0 Income Price p1 P A V V Y Yl Income In gure 115 the expansionary scal policy has positive effects on aggregate demand The expansionary scal policy leads to increase in income with large increase in the interest rate The downward sloping supply curve is the aggregate demand curve Download free ebooks at bookbooncom 37 Advanced Macroeconomics introduction to Macroeconomics 133 Aggregate supply curve Aggregate supply curve is classi ed into two types The Keynesian and Classical aggregate supply curves are based on separate assumptions The classical supply curve assumes that the supply of the factor of production is xed in the classical way The supply of land labor and capital is xed in economy and it does not change Figure 116 Classical and Keynesian aggregate supply curve Interest rate A AS I A AS I 0 v Y Income Income a Classical aggregate supply curve b Keynesian aggregate supply curve Figure 116 shows the Classical and Keynesian aggregate supply curve In the rst diagram AS curve is vertical straight line and in b part it is horizontal line In Classical case all the factors of production in the economy are fully employed Therefore there is no scope to increase the factors of production The supply remains xed for the long period 134 The effects of monetary and scal policy on classical aggregate supply curve A Fiscal policy and aggregate supply curve The expansionary scal policy will shift the IS curve upward without changing output Download free ebooks at bookbooncom Advanced Macroeconomics introduction to Macroeconomics Figure 117 Effect of scal policy on classical aggregate supply curve AS Interest E1 11 E 181 I IS gtInc0me v Y Figure 117 represents the effect of scal policy on the classical aggregate curve supply It shifts towards up It leads to increase in the interest rate The increase in interest rate is shown as I to i1 Income remains same in the long run The income effect is not positive in the long run as far as classical aggregate supply curve is concerned B Effects of monetary policy on classical aggregate supply curve The scal policy is ineffective in the long run as far as the classical aggregate supply curve is concerned The expansionary monetary policy has also no positive effect on output in classical aggregate supply curve It is explained as follows Figure 118 Effect of monetary policy on aggregate supply curve AS 1 A B1 LM1 11 7 LM Interest T E rate I Y 7 Output A Figure 118 shows that the aggregate income is in equilibrium at Y If there is expansionary monetary policy then the LM curve shifts upward The increase in money supply has positive effect on the interest rate The income remains unchanged or same in the long run Therefore the expansionary monetary policy is ineffective in classical aggregate supply curve Download free ebooks at bookbooncom 39 Advanced Macroeconomics introduction to Macroeconomics 135 Derivation of Aggregate supply Wages are exible upward but sticky downwards so that rise in price cannot decrease the real wage rate but falls in price can increase it Downwardly sticky wages gives a I shape to the AS curve labeled ASI with the curve beginning at the existing price level P1 A further combination is possible if wages are sticky upwards and price level P2 lowers the real wage rate The double sticky case yields the positively sloped AS curve throughout its length labeled ASS in gure 119 as Figure 119 Derivation of an aggregate supply curve YYL KT Real output 4 Real output E P1 7 P07 L0 L1 W1Po W1p1 W1p2 Y0 Y1 Y2 Real output The AS curve is derived with the help of demand for labor real wages production function and output All their combinations show the I type aggregate supply curve It is more elaborated in the following equilibrium of aggregate demand and supply 136 Equilibrium of aggregate demand and supply In the modern economy the aggregate demand and supply are always equilibrium with price level and income The demand curve is downward sloping but the supply curve is upward sloping and it is vertical at the top It means it is a combination of Keynesian and Classical supply curve Download free ebooks at bookbooncom 4o Please click the advert Advanced Macroeconomics Introduction to Macroeconomics Figures 120 Equilibrium of aggregate demand and supply curve Pgtllt Aggregate price level Y Y output Figure 120 displays that the aggregate demand and supply intersect at point E It is an equilibrium point with price Pyr and aggregate income Yquot At equilibrium point price and income is equilibrium If the aggregate demand increases then the prices increases U4 Download free ebooks at bookbooncom 41 Advanced Macroeconomics introduction to Macroeconomics Figure 121 Effect of change in aggregate demand and supply Po Aggregate price level Y0 Y1 Output Y Figure 121 illustrates that the aggregate demand and supply are in equilibrium at E1 Suppose the aggregate demand increases and the aggregate demand remain constant then the new equilibrium is achieved at E2 The price level increases and the output also increase up to Y1 It is a short term effect The supply cannot increase in the long run because all the factors of production are fully employed The output YO remains unchanged in the long run Therefore the aggregate supply curve shifts back to A81 The aggregate demand curve and aggregate supply curve intersect each other at E3 It is new equilibrium in the long term In the long run aggregate output does not change only the price level increases from P0 to P1 We often experience increase in the different commodity prices In the same proportion of price income of people also rises Government provides the dearness allowance to the employee Private sector provides higher pay package for contract labors The output of commodities in the economy remains same in the long run We experience in ation but the real income and output remains the same Questions 1 Write a note on following a Income and spending b Balanced budget theorem c What is crowding out and when do you expect it to occur Is monetary or scal policy appropriate in this case 2 Write short note on fullemployment budget surplus Derive the scal and monetary policy effect on the ISLM framework 4 Bring out the relative effectiveness of scal and monetary policies under different conditions Download free ebooks at bookbooncom 42 Advanced Macroeconomics 5 a b 8 10 11 12 13 14 15 16 17 18 19 20 introduction to Macroeconomics Explain the following Show the effect of monetary and scal policies on the Classical supply curve Explain why the aggregate supply curve is vertical How does it differ from the Keynesian aggregate supply curve Write a short note on aggregate supply curve Write a note on neoclassical theory of investment What are the implications of an increase in the taxrate in the ISLM model How does an increase in the tax rate in the ISLM model affect the following iThe IS Curve ii The equilibrium rate of interest If the government were to reduce the income tax how would output and the price level be affected in the short run and the long run Show the impact on aggregate demand and aggregate supply in both cases Derive the income and substitution effects of a wage increase on the hours of work Write a short note on money multiplier Write a short note on the instruments of monetary control Derive the equilibrium of the aggregate demand and supply How does the expansionary scal policy affect ISLM equilibrium Contractionary monetary policy leads to decline in the interest rate Comment In the long run prices have positive effect on wages Explain it in relation to aggregate demand and supply equilibrium Inventories invest in the economy when they predict increase in aggregate demand what do they do when there is contraction in the aggregate demand What is an effect of monetary policy on goods market Examine in detail Draw the owchart of equilibrium of goods and money market Explain the equilibrium of aggregate demand in open and closed economy Download free ebooks at bookbooncom 43 Please click the advert inn r J r 111b Ul W xviimlu i Linrii lTl7112 gt li 11 2 Consumption Function 21 Introduction Consumption function is important because of number of reasons Consumption is part of aggregate demand If income is not consumed then saving rate rises Consumption is an integral part of day today life Most of the traditional and modern theories have explained consumption function The life cycle theory is associated with Franco Modigliani of MIT He is Nobel Prize winner in economic science The permanent income theory is primarily with Milton Friedman of the University of Chicago He is winner of same price in 1976 Both theories are same in their nature and pay attention on microeconomic foundation The other classical theories of consumption such as AndoModigliani approach which proposes that people make consumption decisions according to the stage of life they are in as well as the resources available during lifetime It is developed in 1950 and it is also known as the life cycle hypothesis This approach was criticized by Friedman in 1956 He developed a new approach known as the Friedman s approach of permanent income advocating that consumer choices for consumption pattern is determined majorly by a change in their permanent income as compared to temporary This approach was later replaced with Duesenberey approach It was replaced with relative income approach in 1960 Friedman and Modigliani Approach Friedman and Modigliani begin with the explicit common assumption that observed consumer behavior is a result of an attempt by rational expectation Consumers maximize utility by allocating a life time stream of earning to an optimum lifetime pattern of consumption quot3173 our HiiJg 39 initial create if r 39fand creativity 39 expectations pioyees who can into The Power of Knowledge Engineering us at wwwskfcomknowledge Download free ebooks at bookbooncom Advanced Macroeconomics Consumption Function Consumption and present value of income We assumed that there is single consumer and the utility function of consumer is de ned as c cT 21 The lifetime utility is a function of his real consumption c in all time period up to T The instant before he dies The consumer will try to maXimize his utility that is obtain the highest level of utility subject to the constraints that the PV of his total consumption in life exceed the present value of his total income in life that is quotY 22 This constraint states that the consumer can allocate his income stream to a consumption stream by borrowing and lending but the present value of consumption is limited by present value of income Let us consider a two period case in which the individual has an income stream Y0Y1 and wants to maXimize UC0C1 subject to borrowing and lending constraints as C1 2Y0 Y1 1r 1r C0 23 In Figure 21 the income stream Y0 Y1 locates the point A This point shows the amount of income the individual will earn in period 0 Y0 and the amount of income he will earn in period 1 Y1 Figure 21 Income of individual in two periods A Y1lrY0 Y1 A slope 1r Y 7 l K in periodO Y0 1 r If his income in period 0 is greater than the value of goods and services he wants to consume in that period then he can lend that is save his unspent income Download free ebooks at bookbooncom Advanced Macroeconomics Consumption Function gn C 0 2 money lent in period 0 By lending this amount he will receive in period one an amount equal to SO 1r S1 lrs0 2 Y1 CI 24 The negative sign enters equation 24 because the dissaving in period 1 is of the opposite sign to the saving in period and C1gtY1 By dividing the expression for S1 by t SO the equation yields the tradeoff between present and future consumption S Solr YIC1 1 So So YO CO 25 From the right hand side equality in the equation 25 by cancelling the S0 and multiplying through by YOC0 we obtain K QUHMQ am Thus the above equation explains that reducing consumption in period 0 below income by the 2 lij laxanEuulmiia Eu Are you considering a European busmess degree Eigiiiigsefw HANDELSHEJSKOLEN LEARN BUSINESS at university level MEET a We le cases with cutting edge CUlture 0f new fOOdS mus39c ENGAGE in extracurricular activities and trad39 39 research working individually or in StUdymgitbizgisnzgja newfway of such as case competitions sports teams and ever on m a 53 9 Clean etc make n 39 Brin b I V e speaks English envrronment in the middle of 18 OO ew friends among CBS g acwaluable knowledge and Copenhagen Denmark 0 students from more than 80 experience to boost your career 39 countries39 r Accreditedby EQUIS 7l iil lastwquot Please click the advert See what we look like and how we work on cbsdk Download free ebooks at bookbooncom 46 Advanced Macroeconomics Consumption Function amount SOY0C0 the consumer can enjoy in period 1 consumption in excess income ClY1 by the amount 1rsb From the individual utility function UuC0C1we can obtain a set of difference curves that show the point at which he is indifferent between additional consumption period 1 or period at O at each level of utility These curves U0U1 to U2 raises the individual s level of utility Figure 22 Individual utility function Utility maxi A Y1 B U2 C 1 U1 U0 0 Yo Co s in period 0 At point B the individual s consumption pattern is C0C1 The position of budget line is determined by two variables that is income period and interest rates The relationship between the present value of the income stream and current consumption from above gure gives us the rst general formulation of consumption function Ctfpvt fgt0 27 Where Pvt is present value of current and future income at time t is i 1 rt Thus it can be simply stated that an individual s consumption in time t is an increasing function of the present value of his income in time t Both A Modigliani and Friedman began their analysis of the consumption function with the general form of the function given in equation 28 Download free ebooks at bookbooncom 47 Advanced Macroeconomics Consumption Function 22 The Ando Modigliani Approach The life cycle hypothesis According to this hypothesis the typical individual has an income stream which is relatively low at the beginning and end of his life when his productivity is low and high during the middle years of his life Thus typically income stream is shown as the Y curve in gure 23 where T is the expected life time Figure 23 Lifespan income and consumption of individual V On the other hand the individual might be expected to maintain a more or less constant or perhaps a slightly increasing level of consumption Thus the model suggests that in the early years of a person s life the rst shaded area of gure he is a net borrower In the middle years he saves to repay debt and provide for retirement In later years the second shaded portion of gure he dissaves To assume that in the absence of any particular reason to favor consumption in any period over any other for representative consumer I if present value PVi raises all of his C rises more or less proportionately In other words for consumer i Ct K PIt Oltklt1 28 Here Ki is the fraction of the consumer s PV that he wants to consume in period t It would depend on the shape of his indifferent curve The above equation explains that if an increase in any income entry present or expected raises the consumers estimate of PV he will consume the fraction of K of the increase in the current period If the population distribution by age and income is relatively constant and the tastes between present and future consumption are stable through time we can add up all the individual consumption function 28 to a stable aggregate function presented as CtkPVt 29 The theory involves consumption as function of expected income which of course cannot be measured AndoModigliani began to make the present value term operational by nothing that income can be divided into income from labor YL and income from assets or property YP Thus permanent income is presented as follows Download free ebooks at bookbooncom Please click the advert Advanced Macroeconomics Consumption Function 2 10 Where time 0 is the current period and t ranges from O to the remaining years of life T we assume that the PV of the income from an asset is equal to the value of the asset itself measured at the beginning of the current period ie t X Z tZaO 0 1r 211 Where a is the real household net worth at the beginning of the period We can separate out known current labor income from the unknown or expected future labor income Thus given PV0 can be deduced as T YL P 10 IIOL 2 1 qo 1 1 01 212 The next step in this sequence is to determine how the expected labor income in time 0 evolves yi0 such that 1 T YL Y5 Z 1 t T l 1 1r 213 The financial industry needs a strong software platform That39s why we need you Find your next challenge at wwwsimcorpcomcareers wwwsimcorpcom MITIGATE RISK I REDUCE COST I ENABLE GROWTH SimCorp Download free ebooks at bookbooncom 49 Advanced Macroeconomics Consumption Function Where T1 is the average remaining life expectancy of the population and the term average the PV of future labor income over T1 year Thus expected labor income term 212 can be written as T YL zltmgt 5 1 1 r 214 This gives us an expression for the PV of the income stream as PV0 YOL T 1Yoe 6 0 215 It has only one remaining variable that is not yet measurable average expected labor income Ye The simplest assumption would be that average expected labor income is just a multiple of present labor income Y5 Y0L r5gto The assumption that if current income rises people adjust their expectation of future income up so that Ye rises by the fraction 5 of the increase in YL Alternatively we could assume that Ye is related to both the present labor income and the employment on the theory that as employ t goes up people will expect their chances for future employment and thus income to rise too Thus assumption can be formulated as e W Y m ffY0L 8 gt0 Where N Employment L Size of the labor force AndoModigliani tried a number of similar assumptions and found that the simplest assumption that YawL Thus substituting YOL for Yoe in equation 215 for PV we obtain Download free ebooks at bookbooncom 5 Advanced Macroeconomics Consumption Fu WCEE W PV 1 T11Y0L a0 216 As an operational expression for PV in equation 216both YL and a can be measured statistically Substituting 0 this equation into equation 29 from consumption yield the expression becomes CO K1 T 1YOL Ka0 217 Above equation is a statistically measurable form of the AndoModigliani consumption function The coef cient of YL and a in equation 211 were estimated statistically by AndoModigliani using annual USA data A typical result of their procedure is explained as follows C0 07le 006at 218 This says that an increase of 1 billion in the real labor income will raise the real consumption by 07 billion The MPC out of labor income is 07 Similarly the MPC out of assets is 006 The value of 5 from equation 217 that is implicit in the estimate of the YL coef cient in equation 218 07 k 15 T1 006 1445 So that 5 is about 025 percent This suggests that when the current labor income goes up by 100 in the aggregation estimates of average expected labor income rise by dollar twenty ve Figure 24 Consumption and labor income Slope 07 Download free ebooks at bookbooncom 51 Please click the advert Advanced Macroeconomics Consumption Function The AndoModigliani consumption function of equation 211 is shown in the gure It shows the consumption against the labor income The intercept of the consumption income function is set by the level of asset a The gure 24 shows a constraint consumption income ratio trend as the economy grows Thus constancy of the trends cy ratio can be derived from the AndoModigliani function as follows We can divide all the terms in equation 218 by total real income to be obtained as YL 07006 Y t t E Yr 219 The AndoModigliani model of consumption behavior eXplains all three of the observed consumption phenomena that is 1 Cross sectional budget studies show that sy increases as income y rises so that in cross sections of the population MPCltAPC 2 Business cycle or short run data shows that the cy ratio is smaller than average during boom periods greater than average during boom periods greater than average during stumps so that in the short run as income uctuates MPSltAPS 3 Long run data trend as MPCAPC It eXplains the MPC ltAPC result of the cross sectional budget studies by the life cycle hypothesis It provides an explanation for the cyclical behavior of consumption with the consumption income ratio inversely related to income along a short term function V 1pm quot39u 7 umwh tl n ljpmg mh it 3rqu g 39 I E39E l ng ii urln r Download free ebooks at bookbooncom 52 Advanced Macroeconomics Consumption Function 23 The Friedman approach Permanent income Friedman began with the assumption of individual consumer s utility maximization which gives us the relation between an individual s consumption and present value The model Consumption function is de ned as follows Ct PVt s gtO 219 Where PVt the present value of current and future income at time t is Z Y l rt Cl f PVIs gtO 220 Friedman differs from AndoModigliani beginning with his treatment of PV term in equation 220 multiplying by a rate of return gives us Friedman s permanent income as Y1 F39PV 221 Thus permanent income from the consumers present value which includes human capital The present value of future labor income is included in the above equation Friedman along with AndoModigliani assumes that the consumer wants to smooth his actual income stream into a more or less at consumption pattern This gives a level of permanent consumption 139 139 1 that is proportional to 1 Cp 2 K Yp 222 The individual rate of permanent consumption to permanent income is k presumably depends on the interest rate The return on saving individual tastes shaping the indifference curves and the variability of expected income If there is no reason to expect these factors to be associated with the level of income we assume that the average Ki for all income classes will be the same equal to the population average We can classify a sample of the population by income as C pi K Y P 223 Download free ebooks at bookbooncom 53 Advanced Macroeconomics Consumption Function Strata is done in the cross section budget studies we would expect that the average permanent consumption to each income class I would be K times its average permanent income for all income classes i We observed that total income in a given period is made up permanent income Y which the individual has imputed to himself plus a random transitory income component Y which can be positive negative or zero Here subscript t refers to transitory not time Thus it gives us measured income as the sum of the permanent and transitory component It can be de ned in terms of equation as follows Y YP Yr 224 Similarly total consumption in any period is permanently consumption C1 is random transitory consumption component i and C wh1ch represents pos1t1ve negat1ve or zero dev1atlon from the normal or permanent and trans1tory consumptlon C Cp Ct 225 Friedman s theory of the cross sectional result in MPCltAPC 1 Friedman assumes that there is no correlation between transitory and permanent income In other words Yt i i 1s Just a random uctuatlon around So that covar1atlon of Yp and Yr across 1nd1v1duals 1s zero Implications Suppose we take a sample of families from a roughly normal income distribution and then sort them out by income 139 classes Since Yp and Yr are not related the income class that centers on the population average income will have an average transitory income component yr 2 0 and for that income class if 2 713 2 Friedman assumes that there is no relationship between permanent and transitory consumption so that Ct is just a random veri cation around Cp 3 Finally Friedman assumes that there is no relationship between transitory consumption income and transitory income Friedman assumes that the covariance of Ct and Yt is also zero The last two assumptions that transitory consumption is not corelated with either permanent consumption or transitory income means that when we sample the population and classify the sample by income levels for each income class the transitory variation in consumption will cancel out so that for each income class the equation becomes En 0 C CPI 226 For each income class i Download free ebooks at bookbooncom Please click the advert Advanced Macroeconomics Consumption Function We can now being this series of assumption together into an explanation of the cross section result that MPCltAPC even when the basic hypothesis of the theory is that the ratio of permanent consumption to permanent income and a constant K Consider a randomly selected sample of the population classi ed by income levels A group I with average observed income Above average population income will have a positive average transitory income component Ytl gt O for this I above average group Then observed average income will be greater than average permanent income that is Y1gtYpi All income groups will have average permanent consumption given by C pi K Y pi But since C is not related to either C or Y all groups including the above average income group will have a zero average transitory consumption p1 t1 components so that 61 CPI Linking these two consumption condition gives us Thus the above average income group will have average measured consumption equal to permanent consumption but the average measured income is greater than permanent income so that its measured Ci Yi ratio will be less than K Similarly a below average income group j will have a measured a if ratio gt 239 Do you want your Dream Job More customers get their dream job by using RedStarResume than any other resume service RedStarResume can help you with your job application and CV Go to Redstarresumecom Use code BOOKBOON and save up to 15 enter the discount code in the Discount Code Box Download free ebooks at bookbooncom 55 Advanced Macroeconomics Consumption Function In the gure K represents the relationship between permanent consumption and income The point Y is the population average measured income if the sample is taken in a normal year when measured Average income is a trend Average transitory income will be zero so that Y YP The point Cp is the population average measured and the permanent consumption 24 Friedman consumption function Cyclical movement In an average year when Y 0 the C0 YO point falls on the long run Kline In a year with above trend incomeYi transitory income is positive so that Ypl lt Y1 and the C1 Y1 point below the 239 line giving us the short run function Figure 25 Permanent and transitory income effect C T K A l 3 zquot 3quot i quot i i quot I I Cp I s z g i Cl kpi l I I I Y1 YpiYYp rm Yz Y Thus Friedman s model also explains the cross section budget studies and short run cyclical observation that the cy ratio is fairly constraint that is APCMPC This Model is somewhat less satisfactory than AndoModigliani model In that model assets are only implicitly taken into account as a determinant of permanent income And it relies on less observable aspect of income permanent income and transitory income than the AndoModigliani model which separates out the observable component labor income and the value of assets Download free ebooks at bookbooncom 56 Advanced Macroeconomics Consum tion FM action Figure 26 Consumption and income effect C 1t 1 SRF Co A Y Ar Y 2 9 YpZ Y0 pl Nevertheless the two models are closely related and familiar with transitory high income In Friedman s analysis it could be familiar in the middle years In the AndoModiglian life cycle positive transitory income could be the one at the end of the life cycle Thus the life cycle hypothesis could be one explanation of the distribution of Friedman s transitory income The two models are similar in the starting point of the analysis in the consumption Present value relationship is given in equation rstly as cif1PVi and the explanation of cross section result The AndoModigliani model might be more useful to econometric model builders and forecasts It explicitly includes measured current income and asset to explain consumption But it may also need careful interpretation In cases where income changes are clearly temporary and permanent income consideration are less relevant The strength of Friedman theory is that it is related to the acceptance by many economist of the proposition that people base current consumption saving decision on more than just current and past values of income and assets 25 The Duesenberry Approach Relative income The model developed by Duesenberry in 1949 differs considerably from the AndoModigliani and the Friedman model The Duesenberry model does not begin with the basic assumption present value relationship Duesenberry s analysis is based on two relative income hypotheses A First hypothesis The rst hypothesis is essentially that the consumers are not so much concerned with their absolute and relative level of consumption They are concerned with their consumption relative to the rest of the population The AndoModigliani and the Friedman model are based on the solution to the problem of consumer choice where the individual tries to maximize UuC C CT subject to a present value constraint 0 o n a o n a o n a o n t Download free ebooks at bookbooncom 57 Please click the advert Advanced Macroeconomics Consumption Function In that case only the absolute level of individuals consumption enters the utility function Duesenberry however writes the utility function as 228 Where P s is weighted average of the rest of population s consumption This approach explains that utility increases only if the individual s consumption rises relative to the average This assumption leads to the result that the individual s consumption to income cy ratio will depend on his position in the income distribution A person with an income below the average will tend to have a high cy ratio because essentially he is trying to keep up to a national average consumption standard with a below average income On the other hand an individual with an above average income will have a lower cy ratio because it takes a smaller portion of his income to buy the standard basket of consumer goods This provides the explanation of both the cross section result that MPCltAPC and the long run consistency of cy B Second hypothesis Duesenberry s second hypothesis is that the present consumption is not in uenced by present levels of absolute and relative income but also by levels of consumption in the previous periods It is much more dif cult he argues for a family to reduce level of consumption once attained than to reduce the portion of its income saved in any period AllOptions Try this The secluem A 4 839 30 l2 1 my leg t5 the scqoewce a new Whole numlggrji The M WUW EQr I00 ha Iota re in H4 3 Sequence Download free ebooks at bookbooncom Advanced Macroeconomics Consumption Function Thus assumption suggests that the aggregate ratio of saving to income depends on the level of present income relative to previous peak income Y mathematically In Duesenberry s formulation a0 61 Y 229 ltIC2 Where Y is a real disposal income As present income rises relative to its previous peak sy increases and vice a versa We can convert this Duesenberry saving function into a consumption function by observing that if Y is disposal income cy11sy so that from 22 we can obtain 220 630 631 Y Y 230 As income grows along trends previous peak income will always be last year s income so that Y Y would be equal to 1g where gy is the growth rate of real income If Y grows at 4 percent along trend will be 104 and Q will be constant A Y as required by the long run data of Kuznets Y But as income due to the negative coef cient of 7 in 23 Y To compute MPC we can multiply the cy ratio of 23 by Y to obtain Y2 C 2180Y817 Y The MPC the partial derivatives of C with respect to Y is then a Y MPC C1 ao 2a17 a Y y 231 Comparison of equation 4 giving the MPC and equation 230 giving the APC shows that in the short run with previous peak income xed The Duesenberry model implies MPCltAPC Thus the combination of short run and long run behavior of consumption gives us the Ratchet effect shown in the gure 27 Download free ebooks at bookbooncom 59 Advanced Macroeconomics Consumption Function Figure 27 Ratchet effects of consumption C A LRF C1 C1 C1 The Ratchet effect in consumption C0 C0 0 Y Y0 Y1 With a constant cy ratio at some point like C0 Y0 income falls off and the economy goes into a recession c and y move down along a short run function coc0 with slope given by MPC in equation 24 Recovery of income back to its trend level which is also the peak will take c and y back up coc0 to the initial c0 yopoint Where trend growth resume along the long run function if another recession occurs at clyl consumption and income will fall back along c1c1 and rise back to c1y1 during the recovery Thus Duesenberry s model implies a Ratchet effect in that when income falls off The theories of AndoModigliani and Friedman seem to be more successful than Duesenberry s 26 Money De nition and function In traditional societies goods were exchanged for goods But even today barter system is often practiced in the rural areas Due to monetization of the economy the use of money has increased There are three approaches to demand for money developed by the Classical Cambridge and Keynes The money is supplied in the economy on regular basis by the reserve bank The determinants of money and the velocity of circulation of money determine the total volume of money in the economy 261 Origin of money In traditional society not the actual money but its proxy was used in all the transactions There were various forms of money Such money was commodity representative or credit money Such forms of money are explained as follows 1 Commodity money In the ancient times the barter system existed in societies People were exchanging commodities for commodities through a common understanding between two parties The net gain from sharing of commodities was assumed to be the equal for both parties Such transactions were practiced for a long time in the developing countries But they suffer from a number of limitations Some commodities were not perfectly divisible One party wanted to share commodities for another commodity which were indivisible for example animals such as pigs and cattle were often considered as commodity Download free ebooks at bookbooncom 6 Please click the advert Advanced Macroeconomics Consumption Function Secondly there was absence of common measure value in multi commodities trade If all the commodities are exchanged for commodities then it is difficult to understand and remember value of each commodity into the exchange for another commodity Thirdly perishable commodities cannot be substituted for another commodity They cannot be stored for longer periods of time and carried for long distances Due to all these limitations commodity money use declined slowly in different transactions 2 Representative money The representative money is any type of money that has face value greater than its value as material substance such as precious stones and metals gold or silver which were used extensively in ancient transactions Such representative commodities money was used for transaction of commodities Though the representative money suffered from a number of limitations such as representative commodities are overvalued and other commodities are undervalued Also the representative money is in limited quantity and therefore not available for common transaction which people required all the time 3 Credit money Most of the commodities were exchanged based on the credit basis More assets such as land houses and factory were used against the exchange of commodities But such commodities were not liquid and available with the masses Therefore credit money had limitations in exchange for the commodities In order to overcome all the limitations of commodities representative and credit money money is used as a medium of exchange Now almost all the transactions take place in terms of money THIS ebook IS PRODUCED WITH iText Download free ebooks at bookbooncom 6T Advanced Macroeconomics Consumption Function 262 Money Concept and de nition Money is any object that is accepted as a method of payment for the goods and services It is a medium of exchange Various de nitions are given and money is de ned Money is sometimes de ned as a store of value The important characteristics of money are as follows 1 Acceptability Money has universal acceptability The coins are supplied by the government The currency notes are supplied by the reserve bank Therefore money is widely acceptable to all the people despite its size shape and color for every country 2 Durability Money is durable and cannot be easily destroyed If money is saved for a long time then it remains as it is in terms of color and shape for longer periods Durability depends on quality of paper color size etc Even though it is exchanged and it is circulated in the economy then also money remains durable for longer periods of time 3 Divisibility Money is perfectly divisible It means money can be converted into different forms of notes A ve hundred rupees note is easily converted in to ten rupees notes It can be used to pay an actual amount for goods and services purchased Such divisibility helps commerce and trade Easy divisibility of money is an important feature of money 4 Uniformity Money is uniform as it has equal shape size color etc Money can be used in all transactions because it is uniform Money in the form of currency is available to all the people Uniform money helps to identify money within short periods of time The money printed in the past and present are in the same form If the old coins or notes are going out of exchange or circulation under any change in size or shape the same is informed in newspapers and magazines timely 5 Recognizable All people easily recognize and identify money and use money at the time of need Even small children can easily identify money Money is used in regular transactions all over the world 6 Scarcity Money is scarce and it is not easily available In order to get the money person has to take debt borrow or work for it Farmers have to produce commodities in their farm Industries must do the business Money cannot be transferred easily from one person to another The scarcity factor forces money to be used wisely because it has alternative uses If the money is cheap and it is easily available then the monetary authority decides to reduce its supply through monetary policy and instruments Download free ebooks at bookbooncom 62 Advanced Macroeconomics Consumption Function 7 Stability Money provides stability for individuals as well as the economies The scarce money can be saved and it can be used when it is required During economic crisis and recession money needs to be used wisely so the crisis can be converted into an opportunity More stability is expected with more money Therefore all people like to earn money and store it for future needs 263 Functions of money There are four functions performed by money They are explained as follows 1 Medium of exchange Money is used in all transactions The value of all the commodities and services are converted into money Therefore now a day s commodities are not exchanged for commodities but money is paid for each commodity in exchange Therefore all human beings carry cash and pay the amount of commodity in money terms Thus money is used as a medium of exchange 2 Unit of account Money is used as a medium of exchange It is a scarce commodity Therefore money has to be accountable A detail record is kept of money paid and money received More receipts of money are added into credit account where payments are added in debit The account summary of debit and credit is regularly available from all the transactions The debits are paid from the credits and the balance is maintained Money is used for accounting purposes How much your employer will pay you in wages how much you owe the bank how much a rm has earned and how much a bond is worth are all recorded in some unit of account Gordon 1998 3 Store of value Money is used as a medium of exchange and it is stored to pay or buy goods and services Money is easily stored either in the house or in bank The store of value of money may change with in ation If interest rate adjustment takes place then the money value remains same in the long period Most of the time money is stored in the form of savings or wealth Such wealth is used for future period 4 Standard of deferred payment Money has an important feature that it is a standard of deferred payment Money can be paid in future Most of the people buy goods and services and they pay bills in the future period It is the only method of payment available to money 264 Demand for money Money is demanded for different transactions The money demand is a function of prices interest and monetary base But the money demanded for the transaction purposes is interest inelastic The demand for money approaches are mainly divided into the following two approaches Download free ebooks at bookbooncom 63 Please click the advert Advanced Macroeconomics 1 Consumption Function Classical approach The classical economists have given their views of demand for money The money demand and velocity of circulation of money decides the price level and volume of transaction If the price level is higher than volume of transaction affects whereas the stock of money and velocity of circulation declines The equation is presented as follows MVPT 232 Where M stock of money V velocity of circulation of money P price level T transaction The money supply and velocity of circulation of money decides the price and transaction But it is not always true The money demand is decided by the people People use money as precaution It is not added in the classical approach to demand for money Cambridge approach The demand for money is decided by the price level and the actual holding of cash balances and nominal money It can be de ned as The next step for top performing graduates Masters in Management Designed for high achieving graduates across all disciplines London Business School s Masters in Management provides specific and tangible foundations for a successful career in business This 12month fulltime programme is a business qualification with impact In 2010 our MiM employment rate was 95 within 3 months of graduation the majority of graduates choosing to work in consulting or financial services As well as a renowned qualification from a world class business school you also gain access to the School s network of more than 34000 global alumni a community that offers support and opportunities throughout your career For more information visit wwwlondonedumm email mimlondonedu or give us a call on 44 020 7000 7573 Figures taken from London Business School s Masters in Management 2010 employment report Download free ebooks at bookbooncom 64 Advancech Macroeconomics Consumption Fu WCEE W Md KPY 233 Where Md Money demand K Proportion of national income with people PY Nominal income 265 Money multiplier Money multiplier is mainly in uenced by the high powered money High powered money is de ned as the currency and bank deposits The money supply in uences the currency and the bank deposits The contractionary monetary policy in uences money available to the people The money multiplier is therefore de ned as the ratio of stock of money to high power money It is presented in Figure 28 as Figure 28 High power money in economy Currency Reserves Currency Deposits Money stock m High power money consists of the upper portion of the gure that is currency and reserves The money stock is a broad concept and it consists of currency and reserve It also includes the deposits The money supply is de ned more clearly as M 2 1 Cu H re Cu 234 MM 1 1D rR Cu 0 H 235 Where 1 Interest rate iD Discount interest rate rR Required reserve In order to control the money supply reserve bank always uses the high power money The monetary authority regularly decides the total money supply in economy Download free ebooks at bookbooncom Advanced Macroeconomics Consumption Function 266 Money stock measures There are two views of measuring money stock The traditional view favors transaction theories it ultimately leads to the narrow measure of money stock The asset theories emphasizing broader measure of money Therefore money has no xed measure and it is more of judgment or preference There are different nancial and real assets can be arranged in a descending order with reference to liquidity The currency and demand deposit is the most liquid asset and they are the medium of exchange Time deposits and government bonds are liquid assets but they cannot be converted into the medium of exchange without incurring some cost At the bottom of the liquidity continuum lie automobiles real estate and the like this can be liquidated at a short notice only at a substantial cost The monetary authorities all over the world provide alternate measures of money leaving the choice to individual researchers and to the dictates of speci c situations At present most of the central banks classify the monetary aggregates which are functional characteristics of monetary assets In India money stock measures currently published range from M1 to M4 is de ned as M1 currency with public demand deposits other deposits with the Reserve Bank of India M2M1 saving deposits with the post of ce savings bank M3M1 Time deposits M4 M3 all deposits with the post of ce savings organization The separation of M1 and M3 is based on separation of time deposits with banks from currency and demand deposits with banks The major difference between M1 M3 and M2 M4 is based on the institutional differentiation between banks and post of ce savings organization 267 Sources of change in reserve money Reserve money is to recognize as net monetary liabilities of the central bank These liabilities are created in the process of generating matching assets by the central bank The reserve money comprises as the net monetary liabilities of the central bank that is currency with the public C and banks reserves R It follows from the asset side of the balance sheet as Reserve money 2 Net RBI credit to government RBI credit to Banks RBI credit to commercial sector Net foreign exchange assets of RBI Government s currency liabilities to the public Net non monetary liabilities of RBI The change in reserve money could be treated as changes in assets acquired by the RBI in the course of its operations Download free ebooks at bookbooncom 66gt Please click the advert Advanced Macroeconomics Consumption Function Table 21 Balance sheet of RBI Liabilities Assets 1Currency with general public 1 Net RBI credit to government centre to states 2Bank reserves 2 RBI credit to banks i Cash in hand ii Bankers deposits with the RBI 3Net nonmonetary liabilities 3RBI credit to commercial sector 4Net foreign exchange assets of RBI 5Government s currency liabilities to the public 268 Equilibrium in money market Equilibrium in money market means demand for money is equal to supply of money The interest rate is constant But money supply should be in proportion with price level M LiY P 236 If we assume that prices in the present and past is constant P0P and income is also constant with y0y then money supply in proportion with price in uences the interest rate Alternatively it can be written as LINI 39 was in Education ara Teach with the Best Learn with the Best Agilent offers a wide variety of affordable industryleading electronic test equipment as well as knowledgerich online resources for professors and students 39 55h ag Home I bait Fi 39 l r 39 nili i RF 139393 I w See what Agilent can do for you We have 10039s of comprehensive girl tetramen webbased teaching tools lab experiments application notes brochures DVDs CDs posters and more Agilent Technologies Inc 2012 us 18008294444 canada 18778944414 Anticipate Accelerate Achieve Agilent Technologies Download free ebooks at bookbooncom 67 Advanced Macroeconomics Consumption Function H MMi iDrRCu 039 LiYO P0 237 Money multiplier and interest rate discount interest rate required reserve currency deposit ratio and high power money and past prices are equivalent to interest rate and income in the past period Interest rate and money target It depends on the monetary authority to target money supply or the interest rate If we assume that money supply is a target variable then the following gure 29explains the equilibrium Figure also explains the money stock equilibrium with interest rate The increase in money stock will reduce the interest rate The money stock increases from mO P 0to Ml p The money supply shifts to MS1 from MS The new equilibrium is adjusted at E1 The interest rate falls from i to i1 It is the money supply change on interest rate Figure 29 Money supply and change in interest rate MS Interest i rate E1 11 V MOP MlP MAD 269 Monetary targeting Sometimes monetary authority targets interest rate It remains at the same point but output targeted It is growth targeting and national income forecasting In order to increase the output interest rate is kept constant or a different alternative output is managed by the government Output growth is given higher in employment Thus GDP forecast and xed interest rate policy is used A monetary authority deciding on monetary policy for today this authority needs to forecast how variables such as in ation and output will behave now and in the future which means that it must forecast private behavior in the future But the decision of private actors depends on their expectations about future monetary policy Chari VV and Patrick I Kohoe 2006 Figure 210 Effect of expansionary scal policy on income Download free ebooks at bookbooncom Advanced Macroeconomics Consumption Function Interest rate i LM 181 182 Y0 Y1 Ygtllt Y2 Y3 Y Similarly monetary policy uses the xed interest targeting The level of output or GDP is forecasted at different level Money supply in particular level of interest is provided It is the only output which allows becoming exible Therefore targeting interest rate is sometime very ineffective in the long run There is perfect relationship between money demand and interest rate Such policy is more widely used in the economy Figure 211 Effect of monetary policy on income Interest rate i LM1 W Y1 Ygtllt Y2 ltV 69 Download free ebooks at bookbooncom Advanced Macr ec n mics Appendix Ccmsum ti m Fu mct mm Table 22 Money supply in India Billion Variations over 2011 2012 Fortnight Item Mar 31 Jan 13 Amount 1 2 3 4 5 M3 649949 719257 611 01 Components iiiiiiiv i Currency with the Public 91420 100060 2261 23 ii Demand Deposits with Banks 71766 66991 3947 56 iii Time Deposits with Banks 486398 551992 1090 02 iv Other Deposits with Reserve Bank 365 214 15 65 Sources iiiiiiivv i Net Bank Credit to Government Sector ab 198277 227533 4022 18 a Reserve Bank 39655 49335 4329 b Other Banks 158622 178198 307 02 ii Bank Credit to Commercial Sector ab 423541 467159 1021 02 a Reserve Bank 216 316 10 b Other Banks 423324 466843 1010 02 iii Net Foreign Exchange Assets of Banking Sector 139334 152086 6970 44 iv Government s Currency Liabilities to the Public 1272 1372 00 00 v Banking Sector s Net NonMonetary Liabilities 112476 128893 3358 25 of which Net NonMonetary Liabilities of RB 36835 56971 5353 86 7 Download free ebooks at bookbooncom Advanced Macroeconomics Consumption Function Source RBI statistics Figure 212 money stock measures Manta Measures g 1111 g 11113 1m 1991112 mime 199445 1995415 19914 EMTDB 2mm amen 1 Source RBI statistics Table 23 Measurement of money supply in India Nove til1311 t3g g fg i g f mber Novem Augu Septem Novem Novem the month 2008 2009 2010 5 her 19 July st ber October her 4 her 18 2009 2010 2011 2010 2010 2011 2011 2011 2011 2011 2011 Notes in Circula tion 6811 7882 9369 8863 9631 9705 10081 1 0 8 4 3 89698 6 8 96966 98404 99895 3 Rupee Curren Circulati Com 2 849 970 1116 1058 1069 1163 1174 1174 1174 1174 1174 cy 1xivith on of Smallcoi t e Public 32 157 157 157 157 157 157 157 157 157 157 157 Cash on Hand with Banks 2570 3206 3546 3355 3746 4083 4071 4136 4516 4421 4406 6654 7674 9142 8649 9355 9431 Total 12 34 5 9 0 4 87177 2 8 94161 95219 96805 97738 Demand Deposits 5886 7179 7176 6625 6463 6378 Deposit with Banks 9 7 6 9 71074 2 6 63792 64601 64406 63847 Money Other Deposits with ofthe Reserve Bank 3 557 384 365 428 356 144 283 234 116 131 112 Public Total 67 5942 7218 7213 6668 6477 6406 6 1 1 7 71430 6 9 64026 64717 64537 63960 M1 58 12597 14893 1635 1531 15860 1583 1583 15818 16134 16169 1 0 51 81 7 28 88 7 159936 2 8 Post Office Saving Bank Deposits 504 504 504 504 504 504 504 504 504 504 504 M 910 12647 14943 1640 1536 15911 1588 1588 15869 16184 16220 5 4 55 85 1 32 92 2 160440 6 2 35351 41134 4863 4508 45045 5222 5254 52773 53971 53966 Tune Deposm Wlth Banks 0 3 98 67 3 18 51 1 535931 4 9 M3 912 47948 56027 6499 6040 60906 6805 6838 68591 70105 70136 1 3 49 48 0 46 39 8 695866 6 7 Total Post Office Deposits 2597 2597 2597 2597 2597 2597 2597 2597 2597 2597 2597 M 13 1 4 48207 56287 6525 6066 61165 6831 6864 68851 70365 70396 8 0 45 44 7 43 35 5 698463 3 4 Source RBI statistics Download free ebooks at bookbooncom 71 Advanced Macroeconomics Consumption Function Table 24 Components of Money Stock Rupees crore Year Currency Cash Currency Other Bankers Demand Time Reserve Narrow Broad in with with the deposits deposits deposits deposits money money money circulatio banks public with the with the n RBI RBI M0 M1 M3 23 256 457 810 1 2 3 4 5 6 7 8 9 10 11 195152 1292 43 1249 18 47 545 325 1357 1812 2137 196162 2256 54 2202 23 73 824 1198 2352 3049 4247 197172 5006 205 4801 80 296 3442 4370 5382 8323 12693 198182 15411 937 14474 168 5419 10295 37815 20998 24937 62752 199192 63738 2640 61098 885 34882 52423 202643 99505 114406 317049 200102 250974 10179 240794 2850 84147 179199 1075512 337970 422843 1498355 200203 282473 10892 271581 3242 83346 198757 1244379 369061 473581 1717960 200304 327028 12057 314971 5119 104365 258626 1426960 436512 578716 2005676 P 200405 368661 12893 355768 6478 113996 284017 1607675 489135 646263 2253938 P Source RBI statistics Table 25 Sources of Money Stock Rupees crore Year Net RBI Net RBI Net RBI Other Net RBI Other Bank credit credit credit banks bank credit to banks credit to to Central to State to investments credit to commerci credit to commercial Govemmen Govemmen Govemmen in Govemme a1 commercial sector t ts t Government nt sector sector 23 securities 45 78 1 2 3 4 5 6 7 8 9 197172 4249 621 4870 1755 6625 232 7131 7363 198182 18486 1954 20440 10193 30633 2044 41418 43462 199192 92266 1750 94016 64247 158263 7260 180733 187993 200102 141384 10794 152178 437387 589565 5929 753718 759647 200203 112985 7695 120680 555844 676523 3048 895932 898981 200304 36920 7988 44908 697996 742904 2061 1014089 1016151 P 200405 23258 5283 17975 775880 757906 1390 1279150 1280540 P Source RBI statistics Download free ebooks at bookbooncom 72 Advanced Macroeconomics Consumption Function Questions EOPONQP H P PE NNOO Wr tr tr Ir tr tr tr Ir tr tr t b OVVVCOOVONUTrPUJNr O Explain the Friedman and Modigliani theory of consumption Critically evaluate the Ando Modigliani Approach of the life cycle hypothesis Explain the Friedman s approach of permanent income Critically examine Friedman s approach of consumption function with reference to cyclical movements What is the Duesenberry Approach of relative income Explain Explain the various types of money What are the characteristics of money Explain in detail What are the functions of money What are the approaches to demand for money Explain the term money multiplier in detail How is the money measured Explain the monetary aggregates in detail What are the sources of change in reserve money Explain in detail Explain equilibrium in the money market How does expansionary monetary policy affect equilibrium Net foreign exchange assets of monetary authority changes the reserve money Comment Credit to the commercial banks is an asset for the monetary authority Comment More money supply in the economy leads to increase in the prices Comment Expansionary scal policy helps to keep the interest rate stagnant in the economy Explain Critically examine the effect of monetary policy on income Write a note Consumption function Permanent income Life cycle hypothesis Explain the lifespan income and consumption of an individual The population structure and education helps to change the consumption pattern of a country Comment Download free ebooks at bookbooncom 73 Advancech Macroeconomics oweolate supply wages prices and employment 11 11 Kg 3 Aggregate supply wages prices and employment Aggregate supply and employment in the economy are corelated The aggregate supply also decides the wages The price level rises with rise in wages There is difference in the full employment and natural rate of employment in the economy 31 Philips Curve Philips a New Zealand born economist wrote a paper in 1958 In this paper he has shown the relationship between unemployment and the rate of change of money wage rates in United Kingdom 18611957 Such paper is published in quarterly journal of Economica According to Philips there is an inverse relationship between the rate of unemployment and the rate of increase in money wages If there is higher rate of unemployment then there is lower rate wage in ation In other words there is tradeoff between in ation and unemployment The Philips curve shows that the rate of wage in ation decreases with the unemployment rate Thus w is de ned as wage in current period The W1 is the last period wage Therefore wage in ation is de ned as follows WW 1 W1 31 gW Where g W wage growth W present wage 1 Past wage rate If uquot is de ned as the natural rate of unemployment then wage growth is de ned as gW E u 31 32 Where U unemployment rate in economy Uquot natural rate of unemployment If uu and g W 0 Download free ebooks at bookbooncom 74 Advanced Macroeconomics Ac rec su o ol Wcaoies ori ces and em olo ment 1 And ugtu then g W is negative The wage rate is decreasing but if ugtu then the growth rate of wage is rising The Philips curve implies that wages and prices adjust slowly to change in aggregate demand After using wage in ation it can be further de ned as W VV1 gW W4 I L W4 4 Dividing W1 from both sides gw 2 1 1 W1 33 If we substitute g W E u Wk into equation 33 then 1 1 E u u W l E l E u u W l Therefore gtllt W W11 em u 1 33a It means that the present wage depends on past wage 1 e and difference between natural unemployment and present unemployment It also represents the level of wage today relative to the past level for wages to rise above their previous level of unemployment Unemployment may fall below the natural rate The Philips curve rapidly became a corner stone of macroeconomic policy analysis It suggests that policy makers could choose different combinations of unemployment rates of in ation The Friedman Phelps amendment The Friedman Phelps proposition shows that in the long run the economy will move to the natural rate of unemployment whatever the rate of change of wages and the in ation rate There is no trade off in the long run It is a counter argument to the Philips curve The notion of a stable relationship between in ation and unemployment was challenged by Friedman and Phelps who both denied the eXistence of a permanent tradeoff between in ation and unemployment Snowdon Brian Download free ebooks at bookbooncom 75 Please click the advert Advanced Macroeconomics Aggregate supply wages prices and employment and Howard RVane 2005 311 Wage Stickiness The assumption that wages are slow to adjusts The shift in demand is essential to our derivation of an AS curve It produces a gradual rather than an instantaneous adjustment of the economy to disturbances Wages are sticky or wage adjustment sluggish when wages move slowly over time rather than being fully and immediately exible so as to assure full employment at every point in time We translate the Philips curve in 33 to a relationship between the trade of change of wages gW and the level of employment by N We de ne the unemployment rates as the fraction of the full employment labor force Nquot We assume that u0 then u is de ned as N N T u 34 If we substitute 34 in to 32 then we obtain the Philips curve The Philips curve shows the relationship between the wage this period and the wage last period and the actual level of employment Thus You re full of energy and ideas And that s just what we are looking for UBS 2010 All rights reserved Looking for a career where your ideas could really make a difference UBS s Graduate Programme and internships are a chance for you to experience for yourself what it39s like to be part of a global team that rewards your input and believes in succeeding together Wherever you are in your academic career make your future a part of ours by visiting