Macro final exam

Aggregate Supply

(AS): the relationship between the quantity of goods and services supplied and the price level - because the firms that supply goods and services have flexible prices in the long run but sticky prices in the short run, the aggregate supply relationship depends on the time horizon

The Keynesian Cross

- Keynes proposed that an economy's total income is, in the short run, determined largely by the spending plans of households, businesses, and government. The more people want to spend, the more goods and services firms can sell. The more firms can sell, the more output they will choose to produce and the more workers they will choose to hire. Keynes believed that the problem during recessions and depressions is inadequate spending.

The costs of disinflation

- Laurence Ball estimated sacrifice ratios for 65 disinflation episodes in 19 OCED counties over the last 30 years. He reached three main conclusions 1. Disinflation typically lead to a period of higher unemployment 2. However, faster disinflations are associated with smaller sacrifice ratios 3. Sacrifice ratios are smaller in countries that have shorter wage contracts

LRAS curve

- Y does not depend on P, so the long run aggregate supply is vertical

Deriving aggregate demand (AD)

- Y is a decreasing function of P (via the variation in the real money stock) - shifts in IS or LM shift AD (except changes in P) - expansionary fiscal policy shifts AD right - contractionary monetary policy shifts AD left

Adverse selection and moral hazard summary

- adverse selection: people with riskier projects are more willing to borrow than people with safer projects, because they don't internalize the loss caused by default on others - moral hazard: after borrowing money, incentives for risky behavior increase, also because debtors don't internalize the loss caused by default on others - information asymmetry is the most important market failure in financial markets

The IS curve

- an increase in G (or consumer confidence) shifts the IS curve to the right

The logic of Ricardian equivalence

- consumers are forward looking, know that a debt financed tax cut today implies an increase in future taxes that is equal- in present value- to the tax cut - the tax cut does not make consumers better off, so they do not increase consumption spending. Instead, they save the full tax cut in order to repay the future tax liability - result: private saving rises by the amount public saving falls, leaving national saving unchanged

Exchange rate and fiscal policies

- given that other exchange rate regimes are possible, the Maastricht treaty specifies who makes decisions for this type of exchange rate regimes - according to the treaty, the exchange rate policy of the euro area is decided by the ESCB and the Ecofin

Onset of financial crisis

- house prices and subprime mortgages Size of trigger - back of the envelope calculation - subprime= 15% of $10tn= $1.5tn - assume 50% default, recover 50% - total loss: $375bn - comparable to a 2-3% change in stock market - why did such a small subprime crisis cause such a big shock? - need amplification mechanism

Mutations: why did the Philips curve vanish?

- in the 1970s, inflation was consistently positive and became more persistent - people change the way they form expectations

Why bother with economic fluctuations

- it may be precisely because we understand the role of policy that the cost of business cycles is now low. In the 1930s bad policy management contributed to the severity of the Great Depression - distribution issues: although the cost of recessions is small, it is borne by a few (the unemployed, the unskilled) - long run implications of fluctuations. A badly managed economy performs poorly in the long run, through poor investment performance - more generally, the economy may be characterized by persistence or hysteresis: a given economy may follow different paths depending on the situation at some point in time

Painless disinflation

- proponents of rational expectations believe that the sacrifice ratio may be very small - suppose u= u' and π= πe= 6% - the central bank announces it will do whatever is necessary to reduce inflation from 6 to 2 percent as soon as possible - if the announcement is credible, then πe will fall, perhaps by the full four points - then, π can fall without an increase in u

The traditional view of government debt

- short run (in a closed economy), Keynesian cross, IS-LM and AS-AD models - Keynesian cross: planned expenditure curve shifts up, and output rises, with a multiplier effect - IS-LM: IS shifts up, and both Y and r rise, with the associated increase in Y smaller than in the Keynesian cross model - AS-AD: AD shifts up, and both Y and P rise, with the associated increase in Y smaller than in the IS-LM model - long run in the AS-AD model: no effect, only an increase in prices

The central banks response to ΔG>0

- suppose the government increases G - possible responses by the central bank: hold M constant, hold r constant, hold Y constant - in each case, the effects of the ΔG are different

Fiscal outlooks in developing countries

- the population is aging - health care costs are rising - deficits and the debt are projected to significantly increase - probably more difficulties in countries with more generous welfare states (Europe)

Amplification mechanisms

1. Borrowers balance sheet 2. Lending channel 3. Run in financial institutions 4. Network effects

Problems measuring the deficit

1. Inflation 2. Capital assets 3. Uncounted liabilities 4. The business cycle

What is an open economy?

1. Openness in goods markets: free trade of goods 2. Openness in financial markets: free movement of financial capital 3. Openness in factor markets: ability of firms to decide where to locate and of workers to decide where to work, as within EU In an open economy, - spending need not equal output - saving need not equal investment - we will need to rethink our definition of equilibrium - EX: exports- foreign spending on domestic goods - IM: imports- Cf + If + Gf, spending on foreign goods - NX: net exports, aka the trade balance - GDP in an open economy: expenditure on domestically produced goods and services - National income identity in an open economy: Y= C + I + G + NX

Financial crisis

A major disruption in the financial system that impedes the economy's ability to intermediate between those who want to save and those who want to borrow and invest

Shifts in aggregate demand in the short run

A reduction in the money supply shifts the aggregate demand curve downward. The equilibrium for the economy moves from point A to point B. Because the aggregate supply curve is horizontal in the short run, the reduction in aggregate demand reduces the level of output

AS and Philips curve vs AD and Philips curve

AS: output is related to unexpected movements in the price level; PC: unemployment is related to unexpected movements in the inflation rate - using monetary policy or fiscal policy the government can affect aggregate demand - the Philips curve, the AS side of the economy combined with AD determine output and inflation in the economy in the short run

Why does fiscal policy have a multiplied effect on income?

According to the consumption function C=C(Y-T), higher income causes higher consumption. When an increase in government purchases raises income, it also raises consumption, which further raises income, which further raises consumption, and so on. Therefore, an increase in government purchases causes a greater increase in income

In a small open economy, we do not assume that the real interest rate equilibrates saving and investment. Instead, we

Allow the economy to run a trade deficit and borrow from other countries or run a trade surplus and lend to other countries

Fiscal policy at home

An increase in G or decrease in T reduces saving - change in investment is 0, change in net exports/ savings is less than 0 - higher budget deficit —> lower trade balance - empirically we expect a negative correlation between the budget deficit and net exports (positive correlation between budget deficit and trade deficit)

A fiscal expansion at home in a small open economy

An increase in government purchases or a reduction in taxes reduces national saving and thus shifts the saving schedule to the left. The result is a trade deficit

A shift in the investment schedule in a small open economy

An outward shift in the investment schedule from I(r)1 to I(r)2 increases the amount of investment at the world interest rate r*. As a result, investment now exceeds saving, which means the economy is borrowing from abroad and running a trade deficit

Fiscal policy abroad

Consider what happens to a small open economy when foreign governments increase their government purchases. If these foreign countries are a small part of the world economy, then their fiscal change has negligible impact on other countries. But if these foreign countries are a large part of the world economy, their increase in government purchases reduces world saving. The decrease in world saving causes the world interest rate to rise. The increase in the world interest rate raises the cost of borrowing and thus reduces investment in our small open economy. Because there has been no change in domestic saving, saving S now exceeds investment I, and some of our saving begins to flow abroad. Because NX= S -I, the decision in I must also increase NX. Hence, reduced saving abroad leads to a trade surplus at home

When the government spends more than it collects in taxes it has a budget ________, which it finances by _______ from the private sector or from foreign governments.

Deficit; borrowing

Two causes of rising and falling inflation

Demand- pull inflation - (u-u') - resulting from demand shocks - positive shocks to aggregate demand cause unemployment to fall below its natural rate, which pulls the inflation rate up Cost-push inflation - v - caused by supply shocks - adverse supply shocks raise production costs and induce firms to raise prices, pushing inflation up

A central purpose of the financial system is to

Direct the resources of savers into the hands of borrowers who have investment projects to finance. Sometimes this task is done directly through the stock and bond markets. Sometimes it is down indirectly though financial intermediaries such as banks - another purpose of the financial system is to allocate risk among market participants. The financial system allows individuals to reduce the risk they face through diversification

The aggregate demand curve slopes ______ and tells us that

Downward, the lower the price level the greater the aggregate quantity of goods and services demanded

The impact of any policy on the trade balance can be determined by

Examining its impact on saving and investment. Policies that raise saving or lower investment lead to a trade surplus, and policies that lower saving or raise investment lead to a trade deficit

An increase in world interest rates

Expansionary fiscal policy abroad raises the world interest rate - results: investment decreases, net exports increase

The impact of expansionary fiscal policy abroad on the real exchange rate

Expansionary fiscal policy abroad reduces world saving and raises the world interest rate from r1* to r2*. The increase in the world interest rate reduces investment at home, which in turn raises the supply of dollars to be exchanged into foreign currencies. As a result, the equilibrium real exchange rate falls from €1 to €2

The impact of expansionary fiscal policy at home on the real exchange rate

Expansionary fiscal policy at home, such as an increase in government purchases or a cut in taxes, reduces national saving. The fall in saving reduces the supply of dollars to be exchanged into foreign currency. This shift raises the equilibrium real exchange rate from €1 to €2

Fiscal policy and the growth and stability pact

Fiscal policy and its coordination: Main characteristics - each national government chooses and applies its own fiscal policy - at the same time: fiscal policies are coordinated within the ecofin, the European Commission makes yearly recommendations on the main orientations of the policies, and there is multilateral surveillance by all the countries of the fiscal policy of each country Stability and growth pact (June 1997) - specified the procedures for multilateral surveillance and the sanctions Member States may have to face if they incur deficits which are considered to be excessive - the objective of this pact is to avoid coordination problems in the implementation of national fiscal policies - each euro area country presents a multi annual plan on its intended fiscal policy, which is followed up by the Ecofin and the European Commission - budget deficits should not exceed 3% of country's GDP. What happens if it does? If the macroeconomic environment of the country is particularly bad, nothing happens. - if instead GDP is falling between 0.75% and 2%, the Ecofin and the EC decide whether the macroeconomic conditions are "exceptional". If the situation is declared to be non exceptional, an excessive deficit procedure is opened against the country - if GDP growth is above -.75%, the economic conditions are not considered to be exceptional and an excessive deficit procedure is opened Excessive deficit procedure: The initiative for such a procedure should come from the EC, which elaborates a report on the issue that is sent to the Ecofin - the Ecofin decides whether the deficit is excessive or not (countries vote over this issue) - if the deficit is declared to be excessive, Ecofin provides some recommendations to the country's govt on how to reduce the deficit and gives a deadline of the elimination of excessive deficit - if it is not eliminated in time, Ecofin decides on the imposition of sanctions to the country

Using a policy mix

German unification- - prior to unification, west Germany was exhibiting strong growth and investment - after unification, former east Germany needed strong spending on infrastructure - fear of inflation in former west Germany

A reduction in the money supply in the theory of liquidity preference

If the price level is fixed, a reduction in the money supply from M1 to M2 reduces the supply of real money balances. The equilibrium interest rate therefore rises from r1 to r2 The opposite would occur if the fed had suddenly increased the money supply. Thus, according to the theory of liquidity preference, a decrease in the money supply raises the interest rate, and an increase in the money supply lowers the interest rate

The Keynesian Cross is a basic model of

Income determination. It takes fiscal policy and planned investment as exogenous and then shows that there is one level of national income at which actual expenditure equals planned expenditure. It shows that changes in fiscal policy have a multiplied impact on income Once we allow planned investment to depend on the interest rate, the Keynesian Cross yields a relationship between the interest rate and national income. A higher interest rate lowers planned investment, and this in turn lowers national income. The downward sloping IS curve summarizes this negative relationship between the interest rate and income

The stability and growth pact: sanctions

Initially, non remunerated deposits, which become a fine if the excessive deficit is not eliminated within 2 years - amount: fixed component (.2% of GDP) and variable component (1/10 of the excess over the 3% threshold). The total sanction cannot exceed 0.5% of the country's GDP

Because the accumulation and allocation of capital are a source of economic growth, a well functioning financial system is a key lenient of

Long run economic prosperity

The intersection of the IS curve and the LM curve determines the level of ___________

National income. When one of these curves shifts, the short run equilibrium of the economy changes, and national income fluctuates. - changes in fiscal policy influence planned expenditure and thereby shift the IS curve. The IS-LM model shows how these shifts in the IS curve affect income and the interest rate

Shifting the Philips curve

People adjust their expectations over time, so the tradeoff only holds in the short run - an increase in πe shifts the short run PC upward - the short run tradeoff between inflation and unemployment depends on expected inflation. The curve is higher when expected inflation is higher

Exchange rate

Price at which residents of those countries trade with each other - economists distinguish between two exchange rates: nominal exchange rate and real exchange rate

Trade balance = net capital outflow =

Saving minus investment

Stabilization policy two main questions

Should policy be active or passive? Should policy be conducted by rule or discretion?

