Macro Economic Theory [Doyle]

8/2/2019 Macro Economic Theory [Doyle]

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Accounting relationships

Macro Economic Theory:

Product

Income

Expenditure

National Income

The measure of money

GDP is a

flow variable- only defined for a particular time period

-the amount of money you have is a stock variable there is no

particular time period its a particular point in time

Stock variable- measured at a particular point in time

All the fi nal goods and services produced within a countries borders during a

particular calendar yearmeasured at current market prices

GDP is everything that is produced within a countries borders, so even toyota's

production in the US counts towards the US's GDP

Nominal GDP

GDP DOES NOT INCLUDE:

*Used goods are not counted as part of current GDP Except for the portion of their pricethat reflects something newly produced

Capital gains are not counted

Intermediate goods

GDP (gross domestic product)

Measures all of the output anyware in the world (labor, capital, demand)

GDP + net factor payments from abroad

= GDP+NFP=GNP

Net factor payments (US)

Payments to us - payments made by foreign

Net= something minus something else-

GNP (gross national product)

Main measure of economic activity in macro economics

Shoes Value

Cow=$200 Rancher= $200

Leather=$300 Leather guy= $100

Shoes=$500 Shoe manufacturer= $200

Retai l=$600 Retai le r=$100

Shoe GDP= $600 Income= $600

Example:

GDP- only includes goods and services for which a market transaction is recorded

Licit Market Transaction: these are not counted in GDP

GDP does include clean up costs

GDP should equal the income made by those involved

Output is income-

Measured at current market pricesi.

Price X Q= GDPn

Nominal GDP1)

2009 - $1 100=$100

2010 - $2 100=$200

National output in terms of ""constant" dollars = Y

Nominal GDP/ GDP def lator = real GDP-

GDP deflator

Per Capita GDP= Y/population

The degree of income equality/inequality= GINI Coefficient

The rate of growth in real GDP= Y2010-Y2009/ Y2009= x%

In the long run it shoul d be right around 3%-

Rate of Economic growth

GDP

Friday, September 03, 201 0

11:52 AM

Macro Economics Page 1


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Example: 2010:3 (3rd quarter 2010)

Quarters in the year are in 3 month sets

GDP over time

y

x

Slope= %3

1960 2010

The wave= the business cycle

Expansion: the period in which the rate of GDP growth is positive

Resession: the period lasting at least 2 consecutive quarters during which

the GDP is negative

% (AxB)= %A + %B

% (A/B)= %A- %B= -3% -5%=-8%

Calculating the pErcentage change in the product of 2 varaibles:

Every child will live a better l ife than their parents

American Dream-upward mobility

Crunchy conservative

www.frontporch.com

Look at the part of national income account and who ends up with the output

-> where all the output goes (who gets what) the di vision of national output)

Y=C+I+G+NX

Ex post expenditures - after the fact spending must be the same as GDP

Consumer durables (last a long time)1-

Non durable2-

C= Consumer Expenditures

Changes in the stock of capital [K]

It has nothing to do with financial expenditures

Residential Constructiona)

Business fixed investmentb)

Inventory Investmentc)

I= Investment Expenditure

National income expenditure identity:

National Expenditure

Investment i s spending that effect GDP

No purely fi nancial transactions are effected in the national i ncome account

Does not include transfer payments (TR)

Purchases on goods and services

G= Government Purchases

Exports of goods and services -i mports of goods and services = the current account

defficit (if NX0) = trade deficit (surpl us)

Someone in hong kong buys a car from US= export-

Someone buys a porche from italy= import-

American staying at hotel in rome= import-

Shares of stock and gov bonds dont count ei ther way-

Interest is counted in net exports-

Expenditures within these categories:

NX= Net Exports

An increase in overall level of prices (which are mesured in terms of money) -> which implies adecrease in the value of money.

Deflation: Implies a decrease in the overall level of prices, -> which corresponds an increase in the

value of money

Inflation

On the way the the price of beer doubles

Now you can only get 2 bee rs for $20

-> Friday, 4 beers @ $5 per beer

Changing the value of money:

CPI

Laspeyres Index= past weighted (the quantities used to weight the different prices are fixed)

Paasche Index= present weighted (the quantities used to wei ght different prices are variable)

CPI= The Consumer Price Index

How are they measured?

Capital= produced goods that are intended to

produce other goods for sale

http://www.frontporch.com/http://www.frontporch.com/


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GDP deflator

Suppose 2 goods: Qâ and Q^b

CPI => P^(a)v(T+1) + P^(b)v(T+1) x Q^(B)v(T)

PâvT+1 x QÂvT+1 + PÂ

GDP deflator

Generally the CPI equations overstate the rate of inflation

All multipl e choice

7 or 8 questions that specify a particular transaction

Quiz:

If the quality of the things purchased are improving in quality then the money spent is more

valuable

It doesnt take into account changes in quality-

When a goods price rises people tend to seek out substitutes-

Major Reason why the CPI tends to overstate the actual rate of inflation:

When people substitute A for B because Pb^ then they move to a leve l of subjective well being

The CPI might understate the rate of inflation because:

Labor force- employed

Labor force = = 9.5% currently

Some say it should be measured:

= the unemployment rate= the preparation of the labor force that is currently not working:

Unemployment Rate:



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Working age population-employed

Working age population = 18%

When people change or are in-between jobs (short duration)i.