wwwubscomgraduates argues wwwubscomlgraduates Download free ebooks at bookbooncom 76gt Advanced Macroeconomics supply wages prices and employment N N W W 1 6 1 N 35 Where Nquot Full employment N Actual level of employment The above equation shows the relationship between wage employment relations If we draw the diagram of wage last period and actual level of employment the diagram is drawn as follows Figure 31 Wage and employment relationship A 4quot lquot39 qun Iquot I Iquot I I I quotl quot Wage 139 x I l 39z Jzquot quotI z I l 1quot z I 4r N N Employment The Y axis shows the wage and the X aXis shows the employment The wage shows upward line The WN line shows the wage this period equal to wage that prevailing last period with an adjustment for the level of employment At full employment NN this period of wage is equal to last period s wage equation 35 can be de ned again as follows gtxlt WW01ENlN Within a period the wage increases with the level of employment as shown by WN If employment at its neoclassical equilibrium level Nquot the wage rate level in this period is equal to last period Download free ebooks at bookbooncom 77 Advanced Macroeconomics Aggregate supply wages prices and employment Figure 32 Change in wages and employment A cquot I I I I l I quvv 1 zquot I quot I39 I39 Wage l l lr39 Iquot z I I 39I39 z I I z39 I l z quot I v 39 47 N N Employment Equation 35 implies that WN relationship shifts over time as in the gure 32 If there is over employment this period then WN curves will shift upward next period to WN If there is less than full employment this period WN line will shift downward next period to WN The wage and employment relationship changes with time The WN curve shifts overtime if employment differs from full employment Nyr is de ned as the full employment level The WN curve shifts upward WN in next period Therefore if there is over employment in current period then it shifts upwards and visavis 32 The aggregate supply curve Dynamic The value of national income in current prices can be split up as follows py WNZWN Where Z is a markup prices py 1Z WN l p Z WN Y 36 If we divide the above equation by N then the above equation can be written as WN 12 2 p YN Download free ebooks at bookbooncom Please click the advert Advanced Macreecenemics Aggregate supplyp wagesp prices and empleyment lzW Y N 37 In order to derive the aggregate supply curve following steps are required 1 We relate output to employment We also relate the prices that rms charge to their cost 3 We use the Philips curve relationship between wage and employment If we put all 3 components with each other then we can derive the dynamic aggregate supply curve It is de ned as follow 33 The Production Function Normally production is a function of labor and capital If we link the level of employment of labor to the level of output then the production function can be de ned as follows YaN 38 Where Y level of output produced N amount of labor input a the input coef cient Deloitte DlSCOVCI the truth at WWWdClOittCCaCareers Deloitte 8 Touche LLP and affiliated entities Download free ebooks at bookbooncom 79 Advanced Macroeconomics supply wages prices and employment In simple production function output is proportional to input of labor Level of outcome produced is related to amount of labor input used In the above equation a is a coef cient in production function Cost and Prices We assume that the rm s base price is the labor cost of production The ratio w a is often called as the unit labor cost The higher is the labor cost higher the rms base price Therefore rms set price as markup Z on labor costs Y If a then equation 38 can be written as 1 ZW a 39 P Above equation shows that if the mark up price rises then the price will rise Similarly wage rate rises with price level But as a rises then the price level decreases The mark up over labor costs cover the cost of other factors of production that rms use such as capital raw material It includes an allowance for the rm s normal pro t There are three components of the aggregate supply curve and they are de ned as follows Firstly production function is given in equation 38 Secondly price cost relation in equation 39 Thirdly Philips curve is given in equation as W W11 e N N If we substitute the above equation into equation 39 then it can be rewritten as Plt W11 e a 310 12 N N gtllt The prices are related to mark up prices and last period wage and employment lZ P1 W1 Such equation can be reduced to N N P P11 e 311 Now the prices depend on the past prices and employment Download free ebooks at bookbooncom Please click the advert Advanced Macroeconomics Aggregate supply wages prices and employment Therefore Y a n And Yan We can write alternatively as YaN gtllt The income level is depends on employment If we modify the above equation then N and N employment a is equal to income divided by a a We can replace N and Nyr into equation 311 by y a alternatively we can substitute y a into 311 above equation then Y Y 37 PP1lET a Y Y PP1lE 17 WE 51111513545 11mm 39339 eCV 1 It s only an opportunity if you act on it IlliEA EfETUDEMT Download free ebooks at bookbooncom 81 Advanced Macroeconomics supplyy wagesy prices and employment Ifthe l is de ned as d 6 Y Thus we can obtain the dynamic aggregate supply curve as P P11 MY Y 312 It is a dynamic aggregate supply curve Figure 33 Aggregate supply curve and price level V YY YgtY Y Figure 33 shows the aggregate supply curve in equation 312 The supply curve is upward sloping The aggregate supply curve shifts if output in current period is above the full employment level Yyr then next period the AS curve will shift up AS The aggregate supply curve shows that the wages are less than fully exible Prices increase with the level of output because increased output implies increase in employment therefore increase in labor cost The fact that prices rise with output is entirely a re ection of the adjustment in labor market in which higher employment increases wages Firms pass on these wage increases by raising prices and for that reason prices rise with the level of output 34 The properties of aggregate supply curve There are three properties of aggregate supply curve They are explained as follows 1 Aggregate supply curve is atter then the smaller is the impact of output on employment changes and current wages 2 The position of the aggregate supply curve depends on the past level of prices Download free ebooks at bookbooncom Advanced Macroeconomics supply wages prices and employment 3 The aggregate supply curve shifts overtime if output maintained above the yyr then overtime wages continue to rise and the wage increases are passed on as increased prices In order to make the aggregate supply curve dynamic the yy is the rst condition Second condition is a P P1l 10 Y And thirdly p1p0 and P2P1 All the three conditions make the dynamic ggregate supply curve 341 The effects of monetary and scal policy on aggregate supply curve The monetary and scal policy effects are further divided into short medium and long term effects Due to rise in money supply the wages increases and the output and prices also increase It is divided in to three parts as follows 1 Short run effects In gure 34 the aggregate supply curve is ASO It is drawn for a given past price level P1 It poses through the full employment output level YJ At the price level P1 output is at the full employment level There is no tendency for wages to change Hence costs and prices are also constant from period to period The aggregate supply curve has drawn relatively at It suggests a small effect of output and employment changes on wages Figure 34 Effect of aggregate demand on prices and income In gure 34 the initial equilibrium at E is disturbed by an increase in the money stock It shifts the aggregate demand curve from AD0 to ADI Short run equilibrium is at E At this point both the price level and output increases Prices are higher because the output expansion has caused an increase in wages The ASC is drawn quite at It re ects the assumption that wages are quite sticky Suppose nominal money stock is increasing at each price level real balances are higher The interest rate is lower hence the demand for output rises The AD0 curve shifts upward to the right that is AD At initial price level pp1 there is now an excess demand for goods At point E both prices and output have risen A monetary expansion has led to a short run increase in output In simple words AD0 shifts to ADI The output increases to Y1 The prices increase from p0 to pl 2 The medium term adjustment Download free ebooks at bookbooncom Advanced Macroeconomics oreoate supply wages prices and employment 11 11 to The next point comes as the medium term adjustments in aggregate demand and supply curve The short run equilibrium point at E is not the end of the point At point B output is normal Therefore W W11 e NXI Tn The above equation indicates that prices will keep on rising in the second period Supply curve passes through the full employment output level The price level is equal to P1 We show thus by shifting the aggregate supply curve up to AS1 to A82 With the new aggregate supply curve AD schedule unchanged at the higher level AD The new equilibrium is achieved at E If we compare EltoE2 then output falls and price level increases In short the aggregate supply increases from AS0 to A81 The output decreases from Y1 to Y2 The price level increases from P1 to P2 The diagram shows the as AD1 shifts from AD0 the new equilibrium is adjusted at E1 But the Aggregate supply shifts back and income declines from Y2 to Y1 It is a new equilibrium adjustment Figure 35 Effect of aggregate supply on prices and income P2 P1 35 Long term adjustment In the long run the price increases the output remains constant As long as output is above normal employment the wages are rising Because wages are rising the rm experience increase in cost These are passed on at each output level In the long short and medium term equilibrium shifts from E E1 to E2 As a result output will be declining and level of price will keep rising In short output comes back at Yquot There is no change in output and price increases from P0 to P1 The dynamic aggregate supply curve in short long and medium term and the monetary expansion is given as follows Download free ebooks at bookbooncom Advanced Macroeconomics supplyy wagesy prices and employment Table 31 Effect of monetary policy on output prices aggregate demand and supply Period Output Prices ASC ADC Short run YWY1 increases pwp1 increases ADH AD1 Medium run YHY2 decreases psz increases ASWAS1 Long run Output back to Yno Pzap1 increases AS1 gtAST ADH ADT Change 36 In ation expectation and aggregate supply curve In ation is linked to the aggregate supply curve The wage in ation and the aggregate supply curve is related to output The Philips curve and the aggregate supply curve are directly related to level of employment in the economy The previous growth equation is given as 8W 6 Ll Wk 313 gW The rate of wage in ation E Measures the responsiveness of wages to unemployment Uyr 2 Natural rate of unemployment U Unemployment The growth rate of wage is negatively related to epsilon and natural rate of unemployment and actual unemployment N N If we assume that UO and u 2 then N N N gw E T Similarly we can also write the above equation as follows g EN Nj w N 314 The growth rate of wage is related to unemployment and natural rate of unemployment NY a and NY a that means 6 2 7 8w 2 T a 315 Download free ebooks at bookbooncom Please click the advert Advanced Macroeconomics Aggregate supply wages prices and employment If we divide the denominator and numerator by a then the following growth of wage in ation will get replaced as lml E Ygtllt 316 The above equation explains that the growth of wages is related to the epsilon Y and Yquot gw Y Y Eh Then 8w 2 MY Yl 317 It is a wage Philips curve encsson com YOUR CHANCE TO CHANGE THE WORLD Here at Ericsson we have a deep rooted belief that the innovations we make on a daily basis can have a profound effect on making the world a better place for people business and society Join us In Germany we are especially looking for graduates as Integration Engineers for 0 Radio Access and IP Networks 0 IMS and IPTV We are looking forward to getting your application To apply and for all current job openings please visit our web page wwwericssoncomcareers ERICSSON Download free ebooks at bookbooncom 86 Advanced Macroeconomics supply wages prices and employment 1 There are three foundations on which the aggregate supply curve is built They are explained as follows 2 The Philips curve shows that the wage increases more rapidly than it lower the level of unemployment 3 There is a relationship between the unemployment rate and the level of output The assumption of markup pricing is that the rm prices are based on labor costs They are higher because wages are higher Therefore we develop the aggregate supply curve into two directions We notify the aggregate supply curve to include in ation Secondly we transform the aggregate supply curve into a relationship between output and the in ation rate rather than price level Friedman and Phelps pointed out one major ow in the wage Philips curve as described in equation 6 It ignores the effect of expected in ation on wage setting Workers are interested in real wage not nominal wage Therefore if YY the gWO or ww1 Secondly YgtY then gWgtO and wgtw1 It means when income is above the Yyr then growth of wage is above zero and current wages are above the past wage Thirdly YltY then gWltO and wltw1 It means if income is above Yyr then gW is less than gw and present wage is less than last period wage When in ation is expected the wage Philips curve becomes 8w 7T6 1Y Y 318 In the above equation 76 is the expected in ation rate The above equation is called the augmented wage Philips curve It is the original Philips curve augmented or adjusted to take account of expected in ation At any given level of output the wages and prices increase more It means there is higher expected rate of in ation The assumption is that nominal wage rise one percent faster for each extra one percent of expected in ation 37 Aggregate supply curve Next step is to transform the augmented wage Philips curve shows relationship between the in ation rate and the rate of output in which it depends on the expected rate of in ation There are assumptions for the aggregate supply curve which are as follows The assumption is that the rms maintain a constant markup prices over wages The rate of increase of prices or the rate H P 1 P 1 of in ation as Hgw It means that in ation is equal to rate of wage Alternatively 319 Download free ebooks at bookbooncom Advanced Macroeconomics Aggregate supply wages prices and employment Substituting the rate of wage increase 318 into 319 yield the dynamic aggregate supply curve H He 107 Y 320 The above equation shows that one of the two building blocks of a model of the in ation prices It is the expected augmented aggregate supply curve 371 Short run aggregate supply curve The Short run aggregate supply curve examines the relationship between in ation output and expected in ation rate that isH Y and He Secondly given the expected in ation rate the aggregated supply curve shows the in ation rate rising with the level of output That the higher the level of output the higher the rate of in ation Download free ebooks at bookbooncom 88 Please click the advert Advanced Macroeconomics Aggregate supply wages prices and employment Figure 36 Short run aggregate supply curve and income effect A R SAS 10 SAS Percent 5 gt Y Y1 Y Figure 36 depicts that higher the expected in ation rate the higher is the SAS Thus at SAC the expected in ation rate is 10 percent For any expected in ation rate there is a corresponding short run aggregate supply curve It is parallel to SAS and SAS with the vertical distance between any two short run supply curve which is equal to difference in He between them The Graduate Programme IJOIDEd becausg for Engineers and Geoscientists I wanted real responSIblllty MaerskcomMitas as a g a Hi this 135quot Iwas a construction supervisor in the North Sea advising and WE helping foreman n solve problems MAERSK Download free ebooks at bookbooncom 89 Advanced Macroeconomics supply wages prices and employment In the above gure the He is constant on a SAS curve It is ve percent on short run aggregate supply and 10 percent on SAS Each short run ASC is shown quite at re ecting the fact that in the short run it takes a large change in output to generate to a given change in in ation The short run aggregate supply curve shifts with the expected rate of in ation The in ation rate is corresponding to any given level of output Therefore changes over time as the He changes The higher is the expected He the higher is the in ation The 7 rate is corresponding to a given level of output 372 Long run aggregate supply curve If the in ation rate remains constant for any long run period rms and workers will expect that in ation rate to continue 6 The expected in ation rate will become equal to the actual rate The assumption that H H distinguishes the long run from the short run aggregate supply curve The long run aggregate supply curve describes the relationship between in ation and output when actual and expected in ation is equal In terms of equation it is presented as Hlee The equation can be further explained as H 2 He 10 Y It shows that YY r The meaning of vertical long run aggregate supply curve is that in the long run the level of output is independent of the in ation rate In gure 37 the points of short run aggregate supply curve show the expected in ation which is equal to actual in ation The long run curve is thus the vertical line The long run aggregate supply is Yyr at level of output The short run aggregate supply curve shows that point A where 5 percent in ation is observed If the in ation rises from 5 percent to 10 percent then SAS curve shifts upwards from SAS to SAS Figure 37 Short run aggregate supply curve and in ation Download free ebooks at bookbooncom 9 Advanced Macroeconomics Aggregate supply wages prices and employment T SAS R F SAS 10 SAS A Percent 5 G Y Y7 38 The Modi ed Philips Curve The Philips curve shows the relationship between unemployment and in ation The in ation is equivalent to the growth of wage The original Philips curve is given as gtllt gwEuu 321 Growth is equal to the actual minus the natural rate of unemployment rate and E is negatively related Thus H g w As the in ation increases the growth of wage also increases then H e u u 322 The Philips curve is replaced with the in ation The Philips curve is downward sloping and it shows the inverse relationship between in ation and unemployment 1f 7r eu u T3 45percent then Tt4 For example if u5 percent then Tt0 and if u4 percent the Tt3 percent 39 Expected augmented Philips Curve 323 Now 7Z6 is called as augmented Philips curve But suppose 7Z39e 0 then Download free ebooks at bookbooncom 91 Please click the advert Advanced Macroeconomics Aggregate supply wages prices and employment 7239 0 percent 3 45 percent 5 percent SIMPLY CLEVER SKDDA We will turn your CV into an opportunity of a lifetime Do you like cars Would you like to be a part ofa successful brand Send US your CV on We will appreciate and reward both your enthusiasm and talent WWWIemplouerforlife39com Send us your CV You will be surprised where it can take you r Vi Download free ebooks at bookbooncom 92 Advanced Macroeconom cg Aggregate Swogo yg weigegp Lor ceg and emgo oyment Figure 38 Augmented Philips curve 9 6 In ation 3 k 3 Ix I I 4 gt x I 39 I 39 39 39 39 z 39 x I 39 K 39 I gt UU Unemployment u e In the short run there is choice but in the medium run there is no choice In the long run 7r 2 7T 93 Download free ebooks at bookbooncom Advanced Macroeconomics supply wages prices and employment Long run Philips curve In the long run uu means the natural rate of employment is equal to permanent unemployment Uu 324 In the long run Philips curve is vertical Extended Philips curve 7r e E u u 325 Where 1T in ation rate 6 o 3 7r expected in ation rate e Philips curve states that in ation rate 7r declines relative to the previous trend if the actual unemployment rate exceeds e the natural rate u But often it is argued that the rate of in ation depends not only on the expected in ation rate 7t and the level of the unemployment rate but also on the change in the unemployment rate The extension of equation 325 where we have added another term 3 U U1 to the Philips curve the coefficient 5 measures the extent to which changing unemployment Iu 4 affects in ation 7r7reEuu3 1 326 The above equation is useful for policy decision It suggests that there is a concrete trade off The more rapid the reduction in unemployment the fewer disin ations is achieved at each unemployment level 310 Criticism The grease effect of in ation for growth as suggested by the conventional Philips curve does not hold after a threshold level of in ation If monetary policy tolerates somewhat higher in ation as a means to sustain higher growth momentum it may at some stage just become a sure path to sacri cing both in ation and growth objectives The justi cation for in ation tolerance is often based on the perception of a positive relationship which invariably turns negative after a threshold level of in ation The mainstream monetary policy emphasis on low and stable in ation re ects this realization a central bank can best contribute to the growth objective by ensuring a low and stable in ation regime Pattanaik S and GVNadhanael 2011 Download free ebooks at bookbooncom Please click the advert Advanced Macroeconomics Aggregate supply wages prices and employment Questions Explain the Philips curve in detail Explain the dynamic aggregate supply curve Explain the term production function in short What are the properties of aggregate supply curve Explain the effects of monetary and scal policy on aggregate supply curve Explain the long term adjustments in the aggregate supply curve Explain the in ation expectation and aggregate supply curve in short Critically explain the short run aggregate supply curve and relationship of in ation output and in ation rate What is the modi ed Philips curve DSX NP P H P PE 10 Why is the Philips curve criticized 11 Explain the Friedman Phelps amendment on Philips curve 12 Explain the relationship of wages and employment The Agilent InfiniiVision X Series and 1000 Series offer affordable oscilloscopes for your labs Plus resources such as lab guides experiments and more to help enrich your curriculum and make your job easier BEIJIEIJH E u39l n 39 39luk 00 for II rqtlr ir39srt mr r a Agilent Technologies Inc 2012 us 18008294444 canada 18778944414 Anticipate Accelerate Achieve Agilent Technologies Download free ebooks at bookbooncom 95 Advanced Macroeconomics pen economy Macro economy 4 Open economy Macro economy 41 Introduction Economies in the present situation are global economies They are integrated in terms of the nance trade and culture The foreign exchange market equity and commodity markets are lined with each other as well as at the global level The domestic and the international trading of equities shares and commodities are allowed in almost all the countries Due to the free ow of capital the exchange rate appreciation and depreciation the domestic and international price level effects on the ISLM framework the exchange rate the international and domestic prices and the interest rate shows the equilibrium balance of payment Export promotion yields more foreign exchange when there is exchange rate depreciation The monetary policy of reserve bank effects on the money supply But higher money supply leads to rise in prices whereas it lowers the interest rate International investors withdraw their money at lower domestic interest rate They invest money where there are higher returns The money supply interest rate and the exchange rate policies decide the capital in ow and out ow Therefore there is competition for currency depreciation 411 Balance of payment and exchange rate The balance of payment and exchange rate are linked with each other Balance of payment records all the monetary transaction of a resident country with the rest of the world The balance of payment is mainly divided as current and capital account The current account is in uenced by the exports and imports of a country including the transfer of payments Download free ebooks at bookbooncom Advanced Macroeconomics pen economy Macro economy The services included are freight royalty payments and interest payments The services also include net investment income and the interest and pro ts on the assets Transfer payments mainly consist of the remittances gifts and grants The trade balance consists of trade in services and the net transfers The de cit in balance of payment is de ned as the payment of country s residents in that country s balance of payment For example import of cars foreign gifts machinery etc Such imports increase the current account de cit But the export of the agricultural commodities machinery garments and diamond units improves the current account de cit resulting in increasing the surplus in the country s current account Similarly if the net transfers exceeds the net payments then capital account becomes surplus If the current account along with the capital account is surplus then the country can have surplus in the balance of payment The current account records the purchases in addition to the sale of assets They consist of stocks bonds etc If the capital surplus is the net capital ow the receipt from the sale of stocks bonds bank deposits and other assets exceeds payments for purchases of the foreign assets 412 External balance must be balance The de cit arises when the country s current account s expenditure is more outside nation than it receives from the sales to the rest of the world The de cit needs to nance by selling assets or by borrowing abroad The sale of assets means country runs into capital account de cit but current account de cit can be nanced by more capital in ow Therefore CADNCIO 41 Where CAD current account de cit NCI Net capital in ow If the country has no assets of foreign exchange reserves then rstly the country has to achieve the current account balance But now most of the countries do not follow the strategy All countries are not always promoting exports Sometimes emphasis is given on the capital in ow The capital account is important in the present globalization phase The capital account is mainly divided into two parts Firstly it is transaction of private sector coupled with of cial reserves The second form of transaction is in permission with the Reserve Bank and the government In India current account de cit is nanced by the Government of India and the Reserve Bank of India It maintains the reserves in the form of foreign currency The central bank also holds the foreign currency The central bank also buys the foreign currency which is earned by the private sector and its reserves of foreign currency Similarly the reserve bank also sells foreign currency when there is a decline in the value of domestic currency But the policies are cautious because some policies are framed for long term and some are for short term Sometimes foreign exchange market is highly volatile Download free ebooks at bookbooncom 97 Advancech Macroeconomics pen economy Macro economy Domestic value of currency may decline or increase Consequently the reserve bank observes the market situation very carefully rather than immediate intervention Therefore the balance of payment surplus de cit is equal to increase or decrease in foreign exchange reserves ie the current and capital account surplus de cit and the net capital in ow are also affected If current account and capital account are de cit then the balance of payment is de cit The reserve bank has to sell the gold or foreign currency If current account is surplus and capital account de cit then the balance of payment may be in de cit 413 Fixed exchange rate Fixed exchange rate is de ned as the system wherein the central bank is ready to buy and sell currency at a xed price in terms of all the other countries currencies The central bank buys and sells any amount of currency at a given price Central bank intervenes in the foreign exchange market It is mainly done for buying or selling of foreign currency In order to correct the balance of payment the interventions in foreign exchange market are conducted In order to insure the price the excess supply is taken away at xed price whereas excess demand is lled with the same price Such practice also exists in agricultural commodity markets Government ensures the prices with available supply and demand of the commodities Government purchases the agricultural commodities from farmers at xed prices but it sells at a higher price In India it is called as minimum support price for crops Reserve bank keeps the necessary reserves to maintain the currency at a xed rate It provides the stability to economy But xed exchange rate suffers from a number of limitations It does not represent the true picture of economy Sometimes the currency is overregulated 414 Flexible exchange rate The reserve bank cannot intervene in the foreign exchange market of the global economies Most of the economies are open to trade with all The domestic currency is freely allowed to ow with other currencies The exchange rate is exible and it is more dependent on the current and capital account Such demand and supply of foreign currency decides the value of domestic currency The study of Magud Nicolas etal 2012 explains that countries with less exible exchange rate regimes may stand to bene t the most from regulatory policies that reduce banks incentives to tap external markets and to lendborrow in foreign currency these policies include marginal reserve requirements on foreign lending currency dependent liquidity requirements and higher capital requirement and or dynamic provisioning on foreign exchange loans Most of the times exchange rate is allowed to freely determine the value of domestic currency in foreign exchange market The central bank does not intervene in the foreign exchange market The of cial reserves of foreign currency are kept zero The current along with the capital account is freely adjusted Such clean oating does not exist in the modern world Most of the exchanges are managed exchange rates Under the managed dirty oating exchange rate the reserve bank buys or sells the foreign currency in order to correct the foreign exchange market Such practices are regularly observed in the foreign exchange market Under oating exchange rates the exchange rate is determined together with the interest rate in the nancial sector This re ects the importance of international nancial capital ows relative to ows in goods and services which in the modern world are very small in comparison Thus the most important factors determining exchange rates are not the competitiveness of goods and services but the stock of money and the stock of bonds outstanding and the level of income Pentecost 2006 India moved away from pegged exchange rate to the liberalized exchange rate management system in 1992 coupled with the market determined exchange rate regime in 1993 which is considered as an important structural change in the exchange rate market Download free ebooks at bookbooncom Please click the advert Advanced Macroeconomics pen economy Macro economy With increased volatility in exchange rate and to mitigate the risk arising out of excess volatility currency futures were introduced in India in 2008 marking itself as second important structural change If it is believed that the currency futures will help in hedging the exposures of exchange rate to the unfavorable movements in exchange rate The role of derivatives for risk taking and risk management cannot be understood by any means and it has increased signi cantly in the recent times The research also supports that there is two way causality between the volatility in the spot exchange rate and the trading activity in the currency future market Sharma 8 2011 42 Open economy and goods market In an open economy the domestic rms export their output and domestic consumers import the commodities from other countries The spending on domestic goods decides the domestic outcome Domestic residents spending ACIG Spending on domestic goods 2 A NX CIG XQ CIGNX 42 Download free ebooks at bookbooncom Advanced Macroeconomics pen economy Macro economy Where the CIG remain the same as compare to the earlier equation The NX means the net exports and imports It is the spending of domestic residents on foreign goods and trade surplus Domestic spending depends on income and interest rate 421 Net exports If the income of the domestic people is increasing then imports also increases The real exchange rate remains x The rise in real exchange rate that is real depreciation improves the trade balance The demand for domestic goods will increase especially those produced at home NXX Yf RQY R Nx Y Yf R 43 It means that the net export is a function of income income spending on foreign goods and real exchange rate If foreign income increases then the demand for domestic goods will rise The trade balance may become surplus Real depreciation of domestic currency will improve the trade balance A rise in income increases import spending It may worsen the trade balance 422 Goods market equilibrium The marginal propensity to imports is de ned as the per unit increase in the income to import If the money is spent on foreign goods then IS curve will be steeper If interest rate is reduced then it will give small rise in the income and output The real exchange rate affects goods market that is the IS curve The depreciation of exchange rate increases the demand for domestic goods The IS curve shifts to the right with same interest rate If the income of the foreigners increases then the demand for export also increases The IS curve is as follows YA YiNX YYf R 44 The level of income is decided by the foreign domestic income and the real exchange rate It is interesting to examine how the foreign income changes in IS curve and equilibrium level of income Download free ebooks at bookbooncom 1 Please click the advert Advanced Macroeconomics Open economy Macro economy Figure 41 Effect of scal policy on income IY E1 LM 1S1 IS Y1 Figure 41 shows that increase in foreign income has positive effect on the IS curve The IS curve shifts to the right side The level of domestic income rises due shift of IS curve towards right It also increases the interest rate in domestic economy Due to decline in interest rate the foreign capital ow declines Low investment in domestic economy reduces the exports Hence the level of income and output in domestic economy continuously declines The interest rate declines s observed in the gure The long term equilibrium is observed at E It has the only solution to increase the export It is the real depreciation of currency It may raise the domestic exports 1 iii Vin l a Nido Download free ebooks at bookbooncom 101 Advanced Macroeconomics pen economy Macro economy 423 Capital mobility In globalization all economies are integrated with trade and nance The money and capital market of one country gets integrated with other countries money and capital market globally The bonds and stocks are traded across several countries for purchase and sale Therefore households hold onto their wealth in the forms of physical and nancial assets of more than one country Their yield depends on the capital and money market and monetary scal policies of any other country Under the xed exchange rate investors do not face any risk in wealth management or investment The government policies are protective and investors hold assets which gives more return Therefore there is equality in the return in asset market But in reality such markets do not exist There are wide differences among countries in terms of their money and capital market In India money market is seasonal The demand for cash is high during harvest seasons The foreign investment direct and indirect taxes government policies scal policies monetary policies are different All these factors continuously impact the capital in ow and out ows They are directly related to income and unemployment The interest rates are not equal among all the countries But under the current and capital account convertibility the capital is perfectly mobile internationally The investors purchase assets bonds and debentures of any country while choosing such assets and bonds they choose with lower transaction cost In such situation maximum people take chance to invest money where there are higher returns There is also competition among the countries to bring in more capital ow In global economy there is no difference among the countries interest rate If the difference exists then capital ow moves in larger quantity to cross borders in search of the higher returns International investors always see the monetary policy and interest rate behaviors of each country The balance of payment also gets affected because it results in the capital out ow The monetary and scal policies affect the capital account and balance of payment Now in globalization monetary and scal policies are not much effective for trade balance but the capital account gets in uenced Both monetary and scal policies may affect domestic as well as foreign economies It is done through the balance of payment changes and capital in ows At the aggregate level the cumulative gross capital ows appear to increase by 005 percentage point in response to one percent point increase in interest rate differential Moreover contrary to general perceptions stronger growth in OECD countries actually coexist that RBI S monetary policy needs to continue its focus on objectives relating to the in ation and growth The magnitude and composition of capital ows that might change in response to the monetary policy action could be managed using other instruments as has been the case in the past Monetary policy should not be constrained by the explicit impact on capital in ows since other determinants of capital in ows could dominate the impact of interest rate differential most of the time Verma Radheshyam and Anand Prakash 2011 423 Balance of payment and capital in ows If the domestic rate of interest is above the world interest rate then the capital ow will be to the resident country from abroad The capital ow will be unlimited The balance of payment is now affected by both trade balance and capital ow It is as follows BPNXYYP R CFiif 45 The equation explains that trade balance is in uenced by the income foreign income and real exchange rate The capital account simply explains the difference of interest rate between domestic and resident country If the imports and interest rate falls of any country the balance of payment worsens But if the interest rate increases above world level then capital account improves If the capital in ow increases then it can be used to nance trade de cit The interest rate can be maintained to attain the equilibrium in balance of payment Download free ebooks at bookbooncom T 2 Advanced Macroeconomics pen economy Macro economy 424 Equilibrium in internal and external balance All the economies face the problem of internal and external balance In external balance the economy is in equilibrium in the balance of payment The reserve keeps its balance after losing the reserve or gaining the reserves It won t be continued for long period of time Internal balance exists when output is at the full employment level The countries maintain internal balance or full employment in the long run Figure 42 Internal and external equilibrium in economy I Surplus Unemployment Surplus over employment E4 E3 If De cit unemployment E De cit over employment E1 E2 y 39Y Figure 42 exhibits that the balance of payment is equal to zero The balance of payment is de cit if interest rate is below the international interest rate It is at point E1 where unemployment is higher But at point E2 the balance of payment is surplus and there is over employment The point is of surplus in BoP and over employment At point E the expansionary monetary policy would reduce the unemployment problem but balance of payment de cit exists The capital ow is sensitive it would continue to create capital de cit and nally the balance of payment is de cit But both monetary and scal policy will help to achieve the internal and external trade balance simultaneously The effects are presented in the next section The study of Tim Callen and Paul Cashin 1999 has used three approaches an intertemporal model of the current account that allows for capital controls a composite model of macroeconomic indicators that yields probabilities of future balance of payments crisis and scenarios that examine the path of the current account consistent with the stabilization of India s external liability to GDP ratio The result indicates that India s inter temporal budget constraint is satis ed and that the path of its current account imbalances is sustainable with some support for the optimality of its external borrowings 43 The Mundell Fleming model Capital mobility under xed and exible exchange rate in an open economy is developed by Robert Mundell and Marcus Fleming Robert Mundell was professor at Columbia University and the late Marcus Fleming was a researcher at International Monetary Fund They developed this model in 1960 The model was a research study before exible exchange rate came into existence Download free ebooks at bookbooncom l 3 Advanced Macroeconomics pen economy Macro economy 431 Capital mobility under xed exchange rate In a xed exchange rate regime the tight monetary policy allows interest rate to rise Therefore the portfolio holders worldwide shift their wealth to take advantage of higher interest rate There is surplus in balance of payment because of capital ow The foreigners buy domestic assets and securities In such a process there is surplus in capital account and exchange rate appreciates The reserve bank holds more foreign exchange through increased sale of domestic currency It continues till the interest rates are back in line with those in the world market The following steps occur in the xed exchange rate Reserve bank tightens the money supply through monetary policy interest rate rise as a result Capital in ow and balance of payment are surplus Pressure for currency appreciation increases Interventions by selling home currency for foreign currency Monetary expansion due to intervention lowers interest rate NP P H P F E Back initial interest rates money stock and balance of payment 432 Monetary expansion Under perfect capital mobility the balance of payments can be in equilibrium only at the interest rate iif At higher interest rate the capital in ow is observed and at lower interest rate capital out ow is observed A monetary expansion in domestic economy cuts the interest rate up to E It causes the downward pressure on exchange rate The monetary authority sells the foreign exchange and buys domestic currency until LM curve shift back to initial position Figure 43 Monetary expansion and interest rate effect LM1 BOPO V Figure 43 presents the balance of payment line which is horizontal Due to perfect capital mobility the domestic and foreign interest rate is at equilibrium E The central bank has to intervene if the interest rate goes down The balance of payment cannot attain equilibrium and the central bank needs to maintain the exchange rate Download free ebooks at bookbooncom MM Please click the advert The gure also shows that as the monetary expansion takes place the LM curve shifts to LMl At point E there is a large balance of payment de cit and hence pressure for exchange rate depreciation The central bank sells foreign currency and receives domestic money in exchange The supply of domestic money declines As a result LM curve shifts towards right The process continues until it is restored at E The contraction of the monetary policy leads to more loss of reserves and it forces the reserve bank to force monetary expansion It returns to initial equilibrium The study by Mankiw NG and Ricardo R 2002 explains that if a central bank that wants to achieve maximum stability of economic activity it should give substantial weight to the growth in nominal wages when monitoring in ation This conclusion is deduced from the fact that wages are more cyclically sensitive than most other prices in the economy Moreover compared to other cyclically sensitive prices wages are not subjected to large idiosyncratic shocks Thus if nominal wages are falling relative to other prices it indicates a cyclical downturn which in turn calls for more aggressive monetary expansion Conversely when wages rise faster than other prices targeting the stability price index requires tighter monetary policy than does targeting conventional in ation i T i f we 1 our atic iiiitCEii39 create efand creativity 39 eyond expectations nest employees who can i into The Power of Knowledge Engineering us at wwwskfcomknowledge Download free ebooks at bookbooncom Advanced Macroeconomics pen economy Macro economy 433 Fiscal expansion A i 11 Ilf BOPO IS1 IS Income Figure 44 Effect of scal policy and domestic interest rate A i 11 Ilf BOPO IS1 IS Income In the scal expansion IS curve shifts towards right It increases the interest rate and the level of output At higher interest rate capital ows in domestic country it leads to exchange rate appreciation To maintain the exchange rate the central bank expands the money supply In this process credit to individuals and business man increases and thus overall income increases The currency appreciates due to high capital ows It reduces the exports and the income The IS curve shift back to original position where iIf The gure above shows that the balance of payment remains in equilibrium The following steps occur during the scal expansion The IS and LM curve intersect each other at point E But expansionary scal policy shifts IS curve to 181 The interest rate rises from E to E1 At higher rate of interest the capital ows in domestic country Therefore the domestic currency appreciates The reserve bank sells the currency in such a period The money supply expands and the equilibrium shifts from E1 to E Download free ebooks at bookbooncom l 6 Advanced Macroeconomics Dpen economy Macro economy Table 41 The Mundell Fleming model policy effects Policy Floating Fixed Impact on Y e NX Y e NX Fiscal 0 Increase Decrease Increase 0 0 expansion Monetary Increase Decrease Increase 0 0 0 expansion Import 0 Increase 0 Increase 0 Increase restriction 434 Perfect capital mobility and exible exchange rate Under this model the domestic prices are assumed to remain xed and only exchange rate adjusts The model is developed to show how the monetary and scal policy works in an economy with fully exible exchange rates and perfect capital mobility In the exible exchange rate central bank does not intervene in foreign exchange market The value of the domestic currency gets decided on the basis of demand and supply The balance of payment must be equal to zero An automatic adjustment takes place The current account de cit gets nanced by private capital in ows A current account surplus is balanced by the capital out ows The adjustments in the exchange rate ensure that the sum of the current and capital account is zero Under this model the central bank supplies money at their assumption because money supply cannot correct balance of payment de cit The balance of payment is in equilibrium with interest rate It is equilibrium under perfect capital mobility IifBoP But if the real exchange rate determines the aggregate demand then real exchange rate shifts the IS curve The country faces depreciation in the domestic currency In this case the domestic prices become more competitive Figure 45 Effect of depreciation and appreciation of currency on interest rate A Appreciation lt I I If Igt Depreciation IS Download free ebooks at bookbooncom l 7 Please click the advert Advanced Macroeconomics Open economy Macro economy Figure 45 shows that under perfect capital mobility exible exchange rate and capital ows affect the aggregate demand If the interest rate falls above international interest rate then the capital out ows leads to exchange depreciation It leads to gain in competitiveness and hence a rise in demand for domestic goods The IS curve shifts towards right If interest rate goes up then the capital ow leads to depreciation of currency It leads to loss of competitiveness of exports and a decline in demand for the domestic goods It shows leftward shifting of IS curve If the interest rate is higher than the international interest rate then capital in ow takes place because people invest more money in domestic assets It leads to the currency appreciation so the goods to foreigners become more expensive Therefore aggregate demand falls The aggregate demand forces to shift IS curve to left any point below of IIf It further depreciates the domestic currency Thus competitiveness improves and aggregate demand increases Again the IS curve shifts to rightward 435 Export led policies Most of the countries encourage exports of their goods The increase in exports affects initial interest rate exchange rate and output in the domestic economy The demand for goods exceeds the supply At initial exchange rate interest rate and output rises Therefore the IS curve shifts towards IS The increase in output increases the demand The rise in income increases the money demand and thus raises the interest rate elm quotlilill l39ll lilili39all Are you considering a European busmess degree LEARlll BUSINESS at university level We le cases with cutting edge Copenhagen Busmess School HANDELSHEJSKOLEN MEE 39 T a culture of new foods musnc ENGAGE in extracurricular activities and trad39 39 research working indeuaHy or in StUdymgitbizgisnzgja newfway of such as case competitions Sports teams and ever on m a 53 9 Clean etc make n 39 Brin b I V e speaks English envnronment in the middle of 18 OO eW friends among CBS g acwaluable knowledge and Copenhagen Denmark 0 students from more than 80 experience to boost your career 39 countries39 zillgfg liglion ofMBAs See what we look like and how we work on cbsdk Download free ebooks at bookbooncom 108 Advanced Macroeconomics pen economy Macro economy Fiscal policy effect If government has the expansionary scal policy then it reduces the direct and indirect taxes Similarly government spending on various infrastructure and welfare schemes increases The export rises because of the export led policy of government But expansionary scal policy increases the interest rate It leads to the appreciation of currency The export falls and imports increases This time crowding out will not take place because exchange rate appreciation will lead to decline in exports Under xed exchange rate it does not increase output but it appreciate exchange rate It shifts the demand for goods to foreign goods and reduces the demand for domestic goods Figure 46 Effect of expansionary scal policy in open economy E1 BOPO 181 L V O Y Income Figure 46 displays the ISLM curve equilibrium at point E The IS curve shifts because of demand for exports The increase in exports leads to increase in income The new equilibrium is achieved at E1 At E1 point the balance of payment is not in equilibrium It is an exchange rate appreciation point The interest rate is higher than the international interest rate The capital out ow is observed in domestic economy Therefore the economy shifts back to equilibrium point E 436 Monetary policy In expansionary monetary policy money stock increases in the domestic economy The interest rate declines and the income increases The exchange rate depreciates and export becomes competitive The demand for export rises The gure points that the expansionary monetary policy shifts LM to LMlandthe interest rate declines up to E The interest rate falls below the foreign rate of interest At lower interest rate the capital out ows from domestic economy The exchange rate depreciates at this point It leads to import prices to rise The domestic goods become competitive therefore the output rises The IS curve shifts towards right It continues up to the exchange rate depreciation It raises the demand and output to the level indicated by point E It is an equilibrium point with more output equilibrium interest rate and exchange rate The conclusion is that monetary expansion improves the current account through the induced depreciation Download free ebooks at bookbooncom M39 Advanced Macroeconomics Queen economy Macro economy Figure 47 Effect of expansionary monetary policy on income BOP0 Income V The study suggests that large capital in ows and less exible exchange rate regimes tend to exacerbate domestic credit cycles The fact that the exchange rate regime is statistically signi cant despite controlling for capital in ows suggests that the impact of exchange rate exibility is likely working through a transmission channel that goes beyond the monetary expansion associated with capital in ow A large share of capital in ow could be intermediated through the banking system or the credit multiplier might be larger in economies with less exible exchange regimes Magud Nicolas E etal 2011 Download free ebooks at bookbooncom M Please click the advert Advanced Macroeconomics pen economy Macro economy 44 Competitive depreciation It is simple to understand that the increase in monetary expansion leads to exchange rate depreciation via cut in interest rate The net exports rises and therefore increase in output and employment The demand for domestic goods rises because the imports are costlier It re ects in the different countries output and employment and both declines But all countries will try to follow the same policies This is because it improves their trade balance and capital account The country s different competitive policies export unemployment and disequilibrium in balance of payment of other countries All economies will increase money supply and reduce interest rate Countries will try to reduce the interest rate to depreciate the currency It depends on the internal business cycle Different countries nd the boom and recession at different points Depreciation and recession shift towards countries demand for goods It achieves the full employment A number of factors correct the disequilibrium But competitive depreciation shifts the demand rather than increase in demand The crowding out in real exchange rate may force a country to remain at equilibrium where they started At this point both coordinated scal and monetary policies are required to increase the export The study of Chikako Baba and Annamaria Kokenyne 2011 explains that capital control is generally associated with a decrease in in ow and a lengthening of maturities but the relationship is not statistically signi cant in all cases and the effects are temporary Control is more successful in providing room for the monetary policy than dampening currency appreciation pressure The study also describes that macroeconomics impact of capital control depends on the extensiveness of the policy the level of capital market development the support provided by other policies and the persistence of capital ow 45 The role of prices in open economy In an open economy prices are in uenced by the exchange rate The exchange rate is de ned as SimCorp is a leading provider of software solutions for the financial industry We work together to reach a common goal to help our clients succeed by providing a strong scalable lT platform that enables growth while mitigating risk and reducing cost At SimCorp we value commitment and enable you to make the most of your ambitions and potential Are you among the best qualified in finance economics IT or mathematics www5imcorpcom MITIGATE RISK I REDUCE COST I ENABLE GROWTH SimCorp Download free ebooks at bookbooncom l l l Advanced Macroeconomics Where R Real exchange rate e Nominal exchange rate pf Prices in foreign countries p Domestic prices If we reorganize the above equation then E l economy Macro economy 46 47 In an open economy prices are in uenced by the real and nominal exchange rate In an open economy with xed exchange rate an increase in the price level reduces demand for additional goods An increase in our commodity prices makes our goods less competitive with foreign produced goods Given the exchange rate when the prices of goods rises our goods become more expensive for foreigners to buy Their goods become relatively cheaper for us to buy An increase in our price level shifts demand away from our goods towards imports as well as reducing exports Figure 48 Effect of devaluation on price level Po Price level AS AD NXO A Ygtllt V Figure 48 illustrates that AD is downward sloping curve The demand is equal to aggregate spending by domestic residents plus net exports Now we can de ne aggregate demand curve as follows 112 Download free ebooks at bookbooncom Advanced Macroeconomics pem economy Macro economy AD ANX 48 The AD is drawn for a given level of foreign prices a given nominal money supply given scal policy and xed exchange rate An increase in nominal money stock shifts the schedule upward as does expansionary scal policy Equilibrium point B shows the aggregate supply and demand intersect each other The full employment level is Yquot and equilibrium point is B At this point there is some unemployment in economy The trade balance equilibrium is NXO An increase in domestic income raises imports and worsens trade balance To restore trade balance equilibrium domestic prices would have to be lower This would make the home country more competitive and it can raise exports and reduce imports The trade balance equilibrium is downward sloping It is steeper than the demand schedule for domestic goods The schedule is drawn for a given level of prices abroad At point B home country has trade de cit Our prices are too high or our income is too high to have export equals imports To achieve trade balance equilibrium country should become competitive through exporting more and importing less Country could reduce its level of income in order to reduce the import spending In a xed exchange rate system it is possible for the central bank to use its reserves to nance temporary imbalances of payments which means to meet the excess demand for foreign currency at the existing exchange rate arising from balance of payment de cits A country experiencing balance of payment dif culties can borrow foreign currencies abroad The current account de cit cannot be nanced by borrowing from abroad without raising the question of how the borrowing will be repaid If a country explains that the money would be used for export boost or nance the temporary de cit then loans will be available But if loan is used for unproductive purposes then problem arises 46 Automatic adjustment When there is balance of payment de cit the demand for foreign exchange is larger than the amount being supplied by the private market and central bank When reserve bank sells foreign exchange it reduces domestic high power money and therefore the money stock declines It sterilizes its foreign exchange intervention by buying bonds as it sells foreign exchange to keep the exchange rate from depreciating and reducing the domestic money stock The aggregate demand schedule will shift downward and to the left The gure shows unemployment at E It leads to the decline in wages and costs which are re ected in a downward shifting aggregate supply E moves downward as both the demand and supply schedules shift The short run equilibrium moves in the direction of point B At point B country has automatically achieved long run equilibrium The trade balance is in equilibrium there is no pressure on the exchange rate Therefore there is no need for exchange market intervention and Reserve Bank does not require further changes in money supply The constant wage and costs does not allow where trade balance is achieved at full employment Despite several unexpected adverse developments on the external and domestic fronts India s external situation has remained satisfactory The Reserve Bank continues to follow the approach of watchfulness caution and exibility by closely monitoring the developments in the nancial markets at home and abroad It will cooperate its market operations carefully particularly with regard to the foreign exchange market with appropriate monetary regulatory and other measures as considered necessary from time to time RBI 2012 Download free ebooks at bookbooncom Please click the advert Advanced Macroeconomics Open economy Macro economy 47 Expenditure switching and reducing policies The combined expenditure switching policies will shift demand between domestic and imported goods