The anatomy of a crisis

Six elements at the center of most financial crises: 1. Asset-price booms and busts - often a period of optimism leading to a big increase in asset prices precedes a financial crisis - sometimes people bid up the price of an asset above its fundamental value. In this case, the market for that asset is said to be in the grip of a speculative bubble - later, when sentiment shifts and optimism turns to pessimism, the bubble bursts and prices begin to fall - the decline in asset prices is the catalyst for the financial crisis - in 2008 and 2009, the crucial asset was residential real estate 2. Insolvencies at financial institutions - a large decline in asset prices may cause problems at banks and other financial institutions. To ensure that borrowers repay their loans, banks often require them to post collateral. A borrower has to pledge assets that the bank can seize if the borrower defaults. Yet when assets decline in price, the collateral falls in value, perhaps below the amount of the loan. In this case, if the borrower defaults on the loan, the bank may be unable to recover its money - banks rely heavily on leverage, the use of borrowed funds for the purposes of investment. Leverage amplifies the positive and negative effect of asset returns on a banks financial position - a key number is the leverage ratio- the ratio of bank assets to bank capital - if the value of bank assets falls by more than 5%, then its assets will fall below its liabilities, and the bank will be insolvent. In this case, the bank will not have the resources to pay off all its depositors and other creditors 3. Falling confidence - decline in confidence in financial institutions - as insolvencies mount, every financial institution becomes a possible candidate for the next bankruptcy. Individuals with uninsured despots in those institutions pull out their money. Facing a rash of withdrawals, banks cut back on new lending and start selling off assets to increase their cash reserves - as banks sell off some of their assets, they depress the market prices of these assets. Because buyers of risky assets are hard to find in the midst of a crisis, the asset prices can sometimes fall precipitously. Such a phenomenon is called a fire sale 4. Credit crunch - with many financial institutions facing difficulties, would be borrowers have trouble getting loans, even if they have profitable investment projects. In essence, the financial system has trouble performing its normal function of directing the resources of savers into the hands of borrowers with the best investment opportunities 5. Recession - economic downturn - with people unable to obtain consumer credit and firms unable to obtain financing for new investment projects, the overall demand for goods and services declines. Within the context of the IS-LM model, this event can be interpreted as a contractionary shift in the consumption and investment functions, which in turn leads to similar shifts in the IS curve and the aggregate demand curve. As a result, national income falls and unemployment rises 6. A vicious cycle - the economic downturn reduces the profitability of many companies and the value of many assets. The stock market declines. Some firms go bankrupt and default on their business loans. Thus, we return to steps 1 and 2. The problems in the financial system and the economic downturn reinforce each other

The Great Depression: spending hypothesis vs monetary hypothesis

Spending hypothesis - decline in income in early 1930s coincided with falling interest rates. This fact has led some economists to suggest that the cause of the decline may have been a contractionary shift in the IS curve. This view is sometimes called the spending hypothesis because it places primary blame for the Depression in an exogenous fall in spending and goods Money hypothesis - money supply from 25% from 1929 to 1933, during which time the unemployment rate rose from 3.2% to 25.2%. This fact provides the motivation and support for the money hypothesis, which places primary blame for the Depression on the Fed for allowing the money supply to fall by such a large amount

Deriving the LM curve

The LM curve shown in panel b summarizes the relationship between the level of income and the interest rate. Each point on the LM curve represents equilibrium in the money market, and the curve illustrates how the equilibrium interest rate depends on the level of income (higher the level of income, higher demand for real money balances, higher the equilibrium interest rate). For this reason, the LM curve slopes upward

How monetary policy shifts the LM curve

The LM curve tells us the interest rate that equilibrates the money market at any level of income. Yet, the equilibrium interest rate also depends on the supply of real money balances M/P. This means that the LM curve is drawn for a given supply of real money balances. If real money balances change, the LM curve shifts We can use the theory of liquidity preference to understand how monetary policy shifts the LM curve. Suppose that the Fed decreases the money supply from M1 to M2, which causes the supply of real money balances to fall from M1/P to M2/. Holding constant the amount of income and thus the demand curve for real money balances, we see that a reduction in the supply of real money balances raises the interest rate that equilibrates the money market. Hence, a decrease in the money supply shifts the LM curve upward.

The aggregate demand curve (graph)

The aggregate demand curve AD shows the relationship between the price level P and the quantity of goods and services demanded Y. It is drawn for a given value of the money supply M. The aggregate demand curve slopes downward: the higher the price level P, the lower the level of real balances M/P, and therefore the lower the quantity of goods and services demanded Y

The theory of liquidity preference is a basic model of

The determination of the interest rate. It takes the money supply and the price level as exogenous and assumes that the interest rate adjusts to equilibrate the supply and demand for real money balances. The theory implies that increases in the money supply lower the interest rate Once we allow the demand for real money balances to depend on national income, the theory of liquidity preference yields a relationship between national income and the interest rate. A higher level of income raises the demand for real money balances, and this in turn raises the interest rate. The upward sloping LM curve summarizes this positive relationship between income and the interest rate

Net exports are:

The difference between exports and imports. They are equal to the difference between what we produce and what we demand for consumption, investment, and government purchases

What will happen to the trade balance and the real exchange rate of a small open economy when the government purchases increase, such as during a war?

The increase in government spending decreases government saving and thus decreases national saving; this shifts the saving schedule to the left. Given the world interest rate r*, the decrease in domestic saving causes the trade balance to fall The decrease in national saving causes the (S-I) schedule to shift to the left, lowering the supply of dollars to be invested abroad. The lower supply of dollars causes the equilibrium real exchange rate to rise. As a result, domestic goods become more expensive relative to foreign goods, which causes exports to fall and imports to rise, decreasing the trade balance

The failure of forecasting during the Great Recession

The red line shows the actual unemployment rate from 2007 to 2010. The green lines show the unemployment rate predicted at various points in time. For each forecast, the symbols mark the current unemployment rate and the forecast for the subsequent five quarters. Note that the forecasters failed to predict the substantial rise in the unemployment rate

The aggregate demand curve summarizes

The results from the IS-Lm model by showing equilibrium income at any given price level. The aggregate demand curve slopes downward because a lower price level increases real money balances, lowers the interest rate, stimulates investment spending and thereby raises equilibrium income

In the small open economy, the real interest rate equals the world real interest rate:

The trade balance is determined by the difference between saving and investment at the world interest rate

Standard measures of the budget deficit are imperfect measures of fiscal policy because

They do not correct for the effects of inflation, do not offset changes in government liabilities with changes in government assets, omit some liabilities altogether, and do not correct for the effects of the business cycle

EMU: a Keynesian cross application

Total income is given by Y= C + I + G + (X-M) where (X-M) is net exports In addition, assume consumption function is given by C= Co + c1(Y-T) Import function: IM= IMo + m(Y-T) Increase in the home consumption of foreign goods following an increase in disposable income Replacing the consumption function and the import function in the initial equation: Y= Co + c(Y-T) + I + G + X- IMo - m(Y-T) The fiscal policy multiplier is then: Derivative of Y/G= 1/(1-c+m) The multiplier indicates by how much GDP will rise following an increase in public expenditures The multiplier is always positive, but it can be small if the marginal propensity to import is greater than the marginal propensity to consume - taking the € area as whole, given that within € area trade is very important, the degree of openness is much smaller: then, the multiplier for the € area as a whole is likely to be much closer to the multiplier of a closed economy - thus, in this simply framework, an expansionary fiscal policy at the € level will be much more efficient than an expansionary fiscal policy at the national level

The two theories of aggregate supply- the sticky price and imperfect information models- attribute deviations of output and employment from their natural levels to

Various market imperfections - according to both theories, output rises above its natural level when the price Elena exceeds the expected price level, and output falls below its natural level when the price level is less than the expected price level

Percentage change in nominal exchange rate

% change in e= % change in € + (π* - π) % change in = % change in + diff in nom ex rate real ex rate inflation rates This equation states that the percentage change in the nominal exchange rate between the currencies of two countries equals the percentage change in the real exchange rate plus the difference in their inflation rates. If a country has a high rate of inflation relative to the US, a dollar will buy an increasing amount of the foreign currency over time. If a country had a low rate of inflation relative to the US, a dollar will buy a decreasing amount of the foreign currency over time - we know that high growth in money supply leads to high inflation. We have just seen that one consequences of high inflation is a depreciating currency: high π implies falling e. In other words, just as growth in the amount of money raises the price of goods measured in terms of money, it also tends to raise the price of foreign currencies measured in terms of the domestic currency

Purchasing power parity has two important implications

1. Because the net exports schedule is flat, changes in saving or investment do not influence the real or nominal exchange rate 2. Because the real exchange rate is fixed, all changes in the nominal exchange rate result from changes in price levels Is the doctrine of purchasing power parity realistic: no; many goods are not easily traded, and even tradable goods are not always perfect substitutes; real exchange rates do in fact vary over time

Aggregate demand

- (AD): the relationship between the quantity of output demanded and the aggregate price level. In other words, the aggregate demand curve tells us the quantity of goods and services people want to buy at any given level of prices

Network effects

- Financial institutions often lenders and borrowers at the same time - two important sources of network effects: 1. Interest rate swaps: allow one party to alter a stream of payments made or received for free - interest rate swap—> if one party falls, the other will fall too 2. Credit default swaps: form of insurance allowing a buyer to own an asset without bearing its full default risk - CDS deliver high interconnectivity - CDS allow lenders to insure themselves against borrowers risk of default - sellers of CDS are mutually vulnerable - CDS make it easier for sellers of insurance to assume and conceal risk - CDS foster uncertainty about who bears credit risk on given loans or securities

The IS-LM curve graphically

- IS curve represents the equilibrium in the market for goods and services - LM curve represents the equilibrium in the market for real money balances - IS and LM curves together determine the interest rate and national income in the short run when the price level is fixed

Financial crisis timeline

- July 2007: subprime crisis erupts in the US - September 2007: northern rock collapses - house prices continue to fall, economic activity is going down, central banks increase money supply - march 2008: bear sterns acquired by JP Morgan - September 2008: federal takeover of Fannie Mae and Freddie Mac, Merrill Lynch sold to Bank of America - September 2008: Lehman Brothers go bankrupt Reaction of governments and central banks - US: Fed cuts its federal funds rate from 5.25 in September 2007 to about zero in December 2008 - US: October 2008, congress spent large amounts to rescue the financial system - US: expansionary fiscal policy after Barack Obama's election - UK and Germany, April 2009: nationalization of Banks - Spain, June 2012: bailout of Spanish banks. Capital comes from European Union funds

Theory of liquidity preference

- Keynes offered his view of how the interest rate is determined in the short run. His explanation is called the theory of liquidity preference because it posits that the interest rate adjusts to balance the supply and demand for the economy's most liquid asset- money. Just as the Keynesian Cross is a building block for the IS curve, the theory of liquidity preference is a building block for the LM curve - to develop this theory, we begin with the supply of real money balances. If M stands for the supply of money and P stands for the price level, then M/P is the supply of real money balances. The theory of liquidity preference assumes there is a fixed supply of real money balances. That is, (M/P)= M/P The money supply M is an exogenous policy variable chosen by a central bank such as the federal reserve. The price level P is also an exogenous variable in this model. We take the price level as given because the IS-LM model explains the short in when the price level is fixed. These assumptions imply that the supply of real money balances is fixed and does not depend on the interest rate. Thus, when we plot the supply of real money balances against the interest rate, we obtain a vertical supply curve

The money market and the LM relation

- M= nominal money supply controlled by he central bank - PL(Y,r)= demand for money (function of nominal income and the interest rate) - equilibrium interest rate solves: M/P= L(Y,r)

Problems with Ricardian Equivalence

- Myopia: proponents of the Ricardian view of fiscal policy assume that people are rational when making such decisions as choosing how much of their income to consume and how much to save. When the government borrows to lay for current spending, rational consumers look ahead to the future taxes required to support this debt. Thus, the Ricardian view presumes that people have sustained knowledge and foresight. One possible argument for the traditional view of tax cuts is that people are shortsighted, perhaps because they do not fully comprehend the implications of government budget deficits. It is possible that some people follow simple and not fully rational rules of thumb when choosing how much to save. Suppose that a person acts on the assumption that future taxes will be the same as current taxes. This person will fail to take into account future changes in taxes required by current government policies. A debt financed tax cut will lead this person to believer that her lifetime income has increased, even if it hasn't. - borrowing constraints: the Ricardian view of government debt assumes that consumers base their spending not on their current income but on their lifetime income, which includes both current and expected future income. According to the Ricardian view, a debt-financed tax cut increases current income, but it does not alter lifetime income or consumption. Advocates of the traditional view of government debt argue that current income is more important than lifetime income for those consumers who face binding borrowing constraints. A borrowing constraint is a limit on how much an individual can borrow from banks or other financial institutions. A person who would like to consume more than her current income- perhaps because she expects higher income in the future- has to do so borrowing. If she cannot borrow to finance current consumption, or can borrow only a limited amount, her current income determines her spending, regardless of what her lifetime income might be. In this case, a debt financed tax cut raises current income and thus consumption, even though future income will be lower - future generations: if consumers expect that the burden of repaying a tax cut will fall on future generations, then a tax cut now makes them feel better off, so they increase spending - barro argues that because future generations are the children and grandchildren of the current generation, we should not view these various generations as independent economic actors. Instead, he argues, the appropriate assumption is that current generations care about future generations. Thus altruism between generations is evidenced by the gifts that many people give their children, often in the form of bequests at the time of their deaths

The Philips curve: history

- William Philips was born in New Zealand but left to Australia before finishing school - worked a variety of jobs, including a crocodile hunter and cinema manager - got to Britain in 1938, would later join the Royal Air Force and spend 3.5 years interned in a prisoner of war camp in Indonesia - in 1946, he was made a member of the order of the British empire for his war service - after the war moves to London, begins studying soc at LSE but changes to Econ - 1951 became lecturer at LSE, 1958 became professor - Philips curve paper published that year - Philips shows that there is a negative empirical relation between inflation and the unemployment rate - an inverse relationship between inflation and unemployment until the late 1970s - this has important implications: "trade off" between inflation and unemployment - beginning in 1970, the relation between the unemployment rate and the inflation rate disappeared in the US

Central bank independence

- a policy rule announced by a central bank will only work if the announcement is credible - credibility depends in part on the degree of independence of the central bank - more independent central banks are strongly associated with lower and more stable inflation because they are allowed to make decisions free from political influence - researchers have also found that there is no relationship between central bank independence and real economic activity. In particular, central bank independence is not correlated with average unemployment, the volatility of unemployment, the average growth of real GDP, or the volatility of real GDP. Central bank independence appears to offer countries the benefit of lower inflation without any apparent cost

Shifts in the aggregate supply curve

- a supply shock alters production costs, affecting the prices that firms charge (ex include bad weather reducing crop yields and pushing up food prices, and danger of a war pushing up oil prices) - favorable supply shocks lower costs and prices

Okun's Law across countries

- a value of B of 0.39 tells us that output growth 1% above the normal growth rate for 1 year decreases the unemployment rate by 0.39% Interpreting differences - behavior of firms - firing and hiring regulations - in general, the relation between changes in unemployment and output growth is Okun's law

Planned expenditure

- actual expenditure is the amount households, firms, and the government spend on goods and services- it equals the economy's gross domestic product - planned expenditure is the amount households, firms, and the government would like to spend on goods and services - why would actual expenditure ever differ from planned expenditure? Firms might engage in unplanned inventory investment because their sales do not meet their expectations. When firms sell less of their product than they planned, their stock of inventories automatically rises; conversely, when firms sell more than planned, their stock of inventories falls. Because these unplanned changes in inventory are counted as investment spending by firms, actual expenditure can be either above or below planned expenditure - assuming that the economy is closed, so that net exports are zero, we write planned expenditure PE as the sum of consumption C, planned investment I, and government purchases G: PE= C + I + G —> PE= C(Y-T) + I + G This equation shows that planned expenditure is a function of income Y, the level of planned investment I, and the fiscal policy variables G and T

Planned and actual expenditure

- actual expenditure: the amount households, firms, and the government spend on goods and services - planned expenditure: the amount households, firms, and the government would like to spend on goods and services - why may actual expenditure differ from planned expenditure? - firms accumulate/reduce inventories of goods when their sales are lower/higher than expected - as these unplanned changes in inventories are counted as investment spending by firms, actual expenditure can be different from planned expenditure Planned expenditure - PE= C + I + G - consumption C: the main determinant of C is disposable income (Y-T) - the consumption function C=C(Yd) : increases in disposable income lead to increases in consumption C (behavioral equation) - specifically: C= Co + c1Yd, where c1 is the propensity to consume and is in between 0 and 1, Co is autonomous consumption (C when Yd is zero) - C is endogenous because it responds to production - investment (I) is an exogenous variable: given and does not respond to changes in production (Y) - govt spending - G and T describe government fiscal policy (the choices of taxes and government spending by the government), G and T are exogenous

Fiscal policy and the multiplier: government purchases

- consider how changes in government purchases affect the economy. Because government purchases are one component of expenditure, higher government purchases result in higher planned expenditure for any given level of income. If government purchases rise by ΔG, then the planned expenditure schedule shifts upward by ΔG. The equilibrium of the economy moves from point A to point B. This graph shows that an increase in government purchases leads to an even greater increase in income- change in Y is larger than change in G. The ratio ΔY/ΔG is called the government purchases multiplier; it tells us how much income rises in response to a $1 increase in government purchases. An implication of the Keynesian Cross is that the government purchases multiplier is larger than 1.