Frictional unemployment1)

Long term unemployment due to changes in the empl oyment market (long duration)i.

Usually caused by changes in technology or common practicesii.

Structural Uunemployment2)

Indeterminate terminationi.

Example people layed off during a recession they wont be hi redii.

Cyclical unemployment3)

3 major types of Unemployment:

CPI

Systematically overstate the actual rate of inflation

Tends to understateboth the impactand actual rate of inflation because:

it doesnt take into account reductions in wel fare that result from changing consumption patterns

when prices rise

1)

It doesnt include i mpact prices2)

Its used to convert nominal GDP to normal gdp

GDP Deflator

What is the full employment unemployment rate?

some immutable constantThe full employmet unemployment rate0%

Unemployment rate

Or between the unemployment rate and the rate of economic growth

There is a negative rel ationship between the unemployment rate and GDP

How the economy behaves in the long run at full employment

Fresh Water Macroeconomics: (classical approach)

Micro theory- long run theory of the firm: varaible

short run : fixed

Long run=> prices are completely f lexible, and all markets clear

Short run=> prices are sticky or fixed, and some markets if not all markets don't clear

The long run vs. the short run:

Kains: short run

The entire economy is always le ading toward full employment

Y*=AF(K,L)

*in the long run the full employment level of GDP is determined by the state of

production technology (A), the shape of the production function (F), and the

amount ofcapital (K), and labor (L) employed in the production process when

the economy is at full employment

In the long run what determines the full employment, potential level of GDP? The "Natural"

full employment level of GDP:

It has entirely to do with the supply and productive capacity but nothing to do with

spending

The long run Macro Economic Theory: self regulating economy

Exogenous= determined outside the theoretical framework

Endogenous= determined within the theoretical framework

Chapter 3:

dY=Y*=AF(K,L)

dL (y)

L

y

L

y

L = MPL= Marginal product of labor

The MPL is positive1)

The marginal product of labor is decreasing2)

Each additional worker causes output to increase but

the increase in output attributable to the l ast unit of

labor is less than that attributable to the previ ous unit of

labor

-



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The perfectly competitive firm: maximize profits by setting output such that MPL*P=W

When a firm is maximizing profits they vary the number of employment

MPL*P= the marginal revenue product of labor

w= the nominal wage

Labor increases=> MRP is decreasing

Because MPL decreases => so I increses L as long as MRP > w=>

MPL*P=W=> MPL= W/P

When:

Y*=F(K,L)W/P

L

DL (MPL)

SL (income/leisure trade off)

Labor Market Framework

W/P

L

SLSL'

DL (MPL)

W/P*

W/P'

L*

Increase in immigration => Supply of Labor will i ncrease=> W/P decrease to W/P' and L increases to L'

L' ^Y=AF(K,L^) => L in the long run causes Y

=> K/P => %Y^

Increase in immigration increasing demand for labor drives down wages

SL

DL

L

W/P

W/P*

L' L*

^ Mortality rate among working age adults => supply of labor would

Decrease

SL'

W/P'

=> K => labor redundancy => v DL=> v W/P until workers became so "immiserated" that they would

eventual ly realize that "they had nothing to lose but their chains"

W/P

L

DL (MPL)

SL

W/P*

L* L'

^K => MPL at all leve ls of employment

K2

K1

GDP

L

^ Demand for Labor => W/P ^ to W/P' and L^ to L'

W/P'

DL' (MPL')

The amount by which output increases the income increases thus the

standard of livi ng increases



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Would el iminating ten-year drive down higher education costs?

Economics of Ten-year Professors

SL

DL

W/P

L

W/P*

L*

Eliminating Ten-year would cause a decrease in supply

SL'

DL'

W/P'

L'

Labor

All di fferent types of labor are substitutes

The real wage for labor type a to increase the demand for labor type b will increase and that will drive

the W/Pb(real wages) to increase

w/p(mi n) => DL =>w/p^

Y=A(K,L)

Arrogate Production function

SL

DL

W/P

LL* L'

W/p*

DL' (MPL)

W/P'

^ A => ^ MPL => ^ DL=> ^ W?P => ^L

r* (real interest rate)

C,I,G,T,TR,S,SPUT, SGUT

Section 3.2

Y=C+I+G

Given the l ong run output (Y*). What causes C+I+G = Y*

Consumption has an exogenous component (not dependent on income)

a(r,w) => autonomous consumption

r=money interest rate(i) - rate of inflation ()

c/disposable income=(Y+TR-T)

MPS= 1-MPC

=1-b

b= the marginal propensity to consume => 0


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payments / change in income T/Y

Proportional taxati on=> the average ta rate stays constant because the marginal tax rate is constant

from dollar "one:

Progressive taxation the average tax rate rises as income rises because of increasing marginal tax rates

Regressive taxation- the average tax rate raises when income falls

$250,000=$250,000.00 the di viding line between the top 2% of distributi on of income and

everybody else. Proposed tax increase from 35% to 39% or increase above $250,000

Progressive tax code

Y t(Marginal)

0-$23K 0%

25k-50k 25%

50k- 125k 30%

125k-250k 35%

250- 39%

Laugher curve:

T

t

t=marginal tax rate

T=tax revenues

% (tY)= %t+%Y

If tv by a smaller % then Y^, (tY)^

(TR,T,G)

Exogenous= determined outside the theoretical framework within which we're working

Government purchases: G=G

Given Y=C+I+G, what causes people to want to buy what exactly is bei ng produced?

