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Aggregate supply and aggregate demand Chapters 31, 32, and 33. By Thuy Le. Chapter 31. Open-Economy Macroeconomics: Basic Concepts. Chapter 31. Prior to this you’ve only studied closed economies economies that do not interact with other economies in the world - PowerPoint PPT Presentation
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CHAPTER 31
Prior to this you’ve only studied closed economies economies that do not interact with other
economies in the world
In macroeconomics, many new situations arise when studying open economies economies that interact freely with other economies
around the world
CHAPTER 31
An open economy allows for a greater flow of goods and services. Some terms to know are: Exports: goods and services that are produced
domestically and sold abroad Imports: goods and services that are produced
abroad and sold domestically Net exports/Trade balance: the value of a nation’s
exports minus the value of its imports
CHAPTER 31
More terms to know: balanced trade: a situation in which exports equal
imports trade deficit: an excess of imports over exports trade surplus: an excess of exports over imports
CHAPTER 31
There are many variables which can affect international trade. Some of them are: Consumers’ preferences for foreign and domestic
goods Prices of goods at home and abroad Incomes of consumers at home and abroad The exchange rates at which foreign currency trades
for domestic currency Transportation costs Government policies
CHAPTER 31
Residents of an open economy participate in the market for goods and services, but they can also participate in the world financial market.
When talking about the flow of financial resources economists use the term net capital outflow, formerly known as net foreign investment. the purchase of foreign assets by domestic residents
minus the purchase of domestic assets by foreigners
CHAPTER 31
There are many terms related to a country’s NCO. Some are: Foreign direct investment: Domestic residents
actively manage the foreign investment Ex: Thuy, a U.S. resident, is the owner of the H.B. Reese
Company and builds a plant in China so she can produce Reese’s cups on the cheap
Foreign portfolio investment: Domestic residents purchase foreign stocks or bonds, supplying loanable funds to a foreign firm. Ex: Nick, a U.S. resident, purchases stocks of Adidas, his
favorite German shoe company
CHAPTER 31
NCO measures the imbalance in a country’s trade in assets:
When NCO > 0, there is capital outflowWhen NCO < 0, there is capital inflow
It is important to remember that NCO will always equal NX. Every transaction that affects NX also affects NCO by
the same amount
CHAPTER 31
Earlier, you learned about GDP equaling C + I + G + NX. This identity can now be used with NCO so we can relate the flow of trade to savings and investment.Y = C + I + G + NX is also true when written as
Y – C – G = I + NX , and this can be rearranged to be
S = I + NX since S = Y – C – G, which means
S = I + NCO since NX = NCO
CHAPTER 33
When S > I, the excess loanable funds flow abroad in the form of positive net capital outflow.
When S < I, foreigners are financing some of the country’s investment, and NCO < 0.
CHAPTER 31 In addition to NX and NCO, economists also look
at two other variables when studying international transactions. They are: nominal exchange rate: the rate at which a person can trade
the currency of one country for the currency of another and
real exchange rate: the rate at which a person can trade the goods and services of one country for the goods and services of another
e x PP*
P = domestic priceP* = foreign price (in foreign
currency)e = nominal exchange rate
CHAPTER 31
Exchange rates change from time to time. When they do, a nation’s currency is said to be appreciating or depreciating. Appreciation: an increase in the value of a currency
as measured by the amount of foreign currency it can buy
Depreciation: a decrease in the value of a currency as measured by the amount of foreign currency it can buy
CHAPTER 31
The simplest theory of exchange rates is the purchasing power parity, which is based on the law of one price. The purchasing power parity: a theory of exchange
rates whereby a unit of any currency should be able to buy the same quantity of goods in all countries
CHAPTER 32
The previous chapter explained the basic concepts and vocabulary of the open economy.
This chapter ties these concepts together into a theory of the open economy.
To understand open economies you have to focus on two main markets. The loanable funds market The foreign-currency exchange market
CHAPTER 32
The link between the two markets is NCO, which is included in two important identities S = I + NCO NCO = NX
NCO is part of the demand in loanable funds market and is the source of supply in the foreign currency exchange market.
All three graphs are commonly drawn together to show this relationship.
CHAPTER 32
Many policies and events can affect the open market and in turn affect all three graphs.
Some possible things are: Government budget deficits Trade policies Political instability/Capital flight
CHAPTER 32
Budget deficits Decreases the supply of loanable funds Increases the RIR Reduces NCO Decreases the supply of dollars Causes the dollar to appreciate
CHAPTER 32
Trade policies: a government policy that directly influences the quantity of goods and services that a country imports or exports. Some examples are: Tariff : a tax on imports Import quota : a limit on the quantity of imports “Voluntary export restrictions”: the government
pressures another country to restrict its exports which is essentially the same as an import quota
CHAPTER 32
Capital flight: a large and sudden reduction in the demand for assets located in a country.
Capital flight Increases NCO Increases the demand for loanable funds Increases the RIR Increases the supply of dollars Causes the dollar to depreciate
CHAPTER 33
Over the long run, real GDP grows about 3% per year on average.
In the short run, GDP fluctuates around its trend.Recessions: periods of falling real incomes
and rising unemploymentDepressions: severe recessions
Short-run economic fluctuations are often called business cycles.
CHAPTER 33
There are three facts about economic fluctuations Economic fluctuations are irregular and
unpredictable. Most macroeconomic quantities fluctuate together. As output falls, unemployment rises.
CHAPTER 33
Explaining these fluctuations is difficult, and the theory of economic fluctuations is controversial.
Most economists use the model of aggregate demand and aggregate supply to study fluctuations.
This model differs from the classical economic theories economists use to explain the long run.
CHAPTER 33
The previous chapters are based on the ideas of classical economics
The Classical Dichotomy is the separation of variables into two groups: Real: quantities, relative prices Nominal: measured in terms of money
The neutrality of money: Changes in the money supply affect nominal but not real variables.
CHAPTER 33
Most economists believe classical theory describes the world in the long run, but not the short run.
In the short run, changes in nominal variables (like the money supply or PL) can affect real variables (like Y or unemployment).
To study the short run, we use a new model.
CHAPTER 33
Terms to know: aggregate-demand curve: a curve that shows the
quantity of goods and services that households, firms, the government, and customers abroad want to buy at each price level
aggregate-supply curve: a curve that shows the quantity of goods and services that firms choose to produce and sell at each price level
CHAPTER 33
The aggregate demand curve is downward sloping because of The wealth effect The exchange-rate effect The interest-rate effect
AD will shift if there is a change in GDP Money supply
CHAPTER 33
The aggregate supply curve is Upward-sloping in the short run Vertical in the long run P
Y
SRAS
LRAS
CHAPTER 33
LRAS is vertical because YN determined by the economy’s stocks of labor, capital, and natural resources, and on the level of technology. An increase in P does not affect
any of these, so it does not affect YN.
P
Y
LRAS
YN
CHAPTER 33
LRAS will shift if there is a change in Any factors of production Natural resources Technology
SRAS will shift if LRAS shifts There is a change in price level/expectations There is a supply shock
CHAPTER 33
There are 3 theories of SRAS The sticky wage theory The sticky price theory The misperceptions theory
The imperfections in these theories are temporary. Over time, sticky wages and prices become flexible misperceptions are corrected
In the LR, PE = P AS curve is vertical