Adaptive expectations

- adaptive expectations: people form their expectations of future inflation based on recently observed inflation - ex) expected inflation = last years inflation, πe= π(-1) - then, the Philips curve becomes π= π(-1) - B(u-u') + v - states that inflation depends on past inflation, cyclical unemployment, and a supply shock. When the Philips curve is written in this form, the natural rate of unemployment is sometimes called the non accelerating inflation rate of unemployment, or NAIRU - the first term in this form of the Philips curve, π(-1), implies that inflation has inertia. If unemployment is at the NAIRU and if there are no supply shocks, the continued increase in the price level neither speeds up nor slows down. This inertia arises because past inflation influences expectations of future inflation and because these expectations influence the wages and prices that people set - in the model of AS and AD, inflation inertia is interpreted as persistent upward shifts in both the aggregate supply curve and the aggregate demand curve. If prices have been rising quickly, people will expect them to continue to rise quickly. Because the position of the short run aggregate supply curve depends on the expected price level, the short run aggregate supply curve will shift upward over time. It will continue to shift upward until some event changes inflation and thereby changes expectations of inflation - The aggregate demand curve must also shift upward to confirm the expectations of inflation. Most often, the continued rise in aggregate demand is due to persistent growth in the money supply. If the Fed suddenly halted money growth, aggregate demand would stabilize, and the upward shift in aggregate supply would cause a recession. The high unemployment in the recession would reduce inflation and expected inflation, causing inflation inertia to subside - the Philips curve with adaptive expectations offers a trade off: a low unemployment rate leads to an increase in the inflation rate - including expectations in the analysis, what do we observe in the data?

From the IS-LM model to the aggregate demand curve

- aggregate demand curve describes a relationship between the price level and the level of national income - for a given money supply, a higher price level implies a lower level of income - we use IS-LM model to show why national income falls as the price level rises, and we examine what causes the aggregate demand curve to shift - to explain why the aggregate demand curve slopes downward, we examine what happens in the IS-LM model when the price level changes. For any given money supply M, a higher price level P reduces the supply of real money balances M/P. A lower supply of real money balances shifts the LM curve upward, which raises the equilibrium interest rate. Here the price level rises from p1 to p2, and income falls from Y1 to Y2. The aggregate demand curve plots this negative relationship between national income and the price level. In other words, aggregate demand curve shows the set of equilibrium points that arise in the IS-LM model as we vary the price level and see what happens to income

Measurement problem 1: inflation

- almost all economists agree that the government's indebtedness should be measured in real terms, not in nominal terms. The measured deficit should equal the change in the government's real debt, not the change in its nominal debt - the budget deficit as commonly measured does not correct for inflation - the deficit is government expenditure minus government revenue. Expenditure should include only the real interest paid on the debt rD, not the nominal interest paid iD. Because the difference between the nominal interest rate I and the real interest rate r is the inflation rate π, the budget deficit is overstated by πD - this correction for inflation can be large, especially when inflation is high, and it can often change our evaluation of fiscal policy - part of the expenditures correspond to the interest to be paid on the debt itself; in the presence of inflation, the interest to be paid is actually falling in real terms

Appreciations and depreciations

- an appreciation of the domestic currency is an increase in the price of the domestic currency in terms of the foreign currency, which corresponds to an increase in the exchange rate - a depreciation of the domestic currency is a decrease in the price of the domestic currency in terms of the foreign currency, or a decrease in the exchange rate - real exchange rate is €= e x (P/P*) - the real exchange rate can be seen as the amount of the basket of goods one can buy in the foreign country for the price of a basket of goods in the domestic country - the higher is €, the more valuable (expensive) is the domestic currency - empirically, we expect a negative correlation between the exchange rate and net exports

Summary of Keynesian cross

- an increase in demand leads to an increase in production and a corresponding increase in income. The end result is an increase in output that is larger than the initial shift in demand, by a factor equal to the multiplier - to estimate the value of the multiplier, and more generally, estimate behavioral equations and their parameters, economists use econometrics

Saving and investment

- an open economy version of the loanable funds model - includes many of the same elements: - production function Y= F(K,L) - consumption function C= C(Y-T) - investment function I= I(r) - exogenous policy variables G and T are fixed Assumptions: - domestic and foreign bonds are perfect substitutes - perfect capital mobility: no restrictions on international trade in assets - economy is small, cannot affect the world interest rate denoted r* - national saving: the supply of loanable funds S= Y - C(Y-T) - G (national saving does not depend on interest rate) - investment: the demand for loanable funds. Investment is still a downward sloping function of the interest rate, but the exogenous world interest rate determines the country's level of investment - if the economy were closed, the interest rate would adjust to equate investment and saving - but in a small open economy, the exogenous world interest rate determines investment and the difference between saving and investment determines net capital outflow and net exports - in a closed economy, savings and investment are equal, and that pins down the interest rate - in an open economy, interest rates are exogenous and the level of investment adjusts accordingly

Lending channel

- bank lending links financial system to the real economy - balance sheet of lenders worsens, cut down on lending - mechanism:

The short run: the horizontal aggregate supply curve

- because of price stickiness, the short run aggregate supply curve is not vertical - because price level is fixed, we represent this situation with a horizontal aggregate supply curve - the short run equilibrium of the economy is the intersection of the aggregate demand curve and this horizontal short run aggregate supply curve - in this case, changes in aggregate demand do affect the level of output. For example, if the Fed suddenly reduces the money supply, the aggregate demand curve shifts inward. The intersection movement represents a decline in output at a fixed price level - thus, a fall in aggregate demand reduces output in the short run because prices do not adjust instantly. After the sudden fall in aggregate demand, firms are stuck with prices that are too high. With demand low and prices high, firms sell less of their product, so they reduce production and lay off workers. The economy experiences a recession.

Shocks in the IS-LM model

- because the is-lm model shows how national income is determined in the short run, we can use the model to examine how various economic disturbances affect income- specifically, shocks to the IS curve and shocks to the LM curve - shocks to the IS curve are exogenous changes in the demand for goods and services. - such changes in demand can arise from investors animal spirits: exogenous and perhaps self fulfilling waves of optimism and pessimism - ex) firms become pessimistic about the future of the economy and this pessimism causes them to build fewer new factories. Thus reduction in the demand for investment goods causes a contractionary shift in the investment function: at every interest rate, firms want to invest less. The fall in investment reduces planned expenditure and shifts the IS curve to the left, reducing income and employment - shocks may also arise from changes in the demand for consumer goods: increases consumer confidence in the economy induces consumers to save less for the future and consume more today. We can interpret this change as an upward shift in the consumption function. This shift in the consumption function increases planned expenditure and shifts the IS curve to the right, and thus raises income - shocks to LM curve arise from exogenous changes in the demand for money. Ex) suppose that new restrictions on credit card availability increase the amount of money people choose to hold. According to the theory of liquidity preference, when money demand rises, the interest rate necessary to equilibrate the money market is higher. Hence, an increase in money demand shifts the LM curve upward, which tends to raise the interest rate and depress income

Leading economic indicators

- business economists are interested in forecasting to help their companies plan for changes in the economic environment - government economists are interested in forecasting for two reasons: 1, the economic environment affects the government (ex influences tax revenue), 2, the govt can affect the economy through its use of monetary and fiscal policy - one way that economists arrive at their forecasts is by looking at leading indicators, which are variables that tend to fluctuate in advance of the overall economy. - each month the Conference Board announces the index of leading economic indicators, including ten data series that are often used to forecast changes in economic activity: 1. Average weekly hours in manufacturing: because businesses often adjust the work hours of existing employees before making new hires or lay offs, average weekly hours is a leading indicator of employment changes ( inc in hours, inc in hiring; dec in hours, inc in firing) 2. Average weekly initial claims for unemployment insurance: the number of people making new claims on the unemployment insurance system: inc in number, inc in layoffs and dec in production; vice versa) 3. Manufacturers new orders for consumer goods and materials: direct measure of the demand for consumer goods that firms are experiencing. Because an increase in orders depleted a firm's inventories, this statistic typically predicts subsequent increases in production and employment 4. Manufacturers new orders for nondefense capital goods, excluding aircraft: when firms experience increased orders, they ramp up production and employment. 5. ISM new orders index: based on the number of companies reporting increased orders minus the number reporting decreased orders. This indicator measures the proportion of companies that report rising orders and thus shows whether a change is broadly based. When many firms experience increased orders, higher production and employment will likely soon follow 6. Building permits for new private housing units: construction of new buildings is part of investment, a particularly volatile component of GDP. And increase in building permits means that planned construction is increasing, which indicates a rise in overall economic activity 7. Index of stock prices: an increase in stock prices indicates that investors expect the economy to grow rapidly; a decrease in stock prices indicates that investors expect an economic slowdown 8. Leading credit index: when credit conditions are adverse, consumers and businesses find it harder to get the financing they need to make purchases. Thus, deterioration of credit conditions predicts a decline in spending, production, and employment. 9. Interest rate spread: the yield on 10-year treasury bonds minus the federal funds rate: this spread reflects the markets expectation about future interest rates, which in turn reflect the condition of the economy. A large spread means that interest rates are expected to rise, which typically occurs when economic activity increases. 10. Average consumer expectations for business and economic conditions: increased optimism about future economic conditions among consumers suggests increased consumer demand for goods and services, which in turn will encourage businesses to expand production and employment to meet the demand

How monetary policy shifts the LM curve and changes the short run equilibrium

- change in money supply alters the interest rate that equilibrates the money market for any given level of income and thus shifts the LM curve. The IS-LM model shows how a shift in the LM curve affects income and the interest rate - consider an increase in the money supply. Increase in M leads to an increase in real money balances M/P because the price level P is fixed in the short run. The theory of liquidity preference shows that for any given level of income, an increase in real money balances leads to a lower interest rate. Therefore, the LM curve shifts downward. The equilibrium moves from point A to point B. The increase in the money supply lowers the interest rate and raises the level of income Story: - begin with the money market, where the monetary policy action occurs. When the Fed increases the supply of money, people have more money than they want to hold at the prevailing interest rate. As a result, they start depositing this extra money in banks or using it to buy bonds. The interest rate r then falls until people are willing to hold all the extra money that the Fed has created; this brings the money market to a new equilibrium. The lower interest rate has ramifications for the goods market. A lower interest rate stimulates planned investment, which increases planned expenditure, production, and income Y

Interest rates and house prices

- cheaper to get a mortgage with a low interest rate - in addition, developments in the mortgage market that made it easier for those borrowers with higher risk of default (based on their income and credit history, subprime borrowers) to get a mortgage Why? - securitization: mortgage originators make loans, bundle them into "mortgage securities" and sell them to banks or insurance companies- which may not understand fully the risks they are taking - insufficient regulation (according to some economists) or bad regulation Bad regulation: it has been argued that government policies encourages high risk lending to make home ownership more attainable to low income families

Changes in government purchases- IS-LM curve

- consider an increase in government purchases of ΔG. The government purchases multiplier in the Keynesian cross tells us that this change in fiscal policy raises the level of income at any given interest rate by ΔG/(1-MPC). Therefore, the IS curve shifts to the right by this amount. The equilibrium of the economy moves from point A to point B. The increase in government purchases raises both income and the interest rate Story: - when the government increases its purchases of goods and services, the economy's planned expenditure rises. The increase in planned expenditure stimulates the production of goods and services, which causes total income Y to rise. These effects should be familiar from the Keynesian cross - now consider the money market, as described by the theory of liquidity preference. Because the economy's demand for money depends on income, the rise in total income increases the quantity of money demanded at every interest rate. The supply of money, however, has not changed, so higher money demand causes the equilibrium interest rate to rise - the higher interest rate arising in the money market has ramifications back in the goods market. When the interest rate rises, firms cut back on their investment plans. This fall in investment partially offsets the expansionary effect of the increase in government purchases. Thus, an increase in income in response to a fiscal expansion is smaller in the IS-LM model than it is in the Keynesian cross (where investment is assumed to be fixed)

Theories of price stickiness

- coordination failure: firms hold back on price changes waiting for others to go first - cost based pricing with lags: price increases are delayed until costs rise - delivery lags, service, etc: firms prefer to vary other product attributes, such as delivery lags, service, or product quality - implicit contracts: firms tacitly agree to stabilize prices - nominal contracts: prices are fixed by explicit contracts - costs of price adjustment: firms incur costs of changing prices - procyclical elasticity: demand cubes become less elastic as they shift in - pricing points: certain prices have special psychological significance - inventories: firms vary inventory stocks instead of prices - constant marginal cost: marginal cost is flat and markups are constant - hierarchical delays: bureaucratic delays slow down decisions - judging quality by price: firms fear consumers will mistake price cuts for reductions in quality