What causes long run equil ibrium in the goods and services market?

What determines the real interest rate in the long run?

What determines the level of national saving in the long run?

*Y=C+I+G (when the goods are in equil ibrium)

Private Saving: Sp=T+TR-T-C

Public Saving: SG=T-TR-G (when positive > government is running a surplus, when negative

the gov is running a budget deficit)

S=Sp+ SG= Y+TR-T-C+T-TR-G

=Y-C-G

Proof:-

*Y-C-G=I (National Saving)

**S=I (in the long run if saving= the goods market is in equi librium)

S>I => Y-C-G>I => Y>C+I+G

=>then spending is lower than GDP

S Y-C-G < I => Yspending is higher than GDP

Bear in mind:

Loan able Funds Framework

SV

S,I

I

V*

(S,I)*

Anything that causes a change in saving at all real interest rates wil l shift the

saving function.

Anything that causes a change in investment at all interest rates will shi ft the I

function.

i=r+

So if

r=iIf r ^ => PbV => DsV => PsV

^T => Gov budget Deficit V

(Sgov but Spriv V) => V C bc disposable income V => S => S=Y-C-G

EX. Congress decides to increase taxes:



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Fiscal Policy => undertaken by the executive and legislative brands of Gov. =>G,TR, and/orT

Monetary Policy is uncertain by the central bank (FED) => M

SV

S,I

I

V*

(S,I)*

S'

V'

In the very long run => ^T => ^S => Vr => ^I =>K^ => Y^ b.c. Y=AF(K,L)

10 multi choice

1 labor market

Taxes

Transfer payments

Government spending

Fiscal policy

1 saving investment

2 short answer

Quiz on Monday:

r

S,I

S

*Y= C+I+G

Y-C-G=I

S=I

r*

(S,I)*

Saving wil l increase as people's wealth goes

down.

vW=> Cv => S^ => S shi fts to S' => (S, I)'

How will a decrease in the housing market effect this

graph?S'

I

(S,I)'

Means a decrease in private spending, especially investment, That results from highe r real interest

rates following a fiscal expansion.

Crowding out:

S

I

r

(S,I)(S,I)*

r*

^G=> example of expansionary fiscal policy since,

everything else held constant it will cause gov budget

defici t to => Sv=> r^ to r', (S


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$20=$20.00 $.01 oz gol d

$2000=$2000.00 1 oz gold

This would lead people to buy gold and sell it to the treasury which would

increase the money supply and lead to inflation

Price of gold falls to $1000 oz

The value of money is what it is able to buy

Money that derives its value because of government proclamationi.

Fiat Money2)

Checkable deposits1)

Monetary system in which the l iabil ities of financial institutions function as the main

medium of exchange

i.

Credit Money3)

.

FOMC- centered in New York

Whenever the Fed engages in an open market purchase of anything it

causes the money supply to increase

Whenever the Fed engages in an open market sale of anything it

causes the money supply to decrease

Fed purchases or sales of short term US government debt securities (t -bills)

Open market operations

The main tool the FED uses in monetary policy- changes in the money supply caused by

the central bank action

Money stock is totally determined by the Federal Reserve (the fed)

-role of the central bank

MV=PY

(M*V=P*Y)

Equation of Exchange:

Money Supply

M1= Currency in the hand of the public + checkable deposits at banks + nonbank issued travelers

checks

M2= M1+ other less li quid forms of money (savings deposits in banksetc)

M3= M2 + other even less liquid forms of money (large CD's etc)

3 Major Monetary arrogates:

Y= real GDP

P*Y= nominal GDP

P=The price le vel

M= the money supply

A number that reflects the amount of time s on average that each dollar in the

money stock changes hands during the course of the year in the income

determination process [the number of times the money stock changes hands]

PY (1 billi on)/ m(100 million)

v=10

v= PY/m

V= velocity (the velocity of money)

Increasing money supply

Quantitative Easing:

Increasing money supply

Expansionary Monetary Policy:

Decreasing money supply

Contractionary Monetary Policy:

What changes in velocity signify?

The quantity theory of money.

Veloci ty can be used as a "proxy" variable that impl ies changes in the demand for money

V= PY/M

M= 1/v PY

= kPY where k=1/v= the Cambridge "K"

When the money market is i n equil ibrium: Qs= Qd => S=D

The nominal demand for money= kPY

1/V=k= the proportion of peoples income that they choose to hold in the form of

money on average.

