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Intermediate Theory Money, Income, and Employment

by: Erna Gislason

Intermediate Theory Money, Income, and Employment ECON 420

Marketplace > University of North Carolina - Chapel Hill > Economcs > ECON 420 > Intermediate Theory Money Income and Employment
Erna Gislason
GPA 3.63

Michael Aguilar

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Michael Aguilar
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This 17 page Class Notes was uploaded by Erna Gislason on Sunday October 25, 2015. The Class Notes belongs to ECON 420 at University of North Carolina - Chapel Hill taught by Michael Aguilar in Fall. Since its upload, it has received 90 views. For similar materials see /class/228686/econ-420-university-of-north-carolina-chapel-hill in Economcs at University of North Carolina - Chapel Hill.


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Date Created: 10/25/15
Chapter 9 The 39 39 39 I 39 91 Monetarist Propositions Below are listed four propositions that characterize the monetarist position The supply of money is the dominant influence on nominal income 2 In the long run the influence of money is primarily on the price level and other nominal magnitudes In the long run real variables such as output and employment are determined by real not monetary factors I 3 In the short run the supply of money does influence real variables Money is the dominant factor causing cyclical movements in output and employment 4 The private sector is inherently stable Instability in the economy is primarily the result of government policies The central policy that follows from these propositions is that stability in the growth of money supply is crucial for a stable economy Monetarists believe that such stability is best achieved by adopting a rule for monetary policy The second monetarist proposition from above asserts that in the long run economic activity measured in real dollars does not depend on the quantity of money In the long run real output is determined by real factors such as stock of capital goods the size and quality of the labor force and the state of technology The third proposition from above states that in the short run output and employment ARE strongly influenced by changes in the supply of money 92 the f 39 39 of the Quantity Theory of Money The monetarist are showing how the Velocity of money is not constant as is was before with Keynes model page 194 They are showing how VELOCITY VARIES POSITIVELY WITH THE INTEREST RATE 1 Contrary to the early Keynesians Friedman argued that the demand for money was stable 2 Contrary to the near liquidity trap characterization Friedman maintained that the interest elasticity of money demand was certainly not infinite and was in fact quotrather smallquot 3 quotThe quantity of money far from being unimportant was the dominant influence on the level of economic activity PAGE 198 HAS THE EXPLANATION OF ALL THE DIFFERENCED BETWEEN FREIDMANS THEORY AND THE OTHER ONES BUT IT IS KIND OF CONFUSING Friedman39s money demand function can be written as follows Md LPY rb re rd P price level Y real income Rb nominal interest rate on bonds Re nominal return on equities Rd nominal return on durable goods Money demanded is assumed to depend on nominal income the product of the first two arguments in the demand function An increase in nominal income would increase money demanded FOR A GIVEN LEVEL OF NOMINAL INCOME FRIEDMAN ASSUMES AS DID KEYNES THAT THE AMOUNT OF MONEY DEMENDED DEPENDS ON THE RATE OF RETURN OFFERED ON ALTERNATIVE INVESTMENTS These other assets are 1 Bonds 2 Equities 3 And durable goods The difference between Friedman and Keynes 1 Friedman views the money demand function as stable 2 Friedman does not segment money demand into components representing transaction balances speculative demand and precautionary demand Money like other quotgoodsquot had attributes that make it useful but Friedman does not find it helpful to specify separate demands based on each of the uses of money 3 Friedman includes separate yields for bonds equities and durable goods Friedman39s money demand theory can be used to restate the Cambridge equation as follows Md krb re rdPY In Friedman39s view a quantity theorist belivies the following 1 The money demand function is stable 2 This demand function plays an important role in determining the level of economic activity 3 The quantity of money is strongly affected by money supply factors With a stable money demand function an exogenous increase in the moneysupply must either lead to a rise in PYor cause declines in rb re and rd which will cause k to rise with indirect effects on PY Friedman39s equation can again be rewritten as PY 1km Chapter 10 Output Inflation and 39 In chapter 9 we analyzed the monetarist proposition that short run changes in the money supply are the primary determinant of fluctuations in output and unemployment In the long run the influence of money is primarily on the price level and other nominal magnitudes In the long run REAL variables such as real output and employment are determined by real not monetary factors Changes in the aggregate