and expenditure reducing policies in order to cope with the two targets that is internal and external balance Reducing current account de cit is used to reduce aggregate demand It is expenditure reducing policies NX Y CIG 49 Where NX Trade surplus 1 Actual investment The balance of trade de cit can be reduced by reducing spending CIG relative to income Y through restrictive monetary or scal policy The link between external de cit and budget de cit as NXSITG 410 S denotes private saving TG is the budget surplus If the saving and investment is constant then changes in the budget would translate one for one into changes in the external balance Budet cuttin wouldbrin about eual the external de cit I l ly t 39ur 39 Download free ebooks at bookbooncom 114 Advanced Macroeconomics pen economy Macro economy 48 Devaluation There is unemployment and automatic adjustment and the desirability of free trade which argues against the use of tariff Both suggest the need for an alternative policy for restoring internal and external balance The major policy instrument for dealing with payment de cit is devaluation which usually has to be combined with restrictive monetary and scal policy Figure 49 Effect of devaluation on exports AS Price level E AD NX AD NX O Y Y Devaluation is de ned as increase in the domestic currency price of foreign exchange It increases the relative price of imported goods in the devaluing country and reduces the relative prices of exports from devaluing country India has devalued its currency to boost its exports and reduce imports Devaluation is the expenditure switching policy In devaluation NX schedule shifts NX With the lower demand for exports and with a xed exchange rate output would decline Aggregate demand schedule shift left as a result of fall in exports The lower level of income reduces imports but not enough to make up for the loss of export revenue The net effects are therefore unemployment and a trade de cit The automatic adjustment mechanism would work but slowly to restore equilibrium the country can devalue its currency This has the obvious advantage that it does not require a protracted recession to reduce domestic costs Given prices of foreign goods in terms of foreign currency devaluation raises the relative price of foreign goods Import falls and export rises The disturbance to the economy takes place in the trade account The NX O the locus back to the full employment level of income as we could do with a devaluation both internal and external balance would be attained The central bank can change the exchange rate as an instrument of policy It can change the exchange rate for policy purposes It devalues currency when current account looks as though it will be in for a prolonged de cit In a system of clean oating by contrast the exchange rate moves freely to equilibrate the Balance of Payment BoP In a system of dirty oating the central bank attempts to manipulate the exchange rate while not committing itself to any given rate The dirty oating system is thus an immediate between a xed rate system and clean oating system 49 Exchange rate and prices The effect of devaluation on trade balance is always positive Devaluation reduces the relative prices of the country s goods Download free ebooks at bookbooncom MS Advanced Macroeconomics pen economy Macro economy Price levels also change along with the exchange rate A country achieves a real devaluation when devaluation reduces the price of the country s own goods relative to the price of foreign goods The real devaluation occurs when e p rises or when the exchange rate increases by more than the price level Figure 410 Effect of devaluation on trade balance and income E Price E Pe0 Nx0 pe NX O A o l Y V Figure 410shows that in short tem a country might absorb an external shock and stay at E It can borrow from abroad and nance external de cit But in long term country can come at point E It can devalue its currency and come at point E But if domestic prices are increasing then it frustrates devaluation Therefore devaluation increases the general price level at domestic level It is a deviation crisis 410 Crawling peg exchange rate In order to avoid the wide de cit in balance of payment countries follow a crawling peg exchange rate policy Under this system the exchange rate is depreciated at a rate roughly equal to the in ation differential between the country and its trading partners In India reserve bank often follows this policy The idea of crawling peg is to maintain the real exchange rate RzP Pe constant by raising e at the same rate as PPf is rising 4101 Exchange rates and relative price adjustment If we assume that wages and prices adjust to achieve full employment But prices are based on labor cost or wages Suppose wages are exible in real terms because labor wants to maintain the purchasing power of wages It is an outcome of the bargaining between the rms and its workers Changes in the cost of living triggered by devaluation would lead to changes in money wages which would feed back into prices which in change could offset the effects of the nominal devaluation Changes in prices feed back into wages and from there into prices It is one of a wage price spiral that may produce considerable volatility in the price level Small disturbances can sometimes set off quite large changes in the price level Suppose a country has to devalue its currency to restore the trade balance The devaluation raises imports and thereby raises consumer prices To maintain the real wages workers demand high money wages which grant and pass on by raising prices Real wages are constant which means wages and the price levels have risen in the same proportion Wage increase has been fully passed on which means that real wage in terms of domestic output is also unchanged Download free ebooks at bookbooncom W6 Please click the advert Advanced Macroeconomics pen economy Macro economy The two results imply that relative prices are unchanged out of that the nominal devaluation has no effect on the real exchange rate If government does not increase the money stock then the higher prices reduce real balances and aggregate demand with income down the current accounts improves When wages rise the government raises the money stock so as not to create unemployment It is important that under devaluation reserve bank should not accommodate nominal price increase if it wants to achieve a real devaluation The idea of stick real wages is important that of real disturbances Suppose due to superior technology if the demand for export declines then relative prices of goods must fall in order to encourage foreign goods But if government devalues currency and the workers succeed in restoring their real wages and prices are marked up on wages then there will be no changes in the relative price of our goods The only way to reduce the real wage would be prolonged unemployment In an open economy with substantial cost of living indexation in wage agreement it may indeed be very difficult to change real wages and relative prices through exchange rate changes In general countries that devalue their currencies have to use restrictive aggregate demand policies to make sure that induced increase in prices does not simply undo the real effects of the nominal devaluation 411 J curve effect The effects of changes in relative prices on the trade balance and the possibility that depreciation worsens the trade balance The trade balance measured in terms of domestic goods as ePf NX X Q P 411 Do you want your Dream Job More customers get their dream job by using RedStarResume than any other resume service RedStarResume can help you with your job application and CV Go to Redstarresumecom Use code BOOKBOON and save up to 15 enter the discount code in the Discount Code Box Download free ebooks at bookbooncom M7 Advanced Macroeconomics pen economy Macro economy Where X The foreign demand for goods Q Own import quantity ePPQ value of import in terms of domestic goods Suppose exchange rate depreciates plus domestic and foreign prices p and pf are unchanged then the relative price of imports ePf P rises It has two effects Firstly the physical volume of imports does not change their value measured in domestic currency This means higher import spending and thus a worsening of the trade balance This is the source of the potentiality preserve response of the trade balance to exchange depreciation There are two volume responses that run in the opposite direction Export should rise because our goods are now cheaper for foreigners to buy and the volume of imports should decline because imports are more expensive The short term volume effect within a year is quite small and thus does not outweigh the price effect The long term volume effects by contrast are quite substantial and certainly enough to make the trade balance respond in the normal fashion to a relative price change Low short term and high long term volume effects result from the time consumers and producers take to adjust to changes in relative prices Some adjustments may be instantaneous but it is clear that tourism patterns With particular de cit the depreciation raises the relative prices of imports The short run effects result primarily from increased import prices with very few offsetting volume effects Therefore trade balance initially worsens Over time as trade volume adjust to the changes in relative prices export rise and import volume progressively decline The volume effects come to dominate and the long run trade balance shows an improvement This pattern of adjustment is referred to as the I curve effect The response of the trade balance looks like I It is presented in the following diagram Download free ebooks at bookbooncom Advanced Macroeconomics Queen economy Macro economy Figure 411 The J curve effect Trade de cit Time Devaluation Time The I curve effect provides important clues for the interpretation of macroeconomics and it is observed across countries It particularly shows why appreciations typically do not lead to improvement in the current account in the short run 412 The Monetary Approach to Balance of Payment MABoP It is frequently suggested that external balance problem is monetary in nature For any given BoP de cit a suf cient contraction of the money stock will restore external balance by raising the interest rates and reducing spending It generates a contraction in economic activity a decline in income and therefore a decline in imports The BoP identity we have BOPAHADC AMADCAR Where AH High power money MM Monetary sector equilibrium AR Target variable Download free ebooks at bookbooncom 119 Please click the advert Advanced Macroeconomics pen economy Macro economy AM Endogenous variable ADC Domestic credit The above equation shows that the balance of payment is equal to the change in high power money and domestic credit The change in money supply is equal to the change in domestic credit and reserves In the external sector change in money supply AM is an exogenous variable Reserves can be further stated as XZ AFAR 412 Where AR is a target variable Z is an exogenous variable XAF is an exogenous variable A more sophisticated interpretation of the problem recognizes the link among the balance of payment de cit foreign exchange market intervention and the money supply The automatic mechanism is for a sale of foreign exchange as a rise in the case of a balance of payment de cit It can re ect in an equal reduction in the stock of high powered money The de cit in current account country sells foreign exchange and in return receives high powered money thereby reducing the money stock A surplus current account increases the outstanding stock of high powered money when it buys foreign exchange thereby expanding the money stock 4121 Instrument target approach If there is a change in domestic credit then in ation increases The exchange rate change will lead to increase in reserves similarly AllOptions Try this The sequent lr 1 0 l2 Hr M3 is 01f 00 place in Tbill paquamce 135 Me member Download free ebooks at bookbooncom 120 Advanced Macroeconomics pen economy Macro economy ADC I39I C 3 Through gure 412 the change is explained as follows The diagram shows that a point is a domestic credit As money supply credit increases the in ation also increases Figure 412 Money supply and domestic credit MM A AR la Con ict of R 4F a 77 ADC ADC V The change in reserves is interpreted as ARAMADC The change in reserves will have positive effect on the money supply and negative effect on domestic credit Therefore the monetary authority would keep the balance between the two The assumption is that in ation is a function of money supply change U f AM 412 In ation is a function of change in money supply Money supply is an independent variable It can be further stated as follows H a AM 1 Therefore H AM 61 Then Download free ebooks at bookbooncom HZ H Advanced Macroeconomics pen economy Macro economy ARAMADC If we substitute AM in above equation then it can be rearranged as ARlll ADC a The policy instruments are as follows Fl 0 aADC AR ADC 0 Similarly AR and in ation in economy can be explained as follows In the 413 gure it shows that in ation and reserves are equilibrium at point A But contraction in domestic credit increases money supply from MMO to MMI The change in domestic credit will decline MM1 to net line after the credit restriction Thus change in domestic credit reduce the same reserves and at lower in ation T Aamp B For the same in ation 7 higher reserves are expected A R BampC Figure 413 Effect of money supply and in ation AR MM MMl B AR A c Av Ar 71 0 Jr 1 11 11 Second line The change in foreign exchange reserves are equivalent to the ow of foreign capital and difference in export and import XZ AFAR 413 The above equation can be interpreted alternatively as export minus import and change in foreign capital is equal to change in reserves ARXZ AF X Z fE H 414 Download free ebooks at bookbooncom 122 Please click the advert Advanced Macroeconomics Open economy Macro economy Here trade balance is positively related to the exchange rate and negatively related to the in ation If the in ation is higher trade balance is negative It can be further stated as XZ thOE ARbnCEAF 415 It means the reserves are negatively related to in ation and positively related to exchange rate and foreign capital A policy frame work is given as follows n 0 CE AF 9 AR CEAF O The above variables are shown in diagram as follows MM curve shifts due to monetary policy Capital ow is very important for macroeconomic stabilization In the diagram E0 is shown as equilibrium in both sectors Monetary sector equilibrium is shown as upward line THIS ebook IS PRODUCED WITH iText Download free ebooks at bookbooncom 123 Advanced Macroeconomics pen economy Macro economy Figure 414 Macroeconomic stabilization in economy AR k Both sectors equilibrium MM AEAF gt H ADC 21 v The external sector is explained in more detail in the following diagram External sector equilibrium The gure that the external sector equilibrium as X ZAFAR 416 Figure 415 External sector equilibrium all 31 It p I JEHF tR a I I H 4 s rR 3 31 JL iii J I In the gure 415 Y axis is the exchange rate and foreign capital whereas the X axis shows the in ation The above gure represents the link between exchange rate and in ation It can be de ned more broadly with change in exchange rate as follows The diagram also shows the equilibrium between reserves and in ation The point A shows the devaluation phenomena After devaluation the in ation remains same and it is possible to get higher reserves Same in ation TI and higher R reserves at point B are maintained But at point C there is less reserves and more in ation If we compare point A and C then one gets same reserve and higher in ation devaluation phenomena After devaluation the in ation remains same and it Secondly at same reserves there is high in ation Point A and C Therefore everything depends on real exchange rate The real exchange rate is de ned as Download free ebooks at bookbooncom 124 Advanced Macroeconomics ETPf R p T Where R Real exchange rate E Nominal exchange rate Pf Price in foreign countries P Prices of domestic currencies Loen economy Macro economy 417 When we superimpose the above two conditions the gure evolves itself as one shown in 416 Figure 416shows that the money supply exchange rate and foreign capital are equilibrium at E with no If the money supply gets reduced then MM line shifts to MM The new equilibrium is achieved with higher reserves with lower in ation Figure 416 Change in money supply and in ation in economy AR 15 E CEAF MM1 H01 ARd MM ARO Ho CEAF 7t The above diagram shows that the reserve changes could be 15 percent The instrument targets are explained as ADC E AR The emphasis of monetary consideration in the interpretation of external balance problem is called the monetary approach to the balance of payment The monetary approach has been used extensively by the IMF in its analysis and design of economic policies for countries in balance of payment trouble The use of domestic credit ceiling is a crude policy to 125 Download free ebooks at bookbooncom Advanced Macroeconomics pen economy Macro economy improve balance of payment 413 Exchange rate overshooting Monetary authority supply money regularly in the economy The devaluation improves the trade balance in the short run But in the long run along with money supply the prices also rise in the economy Exchange rate devaluation money supply and prices remain in equilibrium Assumption The exchange rate overshooting model is based on the following assumptions They are explained as follows 1 There is perfect capital mobility in the economy 2 Exchange rate is exible 3 Prices are freely allowed to change The model explains the relationship between output and prices Secondly interest rate exchange rate and monetary policy are linked In the long run monetary expansion leads to exchange rate depreciation It is because higher prices with no change in competitiveness The following diagram shows the link between in ation interest rate and income Figure 417 Effect of monetary policy on income in open economy R In ation LMO De ation Appreciatio Appreciation LMl Eo rrf E2 E1 151 De ation Depreciation In ation Deprec1 tion IS 0 V Y The monetary policy assumes the exible exchange rate The equilibrium point is observed at E0 Download free ebooks at bookbooncom 126 Advancech Macroeconomics pen economy Macro economy The monetary expansion leads to shift of LM0 line to LMI The new equilibrium point is achieved at E1 The exchange rate depreciates because domestic interest rate is less than foreign interest rate rltrf The exports become competitive and they rise because of competitiveness The ISO shifts to 181 This is because export rises Equilibrium point is achieved at E2 This is end of phase one At point E2 YgtY prices rises mp falls and LM1 curve shifts LMO It shifts back to original point LMO Interest rate rises and the equilibrium point is achieved at E3 The exchange rate appreciates rate of domestic interest rate is below the foreign interest rate rgtrf Exports fall due to lack of competitiveness in the global market IS curve shift back to 181 The equilibrium is achieved at E0 In the long run output returns to normal level Money prices and the exchange rate rises in the same proportion The short run effects of monetary expansion leads to rise in M P e epp and Y The prices are unaffected by monetary expansion In the long run exchange rate e prices p have positive effects In the long run the relation of money supply to prices M P real exchange rate epp and income Y is unaffected It is presented in table as follows Table 42 Effect of monetary expansion money supply exchange rate and prices Period MP e P epp Y Short run 0 Long run 0 0 0 4131 Exchange rate overshooting The analysis of monetary policy under exible exchange rate given above leads to an important insight about the adjustment process The important feature of the adjustment process is that exchange rate and prices do not move in the same direction When a monetary expansion pushes interest rates down the exchange rate adjusts immediately and there is an abrupt change in relative prices and competitiveness The overshooting of exchange rate means exchange rate rises above the money supply The prices slowly adjust in the long run Therefore in the long run money supply exchange rate and prices are in equilibrium Figure 418 shows the overshooting The depreciation and appreciation is equal to depreciation For example depreciation is 10 percent and appreciation is 5 percent The real depreciation effect is calculated as follows DAD 1055 Therefore the real depreciation after reducing the appreciation effect is 5 percent The effect of money supply prices and exchange rate is shown in the following diagram Download free ebooks at bookbooncom 127 Advanced Macroeconomics pen economy Macro economy Figure 418 Exchange rate overshooting MPE Rs O Tlme The diagram above explains that m p will remain unchanged in the long run Prices imply that P must rise proportionately with money supply The ratio epf p that is real exchange rate should remain unchanged because IS1 shift back to same as before Exchange rate E must rise proportionately with P ET X M PT 418 In the above diagram initial economy is in full employment equilibrium The exchange rate is in equilibrium at A suppose exchange rate depreciates up to A The effect is more than the increase in money supply Prices adjust only gradually in the short run The relative price of imports EP P increases sharply That gain in competitiveness causes a transitory income expansion But over time prices rise and the exchange rate appreciates In the long run nominal money the exchange rate and prices rise in the same proportion The real balances M P and relative price of import are therefore unchanged The exchange rate overshoots its new equilibrium level In response to a disturbance it rst moves beyond the equilibrium Ultimately it reaches and then gradually returns to the long run equilibrium position Overshooting means that monetary policy produces large change in exchange rate 4132 Policy Dilemma The government wants to achieve not only external balance but also the internal balance Internal balance means that output is at the full employment level Yquot External balance occurs when the trade balance is zero Important point about internal and external balance is that there is sometimes a policy con ict between the solutions to the two problems It can happen that policies to improve the external balance will worsen internal balance The policy dilemma shows that in region Iamp III monetary and scal policy can move the economy towards internal and external balance In region II amp IV there is a policy dilemma Download free ebooks at bookbooncom Please click the advert Advanced Macroeconomics Open economy Macro economy Figure 419 Policy dilemmas to achieve equilibrium in economy II Recession de cit III Boom de cit NX0 Ygtllt At point A the economy is in a position of recession and de cit Here we have to choose whether we want to use tight policies to achieve trade balance equilibrium or expansionary policies to achieve full employment If we are unable to reach one target it gets it further away from the other Such a situation is called a policy dilemma and it can always arise when there are more targets of policy than instruments with which to move the economy towards its targets In this case we have only one policy instrument But we have two independent targets that is external and internal balance The policy dilemma can be solved by nding another policy instrument to cope with the multiple targets The next step for top performing graduates Designed for high achieving graduates across all disciplines London Business School s Masters Masters in Management I I I I I I I I in Management prOVIdes speCIfic and tangible foundations for a successful career in busmess This 12 month fulltime programme is a business qualification with impact In 2010 our MiM employment rate was 95 within 3 months of graduation the majority of graduates choosing to work in consulting or financial services As well as a renowned qualification from a world class business school you also gain access to the School s network of more than 34000 global alumni a community that offers support and opportunities throughout your career For more information visit wwwlondonedumm email mimlondonedu or give us a call on 44 020 7000 7573 Figures taken from London Business School s Masters in Management 2010 employment report Download free ebooks at bookbooncom 129 Advanced Macroeconomics pen economy Macro economy 4133 Policy Dilemma twin de cit The policy dilemma explains that there is need to achieve internal balance or external balance The dilemma is also to achieve scal de cit versus the current account de cit Internal balance comprises of the budget surplus with taxes minus government expenditure BSTG The external balance means export minus imports the net export positive NXXZ Now BStY G Where TtY NXmY Adjustments 1 Economy b caught under I ISLM curve intersect trade surplus if we conduct monetary policy LM curve shift to LM1 It shifts rightward There is no dilemma In zone 111 there is no con ict since we reduce the trade de cit there is no dilemma 2 An expansionary monetary policy will increase in the trade de cit ie of paying for the excess of imports over exports So there is policy dilemma This dilemma cannot be solved in the above situation because there are two targets and one instrument that are internal and external balance and income In order to solve the dilemma we need a second instrument Figure 420 Internal and external adjustment with income 100 Y9 500 I V YIB3000 Y Internal balance 600 External balance Explanation Download free ebooks at bookbooncom 13 Advanced Macroeconomics pen economy Macro economy The balance of payment comprises of the net exports and capital account de cit It can be arranged further and solved as follows BOP NX CAD XZ AF BOP XmY rrf 419 Here the balance of payment comprises of export minus import and the domestic income The balance of payment is also related to the capital in ow Capital in ow depends on the difference between the domestic and international interest rate Figure 421 Adjustment of balance of payment de cit and money supply IV 111 Recession Bop surplus Boom G l G l MP P 1 j 11b G t Bop BD Boom de cit MP Ila L t G A V Increase in exports is the best strategy to improve the balance of payment But increase in income will have negative effect on the balance of payment Because people will import goods YT 9 BoP xlz from foreign countries and the balance of payment will be de cit Similarly if the rate of interest rate rises then balance of payment also becomes surplusr increases then BoP increases If the government expenditure increases then investment economy also rises It consequently increases the income Increased income G leads to investments and thereby again generating more income It is opposite when government reduces the expenditure then income decreases and therefore rate of interest decreases G decreases then income decreases and r decreases Download free ebooks at bookbooncom 131 Advanced Macroeconomics pen economy Macro economy Secondly as money supply MP increases income Y increases and the rate of interest decrease Alternatively MP increases and r decreases or vice versa Therefore any increase in income leads to effects in balance of payment The balance of payment worsens The vertical line shows the internal balance resulting in full employment At every point on ISO the balance of payment is equal to zero Above the line any point shows the balance of payment surplus Every point below the line BoPO is the zone is de cit in the balance of payment New challenges have emerged in the form of large and rapid movements in the exchange rate The consequences of these movements for both ow and stock indicators are unquestionably adverse However in the event of a prolonged nonresolution of global problems considerations of nancial and external stability are critical A prudent policy approach is to accommodate the pressure of depreciation in a way which reduces the likelihood of a much more severe and perhaps uncontrollable shock RBI 2012 The above explanation can be presented with the following example The break even in BS implies BSO 0 02y 600 60002 Y Y 3000 Break even in NX x mY O 100 02Y Y5OO Appendix Download free ebooks at bookbooncom 132 Please click the advert Advanced Macroeconomics Open economy Macro economy Graph 41 Foreign exchange reserves in India Foreign Exchange Reserves Rs Crore 1600000 1400000 1200000 1000000 800000 600000 400000 200000 V b 4 Q Q Q Q Q Q Q Q Q N 0 Q 0 Q9 9 r19 9 SDR39s Gold Foreign currency assets Reserve Tranche Source RBI statistics 39 ilrf I dgcg o 13 Resources in 5 Teach with the Best Learn with the Best Agilent offers a wide variety of affordable industryleading electronic test equipment as well as knowledgerich online resources for professors and students We have 10039s of comprehensive webbased teaching tools 39 lab experiments application notes brochures DVDs CDs posters and more Agilent Technologies Inc 2012 us 18008294444 canada 18778944414 Anticipate Accelerate Achieve Agilent Technologies Download free ebooks at bookbooncom 133 Advanced Macroeconomics Dpen economy Macro economy Graph 42 Foreign trade of India India39s Foreign Trade Rs Crore 2000000 1500000 1000000 I 500000 I 0 500000 1000000 Fl Fl Fl FI FI Fl FI FI Fl Fl FI FI Fl FI FI N N N N N N Exports Imports Tota Balance Source RBI statistics Table 43 India s Overall Balance of Payments Billion Item 200708 R 200809 R Debit Net Credit Debit Net Credit 2 3 4 5 6 1 A CURRENT ACCOUNT I MERCHANDISE 6680 10357 3677 8580 14054 5474 II INVISIBLES abc 5981 2939 3042 7704 3506 4198 a Services 3630 2068 1562 4880 2396 2484 i Travel 455 372 83 502 433 69 ii Transportation 402 463 61 521 585 65 iii Insurance 66 42 24 65 52 13 iv Gnie 13 15 2 18 38 20 v Miscellaneous 2694 1176 1518 3774 1287 2487 of which Software Services 1620 135 1485 2122 116 2006 Business Services 674 665 10 855 709 146 Financial Services 129 126 4 204 136 69 Communication Services 97 35 62 105 50 55 b Transfers 1777 93 1685 2169 126 2043 i Of cial 30 21 10 30 19 11 ii Private 1747 72 1675 2139 107 2032 c Income 573 778 205 655 984 329 Download free ebooks at bookbooncom 134 Advanced Macroeconomics DEGQED economy METCIFCO economy i Investment Income 555 734 180 617 924 307 ii Compensation of Employees 18 44 26 38 60 22 Total Current Account II 12661 13296 635 16284 17560 1276 CAPITAL ACCOUNT 1 Foreign Investment ab 10865 9121 1744 7755 7405 351 a Foreign Direct Investment iii 1499 861 638 1965 964 1001 i In India 1399 1394 1914 1906 Equity 1077 4 1073 1462 1454 Reinvested Earnings 309 309 415 415 Other Capital 12 12 37 37 ii Abroad 100 857 756 51 956 905 Equity 100 680 579 51 620 569 Reinvested Earnings 44 44 50 50 Other Capital 133 133 287 287 b Portfolio Investment 9366 8260 1106 5790 6441 650 i In India 9357 8257 1100 5783 6425 642 of which FIIs 9079 8257 822 5735 6425 691 ADRGDRs 266 266 49 49 ii Abroad 9 3 7 7 15 8 2 Loans abc 3303 1668 1635 2854 2506 348 a External Assistance 170 86 85 244 129 1 15 i By India 1 1 3 19 16 ii To India 169 84 85 241 110 131 b Commercial Borrowings 1219 309 911 708 343 365 i By India 64 65 1 92 36 56 ii To India 1155 243 912 616 307 309 c Short Term to India 1914 1274 639 1901 2034 133 i Suppliers Credit gt 180 days amp Buyers Credit 1712 1274 438 1778 1777 2 ii Suppliers Credit up to 180 days 202 202 123 257 135 3 Banking Capital ab 2240 1768 472 2954 3146 192 a Commercial Banks 2237 1751 486 2948 3119 170 i Assets 784 507 276 1148 1306 158 ii Liabilities 1453 1244 209 1801 1813 12 of which NonResident Deposits 1181 1174 7 1710 1506 204 b Others 3 17 14 6 27 22 4 Rupee Debt Service 5 5 5 5 5 Other Capital 1171 737 434 761 973 212 Total Capital Account 1 to 5 17579 13300 4279 14324 14034 290 Errors amp Omissions 52 52 15 15 Overall Balance Total Current Account Capital Ac count and Errors amp Omissions ABC 30293 26596 3697 30673 31644 971 Monetary Movements iii 3697 3697 971 971 Download free ebooks at bookbooncom Advanced Macroeconomics E l economy Macro economy i MF ii Foreign Exchange Reserves Increase Decrease 3697 3697 971 971 of which SDR allocation Source RBI statistics Questions NQP rPP PE 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 b C d 6 Explain the relationship of balance of payment and exchange rate Why must the external balance be in balance Explain the difference between xed and exible exchange rate How does the open economy affect the goods market Explain Capital in ow affects the balance of payment equilibrium What is the effect of the exchange rate in it How does internal and external equilibrium get disturbed What are the policies required to correct it Explain the Mundell Fleming model with relation to xed exchange rate and capital mobility Explain the Mundell Fleming model with reference to xed exchange rate along with the effect of the monetary and scal policy on it What is the effect of exible exchange rate and monetary and scal policy on Mundell Fleming model Explain the term competitive depreciation Explain the role of prices in an open economy Explain the term devaluation in detail What is I curve effect Explain the monetary approach to balance of payment What is exchange rate overshooting Explain policy dilemma in the equilibrium of economy What are the adjustments required to reduce the twin de cit in an economy Exchange rate overshooting reduces the trade de cit of country Explain the external sector equilibrium in detail What is the macroeconomic stabilization approach Explain Exchange rate depreciation leads to increase in the price level in a country Explain Devaluation of currency helps to reduce the trade de cit Discuss Export lead policies help to achieve the balance of payment equilibrium How can the disequilibrium in the capital account of a county corrected Explain the relation of currency appreciation and depreciation with effect to interest rate How it will help to make equilibrium in the balance of payment Write a note on the followings Mundell Fleming model Perfect capital mobility and exible exchange rate Policy effect of Mundell Fleming model Goods market equilibrium in an open economy Exchange rate system Download free ebooks at bookbooncom 136 Advanced Macroeconomics Modern Macroeconomics 5 Modern Macroeconomics 51 Introduction Modern macroeconomics discusses the new development in macroeconomics The usual national economy and equilibrium is a part of traditional macroeconomics But modern economics debates the ef ciency wage hypothesis insider and outsider models implicit contracts search and match models etc Such topics also review the labor market behaviors in an economy Modern economies are dynamic and changing with the global factors The labor markets are dynamic and they are directly in uenced by the global production methods It is dif cult for the workers to nd a job with advanced skills Firms are also competitive to gain more pro t and replace workers with skills and ef ciency The search and match model show the equilibrium level of employment and wages The nominal wages in the economy are changing and more in ation in economy leads to more rise in wages and prices Workers are also alert to the change in the prices of commodities They expect higher wages to cope up with rising prices and the standard of living 52 The ef ciency wage hypothesis The ef ciency wage hypothesis is well discussed in relation work capacity and nutrition As per discussed in previous chapter the workers may make mistakes for expected prices The expected prices are higher than the actual prices Wages are set too high and it results in unemployment The nominal wages are set too high either because workers are concerned about their relative position in the labor market This is also because workers expect prices to be high The workers who are identical to the rms can be offered less than what the rms currently pay Workers should be accepted to a rm that seeks any opportunity to increase pro t Ef ciency wage theory explains that rms may not nd it pro table to hire more workers at reduced wages The ef ciency wage theory explains that if workers offer to work for lower wages rms do not want to reduce wages Firms may simply pay higher wages because there is more bene t to them It pays more to workers because of the higher output skill enhancement etc The ef ciency wage is equal to the marginal cost of increasing the wage exactly equal to marginal gain in the productivity of the rm s workers Firms cannot observe each worker in daily routines Monitoring each worker s unproductive activities is an expensive task for any rm Workers spend time on various activities such as newspaper reading gossip chatting calling and sending SMS to friends union activities politics at different levels etc Most of the times workers spending time on other activities but they do not like to work for which they are hired Such activities reduce the productivity and total production The workers contract and wage offer do not agree to shrink at all Firms discourage quitting and shirking of the workers at work It sends wrong signal to other workers Highly paid workers have high consumption expenditure Higher wage is an incentive for workers to work more and be punctual The nutritious food improves health and increases productivity It is similar to nutrition and ef ciency wage theory Undernourished workers affect production as they remain absent for long period of time It reduces the productivity and production in the rm Well nourished workers can improve the rms comparative wage condition The rm pays high wages where labor cost increases It is compensated for greater upsurge in the productivity Suppose there are N workers in the economy and labor supply is inelastic If wp is a real wage and e is the workers efforts then the bene t to workers is given as Download free ebooks at bookbooncom Please click the advert Advanced Macroeconomics Modern Macroeconomics 3 K e employed by rm 51 p 8 O if not employed by rm The rst condition explains that workers are employed and they do not shirk Therefore bene ts are equal to W P But suppose workers shirk rm s re and remove the workers and then the workers think of the net bene ts If the net bene ts are lower shirking is higher NBshirking S B Where B means exerting efforts W W e p e 52 The net bene ts of shirking depend on the efforts The expected loss from shirking is that cheating is detected 4 times the loss of income from ring is W Expected loss of shirking U 7 Expected loss of wages from cheating is equal to gain from cheating You re full of energy and ideas And that s just what we are looking for U35 2010 All rights reserved Looking for a career where your ideas could really make a difference UBS s Graduate Programme and internships are a chance for you to experience for yourself what it39s like to be part of a global team that rewards your input and believes in succeeding together Wherever you are in your academic career make your future a part of ours by visiting wwwubscomgraduates alsUBs wwwubscomlgraduates Download free ebooks at bookbooncom 13 Advanced Macroeconomics Modern Macroeconomics E y 53 Firms must pay high wage to avoid shrinking of workers Sometimes workers leave job because of various reasons But if the unemployment rate is higher in the economy then u is large In such situations if workers are caught while shirking and cheating they workers do not get employment for a long period of time Firms get more labor at lower wage in the economy but it is opposite when unemployment is low Firms must pay high wages to reduce shirking The following diagram shows unemployment and no shirking condition which declines with full employment The rm s behavior is only to earn more pro t The workers ef ciency is given as follows Y Fe n 54 There are number of workers who always shirk Therefore a rm s pro t is given as 7r FeN KNS 55 I Figure 51 Real wage and employment in economy A Wp Real wage WPNs WP ND 439 Employment v N NS N D Figure 51 depicts that the N is the demand for labor The N on shirking condition is upward sloping At higher wage there is less shirking The marginal product of labor is Download free ebooks at bookbooncom 139 Advanced Macroeconomics Modem Macroeconomics W eMPeN eF 6N 56 p The wage is at equilibrium where there is no shirking and demand curve intersect The equilibrium is W P NS in the gure It is an ef ciency wage N N NS is the total unemployment in the economy If there is perfect monitoring of workers through television and cameras then the intersection point is N N D But due to nonmonitoring there is intersection of labor demand and NSC at point E If the real wage is wp ltwpNS more than shirking and employment NNSltND this would force to rise in real The shirking is less It is opposite when W P gt WPNS The demand for workers at wage NNSgtND results so that wage will fall and workers cannot bid down wages to the competitive level There is involuntary unemployment N N NS in the economy If there is full employment then red workers will join the next best rm There is too much competition to get skilled labor Shapiro and Stiglitz explained that rms choose to pay higher wage than the market clearing wage This is because rms are unable to detect shirking on the job Similarly higher wage is incentive for the workers to work more Friedman argues that the workers should get higher wage because of cost of living It always rises over time Long run and staggered wage setting Keynes has assumed that the wages are set less frequently than the employment chosen by the rm The nominal wage is said to be sticky The rm set wages less frequently than it hires or res workers Figure 52 displaysthat real wage is WOpO and unemployment that is natural unemployment is Nquot Suppose the price level rises from P0 to P1 The nominal wage adjustment takes time but in the short run real wage declines to wOp1 Firms employ more labor unemployment in the economy declines The output rises In the gure it is shown in the B panel It is inversely related when the price level declines and nominal wage declines The rm reduces the total workers through hire and re policy the resultant output declines It continues till the real wage is equal to the ef ciency wage The natural rate of unemployment is Uquot Panel A shows the Quasiequilibrium rate of unemployment It is a point of equilibrium of pro t maximization and NSC It is shown because there is aggregate excess supply of labor It is the only point where demand for labor is consistent with wage setting behavior that differs shirking If the price level is p1 and unemployment is below the natural rate The new Keynesian assumes that adjustment begins with some fraction of rms adjusting their nominal wages over any given period of time Download free ebooks at bookbooncom Muff Please click the advert Advanced Macroecomomice Modem Macroecomomicg Figure 52 Wage setting in the long run Real wage W 11 NSC AS WW0 A WOPO lt WO p 1 39 4 l 439 A A7 L N N1 N Employment J Y Y1 Aggregate output 7 A A Y1 YfK N ygtxlt v Nquotlt N1 Employment v Aggregate output Deloitte D18COVCI the truth at WWWdClOittCCaCareers Deloitte 8 Touche LLP and affiliated entities Download free ebooks at bookbooncom 141 Advanced Macroeconomics Modern Macroeconomics 521 Staggered wage contracts According to Taylor the contract decisions are staggered in which all wage contract decisions in the economy are not made at the same point of time Wages are predecided because the cost of adjustment of wage is higher Firms rst explain the remuneration of workers x the production and sale in future It does not monitor the workers performance very frequently But workers always search the probable wages elsewhere If they get good salary in other rms then workers shift and their wage rise It is observed at different point of time It is only dependent on the information available to rm and workers Sometimes rms set wages higher and it keeps on at a high level In such cases workers do not have chance to leave the job because they do not nd alternatives to the present job Sometimes due to high cost of wage adjustment the contracts are set in rst year and half contracts are set in the next year There are two cohorts of workers each negotiating a wage contract for two periods in a staggered manner In simple mathematical term it is called as t t1 and t2 The rst contract overlaps with the second cohorts contract It is set in T1 period The rst and second cohort contracts overlap in T1 period The rm faces average cost The current wage contract is signed as Xt and previous contract wages signed in period T1 as t1 XH or Wt12Xt1Xt 57 Here Xt is the wage contract settlement signed in period t Sometimes the rms pay the average wage in the next contract or period It depends on the labor market If the workers want high wages then they should negotiate for t1 period There is also a possibility that the economy will downturn and unemployment will rise It reduces the changes of increase in wage Wage adjustment The prices cannot be controlled and they are always on a rise It is the rm which decides the amount of increment in wages If the rm is competitive then they increase the wage rate But if the rm is less competitive then it adjusts slowly It is the time in which all the rms adjust their wages and prices It is a natural equilibrium achieved in the economy The decline in prices forces rms to reduce the nominal wage and consequently the temporary real wage increases But if real wages are less then fewer workers will agree to work If the real wages are higher than the ef ciency wage then more workers will not work If the ef ciency wage is higher than the market wage then workers will not shirk as it proves costlier to them 53 The government budget constraint and debt dynamics Some taxes fall on income others on expenditure and some on the holdings of property But one way or another the amount that someone pays depends on his or her economic activity none of these levies looks like the lump sum taxes Barro 2001 The budget constraint is given as Gt TT TN TDt rBt 1 Mt Mt 1Bt Bt 1 58 Where Download free ebooks at bookbooncom 142 Advanced Macroeconomics Modem Macroeconomics G Public current and capital expenditure Tt Tax revenue TN Non tax revenue TD Revenue from disinvestment Bt Stock of domestic public debt Mt Stock of credit allotted by central bank The total government revenue is de ned as T TNTTTD Therefore the budget constraints are given as AB 2 Br Bt l Gt I rBt l 59 The left hand side explains the scal de cit The primary de cit is the noninterest component of scal de cit which is Primary de cit 2 Gt I D t Download free ebooks at bookbooncom 143 Advanced Macroeconomics Modem Macroeconomics Another way of writing budget constraint is AB B BF1 HEP1 G T 510 The scal de cit is the government expenditure that is not related to the repayment of the debt G plus repayment of the debt rB less government revenue T The difference between the scal de cit and interest payments is the primary de cit The above equation is rewritten differently as Br 2 1 rBt1 D 511 Dr is a primary de cit If we divide the above equation by Yt then the equation evolves as Br B lr Yt 512 Yt l X If bi Br Yr the debt GDP ratio 6 Di The primary de cit GDP ratio and the one period rate of GDP be We can rewrite the above equation as 1 b d t l t b t lg The debt GDP ratio increases because rstly governments issue debts to cover a primary de cit Secondly the government must pay interest on eXisting debt It is expressed as 1r1g If primary de cit is zero then lr b b1 513 1 g If government increases the interest on eXisting debt then the debt GDP ratio increases But if GDP increases at the rate 1g with increase in tax revenue the GDP increases This helps to decline the debt GDP ratio The net effect on the increase in GDP and interest is debt GDP ratio If ggtr the debt GDP ratio will not increase it is at sustainable basis It can be presented with the help of graph as Download free ebooks at bookbooncom 1 44 Please click the advert Advanced Macroeconomics Modern Macroeconomics Figure 53 Debt and gross domestic product with effect of interest and growth A Btbt1 DebtGDP ratio Slope 1r1g c1t f 1 quot b quot d a1 1 g Figure 53 shows that the debtGDP ratio in period t is bt The rst is the primary de citGDP ratio is dt The second is the ratio of one plus interest rate to growth rate of GDP times The debt GDP ratio of the previous period is t1 The steady state debt GDP which does not change with time it is given by I WEI 5191151335 11951311 39339 eUS 139 I 7 em Its oniy an Opportunity if you act on it IKEASE39ETUDEMT Download free ebooks at bookbooncom T45 Advanood Maoroooonom og Modorn Maorooconom og Figure 54 Unstable steady state conditions in debt GDP ratio 1r 1g gt1 bt T Slope Debt GDP ratio in period tl Unstable steady state Download free ebooks at bookbooncom 146 Advanced Macroeconomics Modem Macroeconomics Figure 54 illustrates that a Debt GDP value other than I will gravitate towards b If the interest rate is greater than the growth rate of GDP then the debt is considered to be unstable A steady state 91 91 1 b is a condition It is given as b1rbd lg bgrd lg lg bgrd 6M 531 Primary de cits and stability The rst part of the gure shows 1r1glt1 or rgtg It is a stable steady state The debt GDP ratio at any time t bt moves close to the steady state value b The second gure displays 1r 1ggt1 or rgtg it depicts unstable steady state The debt GDP ratio moves towards bt The value is I over time for any starting value of bt other than I the steady state value itself It is 1r 1ggt0 if rgt1 and ggt1 The second gure indicates that economy could settle at a debt GDP ratio which is constant at b The constant debt GDP ratio is not problem foreconornist But the constant value of debt GDP leads to non repayment of debt The debt GDP ratio will tend towards b bt b It means government is not paying the principle sum of debt borrowed The gure also shows that rgtg it means Debt GDP ratio increases The debt will be larger than GDP and when the debt is larger the entire GDP is insuf cient to pay the interest on debt Government becomes bankrupt in this case Further loans are denied by all the government and various international institutions The results is in conformity with the recent trend in Indian public nance where the high interest rate fuelled the accumulation of more debt through increase in interest payments and the consequent debtde cit spiral Chakraborty LS2002 From the above discussion it can be concluded that if the government increases taxes above its expenditure and use revenue to rst pay off the eXisting government debt and then purchase nancial assets from the private sector For primary de cit to be positive government must accumulate enough assets This can be done by running the average value of b But government should nd the alternatives and raise enough revenue to service the interest on it Under balance budget government set close to zero scal de cit If GTrBO the rate of interest on debt is rBgtO positive we must have GTltO the government has a primary surplus It is expressed as follows Figure 55 shows that if the government continues to have primary surplus the debt GDP ratio is bquot It can repay debt eventually It can accumulate a stock of positive assets GDP as b Download free ebooks at bookbooncom M7 Please click the advert Advanced Macroeconomics Modern Macroeconomics Figure 59 explains government has primary surplus The debt GDP ratio of byr diverge away from the steady state debt GDP ratio of I If I is positive the government manages debt GDP ratio to its steady state value Government will never pay the debt I raised It is not solved here At blt b government gets of debt It accumulates more assets at increasing debt Figure 55 Repayment of government debt over time bt A Btbt1 DebtGDP 1 r Slope V b b bt 1 dt l encsson com YOUR CHANCE TO CHANGE THE WORLD Here at Ericsson we have a deep rooted belief that the innovations we make on a daily basis can have a profound effect on making the world a better place for people business and society Join us In Germany we are especially looking for graduates as Integration Engineers for 0 Radio Access and IP Networks 0 IMS and IPTV We are looking forward to getting your application To apply and for all current job openings please visit our web page wwwericssoncomcareers ERICSSON Download free ebooks at bookbooncom 148 Advanced Macroeconomics Modem Macroeconomics Figure 56 Government assets with rising debt bt 1h Btzbt1 DebtGDP l r Slope 2 1 g I b b1 dt v Debt management policy should ensure that the states can borrow on terms comparable to those of the centre so that the spread of interest rates between the debt of the centre and the states is reduced Chakraborty P 2005 Another study shows that India s public de cit bias and indebtedness cannot be sustained much longer especially with stepped up external liberalization Thus there is a strong case for adopting scal responsibility legislation that involves a high degree of transparency well designed scal policy rules at the national and subnational levels of government short run contingency measures and a multiyear macro budgetary process an institutional framework for implementation of rules and appropriate preparation and sequencing including the phase in of supporting structural reforms Kopits G 2001 54 Rational expectation Every person is economical by nature Such an economic agent does not know the future with certainty and therefore has to base his her plans and decisions including the price setting or forecasts or expectations for the future Such expectations about the future are made up of a rational fashion The economic agents use all the available information to come out with best possible forecasts In this chapter real business cycles and rational expectation model is explained Both models explain that economic uctuations are caused entirely by real shocks such as crop failure change in prices and global recession that hit the economy negatively The change in prices and output for markets is always in equilibrium Download free ebooks at bookbooncom Advanced Macroeconomics Modem Macroeconomics The Fraction less neoclassical model of the labor market The demand and supply of labor depends on the real wage The real wage W P is the ratio of the wage rate w to the price level p or the amount of goods that can be bought with an hour of work w p The diagram shows that the ND is labor demand At lower real wage rms want to hire more labor The labor supply and demand intersect at point B The upward sloping supply curve shows that the NS more labors are supplied at higher real wage The rms are competitive and they are willing to pay real wage equal to the value of the marginal product of labor Firms capital stock is xed in the short run but in the long run rms can increase the capital stock But in the short run the marginal productivity of workers does not change If more workers are added in the short run then marginal productivity declines It is because additional workers will have low machines to produce output Thus marginal productivity of labor declines in the short run Hence rms employ labor where marginal productivity of labor is equal to real wage They employ labor if the real wage is lower and the demand curve for labor is downward sloping Figure 57 Equilibrium of real wage and labor market Wp i NS Wpgtxlt 3 Real wage ND 0 A Labor 439 The supply curve shows that laborers are ready to work more when there is real wage rise As the real wage rises more workers come into the labor force to seek work But the aggregate supply curve could be completely inelastic if the amount of labor supplied in sensitive to the real wage In gure 57 Nyr is a full employment level The rm employs labor up to Nyr with wp real wage In the frictionless neoclassical model there is assumed to be a full employment level This is about labor only But output is also produced at Yyr where all the existing factors of production are used All the capital stock land raw material is fully used with labor stock Nquot In gure 58 the output and price level is shown Download free ebooks at bookbooncom 15 Please click the advert Advanced Macroeconomics Modern Macroeconomics Figure 58 Output and price level in economy P As P1 P AfO Y lt output if There is initial equilibrium of price level and wage in the economy But as the price level changes from P to P1 then wage rate is also changes It changes in proportion with price The real wage and output remains unchanged Therefore the aggregate supply curve is a vertical line Therefore in the fraction less neoclassical model aggregate supply explains that the unemployment is always at the natural rate output always at the full employment level and any unemployment is purely fractional Thus change in money stock changes the price level leave output and employment unchanged The money wages rise but the real wages remain same The labor supply and demand does not change in the model The Graduate Programme for Engineers and Geoscientists MaerskcomMitas Ijoined MITAS because I wanted real responsibility 4 amp ii In as 1 5quot Iwas a construction supervisor in the North Sea advising and WE helping foreman a solve problems MAERSK Download free ebooks at bookbooncom 151 Advanced Macroeconomics Modern Macroeconomics 541 Market clearing Approach Lucas supply curve The great economist Robert Lucas has given the theory of rational expectation He explains that the markets are clear and the expectations are rational He changed the fractional neoclassical model slightly and assumed that some people do not know the aggregate price level but do know the absolute wage or price at which they buy and sell commodities The workers do not know the real wage They only know the price level Therefore they divide the price level and wage It clearly gives them the amount of money which buys the goods from their wage At the given real wage rate wp the rm does not know much work to be done But both workers and rm expect the price level to change that is pe Figure59 shows that the labor supply is Nsquot The level of full employment is Nyr at wage rate wquot The equilibrium of real wage can be de ned as WPWPe It is possible that workers do not know the price The rms are also not informing them For the rms if the price exceeds the expected price level ie pgtpe then rms demand more labor This is because actual price level is P and nominal wage is W0 The real wage is WOp It is lower than nominal wage say wO The real wage is wOp it is lower than the same nominal wage and pe That is pgtpeWOPltwOPe Figure 59 Nominal wage and labor supply and demand Ns Nominal wage W1 1 W ND1 ND 0 A N1k N1 N 7 Labor supply and demand Figure 59 speculates that rms know the price level which is greater than actual price level PgtPe Therefore labor demand shifts to ND1 The nominal wage rises from N to N1as per the gure Consequently under imperfect information of the workers a rise in the price level lead to an increase in the level of employment and nally the output Now we can show exactly inverse of the above condition The rm predicts that the actual price level below the expected price level In this case employed workers demand shift left from ND1 to NDquot Download free ebooks at bookbooncom 152 Advanced Macroeconomics Modern Macroeconomics Employment and output falls It is possible that rms and workers differ on the available information Workers are careful about the real wage If the real wage is higher than price level output will not increase It means the demand for the production in a given market is affected by increase in aggregate demand or the aggregate price level 542 Lucas supply Curve Following adjustments are given in price output and wage Table 51 Adjustments of prices output and wages Price output and wage Under predicted Correctly predicted Over predicted PPe price level Increase Equilibrium Decrease wpwp real wage Decrease Equilibrium Increase YY output increase Equilibrium Decrease If the demand for rms product increases then workers demand of their services also increases Therefore the demand of employment shifts P The Lucas supply cure is given as Y l 515 P 6 Where PPe price and expected price ratio The Lucas supply curve explains that the amount of output rms is willing to supply increases as the ratio of the actual to the expected price level increases It is PPe The table shows that if the predicted price level is too high then the actual price level is below the expected price level The actual real wage turns out to be too high for full employment and the level of output will be below the full employment level Lucas supply curve and aggregate demand supply is given as follows The aggregate demand curve is given as p IBM 516 Y rA