The nominal money suppl y= M

V=3

Thus, 1/v=k=1/3

Suppose:

Equation of Exchange: MV=PY

The demand for money= the demand to hold money not

have money



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So, people are holding 1/3 of their income in the form of money

An increase in V is synonymous with a decrease in demand for money(md)

A Decrease in V is synonymous wi th an increase in the demand for money (md)

-Suppose V^ to 5 => the de mand for money goes down =Kv to 1/5

Oct 12 you predict a huge financial panic=> a huge v demand for securities=> P to

decrease=> a flight to liquidity => k increases => v to decrease

MV=PY

The nominal version:

M/P= real money suppl yY=real GDP

(M/P)V=Y

MV=PY

V=exogenous (constant)

Y= depends on 3 things

*the price level is proportionate to the money supply. And a certain proportionate change in the

money supply wi ll cause an equiproportionate change in the price leve l

The real version:

M= $1t

V=4

P=1

Y=$4t

$1t * 4=1*$4t

Suppose M by 100%

$2t * 4=?*$4t

?=P=2

Money determines the level of prices

The money supply relative to velocity and real GDP determines the price level

M=kPY

But if M ^ to $2t => $2t>1/4*1*$4t=> Ms/Md =>

The thing that causes the money market to get back into equi libri um in the long run is to increase prices

$1t= 1/4*1*$4t

Proponents of money neutrality believe: the changes in M only effect nominal variables (like the price le vels)

Opponents of mone y neutrality believe the changes in money can effect real aggregates, like GPD, real

exchange rate, the equilibrium real investment rate, real usages etc.

The neutrality of Money hypothesis:

%M+%V =%P+ %Y

=Rate of money growth + rate of change in vel ocity= The rate of inflation/deflation + rate of growth of real gdp

This is to show you what determines the rate of i nflation in the l ong run

The rate of economic growth is determined by the supply side factor

%M=20%

%V =3% 20%+0%-3%=17%

%P=17%

Inflation is always a monetary phenomena

Whenever you see inflation or deflation, in the long run its always up to one thing

Decrease government purchases, decrease transfer payments, increase taxes => lower deficit1)

Borrow from public => potential problem is very high interest rates to compensate for default risk2)

Borrowing from the central bank => central bank buys government bonds => M => debt moneti zation3)

There are three ways that government can deal with a budget deficit:

The dynamic terms:

During periods of inflation, borrowers tend to benefit and lenders suffer because the value of money borrowed

is higher than the value of money repaid

The nominal interest rate= r+=I

Real interest rate= nominal interest rate - rate of inflation (r=i-)Test ch. 2-5

Open economy= international trade, capital flows

Y=C+I+G+NX

Y-C-G=I+NX

S=I+NX

The Key difference between open and closed economy

NX=net exports(exports-imports)



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*S-I=NX NX CA de ficit or a trade deficit, i.e . imports are

greater than exports => net international borrowing (a

trade deficit country is always a net international

debter-capital inflows)

NX>0 => CA surplus or a trade surplus, ie. Exports are

greater than imports => net international lending (a

trade surplus country is always a net international

creditor- net capital outflows)

Perfect capital mobil ity => any country can engage in as much international borrowing or lending as it

wishes at rw=the world real interest rate

S global

I global

rw

S,IS,I*

rw*

rw

Every country is a "small open economy"

=> no country by i tself can affect rw

If a countries net exports is greater than zero then Y> C+I+G => a countries GDP or income is greaterthan domestic spending =>it exports the difference => a country is liv ing well within its means => it is

earning more than its spending

If NX Y a countries GDP is le ss than domestic spending => its imports the difference => a country is l iving

beyond its means

What one of the major things that started the US to have trade deficit to the rest of the world?

Ex.

S

I

rw

(S-I),NXS=I*

rw*

At rw, S=I, NX=0

=> decrease in taxes => saving to go down

=>A->B = (S-I) S => NXnet intl

borrowing

S'

A B

S

I

r

yL*

r*

This country is running a trade deficit

Rw bs i

S-I=NX at rw

S-I>0 => NX>0 => CA surplus

S-I NX CA deficit

T, TR and G that will increase NX

^T => v C=> ^ S => now S' => at rw, S=I=> NX=0 => CA=0

S'

Borrowing => capital inflows => a trade deficit country is a net debter

When we were running a trade deficit, we re we engaged in net international borrowing or lending?

S v T => v S => Sv relative to I => S-Iv =>-

What was Bush trying to persuade the Japanese to do with respect to fiscal poli cy?



12/24

NX v => the trade surplus goes down

-> foreigners were saving too much

Ben Bernanky blamed the US deficit on "Foreign Savings glut"

S

I

r

S-I

Rw~*

rw

As rw decreases, S- I gets more negative => NX

decreases => CA deficit grows

S I

I'

Theory of Purchasing Power Paridy (PPP)

In theory a unit of countries money should be worth the same in terms of goods and

services evry ware in the world.