demand which Friedman believes are dominated by changes in the supply of money cause temporary movements of the economy away from the natural rate Expansionary monetary policies for example move output above the natural rate and move the unemployment rare below the natural rate for a time The increased demand resulting from such an expansionary policy would also cause prices to rise Friedman does not believe that equilibrating forces cause output and employment to return to their natural rate over a longer period He says that the natural rate of employment will be such that labor demand equals labor supply at an equilibrium real wage The natural rates of output and employment do NOT depend on aggregate demand The difference between the monetarists and the classical economists is that the monetarists do not assume that the economy is necessarily at these natural levels of employment and output in the short run Monetarists do not believe that labor suppliers have perfect info about real wage Therefore labor supply may not be given by the natural supply schedule 102 Monetary Policy Output and Inflation Phillips curve The schedule showing the relationship between the unemployment and the inflation rates The Phillips curve is a negative relationship between the unemployment rate and the inflation rate High rates of growth in aggregate demand stimulate output and hence lower the unemployment rate Such high rates of growth in demand also cause an increase in the rate at which prices rise meaning that the inflation rate rises Lower rates of inflation can be achieved but only at higher rates of unemployment In the short run an increase in the rate of growth in the money supply moves inflation up and unemployment down Friedman points out that in the short run product prices increase faster than factor prices the crucial factor price being the money wage Thus real wage WP faIIs This is necessary for output to increase because firms must be on the labor demand schedule Firms expand employment and output only with a decline in the real wage Friedman does not argue that workers are always on the labor supply schedule That schedule expresses labor supply as a function of the ACTUAL real wage and Friedman does not assume that workers know the real wage In the short run after a period of stable prices workers are assumed to evaluate the nominal wage offers quotat the earlier price levelquot Prices have risen but workers have not yet seen this rise and they will increase labor supply if offered a higher money wage even IF THIS INCREASE IN THE MONEY WAGE IS LESS THAT THE INCREASE IN THE PRICE LEVEL EVEN IF THE REAL WAGE IS LOWER In the short run labor supply increases because the expected real wage is higher as a result of the higher nominal wage and unchanged view about the behavior of prices Labor demand increases because of the fall ofactual real wage paid by the employer As suppliers of labor anticipate that prices are rising the PC will shift upwards and to the right Suppliers of labor will demand a higher rate of increase in money wages and as a consequence a higher rate of inflation will now correspond to any given unemployment rate INCREASES IN THE MONEY GROWTH RESULT IN TEMPORARY REDUCTIONS IN UNEMPLOYMENT BUT IN THE LONGER RUN WE SIMPLY MOVE UP THE VERTICAL PHILLIPS CURVE 103 A Keynesian View of the output inflation Tradeoff For the Keynesians an expansionary aggregate demand policy such as an increase in the rate of growth in the money supply will cause a series of shifts to the right in the aggregate demand schedule In the short run output the price level and employment will all rise This is the same thing as the monetarist The more quickly aggregate demand grows the larger will be the rightward shifts in the aggregate demand schedule and the faster will be the rate of growth in output and employment The Keynesian model then implies a tradeoff between inflation and unemployment High rates of growth in demand correspond to low levels of unemployment and high rates of inflation In the short run the Phillips curve implied by the Keynesian model is downwardsloping In the long run in the Keynesian model as in Friedmans analysis the Phillips curve is vertical In the long run leftward shifts in the labor supply and the aggregate supply schedules reverse the increases in output and employment that result from the expansionary aggregate demand policy Output and employment return to their initial levels The Keynesian view is that aggregate demand policies are aimed at stabilizing output and employment in the short run Because the Monetarist LM curve is so steep a change in the supply of money would not cause much to change Small shocks may cause output and employment to deviate somewhat from the natural rate but Friedman and other monetarists do not believe that our knowledge of the economy allows us to predict such shocks and design policies with sufficient precision to offset them Basically says that we do not have perfect information 104 Evolution of the Natural Rate Concept Friedman thought that a monetary policy could not permanently lower unemployment below the natural rate not without causing