Where M Money supply Y Income 7 A Rate of interest on assets Download free ebooks at bookbooncom 153 Please click the advert Advanced Macroeconomics Modern Macroeconomics Figure 510 Price level and income effect P it AS PPe A Price level V O Y Y The Lucas model has linked the aggregate supply and demand curve with the rational expectations People use all relevant information informing expectations of economic variables If we assume that people do not make error then PPe and the output is expected to be at the full employment level Yquot The price level must be equilibrium where ADAS People expect full employment and YY Therefore actual wage rate is equal to the real wage rate Therefore people do not make systematic errors SIMPLY CLEVER SKDDA We will turn your CV into an opportunity of a lifetime T39vgr39 J l Iiquottrquot 5 T fng flu a all Do you like cars Would you like to be a part ofa successful brand We will appreciate and reward both your enthusiasm and talent Send us your CV You will be surprised where it can take you Send us your CV on wwwemployerforlifecom i3 Download free ebooks at bookbooncom 154 Advanced Macroeconomics Modem Macroeconomics People also predict the money stock It is assumed as the Me The predicted price level is Pe So Me Y r14 Therefore equation 515 is used for price and expected price prediction Now we have to see the different possibilities P 517 with increase in money supply and change in aggregate demand and supply curve Download free ebooks at bookbooncom 15353 Advanced Macroeconomics Modern Macroeconomics Figure 511 Price level and anticipated unanticipated money A81 H N E Price level AS Price level E AS E P1 P Poe AD1 P Poe E AD1 AD Q v Output Y Y 7 Vi Y Output Y1 A Anticipated money B Unanticipated Money Diagram A in gure 511 shows that the price level and expected price is at equilibrium e Suppose there is a change in money supply then the aggregate demand curve shifts upward But Pe increases with same proportion of rise in money stock The output remains unchanged At new equilibrium E1 the price level is P equal to expected price level P P16 The workers and rms know that that the money stock and aggregate demand going to increase on proportion with P16 Poe The nominal wage increases and the real wage remain same As we have observed in the classical case there is nominal effect on wages and prices The diagram B explains that change in money stock causes the aggregate demand to shift to AD1 At new equilibrium workers do not expect to rise in price level So aggregate supply does not shift upward The new equilibrium is achieved at E Hence the actual prices increases Pgt Poe above expected price level The outcome increases from Yyr to Y1 But under rational expectation hypothesis the point B does not remain last and the prices are above expectation instead of rise in output As a result the rms households workers revise their expectation or forecast it They revise their price expectations of Ple Thus AS curve shifts to A81 The effect of money supply does not remain effective forever It soon re ected in prices Money is natural in the long run The change in money supply is used as new information tool to calculate price and wages Expectations play an important part in the working of an economy If a theory takes them to be exogenous not a lot can be explained and forecasts are hardly possible because the given expectations are liable to change at any instant Felderer and Homburg 1992 Download free ebooks at bookbooncom 156 Please click the advert 543 Criticism Lucas model is almost similar like the classical model It assumes that scal and monetary policy is ineffective In the long run the income real prices and wages remain unchanged Economy remains at full employment level There is full employment then if agents make the mistakes and government announces the new statistics where market clears and full employment can be achieved There is no need of either scal or monetary policy for full employment This approach is confusing to an economic agent Sometimes agents only follow the governments and policy makers 55 The New Keynesian alterative The new Keynesian macroeconomics explains about the contracting approach to counter the Lucas curve Such approach also starts from the labor market and the frictionless neoclassical model The model assumes that wages of workers are xed by contract at the beginning of a period while the prices of goods may change within the period Firms x the wage which makes the equilibrium in the labor market and the frictionless neoclassical model The model assumes that wage of workers are xed by contract at the beginning of a period The prices of goods may change within each period Firms x the wage which makes the equilibrium in the labor market They x the nominal wage They will be equal to real wage WP in the long run The P6 is the expected price level Therefore WmP6WP 518 The Agilent InfiniiVision XSeries and 1000 Series offer affordable oscilloscopes for your labs Plus resources such as lab guides experiments and more to help enrich your curriculum and make your job easier Barium EM39I Eimila np managin E Iquot r up Lit us 18008294444 canada 18778944414 Agilent Technologies Inc 2012 Download free ebooks at bookbooncom Advanced Macroeconomics Modem Macroeconomics It means expected prices are equal to the actual price level The wage set equal to real wage If we assume that real wage is equal to W P to the Vyr then the nominal wage is W sze am If the wage set by rm they produce for the market Therefore rm will produce more to real wage Thus in the short run aggregate supply curve is YfpWn 520 Where Wn is substituted from above equation YfPVPe 521 It means that income is also equal to change in price and expected price level This approach also implies that the anticipated changes in money stock have real effects on output while unanticipated changes are not The above approach explains that contracts are not signed for one period They are not renegotiated at the same time The prices adjust slowly in economy The supply curve shifts slowly Sometimes old contracts are negotiated Monetary policy allows change in output for years and there are some contracts live longer in economy 56 Ricardian equivalence Government expenditure is nanced by raising tax revenue Increase in government expenditure increases the consumption expenditure It is CIAY The consumption expenditure may decline as the tax increases It further reduces the disposable income which is available for spending If the government expenditure is tax nanced then AYAGCAGCJU AGCAY QAG Or AYG CQAGG CQ Or AG C lbonds 522 1 AthzAGlt1 Download free ebooks at bookbooncom Advanced Macroeconomics Modem Macroeconomics The IS curve shifts right when there is large bond than tax nancing Bond nancing does not reduce disposable income The tax reduces disposable income and lowers aggregate expenditure The Ricardian equivalence is named after the classical economist David Ricardo 17721823 He argued that the impact on real income is the same whatever government expenditure is tax nanced or bond nanced The IS curve shifts left whether government follows the tax or bond nancing Due to high expenditure government issues bonds and increases the expenditure It pays interest on bonds in future Therefore government substitutes the current tax that it could have imposed to nance it expenditure with future tax The individuals are self motivated and attempt to maximize his or her pro t They save more and reduce taxes Saving will be used to increase in tax Therefore individuals save money which is equivalent to the increase in future tax The Ricardian equivalence is based on two assumptions 1 Individuals are forward looking and they have perfect foresight 2 The government budget is inter temporally balanced When government nances its expenditure by selling bonds households recognize that it is a balanced budget There will be more taxes in future to pay back the borrowing on the bonds sold today Therefore present burden of taxes is current taxes plus the present value of taxes in the future It is required to pay the interest on current bond sales Government pays an interest on them 1 Market price for bonds is PB 2 j Z If AB be the number of bonds sold to nance the increased government expenditure then nominal value of bonds is AB Value of bonds 2 PBAB 523 l AB The annual interest payments on the bond sold will be I 1 Government pays interest on bonds in each period Such payments increase the taxes Therefore Pv future taxes 2 PV interest payment AB AB 1 139 1 i2 E z 524 AB The real present value of implied future taxes will then be The current period tax burden on individuals who have 1 perfect foresight and realize the intertemporal nature of the budget individual follow the proposition of RE AB T T 525 Download free ebooks at bookbooncom 159 Please click the advert Advanced Macroeconomics Modem Macroeconomics Current expenditure is nanced by current taxes and the real value of debt issued to nance current expenditure as given by 2 E 526 I7 ll The current period budget constraint of the government can then be written as AB G T 527 ll Right hand side is current period tax burden experienced by people It is further stated as Ylg lEzY TREzY G 528 The current burden of the government is the current taxed levied T which affects the amount of disposable income in the hands of individuals In the Ricardian approach the current burden of government by contrast is the goods and services it absorbs Goods market equilibrium is given as Download free ebooks at bookbooncom Advanced Macroeconomics Modem Macroeconomics YCIG 2C0 C1Y G C2i Hea bi HeG Y1 C1 C0 G1 C1 C21 Hea bi He 529 It leads to two propositions 1 Increase in expenditure is nanced by government through taxes or bonds Therefore AY 1 C1 AG 1 C1 AY AG 530 The IS curve under RE effect will shift the same distance irrespective of government expenditure on taX or bond nanced It is because bond sales impose the same burden on individuals as the taxes that would have been imposed in their place 11 A tax cut nanced by bonds sales has no effect on output The bond sales in present have the effect on future taxes They will have to be levied to pay back the interest the bonds Download free ebooks at bookbooncom 161 Advanced Macroeconomics Modem Macroeconomics The present value of higher taxes is equal to the present tax cut The disposable income can again be de ned as Y Y TCS 531 S Y C T CCY Gi He Under RE 532 SY CY Gi He T G unchanged when current taxes are substituted by debt AS 2 AT The taxes have equal and opposite effect on saving Tax cut increases disposable income by the amount Y AT and a fraction C1Y AT of this is spent by individual and IS shift upwards RE approach explains that when government dissaves the private sector saves and aggregate savings in an economy do not alter much People save to pay for the anticipated higher taxes in the future when the government dissaves 561 Criticisms 1 Ricardian Equivalence RE gives people more freedom to look ahead in future People are short sighted There is no xed time and future time is not given Most of the households struggle to satisfy their minimum credit needs than long term adjustments 2 RE is true to a certain extent consumers may cut high consumption They reduce it with available credit 3 In India nancial system is under developed People do not know much about bond nancing 4 However though individuals may not have perfect insight they are forward looking as any policymaker who is smart realizes fast on the job Individuals anticipate policy gure out if they are credible and take offsetting action if necessary 57 Search and matching model In the global world the jobs and employment skills are always changing The global production methods decide the types of production The sectors in the economy are heterogeneous and workers and rms will try to match their needs and skills Sometimes training is given to ful ll the needs But such efforts are not enough in changing the world The wages and employment respond with shock often resulting in loss of jobs 571 The Model The employed workers in the economy are de ned as E and unemployed as U The numbers of jobs lled are E and vacant posts are V making E equal to F The labor force is xed at I Thus E U L 533 There is xed cost of c per unit time However of maintaining a job C can be thought of as re ecting the cost of capital Download free ebooks at bookbooncom 162 Advanced Macroeconomics Modem Macroeconomics Workers producing output at rate A per unit time and he is paid wage w per unit time Therefore AgtC w is determined exogenously Suppose costs of efforts and job search are ignored then workers utility per time is w if employed and 0 if unemployed Therefore pro t per unit of time is AWC if it is lled and c if it is vacant Workers aim at discounted value of lifetime pro ts The discounted rate is r and it is exogenous and constant The positive level of unemployment and vacancies can coeXist without being immediately eliminated by hiring The unemployment and vacancies assumed to yield a ow of new jobs at the same rate per unit time MM UV KU VrOS SIOsrs1 534 The above equation shows a complicated process of employer recruitment workers search and mutual evaluation when it eXhibits as 8 I gt 1 There are thick market effects Increasing the level of search makes the matching process operate more effectively It yields more output per input When there is matching function it is decreasing returns 3 I lt l there is crowding out effect Such crowding out is observed in ISLM model with expansionary scal policy The dynamics of the number of employed workers is given by E M UV bE The steady state must focus M and E as M U V E 535 a denotes the rate of per unit time that unemployed workers nd jobs and the rate per unit time that vacant jobs are lled a and a given by a MU V U a MU V V The return on being employed is divided of as w per unit time minus the probability b per unit time of a capital loss of VEVU Thus rVE w b The r is interest rate similarly rVF A W CVF VV rVu aVE VU rV U caVF VV 536 When an unemployed worker and a rm with a vacancy meet they must choose a wage It must be high enough that the worker wants to work Both workers and rm do not nd a replacement These requirements do not uniquely determine the wage The range of wages determines who is better off to them when they meet Both should be set the same wage as given Download free ebooks at bookbooncom 163 Advanced Macroeconomics Modem Macroeconomics VEVUVFVV 537 Here new vacancies can be created and the value of vacancy cannot be zero The labor supply is perfectly inelastic at L and labor demand is perfectly elastic at AC Since ACgtO there is full employment at this wage Shift in labor demand changes in A and leads to immediate changes in the wage and leaves employment unchanged 572 Solving the model Suppose there is full employment E and the value of vacancy VV at initial level VV is zero then the wage determination and value of vacancy given a and a as n V w 538 U abr Also implies A n m w 539 If VE VV and VF VV are equal then w A w abr abr Solving this condition for w yields abrA 540 aa 2b2r When a and a are equal the rm and the workers divide the outcome from the job equally When a exceeds a workers can nd new jobs more rapidly than rms can nd new employers and so more than half of the output goes to the workers When a a reverse exceeds occur The value of vacancy is I VV C 0VF Therefore VFVV gives rVV Ca 541 Substituting values in the above we get abr aa2b2r abr rVV Ca Download free ebooks at bookbooncom l 64 Please click the advert Advanced Macroeconomics Modern Macroeconomics 06 C aa2b2r 542 The above equation express rVV in terms of C A rb a and a A and a are endogenous The fact that aM U VU that MbEand EUZ It implies a L E Similarly PM V 543 We need to express M U V and V in terms of E In steady state M U V equal bE It implies E kU Vr 1 A L do e Download free ebooks at bookbooncom 165 Advanced Macroeconomics Modem Macroeconomics lr 9E kU lr 9E kL E 544 Substituting this expression and the fact that M UV equals bE into the above equation bE ly bE ki Ey KlybEr lr E r The above equation implies that a is increasing in E and that 06 is decreasing er is a decreasing function of E As E approaches L a approaches in nity and a approaches 0 hence er approaches c Similarly as E approaches 0 a approaches 0 and a Thus in this case er approaches AC which we have assumed to be positiveH The equilibrium level of employment is determined by the intersection of the er locus with the free entry condition which implies erO Imposing this condition on yields aE aEaE2b2r 546 Where the function aE and aE are given in the above equation This expression implicitly de nes E and thus completes the solution of the model Download free ebooks at bookbooncom 166 Advanced Macroeconomics Modern Macroeconomics Impact of shift in labor demand Figure 512 Labor demands in economy er AC Figure 512 illustrates that if A and C changes in the same proportion the value of E for which the condition holds does not change Thus the model implies that long run productivity growth does not affect employment It means 06 and a do not change and thereby the wage changes by the same proportion Figure 513 Equilibrium of employment in the search and matching model er AC A C Figure 513 displays that equilibrium falls In a Walarasian market in contrast employment is changed at L institutively in the absence of a frictionless market workers are not available at less cost as per the prevailing wage The decline in A with C xed raises rms costs of searching for workers relative to the pro ts they obtain when they nd one Thus the number of rms and employment falls Effects of a fall in labor demand in search and matching model In the above equation M V U equals bE in steady state implies that steady state vacancies are bE KY L E H Thus the decline in A and the resulting decrease in the number of rms reduces vacancies The model therefore implies a negative relation between unemployment and vacancies a Beveridge Curve When E falls and it causes a to fall and 06 to rise When unemployment is higher workers cannot nd jobs as early as before and rms can ll positions more rapidly Download free ebooks at bookbooncom T67 Please click the advert The rms wherein positions are lled to discharge their workers stock the reduced attractiveness of hiring in contrast causes Vv to fall Thus there is exit and as a result discontinuous drop in V This could take the form of some rms with opening stopping their attempts to ll them With employment and unemployment the same as before but vacancies lower The ows into unemployment exceed the out ows and so unemployment rises Thus the fall in A leads only to a gradual rise in unemployment Finally unemployment rises the value of vacancy would rise if vacancies did not change thus vacancies must rise as unemployment rises This implies that the initial drop in V exceeds its steady state response that is there is overshooting A temporary change in A leads to smaller employment responses The value of lled job is clearly higher than A is temporarily low than when it is permanently low Thus there is a smaller fall in the number of vacancies and hence a smaller rise in unemployment But since the matching process is not instantaneous unemployment remains above normal for a time after A return to its initial value Thus labor market frictions create channels that make the effects of a shock more persistent In extreme cases of an in nitesimally brief decline AW and Vu are unaffected In case rms and workers simply share the loss equally by reducing the wage by half the amount that A falls and there is no impact on employment or unemployment 73 Criticism This model does not explain the critical changes that impact a cyclical shift in labor demand They are divided between employment and wages According to Walarasian case labor market adjust immediately to a change in A But with frictions both permanent and temporary changes in a trigger complicated adjustment processes for vacancies unemployment and wages 2 our BiiJG 39 rural create if 39fand creativity 39 13rd expectations 3 mployees who can into The Power of Knowledge Engineering us at wwwskfcomknowledge Download free ebooks at bookbooncom Advanced Macroeconomics Modem Macroeconomics 58 Implicit contracts Sometime there are long term relationships of rms and workers Firms do not hire new workers each time This is mainly because of training cost The old workers are more ef cient than new ones Some workers are skilled for particular jobs They cannot leave the rm or the rm cannot afford to leave them It is a long term attachments and arrangements Such long term contracts do not require rms to set wages The workers remain in the job for the long period to obtain a higher income Some workers learn and get experience It makes workers more competitive equally in other rms Therefore they get experience or learn the new methods of production current wage is not given much importance 581 The Model The rm always makes a pro t after payment of wages H AFL wL 547 Where L Quantity of labor the rms employ W Real wages A Factor that shifts the pro t function Download free ebooks at bookbooncom 169 Advanced Macroeconomics Modem Macroeconomics We assume only single period and A is random Then workers decide whether to work for the rm or not They consider the expected utility they obtain in the single period Their hours and income varies with response to uctuations in A If A is distributed directly then the k possible values of A indexed by 1 Pi denotes the probability that AAi Therefore rms pro t is EH 2k PiAiFLi WiLi i1 548 Where Li Quantity of labor Wi Real wage We consider AAi the rm maximizes pro t and risk is natural Each worker is assumed to work the same amount The representative workers utility is UUcVL 549 Where U Given utility from consumption V Disutility from working Utility is negative and workers are risk averse Workers consumption is assumed to equal their labor income wL Workers do not have insurance against employment and wage uctuations Some workers have information of wage in rival rm The workers expected utility from current job is Eugt ZPiUCigt VLi 550 There is some expected utility and workers must attain to be willing to work for the rm There is no mobility if there is contract between workers and rm At the time of contract only average level of utility is offered It is not what individuals expect Download free ebooks at bookbooncom T7 Advanced Macroeconomics Modern Macroeconomics 582 Wage contract Firm decides the contract with workers Under contracts real wage and rigidity arise immediately The fall in demand for labor causes the rms to reduce employment at the xed real wage while labor supply does not shift and thus creates unemployment the cost of labor does not respond because by assumption the real wage is xed But it is not practical The wages are xed and rms choose employment The marginal productivity of labor is xed The employment varies with A and marginal disutility of workers depends on A Sometimes marginal product of labor in generally is not equal to the marginal disutility of work In contrast both parties should get better off If the disutility of work is less workers can work more and the workers and rms may get better off 583 Ef cient contracts The implicit contract means actual contract does not explicitly specify employment and the wage is the function of state The rms and workers do a contract and specify the wage and hours for each possible realization of A The assumptions are that the rms offer a worker at least minimum level of expected utility uO but it is otherwise constrained The Li and Wi determine Ci we think of the rm s choice variable as L and C in each state rather than as L and W The Lagrangian of the rm s problem is therefore 6 iPxAiFm Cmmiewm mi uogt 1st order condition for Ci is Pi PiU 39Ci o UvCi 2 551 The above equation implies that the marginal utility of consumption is constant across state and thus that consumption is constant across states Thus the risk neutral rm fully insures the risk adverse workers The 1st order condition for Li is P39AiF39Li lPiV39UJi 552 The above equation implies E C where C is the constant level of consumption Substituting this into above equation and dividing both sides by Pi yields Download free ebooks at bookbooncom T71 Please click the advert Advanced Macroeconomics Modern Macroeconomics V39Li AiF39Li WC 553 59 Insider Outsider model The approach explains that various types of labor turnover costs create rents and market power for incumbent workers in existing rms They are called the insiders It allows the insiders to push their wages above the market clearing wages without losing their jobs Insiders are experienced incumbent employees whose positions are protected by labor turnover cost Outsiders are taken to be unemployed All rms from garments to the automobiles are doing such experiments regularly The rm has cost of hiring and ring labor The hiring cost includes the costs of searching screening negotiating with and training newly hired workers The ring costs include costly ring procedures and severance pay that are often part of job security legislation The labor turnover costs arise when insider workers refuse to cooperate with outsiders Outsiders try to get jobs by underbidding the wages of insiders If outsiders unemployed workers are ready to work at lower wage then insider workers will not cooperate They will not cooperate to outsiders It affects production and it may cause a decline in production Therefore rms will not employ the outsiders at low wage But if the rm accepts it and employs workers at lower wage then outsider must see the working environment and conditions Thus if they are not given the lower wage and working condition certainly raises the cost of accepting employment elm quotlilill l39ll lilili39all Are you considering a European busmess degree LEARN BUSINESS at university level We mix cases with cutting edge research working individually or in teams and everyone speaks English Bring back valuable knowledge and experience to boost your career Copenhagen Busmess School HANDELSHEJSKOLEN MEET a culture ofnew foods music and traditions and a new way of studying business in a safe clean environment in the middle of Copenhagen Denmark ENGAGE in extracurricular activities such as case competitions sports etc make new friends among CBs 18000 students from more than 80 countries Accredited by I fMBA Association 0 s See what we look like and how we work on cbsdk Download free ebooks at bookbooncom 172 Advanced Macroeconomics Modem Macroeconomics 591 Model Let us understand that there are N1 and NE labor N1 is insider labor and NE is outsiders The NI NE is total workforce for a rm The demand for insider and outsider labor is downward sloping For insider labor the demand curve for labor is the sum of marginal product of labor MPNF plus the marginal cost of ring that labor MCF The demand curve for the insider worker is marginal cost minus the marginal cost of hiring workers IDCF MCF 554 EDCF MCH 556 If there is no labor turn over cost then MCHMCHO and the traditional demand curve for labor would be given by F if we assume that WER means that wages of insiders is equal to their reservation wage The insiders get more wages because of insiders wages and sum of the marginal cost of hiring and ring labor WEMCHMCF If the wage is less then rm replaces outsiders with insiders Figure 514 Real wage insider and outsider equilibrium Real wages W1 B WER B EDC IDC m m m labor demand NN1NE Figure 514 shows that Myr is the insiders demand The wage earned by them is W1 At this point no outsiders are employed At point B the marginal productivity after deducting for labor turnover costs is below the entrant wage WE There are unemployed workers between m and m The hiring situation will occur when insiders in the rm are less than m The rm will hire more outsiders and re insiders This situation is greater than m The insiders will be red even when they accept wages equivalent to outsiders This is because their productivity is low and it is below WE But it is inversely related when outsiders have more productivity Download free ebooks at bookbooncom T73 Advancech Macroeconomics Modem Macroeconomics Now we can see at the aggregate level where aggregate demand is ND It comprises as NINE At labor demand mquot it is an aggregate labor demand 592 Criticism The insiders and outsiders model fail to explain the new rm and their employment They could hire unemployed workers This would reduce the competitive wage The IDC curve could shift back sometimes rms operate in small size at different locations It is not always the same units produced in terms of size quality etc Such heterogeneous production skills many does not affect rms much on the inside outside model Labor market is dynamic sometimes it automatically clears Insiders have more favorable opportunities than outsiders policies that create a more level playing eld in the labor market can improve both ef ciency and equity This is so regardless of primary versus secondary sectors employed unionized versus nonunionized workers and so on The two policies ie power reducing policies and enfranchising policies create a more level playing eld between insiders and outsiders Power reducing policies such as restrictions on strikes and picketing relaxing job security legislation are formulated These policies are usually not Pareto improving since they tend to reduce insiders welfare Thus the insider may resist these policies either through the political process or rent creating activities at the place of work These insiders responses will of course limit the effectiveness of the power reducing policies Enfranchising policies often take the form of vocational training programs and job counseling for the unemployed pro t sharing schemes Schemes to convert wage claims into equity shares employment voucher for the long term unemployment policies to reduce barriers to the entry of new rms Lindbeck and Snower 2002 510 Real business cycle Real business cycle means that the uctuations in employment and output in the economy are results of variety of real shocks Markets adjust with shocks and it remains in equilibrium in the long run It is sometimes called boom and recession in the economy When economy goes down it is regularly re ected in the data when governments announces or publish reports According to Keynesion view government must intervene to smooth business cycle uctuations But monetary economists explain that government must not interfere in the economy and let market forces play the power to make equilibrium There are three kinds of policies that is monetary scal and exchange rate policy All policies affect private demand consumption and investment spending The supply side also affects the production side that is natural resources climate change and technological innovations The demand shocks may arise because of collapse of investor con dence due to domestic and international events change in consumption spending change in government expenditure and money supply Figure 515 exhibits that if there are demand shocks then AD shifts to AD1 It results in decline in price P1 and output from YO to Y1 in panel C The supply shocks are also observed The AS curve shifts to AS1 The panel D shows the shift of aggregate output towards the left and new output is observed at Y2 The supply side shocks in the real business cycle are as follows Unfavorable natural events adversely affect output in the economy For example earthquakes drought oods etc Signi cant increase or decrease in the oil prices They are highly volatile now War political environment instability labor disputes disturb the production H P Pt Government imports export policy imports quotas Download free ebooks at bookbooncom 174 Please click the advert Advanced Macroeconomics Modern Macroeconomics 5 New techniques innovations capital and labor skill changes the productivity The supply side shocks are temporary in nature The demand side shocks stressing productivity These stem from technological progress and so real over nominal shocks But from the real business cycle economic agents act to maximize their utility subject to production possibilities and resources constraints In the economy the agent has a xed utility function consumption and leisure The business cycle affects these three The financial industry needs a strong software platform That39s why we need you Find your next challenge at wwwsimcorpcomcareers wwwsimcorpcom MITIGATE RISK I REDUCE COST I ENABLE GROWTH SimCorp Download free ebooks at bookbooncom T75 Adiaimed Macroeconomics Modem Maeroeconom cs Figure 515 Effect of real business cycle on prices employment and output Y P0 P1 AggPrice level 0 Po Agg P1 Price level Aggregate output Aggregate output U CZH NZ U U H N k 1 1P logC BlogH N 10 C lo H N 2 1 g 1 3 g 1 1P 1P 557 Where H Fixed time endowment of the individual N Labor supplied in time i C Therefore HNI is a leisure enjoyed by person 1 in time t Here p is intertemporal discount rate Download free ebooks at bookbooncom 176 Advanced Macroeconomics Modem Macroeconomics Each agent is rational and supply labor in economy The production is a function of capital and labor Yr KAN 4K 3 0 558 Capital stock in the economy is xed in the short run Therefore the capital stock at time t is given as Km 1 amt It 559 Where a is depreciation In the economy investment and capital stock decides the present capital in economy We must subtract consumption from the above equation Now investment is income minus consumption Kt1 1 aKt Yt Ct 5 60 Now consumption depends on propensity to save from income Therefore consumption is constituted in the above equation C1SYt as Kt1 1 6Kt 5K 561 Now the person will decide how much to work and how to maximize consumption and leisure The life time budget constraints is given as C1 C2 VVINI le fetime 1r 1r 562 Here w is real wage wp But the consumer has budget constraints It is given as W2H 12 lifetime I 563 w1H Il If we multiply 1r then 1FW1H11VV2H 12 1rlifetime 564 If the agent does not enjoy the leisure in period 2 then 1 rWlH WZH 1 HEMme W2 2 565 Download free ebooks at bookbooncom T77 Advanced Macroeconomics Modem Macroeconomics If the agent do not enjoy the leisure in period 2 then I 1rW1H W1 lt1rgtYm w 1 1 739VV2 1 739VV1 566 Both points are presented in the following gure then Slope of budget line g 567 OB w 1 rW1 l rW1 W2 Figure 516 shows the preference of individual in two periods Individual enjoys leisure ODl and spend N1DB1 hours in work in period 1 Suppose in rst period wage W1 increases The slope of budget line is OA Now it becomes ABI There is substitution and income effect Current productivity and income is high It encourages for substitution of current to future work The substitution effect denominates that the current labor supply rises N11 D39B It is a current wage rate Now the labor supply can be written as N 1W3 r w2 568 Here rate of interest also decides the supply of labor The demand for labor is equal to the marginal productivity of labor It is explained as WMPN The labor demand is given as D D N N MPN 569 Figure 516 Labor demand and supply in two periods Period 2 l K E W1 E Period 1 39 T 11 W l D D1 WA slope Q lt1rgtwl W2 Download free ebooks at bookbooncom Please click the advert Advanced Macroeconomics Modern Macroeconomics Figure 516 shows the labor demand and supply The A part of the gure shows the production function More sophisticated and modern technology will produce more output with same inputs As the labor productivity increases then the labor demand curve shifts towards ND MP The individual supply more labor then the total employment increases up to N11 output and income increases from Y1 to Rising income reduces the interest rate via saving It shifts the labor supply left declines in interest rate increases the present value of future income and makes the return from current labor supply unattractive The income and output thus nally increases to K and real wage is de ned as W The real wages are procyclical with output when the economy goes into a boom period in real business cycle leisure falls and labor supply increases Consumption rises because output and income rises In boom leisure and consumption shows inverse relationship Both goods are normal goods For real business cycle these two variables are eXpected to move together The real wage increases in boom Therefore there are high returns to working Hence economic agents work more and reduce leisure In boom the production technology is relatively favorable resulting high wage and marginal product of labor Technology shocks are of suf cient magnitude to eXplain observed business cycle and the related question of whether observed changes in employment can actually be eXplained as the voluntary choices of economic agents facing changing production possibilities Froyen 2002 nm nna 39in H39lll I n L mare than upping 1 the qumup umt quot it you H fur n Download free ebooks at bookbooncom 179 Advanced Macroeconomics Modern Macroeconomics 5101 Criticism Real business cycle explains that individual reallocates the leisure and labor overtime He reduces the quantity of labor when the real wage declines If individual gets more real wages today then he will work more today and relatively low in the future There is no study which nds that individual response to the expected real wage changes by considerably reallocating leisure over time Most of the time unemployment is voluntary unemployment and we can overcome by optimizing behavior There is no relation of any corrective policy or government intervention and unemployment Sometimes the information asymmetries exist In reality shocks affect economy differently but they are nominal in nature The real shock is a result of optimum output for the economy There is no single stabilization policy useful It is a world of art and it is an automatic correction over time The real business theories need not rely on technology shocks to explain economic uctuations In an indeterminate RBC model with capacity utilization and mild increasing returns to scale demand shocks can play a pivotal role in explaining actual economic uctuation Benhabib and Yiwen 2003 Figure 517 Production functions and adjustment in employment and wages T Y YA FIlt N 71 Output YFI lt N Yo 4 gt NDMP MMPN N0 N 1 N11 Employment Download free ebooks at bookbooncom Please click the advert Advanced Macreecemem cs Medem Macreecenem cs Questions Explain the ef ciency wage hypothesis How does the ef ciency wage hypothesis help to achieve equilibrium in output and employment Discuss What is the concept of the staggered wage contract Explain the government budget constraints Debt and gross domestic product is related to interest rate Explain Examine the primary de cit and its stability What is rational expectation hypothesis Explain Explain the Lucas supply curve in detail DPONQP H P PE Why is the Lucas supply curve criticized 10 Explain the term Ricardian equivalence 11 What is the implicit contract How does it help rms to decide the wages 12 Why implicit contracts are criticized by the policy makers Do you want your Dream Job More customers get their dream job by using RedStarResume than any other resume service RedStarResume can help you with your job application and CV Go to Redstarresumecom Use code BOOKBOON and save up to 15 enter the discount code in the Discount Code Box Download free ebooks at bookbooncom ll Advanced Macroeconomics Modern Macroeconomics Appendix Table 52 Debt indicators of central and state government Select Debt Indicators of Central and State Governments As Percentage to GDP in India 19801981 to 20102011 Combined Combined Domestic Total Domestic External Total Aggregate Liabilities of Liabilities of Liabilities Liabilities Liabilities Liabilities Centre amp Centre amp Year of Centre of Centre of Centre of States States States 198081 3333 777 411 1842 4007 4784 198182 327 722 3992 1853 4006 4728 198283 3726 716 4442 1935 4427 5143 198384 3602 68 4282 1942 433 501 198485 3884 667 4551 2035 4691 5358 198586 4242 645 4887 2181 5079 5724 198687 4645 645 529 222 5511 6156 198788 4816 649 5465 2268 5704 6353 198889 4806 606 5412 2209 5693 6299 198990 4918 581 5499 2252 5857 6438 199091 4969 553 5522 225 5921 6475 199192 4853 564 5417 2246 5827 6391 199293 4779 562 5341 2237 5803 6365 199394 4974 547 5521 2171 5977 6523 199495 4801 501 5303 2137 5807 6309 199596 4657 43 5087 2105 568 611 199697 4508 393 4901 209 5542 5935 199798 4734 362 5096 2186 5821 6183 199899 4766 327 5093 2303 5935 6262 199900 4931 299 5231 2643 6361 666 200001 5245 314 5558 2826 6746 7059 200102 5682 314 5996 3031 7291 7605 200203 6109 243 6352 3204 7786 8029 200304 6137 167 6305 3279 7942 8109 200405 5964 188 6151 3128 7668 7855 200506 5866 255 6121 3108 7489 7744 200607 5673 239 5912 2892 717 741 200708 5466 225 569 2664 6918 7143 200809 5439 22 5659 2634 699 7211 Source RBI statistics Download free ebooks at bookbooncom Advanced Macroeconomics Modern Macroeconomics Table 53 Fiscal indicators of central government Select Fiscal Indicators of Central Government As Percentage to GDP in India Part 111 19701971 to 20112012 Defence Revenue Revenue Interest Capital Capital Total Year Expenditure Payments Subsidies Capital Expenditure Outlay Expenditure 197071 677 131 02 259 539 204 1216 197172 801 135 021 308 59 226 1392 197273 831 142 038 303 608 179 1439 197374 719 133 054 253 518 152 1237 197475 724 128 053 269 543 208 1267 197576 829 146 056 294 641 267 147 197677 911 164 104 282 594 206 1505 197778 886 16 125 256 622 218 1508 197879 959 178 132 258 726 217 1685 197980 966 188 149 275 586 2 1552 198081 991 179 14 248 575 211 1566 198182 902 187 114 253 577 246 1479 198283 981 206 118 263 631 244 1612 198384 10 216 13 262 597 235 1597 198485 1111 24 162 283 64 271 175 198586 1206 267 17 284 666 272 1872 198687 1298 294 173 333 701 294 1999 198788 129 314 167 334 617 26 1907 198889 1274 336 182 314 589 242 1863 198990 1317 364 215 296 588 242 1905 199091 1291 377 213 271 558 213 1849 199192 1257 406 187 25 445 169 1702 199293 1232 413 144 234 398 178 1629 199394 1249 424 134 252 389 151 1638 199495 1202 434 117 229 38 147 1582 199596 1174 42 106 225 322 118 1496 199697 1153 431 112 214 305 103 1458 199798 1181 43 121 231 339 115 152 199899 1236 445 135 228 359 108 1595 199900 1276 462 125 241 251 123 1527 200001 1322 472 128 236 227 118 1549 200102 1323 472 137 238 267 117 159 200203 138 48 177 227 304 119 1684 200304 1314 45 161 218 396 124 1711 200405 1186 392 142 234 352 162 1538 200506 119 358 128 217 179 148 137 200607 1199 35 133 199 16 14 1359 200708 1192 343 142 184 237 214 1529 200809 1422 344 232 205 161 136 1583 Source RBI statistics Download free ebooks at bookbooncom Please click the advert Advanced Macroeconomics international adjustments Policy implications 6 International adjustments Policy implications 61 Government budget constraints Every government has revenue receipts and revenue and capital expenditure It always makes the balance between receipts and expenditure Fifth chapter has explained about the budget constraint But in the welfare state expenditure of government is always higher than income and therefore de cit occurs Government nances its de cit through two methods Firstly it either sells bonds or prints money By printing money the high power money increases But through open market operation government buys up a part of the debt that sells treasury bills BDSBAMb Where BD Budget de cit SB Sales of bonds Mb Increase in monetary base In the short period increase in de cit may cause rise in the interest rate because of government expansionary scal policy The target is kept to not increase the rate of interest Government monetizes its de cit when it purchases a part of the AllOptions Try this The S lC lUEMC A 4 839 l0 l2 1 late lei is the scqoewce a new IW l1OIE Wmlamji The OOH1 place m Halts madame M Ma number Download free ebooks at bookbooncom Advanced Macroeconomics international adjustments Policy implications debt sold by the treasury to nance the de cit Government faces dilemma to monetize de cit because it does not nance the de cit the scal expansion not being accompanied by accommodating monetary policy raises interest rate and thus crowding out private expenditure Government buys securities thereby increasing the money supply and hence allowing an increase in income without rising interest If there is full employment then monetization of debt could lead to in ation Higher aggregate demand will lead to rise in real interest rate The crowding out will occur and it leads to high in ation Government should supply money at constant level at the same time interest rate should allow to rise At full employment it could lead to in ation An unwise scal expansion could lead to more monetary expansion It depends on the government whether to pursue an accommodating monetary policy or whether to rather stay with an unchanged monetary target or even offset a scal expansion by a tightening of monetary policy Government has to compare the cost of higher in ation with those of higher unemployment wherever expansionary policy threatens to cause in ation In India in ation in nonfuel commodities is seen as a more important driver of domestic in ation rather than fuel in ation The exchange rate passes through coef cient is found to be modest but nonetheless sharp depreciation in a short period of time can add to in ationary pressures Kapur 2012 High output growth and low in ation are among the most important objectives of macroeconomic policy But there is perceived tradeoff between lowering in ation and achieving high growth Empirical evidence emphasizes that the growth in ation relationship depends on the level of in ation at some low levels in ation may be positively corelated with growth but a higher level in ation is likely to be harmful to growth In other words the relationship between in ation and output growth is nonlinear Mohanty D etal 2011 611 The In ation tax Government prints money and increases high powered money The source of revenue is sometimes known as seigniorage which is the governments ability to raise revenue through its right to create money When government nances de cit by creating money then money can be printed period after period It uses money to pay for the goods and services it buys This money is absorbed by the public The real income growth aside public adding to its holding of nominal balances would be to offset the effects of in ation In the long run prices rise then the purchasing power of a given stock of nominal balances is falling To maintain a constant real value of money balances the public has to be adding to its stock of nominal balances at a rate that will exactly offset the effects of in ation When public is adding to its stock of the nominal balances in order to offset the effects of in ation on holding of real balances it is simultaneously using a part of its income to increase the holding of nominal money Persons are doing it to prevent his or her wealth from falling as a result of in ation In ation acts just like a tax because people are forced to spend less than their income and pay the difference to the government in exchange for extra money Therefore government can thus spend more in the economy and the public spends less Government has money to nance extra spending When government nances its de cit by issuing money the public adds to its holding of nominal balances to maintain the real value of money balances constant It means government is nancing itself through the in ation tax If the output is constant then ITRIRRMB Where Download free ebooks at bookbooncom Advanced Macroeconomics international adjustments Policy implications ITR In ation tax revenue IR In ation rate RMB Real money base The in ation tax is clearly distortionary but so are the other alternative taxes Many of the distortions from in ation come from a tax system that is not in ation neutral for example from nominal tax brackets or from the deductibility of nominal interest payments These could be corrected allowing for a higher optimal in ation volatility indexed bonds that can protect investors from in ation risk Blanchard Olivier etal 2003 Figure 61 In ation and tax revenue c IR In ation tax revenue i IR 9 3 g 3 AA 7 7t In ation rate When in ation is zero the government gets no revenue from in ation As the in ation rate rises the amount of in ation tax received by the government also increases But as the in ation rate rises people reduce their real holding of the money base This is because the base is becoming increasingly costly to hold Individuals hold less currency and banks hold as little excess reserves as possible The real monetary base falls so much that the total amount of in ation tax revenue received by the government falls It is starting point at c and this signi es that there is maximum amount of revenue than government raises through the in ation tax The maximum is shown as amount IRquot The in ation rate denoted as Ttquot is the steady state in ation rate at which the in ation tax is at its maximum At initial point there is no in ation and printing of money Economy is at 0 But in the long run government cuts taxes and nances the de cit by printing money The de cit is at IR and in ation in economy is Tt But the second point government wishes to increase revenue The economy is on the rising part of the curve Government de cit is also at high IR rate In the less developed countries banking sector is less developed People hold maximum cash balances Government gets revenue from in ation 62 Hyperin ation In hyperin ation the annual in ation rate reaches thousand percent per annum When in ation becomes high it knocks through monthly statistics In hyperin ation people spend signi cant amount of resources minimizing the in ationary damage They shop very often and reduce the real balances to a remarkable extent to avoid the in ation tax but they have to compensate by going to the bank more often that is hourly or may be daily rather weekly Download free ebooks at bookbooncom Please click the advert Advanced Macroeconomics International adjustments Policy implications 621 De cit and hyperin ation Economies suffer from de cit in hyperin ation During war hyperin ation is generated and it increases the debt and reduces the tax generating capacity of the country But large de cit forces government to print money to nance de cit Tax collection system As the in ation rises the real revenue from taxation falls But in principle the tax system can be indexed to adjust for the in ation But that is dif cult in practice 622 Nominal interest rates and de cits The budget de cit includes the interest payments on the national debt The nominal interest rate tends to rise When in ation increases The higher in ation generally increases the nominal interest payments that are made by the government and the measured de cit therefore increases In short high nominal rates are not necessarily high real rates of interest If in ation gets reduced then de cit Will decline It Will lower the interest rates IADTDITND Where IAD In ation adjusted de cit THIS ebook IS PRODUCED WITH iText Download free ebooks at bookbooncom 187 Advancech Macroeconomics interiational adjustments Policy implicatio is TD Total de cit IT In ation tax ND National debt Above equation removes the component of interest payments on the debt that is attributed directly to in ation and gives a more accurate picture of what the budget situation would be at a very low in ation rate than does the actual de cit 623 In ation tax and accelerating hyperin ation The money growth is high during hyperin ation It leads to monetary nancing of the de cit If tax revenue is limited then government prints money It is faster than people s realization It further leads to rise in in ation But government prints money and spends more or nances its expenditure The process continues till it breaks down A rise in the in ation rate leads workers to supply more labor over the contract period generating a signi cant positive long run in ation rate Given standard calibrations optimal monetary policy is associated with a long run in ation rate around two percent Ahrens S and Dennis J Snower 2012 Stopping hyperin ation Government regularly reforms the direct and indirect taxes in economy The exchange rate of the new money is pegged to foreign currency in order to provide an anchor for prices and expectations But it is not enough The monetary scal and exchange rate policies are combined with income policies in this approach to stabilization People expect less in in ation nominal interest rates decline and the demand for real balance rises The demand for real balances increases then government can create money without creating in ation Thus at the beginning of a successful stabilization there may be a bonus for the government it can temporarily nance part of the de cit through the printing of money without renewing in ation But it certainly cannot do so for much more than a year without reigniting in ation 624 Budget de cit and the public debt The de cit is actual and structural The structural de cit or the full employment or high employment or cyclically adjusted de cit is the level at which the de cit would be if output were at its full employment level The cyclical component of de cit re ects the impact of recessions or booms on tax revenue and government outlays such as unemployment compensation When economy goes into recession the budget automatically worsens as government tax revenue falls and outlays increase Conversely in a boom the budget automatically improves 63 Laffer curve Arthur Laffer a former professor of economics has proposed the Laffer curve The Laffer curve relates tax revenues to the tax rate The curve shows total tax revenue rst increasing as the tax rises and then eventually decreases In the income tax category if the tax rate is zero the government tax revenue is certainly zero The point A shows such a situation in graph Now suppose tax rate is 100 percent then government revenue is 100 percent From point A and B government takes some income from tax But beyond point C at tax rates above 60 percent any increase in the tax rate reduces total revenue a cut in tax rate increase total tax revenue A point beyond C a cut in the tax rate causes people to work so much more than the increased work efforts out weight the reduced taxes on the amount they used to work But such an effort makes people work more At higher after tax wage a worker needs to work less to support the same standard of living When the after tax wage rises the response is to work less earn more income and have more leisure Download free ebooks at bookbooncom d Advanced Macroeconomics lnternational adjustments Policy implications Figure 62 Tax rate and tax revenue for government Tax revenue Tax revenue 64 Controlling de cit A large de cit impairs economic growth by reducing the national saving and capital formation De cit creates vicious cycle of borrowing and higher debt service costs which in turn make it still more dif cult to reduce the de cit In India central as well as state governments have spent much more on the various welfare programs Download free ebooks at bookbooncom Advanced Macroeconomics international adjustments Policy implications Therefore it has resulted in to large de cit in their budgets Such de cit is continuously rising Now the FRBM act is prepared to control the de cit Central and state governments are supposed to follow the guideline of act and control the de cit 641 The mechanism of de cit nancing Government is not different from individual It also requires enough balances to withdraw money If there are no balances then government should borrow money It is neither by debt to the public or from central bank When treasury nances its de cit by borrowing from its public it engages in debt nancing The budget constraints can be explained as PBDABfABpAA AHABpAA 61 Where The de cit is nanced by borrowing either the central bank ABf or from private sector ABp or by selling assets AA The change in central banks holdings of treasury debts causes a corresponding change in high powered money AH so that it is in this sense that the central bank monetizes the debt When government sells public land or public sector enterprises the receipts from the sale can be used to nance the de cit or to entire public debt It is a temporary solution There is a limit to sale assets and they are limited 65 Debt management The sale of treasury bills is regular in the economy It is done by the reserve bank Government auctions treasury bills to prospective buyers each week and issues longer term debt less regularly Issues of treasury debt are not all made for the purpose of nancing the budget de cit Most debt issues are made to re nance parts of the national debt that are maturing The treasury bills have to pay the face amount to the holder Treasury options the funds to make those payments by further borrowing The process by which treasury nances and re nances the national debt is known as debt management Only a minor part of debt management is concerned with nancing the current budget de cit ie with net debt issue as opposed to re nancing the large eXisting stock When government has more taX revenue government can retire debt Government accomplishes this by not renewing maturing debt but rather paying off bonds or treasury bills that are coming due The public debt stock declines If future government spending were known with certainty then optimal tax rate would be constant Because future government spending is uncertain the optimal taX rates sets the present values of revenue equal to the present value of expected spending As information about spending becomes available the optimal taX rate changes under this view the budget de cit is simply the difference between government spending and the amount of revenue generated by this tax rate and the debt will rise and fall accordingly over time Elmendorf Douglas W and N Gregory Mankiw 1998 66 The dynamic of de cit and debts The de cit is primary and no interest de cit and interest payments on the public debt Download free ebooks at bookbooncom 19 Advanced Macroeconomics international adjustments Policy implications Total de cit Primary de cit Interest payments The primary de cit or surplus represents all government outlays except interest payments less all government revenue The primary de cit is also called the non interest de cit Primary de cit 2 Non interest outlays Total revenue The budget will be in de cit unless the interest payments on the debt are more than matched by a primary surplus If there is a primary de cit in the budget then the total budget de cit will keep growing as the debt grows because of the de cit and interest payments rise because the debt is growing If economy is not growing any policy that leads debt to keep on growing cannot be viable This is because ultimately the debt will be unmanageable largely relative to the size of the economy The debt income ratio is de ned as Debt ratio DebtPY Where PY is nominal GDP The ratio of debt to GDP falls when nominal GDP grows more rapidly than the debt The debt grows because of de cits The denominator nominal GDP grows as a result of both in ation and real GDP growth The Debt income ratio rises when Abbry zgt0 62 Where R Real or in ation adjusted interest rate Z Non interest or primary budget surplus measured as a fraction of GDP Y Growth rate of real GDP B Debt income ratio The debt income ratio depends on the relationship among the real interest rate the growth rate of output the noninterest budget surplus The higher the interest rate and lower the growth rate of output the more likely the debt income ratio is to be rising A large noninterest surplus tends to make the debt income ratio fall Download free ebooks at bookbooncom 191 Please click the advert Advanced Macroeconomics International adjustments Policy implications Figure 63 illustrates the aggregate demand curve The tax cut is temporary and the budget de cit is nanced by selling debt to be the private sector A cut in taxes is to shift the aggregate demand curve out from AD to ADI Because the private sector is buying bonds during the period of the de cit it ends up holding a higher stock of government bonds If individuals hold government bonds then such bonds are the part of their wealth At given level of income aggregate demand should rise when the stock of government bonds rises because individuals holdings those bonds have higher wealth The higher wealth increases consumption demand and the demand curve shift out the right The nal aggregate demand curve returns to original equilibrium after government spending The AD and AD2 difference from the higher stock of government bonds price B compared with B on the initial aggregate demand curve Figure 63 Output and price