Measurement problem 3: uncounted liabilities

- current measure of deficit omits important liabilities of the government - future pension payments owed to current government workers, future social security payments, contingent liabilities (covering insured deposits when banks fail) (hard to attach a dollar value to contingent liabilities due to inherent uncertainty) - one might argue that social security liabilities are different from government debt because the government can change the laws determining social security benefits. Yet, in principle, the government could always choose not to reap all of its debt: the government honors its debt only because it chooses to do so - contingent liability: the liability that is due only if a specified event occurs

Automatic stabilizers

- definition: policies that stimulate or depress the economy when necessary without any deliberate policy change - designed to reduce the lags associated with stabilization policy - examples: income tax, unemployment insurance, welfare - system of income taxes automatically reduces taxes when the economy goes into a recession: without any change in the tax laws, individuals and corporations pay less tax when their incomes fall

The Ricardian view

- due to David Ricardo (1820)- but who argues that it would not hold in the real world- and more recently advanced by Robert Barro - According to the so-called "Ricardian equivalence", a debt financed tax cut has no effect on consumption, National saving, the real interest rate, investment, net exports, or real GDP, even in the short run

The Lucas Critique

- due to Robert Lucas, who won the Nobel prize in 1995 for rational expectations - forecasting the effects of policy changes has often been done using models estimated with historical data - Lucas pointed out that such predictions would not be valid if the policy change alters expectations in a way that changes the fundamental relationships between variables - Lucas emphasized that economists need to pay more attention to the issue of how people form expectations of the future. Expectations play a crucial role in the economy because they influence all sorts of behavior. - expectations depend on many things, but one factor, according to Lucas, is especially important: the policies being pursued by the government. When policymakers estimate the effect of any policy change, they need to know how people's expectations will respond to the policy change

Arguments against active policy

- economic stabilization would be easy if the effects of policy were immediate. - economic policy makers face the problem of long lags, the lengths of which are hard to predict - policies act with long and variable lags, including - inside lag: the time between the shock and the policy response (takes time to recognize shock, takes time to implement policy especially fiscal policy) - outside lag: the time it takes for policy to affect economy - if conditions change before policy's impact is felt, the policy may destabilize the economy - a long inside lag is a central problem with using fiscal policy for economic stabilization. This is especially true in the US, where changes in spending or taxes rehire the approval of the president and both houses of Congress. The slow legislative process often leads to delays which make fiscal policy an imprecise tool for stabilizing the economy. Inside lag is shorter in countries with parliamentary systems - monetary policy has a much shorter inside lag than fiscal policy because a central bank can decide on and implement a policy change in less than a day, but monetary policy has substantial outside lag. Monetary policy works by changing the money supply and interest rates, which in turn influence investment and aggregate demand. Many firms make investment plans far in advance, however, so a change in monetary policy is thought not to affect economic activity until about 6 months after it is made - advocates of passive policy argue that, beagle of lags, successful stabilization policy is almost impossible. Indeed, attempts to stabilize the economy can be destabilizing

Long run effects of expansionary policy

- eg. higher G or higher M

Shocks to aggregate demand

- ex: the introduction and expanded availability of credit cards. Because credit cards are often a more convenient way to make purchases than using cash, they reduce the quantity of money that people choose to hold. This reduction in money demand is equivalent to an increase in the velocity of money. When each person holds less money, the money demand parameter k falls. This means that each dollar of money moves from hand to hand more quickly, so velocity V rises - if the money supply is held constant, the increase in velocity causes nominal spending to rise and the aggregate demand curve to shift outward. In the short run, the increase in demand raises the output of the economy (economic boom). At the old prices, firms now sell more output. Therefore, they hire more workers, etc. - over time, the high level of aggregate demand pulls up wages and prices. As the price level rises, the quantity of output demand declines, and the economy gradually approaches the natural level of production. But during the transition to the higher price level, the economy's output is higher than its natural level - in order to dampen this boom, the Fed might reduce the money supply to offset the increase in velocity. Offsetting the change in velocity would stabilize aggregate demand

Run on financial institution

- first mover advantage: balance sheet worsens, other lenders face adverse shocks - runs on banks: (Northern Rock): banks liquidate assets quickly—> fire sales. Effect amplified if assets are very liquified, banking crisis is systematic - if banks portfolios of assets are similar, Fire sales lead to market freezes

Policies to prevent crises

- focusing on shadow banks - restricting size - reducing excessive risk taking - making regulation work better - taking a macro view of regulation

Institutions and economic policy

- implementation of a European monetary union (EMU) decided in the Maastricht theory (1993) - Maastricht treaty establishes a series of convergence criteria that have to be fulfilled by participating countries to the EMU (low inflation, interest rate similar to that of low inflation countries, stability of exchange rate, low public deficit, and low public debt) - January 1,1999: irreversibly fixed exchange rates between the 11 participation countries (France, Germany, Spain, Italy, the Netherlands, Austria, Finland, Ireland, Belgium, Luxembourg, and Portugal) - Greece joins in 2001 - January 1,2002: national currency notes and coins start to be progressively replaced by euro notes and coins in the 12 participating countries - new members include Slovenia (2007), Cyprus and Malta (2008), Slovakia (2009), and Estonia (2011) - European system of central banks (ESCB): composed of the ECB and the national central banks of the 28 EU member states (whether they have adopted the euro or not) - Eurosystem: composed of the ECB and the national central banks of the countries that have adopted the euro - the ESCB is independent from member states and from other European institutions - governing bodies of the European Central Bank: governing council: formulates the monetary policy for the euro area (decisions on monetary objectives, key interest rates, the supply of reserves in the Eurosystem)

The model of aggregate supply and aggregate demand

- in classical macroeconomic theory, the amount of output depends on the economy's ability to supply goods and services, which in turn depends on the supplies of capital and labor and on the available production technology. Flexible prices are a crucial assumption of the classical theory. - the economy works quite differently when prices are sticky. In this case, output also depends on the economy's demand for goods and services - demand, in turn, depends on a variety of factors: consumers confidence about their economic prospects, firms perceptions about the profitability of new investments, and monetary and fiscal policy. - because monetary and fiscal policy can influence demand, and demand in turn can influence economies output over the time horizon when prices are sticky, price stickiness provides a rationale for why these policies may be useful in stabilizing the economy in the short run - model of aggregate supply and aggregate demand: this macroeconomic model allows us to study how the aggregate price level and the quantity of aggregate output are determined in the short run. It also provides a way to contrast how the economy behaves in the long run and how it behaves in the short run

Credit markets: the failure

- in order to better understand the credit crunch, we need to study the market failures characterizing the credit market - the key market failure: asymmetric information - the debtor knows his intentions are ability to repay better than the creditor - 2 important implications: adverse selection and moral hazard

Changes in taxes- IS-LM curve

- in the IS-LM model, changes in taxes affect the economy much the same as changes in government purchases do, except taxes affect expenditure through consumption. - consider a decrease in taxes ΔT. The tax cut encourages consumers to spend more and therefore increases planned expenditure. The tax multiplier in the Keynesian cross tells us that this change in policy raises the level of income at any given interest rate by ΔT x MPC/(1-MPC). Therefore, the IS curve shifts to the right by this amount. The equilibrium of the economy moves from point A to point B. The tax cut raises both income and interest rate. Once again, because the higher interest rate depresses investment, the increase in income is smaller in the IS-LM model than it is in the Keynesian cross

Critiques to OCA

- in the US, the amount of resources devoted to this type of transfers is important - critiques to this theory: - the exchange rates among € area counties were already to a certain extent stable before the implementation of the monetary union - exchange rates were not used so much as an adjustment mechanism even before EMU - once a monetary union is implemented, it's mere existence is likely to render more homogenous the participant countries or regions - then, maybe that a group of countries or regions that do not initially constitute an optimal currency area will end up constituting one if the monetary union is implemented - for instants, Germany was created as a country in the 19th century, and one of the initial steps was the creation of a monetary union among the different German states • perhaps that initially German stages did not constitute an OCA, but some years after the implementation of the monetary union this started to be the case • the same may apply to Italy, which was created as a country also in the 19th century

Aggregate supply in the long run

- in the long run, output is determined by the amount of capital, labor, and the technology: Y= F(K,L) - Y is the full employment or natural level of output, at which the economy's resources are fully employed

The sacrifice ratio: the thatcher disinflation

- inflation fell by 12%, total cyclical inflation was about 9% - sacrifice ratio: total cyclical unemployment/ total disinflation—> 9/12= 0.75 percentage points of cyclical unemployment were generated for each percentage point reduction in inflation - the sacrifice ratio ended up being lower than many economists had predicted - possible explanation: policy was very credible, which influenced expectations - however the sacrifice ratio was not zero, suggesting that in reality expectations are somewhere between the two ways we have seen

The failure of the stability and growth pact

- initially, pact implemented following the rules - the credibility of the pact was damaged by the fact that France and Germany incurred a deficit above the limit in 2003 and no excessive deficit procedure was opened against these countries - reasons provided: these countries had done structural reforms of their pension systems, thus reducing future deficits

Institutional organization of the ESCB

- it consists of the 6 members of the executive board, plus the governors of the national central banks of all euro area countries - in most of the cases, decisions taken by simply majority - executive board: implements monetary policy for the euro area in accordance with the guidelines specified and decisions taken by the Governing council. In so doing, it gives the necessary instructions to the euro area national central banks (NCBs) - general council: - includes the governors of the NCBs of all the EU countries, independently on whether or not they have joined the euro - prepares the irrevocable fixing of the exchange rates of the EU member states currencies which do not participate yet to the euro - capital and currency resources of the ECB - the capital of the ECB comes from the national central banks of all EU member states - foreign currency reserves: paid by NCBs

Purchasing power parity

- law of one price: states that the same good cannot sell for different prices in different locations at the same time. - the law of one price applied to the international marketplace is called purchasing power parity: it states that if international arbitrage is possible, then a dollar (or any other currency) must have the same purchasing power in every country. The argument goes as follows. If a dollar could buy more wheat domestically than abroad, there would be opportunities to profit by buying wheat domestically and selling it abroad. Profit seeking arbitrageurs would drive up the domestic price of wheat relative to the foreign price. Similarly, if a dollar could buy more wheat abroad than domestically, the arbitrageurs would buy wheat abroad and sell it domestically, driving down the domestic price relative to the foreign price. Thus, profit seeking by international arbitrageurs causes wheat prices to be the same in all countries

Aggregate supply in the short run- set price vs sticky price

- many prices are sticky in the short run - in the Keynesian cross and in the IS-LM model, we are assuming the other extreme: All prices are stuck at a predetermined level in the short run. Firms are willing to sell as much at that price level as their customers are willing to buy - therefore, the short run aggregate supply curve is horizontal Short run effects of an increase in M: - in the short run when prices are sticky, an increase in aggregate demand causes output to rise We will now consider a less extreme view of the short run AS - instead of assuming that prices cannot move, we assume that they can, but that they are "sticky" - we consider two prominent models of aggregate supply in the short run: sticky price model and imperfect information model - both models imply: Y= Y' + a(P-Pe) Y= aggregate output, Y'= natural rate of output, a= a positive parameter, P= actual price level, Pe= expected price level

How the short run and the long run difffer

- most macroeconomists believe that the key difference between the short run and the long run is the behavior of prices. In the long run, prices are flexible and can respond to changes in supply or demand. In the short run, prices are sticky at some predetermined level. Because prices behave differently in the short run than in the long run, various economic events and policies have different effects over different time horizons - based on the classic dichotomy, in the long run, changes in the money supply do not cause fluctuations in output and employment - in the short run, however, many prices do not respond to changes in monetary policy. A reduction in money supply does not immediately cause all firms to cut the wages they pay, all stores to change the price tags on their goods, etc. instead, there is little immediate change in many prices; that is, many prices are sticky. This short run price stickiness implies that the short run impact of a change in money supply is not the same as the long run impact - The failure of prices to adjust quickly and completely to changes in the money supply means that, in the short run, real variables such as output and employment must do some of the adjusting instead. In other words, during the time horizon over which prices are sticky, the classical dichotomy no longer holds.

The sticky price model

- most widely accepted explanation for the upward sloping short run aggregate supply curve - this model emphasizes that firms do not instantly adjust the prices they charge in response to changes in demand- sometimes prices are set by long term contracts between firms and customers. Even without formal agreements, firms may hold prices steady to avoid annoying their regular customers with frequent price changes. Some prices are sticky because of the way certain markets are structured (menu costs), and sometimes sticky prices can be a reflection of sticky wages: firms base their prices on the costs of production, and wages may depend on social norms and notions of fairness that evolve only slowly over time - there are various ways to formalize the idea of sticky prices to show how they can help explain an upward sloping aggregate supply curve - we first consider the pricing decisions of individual firms and then add together the decisions of many firms to explain the behavior of the economy as a whole - we have to depart from assumption of firms as price takers in perfect competition, and assume that these firms have at least some market power over the prices they charge

International capital flows

- net capital outflow: S-I = net outflow of "loanable funds" = net purchases of foreign assets - when S>I, country is a net lender - when S<I, country is a net borrower - NX= S-I —> trade balance = net capital outflow —> thus, a country with a trade deficit (NX<0) is a net borrower (S<I) - borrowing is connected to importing and lending is connected to exporting - the present value of exports must be equal to the present value of imports: X2/(1 + r) + X1 = M2/(1 + r) + M1 - no countries will ever experience trade deficits forever

The fiscal compact

- new mechanism for the coordination of fiscal policies approved in December 2011, after the Greek, Irish, and Portuguese bailouts - known as the "fiscal compact" - signed in March 2012 by all EU countries except Czech Republic and Uk - national budgets have to be in balance or in surplus: achieved if the annual structural government deficit does not exceed 0.5% of nominal GDP - balance budget rule to be incorporated in the national legal system by the end of 2012 - "excessive deficit procedure" to be more automatic: European commissions proposals to be supported except when a qualified majority is against the decision - coordination mechanism: public debt issuance plans to be reported to the EC and the council - euro area member states to hold meeting at least twice a year. Nomination of a president of the euro area summits

Expansionary fiscal policy

- note that equilibrium output increases less than it would with constant interest rates - horizontal IS shift: AF= ΔG x multiplier (the result we had in the Keynesian cross model) - when Y increases the money market is in a situation of excess demand. Therefore interest rate increases, investment decreases, and Y falls - this second order effect is known as financial crowding out (public expenditure crowding out private expenditure) - crowding out is bigger the steeper the LM curve - in general: the flatter the LM curve, the more effective fiscal policy