an everaccelerating inflation Causes of unemployment can be linked to FRICTIONAL AND STRCTUAL reasons Low labor in a country might be expected to lead to a higher natural rate of unemployment because as demand is shifted from one region on the country to another workers would not be quick to follow Poor information aboutjob vacancies might also lead to a higher natural rate of unemployment as workers take longer to find initial jobs or to move between jobs If the natural rate of unemployment is a useful concept it must be time varying Hysteresis it property that when a variable is shocks away from an initial value it shows no tendency to return even when the shock is over Persistently high unemployment rates in many European countries have led economists to argue that unemployment exbits hysteresis Chapter 11 Keynesian really wants the government to be stabilized by aggregate demand management The central policy of the NEW CLASSICAL economics is that the stabilization of real variable such as output and employment cannot be achieved by aggregate demand management New Classical Policy Ineffectiveness Proposition asserts that systematic monetary and fiscal policy actions that change aggregate demand will NOT affect output and employment even in the short run This is the exact opposite of what the Monetarist believe Pretty much all that Keneysians said was that in the short run you can increase output and labor but in the long run it is all just going to stay the same Keynesians and Monetarists have said that labor suppliers form and expected price by looking at past behavior of prices New classical economists say that is stupid NCE say people choose based on rational expectations I think later n he mentions that this is bullshit because there is no way that the average citizen uses all information to make an informed descion because that would take up way too much time Rational Expectations expectations formed on the basis of all available relevant information concerning the variable being predicted Moreover economic agents are assumed to use available information intelligently that is they understand the relationships between the variables they observe and the variables that they are trying to predict The crucial difference between the new classical case and the Keynesian case concerns the variables that determine the positions of the labor supply and aggregate supply schedules Increases in the expected price level will shift both schedules to the left The expected price level depends on the expected level of the variables in the model that actually determine the price level These include the expected levels of the money supply Me government spending Ge and tax quot 39 V and 39 le In the Keynesian or monetarist analysis the increase in the money supply leads to an increase in employment and output in the short run that is until labor suppliers correctly perceive the increase in the price level that results from the monetary policy action Says that any set of systematic policy actions will be anticipated and will not affect the behavior of output or employment There was some other random stuff in that section but it can really just be seen by looking at the graph 112 A broader View of the New Classical Position New classical economists are critical of Keynesian economies as a whole Say that the Keynesian system was based off individual optimizing behavior The Keynesian model is in their view made up of ad hoc elements which were failed attempts to explain the observed behavior of the economy in the aggregate As we learned in Speech class ad hoc means that one event occurred after another and claiming that the first event cause the second event even though that might not be true An example is saying that pickles cause death The fact is that yes everybody that has ever eaten a pickle has died or will die but just because a person eats a pickle does not mean that they will die New classicalist do not think that the market has sticky wages I that the markets do have sticky wages though because there are tings like contracts that ensure people moneyThey favor the classical view that markets including the labor market clear that is prices including the money wage rate move to equate supply and demand 1 Agents optimize 2 Markets clear This is a pretty stupid view Recall that the classical AS curve is vertical Classicalist believed in perfect information but New classicalist believe in rational expectations In this case systematic and hence anticipated changes in AD will not affect output and employment but unanticipated changes in aggregate demand will 113 The Keynesian Counter critigue Keynesians argue that although unanticipated declines in AD might be plausible for brief departures from potential output and employment it is not adequate to explain persistent and substantial deviations that we have experienced Says that yes over a period of a year these changes would be anticipated but by the next year decline in AD would be apparent and not longer unanticipated Keynesian also argues the assumption that individuals use all available relevant information in making their forecasts Such