level with effect of aggregate demand Wu P 3 E2 AD2 E1 D1 P0 E AD 0 l Y Output The next step for top performing graduates Designed for high achieving graduates across all disciplines London Business School s Masters Masters in Management I I I I I I I I In Management prOVIdes speCIfic and tangible foundations for a successful career In busmess This 12month fulltime programme is a business qualification with impact In 2010 our MiM employment rate was 95 within 3 months of graduation the majority of graduates choosing to work in consulting or financial services As well as a renowned qualification from a world class business school you also gain access to the School s network of more than 34000 global alumni a community that offers support and opportunities throughout your career For more information visit wwwlondonedumm email mimlondonedu or give us a call on 44 020 7000 7573 Figures taken from London Business School s Masters in Management 2010 employment report Download free ebooks at bookbooncom 192 Advancech Macroeconomics interma t onal adjustments Policy implicatio is 67 The Borrow Ricardo problem At the aggregate level everyone believed that the national debt would eventually be paid off The government should run a surplus to pay off the debt It should increase taxes in future Then increase in debt would increase individual wealth and at the same time suggest to them that their taxes would be higher in future The net effect on aggregate demand might then be zero Now the government bonds are wealth the issue is raised by David Ricardo It is further given prominence in the work of the new classical economist that is Robert Barro Hence it is known as the BarroRicardo equivalence proposition or Ricardo equivalence The proposition is that debt nancing by bonds issue merely postpones taxation Therefore in many instances it is strictly equivalent to current taxation Borrow Ricardo proposition that government bonds net wealth turns on the augment that people realize their bonds will have to be paid off with future increases in taxes If so an increase in the budget de cit unaccompanied by cuts in government spending should lead to an increase in savings that precisely matches de cit Borrow Ricardo objected because rstly people have nite lifetime the people who receive tax cut today will not be paying off the debt tomorrow It is assumed that people now alive do not take into account the higher taxes their descendants will have to pay in future Secondly many people cannot borrow and thus do not consume according to their permanent income They like to consume but liquidity constraints They cannot borrow and thus do not consume according to their permanent income A tax cut eases their liquidity constraints their inability to borrow are constrained to consuming less than they would want according to their permanent income A tax cut for these people eases their liquidity constraints and allows them to consume more 68 Money and debt nancing Money nancing of the de cit tends to reduce the interest rate in the short run Money nancing increases the nominal money stock The debt nancing does not The debt nancing reduces the level of investment compared with money nancing That is an issue connected with the crowding out question The price level is higher with money nancing than with debt nancing Firstly money nancing increases the money stock and debt nancing does not The higher is the money stock the greater is aggregate demand at any given price level Secondly a rise in price in the case of debt nancing to the wealth effect of a greater stock of debt on consumption The wealth effect on consumption is larger in the case of money nancing than of debt nancing It means that aggregate demand at any given price level will be higher with money than with debt nancing De cit nancing probably increases aggregate demand but because of the possible effects of anticipated future taX liabilities on consumption that is not certain Debt nancing starts from a balanced budget and is not compensated for by higher taxes or reductions in other transfer payments lead to a permanent de cit in the budget because interest has to be paid on the debt Debt nancing raises the interest rate and reduces investment in the short run compared to the effects of money nancing 69 The burden of debt Each individual shares in the obligation to repay the public debt but many individuals own the national debt The debt represents as cancelling out the asset that the debt represents to the individuals who hold claims on the government In case would not on net be a burden on society Debt may be a burden through the potential long run effects of the de cit and debt in the capital stock Debt nancing increases interest rate and reduces investment The capital stock will be lower with debt nancing than otherwise and thus output will be lower as a result of debt nancing of a de cit This is a real burden The debt can also be a burden because the higher taxes needed for debt servicing could have adverse effects on the economy for instance by discouraging investment or work effort Such an effect would reduce output Download free ebooks at bookbooncom Advanced Macroeconomics international adjustments Policy implications The major source of the burden arises from the possible effects of the national debt on the country s net national worth an increase in the national debt can reduce the capital stock and or increase the nation s external debt The result shows that the relationship between FDI both in ow and out ows and growth The relationship between growth and equity ows is smaller and less stable Finally the relationship between growth and short term debt is nil before the crisis and negative during the crisis Aizenman Ioshua Yothin Iinjark and Donghyun Park 2011 Intergenerational burden De cit nancing shifts some of the burden of current government spending to future generations The research lacks in the eld which describes what is fair and unfair in allocating burdens among generations Policymakers politicians and civil society are less concerned on how burdens should be shared across generations Such principals and conclusions have to be based on account of just how much current policies impose burdens on different generations Intergenerational accounting evaluates the costs and bene ts of the entire scal tax and spending system for various age groups in society The study shows that debt crisis produce signi cant and long lasting output losses reducing output by about 10 percent after eight years The results also suggest that debt crisis tend to be more detrimental than banking and currency crisis The signi cance of the results is robust to different speci cations identi cation and endogeneity checks and data sets Davide and Aleksandra 2011 610 Government assets The government has income as well as expenditure If incomes are lesser than expenditure then government tries to nance it through asset sale or borrowing Government runs scal de cit and borrow from public to nance its expenditure Government spends on roads post of ces railway health education and several others The real capital acquired by the government should be treated as an offset against the debt issued The valuation of government assets raises serious issues Government can sell public company hotel garden park or post of ce But government will try to maintain its assets operating In India Indian airline is continuously making operational losses and government is providing aid to run it properly The aim is to provide the service to people But government cannot privatize or sell airline It is always considered as public asset But it is not clear whether that item or service should count as government assets in calculating the government s net worth Due to in ation money value of assets changes Whatever the details concentrating only on government debt rather than on all the government s potential sources of future income and outlays is misleading 611 The budget de cit Usually creating public assets may require borrowing It is a cause of de cit From domestic side the de cit does not match with an increase in saving Government of India has done such task in rst and second ve year plan Suppose government offers consumer lower present taxes nancing a signi cant part of the de cit by borrowing abroad Someone will ultimately have to pay the taxes that nance the interest on those loans from abroad Download free ebooks at bookbooncom H Please click the advert Advanced Macroeconomics International adjustments Policy implications 612 The size of debt budget Over a period of time government expenditure has increased It is mainly because of the acceptance the idea of welfare state This increase re ects largely in the broadening of government social programs especially the growth of transfer program The budget and debt clearly depends on the existing government programs Some government s social programs are widely regarded as desirable Few disputes the need for an additional defense expenditure employment health program etc The social security programs and others are widely previewed In India government of India nances the welfare projects such as Mahatma Gandhi National Rural Employment Guarantee Program MGNREGP National Rural Health Mission NRHM etc But such programs are controversial because their size is not desirable There is corruption inef ciency and lack of transparency in these programs If the government budget is too large and it is in de cit then it pressurizes the interest and nancial stability It is desirable De cit laws put pressure and it is the best way to get spending cuts There is no clear method which will tell us the tax payer s money worth from government spending Therefore the numbers of government programs have been evaluated Different studies show that money programs are ineffective but they are expected Some programs should be stopped or abandoned The private market can take care of these programs Now all government works are on public private partnership model Social security and food stamp have received substantial attention The nal solution is that the individual programs should examine their success and suggest changes which are clearly the most careful way to evaluate government spending But in the long term the aim of the government should be to control de cit and ensure macroeconomic stability The social programs and their success depend on the agreement of policy makers and society But the resources are scarce and they should be used very ef ciently Social programs are must and they can be evaluated regularly to see their effectiveness l39 reps in Education as Teach with the Best Learn with the Best Agilent offers a wide variety of affordable industryleading electronic test equipment as well as knowledgerich online resources for professors and students A BEE I r m quotr We have 10039s of comprehensive rm in W webbased teaching tools lab experiments application notes brochures DVDs CDs posters and more nili i See what Agilent can do for you Agilent Technologies Inc 2012 us 18008294444 canada 18778944414 Anticipate Accelerate Achieve Agilent Technologies Download free ebooks at bookbooncom 195 Advanced Macroeconomics international adjustments Policy implications 613 Merged Bank Fund Model The Polak model alternatively known as the fund model is a model of short term stabilization This model was developed by Jean Jacques Polak in 1957 The Bank model also known for medium term stabilization comprises of the two models namely the Two Gap model proposed by Chenery and Bruno in 1962 and the Harrod Domar model was developed independently by Sir Harrod in 1939 and Domar in 1946 The two gap model was given by the Bank model which is known for the medium term model The structure can be derived as follows A The Fund model Jean Jacques Polak 1957 B The Bank model i Two Gap model Chenery and Bruno 1962 ii HarrodDomar model Both merged models are called the Merge Bank Fund model The differences in both the models are explained as Table 61 Instruments in Bank and Fund model Number Bank Model Fund Model 1 Model 1Two gap model Polak fund model 2 HarrodDomar model 2 These models are medium term models The fund model is short term stabilization 3 Target g Target n AR 4 lnstrument AF Instrument ADC E 5 Exogenous variables n s Exogenous G AF 6 Endogenous variable Endogenous Graph 61 Variables and instruments in model Exogenous variables Exogenous variables Bank Model gt Polak Fund model ats 2Gap model G AF HarrodDomar gt A F Target Target ADC E Instrument g l R AR Instrument Download free ebooks at bookbooncom 196 Advanced Macroeconomics international adjostments Policy implications Flaws 1 No interconnection between g and T 2 No link between DC and g No link between E and AF 3 No link between A F and T and s Target Instrument Endogenous Exogenous Historical factors Parameters AR ADC AM X Y1 v H E Z AF P1 a G AF b 6131 Polak Fund Model Polak 1957 being dissatis ed with the Keynesian overemphasis on scal policy and the inappropriate treatment meted out to monetary policy in the General Theory He attempted to streamline the monetary side of the analysis However Polak clearly stressed that his model was not an alternative to Keynesian model The model was speci ed in nominal term and consequently no explicit distinction was made between price and real income changes The model is based on certain assumptions Download free ebooks at bookbooncom 197 Advancech Macroeconomics international adjustments Policy implicatio is Assumption 1 The demand for money Md depends on nominal income Y with the income velocity of money V being assumed to be a constant Imports Z are a fraction m of nominal income Z mY Money supply M is determined through the identity for monetary balance ie ADCARAM Reserves R are determined through the identity for external balance ie ZXzAFAR P rPWP The money market is in ow equilibrium AmAmd The Polak Fund model is also known as the nancial programming model approach It is used by the IMF for structural adjustment in developing countries The objective of IMF is to help developing countries stride over BOP problem Proof 1 Monetary sector Financial constraints AMADCAR AR AMADC 63 The change in money supply is related to change in domestic credit and change in reserves Similarly changes in reserves are equal to the change in money supply minus change in domestic credit This is monetary sector budget constraints Balance sheet Assets Liabilities ADC AM AR ADC AR AM The country has assets that are domestic credit and reserves The liability of any country is money supply Both assets and liabilities are subjected to change Therefore the targets are to tackle in ation and increase reserves The instrument with monetary authority is domestic credit The parameters are velocity of money and the exogenous variable is government expenditure The historical factor is past income All the variables are explained in the table Target Instrument parameter Exogenous Historical factor I39I AR ADC V G Y 1 Now using the quantity theory of money MVPT Download free ebooks at bookbooncom Advanced Macroeconomics Here we assume V constant for short term pYY nominal income M zr Untema t ona adjustments Policy implications AM V AY The demand for nominal money balance M d2AM depends only on nominal income with the income velocit mone constraint Y Y V AMziAY V Substituting equation 63 into 64 AR AY ADC Now Y 1g y1 Predetermined real growth rate is exogenous PlTp1 The in ation rate is endogenous YPY Y1gY1 1Ttp1 Y1gTTg Y1 Now Ttg0 Y 1gTrY1 YY1gTty1 Nominal income increases because of two factor growth rate and Y1 Y Y1 gTtY1 Y Y1 AY AY gTtY1 Substituting equation 65 into 64 we get AR g 1m ADC 64 65 66 It is the fundamental equation of Monetary Approach to Balance of Payment MABOP where the Balance of Payment BOP is expressed as the difference between the ow demand for money and expansion of domestic credit where increase in domestic credit will be offset by decrease in reserve on a one to one basis 199 Download free ebooks at bookbooncom Please click the advert Advanced Macroeconomics international adjustments Policy implications H AR gm 7gtY1 ADC Conditional on a chosen expansion of domestic credit therefore regrouping variable two endogenous variable AR 7 and it is not possible to nd a unique solution for both therefore regrouping variables g H AR V g ADC 7174 Or g 1 AR Y ADC Y H V 1 V 1 67 Target Instrument Parameter Exogenous Historical factor I39I AR ADC V G Y 1 You re full of energy and ideas And that s just What we are looking for U35 2010 All rights reserved Looking for a career where your ideas could really make a difference UBS s Graduate Programme and internships are a chance for you to experience for yourself what it39s like to be part of a global team that rewards your input and believes in succeeding together Wherever you are in your academic career make your future a part of ours by visiting wwwubscomgraduates wwwubscomlgraduates Download free ebooks at bookbooncom 2 Advanced Macroeconomics international adjustments Policy implications The monetary sector constrains mm line shows the various combinations of AR and T for which the monetary sector 1 g in equilibrium MM line is a straight upward slop1ng line w1th slope EH1 and 1ntercept term Y 1 ADC V While the slope of line cannot change the intercept can be changed as policy instrument ADC When ADC decreases then MM0 line shifts up to MMI Reduction in domestic credit leads to two possibilities 1 Same T and higher AR comparing point A and B 2 Same AR and lower 7 comparing point B and C Therefore an upward shift in mmO line implies either increases reserves for given 7 or decreases in T for given reserves ii External sector nancial constraints External sector depends on the reserves with monetary authority If the economy earns more foreign exchange then the reserves will rise Similarly the external capital ow will rise It is explained as ARXZAF External sector budget constraints ARXAFZ 68 Target instrument exogenous endogenous parameter Historical factor AR AE XAF amp Z a Y1 H g b Z1 The targets are to increase the reserves and control in ation The instrument with monetary authority is exchange rate The exogenous variables are given as X Af and g The exogenous variables are Z The parameters are A and b The historical factors are past income level and past exports Import demand function Import is a function income level and depreciated exchange rate It is de ned as Zf Y E ZaY bE AZaAY bAE ZZ1AZ AZZZ1 Download free ebooks at bookbooncom 2m Advancao Maeraaeanom cs ZZ1aAYbAE Now if AEgtO devaluation AEltO revaluation Here a is marginal propensity to import out of income And b is responsiveness of import to exchange rate agt0bgt0 Subequation 7 into 6 ARXAFZ ARXAFZ1aAYbAE ARXAFZ1aAYbAE ARXAFZ1bAEaAY ARXAFZlbAEagTtY1 ie AYgTtY1 ARXAFZ1agYlbAEaYth ARz lBZTI 2 2 international adjustments Polity mp cat ans 69 610 Download free ebooks at bookbooncom Please click the advert Advanced Macroeconomics international adjustments Policy implications Figure 64 Devaluation and reserves in economy AR B M EEO EE1 Figure 64 displays EE0 line is a downward sloping straight line The slope aY17r and intercept XAF bAEagY1 Discover the truth at wwwdeloittecacareers Deloitte Deloitte Er Touche LLP and affiliated entities 2 33 Download free ebooks at bookbooncom Advanced Macroeconomics international adjnstments Policy implications Here again the slope cannot be changed but the intercept can be changed as it has the instrument AE An increase in change 7 devaluation will shift EEloutward Devaluation of currency leads to two possibilities They are 1 Same 7 higher AR comparing point A and B 2 Same AR and higher 7 comparing point A amp C Figures 65Equilibrium of in ation and reserves in economy AR lVlMO AMADCAR AR1 ARO ARa1 12 EEO 0 H0 711 7r Every point on MM0 line refers to monetary constraints and content AR and T AMADCAR On the other hand EE0 contains AR and Tr XZAFAR A1RBgc2 Now AX uZ ARa1a2H A113B1182H Download free ebooks at bookbooncom 2 4 Advanced Macroeconomics 051 0 21I 81 1821 I azn 182H 81 a1 H 181 051 062 2 Substituting this into AR AR 2 a1 05211 a2 2 AR 2 051182 052181 a2 2 205 International adjustments Policy implications 611 Download free ebooks at bookbooncom Advanced Macroeconomics international adjustments Policy implications Figure 66 Devaluation money supply and its effect on reserves MM1 MM0 AR2 AR1 ARO 13E1 In gure 66 the intersection of MMO and EE0 line shows the value 0th and AR which simultaneously satis es the budget constraints for both monetary and external sector If the objective is to improve their serve position and lower in ation 7 then the domestic credit decreases DC This will shift MMOto MMI If devaluation takes place the EEO line shifts to BE After achieving position E2 there is no shifting of curves because we achieved the higher R at same 7 Conclusion The above analysis is a simpli ed representation of the actual dynamic of in ation TI and reserve R which for the present can be considered as a rst approximation of how these variables interact Above gure shows that high reserves are achieved at same in ation after devaluation reducing the money supply 6132 Bank Model In contrast with Fund s concern with temporary Balance of Payment BoP disequilibria the bank has been charged with nancing growth and development over medium term This is basic approach that the bank uses for its macroeconomic projections and policy work It emphasizes the relationship between saving foreign capital in ows investment and growth 1 Two Gap Growth Model Michel Bruno and Hollis Chenery The two gap model was developed simultaneously by Chenery and Bruno 1962 Mckinnon 1964 and Chenery and Strout 1966 This price model includes the saving constraints but in addition considered the possibility of foreign exchange acting as separate and independent constraints on an economic growth Download free ebooks at bookbooncom 2 6 Advanced Macroeconomics international adjustments Policy implications A The saving constraints YCIXZ YCS CSCIXZ SIXZ IS ZX 612 Current account de cit Industrial resourcesdomestic saving external saving ARXZ AF External sector nancial constraints AFARz ZX 613 Finance by capital ows or running down a depleting reserve That is 0100 100 Substituting equation 613 into 612 ISAFAR I 5 A F AR Saving constraints 614 Iz lAR Figure 67 Foreign reserves and investment in economy AR AR50 ISC31AR saving constraints 1 O Isc100 I Actual investment level min Isc IFc B Foreign exchange trade constraints Investment in domestic economy is determined by the trade constraints If there is more export then reserves will rise Such reserves can be utilized for investment Download free ebooks at bookbooncom 2 7 Advanced Macroeconomics ARXZAF ZX AFAR Z Capital owsReserves CAD Hntemat ona adjustments Policy implications Current Account De cit can be nanced by either running down own saving reserves or by increase K in ows Z XAFAR Import demand function Z aY bE 616 Substituting the import demand function into the equation above aY bEXAFAR aY XAFbE AR Now YY 1AY Here present income depends on the past income and change in income If we substitute the value of Y into above equation then it can be written as aY1AYXAFbE AR aY1aAY XAFbEAR aAY XAFbEaY 1 AR AYBI B is incremental output capital ratio aBIXAFbEaYlAR IFC LXAFbE aY1 LAR 618 a a is marginal propensity to import alt1 l Blt1 gtl 613 1 w LAR FC 2 ab 1 lf AR 0 61 1 IFC XAFbE aY1 a 617 618 Download free ebooks at bookbooncom Please click the advert Advanced Macroeconomics International adjustments Policy implications Figure 68 Equilibrium of foreign reserves and investment AR pt of intersection scic SC 1 FCTC a IFC ISC I quot32 B1 Figure 68 shows that the line which hits rst is called a binding constraint If we draw a line above the point and intersection then SC would be binding constraints The binding constraint can be retained by shifting the line IS AFAR eds eCV WEI 5191151335 WWI 39339 It s only an opportunity if you act on it IlKEA JEfETUlDEMT Download free ebooks at bookbooncom 209 Advanced Macroeconomics international aoijbistments Policy implications IscSAFAR IscsYAFAR SsY If AF increases by one unit then SC increases by one unit Similarly I also increase by one unit then IscsAFAR0 1 FC LXAFbE aY1 I8AR 618 a 619 Figure 69 Foreign reserves and investment change in economy Tc AR SC SC binding s or AF FCIC is binding X or AF Therefore AF increases one unit and 1 increases 03 Shadow prices of capital are higher in those countries where investment is lower Therefore IMin ISC ItCfc Target Instrument Exogenous Parameter Historical factor AR AF 11SampX U1 5 ab Y1 Z1 Download free ebooks at bookbooncom 2M Advanced Macroeconomics II The HarrodDomar model Untema t ona adjustments Policy implications The focus on rapid growth and capital accumulation characteristics of the early work in development economics implied that the aggregate growth theory developed by Harrod 1939 and Domar 1946 become natural It is the rst building block in the World Bank approach to economic development In the HarrodDomar model the economy is supposed to grow at the warranted rate of growth given by S g V SsY i g V i 5 CAD l Y Y Y IY VICOR Incremental capital output ratio AK42 AY 1 Basic logic of HD model 1 I g V Y I g3 1 Where E 8 AY Now 3 7 AY I 7 my AYz I 2M Closed economy Open economy 620 621 Download free ebooks at bookbooncom Please click the advert Advanced Macroeconomics Nominal income 6 nominal investment M mi 9 AYzY Kl I YY 1 Now we divide both side by Y1 I YY1 g K1 K1 1 1 g r r Y1 p 1 1 g r r Y l 19 encsson com YOUR CHANCE TO CHANGE THE WORLD Here at Ericsson we have a deep rooted belief that the innovations we make on a daily basis can have a profound effect on making the world a better place for people business and society Join us In Germany we are especially looking for graduates as Integration Engineers for 0 Radio Access and IP Networks 0 IMS and IPTV We are looking forward to getting your application To apply and for all current job openings please visit our web page wwwericssoncomcareers ERICSSON International adjustments Policy implications 212 Download free ebooks at bookbooncom International adjustments Policy implications Advanced Macroeconomics quotlt Y i 1 P4 1 P1 A Z This when replaced in the above equation can be written as P I gz 41 Y1 P P gziiol Y1 P Now p 1TE P1 17r p 1 P 41 put into the above equation Polak fund model assumes g at second round equation 213 622 Download free ebooks at bookbooncom Advanced Macmecemem cs Hmtemat ena adjustments Pe cy mp icat ems Figure 610 Equilibrium of reserves investment and in ation NIMO EE0gg0 1 ISc1 TCFC H0 g17t Two Gap ISC11 1Fc12 IMM11 12 A Money demand function M MD LYi P P M MD mY zl P P Download free ebooks at bookbooncom 214 Please click the advert Advanced Macroeconomics z ltmy gt gty gt International adjustments Policy implications M M y ll P M mY P 5 Z Z The Graduate Programme IJOIDEd because for Engineers and Geoscientists MaerskcomMitas Iwas a construction supervisor in the North Sea advising and WE helping foremen a solve problems MAERSK 215 Download free ebooks at bookbooncom 0 Advanced Macroeconomics interia t omal adjustments Policy mpl cat o is g 623 For sustainability ggtr Graph 63 Merged Bank Fund model and policy Initial guess E Update of g A Exogenous X AF Histor1ca1 Y1 Z1 The Polak Fund model V a b Instrument V ADC AE AR 7 Exogenous SX Two gap model v B ab g175 Instrument A AF I WarrodDomar Model 3 l Historical factor Y1 614 Rules versus discretion The central bank and central government conduct scal and monetary policy in accordance with preannounced rules that describe how their policy variables will be determined in all future situations or should be allowed to use their discretion in determining the values of the policy variables at different times This concept explains that the most proponent of rules have been non activities whose preferred monetary rule is a constant rate rule We can design rules that have countercyclical features without at the same time leaving any discretion about their actions to policy makers Both economy and knowledge is changing There is no economic case for starting permanent policy rules that would tie the hands of the monetary and scal authorities permanently There are issues to change the rule located The growth rate of money is prescribed by constitution At the other hand it is left to the central bank Each policy can change but constitution cannot change There is tradeoff between future and exible policy Financial sector responds very quickly to shocks and it is so interconnected Reserve bank has considerable discretions and thus exibility to respond to disturbances But it is far from a universal judgment Policy makers should announce the policies they will be following for the foreseeable future Such principles are desirable because they help private sector to forecast future policies But monetary authority does not stick to its target Reserve bank keeps output close to potential and keeps in ation low It helps the private sector to forecast variables as they are interested in future income The rm forecasts demand for goods rather than those like money supply They need to know only the intermediate step in forecasting Download free ebooks at bookbooncom 216 Advanced Macroeconomics international adjustments Policy implications Dynamic inconsistency Rules vs discretion As already discussed in the chapter once the in ation expectations augmented Philips curve is understood we would hope policymakers would keep in ation low on an average It will keep expected in ation low There is long run tradeoff between unemployment and in ation There is no unemployment reducing bene t from keeping in ation high The policy makers who have discretion will be tempted to take short run actions That is in consistent with the economy s best long run interests There is natural outcome with rational will intentioned policy makers The analysis in consistency begins with the assumption that the policy makers share the public dislike of both in ation and unemployment The inconsistency arises when there is short run tradeoff between in ation and unemployment There is no trade off because of the adjustment of in ationary expectations The best long run position for the economy is full employment with zero or at least low in ation Policy makers who announce full employment zero in ation policy will immediately be led to cheat by seeking lower unemployment and slightly higher in ation It is a split between announced and expected plans that give rise to name a dynamic inconsistency The policy makers and adjustments of the economy occur in three sequential steps 1 The policy makers announce a policy with zero in ation 2 Policy makers choose a level of anticipated in ation consisting of the announced policy implying the economy will be positioned on the short run Philips curve at full employment 3 The policy makers reduce unemployment at the expense of a little in ation The Philips curve is xed The policy is optimal although it is inconsistent with the policy at rst point Figure 611 Relationship of unemployment and in ation Equilibrium short run Philips curve In ation A O U SPC u Unemployment Figure 611 depicts that downward sloping curve is the short run Philips curve The curve shows the tradeoff between unemployment and in ation Point A shows the policymakers and public preference point It is a point with full employment and in ation Point A is the best point with zero in ation The economy operates on lower short run Philips curve At this point people and policy makers are ready to take risks and reduce unemployment rate The policy makers push the economy from A to B It is a point where the in ation is high The marginal loss from more in ation equals the marginal bene t from lower unemployment At point B in ation is high and decision makers expect more in ation Download free ebooks at bookbooncom 217 Please click the advert Advanced Macroeconomics international adjustments Policy implications The Philips curve move up to the equilibrium Philips curve The economy reaches at point C with full employment with high in ation All people prefer point A Policy makers and reserve bank promises to reduce the in ation up to point A But it is not possible because again economy will move from point A to B and then C Therefore promising and not performing enough is the best strategy Solutions 1 There are pressures to maintain adequate in ation The policy makers should have reputation for consistency 2 Government chooses policy makers that are antiin ationary 3 Policy makers are dictated to reduce the in ation by providing in ationary gures They are rewarded if they achieve it 4 Low in ation rules can be adopted to prevent the policy makers from making the discretionary choices that lead to dynamic consistency All these policies are adopted at some extent in the economy It depends on the central bank how it tries to reduce in ation But it should adjust with the government If both disagree with each other s policies then in ation cannot be controlled Sometimes effectiveness of policy is not always from one side 615 Lags in the effects of policy In the long run economy is in equilibrium But in short run if economy gets disturbed by an aggregate demand It reduces the income below full employment It is a job of policy makers to respond and direct disturbances The policy makers nd it as a long or short term disturbance It is transitory such as one year reduction in consumption spending EKG DA SIMPLY CLEVER We will turn your CV into an opportunity of a lifetime up a if faraway J J m 4quoter a 39 a an 1347 I quot l tul 391 H In Do you like cars Would you like to be a part ofa successful brand We will appreciate and reward both your enthusiasm and talent Send us your CV You will be surprised where it can take you Send us your CV on wwwempoyerforifecom it Download free ebooks at bookbooncom 2l8 Advanced Macroeconomics international adjustments Policy implications Sometimes changes are short term and the best policy is to do nothing at all Since monetary policy acts with lag decisions about the short term interest rate taken at a certain point in time only in uence the economy at future dates A well structured monetary policy framework requires analytical support in the form of mechanisms for anticipating future in ation and responding to it a head of time Bhattacharya R etal 2008 If demand changes in the short term then suppliers and producers will not make mistakes and adjust the production and inventory the changes They will not adjust capacity This will affect income in this period but it will have very little permanent effect Therefore today s actions take time to have an effect today s actions would be hitting the economy It will tend to move economy away from full employment level This disturbance is temporary and it has no long term effects and policy operates with a lag then the best policy is to do nothing Figure 612 GNP with stabilization policy A GNP with stabilization policy GNP Y v 0v to Itl I t2 t3 Time 7 Figure 612 illustrates that at time to there is disturbance and output declines At point t2 it reaches at equilibrium The expansionary policy might be initiated at time t1 Expansionary policy starts taking effect sometime after output which is now tends to recover faster Sometimes due to expansionary policy the output expands very high and it causes the overshooting of employment It is observed between t2 and t3 By time t3 the restrictive policy is initiated and sometime after output starts turning down towards full employment and may well continue cycling for a while For stabilization one has to think whether it is worth trying to stabilize output or whether the effect of stabilization policy is in fact making things worse Stabilization policy may actually destabilize the economy It is important to understand that actions can be taken as disturbance has occurred and then the process by which that policy action affects economy There are delays or lags at every stage namely Inside lags and outside lags The inside lag is the time period which the policy takes to commence a policy action such as tax cut or an increase in the money supply The outside lag describes the timing of the effects of the policy action on the economy The inside lags are divided as recognizable decision and action lags 6151 The recognition lags It means the period that lapse between the time when disturbance occurs and the time the policy makers recognize that action is required The lag could be negative if the disturbance is predicted and appropriate policy actions considered before it even occurs For example during Diwali Christmas and in June the demand for credit is high During this season reserve bank increases the high power money Download free ebooks at bookbooncom 219 Advanced Macroeconomics international adjustments Policy implications 6152The decision and action lag It means the delay between the recognition of the need for action and the policy decision differs between monetary and scal policy Once the action is recognized the decision lag for monetary policy is short The action lag means the lag between policy decision and its implementation for monetary policy is also short At present decision lag for monetary policy is short and the action lags practically zero For scal policy once the action is recognized then administration has to prepare legislation for that action Both houses should see the bill They should discuss and pass or approve it If the bill is passed regarding taxes then it takes time to change the tax rates and see the pay checks It is an action lag in policy 61 53 Outside lags The outside lags are generally distributed lags once the policy action has taken its effects on the economy spread over time It is a small immediate effect of a policy action but the effect occurs later The impacts of lags are very small and it continues over a long period of time For example the expansionary monetary policy leads to spending and output increases It takes several quarters to see the change in output The lags are because aggregate demand depends on lagged values of income interest rates and other economic variables An open market purchase initially has effect mainly on interest rates and not on income The interest rates in turn affect investment with a lag and also affect consumption by affecting the value of wealth When aggregate demand is ultimately affected the increase in spending itself produce a series of induced adjustments in output and spending 61 54 Monetary and scal policy lags Fiscal policy lags are related to government spending It directly impacts on the aggregate demand It changes income more rapidly than the monetary policy It has short outside lags but it has longer inside lags Therefore long side lags in scal policy is less useful for stabilization and means that scal policy tends to be used relatively infrequently to try to stabilize the economy 61 55 Conclusion The above points highlight that undertaking short term policy actions takes time to set the policies in actions The policies themselves take time to affect the economy But it is not a problem The policy makers cannot be certain about the size and timing of the effects of policy actions 616 Gradualism vs shock therapy Gradualism attempts a slow and steady return to lower in ation Figure 613shows that small reduction in the money growth rate that shifts the aggregate demand curves down from DAD to DAD It helps to move economy a little way along the short run aggregate supply SAS from E to E1 In response to the lower in ation at E1 the short run aggregate supply curve shifts downward to SAS A further small cut in the money growth rate moves the economy to E2 The aggregate supply curve shifts down again and the process continuous Eventually output returns to its potential level at point E at a lower in ation rate There is no massive recession during the adjustment process although unemployment is above normal throughout Download free ebooks at bookbooncom 22f Please click the advert Advanced Macroeconomics lnternat onal adjustments Policy implications Figure 613 Reducing in ation through gradual method 10 In ation 39 Output The Agilent InfiniiVision X Series and 1000 Series offer affordable oscilloscopes for your labs Plus resources such as lab guides experiments and more to help enrich your curriculum and make your job easier BEIJIEIJH E u39l n 39 39luk 7653100 lth 39 r Elm g xgtrl len mj Manama I F1 rifr39lr39rima Agilent Technologies Inc 2012 us 18008294444 canada 18778944414 Anticipate Accelerate Achieve quot Agilent Technologies Download free ebooks at bookbooncom 220 Advanced Macroeconomics international adjustments Policy implications Figure 614 Reducing in ation through shock therapy SAS SAS39 10 DAD DAD L v Y Output 7Y In gure 614 shock therapy tries to cut the in ation rate fast The strategy starts with an immediate sharp cut back in money growth shifting the aggregate demand curve from DAD to DAD and moving the economy from E to E The immediate recession is larger than under gradualism By creating a larger fall in the in ation rate than the gradualist policy the shock therapy causes the short run supply curve to move down faster than it does The shock therapy keeps up the pressure by holding the rate of money growth low Eventually the rate of in ation falls enough that output and employment begin to grow again The economy returns to point E with full employment and lower rate in ation Figure 615 Difference of gradual and shock therapy methods to reduce in ation a Monetary growth b In ation c Output In the gradualism strategy the growth rate of money is initially reduced only slightly and economy never stays far from the natural rate of unemployment But the in ation rate comes down only slowly The shock therapy starts with massive cut in the growth rate of money and a large recession The recession is much worse than it ever is in the gradualist strategy but the reduction in in ation is more rapid Download free ebooks at bookbooncom 222 Advanced Macroeconomics international adjustments Policy implications 617 Credibility A credibility policy is one that the public believes will be kept up and will succeed A belief that policy has changed by itself will drive down the expected rate of in ation and for that reason because the short term Philips curve to shift down Thus credibility policies earn a credibility bonus in the ght against in ation The augmented aggregate supply curve is HHeiY Y 624 If the policy is credible people instantly adjust their expectations of in ation when a new lower money growth rate is adjusted to the short run aggregate supply curve therefore moves down immediately If policy is credible and if expectations are rational the economy can move immediately to new long run equilibrium when there is a change in policy 6171 Criticism There are a number of possibilities due to which it is not practical Firstly credibility may be very dif cult to obtain Secondly past contracts affect past expectations and the contract renegotiations take time This is because of in ationary inertia a rapid return to lower in ation in economies experiencing in ation rates in the 10 to 20 percent range is unlikely It is easiest to change the in ation rate when there are no long term contracts that embody the ongoing in ation negotiations are not signed because they will be gambling too much on the future behaviors of price level Long term nominal contracts disappear and wages and prices are frequently reset In these circumstances a credible policy will have rapids effects But such success cannot be expected in an economy in which the structure of contracts has not been destroyed by extreme in ation It remains true though whatever the structure of contracts the more credible a policy aims to disin ate the economy the more successful that policy will be Credibility is widely regarded around the world as the key to effective monetary policy because it guards against in ation scares and improves the exibility for monetary policy to stabilize employment over the business cycle Friend Marvin Good 2000 Questions Explain the government s budget constraints In ation tax reduces the in ation in economy Explain in detail What is the relationship of de cit and hyperin ation Explain the relationship of the budget de cit and public debt Write a note on the Laffer curve How can the de cit be nanced What is the mechanism for it Write a note on the debt management of government Explain the dynamics of debt and de cit PWNQP H P PE What is Borrow Ricardo problem 10 Write a note on the burden of debt What policies are required to get rid of this debt 11 Size of debt matters for an economy What is the role of welfare programs in government budget 12 Explain the merged bank fund model in detail Download free ebooks at bookbooncom 223 Please click the advert Advanced Macroeconomics 13 a b C d e f 14 15 a b C Write note on following Polak fund model Bank Model Gradualism Credibility Gradualism Credibility What is a rule versus discretion concept Explain Explain the following lags in detail Inside lags Outside lags Monetary and scal policy lags internationai adjustments Poiicy impiications 224 Download free ebooks at bookbooncom Advanced Macroeconomics References References Andrew BA amp Ben S Bernanke 2003 Macroeconomics Published by Dorling Kindersley India private limited Licensees of Pearson education in South Asia India Assar Lindbeck amp Dennis Snower 2002 The insideroutsider theory A survey Discussion paper no534 July 2002 IZA DPNO534 Germany Aizenman Joshua Yothin Iinjark ampDonghyun Park 2011 Capital ows and economic growth in the era of nancial integration and crisis 19902010 NBER working paper number 17502 October 2011 Bernhard Felderer amp Stefan Homburg 1992 Macroeconomics and new macro economics Second edition Springer Verlag Berlin Heidelberg 1992 Germany Blanchard Olivier Giovanni Dell Aricciaamp Paolo Mauro 2010 Rethinking macroeconomic Policy IMF staff position note February 12 2010 SPN102003 Bhattacharya Rudrani and IlaPatnaik Ajay Shah 2008 Early warning of in ation in India NIPFP working paper NIPFPDEA research program on capital ows and their consequences BarroRobert I 2001 Macroeconomics Fourth edition Massachusetts Institute of Technology USA Photo Disc Inc Chari VVand Patrick IKohoe 2006 Modern macroeconomics in practice how theory is shaping policy Federal Reserve Bank of Minneapolis Research Department staff report 376 August 2006 Chakraborty Pinaki 2005 Debt swap in a low interest rate regime unequal gains and future worries EPVV October 1 2005 PP43574362 Chakraborty Lekha S 2002 Fiscal de cit and rate of interest An econometric analysis of the deregulated nancial regime EPVV May 11 2002 PP18311838 Chikako Baba and Annamaria Kokenyne 2011 Effectiveness of capital controls in selected emerging markets in the 2000 s A working paper of IMF 11281 December 2011 Dornbush Rudiger Stanley Fisher Richard Startz 2008 Macro economics Nineth edition TataMcGraw Hill publishing company limited Delhi1 1032 DornbushRudiger and Stanley Fisher 1994 Macroeconomics sixth edition McGraw Hill publishing company limited USA Download free ebooks at bookbooncom 225 Advanced Macroeconomics References D souza Errol 2000 Macroeconomics Person education in South Asia First edition Elmendorf Douglas W N Gregory Mankiw 1998 Government debt Working paper 6470 National Bureau of Economic Research NBER Cambridge MA02138 March 1998 Eric Pentecost 2006 Macroeconomics An open economy approach Macmillan press ltd Hound mills Basingstoke Hampshire RG 21 6XS and London Friend Marvin Good 2000 How the world achieved consensus on monetary policy Journal of economic perspective vol21 November 4 2007 pp 4768 FurceriDavide Zdzienicka Aleksandra 2011 How costly are debt crisis IMF working paper number 11280 Gordon Robert I 1998 Macroeconomics Seventh edition Addison Wesley Longman INC United States IeanOlivier Blanchard and Stanley Fisher 2005 Lectures on Macroeconomics Prentice Hall of India private limited New Delhi110001 Iess Benhabib and Yiwen 2003 Indeterminacy aggregate demand and the real business cycle The working paper of Allied economics at New York university and the center for Analytical Economics at Cornell university March 2003 KapurMuneesh 2012 In ation forecasting Issues and challenges in India RBI working paper series WPS DEPR 12012 Department of economics and policy research Kopits George 2001 Fiscal policy rules for India EPW March 3 2001 PP 749756 Magud Nicolas E Carmen M Reinhart Esteban R Vesperoi 2011 Capital in ows exchange rate eXibility and credit booms NBER working paper 17670 Cambridge MA December 2011 Magud Nicolas E Reinhart Carmen Vesperoni Esteban 2012 Capital in ows exchange rate eXibility and credit booms IMF working paper number 1241 Mankiw NGergory Ricardo Reis 2002 What measure of in ation should a central bank target NBER working paper number 9375 December 2002 Pattanaik Sitikantha and GVNadhanael 2011 Why persistent high in ation impedes growth An empirical assessment of threshold level of in ation for India WPS DEPR172011 RBI working paper series September 2011 RBI 2012 Macroeconomic and monetary developments third quarter review January 23 2012 Richard T Froyen 2002 Macroeconomics Theories and policies Published by Dorling Kindersley India private limited Licensees of Pearson education in South Asia India Download free ebooks at bookbooncom 226 Please click the advert Advanced Macroeconomics References Sharma Somnath 2011 An empirical analysis of the relationship between currency futures and exchange rates volatility in India WPS DEPR 12011 RBI working paper series March 2011 Snowdon Brian and Howard RVane 2005 Modern macroeconomics its origin development and current state Edward Elgar publishing limited Northampton Massachusetts USA Subramaniam SN 2004 Macroeconomics and monetary developments in India Palak publications 2004 Mumbai India Tim Callen and Paul Cashin 1999 Assessing external sustainability in India IMF working paper 211999 Verma Radheshyam and AnandPrakash 2011 Sensitivity of capital ows to interest rate differentials An empirical assessment for India WPS DEPR 72011 RBI working paper series May 2011 L6 d o e Nidout nt a C Download free ebooks at bookbooncom 227 Advanced Macroeconomics Glossary Glossary A Absorption approach An approach to trade balance determination that emphasizes changes in domestic income and expenditure Action lag The period between the time a policy is decided and the time it is implemented Aggregate demand The sum of values of all the nal goods purchased in an economy Aggregate demand curve Relationship between the amount of goods and services people wish to purchase and the price level Aggregate supply curve Relationship between the amount of nal goods and services produced in an economy and the price level Aggregate supply and demand model The unique point that determines the equilibrium price level and output in economy Anticipated in ation In ation expected estimated by people in economy Appreciation The value of the domestic currency increases visavis other countries currency Arbitrage Buying and selling assets to take advantage difference in returns Augmented Philips curve Phillips curve that includes the in ationary expectations as a determinant of the in ation rate Automatic adjustment mechanism It is a mechanism that automatically acts to eliminate balance of payment problem B Balance of payment It is a measure of net ow of currency into the country from abroad Balance of payment de cit It means when more money is leaving the country than is entering it Balance of payment surplus It occurs when more money is entering the country than is leaving it Begger thy neighbor policy An attempt to increase domestic output at the expense of output of other countries Budget constraints The difference between the amount of money the government spends and the revenue that it receives in the form of taxes Download free ebooks at bookbooncom Advanced Macroeconomics Glossary Budget de cit The difference between the amount of money that government spends and the revenue earned through taxes Budget surplus It is the amount of taxes earned is more bythe government than spending in an economy Burden of debt Each individual share of the national debt Business cycle Pattern of expansion and contraction of the economy C Capital account Net ow of dollars into the economy resulting from the acquisition of domestic assets by foreigners Central bank The bank that control the money supply In India it is the Reserve Bank of India Classical adjustment process Process by which the economy automatically moves towards internal and external balance Classical aggregate supply curve Vertical AS curve shows output equals potential output Clean oating Flexible exchange rate in which the central bank does not intervene in foreign exchange markets Consumption function It is equation relating consumption to disposable income Credibility The degree to which the public believes that the government will implement its announced policies Crowding out Reduction in some component of aggregate demand usually investment that results from an increase in government spending Current account Net ow of currency into the country the country resulting from the sale of domestic goods and services and from net transfers from abroad D Debt income ratio Ratio of national debt to GDP Decision lag The period of time required to decide on the proper response to macroeconomic shocks De ation Rate at which the price the price level falls in percentage terms it is opposite of in ation Depreciation Rate at which the capital stock wears out Dirty oating The central bank in exible exchange rate system intervenes in foreign exchange markets in order to affect the short run value of its currency Download free ebooks at bookbooncom 229 Please click the advert Discount rate Interest rate charged by the central bank that borrows money from it Discrete lags The time that passes before an effect is felt Disposable income Income available for a household to spend total income less taxes plus transfers Distributed lags Time that passes while an effect gradually accumulates E Ef ciency wage model The wages might be set above the market clearing rate in order to motivate workers Endogenous growth Steady state growth determined within a particular model Excess reserves Reserves held by banks over and above the level required by the reserve bank Exchange rate The price of foreign currency pre unit of domestic currency Exchange rate overshooting It is a movement of the exchange rate past to its target It is an adjustment of exchange rates toward long run equilibrium is frequently accompanied by a move in the medium run of the exchange rate past its nal position l Tia l f a i our atic limit create efand creativity 39 39eyond expectations nest employees who can i into The Power of Knowledge Engineering us at wwwskfcomknowledge Download free ebooks at bookbooncom Advanced Macroeconomics Glossary Exogenous variables The variables which are determined outside a particular model Expected in ation rate The in ation expected in the future by workers and rms Expected real interest rate The real cost of borrowing or the real return on a deposit Expenditure reducing policies Policies aimed at offsetting the effects of expenditure switching policies Expenditure switching policies A policy aims at increasing purchases of domestic goods and increasing purchases of imported goods External balance It occurs when the balance of payments is neither in surplus nor in de cit when the current account and the capital account exactly offset each other F Face value The amount that a bond pays its holder on expiration The market value of a bond will equal its face value when the market interest rate is equal to the coupon rate on the bond Factors of production Inputs to production capital labor and natural resources are examples Fiscal policy Government policy with respect to government purchases transfer payments and the tax structure Fixed exchange rate system The exchange rate system which is decided by the central government and reserve bank and is managed through the exchange rate system Flexible exchange rate system In this system the exchange rate is allowed to uctuate with the forces of supply and demand Foreign exchange market intervention The sale and purchase of currency in foreign exchange market for the express purpose of increasing or decreasing the value of the domestic currency It is usually carried out by the central bank G Globalization It is movement where the world is moving towards a single global economy Government budget constraints A limit that says the government can nance its de cits only by selling bonds or by increasing the monetary base Government budget de cit Excess of government expenditure over government revenue Government expenditure Total government spending including both government purchases and transfers Government purchases It means government expenditure of money on several goods and services Download free ebooks at bookbooncom 231 Please click the advert Advanced Macroeconomics Glossary Gradualism It is a strategy of moving toward a desired target slowly Gross domestic product It is a measure of all nal goods and services produced in an economy during a period with all domestic owned factors of production Growth rate Rate at which a variable increases in value percentage change in the level of variables H High powered money Currency and banks deposits at the central bank It is also called as the monetary base Hyperin ation A rise in price level is above 1000 percent per year Hysteresis It occurs when temporary uctuations in one variable have permanent effects on another Indicators Economic variables that signal us to whether we are getting close to our desired targets In ation Percentage rate of increase in the general price level In ation taX Revenue gained by the government because of in ation s devaluation of money holding llillquot hiliill lll39r Tali Eu Are you considering a European busmess degree LEARlll BUSINESS at university level We le cases with cutting edge Copenhagen Busmess School HANDELSHEJSKOLEN MEE 39 T a culture of new foods musnc ENGAGE in extracurricular activities and tr 39 39 research working indeuaHy or in Lids513352 a newfway of such as case competitions Sports teams and ever on m a 53 9 Clean etc make n 39 Brin ba I l V e speaks English envnronment in the middle of 18 OO eW friends among CBS g CVa uable knowledge and Copenhagen Denmark 0 students from more than 80 experience to boost your career 39 countries39 ZX 3it i lion ofMBAs See what we look like and how we work on cbsdk Download free ebooks at bookbooncom 232 Advanced Macroeconomics Glossary Inside lag Revenue gained by the government because of in ation s devaluation of money holding Inside outside model Predicts that wages will remain above the market clearing level because those who are unemployed do not sit at the bargaining table Instruments The tools policymakers manipulate directly to affect the economy Internal balance It occurs when output equals potential output International trade It is an exchange of goods and services between countries Inventory cycle Response of inventory investment to changes in sales that causes further changes in aggregate demand Investment Purchase of new capital principally by the business sector IS curve It shows of the combinations of interest rate and the output in the goods market I curve effect It occurs when a currency depreciates the value of net exports rises temporarily and then falls K Keynesian aggregate supply curve It is a horizontal aggregate supply curve shows the relationship between price and output L Labor force It consists of people those are working and they are actively looking for work Liquidity A measure of the ability to make funds available on short notice Liquidity constraints Limitations on ability to make funds available on short notice Liquidity trap It is a horizontal LM curve due to extreme interest sensitivity of money demand LM curve It shows all of the combinations of the real interest rate and the level of output for which the demand for real money balances equals the supply of real money balances M M1 It is currency plus demand deposits M2 It is M1 plus small time and saving deposits overnight repurchases agreements Download free ebooks at bookbooncom 233 Advanced Macroeconomics Glossary Marginal propensity to consume Increase in consumption for each rupee increase in disposable income Marginal propensity to import The increase in the demand for imports that results from a one unit increase in domestic income Marginal propensity to save It is an increase in saving for each rupee increase in disposable income It is equal one minus the marginal propensity to consume Medium of exchange It is one of the roles of