Policy trade off

- on the one hand, we want entrepreneurs to undertake risky but potentially profitable projects, and share the risk with those with money to invest - on the other hand, we want to prevent entrepreneurs from undertaking risky and not profitable projects

Sharing risk

- one function of the financial system is to allocate risk. - risk averse: other things equal, disliking uncertainty about future economic outcomes - equity finance provides a way for entrepreneurs and savers to share the risks and returns associated with the entrepreneurs investment ideas - the financial system allows savers to reduce their risk by spreading their wealth across many different businesses. Reducing risk by holding many imperfectly correlated assets is called diversification - various financial institutions facilitate diversification. Among the most important are mutual funds. Mutual funds are financial intermediaries that sell shares to savers and use their funds to buy diversified pools of assets. - there are limits to how much diversification reduces risk. Some macroeconomic events affect many businesses at the same time. Such risk is called systematic risk. In particular, recessions tend to reduce the demand for most products and thus profitability of most businesses. Diversification cannot reduce this kind of risk. Yet it can largely eliminate the risks associated with individual businesses, called idiosyncratic risk

From the Short Run to the Long Run

- over long periods of time, prices are flexible, the aggregate supply curve is vertical, and changes in aggregate demand affect the price level but not output. Over short periods of time, prices are sticky, the aggregate supply curve is flat, and changes in aggregate demand do affect the economy's output of goods and services - effects over time of a fall in aggregate demand: suppose the economy is initially in long run equilibrium. When the economy is in its long run equilibrium, the short run aggregate supply curve must cross this point as well. Now suppose that the Fed reduces the money supply and the aggregate demand curve shifts downward. In the short run, prices are sticky, so the economy moves from point A to point B. Output and employment fall below their natural levels, which means the economy is in a recession. Over time, in response to low demand, wages and prices fall. The gradual reduction in price level moves the economy downward along the aggregate demand curve to point C, which is the new long run equilibrium. In this equilibrium C, output and employment are back to their natural levels, but prices are lower than in the old long run equilibrium. Thus, a shift in aggregate demand affects output in the short run, but this effect dissipates over time as firms adjust their prices

Indebtedness of the world governments

- over the course of US history, the indebtedness of the federal government has varied substantially - historically, the primary cause of increases in government debt is war. The debt-GDP ratio rises sharply during major wars and falls slowly during peacetime. Many economists think that this historical pattern is the appropriate way to run fiscal policy.

Market failure: moral hazard

- potential investment will cost $1 million up front - the investor has two options: investing the money in a safe and profitable project, and get $1.1 million; take a flight to Monte Carlo, take a bet in order to get $1.95 million with a 50% probability and 0 otherwise - if the investor is using his own money, he would choose the safe and profitable project - however, if he borrows $1 million... Suppose he borrows $1 million and, after borrowing, decides what to do - lender cannot observe or write a contract contingent on his actions - again, if the debtor cannot pay his debt, the bank takes whatever he's got and he walks away with 0 - no punishment for default Suppose interest rate in the period is 5%. At the end of the period the debtor owes $1.05 million - the safe project yields 0.05 million - the monte Carlo adventure yields 0.9 million with a probability of 50%, and 0 with a probability of 50% - the reckless strategy looks profitable in comparison

The Philips curve pre 1970

- pre 1970 inflation was low on average and not very persistent - past inflation is not a very good predictor for current inflation - πe= 0 is not a bad approximation - this yields the original Philips curve: a negative relation between the unemployment rate and the inflation rate - no expectations involved π= -B(u-u') + v

The quantity equation as aggregate demand

- quantity theory says that MV= PY, where M is the money supply, V is the velocity of money, P is the price level, and Y is the amount of output. If the velocity of money is constant, then this equation states that the money supply determines the nominal value of output, which in turn is the product of the price level and the amount of output - quantity equation can be rewritten in terms of supply and demand for real money balances: (M/P)d= kY, where k=1/V represents how much money people want to hold for every dollar of income - supply of real money balances M/P equals the demand for real money balances (M/P)d and that demand is proportional to output Y - if we assume that velocity V is constant and money supply M is fixed by the central bank, then the quantity equation yields a negative relationship between the price level P and output Y. This downward sloping curve is called the aggregate demand curve

The money market and the LM curve

- simple theory in which interest rate is determined by money demand and money supply Two financial assets to choose from: money (used for transactions, pays no interest) and bonds (cannot be used for transactions and pays a positive interest rate) Therefore, the proportion of money and bonds depends on: - ones level of transactions (proportional to nominal income PY) - the interest rate on bonds - assume functional form Md= PL(Y, r) - higher income (expenditure)—> needs more money to buy goods - higher interest rate—> opportunity cost of holding money is higher (lost interests)

IS-LM and Aggregate demand

- so far, we've been using the IS-LM model to analyze the short run when the price level is assumed fixed - however, a change in P would shift LM and therefore affect Y - the aggregate demand curve captures this relationship between P and Y The determination of aggregate demand: - captures the affect of price level on output - is derived from equilibrium in the goods (IS) and financial (LM) markets - goods market (IS): Y= C(Y-T) + I(r) + G - financial markets (LM): M/P= L(Y,r)

The sacrifice ratio

- to reduce inflation, policy makers can contract aggregate demand, causing unemployment to rise above the natural rate - the sacrifice ratio measures the percentage of a year's real GDP that must be forgeone to reduce inflation by 1 pp - a typical estimate of the ratio is 5 - The Phillips curve shows that in the absence of a beneficial supply shock, lowering inflation requires a period of high unemployment and reduced output. But by how much and for how long would unemployment need to rise above the natural rate? Before deciding whether to reduce inflation, policymakers must know how much output would be lost during the transition to lower inflation.

The adjustment to equilibrium in the Keynesian Cross

- suppose the economy finds itself with GDP at a level greater than the equilibrium level, such as the level Y1. In this case, planned expenditure is less than production, so firms are selling less than they are producing. Firms add the unsold goods to their stock of inventories. This unplanned rise in inventories induces firms to lay off workers and reduce production; these actions in turn reduce GDP. This process of unintended inventory accumulation and falling income continues until income Y falls to the equilibrium level If firms are producing at level Y, then planned expenditure PE1 falls short of production, and firms accumulate inventories. This inventory accumulation induces firms to decrease production. Similarly, if firms are producing at level Y2, then planned expenditure PE2 exceeds production and firms run down their inventories. This fall in inventories induces firms to increase production. In both cases, the firms decisions drive the economy toward equilibrium

The goods market and the IS curve

- the Keynesian Cross: - simplest Keynesian model, designed to understand recessions and depressions - in the short run, economy's total income determined by the spending plans of households, businesses, and government Assume: 1. all firms produce the same good 2. The supply of goods is completely elastic at price P, ie P is exogenous 3. The interest rate is given 4. The economy is closed

Ratio of US govt debt to GDP

- the US federal government debt held by the public, relative to the size of the US economy, rises sharply during wars, when the government finances wartime spending by borrowing. It also increases during major economic downturns, such as the Great Depression of the 1930s and the Great Recession following the financial crisis of 2008-2009 - the debt-GDP ratio usually declines gradually during periods of peace and prosperity

Shifts in the aggregate demand curve

- the aggregate demand curve is drawn for a fixed value of the money supply. In other words, it tells us the possible combinations of P and Y for a given value of M. If the Fed changes money supply, then the possible combinations of P and Y change, which means the aggregate demand curve shifts - consider what happens if the Fed reduces the money supply: the quantity equation tells us that the reduction in money supply leads to a proportionate reduction in the nominal value of output PY. For any given price level, the amount of output is lower, and for any given amount of output, the price level is lower. The aggregate demand curve relating P and Y shifts inward - The opposite occurs if the Fed increases the money supply. The quantity equation tells us that an increase in M leads to an increase in PY. For any given price level, the amount of output is higher, and for any given amount of output, the price level is higher. The aggregate demand curve shifts outward.

The euro area debt crisis

- the crisis is not yet over in Europe as: a series of countries experience week or negative growth, peripheral euro area countries face a debt crisis - January 2010: Greek risk premium on 5 years bonds goes over 400 base points - April/ May 2010: first Greek bailout: Greece accepts a EU-IMF loan in order to be able to repay its debt - May 2010: creation of the European financial stability fund with the aim of providing loans to countries in financial difficulties - November 2010: Ireland's 10 year bond yields at 7.7%, Irish bailout - March 2011: EFSF allowed to buy bonds of rescued governments in the primary market - March 2011: Portuguese bailout - July 2011: second Greek bailout - August 2011: ECB decides to purchase Italian and Spanish bonds in the secondary market - November 2011: "technical" governments in Greece and Italy. EFSF allowed to buy euro area countries bonds in the secondary market - December 2011: ECB agrees to lend money on extended terms to European banks and relaxes collateral rules - March 2012: fiscal compact signed - June 2012: bailout of Spanish government - Summer 2012: still high risk premia for Spanish and Italian bonds - July 2012: do "whatever it takes" to save the euro - September 2012: ECB announces that it creates a unlimited bond buying program for those countries requesting its implementation and accepting a series of conditions - Spanish risk premium falls from 639 base points. Italian risk premium falls from 536 to 281 - oct 2012: agreement on a future banking union within the euro zone - dec 2012: first steps for the banking union: big banks will be directly supervised by the ECB by March 2014. The ECB will be able to close down banks which do not follow the rules - jan 2013: renegotiate characteristics of participation of the UK to the EU - March 2013: Cypriot bailout - may 2013: ECB cuts its bank rate to 0.50% to aid recovery. - nov 2013: ECB cuts rate at 0.25% - feb 2014: Greek unemployment a record high at 28% - feb 2015: Greece negotiates a four month extension bailout in return for undertaking a euro zone approved reform program -June 2015: Greece demand installment of IMF debt repayment until end of month, becoming first developed country to do so As talks with IMF, world bank and EU troika remain deadlocked, fears mount that Greece could default on its debts

Global dimensions of the crisis

- the crisis originated in the US subprime market - why did the crisis reach a global scale? - financial globalization: increase in foreign holding of US assets and increase in EU banks exposure to US assets - global regulatory failure: the use of opaque financial instruments is a global phenomenon. Weak regulation for off balance sheet conduits

GDP and its components

- the economy's GDP measures total income and total expenditure in the economy - the graph shows the growth of real GDP from 1970 to 2014. The horizontal line shows the average growth rate of 3% per year over this period. Economic growth is not steady - the shaded areas indicate periods of recession. Starting date of a recession is called the business cycle peak, and the ending date is called the business cycle trough - what determines whether a downturn in the economy is sufficiently severe to be deemed a recession is unclear. - old rule: a recession is a period of at least two consecutive quarters of declining real GDP- this does not always hold

Change in US house price index and rate of new foreclosures

- the fall in the price of houses was big but not unprecedented. However, it lead to a series of repercussions: 1. A substantial rise in mortgage defaults and home foreclosures - why? Many homeowners had bought their homes with very small down payments - when housing prices declined, these homeowners owed more on their mortgages than their houses were worth, and stopped paying their loans - banks servicing their mortgages took houses away in foreclosures procedures and sold them off - this led to a further fall in the price of houses 2. Large losses of the financial institutions that owned mortgage backed securities - by borrowing large sums of money to buy high-risk mortgages, they had bet that housing prices would keep rising - as this was not the case, and the values of those securities had fallen a lot, the financial institutions were close to bankruptcy - Banks stopped trusting each other and avoided interbank lending, which led to a fall in general credit to consumers 3. Higher stock market volatility (similar to 1930s) and difficultly for companies to get resources for business expansion or manage their short term cash flows 4. Decline in consumer confidence, fall in consumption, and GDP contraction (IS shift to the left), increase in unemployment

Market failure: an externality

- the game "heads I win, tails the taxpayers lose": - potential investment will cost $70 million up front, no information asymmetry - with probability 50%, the project will yield $90 million; with probability 50%, the return will only be $30 million - expected payoff is $60 million - ordinarily this investment would never be made... - however, bailout guarantees change the result - suppose everyone knows that the government will protect them if his project fails and he cannot repay - then, the investor can borrow the entire $70 million. From his point of view: with probability 50%, he will make $20 million. With probability 50%, he walks away with nothing but taxpayers foot the bill - solution looks simple. We should not have any kind of bailout guarantees in place. Those who finance bad investment should lose their money and face the consequences. But it is not that simple - a bank is a borrower and lender - assets: bonds, loans, other financial assets - liabilities: loans, bonds, other financial instruments - what if a bank crashes and it cannot pay its debts? - it's liabilities are other banks and companies assets. So, it's bankruptcy can lead to the failure of other banks and companies- it may be the first domino to fall - to avoid a systematic crisis, the government has incentives to rescue the banks - The risk of going bankrupt brings incentives for firms to reduce their risks. However, it is very costly for the government to let a large financial institution go bust, because of its affect on the whole economy. So, the promise to not let financial institutions go bust ends up being not very credible. Now, governments have been capitalizing banks with taxpayers money so that the economy can recover - some economists have warned that bailouts can induce risky behavior - but the alternative might be too bad in the short run and policy makers do not want the risk of a systematic crisis

Unemployment and Okun's law

- the graph shows the unemployment rate from 1970 to 2014, again with the shaded areas representing periods of recession - unemployment rises in each recession. Other labor markets tell a similar story; job vacancies, as measured by the number of help wanted ads that companies have posted, decline during recessions- during an economic downturn, jobs are harder to find - what relationship should we expect to find between unemployment and real GDP? Because employed workers help to produce goods and services and unemployed workers do not, increases in the unemployment rate should be associated with decreases in real GDP. Thus negative relationship between unemployment and GDP is called Okun's law

Why the aggregate demand curve slopes downward

- the money supply M and the velocity of money V determine the nominal value of output PY. Once PY is fixed, if P goes up, Y must go down - because we have assumed the velocity of money is fixed, the money supply determines the dollar value of all transactions in the economy. If the price level rises, each transaction requires more dollars, so the number of transactions and thus the quantity of goods and services purchased must fall - thinking about the supply and demand for real money balances: if output is higher, people engage in more transactions and need higher real balances M/P. For a fixed money supply M, higher real balances imply a lower price level. Conversely, if the price level is lower, real money balances are higher; the higher level of real balances allows a greater volume of transactions, which means a greater quantity of output is demanded