assumption ignores the costs of gathering information Auction market In the classical view the money wage is assumed to adjust quickly to clear the labor market Contractual view In the Keynesian labor market wages are not set to clear markets in the short run but rather are stronglt conditioned by onder term considerations involving employer worker relations Keynesians view te labor market as one in which longterm arrangments are made between buyers and sellers In general such relationships fix the money wage while leaving the employer free to adjust hours worked over the course of contracts Chapter 12 Real business cycle theory is an outgrowth of the new classical theory which in turn built on the original classical economics In fact real business cycle models are sometimes referred to as second generation of nrecalssical models Recall that new classical economists believe macroeconomic models should have two characteristics 1 Agents optimize 2 Markets Clear Real Business Cycle theorists agree RBC focuses on individual optimization Keynesian has involuntary unemployment New Classical and RBC All unemployment is voulantary Where RBC differ with NC is on the causes of fluctuations in output and employment RBC see these fluctuations as arising from variations in the real opportunities of the private economy Factors that cause such change include shocks to technology variations in environmental conditions changes in the prices of imported raw materials and changes in tax rates Fluctuation39s in output also occur with changes in individuals preferences These are the same factors that determined output in the classical model RBC says that supply side variables are also the source of short run changes in output and employment Monetary Policy The defining fwture of RBC models is that real not monetary factors are responsible for fluctuations in outputand employment In BBC models the role of money is to determine the price level much the same as in the original classical model Changes in the quantity of money result in proportionate changes in the price level with no change in output or employment This means that monetary policy should focus on controlling the price level Many fiscal policy actions will affect output and employment in a RBC The effect will be caused by supply side The task of fiscal policy in RBC is to minimize tax distortions subject to providing needed government services such as defense This is where an alternative role for monetary policy emerges alternative to simply keeping inflation low through slow steady money growth Seigniorage the amount of real resources bought by the government with newly created money However this also has its cost because the faster the money supply grows the higher will be the inflation rate Critics have two problems with RBC 1 Whether technology shocks are of sufficient magnitude to explain observed business cycles 2 Wheter observed changes in employment can be explained as the vokuntary choices if economic agents facing changing production possibilites RBC are convinced that the business cycle can be explained as an equilibrium phenomenon Flucations in output come as optimizing economic agents respond to real shocks that affect production posibilites Policies that try to prevent these lucations are unnecessary and misguided Critics of RBC see business cycles as the result of changes in nomnal aggregate demand as well as changes in real supplyside variables 122 New Keynesian Economics Keynesians like to show how aggregate demand affected output and employment Keynesians also really like wage rigidities New Keynesian Economists have not tried to develop one rationale for all price and wage rigidities Rather they believe that a number of features of the wageandpricesetting process explain such rigidities In fact the New Keynesian literature is characterized by what has been called a dizzying diversity of approaches These approaches have common elements 1 In new Keynesian models imperfect competition is assumed for the product market This assumption contrasts with the earlier Keynesian models that assumed perfect competition 2 Whereas the key nominal rigidity in earlier Keynesian models was the money wage new Keynesian models also focus on product price rigidity 3 In addition to factors that cause nominal variables the money wage to be rigid new Keynesian models introduce real rigidities factors that make the real wage or firms realtive price rigid in the face of changes in aggregate demand We consider three types of New Keynesian models 1 Sticky price models 2 Efficiency wage models 3 Insideroutsider models Sticky price models are those in which costs of changing price adjustments when demand changes Consequantly output falls when for example there is a decline in demand Keynesian models viewed the money wage as the variable that failed to adjust to changes in aggregate deman output and employment had to adjust Sticky prices mean that the firm is not a perfect competitor Menu costs refer to any type of cost that a firm incurs if it changes its product price Cost of changing prices 1 MANAGERIAL COSTS gathering info on whether or not to change prices