F/$1 or foreign price of one unit of domestic money

$1/F or the domestic price of one unit of foreign money

The nominal exchange rate:

Long run:

When F/$1 => e^ => domestic money has appreciated (increased in value relative to foreign

exchange)

-

Flex ible or floating Exchange rates

When F/$1 v => e v=> domestic money has depreciated (decreased in value relative to foreign

exchange)

-

Id e changes E1.3/$1 to e1.4/$1 => the dollar has appreciated to one euro has appreciated-

Real exchange rate= e^x PD/PF roughly measures how e xpensive domestic goods are

relative to foreign goods

E=real exchange rate => E^ => a real appreciation => domestic goods have be come relatively

more expensive to foreigners

The real echnage rate is always tending towards the value of 1 at which point purchasing

power parody holds

%e=f-d

Real Exchange Rate

v T=> C^ => Sv => at rw 1 I >S => (s-I) v => NX v => the current account defici t increases

CA deficit => (S-I) net capital inflow => not intl borrowing, so when (S -I) v => borrowing from

abroad

%De=f -d

Quiz review:

E is constantly changing to cause the balance of payments to equal zero (BOP=0):

If a country is running a current account deficit that means its citizens are trying to make more

payments to foreigners than foreigners are trying to make to them

-

=>e v (domestic money depreciates )

If a country is runni ng a trade surplus (NX>0)

Foreigners are trying to make more payments to it then they are trying to make to foreigners

=> domestic money should appreciate

Flexible Exchange rates:

Test:

Short answer

Output in the long run

Saving investment

Long run monetary framework

Ricardian Equivalence:



13/24

Changes in taxes wil l have no effect on saving because they wi ll have no affect on

consumption

If taxes are increased=> gov saving , but private saving goes down by the exact same amount. So

only if consumpti on decreases will saving increase

Tax rate

Laugher Curve :

Its possible that a decrease in taxes can cause an increase in tax revenues

Taxes

If tv => ^ Ls => ^ L* and v w/p => since Y* = AF(K,L) => ^ Y* => ^ t* Y=taxes

One of the things not able to e xplain in the long run is the business cycle

In the short run, assume that prices are fixed

The key feature of short run:

Short Run

P

y

Y*=AF(K,C)

Y*

LRAS

ADC (M*)

Arrogate demand (AD) is drawn for a particular money

supply(m) and therfore for a particular real money

supply(m.p), given P=> at P*, M/P= M*/P*

=>vP =>(M*/P)^=> "real balance

effect"=>^spending => for goods market to be

in equi librium if ( C+I+G)^ =>Y^ =>B => C

P* SRAS

A

B C

In the short run aggregate demand determines GDP

If Y prices will begi n to fall => Short run aggregate shift (SRAS) shif ts down until Y=Y*If output rises above full empl oyment level prices will begin to rise and SRAS shifts up until output

equals full employment level

Resession:

PLRAS

SRAS

AD

Y*

AD'

Y' Y

P1P2P3

vAD in roughl y 2007=> Yv to Y' => Y' a recession => P should fall =>delation

=>P1 to P2 to P3 =>Y ^ back to Y*

The use of fiscal and/or monetary poli cy to "manage" AD

Stabilization Policy

Favorable supply shock:

Supply Shocks:

'



14/24

P

Q

SRAS

AD

SRAS'

Y* Y**

Ch 10: Aggregate Demand (determines the level of GDP in the short run)

ISLM

Keynesian Cross Theory:how planned spending determines/causes the level of GDPP

P B A

C AD

AD*

Y' Y*

LRAS

SRAS

Planned SpendingCp=a+b(Y-T+TR)

Ip=I

Gp=G

Ep=planned spending

E=actual spending

Ep>E => Ip>I =>unplanned

inventory dissimulations =>Ep>y

EpIp unplanned

inventory accumulations => Ep B>A =>

Ep unplanned

invantory decumulations

= (Ip-I) Y^ until

Y=Y* where Y=Ep at C

c

F

D

Suppose YB => D (Ip-I)>0

=> Yv until Y=Y* whereY=Ep at c

Y= E but when Ep >E, the di fference is that Ip>I => an unplanned decrease in I

If people don't want to buy all of the output that is being produced

what happens to it? It's added to inventories

I>Ip

Ip [1/1-b] is the basic Keynesian

spending multiplier

Even small changes in planned spending

can cause large changes on the equal levelof GDP

-

b=.8 1/1-b = 1/1-.8 =1/.2 =5

b=.9 1/1-b = 1/1-.9 =1/.1 =10 Gv by $100b and b=.9

=> multipl ier = 10 so

whenG=-$100b, in

the short run, y=-$1

trillion

In theory a unit of countries money should be worth the same in terms of goods and

Long Run:

Theory of Purchasing Power Parody



15/24

services every ware in the world.

*$/F or the domestic price of one unit of foreign money

The nominal echange rate=* F/$1 or the foreign price of one unit of domestic money

When F/$1 => e^ => domestic money has appreciated (increased in value relative to

foreign exchange)

Flex ible or floating exchange rates

When F/$1 v => ev => domestic money has depreciated (decreased oin value relative to

foreign exchange)

If e changes 1.3/$1 to 1.4/$1 => the dol lar has appreciated to euro has appreciated

e=nominal exchange rate

Real exchange rate= ex PD/PF roughly measures how ex pensive domestic goods are relative

to foreign goods

=real exchange rate => ^ => a real appreciation => domestic goods have become relatively

more expensive

If e^ => domestic goods are more expensive to fore igners

The real exchange rate is always tending towards the value of 1 at which point purchasing

power parody holds

%e=F-D

Real Exchange Rate

Advantages to QE2

QE2 could signifi cantly decrease borrowing costs => spending1)