The determinants of the real exchange rate

- the real value of a currency is inversely related to net exports. When the real exchange rate is lower, domestic goods are less expensive relative to foreign goods, and net exports are greater - the trade balance (net exports) must equal the net capital outflow, which in turn equals saving minus investment. Saving is fixed by the consumption function and fiscal policy; investment is fixed by the investment function and the world interest rate

Hysteresis

- the term used to describe the long lasting influence of history on the natural rate - A recession can have permanent effects if it changes the people who become on employed. For instants, workers might lose valuable job skills when unemployed, which diminishes their ability to find a job even after the recession ends. - another way in which a recession can permanently affect the economy is by changing the process that determines wages. Those who become unemployed may lose their influence on the wage setting process. More generally, some of the insiders in the wage setting process become outsiders. If the smaller group of insiders cares more about high real wages and less about high employment, then the recession may permanently push real wages farther above the equilibrium level and raise the amount of structural unemployment

Imperfect information model summary

- this model assumes that markets clear- that is, all prices are free to adjust to balance supply and demand. In this model, the short run and long run aggregate supply curves differ because of temporary misperceptions about prices - the imperfect information model assumes that each supplier in the economy produces a single good and consumes many goods. Because the number of goods is so large, suppliers cannot observe all prices at all times. They monitor closely the prices of what they produce but less closely the prices of all the goods they consume. Because of imperfect information, they sometimes confuse changes in the overall level of prices with changes in relative prices. This confusion influences decisions about how much to supply, and it leads to a positive relationship between the price level and output in the short run - the imperfect information model says that when actual prices exceed expected prices, suppliers raise their output. The model implies an aggregate supply curve with the familiar form Y= Y' + a(P-Pe) Output deviates from the natural level when the price level deviates from the expected price level - stresses the limited ability of individuals to incorporate information about the economy into their decisions. In this case, the friction that causes the short run aggregate supply curve to slope upward is not the limited availability of information but is, instead, the limited ability of people to absorb and process information that is widely available. This information processing constraint causes price setters to respond slowly to macroeconomic news. The resulting equation for short run aggregate supply is similar to those from the two models we have seen

examples of time inconsistency

- to encourage investment, government announces it will not tax income from capital. But once the factories are built, government reneges in order to raise more tax revenue - to reduce expected inflation, the central bank announces it will tighten monetary policy. But faced with high unemployment, the central bank may be tempted to cut interest rates - aid is given to poor countries contingent on fiscal reforms. The reforms do not occur, but aid is given anyway because the donor countries do not want the poor countries citizens to starve - to encourage research, the government announces that it will give a temporary monopoly to companies that discover new drugs. But after a drug has been discovered, the government is tempted to revoke the patent or to regulate the price to make the drug more affordable In each case, rational agents understand the incentive for the policy maker to renege, and this expectation affects their behavior. And in each case, the solution is to take away the policymakers discretion with a credible commitment to a fixed policy rule

The effects of trade policies

- trade policies are policies designed to directly influence the amount of goods and services exported or imported. Most often, trade policies take the form of protecting domestic industries from foreign competition, either by placing a tax on foreign imports (tariff), or restricting the amount of goods and services that can be imported - protectionist trade policies do not affect the trade balance. Because a trade deficit reflects an excess of imports over exports, one might guess that reducing imports would reduce a trade deficit. Yet our model shows that protectionist policies only lead to an appreciation of the real exchange rate. The increase in the price of domestic goods relative to foreign goods tends to lower net exports by stimulating imports and depressing exports. Thus, the appreciation offsets the increase in net exports that is directly attributable to the trade restriction - although protectionist trade policies do not alter the trade balance, they do affect the amount of trade. Because the real exchange rate appreciates, the goods and services we produce become more expensive relative to foreign goods and services. We therefore export less in the new equilibrium. Because net exports are unchanged, we must import less as well. The appreciation of the exchange rate does stimulate imports to some extent, but this only partly offsets the decrease in imports due to trade restriction. Thus, protectionist policies reduce both the quantity of imports and the quantity of exports

The long run: the vertical aggregate supply curve

- we derive the long run aggregate supply curve from the classical model - according to the classical model, output does not depend on the price level. To show that output is fixed at this level regardless of price level, we draw a vertical aggregate supply curve. In the long run, the intersection of the aggregate demand curve with this vertical aggregate supply curve determines the price level - if the aggregate supply curve is vertical, then changes in aggregate demand affect prices but not output. For example, if the money supply falls, the aggregate demand curve shifts downward. The economy moves from the old intersection of aggregate supply and aggregate demand, to the new intersection. The shift in aggregate demand affects only prices. - the vertical aggregate supply curve satisfies the classical dichotomy because it implies that the level of output is independent of the money supply. This long run level of output is called the full employment or natural level of output: level of output at which the economy's resources are fully employed

How policies influence the real exchange rate: domestically

- what happens to the real exchange rate if the government reduces national saving by increasing government purchases or cutting taxes? This reduction in saving lowers S-I and thus NX- reduction in saving causes a trade deficit - equilibrium real exchange rate adjusts to ensure that NX falls. The change in policy shifts the vertical S-I line to the left, lowering the supply of dollars to be invested abroad. The lower supply causes the equilibrium real exchange rate to rise from €1 to €2- that is, the dollar becomes more valuable. Because of the rise in the value of the dollar, domestic goods become more expensive relative to foreign goods, which causes exports to fall and imports to rise. The change in exports and the change in imports both act to reduce net exports

Financial crisis: policy issues

- when the crisis comes, the incentives to rescue institutions that got too much risk will be there. Is there a way to rescue the bank and punish the shareholders? And would the shareholders be able to discipline its employees - that are paid according to performance and have incentives to take risk? Regulation helps to avoid a crisis. - possible cost: regulation might reduce efficiency in financial markets - limits to monetary policy: the zero bound. Nominal interest rate cannot go below zero - the problem of incentives: if firms expect bailouts, they have less incentives to avoid such problems. What will firms do in the future? Uncertainty about policies might negatively affect investment - the financial crisis is not a short run problem of low aggregate demand. There are fundamental problems behind the credit crunch - monetary and fiscal policies are not enough - trade off between rescuing financial institutions and incentives for banks in the future - some economists argue that the credit crunch will cost a few percentage points of GDP, while effects on growth prospects could be much larger

Macroeconomic policy: summary

1. Advocates of active policy believe: - frequent shocks lead to unnecessary fluctuations in output and employment - fiscal and monetary policy can stabilize the economy 2. Advocates of passive policy believe: - the long and variable lags associated with monetary and fiscal policy render them ineffective and possibly destabilizing - inept policy increases volatility in output, employment 3. Advocates of discretionary policy believe: - discretion gives more flexibility to policymakers in responding to the unexpected 4. Advocates of policy rules believe: - the political process cannot be trusted: politicians make policy mistakes and use policy for their own interests - commitment to a fixed policy is necessary to avoid time inconsistency and maintain credibility

Rules for monetary policy

1. Constant money supply growth rate - advocated by monetarists - symbolizes aggregate demand only if velocity is stable - Milton Friedman - monetarists believe that fluctuations in the money supply are responsible for most large fluctuations in the economy. They argue that slow and steady growth in the money supply would yield stable output, employment, and prices - a monetarist policy rule might have prevented many of the economic fluctuations we have experienced historically, but most economists believe that it is not the best possible policy rule. Steady growth in the money supply stabilizes aggregate demand only if the velocity of money is stable, but sometimes the economy experiences shocks that cause velocity to be unstable 2. Target growth rate of nominal GDP - automatically increase money growth whenever nominal GDP grows slower than targeted; decrease money growth when nominal GDP exceeds target 3. Target the inflation rate - automatically reduce money growth whenever inflation rises above the target rate - many countries central banks now practice inflation targeting but allow themselves a little discretion

Arguments for rules: distrust of policy makers

1. Distrust of policymakers and the political process - misinformed politicians - politicians interests sometimes not the same as the interests of society - economic policy is too important to be left to the discretion of policymakers - if politicians are incompetent or opportunistic, then we may not want to give them the discretion to use the powerful tools of monetary and fiscal policy - political process seen as erratic because it reflects the shifting power of special interest groups - macroeconomics is complicated and politicians often do not have sufficient knowledge of it to make informed judgements - some economists fear that politicians use macroeconomic policy to further their own electoral ends - manipulation of the economy for electoral gain, called the political business cycle, has been the subject of extensive research by economists and political scientists

Sticky price model: suppose two types of firms

1. Firms with flexible prices that set prices as above 2. Firms with sticky prices that must set their price before they know how P and Y will turn out: p= Pe + a(Ye-Y'e) where e denotes "expected" Idea: at a given period, some firms are readjusting their prices, but others are not - assume sticky price firms expect that output will equal its natural rate. Then, p=Pe (firms with sticky prices set their prices based on what they expect other firms to charge) - we can use the pricing rules of the two groups of firms to derive the aggregate supply equation. To do this, we find the overall price level in the economy, which is the weighted average of the prices set by the two groups. If s is the fraction of firms with sticky prices and 1-s is the fraction with flexible prices, then the overall price level is: P= sPe + (1-s)[P + a(Y-Y')] ^ ^ Price set Price set by by sticky flexible price firms price firms Manipulating the expression for the price level, we obtain: P= Pe + (1-s)a/s x (Y-Y') - when firms expect a higher price level, they expect high costs. Those firms that fix prices in advance set their prices high. These high prices cause the other firms to set high prices also. Hence, a high expected price level Pe leads to a higher actual price level. This effect does not depend on the fraction of firms with sticky prices - when output is high, the demand for goods is high. Those firms with flexible prices set their prices high, which leads to a high price level. The effect of output on the price level depends on the fraction of firms with sticky prices. The more firms that have sticky prices, the less the price level responds to the level of economic activity - hence, the overall price level depends on he expected price level and on the level of output - the higher the expected price level is, the higher the prices firms will set- expectations are thus important - output above the natural rate corresponds to price above the expected level Y= Y' + a(P-Pe) where a= s/[(1-s)a] The sticky price model says that the deviation of output from the natural level is positively associated with the deviation of the price level from the expected price elevated

Purchasing power parity: three concepts

1. Law of one price: a same good cannot sell for different prices in different locations 2. Absolute purchasing power parity 3. Relative purchasing power parity Law of one price - if a good is more expensive in London than in Bristol, we have incentives to buy in Bristol and sell in London - applying the same reasoning to goods trades in different countries, goods traded in Paris and London have to sell at the same price when expressed in the same currency - limitations: arbitrage is costly and sometimes virtually impossible, and similar but different goods are not perfect substitutes Absolute purchasing power parity - states that the currency must have the same purchasing power in any country - PPP implies that the nominal exchange rate between two countries equals the ratio of the countries price levels - PPP= e x P= P* - under PPP, the NX curve is horizontal: changes in (S-I) have no impact on e or € Relative PPP - one implication of the absolute PPP is that the real exchange rate does not change - relative PPP states that the real exchange rate does not change: it is constant, but not necessarily equal to 1 - the basket of goods in the UK may be worth more than in Portugal, but the relative price of the 2 baskets does not change

The goals of economic policy are

1. Low inflation 2. Low unemployment However, these goals sometimes conflict - suppose that policymakers were to use monetary or fiscal policy to expand aggregate demand. This policy would move the economy along the short run aggregate supply curve to a point of higher output and higher price level. Higher output means lower unemployment because firms employ more workers when they produce more. A higher price level, given the previous year's price level, means higher inflation. Thus, when policymakers move the economy up along the short run aggregate supply curve, they reduce the unemployment rate and raise the inflation rate. - this tradeoff between inflation and unemployment is called the Philips curve - the philips curve is a reflection of the short run aggregate supply curve: as policymakers move the economy along the short run aggregate supply curve, unemployment and inflation move in opposite directions

Policymakers can respond to a financial crisis in three ways

1. They can use conventional monetary and fiscal policy to expand aggregate demand 2. The central bank can provide liquidity by acting as a lender of last resort 3. Policymakers can use public funds to prop up the financial system - preventing financial crises is not easy, but policy makers have tried to reduce the likelihood of future crises by focusing more on regulating shadow banks, by restricting the size of financial firms, by trying to limit excessive risk taking, by reforming the regulatory agencies that oversee the financial system, and by taking a more macroeconomic perspective when regulating financial institutions

Applying the IS-LM model: three issues

1. We examine the potential causes of fluctuations in national income. We use the IS-LM model to see how changes in the exogenous variables influence the endogenous variables for a given price level. We also examine how various shocks to the goods market and the money market affect the interest rate and national income in the short run 2. We discuss how the IS-LM model fits into the model of aggregate supply and aggregate demand. We examine how the IS-LM model provides a theory to explain the slope and position of the aggregate demand curve. Relax the assumption that price level is fixed and show that the IS-LM model implies a negative relationship between the price level and national income. The model can also tell us what events shift the aggregate demand curve and in what direction 3. Examine the Great Depression of the 1930s.

The interaction between monetary and fiscal policy

A change in one policy may influence the other, and this interdependence may alter the impact of a policy change. - ex: Congress raises taxes. How will this affect the economy? Depends on the Fed's response 1. Fed holds money supply constant - the tax increase shifts the IS curve to the left. Income falls (because higher taxes reduce consumer spending), and the interest rate falls (because lower income reduces the demand for money). The fall in income indicates that the tax hike causes a recession 2. Fed holds interest rate constant - when the tax increase shifts the IS curve to the left, the Fed must decrease the money supply to keep the interest rate at its original level. This fall in the money supply shifts the LM curve upward. The interest rate does not fall, but income falls by a larger amount than if the Fed had held the money supply constant. Fed deepens the recession by keeping interest rate high 3. Fed holds income constant - Fed must raise the money supply and shift the LM curve downward enough to offset the shift in the IS curve. In this case, the tax increase doesn't cause a recession, but it does cause a large fall in the interest rate. Although the level of income is not changed, the combination of a tax increase and a monetary expansion does change the allocation of the economy's resources. The higher taxes depress consumption, while the lower interest rate stimulates investment. Income is not affected because these two effects exactly balance

According to the traditional view of government debt: According to the Ricardian view of government debt:

A debt financed tax cut stimulates consumer spending and lowers national saving. This increase in consumer spending leads to greater aggregate demand and higher income in the short run, but it leads to a lower capital stock and lower income in the long run A debt financed tax cut does not stimulate consumer spending because it does not raise consumers overall resources- it merely reschedules taxes from the present to the future. The debate between the traditional and Ricardian view of government debt is ultimately a debate over how consumers behave.