and communicating to the customers the reason for the change when they could be doing something else Customer good will 3 If during a recseeion they lower prices too much there could be a price war with similar companies 4 Iquot a If these perceived costs of price changes are high enough price stickiness will exist Declines in aggregate demand will result in falls in output and employment not price reductions Efficiency wage models are models in which labor productivity depends on the real wage workers are paid In such models the real wage is set to maximize the efficiency units of labor per dollar of expenditure not to clear the labor market The efficiency of workers depends positively on the real wage they are paid We can use the Henry ford example E eWP So in a production such asY FK N now turns into Y FKeN The goal of the firm is to set the real wage so that the cost of an efficiency unit of labor is minimized or to say the same thng in reverse to maximize the number of efficiency units of labor bought with each dollar of the wage bill At the point where a 1 percent increase in the real wage produces only a 1 percent increase in efficiency the efficiency wage has been reached Real wages do not adjust to clear labor markets In fact firms usually set wage ABOVE the market clearing level Several rationales have been offered for the payment of efficiency wages 1 The shirking model 2 Turnover cost model 3 Gist exchange model increases moral so workers work harder Insider Outsider Models and Hysteresis Provide one explanation of hysteresis in unemployment Insiders union members are the only group that affects the real wage bargain Outsiders those who want jobs do not Recessions cause insiders to become outsiders After the recession with fewer insiders the real wage rises and unemployment persists It is a hypothesis that present unemployment is stroneg influenced by past unemployment Economies can get stuck in EMPLOYMENT TRAPS Hysteresis just another term for EMPLOYMENT TRAPS A variable exhibits hysteresis if when shocked away from an initial value it shows no tendency to return even when the shock is over It is a trap because once insiders become outsiders they have no bargaining power over the real wage and the people on the inside have no real reason to help them since the people on the inside are now getting paid more money Chapter 13 Macroeconomic Models A Summam There are some great graphs on page 265 Classical Model I Views output as completely determined by supply factors I Has a vertical aggregate supply schedule I Both labor supply and labor demand depend only on the real wage which is known to all market participants I The money wage is perfectly flexible and moves to equate demand and supply in the labor I Increases in AD cause the price level to rise The price rise spurs production I To clear the labor market the money wage has to rise proportionally with the price level I This causes the real wage to be unchanged in the new equilibrium The role of AD is to determine the price level I They use the quantity Theory of money 0 Cambridge form is M kPY I If there is an excess supply of money a corresponding excess demand for commodities will drive up the aggregate price level Real Business Cycle I Is a modern version of the classical theory I Output and employment are determined by real variables The labor market is always in equilibrium I All unemployment is voluntary I Role of money is to determine the price level Keynesian model I This is the antithesis of the classical model and RBC I Supply plays no role in output determination The aggregate supply schedule is horizontal indicating that supply is no constraint on the level of production I On the demand side the model concentrates on the determinants of autonomous expenditures government spending taxes and autonomous investment demand Money factors are neglected I Aggregate Demand is important for determining employment I The modern Keynesian model allows for the influence of both supply factors on output and monetary factors on aggregate demand I Keynesian aggregate supply slopes upward to the right I In the short run an increase in the price level will cause firms to supply a higher level of output because the money wage will not rise proportionally with price I They say that there is wage and price stickiness There are two important differences between the Keynesian and Classical frameworks In the classical model output and employment are completely supply determined whereas in the Keynesian theory in the short run output and employment are determined jointly by aggregate supply and demand In the Keynesian system aggregate demand is an important determinant of output and employment 2 Aggregate demand in the classical model is determined soely by the quantity of money In the Keynesian system money is only one of several factors the determine aggregate demand Monetarists Have taken the Cambridge version of the quantity equation I Both monetarist and Keynesians have the AS sloping upward to the right in the short run New Classical I Believe that systematic and therefore predictable changes in aggregate demand will not