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Econ 102 Week 3 Notes

by: Andrea Lans

Econ 102 Week 3 Notes Econ 102

Andrea Lans

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About this Document

These notes cover chapters 5 and 6 of macroeconomics.
Macroeconomic Theory
Class Notes
Economics, Macroeconomics, inflation, open, economy
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This 4 page Class Notes was uploaded by Andrea Lans on Sunday October 9, 2016. The Class Notes belongs to Econ 102 at University of California - Los Angeles taught by Keskinel in Fall 2016. Since its upload, it has received 56 views. For similar materials see Macroeconomic Theory in Economics at University of California - Los Angeles.


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Date Created: 10/09/16
Chapter 5: Inflation Quantity Theory of Money - Links inflation rate to growth rate of $ supply - Velocity: rate at which $ circulates; # times dollar changes hand in given time period • V = T / M T = value of transactions (P x Y = value of output/nGDP); M = $ supply • Quantity Equation: M x V = P x Y - Real money balances: purchasing power of $ supply = M / P - Money demand function: (M/P ) = k Y • k = how much $ people want to hold for each $ of income (exogenous) - k = 1 / V Price level P = nGDP/rGDP • • V is constant Inflation • π = (ΔM/M) - (ΔY/Y) - Money growth in excess of economic growth leads to inflation; 1-for-1 relation btw Δmoney growth rate & Δπ - Gov’t can print $ to spend more w/out raising taxes or selling bonds - Seigniorage: revenue raised from printing $ - Inflation tax: tax on people who hold $ - Real interest rate: r = i - π i = nominal interest rate - Fisher equation: i = r + π ; ↑π, ↑i (Fisher effect is this relationship) • ↑i, ↓money demand • Real money demand = (M/P ) = L(i, Y) = L ( r + Eπ, Y) depends (-) on i, (+) on Y • For given values of r, Y, Eπ, ΔM causes ΔP by same % - 2 real interest rates: ex ante (Eπ , rate people expect), ex post (rate actually realized) • ↑Eπ = ↑i (Fisher effect), ↓(M/P ) ,↑P (make M/P fall) - Inflation only ↓real wages in short run (fixed by contract) - Social costs of inflation: • Costs when inflation is expected 1. Shoeleather cost: costs of reducing $ balances to avoid inflation tax; more trips to banks to withdraw smaller amounts of $ 2. Menu Costs: cost of Δprices; printing new menus, mailing new catalogues 3. Relative price distortions: firms facing menu costs Δprices infrequently; dif. firms Δprices at dif. times —> relative price distortions/inefficiency of allocation 4. Unfair tax treatment: some taxes not adjusted for inflation (capital gains/stocks tax) 5. General inconvenience: harder to compare nominal values from dif. time periods; complicates long-range financial planning • Costs when inflation is different than expected 1. Arbitrary redistribution of purchasing power: many long-term contracts not indexed but are based on Eπ; if dif. than π some gain at others’ expense • π > Eπ: purchasing power transferred from lenders to borrowers • π < Eπ: purchasing power borrowers —> lenders 2. Increased uncertainty: high inflation is more unpredictable; arbitrary redistributions of wealth more likely, ↑uncertainty, risk-averse people worse off - Benefit of inflation: inflation allows real wages to reach equilibrium levels w/out nominal wage cuts; improves functioning of labor markets - Hyperinflation: π > 50%/month; caused by excessive $ supply growth (printing $ rapidly enough) • When gov’t can’t raise taxes/sell bonds it must print $ to finance spending - Classical dichotomy: Separation of real & nominal variables; implies nominal doesn’t affect real - Neutrality of money: Δ$ supply don’t affect real variables; $ neutral in long run Chapter 6: Open Economy Intro - Open economy: spending ≠ output; saving ≠ investment - IM (imports) = Cf +If + Gf = spending on foreign goods; NX = EX - IM • Trade defici:texports > imports (NX) • Trade surplus : exports < imports (-NX) Capital Flows - Net capital outflow: S - I; net outflow of loanable funds; net purchase of foreign assets; difference btw. savings & investments • S > I, country is net lender • S < I, country is net borrower • trade balance = net capital outflow - US is world’s largest debtor nation; $4.3 trillion net indebtedness - Assumptions about capital flows: • Domestic & foreign bonds are perfect substitutes • Perfect capital mobility: no restrictions on international trade • Economy is small, can’t affect world interest rate (r* exogenous & = r) - In small open economy; exogenous world interest rate (r*) determines investment; dif. btw. savings & investment determines net capital outflow & NX • Fiscal policy at home: ↑G or ↓T,↓saving, ↓NX • Expansionary fiscal policy abroad ↑r*, ↑NX Exchange Rates - Nominal: e, price of domestic currency in terms of foreign currency (yen/$) • e = ɛ x (P*/ P) • e = real exchange rate x country’s price level relative to foreign price level • %Δnominal exchange rate = foreign inflation - domestic inflation - Real: ɛ, price of country’s goods in terms of another country’s goods • ɛ = (e x P) / P* P*= foreign currency per unit of foreign good • Real exchange rate = nominal rate x ratio of prices in 2 countries - ɛ is relative price of domestic output in terms of foreign output ↑ɛ, ↓NX (↓exports and ↑imports) • When ɛ low, US goods are inexpensive, export more • • Real exchange rate adjusts so NX (D for $) = net capital outflow (S, vertical curve) - NX(ɛ) = S - I(r*) - Fiscal expansion at home: ↓S, ↓net capital outflow, ↓$ supply in foreign exchange market; ↓NX, ↑ɛ - Fiscal policy abroad: ↑r*, ↓investment, ↑net capital outflow, ↑$ supply in foreign market; ↓ɛ, ↑NX Purchasing Power Parity (PPP) - PPP: goods must sell at same price in all countries; nominal exchange rate adjusts to equalize cost of basket of goods (output) across countries (law of one price) e x P = P* • • cost of basket of domestic goods in foreign currency = cost of foreign goods in foreign currency • Doesn’t hold in real world- international goods not perfect subs, international arbitrage impossible


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