QE2 could boost other asset prices => w => consumption spendi ng2)

QE2 could cause the dollar to depreciate => D relative toF => ev => doll ar depreciates => NX3)

IS-LM curve

r

Y

IS

A

B

CE>Y=>y^

Anything direct spending

disturbances that causes

Ep^ at all r's and Y's shift

IS out (vS =>IS out)

Any direct spending

disturbance that causes

Epv at all r's and Y's shift

IS in. (S^ => IS in)

[IS']: T =>(v gov budget deficit) => v (Y-T+TR)= disposable income => Ep(vC) =>IS in

C-> A = 1/1-b * A = 1/1-b*-bT

[IS'']: optimism within the business community= MPKF => I at all r's => IS out

IS'

IS''

LM Curve

r

IS

YY2 Y1

r2

r1

L=money demand

M=money supply

Money Market:

open mkt. sales => vM)

M=M~ (open mkt. purchases => ^M

Md=Md ( I , Y +) i=r with

+



16/24

(i.e. if P~)

=a measure of the perceived riskiness of non monetary assets

i

m

m

Md(I,y,)

i*

m~

m

m'

I'

Debt instruments (IOU's)

Most bonds are associated with a fixed stream of payment(s) in the future=> those payments

represent interest

**Bond prices and interest rates are negatively related

Pc= coupon payment/nominal interest rate

10%=$10/$100

i=coupon payment/ Pc

Consider a consol= a bond that pays interest forever but which never matures(the principle value

is never paid off)

-suppose interest on newly issued bonds decrease to 5% if you purchase a $100 consol, it wi ll pay

$5/year forever

-demand increases for 10% bonds -> PB increase until i t is no longer more desireable than a newly

issued %5 bond, i.e. PB increase unti l = $200

PB=$50 = 10/I => $50(i)=$10 => i=20%

^DB at $50 => PB^ to $100 => $100 = $10/I => I => 10%

Suppose only 2 Financial assets:

Money & Bonds (M and B)

Supply of financial wealth= MS+BSDemand of financial wealth=Md+Bd

Ms+Bs=Md+Bd =>

**Ms-Md=Bd-Bs

When the financial system is in equilibrium:

Bonds:

Ms=Md then Bd=Bs

Ms-Md=Bd-Bs

Ms>Md=Bd>Bs

Ms at i *, Ms>Md (excess suppl y in the money market) => this suggests

Bd>Bs => PB^ => I decreases until Bd=Bs => in the money market the interest rate falls to I*

until the de mand for money = the supply of money (Md=Ms)

A ----> B

^PB what wil l happen to the demand for corporate stock? => Ds^ => Ps^

^Ps, PB=> D real estate => P^ real estate

All securi ties are more or less substitutes for one another:

When the fed monetary poli cy becomes expansionary:



17/24

i

Time1800 1915

Financial Panics

A financial Panic=> a flight to liquidi ty => decrease in (V)velocity => Md =>Md> Ms= Bs>Bd =>PBv => i^

by enough to cause Bs=Bd=Md=Ms

MS

Md

i

5% = i*

m/p

Md'

15%=I"

In this case, Buy securities=> Ms as a result of Fed open market

purchases => Iv to I"

MS

Md

i

i*

m/p

vMs=>i^=>PBv I"

=> Dsv =>Psv

=>D houses v

=>Phouses v

Bond Market

Money Market

(Md>Ms) => ^ Ms s.t. Md=Ms (by buying bonds)=>

then, interest rates don't have to change

vT=> gov. budget deficit => borrowing => Bs => Bs>Dd => PBv => i^

vPB => ^I =>vDs=> vPsBc stocks are a substitute for bonds-

Big players dont like it bc:

Liquidity preference framework:

LM Curve:

I Ms

m/p

IS-LM

The LM curve shares all

combinations of r and Y at

which the money market is

in equil ibrium, everything

else held constant

Md=Md(i*Y*)

Md (Y0)

Md(Y2)

Md(Y1)

i2

i1

i0

LMr

R2R1R0

Y0 Y1 Y0 Y

Ms Ms'

Strange cases:

LM



18/24


19/24

Assume perfect capital mobility => balance of payments is in equill ibrium at the world real

interest rate

BP=0 at Vw.

Balance of Payments is a way of keeping track of all international transactions

BoP must = 0

Under flexible exchange rates,e will occur until BoP=0

Under fixed exchange rates, official reserve transactions (ORT) occur until BoP=0

What causes this?

CA (current account)= NX= net sales of domestic goods and services to foreigners =>

Domestic payment to foreigners (-) , If it involves a foreign payment to domestic

residents (+)

-

KFA (capital and financial account)= Net sales of securit ies to foreigners by domestic

residents= sales of domestic securities abroad (domestic borrowing) - purchases of

foreign securi ties by domestic residents (domestic lending abroad).