affect real output Such changes will be anticipated by rational economic agents Unanticipated changes in AD for example an increase ein the money supply that could not have been predicted will shift the AD schedule without shifting the AS schedule I Unanticipated changes in AD will cause labor suppliers to make price forecast effors and will therefore affect output and employment Keynesians seem to be the only ones who like policy interventions Might want to take another look at page 268 and 269 If everv single food is the same color I have fucked up ltlatin and Irish Chapter 14 Exchange Rates and the International Monetam System The US economy has become much more open in the sense of having more extensive trade and financial dealings with other economies Balance of Payments Accounts records economic transactions between US and foreign residents both in goods and assets 141 Balance of Payments Accounts Export credit Import Debit Merchandise trade balance measures exports minus imports in the US balance of payments RIGHT NOW IT IS A DEFICIT Current Account In the US balance of payments this is a record of US merchandise exports and imports as well as trade in services and foreign transfer payments Capital Account in the balance of payments is a record of purchases of US assets by foreign residents and purchases of foreign assets by US residents Statistical discrepancy Because not all international economic transactions are properly recorded the statistical discrepancy is the amount that must be added to make the total balance of payments balance of payments balance Official reserve assets holdings of gold special drawing rights and foreign currency holdings 142 Exchange rates and the market for Foreign Exchange Foreign Exchange a general term to refer to an aggregate of foreign currencies To see the link between the balance of payments accounts and transactions in the foreign exchange market we begin by recognizing that all expenditures by US residents on foreign goods services or assets and all foreign transfer payments also represent demands for foreign currencies that is demand for FOREIGN EXCHANGE Thus the total US residents expenditure abroad represents a demand for foreign exchange The total foreign expenditure of US residents represents an equal supply of dollars in the foreign exchange market Total credits in the balance of payments accounts are equal to the supply of foreign exchange A higher exchange rate means that the price of foreign currency had risen When the exchange rate rises we say that the foreign currency has appreciated or that the dollar has depreciated The demand curve for foreign exchange is downwardsloping indicating that as the price of foreign exchange rises the demand for foreign exchange falls The reason is that a rise in the price of foreign exchange will increase the cost in terms of dollars of purchasing foreign goods We would not necessarily expect any effect on the demand for foreign assets as a result of a change in the exchange rate Supply increases as the exchange rate rises because other countries can but more of US goods at the same price For the supply of foreign exchange to increase as the exchange rate rises the foreign demand for our exports must be more that UNIT ELASTIC meaning that a 1 percent increase in the exchange rate must result in an increase in the demand ofmore than one percent A system of exchange rate determination in which there is no central bank intervention is a flexible exchange rate system or as it is sometimes clled a floating rate system If our economy demands more foreign goods such as fuel efficient cars cause our trucks take up way too much gas then there will be a rise in the exchange rate This rise in the exchange rate will cause the quantity of imports demanded to decline because the dollar price of imported goods rises with the exchange rate At the same time exports will increase since are cars are now relatively cheaper to other countries Exchange rate T 39 39 Fixed Exchange Rates Bretton Woods System was a pegged exchange rate system set up at the end of WWII This system tied the US dollar to gold and other countries somewhat based their projected worth of their currency based on that THIS EXAMPLE TALKS ABOUT FIXING THE EXCHANGE RATE We assume that the official fixed exchange rate 10 is below the equilibrium exchange rate in a flexible rate system the equilibrium rate being 125 8 euro 1 dollar At the fixed exchange rate in such a situation the dollar would be said to be OVERVALUED and the euro UNDERVALUED This terminology means that if the exchange rate were marketdetermined the price of the euro relative to the dollar exchange rate would have to rise to clear the market What keeps this from happening is intervention from central banks To keep the rate at 10 the United States must stand ready to buy and sell dollars at that exchange rate If the US central bank will buy euros for one dollar the exchange rate cannot fall below that point because no one would sell else where for less Similarly the exchange rate cannot rise above 10 because the central bank will be willing to sell euros at that price To keep the