money and the assets used to make payments Monetary approach to balance of payment It is emphasizes monetary causes of balance of payments problem Money It is an asset which is used for making immediate payment Money multiplier Ratio of money stock to the monetary base Mundell Fleming model It explores economy with exible exchange rates and perfect capital mobility N National income It is a total payment to factors of production net national product minus indirect taxes Net national product It is GDP minus allowance for depreciation of capital Net exports Exports minus imports Net present value The amount today that is equivalent to a future payment the amount of money that invested at the market interest rate would generate that amount of money Nominal exchange rate The price of one currency in terms of another Nominal interest rateIt is expressed as the payment in current rupee on a loan or other investment in terms of an annual percentage Nominal money supply Nominal value of bills and coins in circulation says nothing about the amount that these bills and coins can purchase 0 Open economy The economy that trades the goods assets and services to other countries Open market operation Reserve bank purchases and sell the treasury bills in exchange of money Download free ebooks at bookbooncom 234 Advanced Macroeconomics Glossary Open market sale It is an operation in which the reserve bank buys government bonds on the secondary market Opportunity cost It is a forgone thing to take an action Outside lags It is a time required for a policy change to take effect P Pegged the interest rate It is a practice of using monetary policy to keep the interest rate near a target level Perfect capital mobility The capital is mobile when it has the ability to move instantly and with a minimum of transactions costs across national borders in search of the highest returns Perfect anticipated in ation When people have perfect foresight with regards to the in ation rate Permanent income theory People for expectations of their future income and choose how much to consume based on those as well as their current income Personnel or personal saving It is an income saved by individuals or families Philips Curve Relation between in ation and unemployment in a sense a dynamic version of the aggregate supply curve Precautionary motive The reason for which people hold moneypeople do not know how much they require for future contingency Price stickiness The prices are unable to adjust quickly enough to keep markets in equilibrium Production function It is a technological relation showing how much output can be produced for a given combinations of inputs Purchasing power parity It is an exchange rate adjusts to maintain equal purchasing power of foreign and domestic currency Q Quantity theory of money It is a theory of money demand emphasizing the relation of nominal income to nominal money R Rational expectations The theory of expectations formation in which expectations are based on available information about the underlying economic variable Real business cycle theory It is a theory that recessions and booms are due primarily to shocks in real activity such as supply shocks rather than to changes in monetary factors Download free ebooks at bookbooncom 235 Please click the advert Advanced Macroeconomics Glossary Real devaluation It means a decline in the purchasing power of the rupee relative to other currencies Real exchange rate It is a purchasing power of foreign currency relative to rupee Real GDP It is a measure of output which adjusts the value of nal goods and services to re ect changes in the price level Real interest rate Return on investment measured in rupees of constant value It is roughly equal to the difference between the nominal interest rate and the rate of in ation Recognition lag The period between the time a disturbance occurs and the time policy makers discover the disturbance Reservation wage It is a lowest wage which individual is willing to accept a job If the wage is lower than the reservation wage then he she will return it down Reserve ratio It is a ratio of bank reserves to bank deposits a primary determinant of the money multiplier Reserves It is a deposit which central bank keeps with itself instead of lending it Revaluation It is an increase in value of the domestic currency relative to the currencies of other countries Ricardian equivalence When there is no difference between taxes and the accumulation of debt is thought to be the same as future taxes The financial industry needs a strong software platform That39s why we need you Find your next challenge at wwwsimcorpcomcareers wwwsimcorpcom MITIGATE RISK I REDUCE COST I ENABLE GROWTH SimCorp Download free ebooks at bookbooncom 236 Advanced Macroeconomics Glossary Rules versus discretion It is an issue whether or not the central bank and government should conduct their policy in accordance with preannounced rules S Saving The money not spent on the daily needs Seigniorage It means the revenue derived from the government s ability to print money Short run It is a period of time short enough that markets are unable to clear therefore output cannot be derived from the potential output Speculative motive It means a people hold money although the return on holding money is small people hold it because it reduces the risk associated with their portfolio assets Stag ation It means simultaneous in ation and recession Standard of deferred payment The assets which are normally used for making payments due at a later date Stock variable A variable that is measured in levels rather than rates of change Store of value It is assets that maintain its value over time Supply shocks It is an economic disturbance whose rst impact is a shift in the aggregate supply curve T Targets It is identi ed goals of policy Total factor productivity The rate at which productivity of inputs increases it is measure of technological progress Trade balance The net ow of rupee into the country due to sales of goods abroad Transactions motive It is a reason people hold money and they use it to purchase goods and services Transfer payment The money given by the government to people They are the welfare payment such as entitlement program U Unemployment gap It means the difference between the actual unemployment rate and the natural rate Unit of account It is an asset in which prices are denoted Download free ebooks at bookbooncom 237 Please click the advert Advanced Macroeconomics Glossary Unstable equilibrium It pushes nearby variables away from itself if a variable is moved slightly away from the unstable equilibrium It forces will push it even further away V Velocity of money It means the number of times the typical rupee changes hands during the year W Wage stickiness When wages are unable to adjust quickly enough to clear the labor market Y Yield curve It shows the change in interest rate as the bonds maturities increase mm iqgmupmuumc 1 tin guruu 5 El l 39i 39 1395va lll39 238 BUSINESS ECONOMICS CEC2 532751 amp 761 PRACTICE MACROECONOMICS MULTIPLE CHOICE QUESTIONS Warning These questions have been posted to give you an opportunity to practice with the multiple choice format of questioning and to help you review and understand more deeply the material taught In no way should you assume that the level of di iculty of the multiple choice questions shown here is the same as that of the questions to be given in the exam 1 Expansionary monetary policy a tends to lead to an appreciation of a nation39s currency b usually has no effect on a currency39s exchange value c tends to lead to a depreciation of the currencies of other nations d tends to lead to a depreciation of a nation39s currency 2 If the number of people classified as unemployed is 20000 and the number of people classified as employed is 230000 what is the unemployment rate a 8 b 87 c 92 d 115 3 It is often true that as the economy begins to recover from a recession the unemployment rate rises Which of the following statements would be the best explanation for this a The unemployment rate would rise because as the economy initially recovers from a recession the demand for goods and services falls so the demand for workers falls b As the economy begins to recover from a recession workers who were previously discouraged about their chances of finding a job begin to look for work again c The unemployment rate seems to rise as the economy begins to recover from a recession because of errors in the way the data are collected d As the economy initially recovers from a recession firms do not immediately increase the number of workers they hire Firms wait to hire more individuals until they are convinced that the recovery is strong 4 If an individual who cannot find a job because his or her job skills have become obsolete this is an example of a frictional unemployment b structural unemployment c cyclical unemployment d seasonal unemployment 5 The natural rate of unemployment is generally thought of as the a ratio of the frictional unemployment rate to the cyclical unemployment rate b sum of structural unemployment and cyclical unemployment c sum of frictional unemployment and cyclical unemployment d sum of frictional unemployment and structural unemployment 6 Firms react to unplanned increases in inventories by a reducing output b increasing output c increasing planned investment d increasing consumption 7 The ratio of the change in the equilibrium level of income to a change in some autonomous increase in spending is the a elasticity coefficient b multiplier c automatic stabilizer d marginal propensity of the autonomous variable 8 Banks can create money a only by illegally printing additional dollar bills b by paying interest to their depositors c by making loans that result in additional deposits d by offering financial services such as stick market brokerage 9 A bank has excess reserves to lend but is unable to find anyone to borrow the money This Will the size of the money multiplier a reduce b increase c have no effect on d double 10 Which of the following represents an action by the Bank of Canada that is designed to decrease the money supply a an increase in federal tax rates b selling government securities in the open market c a decrease in the Bank rate d a transfer of government funds from the Bank of Canada to private banks 11 If the interest rate falls then a bond prices Will remain the same b bond prices Will rise c bond prices Will fall 12 If the quantity of money demanded is less than the quantity of money supplied then the interest rate Will a either increase or decrease depending on the amount of excess demand b increase c decrease d not change 13 Which of the following events Will definitely lead to an increase in the equilibrium interest rate a a decrease in the level of output real GDP b the purchase of government securities by the Bank of Canada c an increase in the level of output real GDP and an increase in the money supply d the sale of government securities by the Bank of Canada 14 If the Bank of Canada reduces the money supply to reduce in ation a exible exchange rate will aid the Bank of Canada in fighting in ation because a as the money supply is decreased the interest rate will increase and the exchange rate will rise causing Canadian exports to fall and Canadian imports to rise b as the money supply is decreased the interest rate will increase and the exchange rate will rise causing Canadian exports to rise and Canadian imports to fall c as the money supply is decreased the interest rate will increase and the exchange rate will fall causing Canadian exports to fall and Canadian imports to rise d as the money supply is decreased the interest rate will increase and the exchange rate will fall causing Canadian exports to rise and Canadian imports to fall 15 When economists refer to quottightquot monetary policy they mean that the Bank of Canada is taking actions that will a increase the demand for money b decrease the demand for money c expand the supply of money d contract the supply of money 16 An increase in total production real GDP causes the demand for money to and the interest rate to a increase increase b increase decrease c decrease decrease d decrease increase 17 Which of the following actions is an example of expansionary fiscal policy a a decrease in welfare payments b a purchase of government securities in the open market c a decrease in the Bank rate d a decrease in the corporate profits tax rates 18 The main cause of cyclical unemployment is that a firms engage in race gender and sex discrimination in their hiring practices b some individuals do not have marketable job skills c the level of overall economic activity uctuates d workers often voluntarily quit a job to look for a better job 19 The aggregate demand AE curve would shift down if a government spending were increased b taxes were increased c the money supply were increased d the interest rate decreased 20 As the economy nears full capacity the shortrun aggregate supply curve a becomes atter b becomes steeper c shifts to the right d shifts to the left 21 If the economy is operating at potential GDP an increase in the money supply will lead to a stag ation b structural in ation c demandside in ation d supplyside in ation 22 The sale of government securities by the Bank of Canada is predicted to a decrease reserves of the chartered banks and eventually lead to an expansion of the money supply b decrease reserves of the chartered banks and eventually cause a contraction of the money supply c increase reserves of the chartered banks and eventually cause a contraction of the money supply d increase reserves of the chartered banks and eventually cause an expansion of the money supply e none of the above 23 To lower interest rates the Bank of Canada could a buy securities b decrease the chartered banks39 reserves c decrease the money supply d raise the treasury bill rate e raise the reserve requirement 24 Suppose a Canadian firm imports 1000 worth of bananas and sells them for 2000 The effect on GDP would be a to decrease the value of GDP by 3000 b to increase the value of GDP by 3000 c to increase the value of GDP by 2000 d to increase the value of GDP by 1000 e no effect on GDP since the bananas were produced outside Canada 25 An increase in the MPS Will cause other factors remaining constant a a parallel shift up in the AEfunction and a parallel shift up in the Lfunction b a rotational shift up in the AEfunction and a rotational shift up in the Lfunction c a parallel shift down in the AEfunction and a rotational shift up in the Lfunction d a rotational shift down in the AEfunction and a rotational shift up in the Lfunction e a rotational shift down in the ASfunction and a rotational shift up in the Lfunction ANSERS To QUESTIONS 1 d 2 a 3 b 4 b 5 d 6 a 7 b 8 c 9 a 10 b 11 b 12 c 13 d 14 a 15 d 16 a 17 d 18 c 19 b 20 b 21 c 22 b 23 a 24 d d BUSINESS ECONOMICS CEC2 532751 amp 761 PRACTICE MACROECONOMICS MULTIPLE CHOICE QUESTIONS Warning These questions have been posted to give you an opportunity to practice with the multiple choice format of questioning and to help you review and understand more deeply the material taught In no way should you assume that the level of di iculty of the multiple choice questions shown here is the same as that of the questions to be given in the exam 1 Expansionary monetary policy a tends to lead to an appreciation of a nation39s currency b usually has no effect on a currency39s exchange value c tends to lead to a depreciation of the currencies of other nations d tends to lead to a depreciation of a nation39s currency 2 If the number of people classified as unemployed is 20000 and the number of people classified as employed is 230000 what is the unemployment rate a 8 b 87 c 92 d 115 3 It is often true that as the economy begins to recover from a recession the unemployment rate rises Which of the following statements would be the best explanation for this a The unemployment rate would rise because as the economy initially recovers from a recession the demand for goods and services falls so the demand for workers falls b As the economy begins to recover from a recession workers who were previously discouraged about their chances of finding a job begin to look for work again c The unemployment rate seems to rise as the economy begins to recover from a recession because of errors in the way the data are collected d As the economy initially recovers from a recession firms do not immediately increase the number of workers they hire Firms wait to hire more individuals until they are convinced that the recovery is strong 4 If an individual who cannot find a job because his or her job skills have become obsolete this is an example of a frictional unemployment b structural unemployment c cyclical unemployment d seasonal unemployment 5 The natural rate of unemployment is generally thought of as the a ratio of the frictional unemployment rate to the cyclical unemployment rate b sum of structural unemployment and cyclical unemployment c sum of frictional unemployment and cyclical unemployment d sum of frictional unemployment and structural unemployment 6 Firms react to unplanned increases in inventories by a reducing output b increasing output c increasing planned investment d increasing consumption 7 The ratio of the change in the equilibrium level of income to a change in some autonomous increase in spending is the a elasticity coefficient b multiplier c automatic stabilizer d marginal propensity of the autonomous variable 8 Banks can create money a only by illegally printing additional dollar bills b by paying interest to their depositors c by making loans that result in additional deposits d by offering financial services such as stick market brokerage 9 A bank has excess reserves to lend but is unable to find anyone to borrow the money This Will the size of the money multiplier a reduce b increase c have no effect on d double 10 Which of the following represents an action by the Bank of Canada that is designed to decrease the money supply a an increase in federal tax rates b selling government securities in the open market c a decrease in the Bank rate d a transfer of government funds from the Bank of Canada to private banks 11 If the interest rate falls then a bond prices Will remain the same b bond prices Will rise c bond prices Will fall 12 If the quantity of money demanded is less than the quantity of money supplied then the interest rate Will a either increase or decrease depending on the amount of excess demand b increase c decrease d not change 13 Which of the following events Will definitely lead to an increase in the equilibrium interest rate a a decrease in the level of output real GDP b the purchase of government securities by the Bank of Canada c an increase in the level of output real GDP and an increase in the money supply d the sale of government securities by the Bank of Canada 14 If the Bank of Canada reduces the money supply to reduce in ation a exible exchange rate will aid the Bank of Canada in fighting in ation because a as the money supply is decreased the interest rate will increase and the exchange rate will rise causing Canadian exports to fall and Canadian imports to rise b as the money supply is decreased the interest rate will increase and the exchange rate will rise causing Canadian exports to rise and Canadian imports to fall c as the money supply is decreased the interest rate will increase and the exchange rate will fall causing Canadian exports to fall and Canadian imports to rise d as the money supply is decreased the interest rate will increase and the exchange rate will fall causing Canadian exports to rise and Canadian imports to fall 15 When economists refer to quottightquot monetary policy they mean that the Bank of Canada is taking actions that will a increase the demand for money b decrease the demand for money c expand the supply of money d contract the supply of money 16 An increase in total production real GDP causes the demand for money to and the interest rate to a increase increase b increase decrease c decrease decrease d decrease increase 17 Which of the following actions is an example of expansionary fiscal policy a a decrease in welfare payments b a purchase of government securities in the open market c a decrease in the Bank rate d a decrease in the corporate profits tax rates 18 The main cause of cyclical unemployment is that a firms engage in race gender and sex discrimination in their hiring practices b some individuals do not have marketable job skills c the level of overall economic activity uctuates d workers often voluntarily quit a job to look for a better job 19 The aggregate demand AE curve would shift down if a government spending were increased b taxes were increased c the money supply were increased d the interest rate decreased 20 As the economy nears full capacity the shortrun aggregate supply curve a becomes atter b becomes steeper c shifts to the right d shifts to the left 21 If the economy is operating at potential GDP an increase in the money supply will lead to a stag ation b structural in ation c demandside in ation d supplyside in ation 22 The sale of government securities by the Bank of Canada is predicted to a decrease reserves of the chartered banks and eventually lead to an expansion of the money supply b decrease reserves of the chartered banks and eventually cause a contraction of the money supply c increase reserves of the chartered banks and eventually cause a contraction of the money supply d increase reserves of the chartered banks and eventually cause an expansion of the money supply e none of the above 23 To lower interest rates the Bank of Canada could a buy securities b decrease the chartered banks39 reserves c decrease the money supply d raise the treasury bill rate e raise the reserve requirement 24 Suppose a Canadian firm imports 1000 worth of bananas and sells them for 2000 The effect on GDP would be a to decrease the value of GDP by 3000 b to increase the value of GDP by 3000 c to increase the value of GDP by 2000 d to increase the value of GDP by 1000 e no effect on GDP since the bananas were produced outside Canada 25 An increase in the MPS Will cause other factors remaining constant a a parallel shift up in the AEfunction and a parallel shift up in the Lfunction b a rotational shift up in the AEfunction and a rotational shift up in the Lfunction c a parallel shift down in the AEfunction and a rotational shift up in the Lfunction d a rotational shift down in the AEfunction and a rotational shift up in the Lfunction e a rotational shift down in the ASfunction and a rotational shift up in the Lfunction ANSERS To QUESTIONS 1 d 2 a 3 b 4 b 5 d 6 a 7 b 8 c 9 a 10 b 11 b 12 c 13 d 14 a 15 d 16 a 17 d 18 c 19 b 20 b 21 c 22 b 23 a 24 d d International Economics midsem Chapter 9 The Political Economy of Trade Policy 91 The Case for Free Trade 1 The efficiency case made for free trade is that as trade distortions such as tariffs are dismantled and removed A government tariff revenue will decrease and therefore national economic welfare will decrease B government tariff revenue will decrease and therefore national economic welfare will increase C deadweight losses for producers and consumers will decrease hence increasing national economic welfare D deadweight losses for producers and consumers will decrease hence decreasing national economic welfare E None of the above Answer C Question Status Previous Edition 2 The opportunity to exploit economies of scale is one of the gains to be made from removing tariffs and other trade distortions These gains will be found by a decrease in A world prices of imports B the consumption distortion loss triangle C the production distortion loss triangle D Both B and C E None of the above Answer E Question Status Previous Edition 3 Judging by the changes in the height of tariff rates in major trading countries the world has been experiencing a great A trade liberalization B surge of protectionism C lack of progress in the tradepolicy area D move towards regional integration E None of the above Answer A Question Status Previous Edition 4 The World Trade Organization WTO was organized as a successor to the A IMF B UN C UNCTAD D GATT E the World Bank Answer D Question Status Previous Edition 5 The WTO was established by the of multilateral trade negotiations A Kennedy Round B Tokyo Round C Uruguay Round D Dillon Round E None of the above Answer C Question Status Previous Edition 6 The SmootHawley Tariff Act of 1930 has generally been associated with A falling tariffs B free trade C intensifying the worldwide depression D recovery from the worldwide depression E nontariff barriers Answer C Question Status Previous Edition 7 A trade policy designed to alleviate some domestic economic problem by exporting it to foreign countries is know as an A international dumping policy B countervailing tariff policy C beggar thy neighbor policy D trade adjustment assistance policy E None of the above Answer C Question Status Previous Edition 8 Trade theory suggests that Japan would gain from a subsidy the United States provides its grain farmers if the gains to Japanese consumers of wheat products more than offsets the losses to Japanese wheat farmers This would occur as long as Japan A is a net importer in bilateral trade flows with the United States B is a net importer of wheat C has a comparative advantage in wheat D has an absolute advantage in producing wheat E None of the above Answer B Question Status Previous Edition 9 The World Trade Organization provides for all of the following except A the usage of the most favored nation clause B assistance in the settlement of trade disagreements C bilateral tariff reductions D multilateral tariff reductions E None of the above Answer C Question Status Previous Edition 10 Which organization determines procedures for the settlement of international trade disputes A World Bank B World Trade Organization C International Monetary Organization D International Bank for Reconstruction and Development E The League of Nations Answer B Question Status Previous Edition 11 The WTO39s intervention against clean air standards A has earned it universal approval B was done in order to limit national sovereignty C has resulted in much criticism D has resulted in much criticism among professional economists E None of the above Answer C Question Status Previous Edition 12 It is argued that the United States would be foolish to maintain a freetrade stance in a world in which all other countries exploit child or prisoner labor or are protectionist On the other hand Ricardo39s classic demonstration of the sources and effects of comparative advantage cogently demonstrates that regardless of other country policy free trade remains the first best policy for a country to follow since it will maximize its consumption possibilities conditional upon other country policies Explain Discuss the contradiction with the argument in the preceding paragraph Answer In the context of the Ricardian model it is true that gains from trade are strictly a result of world terms of trade which differ from domestic marginal rates of substitution In such a world the reason why foreign goods are cheap is of no concern to domestic consumers However in a world which allows for largescale labor migration ignoring labor conditions abroad may ultimately result in living standards for domestic workers to be dragged down Question Status Previous Edition 92 National Welfare Arguments Against Free Trade 1 The optimum tari is A the best tariff a country can obtain via a WTO negotiated round of compromises B the tariff which maximizes the terms of trade gains C the tariff which maximizes the difference between terms of trade gains and terms of trade loses D not practical for a small country due to the likelihood of retaliation E not practical for a large country due to the likelihood of retaliation Answer E Question Status Previous Edition 2 The optimum tari is most likely to apply to A a small tariff imposed by a small country B a small tariff imposed by a large country C a large tariff imposed by a small country D a large tariff imposed by a large country E None of the above Answer B Question Status Previous Edition 3 The prohibitive tari is a tariff that A is so high that it eliminates imports B is so high that it causes undue harm to tradepartner economies C is so high that it causes undue harm to import competing sectors D is so low that the government prohibits its use since it would lose an important revenue source E None of the above Answer A Question Status Previous Edition 4 The existence of marginal social benefits which are not marginal benefits for the industry producing the import substitutes A is an argument supporting free trade and nongovernmental involvement B is an argument supporting the use of an optimum tariff C is an argument supporting the use of market failures as a tradepolicy strategy D is an argument rejecting free trade and supporting governmental involvement E None of the above Answer D Question Status Previous Edition 5 The domestic market failure argument is a particular case of the theory of A the optimum or firstbest B the second best C the third best D the su icing principle E None of the above Answer B Question Status Previous Edition 6 The difficulty of ascertaining the right secondbest trade policy to follow A reinforces support for the thirdbest policy approach B reinforces support for increasing research capabilities of government agencies C reinforces support for abandoning trade policy as an option D reinforces support for freetrade options E None of the above Answer D Question Status Previous Edition 7 The reason protectionism remains strong in the United States is that A economists can produce any result they are hired to produce B economists cannot persuade the general public that free trade is beneficial C economists do not really understand how the real world works D the losses associated with protectionism are diffuse making lobbying by the public impractical E None of the above Answer D Question Status Previous Edition 8 The United States appears at times to have a totally schizophrenic attitude toward protectionism The United States was the country that proposed the establishment of the World Trade Organization as early as the late 1940s and was also the only industrialized country that refused to ratify this at that time The United States has consistently argued on the side of multinational free trade in GATT Rounds and yet maintains many protectionist laws such as those which reserve oil shipments from Alaska to US flag carriers How can you explain this apparent lack of national consistency on this issue Answer This reflects the fact that international trade typically has many winners and relatively fewer but politically powerful losers Short of guaranteed constitutional nonconditional compensatory mechanisms the basic conflict between these two groups will always be there Question Status Previous Edition Hungarian Market 16 14 12 1O 8 M00 nc subsidy e 4 MC1 subsidy 2 MR Million 2 4 6 8 1O 12 14 16 Assume that Boeing US and Airbus European Union both wish to enter the Hungarian market with the next new generation airliner They both have identical cost and demand conditions as indicated in the graph above 9 Refer to above figure Assume that Boeing is the first to enter the Hungarian market Without a government subsidy what price would they demand and what would be their total profits Answer 12 Million 16 Question Status Previous Edition 10 Refer to above figure What is the consumer surplus enjoyed by Hungarian consumers of Boeing aircraft in the situation Answer 8 Million Question Status Previous Edition 11 Refer to above figure Suppose the European government provides Airbus with a subsidy of 4 for each airplane sold and that the subsidy convinces Boeing to exit the Hungarian market Now Airbus would be the monopolist in this market What price would they charge and what would be their total profits Answer 10 Million and 36 Million Question Status Previous Edition 12 Refer to above figure What would be the cost of the subsidy to European taxpayers Answer 24 Million Question Status Previous Edition 13 Refer to above figure What happens to the Consumer Surplus of Hungarian customers as a result of this subsidy Answer An increase of 10 Million Question Status Previous Edition 14 Refer to above figure What is the revenue gain or loss for Europe as a whole including taxpayers Answer A gain of 12 Million Question Status Previous Edition 93 Income Distribution and Trade Policy 1 It is argued that special interest groups are likely to take over and promote protectionist policies which may lead to a decrease in national economic welfare This argument leads to A a presumption that in practice a free trade policy is likely to be better than alternatives B a presumption that trade policy should be shifted to NonGovernmental Organizations so as to limit taxpayer burden C a presumption that free trade is generally a secondbest policy to be avoided if feasible alternatives are available D a presumption that free trade is the likely equilibrium solution if the government allows special interest groups to dictate its trade policy E None of the above Answer A Question Status Previous Edition 2 The authors of the text believe that A secondbest policy is worse than optimal policy B special interest groups generally enhance national welfare C national welfare is likely to be enhanced by the imposition of an optimal tariff D market Failure arguments tend to support freetrade policy E there is no such thing as national welfare Answer E Question Status Previous Edition 3 The median voter model A works well in the area of trade policy B is not intuitively reasonable C tends to result in biased tariff rates D does not work well in the area of trade policy E None of the above Answer D Question Status Previous Edition 4 The fact that trade policy often imposes harm on large numbers of people and benefits only a few may be explained by A the lack of political involvement of the public B the power of advertisement C the problem of collective action D the basic impossibility of the democratic system to reach a fair solution E None of the above Answer C Question Status Previous Edition 5 Protectionism tends to be concentrated in two sectors A agriculture and clothing B high tech and national security sensitive industries C capital and skill intensive industries D industries concentrated in the South and in the Midwest of the country E None of the above Answer A Question Status Previous Edition 6 Export embargoes cause greater losses to consumer surplus in the target country A the lesser its initial dependence on foreign produced goods B the more elastic is the target country39s demand schedule C the more elastic is the target country39s domestic supply D the more inelastic the target country39s supply E None of the above Answer D Question Status Previous Edition 7 The strongest political pressure for a trade policy that results in higher protectionism comes from A domestic workers lobbying for import restrictions B domestic workers lobbying for export restrictions C domestic workers lobbying for free trade D domestic consumers lobbying for export restrictions E domestic consumers lobbying for import restrictions Answer A Question Status Previous Edition 8 The average tariff rate to data on dutiable imports in the United States is approximately A 5 of the value of imports B 15 of the value of imports C 20 of the value of imports D 25 of the value of imports E more than 25 of the value of imports Answer A Question Status Previous Edition 9 In 1990 the United States imposed trade embargoes on Iraq39s international trade This would induce smaller losses in Iraq39s consumer surplus the A less elastic Iraq39s demand schedule B more elastic Iraq39s demand schedule C greater is Iraq39s dependence on foreign products D more inelastic is Iraq39s supply schedule E None of the above Answer B Question Status Previous Edition 10 Today US protectionism is concentrated in A high tech industries B laborintensive industries C industries in which Japan has a comparative advantage D computer intensive industries E capitalintensive industries Answer B Question Status Previous Edition 11 The quantitative importance of US protection of the domestic clothing industry is best explained by the fact that A this industry is an important employer of highly skilled labor B this industry is an important employer of low skilled labor C most of the exporters of clothing into the US are poor countries D this industry is a politically well organized sector in the US E None of the above Answer D Question Status Previous Edition 12 It may be demonstrated that any protectionist policy which effectively shifts real resources to import competing industries or sectors will harm export industries or sectors This may for example happen by the strengthening US dollar in the foreign exchange market Would you propose therefore that export industries lobby against protectionism in International Trade Commission proceedings What of consumer advocates Discuss the pros and the problems of such a suggestion Answer Actually this is an interesting idea It is well known that the public interest is put on hold as the ITC considers only the squeaky wheels of those allegedly hurt by trade While quotconsumersquot may be too amorphous a group to successfully organize and pursue a political agenda the exporters and consumer advocates may be able to form a counter weight to the import competing industries Question Status Previous Edition 94 International Negotiations and Trade Policy 1 The simple model of competition among political parties long used by political scientists tends to lead to the practical solution of selecting the A optimal tariff B prohibitive tariff C zero freetrade tariff D the tariff rate favored by the median voter E None of the above Answer D Question Status Previous Edition 2 The General Agreement on Tariffs and Trade and the World Trade Organization have resulted in A termination of export subsidies applied to manufactured goods B termination of import tariffs applied to manufactures C termination of import tariffs applied to agricultural commodities D termination of international theft of copyrights E None of the above Answer E Question Status Previous Edition 3 The General Agreement on Tariffs and Trade and the World Trade Organization have resulted in A the establishment of universal trade adjustment assistance policies B the establishment of the European Union C the reciprocal trade clause D reductions in trade barriers via multilateral negotiations E None of the above Answer D Question Status Previous Edition 4 Countervailing duties are intended to neutralize any unfair advantage that foreign exporters might gain because of foreign A tariffs B subsidies C quotas D LocalContent legislation E None of the above Answer B Question Status Previous Edition 5 In 1980 the United States announced an embargo on grain exports to the Soviet Union in response to the Soviet invasion of Afghanistan This embargo was mainly resisted by A US grain consumers of bread B US grain producers C foreign grain producers D US communists E None of the above Answer B Question Status Previous Edition 6 Under US commercial policy the escape clause results in A temporary quotas granted to firms injured by import competition B tariffs that offset export subsidies granted to foreign producers C a refusal of the US to extradite anyone who escaped political oppression D tax advantages extended to minorityowned exporting firms E tariff advantages extended to certain Caribbean countries in the US market Answer A Question Status Previous Edition 7 Under US commercial policy which clause permits the modification of a trade liberalization agreement on a temporary basis if serious injury occurs to domestic producers as a result of the agreement A adjustment assistance clause B escape clause C most favored nation clause D prohibitive tariff clause E None of the above Answer B Question Status Previous Edition 8 An issue never confronted effectively by GATT but considered an important issue for WTO is that of A the promotion of freer World trade B the promotion of freer World commodity trade C the promotion of freer World services trade D the lowering of tariff rates E None of the above Answer C Question Status Previous Edition 9 The political wisdom of choosing a tariff acceptable to the median US voter is A a good example of the principle of the second best B a good example of the way in which actual tariff policies are determined C a good example of the principle of political negotiation D not evident in actual tariff determination E None of the above Answer D Question Status Previous Edition 10 A gametheory explanation of the paradox that even though all countries would benefit if each chose free trade in fact each tends to follow protectionist policies is A trade war B collective action C prisoner39s dilemma D benefitcost analysis E None of the above Answer C Question Status Previous Edition 11 When the US placed tariffs on French wine France placed high tariffs on US chickens This is an example of A deadweight losses B multilateral negotiations C bilateral trade negotiations D international market failures E None of the above Answer E Question Status Previous Edition 12 Presumably since the United States is a large country in many of its international markets a positive optimum tariff exists for this country It follows therefore that when any legislator or government official who promotes zerotariff free trade policies is by definition not acting in the public39s best interest Discuss Answer Technically this is true However this is true only within the context of a generally myopic view of international relations If the tariff imposing country is large enough to make a substantial difference in its welfare by seeking an optimum tariff then it cannot hope to remain invisible as its policies are substantially harming its trade partners Foreign repercussions are almost a certainty In such a quotgamequot it is not at all certain that seeking the optimum tariff dominates alternative strategies Question Status Previous Edition 13 It has been claimed that foreign governments have attempted to influence votes in the US that would promote policies of protectionism within the US On the surface this appears to be totally illogical and counter intuitive as this would presumably lessen the possibilities of foreigners39 exports to the US Answer This would make sense only if the form of protectionism is a tariff However if it is a quota then the scarcity rents may be captured by established foreign producers Hence the reaction of the Japanese to automobile quotas was to dramatically increase the highend highly profitable automobiles This would be even more selfevident if the protectionism took the form of a Voluntary Export Restraint VER or a detailed formalized bilateral cartel such as the old MultiFibre Agreement Question Status Previous Edition 10 14 The US producer Boeing and the European Airbus are contemplating the next generation midsized fuel efficient generation of air carrier If both produce their respective models then each would lose 50 million because the world market is just not large enough to enable either to capture potential scale economies if they had to share the world market If neither produce then each one39s net gain would of course be zero If either one produces while the other does not then the producer will gain 500 million a What is the correct strategy for either company b What is the correct strategy for a government seeking to maximize national economic welfare c If a national government decides to subsidize its aircraft producer how high should be the subsidy Answer a enter the market first Then the other company knows that if it also enters it will not be able to cover costs b Subsidize its producer If this allows it to enter first then we get the same solution as answer a above c Any figure above 50 million e g 55 million This would promise positive profits regardless of the decision of the competitor The quotwinnerquot then may turn out to be that country whose voters are least sensitive to onthebooks transparent subsidies given to rich corporations these subsidies will have to continue year after year until the other country stops its subsidies Question Status Previous Edition 15 In recent cases the US placed quotas or protectionist tariffs on imported steel and imported microchips In both cases the damage to quotdownstreamquot industries was obvious to all and relatively easy to quantify and demonstrate Assuming that the US lawmakers are not plain dumb why did they enact these protectionist policies Answer The system by which these protectionist policies are set into law is biased in favor of the producers of import competitive goods Other sectors of the economy that may be affected are not parties in the petitions made to the ITC seeking redress Question Status Previous Edition 95 The Doha Disappointment 1 For most developing countries A productivity is high among domestic workers B population growth and illiteracy rates are low C saving and investment levels are high D agricultural goods and raw materials constitute a high proportion of domestic output E None of the above Answer D Question Status Previous Edition 2 Developing countries have often attempted to establish cartels so as to counter the actual or perceived inexorable downward push on the prices of their exported commodities OPEC is the best well known of these How are such cartels expected to help the developing countries At times importing countries profess support for such schemes Can you think of any logical basis for such support How are cartels like monopolies and how are they different from monopolies Why is there a presupposition among economists that such schemes are not likely to succeed in the long run Answer Such cartels are expected to shift the exporters39 terms of trade in their favor Also they are expected to produce the maximum profit which the market will bear Importing countries may benefit from the price stability generated by the cartel Cartels are like monopolies in that their total output is the same as that which would be generated by a single monopoly They differ from monopolies in that the monopoly profits need to be divided among the producing countries which have different cost structures Question Status Previous Edition 11 3 The US is probably the most open international market among the industrialized countries What then does the US have to gain by joining the WTO Answer There are two answers First the US exporters stand to gain profitable markets if foreign protectionism in areas of US comparative advantage e g soy is removed due to WTO efforts The second is that the WTO offers the US government administration a counterweight to regional and sectoral interests demanding protection It is always politically easier to bring about more efficient resource allocations if the complaints of the losers may be deflected by the presence of a binding treaty with an international organization quotour hands are tiedquot Question Status Previous Edition 96 Appendix to Chapter 9 Proving That the Optimum Tariff Is Positive 1 There are no questions for this section Answer TRUE Question Status 12 New How to Study for Chapter 26 International Trade Chapter 26 discusses the theories involving international trade and considers the arguments both for and against free trade It also discusses recent changes in the trade relations between nations You will need to review the concepts of production possibilities curve from Chapter 2 and the concepts of absolute advantage and comparative advantage from Chapter 3 1 Begin by looking over the Objectives listed below This will tell you the main points you should be looking for as you read the chapter 2 New words or definitions and certain key points are highlighted in italics in the text and in red color Other key points are highlighted in bold type and in blue color 3 You will be given an In Class Assignment and a Homework assignment to illustrate the main concepts of this chapter 4 There are a few new words in this chapter Be sure to spend time on the various definitions There are no new graphs But there is a review of the production possibilities curve first presented in Chapter 2 The numerical example illustrating comparative advantage is complicated Go over it slowly and be sure you understand how each number was derived The calculations are reinforced in the In Class Assignment and the Homework Assignment 5 The teacher will focus on the main technical parts of this chapter You are also responsible for the cases and the ways by which each case illustrates a main principle You are especially responsible for the way by which the case study of the NAFTA illustrates the principles of the chapter 6 When you have finished the text the Test Your Understanding questions and the assignments go back to the Objectives See if you can answer the questions without looking back at the text If not go back and reread that part of the text When you are ready take the Practice Quiz for Chapter 26 Objectives for Chapter 26 International Trade At the end of Chapter 26 you will be able to answer the following questions 1 What happened to the importance of international trade in the 20th century Why 2 What is meant by international competitiveness 3 What is meant by absolute advantage What is meant by comparative advantage This is a review question from Chapter 3 What is the production possibilities curve This is a review question from Chapter 2 Given a set of numbers determine which country has a comparative advantage in which goods Therefore determine which goods will be exported and which imported 6 Using a set of numbers show why trade increases the standard of living in both of the U P 182 Chapter 11 The Balance of Payments 183 trading partners Show how trade affects the production possibilities curve What is intraindustry trade and why might it occur What determines the goods for which a country will have a comparative advantage 0 Who are the people who win from free trade and why do they win and who are the people who lose and why do they lose 11 Analyze the effects of a tariff Explain why tariffs impose overall losses on the country imposing the tariff as well as the other trading partner 12 Explain the optimal tariff Under what conditions does it exist 13 Name at least three of the arguments in favor of trade protection and then explain each argument 14 What is meant by a strategic trade policy What is an infant industry What is a first mover advantage 15 Brie y describe American trade policies over the past 150 years What has happened to American tariff rates since 1945 In what cases does the American government tend to interfere with free trade Why does it do so 16 What was the General Agreement on Tariffs and Trade GATT What is Most Favored Nation Status MFN What is the World Trade Organization WTO 17 Describe the North American Free Trade Agreement NAFTA Name at least three of its main provisions 18 What were the benefits to the United States and to Mexico from the NAFTA In each country who would gain and who would lose 19 Name three of the main arguments made against having the NAFTA passed into law Hpms Chapter 26 The Economics of International Trade latest revision July 2006 As the 20th century drew to a close news people devoted much time to remembering the significant events of the century Certainly one of the most significant occurrences of the 20th century was the growth of a global economy Throughout the century and especially throughout the second half of the century countries became economically interdependent as they had never been before Today almost every important aspect of a nation s economy is linked to events in other countries In particular a much greater share of the national production is sold to foreigners exported than ever before And a much greater share of those goods that people buy are bought from foreigners imported than ever before This increase in economic interdependence occurred for most of the countries of the world including the United States For example in 2005 about 10 of all of the goods and services produced in the United States were sold to buyers in other countries compared to only about 4 in 1959 From 1959 to 2003 American exports increased over 1400 in constant dollars Over the same time period American purchases of goods and services from other countries increased approximately 1500 again in constant dollars Today about one out of every four Americans has a job that is closely linked to international trade And it has been estimated that 183 Chapter 11 The Balance of Payments 184 70 of American manufacturing companies now face significant competition from companies in other countries This rise in the importance of international trade is not an accident It is mainly the result of the enacting of policies to make trade between countries much freer than it was at the end of World War II Most of these policies were initiated by the United States government We shall consider below one illustration of the policies initiated to promote free trade the North American Free Trade Agreement NAFTA In developing policies to promote free trade between nations the United States and other governments have been especially in uenced by economists While there are many things on which economists disagree the desirability of free trade between countries is a view held by the large majority of economists However many noneconomists and some economists have opposed policies to free trade between countries We will consider both the arguments in support of and the arguments against free trade below A major topic of discussion in the late twentieth century was international competitiveness This involves the ability of a nation to design produce and market goods and services that are better or cheaper than those of other countries Through much of the 1980s and early 1990s some people claimed that the United States was losing its international competitiveness especially in relation to Japan Many different remedies were proposed From Chapter 3 we know that the United States will not be able to produce better or cheaper for all products So let us rst consider which goods will be produced and which goods will be imported In doing so we return to the principle of comparative advantage first introduced in Chapter 3 This will allow us to present the reasons that so many economists believe that free trade is highly beneficial for the United States and for the world as a whole 1 The Economists Case for Free Trade In Chapter 3 we discussed Adam Smith s theory of absolute advantage and David Ricardo s theory of comparative advantage in relation to families Both of these early economists applied the same reasoning to nations As Adam Smith put it what is prudence in the conduct of every private family can scarce be folly in that of a great kingdom Here let us focus on Ricardo s argument as this has been the heart of the economists defense of free trade This argument dates to the 1830s In his text Ricardo made several simplifying assumptions and we will do the same here He assumed that there are only two countries let us call them the United States and Rest of World He assumed that there are only two products let us call them agricultural products and manufactured products To simplify we will represent agricultural products by wheat and we shall represent manufactured products by computers Ricardo assumed that the cost of making a unit of a product is determined by the amount of labor time that must be used to produce it and that this cost would not change as the quantity produced is increased Finally he assumed that product quality is the same in both countries that there is no technological change that there are no transportation costs and that 184 Chapter 11 The Balance of Payments 185 there is perfect competition in all markets The chart below shows an illustration based on Ricardo of the labor time to produce a unit of each product in each country In the United States In the Rest of the World Labor Cost Required 1 bushel of wheat 3 hours 8 hours 1 computer 2 hours 4 hours In this madeup example the United States has an absolute advantage in the production of both agricultural goods and manufactured goods This means that the United States can produce both agricultural goods manufactured goods at a lower cost than the Rest of the World The Rest of the World has an absolute disadvantage in the production of both goods But as was shown in Chapter 3 there is a benefit to trading even if one country can produce all products at lower cost than the other country Assume that there are 48 hours of labor available in each country and no trade is possible If the United States devoted all of its hours to wheat it could produce 16 48 divided by 3 bushels of wheat point A If it devoted all of its hours to computers it could produce 24 48 divided by 2 computers point D Or it could produce some combination in between for example 4 bushels of wheat and 18 computers point C or 12 bushels of wheat and 6 computers point B The choices that are available are shown in the production possibilities curve below The production possibilities curve was introduced in Chapter 2 It shows all combinations of goods that can be produced Points inside the curve are inefficient as more goods are capable of being produced Points outside the curve are not attainable The production possibilities curve is drawn as a straight line because Ricardo assumed that the costs of producing are constant that is no matter how many bushels of wheat have been produced another unit will still take 3 hours and no matter how many computers we have produced another unit will still take 2 hours We know from the discussion in Chapter 14 that costs of production actually rise as the quantity produced increased However Ricardo s assumption makes the analysis easier and does not alter the ultimate conclusion of his analysis Production Possibilities Curve Without Trade Wheat 16 185 Chapter 11 The Balance of Payments 186 12 B 4 c D 0 6 l 8 24 Computers Now assume that the two countries can trade freely As we know from Chapter 3 countries will be best off if they specialize in those goods for which they have a comparative advantage not an absolute advantage Comparative advantage occurs where the opportunity cost of producing is lowest In the United States a computer requires the sacrifice of 23 of a bushel of wheat that is the 2 hours needed to produce one computer would also have produced 23 of a bushel of wheat In the Rest of the World a computer requires the sacrifice of 12 of a bushel of wheat In each case you should be able to explain why Therefore the Rest of the World has a lower opportunity cost for computers In the United States a bushel of wheat requires the sacrifice of 112 Computers 32 In the Rest of the World a bushel of wheat requires the sacrifice of 2 computers 84 Therefore the United States has a lower opportunity cost for agricultural goods Even though the United States has an absolute advantage in both products it has a comparative advantage only in wheat In this example the United States should specialize in wheat and trade for computers To illustrate why international trade is seen as desirable begin with Point B on the production possibilities curve on the preVious page It shows that with no trade the United States can produce 12 bushels of wheat and 6 computers Now assume the United States specializes completely in wheat Point A shows that the United States can produce 16 bushels of wheat Suppose that the United States trades 4 of these bushels to the Rest of the World in exchange for computers How much will the United States get in return The answer is 8 computers Test Your Understanding Explain why each bushel of wheat traded will bring back 2 computers from the Rest of the World 186 Chapter 11 The Balance of Payments 187 The United States will have the same amount of wheat 12 bushels and more computers 8 if trade occurs It is better off The Rest of the World is also better off Examine to the production possibilities curve below The solid line indicates the combinations without trade and is repeated from above The dashed line indicates the combinations with trade If the United States specializes in wheat and trades it can have 12 bushels of wheat and 8 computers 4 bushels of wheat and 24 computers or 0 bushels of wheat and 32 computers This occurs because each bushel of wheat traded will bring back 2 computers from the Rest of the World Go over these numbers carefully to be sure you understand how each was derived The production possibilities curve has shifted out to the right More