-

Capital inflows-capital outflows

ORT(offi cial reserve transactions) = Sales of foreign exchange reserves by the domestic

central bank- purchases of foreign exchange reserves by the domestic central bank

-

BoP= CA + KFA + ORT => under fixed exchange rates

Mondell Flemming Model:

Open Economy IS-LM

KFA surplus (ne t borrowing from abroad)

If CA+KFA0

ORT must be negative

From Chinas Persective :

US is running a, CA deficit=

BoP>0=> excess demand for domestic money in fore ign exchange markets=> exchange rate

money appreciates=> exports go down and imports go up=> net exports decrease unti l BoP=0

BoPexcess supply of domestic money in fore ign exchange markets =>exchange rateis

going to go down => domestic money depreciates=> exports increase and imports decrease=>

NX^ until BoP=0

e=F/$1

BoP=0=CA+KFA+ORT

C=a(r,w) + b(Y+TR-T)

I=I(r[-], MPKf[+])

G=G

NX=NX(e,y)

Y=C+I+G+NX

Open economy:

Good Market equi librium condition

Inflation, deflation= value of money for goods and services Appreciation, depreciation= value of money compared to other currencies

E>1=> foreign goods inexpensive

E foreign goods expensive

^ E => real appreciation => v net exports

v E=> real depreciation => NX

E= F/$ * PD/ PF = the price of one unit of domestic goods in terms of foreign goods:

Perfect Capitol Mobility:

NX= NX(e)

rw

BP=0

r

y

BP surplus bc KFA surplus (forei gners buying higher yielding domestic

securitie s => e^ ($ appreciates)

BP deficit bc KFA deficit (domestic residents buying higher foreign

securities) => e v (domesti c money will depreciate)

Under flexible exchange rates

changes in the nominal ex change

rate occur that cause the balance of

payments (BP) to equal zero



20/24

Example: monetary

policy >>> LM

IS

r

Y* Y' y''

r*=rwBP=0

^Ms=> LM shifts down and to the

right=> A->B (rV and y^) => BP def icit

because KFA deficit (more foreign

lending) =>eV (domestic money

depreciates) => NX^ => IS curve shif tsout=> Y sti l further until C at Y''

LM'

A

B

IS'

C

Y

Fiscal Policy >>>

LM

IS

r

Y*

r=rw*

Y

BP=0

^T => IS shifts down and to the left =>r'

BP deficit bc a KFA def icit => eV (domestic

money depreciates) => NX^ => IS up=>

eventually returns to initial position A

IS'

B

A

Under flexible exchange rates changes in fiscal policy will not permanently change anything

>>^T, eV

Fixed Exchange Rates: the central bank pegs the value of money compared to foreign

Gov sets a fixed exchange and whenever there is pressure on it to change the central bank must

intervene in order to maintain the fixed exchange

They require central bank intervention in order to maintain a fixed rate

Pressure to; ^e=>CA^ or KFA^ => ORTV=> more central bank purchases of foreign exchange=> Ms

Pressure to; Ve=> CAV or KFAV so ORT => central bank sales of foreign exchange =>MsV

Flex ible: e (exchange rate) actually does increase

Fixed: buy foreign currency and sell domestic money => Ms until pressure on e^ ceases

BP surplus => pressure on e to appreciate b.c. excess demand for domestic money =>foreigners trying to

make more payments to us then we to them:

Flexible: e actually does decrease

Fixed: Sel l foreign currency => vMs until pressure to e v ceases=> (+ORT)

BP deficit=> pressure on e to depreciate b.c. excess (-ORT) supply of domestic money =>Domestic

residents are trying to make more payments to foreigners than foreigners making to domestic residents

Gold content of =.02oz/

Fixed exchange rates cause a necessity to fi x a price of a key commodity(gold)

Gold content of $=.01/$

e= 1/gold content of =.5/1$

gold content of $

It does not require of imply the value of money will be stableSetting up a gold standard requires fixed exchange rates

^ the value of gold in the commodity market => the value of domestic money => deflation

V the value of gold in the commodity market=> v the value of domestic money => inflation

When you fix the value of money in the terms of a commodity doesnt make the value of money

stable. If the value of money in fluctuating bc of the central bank moving then the gold standard

can be a more stable type of way to use money

Suspension: closed the doors and changed the exchange rate

Gold Standard: Requires Fixed exchange rate.

Fixed exchange in IS-LM framework



21/24

LM

IS

r

YY*

r*

r'

^Ms => rv to r', Y^ to Y' => Capital inflow (KFA defi cit) =>

pressure on e to V => the Fed sells foreign currency =>

MsV => LM shifts back up until pressure on eV is

eliminated i.e. until LM returns to its former position

LM' BP=0

y'

How fiscal policy is Potent and Monetary policy is Not Potent

LMr

YY*

r*

IS

BP=0

IS'

^G=> IS out =>r^ and Y^ but now r>rw, BP surplus

=> Pressure on e^ => buy foreign exchange MS=>

until LM=IS=BP => so A->B->C

a

B

cr'

Y'

IS-LM, Kansian Cross, Multipli er, Understand self adjusting tendencies at work in the economy

^e => appreciation

Ve=> depreciation

Flexible exchange rates:

-> exchange rates are aloud to fl oat but the central bank can effect the exchange rate when

it wants

"Dirty" Float

^e=> reduction

Ve=>devaluation

Fixed:

Fixed Exchange Rate

BP=0

LM

IS

r=rw

r

y

Y* Y

Y=full employment

ODP

Devaluation involves increasing the money supply until the exchange rate

falls to the new desired level and them maintaining the exchange rate at

that level

Fixed=> Flex ible => Fixed

LM

^Ms=> A->B => BP def icit => Pressure on eV, but the central bank lets it fall

(devaluation) => NX^ => IS out => Y^ to Y

Devaluation enables a country to use expansionary monetary policy under fixed

exchange rates

IS'

A

B

C

Why is China so resistant to revaluing its money?