exchange rate from rising the US central bank can supply foreign exchange that is it can exchange euros for dollars in the foreign exchange market Problems with this is 1 Where does the US get all of these euros to supply 2 Countries that must intervene continually to finance deficits will run out of official reserve assets 143 The Current Exchange Rate System There is no one system of exchange rate determination In a managed float central banks intervene in foreign exchange markets to prevent undesirable or disruptive movements in their exchange rates Otherwise their exchange rates float The rest of the pages in this section talk about the Bretton Woods system but by looking at the class notes it does not look like we really focused on this so I am going to skip it 144 quot J ofalternative Exchange Rate Regimes Advantages of Exchange Rate flexibility 1 Flexible exchange rates would allow policymakers to concentrate on domestic goals free of worries about balance payment deficits They would remove potential conflicts that arise between INTERNAL BALANCE domestic goals and EXTERNAL BALANCE balance of payments equilibrium Flexible exchange rates would insulate the domestic economy from economic shocks that originate abroad Iquot Trade balance and te level of economic activity The import schedule is drawn sloping upward because the demand for imports depends positively on income The export schedule is horizontal The demand for US exports is a part of the foreign demand for inports The foreign demand for imports depends on FOREIGN income Exports and imports will be equal if income is at YTB 0 where TB the trade balance equals 0 This level of income generates import demand equal to the exogenous level of exports But there is no reason to expect that YTB 0 will be an equilibrium level of income For example there could be more income and imports will exceed exports causing a deficit in the trade balance Imports 2 Exports x Policy makers want to find an internal balance and an external balance Capital flows and the Level of Economic Activity The primary determinants of capitla flows between nations are expected rates of return on assets in each of the countries With a fixed exchange rate system the effects of expected exchange rate movements on asset returns can be ignored Interest rates in the various countries will be measures of realtive rates of return If we take the rate of return in other countries as given the level of the capital flow into a particular country will depend positively on the level of its interest rate that is F F F net capital inflow a negative value of of F represents a net outflow of deficit on capital account This means that the capital account will therefore depend on how the interest rate varies with the change in economic activity Expansionary monetary policy I Lowering rate of interest Unfavorable to the balance on the capital account I Investment in US by foreigners will decline I US investment abroad will increase I TB and capital account will deteriorate Expansionary fiscal policy I Interest rate will rise Increase in capital inflow I Whether the overall effect on the BoP is favorable or unfavorable depends on the relative strength of these two effects of the fiscal policy induced expansion the favorable effect on the capital account or the unfavorable effect on the trade balance UNLESS THE ECONOMY IS FAR FROM FULL EMPLOYM ENTEXPANSIONARY AGGREGATE DEMAND POLICIES WILL CAUSE THE PRICE LEVEL TO RISE Exchange Rate Flexibility and Insulation from Foreign Shocks A foreign recession results in a fall in exports and a shift to the left in the supply of foreign exchange With a fixed exchange rate system there will be a BoP deficit In a flexible exchange rate system the exchange rate will rise to clear the foreign exchange market Arguments for Fixed Exchange Rates Provide a more stable environment for growth in world trade and international investment I More macroeconomic stability Here are some flaws in a fluctuating exchange rate However there is volatility in a fluctuating exchange rate poses a risk to a domestic exporter or an investor who plans a foreign investment such as a plant in another country People also argue that a fluctuating exchange rate swings and adjustment costs exchange rate fluctuations would cause resources to be shifted into and out of export industries with consequent adjustment cost including frictional unemployment Last argument against is that a fluctuating exchange rate would lead to destabilizing speculation in foreign exchange markets The last couple of sections dealt with certain years that the dollar has fluctuated in and did not really focus on any theory and again the class notes did not show any reference to this Chapter 15 Monetarv and Fiscal Policv in the Open Economv 151 theMundellfleming This chapter just has a few equations that suck The BF schedule will be upward sloping in the case of the imperfect capital mobility f domestic and forigen assets were perfect substitutes a situation called pefect capital mobility investors would move to equalize interest rates among countries


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