goods are possible with trade The United States as a whole is unambiguously better off So is the Rest of the World Production Possibilities Curve With Trade Wheat o o o O o o o o o Chapter 11 The Balance of Payments 188 4 C 0 6 8 18 24 32 Manufactured Goods Test Your Understanding The text does the case for the United States Here do the case for the Rest of the World 1 First in the space below draw the production possibilities curve for the Rest of the World assuming that there are only 48 hours of labor time available Remember that the production possibilities curve shows all possible combinations of goods that can be produced If all of the hours are devoted to agricultural goods Rest of the World can produce units If all of the hours are devoted to manufactured goods Rest of the World can produce units If 40 hours were devoted to agricultural goods and 8 hours to manufactured goods Rest of the World can produce units of agricultural goods and units of manufactured goods If 24 hours were devoted to agricultural goods and 24 hours to manufactured goods Rest of the World can produce units of agricultural goods and units of manufactured goods Show these on the graph below Show the production possibilities curve as a solid line 2 Second in Rest of the World each hour devoted to manufactured goods requires the sacrifice of unit of agricultural goods This is the opportunity cost In the United States each hour devoted to manufactured goods requires the sacrifice of unit of agricultural goods This is the opportunity cost Rest of the World has the absolute advantage in The United States has the absolute advantage in Choose agricultural goods manufactured goods both or neither Rest of the World has the comparative advantage in The United States has the comparative advantage in Choose agricultural goods or manufactured goods Rest of the World should export goods and it should import goods 3 Third imagine that rest of the World specialized completely in manufactured goods All 48 hours were used to produce manufactured goods Rest of the World then trades 6 units of manufactured goods to the United States In return it gets back units of agricultural goods from the United States Is Rest of the World betteroff with trade Why 4 Finally show the production possibilities curve with trade on the graph Show the new production possibilities curve as a dashed line That the United States specializes in wheat in this example while the Rest of the World specializes in computers does not occur just because it is desirable The action of markets brings about this result To illustrate this let us convert the analysis into money terms Assume that workers are paid 15 per hour in the United States and 7 per hour in the Rest of the World Wages must be lower in the Rest of the World because their workers are less productive The costs of making products in the two countries are shown below assuming again that labor in the only cost 188 Chapter 11 The Balance of Payments 189 United States Rest of the World Agricultural Goods 45 56 Manufactured Goods 30 28 People in both countries will buy wheat from the United States because it is cheaper And people in both countries will buy computers from the Rest of the World because they are cheaper The example created here is based on the example provided by Ricardo in the 1830s In his example he showed that there were gains to trading English cloth for Portuguese wine even though Portugal could produce both products at lower cost but was especially better at producing wine His example is quite simplistic as we noted above But even if we make the illustration more realistic the basic conclusion is not changed This basic conclusion is that even if a country can produce all goods at a lower cost than another country there are gains from specializing in those goods for which there is a comparative advantage and trading for those goods in which there is a comparative disadvantage Since comparative advantage depends on relative costs it is impossible for a nation to have no comparative advantage at all All countries bene t from trade because they have more goods and services with trade than without it This conclusion has been one of the most important intellectual arguments of the past two centuries 2 What Determines Comparative Advantage The above example was made up so that the United States had a comparative advantage in wheat production But in reality what does determine the comparative advantage that a country will have The most important theory to answer this question came from two Swedish economists Eli Heckscher 1919 and his student Bertil Ohlin 1933 Their theory has two aspects First countries have abundant amounts of certain factors of production and lesser amounts of other factors of production So the United States has abundant agricultural land while in Sweden agricultural land is very scarce The United States has abundant capital and skilled labor while in China both are relatively scarce But China has abundant unskilled labor while in the United States such labor is relatively scarce The second aspect of the theory is that certain goods require certain factors of production Thus automobile production is capitalintensive wheat production is landintensive textile production is laborintensive computer software production is technologyintensive and so forth The HeckscherOhlin theory says in Ohlin s words 189 Chapter 11 The Balance of Payments 190 Commodities requiring for their production much of the abundant factors of production and little of the scarce factors of production are exported in exchange for goods that call for factors in the opposite proportions In the madeup example above the United States would export wheat because of its abundant land The Rest of the World would export computers either because of more abundant capital or more abundant labor most likely the latter Do the actual patterns of trade fit the predictions of the HeckscherOhlin theory The answer seems to be basically yes Most of American trade as well as that of other countries seems to be consistent with this theory However there is some trade that cannot be explained in this way Test Your Understanding According to a study for the year 1980 the United States had 286 of all of the world s resources It had the following percentages for the individual factors of production Physical Capital 336 Unskilled Labor 019 Skilled Labor 277 Arable Land 293 Semiskilled Labor 191 RampD Scientists 507 The United States is relatively abundant in which of the above factors of production The United States is relatively scarce in which of the above factors of production Go on the Internet What goods and services are the main exports of the United States Illustrate with numbers ie what percent of American exports does that good represent What goods and services are the main imports of the United States Again illustrate with numbers Is the trade pattern of the United States consistent with the HeckscherOhlin theory Explain why or why not 3 Making the Theory More Realistic From the theory of comparative advantage of Ricardo we should expect that countries that are similar would not trade with each other very much Most trade would occur between countries that are very different But this is not what we observe Most American trade is conducted with other industrialized countries whose economies are quite similar to the United States Indeed much trade between these industrialized countries is intraindustry trade trading the same or very similar goods For example in 1992 the United States imported almost 23 billion worth of computers and exported over 17 billion worth of computers How do we explain this result The answer is that the theory of Ricardo assumed perfect competition In perfect competition all products are assumed to be identical In reality most competition involves monopolistic competition Industries are competitive but the products traded are differentiated It is certainly understandable that the United States would export Ford automobiles to Germany and import BMWs Or that the United States would export strawberries grown in the spring and summer to Mexico while importing back from Mexico strawberries grown in the winter 190 Chapter 11 The Balance of Payments 191 4 Winners and Losers from Free Trade The conclusion that trade is beneficial to each country as a whole as well as to the world as a whole is widely accepted by most economists But this does not mean that trade is good for every person Within each country trade generates winners and losers The losers have often been strong opponents of policies that open trade between countries In many cases they have been able to prevent such opening Who are these winners and who are these losers from international trade As we have just seen if trade is free countries will export those goods that require the factors of production that are relatively abundant and import those that require the factors of production that are relatively scarce For the United States this means exporting goods that use large amounts of arable land capital and highly skilled labor It also means importing goods that require large amounts of unskilled labor Suppose as is likely to be the case that the United States has a comparative advantage in production of computer software The ability to trade and therefore to sell in foreign countries increases the demand for American computer software This increase in demand both increases the quantity of computer software products sold and also increases their prices Both the increased quantity sold and the increased prices will increase the shortrun profits of owners of computer software companies They will also increase the demand for labor increasing the number of people employed in the computer software industry as well as their wages Therefore the owners of computer software companies and their workers are both Winners On the other hand assume as is likely to be the case that the United States has a comparative disadvantage in textiles With free trade the United States will import textile products The imports increase the supply of textile products in the United States decreasing their prices The decrease in prices will reduce the profits of the owners of American textile companies in the shortrun The decrease in textile prices will also decrease the demand for American textile workers causing both the number of jobs for American textile workers and their wages to decrease Therefore the owners of American textile companies and their workers are losers from international trade In general for the United States free trade benefits owners of arable farmland as well as highly skilled workers and the companies that employ them Free trade hurts unskilled and semiskilled workers and the companies that employ them In a country such as Mexico the opposite is expected to occur In Mexico free trade should benefit unskilled and semiskilled workers as well as the owners of the companies that employ them In Mexico free trade should hurt highly skilled workers There is some question as to whether this actually occurs Certain owners of arable land in Mexico are winners for example those with land that can grow strawberries or bananas while owners of other arable land are losers for example those with land that can grow wheat 191 Chapter 11 The Balance of Payments 192 In summary owners of factors of production specific to export industries tend to gain from international trade while owners of factors of production specific to importcompeting industries lose But for this statement to be true it must be assumed that the factors of production are specific and not general This means that the factors of production cannot easily shift from one employment to another American textile workers would not be hurt if they could shift easily to work in the computer software industry But for many workers and for most capital such a shift is very difficult and costly The analysis of the benefits of free trade shows clearly that the gain to the winners from free trade exceeds the harm to the losers We know this because we showed that the United States as a whole and the world as a whole is better off with free trade Yet in political decisionmaking the losers are often able to prevent policies that promote free trade To understand why policies that are good for the country as a whole are not enacted review the section on Public Choice in Chapter 11 In this case the bene ts from free trade are widespread many workers and owners increase their incomes plus consumers have more consumer goods available while the costs of free trade are concentrated certain workers and owners lose their jobs or have their incomes reduced 5 Tariffs As just stated those who lose from free trade are often able to obtain government policies that restrict trade The most common of these restrictions is a tarif a tax on imported goods or services Let us show this on the familiar demand and supply graph In the graph below assume that if there were no trade the price of automobiles would be 25000 per automobile The world price is 20000 With free trade buyers would be able to buy 20 million automobiles at the world price of 20000 Given the costs of making automobiles American automobile companies would produce only 10 million automobiles at the world price of 20000 The other 10 million automobiles would be imported Price 000 S ply Curve of American Companies 192 Chapter 11 The Balance of Payments 193 25 20 World Price Demand Curve of American Buyers 0 10 17 20 Quantity of Automobiles Millions Now imagine there is a tariff enacted that raises the price in the United States to 25000 First what are the effects on American consumers American consumers will now buy 17 million automobiles per year instead of 20 million Therefore they lose the satisfaction they would have gained from 3 million new automobiles And American consumers will now pay 25000 per automobile instead of 20000 This extra 5000 per automobile applies to all automobiles not just to the imported ones American consumers will now pay 425 billion for their automobiles 25000 times 17 million instead of 400 billion 20000 times 20 million They will be paying more receiving fewer automobiles and have less choice and variety Second what are the effects of the tariff on American producers By raising the price of foreign automobiles the tariff causes American buyers to shift to American automobiles The prices of American automobiles rise to 25000 This stimulates American automobiles companies to produce more automobiles Therefore American producers gain both from the higher prices and from the additional automobiles produced In the graph they would produce 7 million additional automobiles as a result of the tariff 17 million instead of 10 million and charge 5000 more for their automobiles 25000 instead of 20000 The American automobile companies would be able to charge a higher price because the tariff makes foreign automobiles a substitute more expensive Notice that the American automobile producers gain the benefit of the higher prices on the automobiles they produce But American consumers pay the higher prices not only on the American automobiles but also on the foreign automobiles Therefore the loss to American consumers must be greater than the gain to the American producers As a whole Americans are worseoff This conclusion holds even if we consider the tariff revenue collected by the government as part of the national gain This analysis of the effects of a tariff has thus far assumed that the United States cannot affect the world price of automobiles 20000 by its tariff policies For small countries this is likely to be true But for large countries such as the United States this may not be true If 193 Chapter 11 The Balance of Payments 194 American purchases of automobiles can indeed affect the world price we may have the case of the optimal tariff discussed in Chapter 7 In the case on page 11 the United States imposed a tariff and the American automobile buyers shifted their purchases to American automobiles Now suppose that facing a major loss in sales the foreign automobile producers are forced to lower their prices The world automobile price decreases In effect foreign automobile producers are paying part of the tariff Indeed if the world price fell from 20000 to 15000 foreign automobile producers would be paying the entire tariff Tariffs still cause overall losses But now the United States is able to shift some of the losses on to foreigners For this result to occur the American demand must be able to in uence the world price that is foreign producers must be dependent on American buyers and American buyers must respond strongly to changes in the relative prices of foreign and American products the demand for foreign products must be very elastic Our analysis indicates that the United States as a whole loses when it imposes a tariff But we need to know if tariffs and other forms of protection against imported products impose large or small losses on the United States There have been several studies designed to answer this question The conclusion from these studies is that as a percent of American total income tariffs impose a very small cost A typical estimate would be that American total income is reduced perhaps 01 as a result of tariffs This result occurs because tariffs are imposed on few products But for those products on which tariffs are imposed the burden can be high One study in 1990 for 23 industries on which there were tariffs concluded that Americans lose 149 for each 100 gained by the protected industry The other 049 is pure loss to the United States Political battles as to whether trade should be free or should be protected against imports can be battles over billions of dollars in total 1ncome 6 Arguments for Trade Protection It has been stated several times that most economists support free trade and oppose policies of protection There are however some significant economic arguments made by those who do support policies of trade protection such as tariffs First and foremost there is the infant industry argument If a domestic industry is new it will produce a small quantity of the product As we know from Chapter 15 producing a small quantity will cause costs of production to be high As the companies in the domestic industry increase production they will be able to produce at a lower cost because of economies of scale They may also be able to gain dynamic increasing returns to scale As we saw in Chapter 15 this means that the companies can learn by doing and therefore nd ways to lower their costs Finally the companies in the domestic industry may be able to gain economies of scope Again as we saw in Chapter 15 this means that by producing several products the companies can produce each one at a lower cost The point is that once the companies in the domestic industry sell enough of the products they will be able to produce at a cost that will enable them to 194 Chapter 11 The Balance of Payments 195 compete with the foreign companies At that time the tariff protection would no longer be needed This infant industry argument was used by Alexander Hamilton in a 1791 report that formed the basis for 19th century American trade policies see below In recent times it was used by the Japanese government who protected their domestic steel shipbuilding automobile electronics and computer industries before they became strong international competitors A related argument made for trade protection involves the fact that in some industries trade comes to be dominated by very few companies This of course is oligopoly So for example commercial aircraft is dominated by Boeing and Airbus and microprocessors are dominated by Intel and Motorola There are several industries such as automobiles and steel in which more than half of world trade is conducted by five or fewer companies Why does this occur The answer takes us back to economies of scale When fixed costs are high an increase in the quantity sold by a company will lower the cost per unit of producing the average total cost1 Because of economies of scale the industry will become an oligopoly Review the explanation of natural monopoly from Chapter 19 to be sure you understand the reasons for this Oligopoly companies can earn significant economic profits from their export sales Because of this it matters greatly to a country where the production takes place If these oligopoly companies are located in the United States their economic profits will add to American income at the expense of foreigners Because they can produce at a lower cost it will be very hard for companies in other countries to be able to compete with them They would have what are called first mover advantages This means that the companies that produce first will have cost advantages that make it very difficult for others to begin to compete with them These economic profits will persist Undertaking policies to assure that these particular companies are located in the United States has been called strategic trade policy Companies in high technology industries are especially likely to have such firstmover advantages As we saw in Chapter 19 in high technology companies often experience very high fixed costs but low perhaps zero marginal costs This combination causes them to become oligopolies Because their products are in great demand they can earn great economic profits Several economists who ultimately became important advisors to President Clinton had been advocates of a strategic trade policy toward high technology industries in order to assure that the companies in such industries would earn their economic profits within the boundaries of the United States 1Economies of scale may also occur for the industry as a whole This could occur because one large company brings enough specialized labor into the area to lower the costs of labor for other companies Or it could occur because one large company allows product and production technology to diffuse quickly to other companies in the same area Silicon Valley would be an example of this point A third argument made for trade protection is that domestic production in certain industries provides social benefits that will not be provided if the products are imported For example a growing computer industry provides knowledge that is important for companies 195 Chapter 11 The Balance of Payments 196 that produce computerrelated products and for companies that use the computer services Those who make this point argue that the benefits from expanded computer production do not easily spill over national boundaries The growth of American computer chips led to the growth of an American software industry It did not help the software industry of France A fourth argument made for trade protection involves contracting industries Suppose that the United States develops a comparative advantage in computer and computer products and loses its comparative advantage in production of steel Under free trade the United States will increase its production of computers and computer products and decrease its production of steel The argument of Ricardo assumed that workers would simply shift from steel production to computer production In a world when most workers were unskilled this assumption may not have been too bad But as noted earlier workers usually have specific skills that will be lost if they shift to other industries And because workers have ties to the place in which they live being forced to move will be a large burden for them Tariffs can prevent these very large costs being imposed on these workers For this reason trade that is within an industry commonly has less political opposition than trade between industries It is virtually impossible for a textile worker to become a highly skilled computer professional But it is not as difficult for a worker on a Pontiac to become a worker for Honda in Ohio One study found that 63 of the workers who lost jobs between 1979 and 1999 in import competing industries eventually found another job On average they suffered a 13 pay cut But a quarter of these people took a pay cut of 30 or more There are many people who argue that we should provide aid to these people in finding jobs and wage insurance to make up some of the difference in pay A fifth argument made for trade protection involves the distribution of income As we saw above free trade in the United States increases the incomes of highly skilled workers as well as the incomes of owners of certain types of capital goods It also decreases the incomes of less skilled workers To some people this seems unfair since less skilled workers are likely to have relatively low incomes In this argument a tariff would act to make the distribution of income more equal by increasing the incomes of those whose incomes are likely to be near the bottom of the income distribution Of course there may be better ways to deal with inequality than imposing tariffs A sixth argument made for trade protection involves the environment Indeed many environmental groups are commonly against policies to make international trade freer The main argument of environmentalists is that developing countries such as Mexico either have more lax environmental laws or do not enforce their environmental laws very well There are two ways to make products cheaper improve efficiency or externalize costs impose the costs on others In competitive markets companies will look to lower costs and will therefore externalize costs if they can get away with it Allowing free trade between these countries allows American companies to locate in countries where they can get away with it 1We will 196 Chapter 11 The Balance of Payments 197 examine this argument in the section on NAFTA below A related argument is that free trade also allows American companies to locate production in countries where they can force workers to work many hours per day for very low wages An example of the environmental effects of free trade involves the fact that under the modern method of fishing for tuna called purseseine large numbers of dolphins are killed Since this method of fishing for tuna came into use around 1960 over 6 million dolphins have been killed Most Mexican fishers of tuna continue to use this method of fishing In 1991 the United States banned imports of tuna from Mexico Mexico protested arguing that the United States was simply using the killing of dolphins as a way to protect its own tuna industry The organization that heard the case then called the General Agreement on Tariffs and Trade GATT and now called the World Trade Organization WTO agreed with Mexico and forced the United States to remove its ban This case made many environmental groups suspicious of free trade agreements Free trade they argue creates a separation between the consumption of goods and the environmental damage If buying certain goods oil for example would damage the beaches of California many people will be mobilized to do something to protect the beaches But if eating a hamburger at McDonald s damages the rainforest of Brazil few Californians are likely to know or even care Brazilians who are affects may be powerless to stop the production that damages their forests 1 This situation was common in American history For example until the 1930s policies were governed mainly at the state level This made it very difficult to pass laws to eliminate child labor Northern companies especially in textiles had more capital and better technology Southern states would allow child labor because the cheap labor allowed their companies to compete with the northern companies Northern states would not pass restrictions on child labor because doing so would hurt their companies Until the national government passed laws on the matter child labor was common in American manufacturing Likewise dealing with environmental externalities may be very hard to do at the level of the nation it may require international agreements Finally there are other noneconomic arguments made for trade protection Some products it is argued should be produced domestically because they are sources of national pride For example most Latin American countries have national orchestras Trade theory would dictate that these countries focus on exports of wool or beef and import better symphonies from Europe These Latin American countries believe that their communities are enriched by having their own orchestras And some products it is argued need to be produced domestically because they are essential to the national defense It is also argued that free trade causes individual nations to lose the ability to control their economic lives Most economists take these arguments for protection quite seriously As is often the case there are good arguments on both sides of this issue Test Your Understanding In November of 1999 the World Trade Organization WTO met in Seattle There were about 50000 protestors there There was destruction and some arrests 1 What does the World Trade Organization WTO do You will need to get information from 197 Chapter 11 The Balance of Payments 198 the Internet or newspapers 2 Choose one of the following groups who opposed the World Trade Organization WTO In each case explain the reasons that the group opposes the WTO How does it want the WTO to change You will get the information you need from the Internet or from newspapers a The AFL CIO or any particular labor union b Any Environmental group who opposed the WTO such as the Sierra Club 0 Any other political group who opposed the WTO In this case find some group who was in Seattle to protest but who was not affiliated with a labor union or environmental group 3 Present arguments made by people in support of the World Trade Organization WTO Who are the people supporting the WTO What arguments do they make that it has been good for the world economy You will get the information you need from the Internet or from newspaper accounts 7 American Trade Policies Since the end of World War II the United States has been the leading proponent of free trade around the world But it was not always so For the century and a half up to World War II the United States was basically a protectionist country Over that entire period American tariffs averaged just about 30 This is equivalent to a 30 sales tax on imported products Particularly noteworthy were the socalled Tariff of Abominations of 1828 in which the tariff on imported woolen products reached over 80 and the SmootHawley Tariff of 1930 Tariffs were so high for two reasons First the money raised was a major source of revenue for the federal government And second there was strong pressure for protection from New England producers of manufactured goods As with all tariffs the United States paid a cost for its protectionist policy Because the tariff was high on imported capital goods to protect the New England manufacturers it raised the prices in the United States of all capital goods whether imported or produced at home With higher prices buyers bought fewer capital goods Since capital goods are those that are used in production fewer goods and services were produced in the United States prior to World War II than could have been produced had there been no tariffs Since World War II the United States government has relied much more on income taxes and much less on tariffs for its revenues And American manufacturers found exporting more important than restricting imports In 1947 the United States entered the General Agreement on Tariffs and Trade GA T T The purpose of GATT was to find ways for countries to negotiate bilateral reductions in their tariffs that is both countries agreeing to reduce tariffs As part of GATT the member countries agreed to the Most Favored Nation MFN principle This meant that each country would have a tariff rate for all member countries that was the same as that of the most favored nation the nation that received the lowest tariff rate Over the years tariff rates between most of the industrial countries have been lowered in a series of steps As of now the overall American tariff rate averages only about 3 In the 198 Chapter 11 The Balance of Payments 199 mid1990s the GATT was replaced by the World Trade Organization WTO with the same goals Despite being the leading proponent of free trade over the past 50 years the United States government has still interfered in international trade on several occasions Most of this intervention has been to try to offset the decline of an American industry For example the American steel and automobile companies had once dominated the world But over the 1960s and 1970s they continually lost their share of the world market and even the American market to Japanese companies The key reason for their decline was their inability to raise productivity as much as the Japanese could This made them high cost producers For both industries the United States government intervened to help prevent the decline The tariffs against Japanese steel were discussed in Chapter 16 on Dumping And the Voluntary Export Restraints against Japanese automobiles in the 19805 were discussed in Chapter 7 In a Voluntary Export Restraint the United States government pressured the foreign government to volunteer to limit the sales of a given product in the United States Government loans were also made to the Chrysler Corporation to help it make changes that would allow it to survive The apparel industry in the United States based as it is on unskilled labor also has been in decline for many years To slow this decline there has been a Voluntary Export Restraint against imports of apparel from Asia since 1962 and a MultiFiber Agreement limiting the importation of foreignmade textile products The United States government has also intervened as its electronics and semiconductor industries lost world market share For these industries the intervention mainly involved suits and negotiations with foreign governments to change practices in the foreign country especially Japan While much of the intervention of the American government has involved declining American industries some has not The very high tariff on imported sugar was discussed in Chapter 11 There are restrictions on importing many agricultural products The American government also has provided large subsidies to Boeing to help stimulate sales of commercial aircraft in foreign markets Test Your Understanding The text refers to a paradox On the one hand since the end of World War II the government of the United States has been the leading proponent of free trade around the world Many actions have been taken by the American government to promote free trade Yet on the other hand the American government has imposed trade restrictions on Japanese steel Japanese automobiles textiles agricultural products and so forth The American government has also subsidized certain companies such as Boeing to aid them in international competition How do you explain this paradox You may want to review the section on Public Choice before answering Case Study The North American Free Trade Agreement of 1994 NAFTA From the 1950s until the early 1980s Mexico pursued a development strategy called importsubstitution industrialization This meant that Mexico attempted to avoid dependence on international trade in its pursuit of economic growth and development As late as 1971 199 Chapter 11 The Balance of Payments 200 only about 6 of goods bought by Mexicans were imported Even by 1988 this figure had risen to only 107 Imports and exports were less significant for Mexico than for the United States and much less significant than for the countries of East Asia or Europe Although its trade was limited Mexico was very dependent on the United States as a very high proportion of Mexican exports and imports involved the United States By contrast America was not very dependent on Mexico only about 5 of American imports came from Mexico The Mexican import substitution strategy had been designed to protect domestic Mexican producers against foreign competition The strategy saw exports as necessary only to earn the dollars necessary to be able to buy the capital goods and raw materials needed for industrialization Imports were limited to those capital goods and raw materials through a system of licenses and high tariffs There were restrictions on foreigners owning companies in Mexico The protected market was designed to give Mexican producers the time to grow so that they could become competitive with American European and Japanese manufacturers This is the infantindustry argument discussed above Under pressure from the United States government following its debt crisis of 1982 Mexico shifted away from its importsubstitution industrialization strategy and toward a policy of freer trade called quotliberalization quot The use of licenses to limit imports was virtually eliminated Tariffs were reduced significantly Most of Mexico39s industries were opened to foreign investors In 1986 Mexico joined the GATT Mexican exports expanded greatly in the 1980s and 1990s rising from the 20 billion to about 50 billion by 1994 Most of these Mexican exports were sold to the United States As dependent as it was becoming on trade with the United States Mexico felt threatened by rising trade protectionist sentiments in the United States Beginning in 1990 Mexican President Salinas requested discussions with the United States to create a North American Free Trade Agreement NAFTA In August of 1992 the United States Mexico and Canada signed the agreement to form a North American Free Trade Area NAFTA Canada and the United States had already formed a free trade area in 1989 In a Free Trade Area there are no tariffs between the countries In the agreement all tariffs and duties were to be phasedout over 15 years The agreement was historic there had never been such an agreement between countries with such disparate standards of living The Free Trade Area took effect on January 1 1994 The agreement was and still is a source of considerable controversy in the United States To understand this controversy let us first look at the effects of the agreement on the American economy The main purpose of the free trade agreement was to expand trade and American investment in Mexico Most studies have indicated that the NAFTA did indeed expand trade In 1994 exports among the three countries grew by 19 American exports of a large number of products expanded significantly field crops corn wheat and soybeans and 200 Chapter 11 The Balance of Payments 201 processed foods chemical products plastics pharmaceuticals highgrade steel automobiles and automobile parts machinery and products related to high technology American imports of several products expanded as well crude and refined petroleum fruits and vegetables apparel and textiles footwear and trucking services Imports of cars produced in Mexico also rose In general one would expect American exports of capital or technologyintensive products to expand and Mexican exports of laborintensive products to expand Despite the financial crisis in Mexico in 1995 and the recession of 2001 this seems to be what has occurred One area of concern for both countries was agriculture As discussed in an earlier chapter agriculture has been a highly subsidized and protected industry in most countries The United States had low tariffs 4 on average in 1990 covering 25 of agricultural imports from Mexico but many nontariff barriers Mexico had higher tariffs 11 and import licensing requirements for many products representing over 50 of Mexican agricultural imports from the United States Agriculture has provided the livelihood for more than one quarter of the Mexican labor force Thus Mexico had an interest in slowing the liberalization of agricultural trade Under the NAFTA half of the agricultural goods imported into Mexico from the United States immediately became tarifffree Other tariffs were to be phased out over 15 years However when imports cause an enormous burden of adjustment tariffs are allowed to rise So the United States has restrictions against Mexican sugar peanuts corn beans and winter vegetables In the United States grain farmers and livestock producers should see the market for their products expand Grain especially corn farmers in Mexico should lose some of their market these are typically the small and poor farmers in the south of Mexico Other the other hand American fruit and vegetable farmers should lose some of their market as imports from Mexico increase Those who grow citrus in Florida should lose more than those who grow citrus in California because Mexican imports compete mainly in the winter months Fruit and vegetable farmers in Mexico should gain markets these are the richer commercial farmers in the north of Mexico Another trade issue of concern especially to American automobile and textile companies involved rules of origin The concern here was that other countries especially Japan could ship goods through Mexico or have a small portion of the good produced in Mexico in order to avoid American and Canadian tariffs In the NAFTA it was agreed that cars and light trucks must have 625 58 of the value of their parts and labor be produced in North America in order to qualify for the tarifffree status In addition for several years the advantage of tarifffree status went only to firms that already had assembly plants in Mexico General Motors Ford Chrysler Nissan and Volkswagen A similar provision was adopted for textiles tarifffree status was granted only to goods made with yarn and fabric produced in North America 201 Chapter 11 The Balance of Payments 202 There has been great concern in the United States about the effects of the NAFTA on the American labor market Nearly all studies indicated that there would be a net job gain for the United States Because the NAFTA was expected to generate more American exports to Mexico than American imports it was expected to create more new jobs than would be lost Remember that American tariff rates were already low while Mexican tariff rates were not And those jobs that would be lost would be lost over several years even further reducing the burden of adjustment But there certainly has been hardship on some families as a result of the NAFTA The highest estimate of job losses due to NAFTA is 420000 the American labor force totaled over 146000000 at the end of 2005 Those workers became eligible for employment services training and income support for up to 78 weeks Those Americans most at risk are those who work in the laborintensive manufacturing industries such as textiles and apparel and laborintensive agricultural goods such as sugar fruits and vegetables Most job losers will be noncollege educated workers who tend to be at the lower end of the wage distribution Most job gainers will be more educated workers whose wages are normally at the high end of the distribution But the striking conclusion of the vast majority of studies indicates that the effect on the American labor market has been small Another labor market issue involved labor practices in Mexico It was argued that Mexico allows quotsweatshopquot conditions and therefore gains a labor market advantage in an unacceptable way Mexican labor laws protecting worker rights are similar to the American laws But the enforcement is very weak The North American Agreement on Labor Cooperation NAALC was established to monitor labor issues and address complaints about nonenforcement of labor laws As of this writing it does not have enforcement powers Another fear of many people was that the NAFTA would contribute to worsening environmental problems The argument was that many American companies would locate in Mexico in order to escape from American environmental laws As with worker protection laws Mexican environmental laws are not significantly different from those of the United States however Mexican environmental laws are often poorly enforced due to a lack of enforcement personnel and to corruption In recent years Mexico has increased its efforts at environmental protection It should be stressed however that for American companies to locate in Mexico to take advantage of weak enforcement of environmental laws three conditions must be met 1 the costs of meeting American environmental laws must be high in relation to the total cost of production otherwise it is not worth the cost of the move 2 the industry must have had significant trade protection otherwise the companies would already have located plants in Mexico and 3 the company must be able to relocate production relatively easily The number of companies that meet these conditions is likely to be small Of 442 American industries only 11 meet the first two conditions Of these several are not easily relocated Therefore the cost of American environmental regulations is NOT likely to be a significant incentive for relocation to Mexico 202 Chapter 11 The Balance of Payments 203 Another environmental issue involves food safety standards which are much stricter in the United States Under the NAFTA the United States may prohibit imports of fruits and vegetables from Mexico that do not meet American safety standards Some argue that this raises the possibility of setting the standards so high that environmental standards are in fact a form of trade protection For example in 1996 there was a major dispute over the importation of avocados from Mexico American avocado growers claimed that Mexican avocados brought with them a disease that could destroy local crops Mexican producers believed that their avocados were safe and saw the American claim as a form of trade protection Yet a third environmental issue involves infrastructure along the border roads railways airports and so forth The increase in trade creates bottlenecks along the border A North American Development Bank was created in 1994 with 3 billion in capital provided by both the United States and Mexico to provide financing for border environmental projects both for cleanup and for new infrastructure As of this writing it has done little The evidence above provides what is generally a supportive view of the NAFTA Yet the agreement has been very controversial Let us summarize some of the main arguments used by opponents of the agreement First many opponents of NAFTA focused on the loss of jobs and the decline in wages Most agreed that in the aggregate the effects of the agreement on the American labor market are small But to those who lose their jobs this is no consolation Job losses will cause considerable pain specifically to those people who are least able to adjust They believed that the American program of Trade Adjustment Assistance is insufficient to cope with the problem Second many opponents believed that the NAFTA encourages greater American direct investment in Mexico as it was intended to do This means that more American companies are likely to open companies in Mexico American companies they argued are more willing to invest in Mexico because of the assurance that goods produced in Mexico will have open access to the United States and because under the NAFTA they must be treated the same as Mexican companies The ability of American companies to relocate to Mexico could weaken the power of American labor unions to gain higher wages and better working conditions for their workers It could also weaken the power of American local governments as the companies could use the threat of movement to Mexico to extract certain benefits from the local government agencies Third opponents argued that NAFTA ultimately will reduce American international competitiveness NAFTA they argued allows companies to continue to rely on lowwage labor If this lowwage labor were not available it is possible that these companies would develop new machines and new technologies to be able to continue production These new machines and new technologies would ultimately make workers more productive and therefore lead to higher wages Fourth many opponents believed that the NAFTA would lead to environmental degradation especially along the border This argument was considered above 203 Chapter 11 The Balance of Payments 204 If one believes the majority of studies it appears that there are net benefits to the United States from the NAFTA the benefits exceed the costs for the nation as a whole Over the long term the NAFTA should increase American economic growth should create more jobs than are lost and may improve the American trade balance But the burden of adjustment will fall disproportionately on American lowwage low skilled workers The American distribution of income will become more unequal And there is the potential for greater environmental problems There are benefits from the NAFTA for Mexico as well Mexican businesses gained a secure access to the American and Canadian markets Correspondingly Mexican exports to the United States and Canada have risen significantly The increase in American investment in Mexico brings Mexico more modern machinery and new technology When 1992 presidential candidate Ross Perot announced that he was against the NAFTA the Mexican stock market plunged When he dropped out of the American presidential race it rose significantly Increased competition from American companies should force the Mexican companies to become more productive Lowskilled Mexican workers should benefit either from more jobs being available or from higher wages Higher skilled workers in Mexico should be hurt by the competition with the United States although the evidence so far indicates that they are not being hurt Many Mexican businesses will not be able to compete with the American imports or with the Americanowned companies in Mexico And when agriculture is fully liberalized many small farmers will not be able to compete with the American products The NAFTA will require considerable adjustment within Mexico as well as within the United States NAFTA was an historical document that sought to overcome many difficulties It sought to increase the economic integration of countries that are very different not only in standard of living but also in culture in language and in their legal and accounting systems It will be decades before a full assessment of the NAFTA can be made Yet the NAFTA is here to stay And the main focus today is to advance the principle of economic integration Since 1997 there has been a move to add a fourth country to the NAFTA Chile In 2005 a similar Free Trade Area was agreed to with Central America the Central American Free Trade Area or CAFTA This agreement includes the United States as well as Costa Rica Honduras Guatemala Nicaragua and the Dominican Republic And presently there is a movement to create a free trade area over all of North America Central America and South America a Free Trade Area of the Americas FTAA At this writing President Bush has affirmed his desire to build the Free Trade Area of the Americas building on an initiative introduced by his father in 1990 Whether this will occur remains to be seen Test Your Understanding 1 The North American Free Trade Agreement NAFTA was described in the chapter It created a Free Trade Area between the United States Canada and Mexico Assume now that there is a proposal to extend the Agreement to become the Free Trade Area of the Americas FTAA This 204 Chapter 11 The Balance of Payments 205 means that there would be a Free Trade Area covering all of the Americas North America Central America and South America Debate whether the American Free Trade Agreement should be passed Half of you will be assigned to debate in favor of an American Free Trade Agreement The other half will be assigned to debate against an American Free Trade Agreement 2 The NAFTA was passed in 1992 and went into effect in 1994 Pick a company located in San Diego County It may be a place at which you work or not Your task is to discover how this company has been affected by the NAFTA You may get your information by interviewing people in the company who would be able to know how the company has been affected You may also read articles in a newspaper San Diego Union Tribune North County Times etc or on the Internet Write a short essay describing how this San Diego County company has been affected by the NAFTA 3 As of the summer of 2001 there is a recurrence of a dispute over the ability to Mexican trucks to ship inside the United States The NAFTA provision allowed them this right But the United States government has not allowed it Go to newspapers or the Internet Use sources from the summer of 2001 What are the arguments made by people that Mexican trucks should not be allowed to ship in the United States see the site for the Teamsters Union especially What are the arguments made by people that Mexican trucks should be allowed to ship in the United States What is your conclusion 8 Summary and Conclusion What have we learned in this chapter First we have tried to understand the economists intellectual argument in favor of free trade It is an argument that is two centuries old As part of this argument we have seen that tariffs and other restrictions to free trade make both the country that restricts trade and its trading partner worseoff economically than they otherwise would be Second we have seen that while free trade enhances the well being of all countries it does not enhance the well being of all individuals Free trade creates many winners but it also creates many losers And third we have seen that as with most debates there are good arguments on both sides both in favor of free trade and also against free trade The arguments in favor of free trade have had enormous in uence in the second half of the twentieth century Until World War II the United States was mainly a country that restricted trade Since the end of World War II the United States has become a country that is for the most part open to trade The same opening to trade has occurred throughout the world Western Europe began to open to trade after World War II and is now in the process of becoming an integrated economy Its integration the European Union is a much more complete economic integration than in the NAFTA Trade for the former communist countries and the developing countries had been very small until 1980 Now this trade is becoming significant We saw this change in our case study on the NAFTA Companies now locate various parts of their production around the world Indeed much of our trade simply takes place within various parts of the same company As we enter the 21st century we are indeed becoming a global economy Your study of this chapter will provide you a greater ability to assess to what extent this shift to a global economy is indeed a good thing 205 Chapter 11 The Balance of Payments 206 Practice Quiz on Chapter 26 1 In the United States In the Rest of the World Labor Cost Required 1 Unit of Agricultural Products 6 hours 8 hours 1 Unit of Manufactured Products 2 hours 12 hours Using these numbers the United States has an absolute advantage in a Agricultural Products Only c Both Agricultural Products and Manufactured Products b Manufactured Products Only d Neither Agricultural Products nor Manufactured Products 2 Using the numbers in question 1 the United States has a comparative advantage in a Agricultural Products Only c Both Agricultural Products and Manufactured Products b Manufactured Products Only d Neither Agricultural Products nor Manufactured Products 3 An increase in international trade Will cause the production possibilities curve to a shift out to the right b shift in to the left c become upward sloping d not change 4 A country Will have a comparative advantage in a those products Which require factors of production that are relatively scarce b those products that require factors of production that are relatively abundant c all products for Which it also has an absolute advantage 206 Chapter 11 The Balance of Payments 207 THOSE PRODUCTS FOR WHICH IT CHOOSES TO HAVE A COMPARATIVE CHAPTER 11 THE BALANCE OF PAYMENTS MULTIPLECHOICE QUESTIONS 1 On the balanceofpayments statements merchandise imports are classi ed in the a Current account b Capital account c Unilateral transfer account d Of cial settlements account 2 The balance of international indebtedness is a record of a country s international a Investment position over a period of time b Investment position at a fixed point in time c Trade position over a period of time d Trade position at a fixed point in time 3 Which balanceofpayments item does not directly enter into the calculation of the US gross domestic product a Merchandise imports b Shipping and transportation receipts c Direct foreign investment d Service exports 4 Which of the following is considered a capital in ow a A sale of US financial assets to a foreign buyer b A loan from a US bank to a foreign borrower c A purchase of foreign nancial assets by a US buyer d A US citizen s repayment of a loan from a foreign bank 5 Which of the following would call for inpayments to the United States a American imports of German steel b Gold owing out of the United States c American unilateral transfers to lessdeveloped countries d American firms selling insurance to British shipping companies 207 Chapter 11 The Balance of Payments 208 6 In a country s balance of payments which of the following transactions are debits a b c d Domestic bank balances owned by foreigners are decreased Foreign bank balances owned by domestic residents are decreased Assets owned by domestic residents are sold to nonresidents Securities are sold by domestic residents to nonresidents 7 Which of the following is classi ed as a credit in the US balance of payments a b c d US exports US gifts to other countries A ow of gold out of the US Foreign loans made by US companies Table 111 gives hypothetical figures for US International Transactions On the basis of this information answer Questions 8 and 9 Table 111 US International Transactions Amount Transaction billions of dollars Merchandise imports l 10 Military transactions net 5 Remittances pensions transfers 20 US private assets abroad 50 Merchandise exports 115 Investment income net 15 US government grants excluding military Foreign private assets in the US 25 Compensation of employees 5 Allocation of SDRs 5 Travel and transportation receipts net 20 8 Based on the information provided in Table 111 the goods and services balance equals a b c d 5 billion 15 billion 20 billion 25 billion 9 Based on the information provided in Table 111 the current account balance equals a b c d 5 billion 10 billion 15 billion 20 billion 208 Chapter 11 The Balance of Payments 209 10 Unlike the balance of payments the balance of international indebtedness indicates the international a Investment position of a country at a given moment in time b Investment position of a country over a oneyear period c Trade position of a country at a given moment in time d Trade position of a country over a oneyear period 11 Which of the following indicates the international investment position of a country at a given moment in time a The balance of payments b The capital account of the balance of payments c The current account of the balance of payments d The balance of international indebtedness 12 Concerning the US balance of payments which account is de ned in essentially the same way as the net export of goods and services which comprises part of the country s gross domestic product a Merchandise trade account b Goods and services account c Current account d Capital account 13 If an American receives dividends from the shares of stock she or he owns in Toyota Inc a Japanese firm the transaction would be recorded on the US balance of payments as a a Capital account debit b Capital account credit c Current account debit d Current account credit 14 If the United States government sells military hardware to Saudi Arabia the transaction would be recorded on the US balance of payments as a a Current account debit b Current account credit c Capital account debit d Capital account credit 15 The US balance of trade is determined by a Exchange rates b Growth of economies overseas c Relative prices in world markets d All of the above 16 US military aid granted to foreign countries is entered in the a Merchandise trade account b Capital account c Current account d Of cial settlements account 209 Chapter 11 The Balance of Payments 210 17 If the US faces a balanceofpayments de cit on the current account it must run a surplus on a The of cial settlements account b The capital account c Either the of cial settlements account or the capital account d Both the of cial settlements account and the capital account 18 The current account of the US balance of payments does not include a Investment income b Merchandise exports and imports c The sale of securities to foreigners d Unilateral transfers 19 The US has a balance of trade de cit when its a Merchandise exports exceed its merchandise imports b Merchandise imports exceed its merchandise exports c Goods