The way china keeps a fixe d exchange rate is by pegging the value of the Yuon to the dollar

If the Chinese revalue its currency the Chinese goods will become more expensive

LM'

IS

r

YY*

r=r*BP=0

For the Chinese to revalue the Yuon,VMs until their e($/1Y)^ to the new "desired" leve l => LM up => but

as e^ => NX V => IS in until YV to Y'

BP is horizontal at rw + (risk premium on borrowing from abroad)

LM

IS'

A

B

C



22/24

LM

IS

r

YY*

r*BP=0

BP=0 =0 and to 5%=> BP shifts

up=> At A1 new BP defi cit=>

eV massive depreciation as a

result of capital flight, which

should NX, but VMs in orderto keep e from falling to

practically "0"

Using Supply and demand analysis to understand e

e=f/$1

Q=$in the foreign

exchange market

S (imports of goods and services, foreign lending)

D (exports, foreign borrowing)

Q*

e*

QD QS

Suppose e fixed at e=>Qs>

QD (of domestic may in the

foreign exchange market:

excess supply) => over

valued =>VMs => S shifts,

or QS-QD=ORT

e

S'

Capital inf lows=> foreigners are paying us for IOU's

KFA=capital inflows-capital outflows

CA=$200b

KFA=$200b

BP=Payments to us-payments by US

Foreign lending= purchases of foreign IOU's by US residents

Refers to the decrease in private spendi ng especially investment that results from an increase in

the interest rate when expansionary fiscal policy is adopted( ^G, TR,VT)

i.e. if b=.9

then change in Y=10* change in G

If interest rate is constant if g the n Y= 1/1-b * ^G

IS-LM

Crowding out:

LM

IS

IS'

^G=>IS out=> A->B= (1/1-b*^G)=>but at B1Were "off" LM (excess demand in money market i.e

Md>Ms=Bs>Bd

PBv and r^ => so Y only to Y'

a c b

Prevent crowding out?

=>debt monetization =>the fed buys the

government bonds that were issued in connection

with G=>Ms^=>LM out=> if r, no crowding out

LM'r'

r*

Self adjusting tendencies

If output is greater than full employment output

If out falls below the sras down

Tying together the ISLM and the economy sel f adjusting theory

LM(M/P) Y>YF=>since MP^

IS

FE

But when the price level increases the real money supply decreases (Pigu effect)

What happens when the fed increases the real money supply?

=>LM curve shi fts out bc. (M/P)^ => r V and Y^ =>

y>Yf=>w^=>P^=>(M/P)v=>usP^, LM shifts back to where i t was befoee IS=LM=FE

r

r*

Y*

LM'



23/24

The economy is in the midst of a recession:

LM

LM'

IS

r

YY*

r*

r'

FE Vw=>IS in=>Y to Y' and rV to r'

=>yM>MF=> wv =>Pv

=>m/p^ =>LM graduall y out unti l Y=Yf)

IS'

y'

STagflation:

LM

IS

r

YY*

r*BP=0

FE

FE' Adverse supply shock temporarily reduces Yf

=>Yv to y' => but y>y', so p^=> m/pV=> lm back =>yV

**Anything that y in IS-LM AD by the same amount

Expectations Adjusted Philips curve

5%

4%

= 5.5% 6%

=e+(M-)

=(-)

%(w/p)=%w-%P so if %p=3% and w, then %(w/p)=-3%

If M= then=e

=e+(M-)

In order to get to Mt+1, ^ tot+1 => assuming adoptive expectationseT+n=T+N-1

If=T+1 this period, then next period eT+2=T+1, soT+1 is associated with a higher rate of inflation

that before (T+2)

Policy:Mt+1=Mt+1+

In order to get rid of inflationary expectations, has to rise above M(recession)

T+2

T+1

e=T

T+1 T

What would happen with a private sector spendi ng disturbance effect the fixed exchange rate.

Would it have been worse and how and why?

Test question: Return to the gold standard:

Fed's hands tied under fixed ex change:



24/24

LM

IS

r

YY*

r=rw*BP=0

In the short run they buy bonds to increase the money supply=> lm out=> rV and Y^

Under fixed exchange since r capitol outf lows (KFA deficit=BP deficit)=> pressure on exchange rate to fall (on domestic money to depreciate

below the fixed nominal exchange rate)

The money supply is too high and r is to l ow there is pressure to decrease the exchange rate=> v MS and continue to do so until LM returned to its

former position

Net result is no change

Screen clipping taken: 1/17/2011, 10:29 PM

Suppose the central bank wants to stimulate the economy:

LM'

Documents

Macro Economic Theory [Doyle]