Crises in the financial system begin when

A decline in asset prices, often after a speculative bubble, causes insolvency in some highly leveraged financial institutions. These insolvencies then lead to falling confidence in the overall system, which in turn causes depositors to withdraw funds and induces banks to reduce lending. The ensuing credit crunch reduces aggregate demand and leads to a recession which, in a vicious circle, exacerbated the problem of rising insolvencies and falling confidence

A fiscal expansion abroad in a small open economy

A fiscal expansion in a foreign economy large enough to influence world saving and investment raises the world interest rate from r1* to r2*. The higher world interest rate reduces investment in this small open economy, causing a trade surplus Because the policy change occurs abroad, the domestic saving and investment schedule remain the same. The only change is an increase in the world interest rate from r1* to r2*. The trade balance is the difference between the saving and investment schedules; because saving exceeds investment at r2*, there is a trade surplus. Hence, starting from balanced trade, an increase in the world interest rate due to a fiscal expansion abroad leads to a trade surplus

The IS-LM model is

A general theory of the aggregate demand for goods and services. The exogenous variables in the model are fiscal policy, monetary policy and the price level. The model explains two endogenous variables: the interest rate and the level of national income

IS-LM model

A model of aggregate demand that shows what determines aggregate income for a given price level by analyzing the interaction between the goods market and the money market - two parts of the IS-LM model are the IS curve and the LM curve. IS stands for investment and saving, and the IS curve represents what's going on in the market for goods and services - LM stands for liquidity and money, and the LM curve represents what's happening to the supply and demand for money. Because the interest rate influences both investment and money demand, it is the variable that links the two halves of the IS-LM model. The model shows how interactions between the goods and money markets determine the position and slope of the average demand curve and therefore the level of national income in the short run - the IS curve plots the relationship between the interest rate and the level of income that arises in the market for goods and services. To develop this relationship, we start with a basic model called the Keynesian Cross. This model is the simplest interpretation of Keynes's theory of how national income is determined and is a building block for the more complex and realistic IS-LM model

The impact of protectionist trade policies on the real exchange rate

A protectionist trade policy shifts the net exports schedule from NX(€)1 to NX(€)2, which raises the real exchange rate from €1 to €2. Despite the shift in the net exports schedule, the equilibrium level of net exports is unchanged This fall in the total amount of trade is the reason economists usually oppose protectionist policies. International trade benefits all countries by allowing each country to specialize in what it produces best and by providing each country with a greater variety of goods and services. Protectionist policies diminish these gains from trade. Although these policies can benefit certain groups within society, society on average is worse off when policies reduce the amount of international trade

Arguments for rules: Time inconsistency of discretionary policy

A scenario in which policymakers have an incentive to renege on a previously announced policy once others have acted on that announcement - destroys policymakers credibility, thereby reducing effectiveness of their policies - to make their announcements credible, policymakers may want to make a commitment to a fixed policy rule Ex) public policy about negotiating with terrorist over the release of hostages. The announced policy of many nations is that they will not negotiate over hostages. Such an announcement is intended to deter terrorists: if there is nothing to be gained from kidnapping hostages, rational terrorists won't kidnap any. The purpose of the announcement is to influence the expectations of terrorists and thereby their behavior. But in fact, unless the policy makers are credibly committed to the policy, the announcement has little effect. Terrorists know that once hostages were taken, policymakers face an overwhelming temptation to make some concession to obtain the hostages release. The only way to deter rational terrorists is to take away the discretion of policymakers and commit them to a rule of never negotiating. If policymakers were truly unable to make concessions, the incentive for terrorists to take hostages would be largely eliminated

Shocks to aggregate supply

A supply shock is a shock to the economy that alters the cost of producing goods and services and as a result the prices that firms charge. Because supply shocks have a direct impact on price level, they are sometimes called price shocks: - a drought destroys crops, the reduction in food supply pushes up food prices - a new environmental protection law requires firms to reduce their emissions of pollutants. Firms pass on the added costs to costumers in the form of higher prices - an increase in union aggressiveness pushes up wages and prices of goods produced by union workers - the organization of an international oil cartel: by curtailing competition, the major oil producers can raise the world price of oil All these events are adverse supply shocks, which means they push costs and prices upward. A favorable supply shock, such as the breakup of an international oil cartel, reduces costs and prices

AD curve and AS curve

AS-AD model is a good starting point for understanding business fluctuations - the aggregate demand curve shows us all the combinations of inflation and real growth that are consistent with a specified rate of spending growth - real shocks can generate business fluctuations - LRAS is a vertical line - real shocks directly affect how the factors of production are transformed into output - SRAS is a horizontal line - when spending increases, prices don't move instantly. Prices and wages are sticky and it takes time for them to react to a change in spending - increase in supply of money increases spending, an increase in aggregate demand. Leads producers to produce more output and hires more workers. Doesn't increase real factors of production- prices begin to rise. - increase in spending increases output and growth in the short run, but not in the long run

Most economists analyze short run fluctuations in national income and the price level using the model of

Aggregate demand and aggregate supply - the IS-LM model shows how changes in monetary and fiscal policy and shocks to the money and goods markets shift the aggregate demand curve - we now turn our attention to aggregate supply and develop theories that explain the position and slope of the aggregate supply curve - aggregate supply behaves differently in the short run than in the long run: in the long run, prices are flexible and the aggregate supply curve is vertical. When the aggregate supply curve is vertical, shifts in the aggregate demand curve affect the price level, but the output of the economy remains at its natural level. By contrast, in the short run, prices are sticky and the aggregate supply curve is not vertical. In this case, shifts in aggregate demand do cause fluctuations in output - after examining the basic theory of the short run aggregate supply curve, we establish a key implication: we show that this curve implies a trade off between two measures of economic performance- inflation and unemployment. This tradeoff, called the Philips curve, tells us that to reduce the rate of inflation policy makers must temporarily raise unemployment, and to reduce unemployment they must accept higher inflation

An adverse supply shock: graph

An adverse supply shock pushes up costs and thus prices. If aggregate demand is held constant, the economy moves from point A to point B, leading to stagflation- a combination of increasing prices and falling output. Eventually, as prices fall, the economy returns to the natural level of output point A - the supply shock may also lower the natural level of output and thus shift the long run aggregate supply curve to the left, but we ignore that effect here - if aggregate demand is held constant, the economy moves from point A to point B: the price level rises and the amount of output falls below its natural level. Faced with an adverse supply shock, a policymaker with the ability to influence aggregate demand has a difficult choice between two options: hold aggregate demand constant (output and employment are lower than the natural level)- eventually prices will fall to restore full employment at the old price level; or expand aggregate demand to bring the economy toward the natural level of output more quickly. If the increase in aggregate demand coincides with the shock to aggregate supply, the economy goes immediately from point A to point C. In this case, the Fed is said to accommodate the supply shock. The drawback of this option is that the price level is permanently higher- there is no way to adjust aggregate demand to maintain full employment and keep price level stable

The impact of an increase in investment demand on the real exchange rate

An increase in investment demand raises the quantity of domestic investment from I1 to I2. As a result, the supply of dollars to be exchanged into foreign currencies falls from S-I1 to S-I2. This fall in supply raises the equilibrium real exchange rate from €1 to €2. Increase in investment demand shifts the vertical S-I line to the left, reducing the supply of dollars to be invested abroad. The equilibrium real exchange rate rises. Hence, when the investment tax credit makes investing in the US more attractive, it also increases the value of the US dollars necessary to make these investments. When the dollar appreciates, domestic goods become more expensive relative to foreign goods and net exports fall

What would happen to the trade balance, the real exchange rate, and the nominal exchange rate if a fall in consumer confidence about the future induces consumers to spend less and save more

An increase in saving shifts the (S-I) schedule to the right, increasing the supply of national currency available to be invested abroad. The increased supply of pounds causes the equilibrium real exchange rate to fall from €1 to €2. Because the pound becomes less valuable, domestic goods become less expensive relative to foreign goods, so exports rise and imports fall. This means that the trade balance increases. The nominal exchange rate falls following the movement of the real exchange rate, because prices do not change in response to this shock

An example of the Lucas critique

Arises in the analysis of disinflation - cost of reducing inflation is often measured by the sacrifice ratio, which is the number of percentage points of GDP that must be foregone to reduce inflation by 1 pp. Because estimates of the sacrifice ratio are often large, they have led some economists to argue that policy makers should learn to live with inflation rather than incur the cost of reducing it - according to advocates of the rational expectations approach, however, these estimates of the sacrifice ratio are unreliable because they are subject to the Lucas critique - traditional estimates of the sacrifice ratio are based in adaptive expectations- on the assumption that expected inflation depends on past inflation. Adaptive expectations may be a reasonable premise in some circumstances, but if the policy makers make a credible change in policy, workers and firms setting wages and prices will rationally respond by adjusting their expectations of inflation appropriately. This change in inflation expectations will quickly alter the short run tradeoff between inflation and unemployment. As a result, reducing inflation can potentially be much less costly than is suggested by traditional estimates of the sacrifice ratio

The economy in equilibrium: Keynesian Cross

Assumption that the economy is in equilibrium when actual expenditure equal planned expenditure. This assumption is based on the dues that when peoples plans have been realized, they have no reason to change what they are doing. Recalling that Y as GDP equals not only total income but also total actual expenditure on goods and services, we can write this equilibrium condition as: Actual expenditure= planned expenditure Y= PE

The imperfect information model

Assumptions: 1. Wages and prices are perfectly flexible 2. Each supplier produces one good, consumes many goods 3. Each supplier perfectly knows the nominal price of the good she produces, but does not know the overall price level Consider for example a producer of bicycles. She gets her income from selling bicycles and uses it to buy other goods and services - the amount of bicycles she chooses to produce will positively depend on the price of bikes relative to the price of other goods - however, when making her production decision, she does not perfectly observe this relative price (because she does not perfectly observe the price of other goods) - she tried to infer the value of this relative price using the price of bikes and her expectation of the overall price level - if the producer of bikes experiences an unexpected increase in the price of bikes, she does not know whether this corresponds: 1. To an increase in the relative price level of bikes, in which case the best thing is to increase production 2. Or to an increase in the nominal prices of all goods, in which case the best thing is not to increase production - on average, the producer will conclude that the relative price of bikes has increased to some extent and will raise the production of bikes to some extent - with many producers thinking this way, Y will rise whenever P rises above Pe

To determine how income changes when the interest rate changes, we can combine the investment function with the Keynesian Cross diagram:

Because investment is inversely related to the interest rate, an increase in the interest rate from r1 to r2 reduces the quantity of investment from I(r1) to I(r2). The reduction in planned investment, in turn, shifts the planned expenditure function downward. The shift in the planned expenditure function causes the level of income to fall from Y1 to Y2. Hence, an increase in the interest rate lowers income

What causes the aggregate demand curve to shift?

Because the aggregate demand curve summarizes results from the IS-LM model, events that shift the IS curve or the LM curve cause the aggregate demand curve to shift. For instance, an increase in the money supply raises income in the IS-LM model for any given price level: it thus shifts the aggregate demand curve to the right. Similarly, an increase in government purchases or a decrease in taxes raises income in the IS-LM model for a given price level; it also shifts the aggregate demand curve to the right. Conversely, a decrease in the money supply, a decrease in government purchases, or an increase in taxes lowers income in the IS-LM model and shifts the aggregate demand curve to the left. Anything that changes income in the IS-LM model other than a change in the price level causes a shift in the aggregate demand curve. The factors shifting aggregate demand include not only monetary and fiscal policy but also shocks to the goods market and shocks to the money market. We can summarize these results as follows: a change in income in the IS-LM model resulting from a change in the price level represents a movement along the aggregate demand curve. A change in income in the IS-LM model for a given price level represents a shift in the aggregate demand curve

Shifts in the aggregate demand curve (graph)

Changes in the money supply shift the aggregate demand curve. A decrease in the money supply M reduces the nominal value of output PY. For any given price level P, output Y is lower; thus, a decrease in the money supply shifts the aggregate demand curve inward. An increase in the money supply M raises the nominal value of output PY. For any given price level P, output Y is higher. Thus, an increase in the money supply shifts the aggregate demand curve outward

The IS-LM model shows that monetary policy influences income by

Changing the interest rate. This conclusion sheds light on our analysis of monetary policy- in the short run, when prices are sticky, an expansion in the money supply raises income. But we did not discuss how a monetary expansion induced greater spending on goods and services- a process called the monetary transmission mechanism. The IS-LM model shows an important part of thy mechanism: an increase in the money supply lowers the interest rate, which stimulates investment and thereby expands the demand for goods and services

Market failure: adverse selection

Consider 2 projects that cost $70 million up front: Project 1: - with probability 50%, the project will yield $80 million - with probability 50%, the return will be $70 million - expected return: $75 million Project 2: - with probability 50%, the project will yield $90 million - with probability 50%, the return will be $40 million - expected return: $65 million - if the agent was investing his own money, he would clearly prefer project 1 - now, consider an investor that wants to borrow $70 million to invest in a project - he knows whether his project is type 1 or type 2 - the creditor (bank) does not know - if the project yields more than what he owes, the loan is honored. Otherwise, he gives the creditor whatever he's got and gets 0 - suppose the bank charges an interest rate such that the investor has to pay $80 million in the future. The investors payoff is: - project 1: with probability 50%, $80-$80=0, with probability 50%, 0 - project 2: with probability 50%, $90-$80=$10, with probability 50%, 0. - project 1 yields more than $70 million on average and is less risky- yet at that interest rate, the investor does not find it profitable to invest - project 2 yields less than $65 million and is very risky, exactly because of its riskiness it is profitable for the investor to undertake the investment - adverse selection: only the "bad guy" wants to borrow - example assumes no other cost for default

Is the government debt really a problem?