and services exports exceed its goods and services imports d Goods and services imports exceed its goods and services exports 20 The value to American residents of income earned from overseas investments shows up in which account in the US balance of payments a Current account b Trade account c Unilateral transfers account d Capital account Using the data of Table 112 answer Question 21 Table 112 International Investment Position of the United States US assets abroad US government assets 800 billion US private assets 200 billion Foreign assets in the US Foreign official assets 600 billion Foreign private assets 300 billion 21 Consider Table 112 The US balance of international indebtedness suggests that the United States is a net a Debtor b Creditor c Spender d Exporter 210 Chapter 11 The Balance of Payments 22 23 24 25 26 27 28 29 211 For the first time since World War I in 1985 the United States became a net international a Exporter b Importer c Debtor d Creditor A country that is a net international debtor initially experiences a An augmented savings pool available to finance domestic spending b A higher interest rate which leads to lower domestic investment c A loss of funds to trading partners overseas d A decrease in its services exports to other countries Credit items in the balance of payments correspond to anything that a Involves receipts from foreigners b Involves payments to foreigners c Decreases the domestic money supply d Increases the demand for foreign exchange Debt items in the balance of payments correspond to anything that a Involves receipts from foreigners b Involves payments to foreigners c Increases the domestic money supply d Decreases the demand for foreign exchange When all of the debit or credit items in the balance of payments are combined a Merchandise imports equal merchandise exports b Capital imports equal capital exports c Services exports equal services imports d The total surplus or de cit equals zero In the balance of payments the statistical discrepancy is used to a Ensure that the sum of all debits matches the sum of all credits b Ensure that trade imports equal the value of trade exports c Obtain an accurate account of a balanceofpayments deficit d Obtain an accurate account of a balanceofpayments surplus All of the following are credit items in the balance of payments except a Investment in ows b Merchandise exports c Payments for American services to foreigners d Private gifts to foreign residents All of the following are debit items in the balance of payments except Capital out ows b Merchandise exports c Private gifts to foreigners d Foreign aid granted to other nations 5 211 Chapter 11 The Balance of Payments 30 31 32 33 34 35 36 212 The role of is to direct one nation s savings into another nation s investments a Merchandise trade ows b Services ows c Current account ows d Capital ows When a country realizes a deficit on its current account a Its net foreign investment position becomes positive b It becomes a net demander of funds from other countries c It realizes an excess of imports over exports on goods and services d It becomes a net supplier of funds to other countries Reducing a current account deficit requires a country to a Increase private saving relative to investment b Increase private consumption relative to saving c Increase private investment relative to consumption d Increase private investment relative to saving Reducing a current account de cit requires a country to a Increase the govemment s deficit and increase private investment relative to saving b Increase the govemment s deficit and decrease private investment relative to saving c Decrease the govemment s de cit increase private investment relative to saving d Decrease the government s de cit and decrease private investment relative to saving Reducing a current account surplus requires a country to a Increase the govemment s deficit and increase private investment relative to saving b Increase the govemment s deficit and decrease private investment relative to saving c Decrease the government s de cit and increase private investment relative to saving d Decrease the government s de cit and decrease private investment relative to saving Concerning a country s business cycle rapid growth of production and employment is commonly associated with a Large or growing trade deficits and current account deficits b Large or growing trade deficits and current account surpluses c Small or shrinking trade deficits and current account deficits d Small or shrinking trade deficits and current account surpluses The burden of a current account deficit would be the least if a nation uses what it borrows to finance a Unemployment compensation bene ts b Social Security bene ts c Expenditures on food and recreation d Investment on plant and equipment 212 Chapter 11 The Balance of Payments 213 37 Concerning a country s business cycle account deficits a b c d Rapid growth rates of production and employment Slow growth rates of production and employment Falling interest rates on government securities Falling interest rates on corporate securities is commonly associated with large or growing current 38 According to researchers at the Federal Reserve the loss of jobs associated with a de cit in the current account tends to be Offset by the increase of jobs associated with a surplus in the capital account Reinforced by the decrease of jobs associated with a surplus in the capital account A threat to the level of employment for the economy as a whole Of no longrun economic consequence for workers who lose their jobs a b c d TRUEFALSE QUESTIONS Table 113 shows hypothetical transactions in billions of US dollars that took place during a year Answer the next seven questions on the basis of this information Table 113 International Transactions of the United States Amount Transaction billions of dollars Allocation of SDRs 10 Changes in US assets abroad 100 Statistical discrepancy 15 Merchandise imports 400 Payments on foreign assets in US 20 Remittances pensions transfers 60 Travel and transportation receipts net 30 Military transactions net 10 Investment income net 100 Merchandise exports 350 US government grants excluding military Changes in foreign assets in the US 190 20 Other services net 80 Receipts on US investments abroad 30 Compensation of employees 10 T F 1 Consider Table 113 The merchandisetrade balance registered a deficit of 50 billion 213 Chapter 11 The Balance of Payments 214 Consider Table 113 The services balance registered a surplus of 100 billion Consider Table 113 The goodsandservices balance registered a surplus of 50 billion Consider Table 113 The unilateraltransfers balance registered a de cit of 40 billion Consider Table 113 The currentaccount balance registered a surplus of 30 billion Consider Table 113 The net exports component of the US gross domestic product registered 1 10 billion Consider Table 113 The payments data suggest that the United States was a net demander of 30 billion from the rest of the world The balance of payments refers to the stock of trade and investment transactions that exists at a particular point in time Referring to the balanceofpayments statement an international transaction refers to the exchange of goods services and assets between residents of one country and those abroad The balance of payments includes international transactions of households and businesses but not government Because the balance of payments utilizes doubleentry accounting merchandise exports will always be in balance with merchandise imports On the US balanceofpayments statement the following transactions are credits leading to the receipt of dollars from foreigners merchandise exports transportation receipts income received from investments abroad and investments in the United States by foreign residents On the US balance of payments the following transactions are debits leading to payments to foreigners merchandise imports travel expenditures gifts to foreign residents and overseas investments by US residents The goods and services account of the balance of payments shows the monetary value of international ows associated with transactions in goods services and unilateral transfers An increase in import restrictions by the US government tends to promote a merchandise trade surplus Services transactions on Canada s balanceofpayments statement would include Canadian ships transporting lumber to Japan foreign tourists spending money in Canada and Canadian engineers designing bridges in China On the balanceofpayments statement dividend and interest income are classified as capital account transactions 214 Chapter 11 The Balance of Payments T F T F T F T F T F T F T F T F T F T F T F T F T F T F T F T F 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 21 5 A surplus on Germany s goodsandservices balance indicates that Germany has sold more goods and services to foreigners than it has bought from them over a oneyear period The merchandisetrade account on the balanceofpayments statement is defined the same way as net exports which constitutes part of the nation s gross domestic product A positive balance on the goodsandservices account of the balance of payments indicates an excess of exports over imports which must be added to the nation s gross domestic product For the United States merchandise trade has generally constituted the largest portion of its goodsandservices account Unilateral transfers refer to twosided transactions re ecting the movement of goods and services in one direction with corresponding payments in the other direction Unilateral transfers consist of privatesector transfers such as church contributions to alleviate starvation in Africa as well as governmental transfers such as foreign aid Currentaccount transactions include direct foreign investment purchases of foreign government securities and commercial bank loans made abroad On the US balanceofpayments statement a capital in ow would occur if a Swiss resident purchases the securities of the US government If Toyota Inc of Japan builds an automobile assembly plant in the United States the Japanese capital account would register an out ow If Bank of America receives repayment for a loan it made to a Mexican firm the US capital account would register an in ow On the balanceofpayments statement a capital in ow can be likened to the import of goods and services The capital account of the balance of payments includes privatesector transactions as well as of cialsettlements transactions of the home country s central bank If the current account of the balance of payments registers a de cit the capital account registers a surplus and vice versa Concerning the balance of payments a currentaccount surplus means an excess of exports over imports of goods services investment income and unilateral transfers If a country realizes a currentaccount deficit in its balance of payments it becomes a net supplier of funds to the rest of the world Concerning the balance of payments a currentaccount deficit results in a worsening of a country s net foreign investment position 215 Chapter 11 The Balance of Payments T F T F T F T F T F T F T F T F T F T F T F T F T F T F T F 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 216 In the balanceofpayments statement statistical discrepancy is treated as part of the merchandise trade account because merchandise transactions are generally the most frequent source of error Because a large number of international transactions fail to get recorded statisticians insert a residual known as statistical discrepancy to ensure that total debits equal total credits Concerning the balance of payments the goodsandservices balance is commonly referred to as the trade balance by the news media Since the 1970s the merchandise trade account of the US balance of payments has registered de cit Although the United States has realized merchandise trade deficits since the early 1970s its goodsandservices balance has always registered surplus In the past two decades the US services balance has generally registered surplus The US unilateraltransfers balance has consistently registered surplus in the past two decades Because the balance of payments is a record of the economic transactions of a country over a period of time it is a ow concept The United States would be a net creditor if the value of US assets abroad exceeded the value of foreign assets in the United States If a country consistently realizes a currentaccount surplus in its balance of payments it likely will become a net debtor in its balance of international indebtedness By the mid1980s the United States had evolved from the status of a netcreditor nation to a netdebtor nation in its balance of international indebtedness The netdebtor status that the United States achieved in its balance of international indebtedness by the mid1980s re ected the continuous currentaccount surplus that the United States attained in its balance of payments during the 1970s Although a netdebtor country may initially benefit from an in ow of savings from abroad over the long run continued borrowing results in growing dividend payments to foreigners and a drain on the debtor country s economic resources The official reserve assets of the United States consist of holdings of gold and foreign corporate securities That US importers purchase bananas from Brazil constitutes a debit transaction on the US balance of payments 216 Chapter 11 The Balance of Payments T F T F T F T F T F T F T F T F T F 49 50 51 52 53 54 55 56 57 217 That German investors collect interest income on their holdings of US Treasury bills constitutes a credit transaction on the US balance of payments That US charities donate funds to combat starvation in Africa constitutes a debit transaction on the US balance of payments To reduce a current account deficit a country should either decrease the budget deficit of its government or reduce investment spending relative to saving Most economists belief that in the 1980s a massive out ow of capital caused a current account de cit for the United States A current account deficit for the United States necessarily reduces the standard of living for American households Rapid growth of production and employment is commonly associated with large or growing trade surpluses and current account surpluses Often countries realizing rapid economic growth rates possess longrun current account de cits For the United States a consequence of its current account deficit is a growing foreign ownership of the capital stock of the United States and a rising fraction of US income that must be diverted abroad in the form of interest and dividends to foreigners Most economists contend that any reduction in the current account deficit is better achieved through increased national saving than through reduced domestic investment 217 Chapter 11 The Balance of Payments ANSWERS Answers to MultipleChoice Questions Answers to TrueFalse Questions W QP PWPf W QP PWPf Oh gh c HHHHHHHHHHHHEHEHHEHHHEHGEEEHHHH 9 10 11 12 13 14 15 16 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 nnrnrnmn EHHEEEHHHHHHGHEHHEHEHHHHHE 17 18 19 20 21 22 23 24 h U c GG 218 218 25 26 27 28 29 30 31 32 9939799915 33 34 35 36 37 38 9999999999 Chapter 11 The Balance of Payments 219 steel made in Japan d a a higher price for Japanese steel c a lower standard of living in the United States adva b a higher price for American steel d all of the above ntag e 7 When Japanese autos are sold in the United States and American autos are sold in Japan we have 5 If the a free trade b quotas c intraindustry trade d tariffs United States 8 Which of the following is an argument for trade protection engages in a the infant industry argument greater b Chapter 5 international trade those who are likely to lose are a skilled workers in the United States c owners of capital goods in the United States b unskille d workers in the United States d compute r experts in the United States 6 Which of the following would result if a tariff is imposed on 219 Chapter 11 The Balance of Payments 220 The Standard Trade Model 51 A Standard Model of a Trading Economy 1 The concept quotterms of tradequot means A the amount of exports sold by a country B the price conditions bargained for in international markets C the price of a country39s exports divided by the price of its imports D the quantities of imports received in free trade E None of the above Answer C Question Status Previous Edition 2 A country cannot produce a mix of products with a higher value than where A the isovalue line intersects the production possibility frontier B the isovalue line is tangent to the production possibility frontier C the isovalue line is above the production possibility frontier D the isovalue line is below the production possibility frontier E the isovalue line is tangent with the indifference curve Answer B Question Status Previous Edition 3 Tastes of individuals are represented by A the production possibility frontier B the isovalue line C the indifference curve D the production function E None of the above Answer C Question Status Previous Edition 4 If PCPF were to increase in the international marketplace then A all countries would be better off B the terms of trade of cloth exporters improve C the terms of trade of food exporters improve D the terms of trade of all countries improve E None of the above Answer B Question Status Previous Edition 5 If PCPF were to increase A the cloth exporter would increase the quantity of cloth exports B the cloth exporter would increase the quantity of cloth produced C the food exporter would increase the quantity of food exports D Both A and C E None of the above Answer B Question Status Previous Edition 220 Chapter 11 The Balance of Payments 221 6 If PCPF were to increase A world relative quantity of cloth supplied and demanded would increase B world relative quantity of cloth supplied and demanded would decrease C world relative quantity of cloth supplied would increase D world relative quantity of cloth demanded would decrease E None of the above Answer C Question Status Previous Edition 7 A country will be able to consume a bundle which is not attainable solely from domestic production only if A the world terms of trade differ from its domestic relative costs B the country specializes in one product C the country avoids international trade D the world terms of trade equal the domestic relative costs E None of the above Answer A Question Status Previous Edition 8 Terms of trade refers to A what goods are imported B what goods are exported C the volume of trade D the prices at which trade occurs E None of the above Answer D Question Status Previous Edition 9 If points A and B are both on the production possibility frontier of a country then A consumers are indifferent between the two bundles B producers are indifferent between the two bundles C at any point in time the country could produce both D Both cost the same E The country could produce either of the two bundles Answer E Question Status Previous Edition 10 If the economy is producing at point a on its production possibility frontier then A all of the country39s workers are specialized in one product B all of the county39s capital is used for one product C all of the county39s workers are employed D all of its capital is used but not efficiently E None of the above Answer C Question Status Previous Edition 221 Chapter 11 The Balance of Payments 222 11 If at point A on the production possibility frontier and the community indifference curve cuts through point a from northwest to southeast then the optimal autarky production bundle is A at point A B to the right of point A C to the left of point A D to the northeast of point A E to the southwest of point A Answer B Question Status Previous Edition 12 If two countries with diminishing returns and different marginal rates of substitution between two products were to engage in trade then A the shapes of their respective production possibility frontiers would change B the marginal rates of substitution of both would become equal C the larger of the two countries would dominate their trade D the country with relatively elastic supplies would export more E None of the above Answer B Question Status Previous Edition 13 If a country began exporting product A and importing product B then as compared to the autarky no trade situation the marginal cost of product A will A increase B decrease C shift outward D shift inward E None of the above Answer A Question Status Previous Edition 14 If a small country were to levy a tariff on its imports then this would A have no effect on that country39s economic welfare B increase the country39s economic welfare C decrease the country39s economic welfare D change the terms of trade E None of the above Answer C Question Status Previous Edition 15 An increase in a country39s net commodity terms of trade will always A increase the country39s economic welfare B increase the country39s real income C increase the country39s quantity of exports D increase the country39s production of its import competing good E None of the above Answer E Question Status Previous Edition 222 Chapter 11 The Balance of Payments 223 16 If the United States exports skilledlabor intensive products and services then we should expect unions representing skilled labor to A lobby in favor of tariffs B lobby against the imposition of tariffs C be indifferent to the issue of tariffs D lobby in favor of improved terms of trade E Not enough information Answer E Question Status Previous Edition 17 Suppose now that Home experiences growth strongly biased toward its export cloth A this will tend to worsen Home39s terms of trade B this will tend to improve Home39s terms of trade C this will tend to worsen Foreign39s terms of trade D this will have no effect on Foreign39s terms of trade E None of the above Answer A Question Status New 18 Suppose that Home is a quotsmall countryquot and it experiences growth strongly biased toward its export cloth A this will tend to worsen Home39s terms of trade B this will tend to improve Home39s terms of trade C this will tend to worsen Foreign39s terms of trade D this will have no effect on Foreign39s terms of trade E None of the above Answer D Question Status New 19 Other things being equal a rise in a country39s terms of trade increases its welfare What would happen if we relax the ceteris paribus assumption and allow for the law of demand to operate internationally Answer Let us assume that the terms of trade or technically the net commodity terms of trade improve thus the relative price of a country39s exports increase This would logically lead to a shift away by world consumers to substitute goods If the demand for a country39s exports is elastic the quantity decrease would be proportionally larger than the per unit price increase This term of trade effect would actually lower the country39s real income and economic welfare Question Status Previous Edition 223 Chapter 11 The Balance of Payments 224 A B 20 Refer to above figure Albania refused to engage in international trade for ideological reasons To maximize its economic welfare it would choose to produce at which point in the diagram above Suppose the P APB at point a was equal to 1 Given this information in which good A or B does Albania enjoy a comparative advantage Now that the Cold War is over Albania is interested in obtaining economic welfare gains from trade The relevant international relative price is P APB 2 Albania would therefore choose to produce at which point a b or c Given this additional information in which good does Albania enjoy a comparative advantage Answer Albania would choose to produce at point a With no reference to world terms of trade one cannot establish Albania39s comparative advantage Later when Albania discovers that the relative price of A equals twice the price of B it knows that it has a comparative advantage in A Therefore Albania would produce at production point b Question Status Previous Edition 21 Refer to above figure Now suppose that the relative price of A is actually not higher than Albania39s autarkic level of 1 but quite the opposite eg P APB 05 Would Albania still be able to gain from trade If so where would be its production point Given the information in this question where is Albania39s comparative advantage Answer Yes As long as the world39s terms of trade differed from those of Albania that country stands to gain from international trade In this particular case its point of production with trade would be at point c Question Status Previous Edition 52 International Transfers of Income Shifting of the RD Curve 1 When the production possibility frontier shifts out relatively more in one direction we have A biased growth B unbiased growth C immiserizing growth D balanced growth E imbalanced growth Answer A Question Status Previous Edition 224 Chapter 11 The Balance of Payments 225 2 Exportbiased growth in Country H will A improve the terms of trade of Country H B trigger antibias regulations of the WTO C worsen the terms of trade of Country F the trade partner D improve the terms of trade of Country F E decrease economic welfare in Country H Answer D Question Status Previous Edition 3 Immiserizing growth is A likely to occur if the exporting country is poor B likely to occur if the exporting country is rich C likely to occur when terms of trade change D likely to occur if relative supplies are elastic E None of the above Answer E Question Status Previous Edition 4 If the poor USAID recipient countries have a higher marginal propensity to consume each and every product than does the United States then such aid will A worsen the US terms of trade B improve the US terms of trade C leave the world terms of trade unaffected D worsen the terms of trade of both donor and recipient countries E None of the above Answer B Question Status Previous Edition 5 If the US has a higher marginal propensity to consume MPC imports as compared to both its MPC for exportables and nontradables then such aid will A worsen the US terms of trade B improve the US terms of trade C leave the world terms of trade unaffected D worsen the terms of trade of both donor and recipient countries E None of the above Answer B Question Status Previous Edition 6 If beginning from a free trade equilibrium the net barter terms of trade improve for a country then it will A increase production of its import competing good B increase consumption of its export good C increase the quantity of its imports D experience an exportbiased shift in its production possibility frontier E None of the above Answer C Question Status Previous Edition 225 Chapter 11 The Balance of Payments 226 7 After WWI Germany was forced to make large reparationstransfers of real income to France If the marginal propensity to consume was equal in both countries and if France39s demand was biased toward food relative to Germany39s demand pattern then we would expect to find A the world39s relative price for food remains unchanged B the world39s relative price for food increase C the world39s relative price for food decrease D the world relative price for both food and nonfood rise E None of the above Answer B Question Status Previous Edition 8 If France exported manufactures whereas Germany exported food then the reparations from Germany to France would A improve France39s international terms of trade B cause France39 terms of trade to deteriorate C cause both France39 and Germany39s terms of trade to deteriorate D cause both France39 and Germany39s terms of trade to improve E None of the above Answer B Question Status Previous Edition 9 If a country lent money to another this must A lower the terms of trade of the recipient country B lower the terms of trade of both countries C improve the terms of trade of the recipient country D improve the terms of trade of the donor country E None of the above Answer E Question Status Previous Edition 10 During the 19th Century economic growth of the major trading countries was biased toward manufactures and away from food The less developed countries of that time were net exporters of food From this information we would expect to have observed A falling terms of trade for the less developed countries B improving rising terms of trade for the less developed countries C no change at all in the terms of trade of the less developed countries D a decrease in the relative price of food E None of the above Answer B Question Status Previous Edition 11 Immiserizing growth could occur to A a poor country experiencing exportbiased economic growth B a poor country experiencing importbiased economic growth C a poor country experiencing growth in its nontraded sector D a poor country experiencing capitalintensive biased growth E None of the above Answer A Question Status Previous Edition 226 Chapter 11 The Balance of Payments 227 12 A large country experiencing importbiased economic growth will tend to experience A positive terms of trade B deteriorating terms of trade C improving terms of trade D immiserizing terms of trade E None of the above Answer C Question Status Previous Edition 13 In the period preceding the recent Financial Crisis in Asia the South East Asian countries were receiving large inflows of financial capital Following John Maynard Keynes39 theory this should have caused A a glut in their banking asset situation B an improvement in their terms of trade C deterioration in their terms of trade D a fluctuation upward and then downward in their terms of trade E None of the above Answer B Question Status Previous Edition 14 If a there are no international loans or capital flows then if a country39s terms of trade improve we would find that A the value of its exports exceeds the value of its imports B the value of its exports becomes less than that of its imports C the value of its exports exactly equals that of its imports D the quantity of its exports equals that of its imports E None of the above Answer C Question Status Previous Edition 15 If the US Agency for International Development transfers funds to poor countries in SubSaharan Africa the conventional assumption following Keynes39 analysis would presume that this would tend to A worsen the US terms of trade B improve the US terms of trade C worsen the terms of trade of the African aid recipients D improve the terms of trade of the African aid recipients E None of the above Answer A Question Status Previous Edition 16 If a country39s growth is biased in favor of its import this should unequivocally improve its terms of trade and its economic welfare Discuss Answer Suppose Japan experiences economic growth biased in favor of its import substitutes For example assume that Japan imports components and exports final goods but that it experiences a major growth in its components manufacture sector Since Japan is internationally a large country in these markets this would tend to hurt its component supplier39s terms of trade and help Japan39s However such a bias in economic growth may tend to lessen the volume of international trade At an extreme Japan may become an exporter of components and an importer of final goods If the result is a lessening of specialization and of the volume of trade then this effect will lower Japan39s welfare associated with gains from trade If an actual change in the pattern of comparative advantage occurs a possibility this may cause dynamic dislocations whose harm overpowers static gains for a relatively long period of time Question Status Previous Edition 227 Chapter 11 The Balance of Payments 228 17 It is impossible for economic growth in a small country to lower that country39s economic welfare regardless of the bias of the growth Explain Answer This is a true statement The reason economic growth may hurt a country is if the terms of trade effect counters and dominates the growth effect In the case of the small country there is no terms of trade effect Question Status Previous Edition 18 At the conclusion of World War I Germany as a punishment was obliged to make a large transfer to France in the form of reparations Is it possible that the actual reparations may have improved Germany39s economic welfare Answer Such a result is not likely However theoretically if France39s income elasticity of demand for Germany39s exports was higher than Germany39s income elasticity of demand for its own exportable then the real income transfer associated with these reparations may have improved Germany39s terms of trade and improved its balance of payments thus helping Germany in manner unanticipated in the Treaty of Verssaille Explain Question Status Previous Edition 19 If a country39s net barter terms of trade improve increase it is possible that this could decrease the value of its exports demanded and hence harm its economic welfare Discuss this possibility What alternative measure for quotterms of tradequot does this suggest Answer An quotimprovementquot in the terms of trade occurs when the price of a country39s exports rises by more than the price of its imports If demand for this country39s exports is inelastic then this could decrease demand for its exports in the world This is treated under the topics of the MarshalLerner conditions for the effects of a depreciation on the balance of payments This suggests that we may wish to use some kind of quotincome terms of tradequot the would explicitly consider both changes in relative tradables prices and also quantities of export the latter not dealt with by the net barter terms of trade Question Status Previous Edition 53 Tariffs and Export Subsidies Simultaneous Shifts in RS and RD 1 If the US a large country imposes a tariff on its imported good this will tend to A have no effect on terms of trade B improve the terms of trade of all countries C improve the terms of trade of the United States D cause a deterioration of US terms of trade E raise the world price of the good imported by the United States Answer C Question Status Previous Edition 2 If Slovenia is a small country in world trade terms then if it imposes a large series of tariffs on many of its imports this would A have no effect on its terms of trade B improve its terms of trade C deteriorate its terms of trade D decrease its marginal propensity to consume E None of the above Answer A Question Status Previous Edition 228 Chapter 11 The Balance of Payments 229 3 If Slovenia is a large country in world trade then if it imposes a large set of tariffs on many of its imports this would A have no effect on its terms of trade B improve its terms of trade C deteriorate its terms of trade D decrease its marginal propensity to consume E None of the above Answer B Question Status Previous Edition 4 If Slovenia were a large country in world trade then if it imposes a large set of tariffs on its imports this must A cause retaliation on the part of its trade partners B harm Slovenia39s real income C improve Slovenia39s real income D improve the real income of its trade partners E None of the above Answer E Question Status Previous Edition 5 If Slovenia were a large country in world trade then if it instituted a large set of subsidies for its exports this must A have no effect on its terms of trade B improve its terms of trade C deteriorate its terms of trade D decrease its marginal propensity to consume E None of the above Answer C Question Status Previous Edition 6 If Slovenia were a large country in world trade then if it instituted a large set of subsidies for its exports this must A cause retaliation on the part of its trade partners B harm Slovenia39s real income C improve Slovenia39s real income D improve the real income of its trade partners E None of the above Answer D Question Status Previous Edition 7 An export subsidy has the opposite effect on terms of trade to the effect of an import tariff Domestically a tariff will raise the price of the import good deteriorating the domestic terms of trade A production subsidy for the export product will lower the local price of the export good lowering the domestic terms of trade for the country Hence the export subsidy and the import tariff have the same effect This analysis seems to contradict the first sentence in this paragraph Discuss this paradox Answer While this Lerner equivalence may well occur domestically internationally the tariff will improve a country39s terms of trade An export subsidy on the other hand will in fact lower the international price of the now readily available export good hence hurting a country39s terms of trade Question Status Previous Edition 229 Chapter 11 The Balance of Payments 230 A d B 8 Suppose as a result of various dynamic factors associated with exposure to international competition Albania39s economy grew and is now represented by the rightmost production possibility frontier in the figure above If its point of production with trade was point c would you consider this growth to be export biased or import biased If Albania were a large country with respect to the world trade of A and B how would this growth affect Albania39s terms of trade Its real income Answer If point c is the production point with trade then Albania has a comparative advantage in good B Therefore from the shape of the new production possibility frontier as compared to the original one this is clearly an exportbiased growth This ceteris paribus would tend to worsen Albania39s terms of trade The terms of trade effect would again ceteris paribus worsen its real income However the growth itself acts in the opposite direction Question Status Previous Edition 9 Suppose as a result of various dynamic factors associated with exposure to international competition Albania39s economy grew and is now represented by the rightmost production possibility frontier in the figure above If its point of production with trade was point b would you consider this growth to be export biased or import biased If Albania were a large country with respect to the world trade of A and B how would this growth affect Albania39s terms of trade Its real income What if Albania were a small country Answer If the production with trade point was point b then the observed growth is a case of importbiased growth and would improve Albania39s terms of trade If Albania were a small country the world39s terms of trade would not change at all In such a case economic growth with no induced change in income distributions would always increase its real income Question Status Previous Edition 10 Suppose Albania is exporting product B and experienced economic growth biased in favor of product B as seen in the figure above We are also told that Albania39s new consumption point is at point d Would you still consider the economic growth which took place biased in favor of B If Albania were a large country how would this growth affect its terms of trade Answer This is a relatively difficult case On the one hand the growth is still technically export biased However Albania39s consumption clearly shifted in favor of its import product A In this case the deterioration in the terms of trade would be much more pronounced than before and may lead to a case of immiserizing growth However for this to occur there must have been a major shift in the taste patterns the old community indifference map is not longer applicable Therefore when we try to judge the direction and magnitude of the welfare change we are comparing the old versus new taste preferences which raises the classic index number problem Question Status Previous Edition 230 Chapter 11 The Balance of Payments 231 54 Appendix to Chapter 5 Representing International Equilibrium with Other Curves 1 Home39s offer curve shows A how Home39s desired exports vary with biased growth in Foreign B how Foreign39s desired imports vary with Home s level of exports C how Home39s desired exports vary with the terms of trade D how Foreign39s desired imports vary with the relative price E None of the above Answer C Question Status New 2 As one moves from the origin up Home39s offer curve Foreign39s terms of trade A remain constant B worsen C improve D may improve or worsen E None of the above Answer B Question Status New 3 If a straight line a ray from the origin does not cross through the point where the offer curves of the two trading countries intersect then A there will be an excess demand for both products B there will be an excess supply of both products C there will be an excess demand for one of the traded products D the terms of trade represented by the slope of the ray will represent the equilibrium terms of trade E None of the above Answer C Question Status 231 New c domestic companies may social benefits that will not be provided if the goods are imported d all of the above 9 The organization that now makes rules regarding international trade is called the a GATT b WTO c Congress of the United States d IMF 10 When the United States Canada and Mexico agreed to end tariffs between their countries they created a a common market b a single country c a free trade area d an economic union Answers1C 2B 3A 4B 5B 6D 7C 8D 9B10C CHAPTER 2 FOUNDATIONS OF MODERN TRADE THEORY MULTIPLECHOICE QUESTIONS 1 The mercantilists would have objected to a Export promotion policies initiated by the government b The use of tariffs or quotas to restrict imports c Trade policies designed to accumulate gold and other precious metals d International trade based on open markets 2 Unlike the mercantilists Adam Smith maintained that a Trade bene ts one nation only at the expense of another nation b Government control of trade leads to maximum economic welfare c All nations can gain from free international trade d The world s output of goods must remain constant over time 52 Chapter 2 Foundations of Modern Trade Theory 53 3 The trading principle formulated by Adam Smith maintained that a International prices are determined from the demand side of the market b Differences in resource endowments determine comparative advantage c Differences in income levels govern world trade patterns d Absolute cost differences determine the immediate basis for trade 4 Unlike Adam Smith David Ricardo s trading principle emphasizes the a Demand side of the market b Supply side of the market c Role of comparative costs d Role of absolute costs 5 When a nation requires fewer resources than another nation to produce a product the nation is said to have a an a Absolute advantage in the production of the product b Comparative advantage in the production of the product c Lower marginal rate of transformation for the product d Lower opportunity cost of producing the product 6 According to the principle of comparative advantage specialization and trade increase a nation s total output since a Resources are directed to their highest productivity b The output of the nation s trading partner declines c The nation can produce outside of its production possibilities curve d The problem of unemployment is eliminated 7 In a twoproduct twocountry world international trade can lead to increases in a Consumer welfare only if output of both products is increased b Output of both products and consumer welfare in both countries c Total production of both products but not consumer welfare in both countries d Consumer welfare in both countries but not total production of both products 8 As a result of international trade specialization in production tends to be a Complete with constant costs complete with increasing costs b Complete with constant costs incomplete with increasing costs c Incomplete with constant costs complete with increasing costs d Incomplete with constant costs incomplete with increasing costs 9 A nation that gains from trade will find its consumption point being located a Inside its production possibilities curve b Along its production possibilities curve c Outside its production possibilities curve d None of the above Using the data of Table 21 answer Questions 10 through 15 53 Chapter 2 Foundations of Modern Trade Theory 54 10 11 12 13 14 15 Table 21 Output Possibilities for the US and the UK Output per Worker per Dav Country Tons of Steel Televisions United States 5 45 United Kingdom 10 20 Refer to Table 21 The United States has the absolute advantage in the production of a Steel b Televisions c Both steel and televisions d Neither steel nor televisions Refer to Table 21 The United Kingdom has a comparative advantage in the production of a Steel b Televisions c Both steel and televisions d Neither steel nor televisions Refer to Table 21 If trade opens up between the United States and the United Kingdom American rms should specialize in producing a Steel b Televisions c Both steel and televisions d Neither steel nor televisions Refer to Table 21 The opportunity cost of producing one ton of steel in the United States is a 3 televisions b 10 televisions c 20 televisions d 45 televisions Refer to Table 21 Mutually advantageous trade will occur between the United States and the United Kingdom so long as one ton of steel trades for a At least 1 television but no more than 2 televisions b At least 2 televisions but no more than 3 televisions c At least 3 televisions but no more than 4 televisions d At least 4 televisions but no more than 5 televisions Refer to Table 21 The United Kingdom gains most from trade if a 1 ton of steel trades for 2 televisions b 1 ton of steel trades for 3 televisions c 2 tons of steel trade for 4 televisions d 2 tons of steel trade for 5 televisions 54 Chapter 2 Foundations of Modern Trade Theory 55 16 17 18 19 20 Concerning international trade restrictions which of the following is false Trade restrictions a Limit specialization and the division of labor b Reduce the volume of trade and the gains from trade c Cause nations to produce inside their production possibilities curves d May result in a country producing some of the product of its comparative disadvantage If a production possibilities curve is bowed out ie concave in appearance production occurs under conditions of a Constant opportunity costs b Increasing opportunity costs c Decreasing opportunity costs d Zero opportunity costs Increasing opportunity costs suggest that a Resources are not perfectly shiftable between the production of two goods b Resources are fully shiftable between the production of two goods c A country s production possibilities curve appears as a straight line d A country s production possibilities curve is bowed inward ie convex in appearance The tradingtriangle concept is used to indicate a nation s a Exports marginal rate of transformation terms of trade b Imports terms of trade marginal rate of transformation c Marginal rate of transformation imports exports d Terms of trade exports imports Assuming increasing cost conditions trade between two countries would not be likely if they have a Identical demand conditions but different supply conditions b Identical supply conditions but different demand conditions c Different supply conditions and different demand conditions d Identical demand conditions and identical supply conditions Use the data in Table 22 to answer Questions 21 through 26 21 Table 22 Output Possibilities for South Korea and Japan Output per Worker per Day Country Tons of Steel VCRs South Korea 80 40 Japan 20 20 Refer to Table 22 The opportunity cost of one VCR in Japan is a 1 ton of steel b 2 tons of steel c 3 tons of steel d 4 tons of steel 55 Chapter 2 Foundations of Modern Trade Theory 56 22 23 24 25 26 27 28 Refer to Table 22 The opportunity cost of one VCR in South Korea is a 12 ton of steel b 1 ton of steel c 112 tons of steel d 2 tons of steel Refer to Table 22 According to the principle of absolute advantage Japan should a Export steel b Export VCRs c Export steel and VCRs d None of the above there is no basis for gainful trade Refer to Table 22 According to the principle of comparative advantage a South Korea should export steel b South Korea should export steel and VCRs c Japan should export steel d Japan should export steel and VCRs Refer to Table 22 With international trade what would be the maximum amount of steel that South Korea would be willing to export to Japan in exchange for each VCR a 12 ton of steel b 1 ton of steel c 112 tons of steel d 2 tons of steel Refer to Table 22 With international trade what would be the maximum number of VCRs that Japan would be willing to export to South Korea in exchange for each ton of steel a 1 VCR b 2 VCRs c 3 VCRs d 4 VCRs The earliest statement of the principle of comparative advantage is associated with a Adam Smith b David Ricardo c Eli Heckscher d Bertil Ohlin If Hong Kong and Taiwan had identical labor costs but were subject to increasing costs of production a Trade would depend on differences in demand conditions b Trade would depend on economies of largescale production c Trade would depend on the use of different currencies d There would be no basis for gainful trade 56 Chapter 2 Foundations of Modern Trade Theory 57 29 If the international terms of trade settle at a level that is between each country s opportunity cost a b c d There is no basis for gainful trade for either country Both countries gain from trade Only one country gains from trade One country gains and the other country loses from trade 30 International trade is based on the notion that a b c d Different currencies are an obstacle to international trade Goods are more mobile internationally than are resources Resources are more mobile internationally than are goods A country s exports should always exceed its imports 31 Refer to Figure 21 The relative cost of steel in terms of aluminum is a b c d 40 tons 20 tons 05 tons 025 tons Production Possibilities Schedule Figure 21 Tons of Aluminum 2000 000 2000 4000 Tons of Steel 32 Refer to Figure 21 The relative cost of aluminum in terms of steel is a b c d 40 tons 20 tons 05 tons 025 tons 57 Chapter 2 Foundations of Modern Trade Theory 58 33 34 35 36 37 38 39 Refer to Figure 21 If the relative cost of steel were to rise then the production possibilities schedule would a Become steeper b Become atter c Shift inward in a parallel manner d Shift outward in a parallel manner Refer to Figure 21 If the relative cost of aluminum were to rise then the production possibilities schedule would a Become steeper b Become atter c Shift inward in a parallel manner d Shift outward in a parallel manner When a nation achieves autarky equilibrium a b c d Input price equals nal product price Labor productivity equals the wage rate Imports equal exports Production equals consumption When a nation is in autarky and maximizes its living standard its consumption and production points are a b c d Along the production possibilities schedule Above the production possibilities schedule Beneath the production possibilities schedule Any of the above If Canada experiences increasing opportunity costs its supply schedule of steel will be a b c d Downwardsloping Upwardsloping Horizontal Vertical If Canada experiences constant opportunity costs its supply schedule of steel will be a b c d Downwardsloping Upwardsloping Horizontal Vertical The gains from international trade increase as a b c d A nation consumes inside of its production possibilities schedule A nation consumes along its production possibilities schedule The international terms of trade rises above the nation s autarky price The international terms of trade approaches the nation s autarky price 58 Chapter 2 Foundations of Modern Trade Theory 59 40 41 42 43 44 45 In a twocountry twoproduct world the statement Japan enjoys a comparative advantage over France in steel relative to bicycles is equivalent to a France having a comparative advantage over Japan in bicycles relative to steel b France having a comparative disadvantage against Japan in bicycles and steel c Japan having a comparative advantage over France in steel and bicycles d Japan having a comparative disadvantage against Japan in bicycles and steel Ricardo s theory of comparative advantage was of limited realworld validity because it was founded on the Labor theory of value Capital theory of value Land theory of value Entrepreneur theory of value 999 Assume that labor is the only factor of production and that wages in the United States equal 20 per hour while wages in the United Kingdom equal 10 per hour Production costs would be lower in the United States than the United Kingdom if a US labor productivity equaled 40 units per hour while UK labor productivity equaled 15 units per hour b US labor productivity equaled 30 units per hour while UK labor productivity equaled 20 units per hour c US labor productivity equaled 20 units per hour while UK labor productivity equaled 30 units per hour d US labor productivity equaled 15 units per hour while UK labor productivity equaled 25 units per hour According to Ricardo a country will have a comparative advantage in the product in which its a Labor productivity is relatively low b Labor productivity is relatively high c Labor mobility is relatively low d Labor mobility is relatively high The Ricardian model of comparative advantage is based on all of the following assumptions except a Only two nations and two products b Product quality varies among nations c Labor is the only factor of production d Labor can move freely within a nation The writings of G D A MacDougall emphasized which of the following as an explanation of a country s competitive position a National income levels b Relative endowments of natural resources c Domestic tastes and preferences d Labor compensation and productivity levels 59 Chapter 2 Foundations of Modern Trade Theory 60 TRUEFALSE QUESTIONS T F l T F 2 T F 3 T F 4 T F 5 T F 6 T F 7 T F 8 T F 9 T F 10 T F 11 T F 12 T F 13 T F 14 According to the mercantilists a nation s welfare would improve if it maintained a surplus of exports over imports The mercantilists maintained that a freetrade policy best enhances a nation s welfare The mercantilists contended that because one nation s gains from trade come the expense of its trading partners not all nations could simultaneously realize gains from trade According to the pricespecie ow doctrine a tradesurplus nation would experience gold out ows a decrease in its money supply and a fall in its price level The trade theories of Adam Smith and David Ricardo viewed the determination of competitiveness from the demand side of the market According to the principle of absolute advantage international trade is beneficial to the world if one nation has an absolute cost advantage in the production of one good while the other nation has an absolute cost advantage in the other good The principle of absolute advantage asserts that mutually beneficial trade can occur even if one nation is absolutely more ef cient in the production of all goods The basis for trade is explained by the principle of absolute advantage according to David Ricardo and the principle of comparative advantage according to Adam Smith The principle of comparative advantage contends that a nation should specialize in and export the good in which its absolute advantage is smallest or its absolute disadvantage is greatest The Ricardian theory of comparative advantage assumes only two nations and two products labor can move freely within a nation and perfect competition exists in all markets Assume that the United States is more efficient than the United Kingdom in the production of all goods Mutually beneficial trade is possible according to the principle of absolute advantage but is impossible according to the principle of comparative advantage It is possible for a nation not to have an absolute advantage in anything but it is not possible for one nation to have a comparative advantage in everything and the other nation to have a comparative advantage in nothing Ricardo s theory of comparative advantage was of limited relevance to the real world since it assumed that labor was only one of several factors of production Compared to Ricardian trade theory modern trade theory provides a more general view of comparative advantage since it is based on all factors of production rather than just labor 60 Chapter 2 Foundations of Modern Trade Theory T F 15 T F 16 T F 17 T F 18 T F 19 T F 20 T F 21 T F 22 T F 23 T F 24 T F 25 T F 26 T F 27 T F 28 61 Constant opportunity costs suggest that the relative cost of producing one product in terms of the other will remain the same no matter where a nation chooses to locate on its production possibilities schedule There are two explanations of constant opportunity costs 1 factors of production are imperfect substitutes for each other 2 all units of a given factor have different qualities With increasing opportunity costs a nation totally specializes in the production of the commodity of its comparative advantage with constant opportunity costs a nation partially specializes in the production of the commodity of its comparative advantage A nation s trade triangle denotes its exports imports and terms of trade International trade leads to increased welfare if a nation can achieve a posttrade consumption point lying inside of its productionpossibilities schedule If the US posttrade consumption point lies along its production possibilities schedule the United States achieves a higher level of welfare with trade than without trade If productivity in the German computer industry grows faster than it does in the Japanese computer industry the opportunity cost of each computer produced in Japan increases relative to the opportunity cost of a computer produced in Germany If Japan loses competitiveness in computers Japanese computer workers lose jobs to foreign computer workers and the wages of Japanese computer workers tend to fall relative to the wages of foreign computer workers With constant opportunity costs a nation will achieve the greatest possible gains from trade if it partially specializes in the production of the commodity of its comparative disadvantage By reducing the overall volume of trade import restrictions tend to reduce a nation s gains from trade With increasing opportunity costs comparative advantage depends on a nation s supply conditions and demand conditions with constant opportunity costs comparative advantage depends only on demand conditions According to the principle of comparative advantage an open trading system results in resources being channeled from uses of low productivity to those of high productivity The existence of exit barriers tends to delay the closing of inefficient firms that face international competitive disadvantages MacDougall s empirical study of comparative advantage was based on the notion that a product s labor cost is underlaid by labor productivity and the wage rate 61 Chapter 2 Foundations of Modern Trade Theory T F 29 T F 30 T F 31 T F 32 T F 33 T F 34 T F 35 T F 36 T F 37 T F 38 T F 39 T F 40 ANSWERS 62 The MacDougall study of comparative advantage hypothesized that in those industries in which US labor productivity was relatively high US exports to the world should be lower than UK exports to the world after adjusting for wage differentials The basic idea of mercantilism was that wealth consisted of the goods and services produced by a nation According to Adam Smith international trade was a winwin situation since all nations could enjoy gains from trade The pricespecie ow mechanism illustrated why one nation s gains from trade were accompanied by another country s losses Complete specialization usually occurs under the assumption of increasing opportunity costs Adam Smith contended that gold silver and other precious metals constituted the wealth of a nation The pricespecie ow mechanism illustrated why nations could not maintain trade surpluses or trade deficits over the long run The marginal rate of transformation equals the absolute slope of a country s production possibilities schedule Assume that Germany has higher labor productivity and higher wage levels than France Germany can produce a commodity more cheaply than France if its productivity differential more than offsets its wage differential Ricardo s theory of comparative advantage does not take into account demand conditions when determining relative commodity prices If Canada has a higher wage level and higher labor productivity than Mexico Canada will necessarily produce a good at a higher labor cost than Mexico If Argentina has a comparative advantage over Brazil in beef relative to coffee Argentina will specialize in beef production Answers to MultipleChoice Questions P eP PE manna 6 a 11 a 16 c 21 a 7 b 12 b 17 b 22 d 8 b 13 a 18 a 23 d 9 c 14 b 19 d 24 a 10 c 15 b 20 d 25 d 62 Chapter 2 Foundations of Modern Trade Theory 26 27 28 29 Answers to TrueFalse Questions WWWWWWWWWWNNJNNNNNNNHHHHHHHr kr kr k ppms999wNEQPWNQMWNEQPWNQMWNEQP WNP P PWP 7995 aweaaewwwewweaeweweawaawwaawwwawwwewwewa 30 31 32 33 35quot 34 35 36 37 39995 63 38 39 40 41 h n 42 43 44 45 9778 63 Chapter 2 Foundations of Modern Trade Theory 64 64
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