Consider a tax cut not accompanied by a cut in expenditures or an increase in expenditures not accompanied with corresponding increase in taxes —> increase in debt (the government finances it by borrowing) What will the effects of such a policy be? Two viewpoints: 1. Traditional view 2. Ricardian view

The role of net exports

Consider the expenditure on an economy's output of goods and services. In a closed economy, all output is sold domestically, and expenditure is divided into three components: consumption, investment, and government purchases. In an open economy, some output is sold domestically and some is exported to be sold abroad. We can divide expenditure on an open economy's output Y into four components: - Cd: consumption of domestic goods and services - Id: investment of domestic goods and services - Gd: government purchases of domestic goods and services - X: exports of domestic goods and services The division of expenditure into these components is expressed in the identity Y= Cd + Id + Gd + X The sum of the first three terms is domestic spending on domestic goods and services. The fourth term is foreign spending on domestic goods and services Domestic spending on all goods and services equals domestic spending on domestic goods and services plus domestic spending on foreign goods and services. Hence, total consumption C equals consumption of domestic goods and services Cd plus consumption of foreign goods and services Cf- as such for I and G. We can get the equation: Y= (C-Cf) + (I-If) + (G-Gf) + X Or, rearranged: Y= C + I + G + X - (Cf + If + Gf) The sum of domestic spending on foreign goods and services is expenditure on imports (IM). We can thus write the national income accounts identity as: Y= C + I + G + X - IM Because spending on imports is included in domestic spending (C + I + G) and because goods and services imported from abroad are not part of a country's output, this equation subtracts spending on imports. Defining net exports to be exports minus imports, the identity becomes: Y= C + I + G + NX

Philips curve: the short run tradeoff

Consider the options the Philips curve gives to a policymaker who can influence aggregate demand with monetary or fiscal policy - at any moment, expected inflation and supply shocks are beyond the policymaker's immediate control. Yet, by changing aggregate demand, the policymaker can alter output, unemployment, and inflation - the policymaker can expand aggregate demand to lower unemployment and raise inflation, or the policymaker can depress aggregate demand to raise unemployment and lower inflation

If the real interest rate does not adjust to equilibrate saving and investment in this model, what does determine real interest rate?

Consider the simple case of a small open economy with perfect capital mobility. - "small": this economy is a small part of the world market and thus can only have a negligible effect on the world interest rate - "perfect capital mobility": residents of the country have full access to world financial markets. Government does not impede international borrowing or lending - because of this assumption of perfect capital mobility, the interest rate in our small open economy, r, must equal the world interest rate r*, the real interest rate prevailing in world financial markets r= r* Residents of the small open economy need never borrow at any interest rate above r*, because they can always get a loan at r* from abroad. Similarly, residents of this economy need never lend at any interest rate below r*, because they can always earn r* by lending abroad. Thus, the world interest rate determines the interest rate in our small open economy - what determines the world real interest rate? In a closed economy, the equilibrium of domestic saving and domestic investment determines the interest rate. Barring interplanetary trade, the world economy is a closed economy. Therefore, the equilibrium of world saving and world investment determines the world interest rate. Our small open economy has a negligible effect on the world interest rate because being a small part of the world it has a negligible effect on world saving and world investment. Hence, our small open economy takes the world interest rate as exogenously given

Shifts in investment demand

Consider what happens to our small open economy if its investment schedule shifts outward- that is, if the demand for investment goods at every interest rate increases. This shift would occur if, for example, the government changed the tax laws to encourage investment by providing an investment tax credit. At a given world interest rate, investment is now higher. Because saving is unchanged, some investment must now be financed by borrowing from abroad. Because capital flows into the economy to finance the increased investment, the net capital outflow is negative. Because NX= S-I, the increase in I implied a decrease in NX. Hence, starting from balanced trade, an outward shift in the investment schedule causes a trade deficit

Policy responses to a crisis

Conventional monetary and fiscal policy - financial crises raise unemployment and lower incomes because they lead to a contraction in the aggregate demand for goods and services. Policymakers can mitigate these effects by using the tools of monetary and fiscal policy to expand aggregate demand. The central bank can increase money supply and lower interest rates. The government can increase government spending and cut taxes. That is, a financial crisis can be seen as a shock to the aggregate demand curve, which can be offset by appropriate monetary and fiscal policy - limits: stimulus packages add to the government budget deficit, increase in govt debts are a concern because they place a burden on future generations of taxpayers and call into question the government's own solvency Lender of last resort - a situation in which a solvent bank has insufficient funds to satisfy its depositors withdrawals is called a liquidity crisis - the central bank can remedy this problem by lending money directly to the bank - when a central bank lends to a bank in the midst of a liquidity crisis, it is said to act as a lender of last resort - the goal is to allow a bank experiencing unusually high withdrawals to weather the storm of reduced confidence. Without such a loan, the bank might be forced to sell its illiquid assets at fire sale prices - shadow banks: diverse set of financial institutions that perform some functions similar to those of banks but do so outside the regulatory system that applies to traditional banking Injections of government funds - governments use of public funds to prop up the financial system - most direct action of this sort is a giveaway of public funds to those who have experienced loss. Deposits insurance is one example - giveaways of public funds can also occur on a more discretionary basis - another way for the government to inject public funds is to make risky loans: if the government makes loans that might not be repaid, it is putting public funds at risk. If the borrowers do indeed default, taxpayers end up losing - another way for the government to use public funds to address a financial crisis is for the government itself to inject capital into financial institutions

Long run equilibrium graph

In the long run, the economy finds itself at the intersection of the long run aggregate supply curve and the aggregate demand curve. Because prices have adjusted to this level, the short run aggregate supply curve crosses this point as well

Sticky price model: Firm's desired price

Depends on two macroeconomic variables: 1. The overall level of prices P. A higher price level implies that the firms costs are higher. Hence the higher the overall price level, the more the firm would like to charge for its product 2. The level of aggregate income Y. A higher level of income raises the demand for the firm's product. Because marginal cost increases at higher levels of production, the greater the demand, the higher the firm's desired price An individual firm's desired price is: p= P + a(Y-Y') The desired price p depends on the overall level of prices P and on the level of aggregate output relative to the natural level Y-Y'. The parameter a (which is greater than 0) measures how much the firm's desired price responds to the level of aggregate output

Does the IS-LM model actually capture what happens in the economy?

Does the IS-Lm model pass two tests? - are the assumptions of IS-Lm reasonable? - are the implications of IS-LM consistent with real world observations? - the IS-LM model indeed predicts a decrease in output after a contractionary monetary policy (shift of the Lm to the left) - assuming a production function Y=f(N), the decrease in output is expected to be accompanied by a decrease in employment - assuming that participation is constant, this leads to an increase in unemployment - the IS-LM model assumes that prices are constant. According to the empirical observations, thus may not be a bad approximation in the short run, as prices remain almost unchanged for the first six quarters Summary: - the IS-LM model is consistent with economic observations in the short run - the IS-LM model is a useful tool for short run analysis

The US trade deficit

During the 1980-2000s, the US ran large trade deficits. As accounting identities require, this trade deficit had to be financed by borrowing from abroad (or by selling US assets abroad). During this period, the US went from being the world's largest creator to the world's largest debtor What causes the trade deficit? The staff of the trade deficit coincided with a fall in national saving- explained by the expansionary fiscal policy in the 1980s. Legislation passed that substantially cut personal income taxes from 1981 to 1984; because these tax cuts were not met with equal cuts in government spending, the federal budget went into deficit. Such a policy should reduce national saving, thereby causing a trade deficit- that us what happened. Because the government budget and trade balance went into deficit at roughly the same time, these shortfalls were called the twin deficits In the 1990s: tax increases signed, congress kept a lid on spending, rapid productivity growth raised incomes and thus further increased tax revenue. Developments moved federal budget from deficit to surplus, which caused national saving to rise Increase in national saving did not coincide with a shrinking trade deficit, however, because domestic investment rose at the same time. The boom in IT caused an expansionary shift in the US investment function. Even though fiscal policy was pushing the trade deficit toward surplus, the investment boom was an even stronger force pushing the trade balance toward deficit Early 2000s: tax cuts signed, war on terror led to substantial increases in government spending. More budget deficits; national saving fell to historic lows, and trade deficit reached historic highs. Years later: trade deficit started to shrink as economy experienced decline in housing prices. Led to substantial decline in residential investment

Debt: the US experience in recent years

Early 1980s through early 1990s - debt-GDP ratio: 25.5% in 1980, 48.9% in 1993 - due to Reagan tax cuts, increases in defense spending and entitlements Early 1990s through 2000 - $290b deficit in 1992, $236b surplus in 2000 - debt-GDP ratio fell to 32.5% in 2000 - due to rapid growth, stock market boom, tax hikes Early 2000s - the return of huge deficits due to the Bush tax cuts, 2001 recession, Iraq war The 2008-2009 recession - fall in tax revenues - huge spending increases (bailouts of financial institutions and auto industry, stimulus package)

Forecasting the macroeconomy

Economic developments are often unpredictable given our current understanding of the economy Because policies act with lags, policymakers must predict future conditions - two ways economists generate forecasts: 1. Leading economic indicators: data series that fluctuate in advance of the economy. A large fall in a leading indicator signals that a recession is more likely to occur in the coming months 2. Macroeconometric models: large scale models that can be used to forecast the response of endogenous variables to shocks and policies

Dealing with asymmetric information

Economists use the phrase asymmetric information to describe a situation in which one party to an economic transaction has more information about the transaction than the other. There are two classic types of asymmetric information 1. Adverse selection - concerns hidden knowledge about attributes - entrepreneurs have more information about whether their investment projects are good ones than those who provide the financing - adverse selection describes the tendency of people with more information (entrepreneurs) to sort themselves in a way that disadvantages people with less information (those providing the funding) 2. Moral hazard - concerns hidden knowledge about actions - moral hazard is the risk that an imperfectly monitored agent will act in a dishonest or otherwise inappropriate way - entrepreneurs investing other people's money may not look after the investment projects as carefully as those who invest their own money The financial system as developed various institutions that mitigate the effects of adverse selection and moral hazard. Banks are among the most important. When a person applies for a bank loan, he must fill out an application that asks detailed questions about his business plan, employment background, credit history, criminal record, and other financial and personal characteristics. Because the application is then scrutinized by loan officers trained to evaluate businesses, the bank stands a good chance of uncovering the hidden attributes that lead to adverse selection. In addition, to reduce the problem of moral hazard, bank loans may contain restrictions on how the loan proceeds are spent, and the loan officers may monitor the business after the loan is made

Debates on the EMU

Optimal currency area theories - theory by Robert mundell, Nobel laureate for this theory in 1999 - when a series of countries set up a monetary union, the exchange rate among the national currencies of participating countries becomes irreversibly fixed - thus implies that they completely give up the use of the exchange rate among their national currencies as an economic policy instrument

AS-AD in the short run

Equilibrium in the AS-AD model: obtained putting together aggregate supply and aggregate demand curves (short run relationships) - we also know what shifts those curves (aggregate supply ex would be a fall in oil prices, aggregate demand ex would be increase in money supply or public expenditures) Demand: - a positive demand shock leads to higher output and higher price level in the short run (examples include increase in government spending and increase in money supply) - a negative demand shock leads to lower output and lower price level in the short run (fall in consumer confidence, decrease in the money supply) In these examples, does the supply change? - in equilibrium, aggregate demand is equal to aggregate supply, so if Y changes, supply was surely affected - important difference: the aggregate supply curve did not move. Firms changed their supply, but that was a movement along the aggregate supply curve not a shift of the aggregate supply curve Supply: - a positive supply shock leads to higher output and lower price level in the short run (ex include exogenous fall in oil prices, unexpected technological advances that reduce production costs) - a negative supply shock leads to lower output and higher price level in the short run (ex include exogenous increase in oil prices, a drought that destroys crops) In these examples, did demand change? - in equilibrium, aggregate demand is equal to aggregate supply, so if Y changed then demand was surely affected - important difference: the aggregate demand curve did not move. There was a movement along the curve but not a shift of the curve

The interest rate, investment, and the IS curve

Equilibrium in the goods market: - actual expenditure (Y)= planned expenditure (PE) - change now one of the assumptions, and assume that the investment is not exogenous anymore, but rather negatively depends on the interest rate r- I= I(r) - the rate of interest is the cost of borrowing to finance investment projects. As the cost gets higher, planned investment gets lower

Expansionary fiscal policy vs expansionary monetary policy

Expansionary fiscal policy: - an increase in government purchases or a decrease in taxes - shifts the IS curve to the right. This shift in the IS curve increases the interest rate and income. The increase in income represents a rightward shift in the aggregate demand curve. Similarly, contractionary fiscal policy shifts the IS curve to the left, lowers the interest rate and income, and shifts the aggregate demand curve to the left Expansionary monetary policy: - shifts the LM curve downward - this shift in the LM curve lowers the interest rate and raises income. The increase in income represents a rightward shift in the aggregate demand curve. Similarly, contractionary monetary policy shifts the LM curve upward, raises the interest rate, lowers income, and shifts the aggregate demand curve to the left

business cycle

Fluctuations in economic activity, such as employment and production - this term suggests that economic fluctuations are regular and predictable, but they are not. Recessions are actually as irregular as they are common.

Stabilization policy

Fluctuations in the economy as a whole come from changes in aggregate supply or aggregate demand. Economists call exogenous events that shift these curves shocks to the economy. A shock that shifts the aggregate demand curve is called a demand shock, and a shock that shifts the aggregate supply curve is called a supply shock. These shocks disrupt the economy by pushing output and employment away from their natural level. One goal of the mode of aggregate supply and aggregate demand is to show how shocks cause economic fluctuations - another goal of the model is to evaluate how macroeconomic policy can respond to these shocks. Economists use the term "stabilization policy" to refer to policy actions aimed at reducing the severity of short run economic fluctuations. Because output and employment fluctuate around their long run natural levels, stabilization policy dampens the business cycle by keeping output and employment as close to their natural levels as possible - monetary policy is an important component of stabilization policy

Shocks to aggregate demand and aggregate supply cause economic

Fluctuations. Because the Fed can shift the aggregate demand curve, it can attempt to offset these shocks to maintain output and employment at their natural levels

Shifts in aggregate demand

For a given price level, national income fluctuates because of shifts in the aggregate demand curve. The IS-LM model takes the price level as given and shows what causes income to change. The model therefore shows what causes aggregate demand to shift

A reduction in the money supply shifts the LM curve upward

For any given level of income, a reduction in the money supply raises the interest rate that equilibrates the money market. Therefore, the LM curve shifts upward The LM curve shows the combinations of the interest rate and the level of income that are consistent with equilibrium in the market for real money balances. The LM curve is drawn for a given supply of real money balances. Decreases in the supply of real money balances shift the LM curve upward. Increases in the supply of real money balances shift the LM curve downward

How shifts in aggregate demand lead to short run fluctuations

Here the economy begins in a long run equilibrium, point A. When aggregate demand increases unexpectedly, the price level rises from P1 to P2. Because the price level P2 is above the expected price level Pe2, output rises temporarily above the natural level, as the economy moves along the short run aggregate supply curve from point a to point B. In the long run, the expected price level Pe3 rises, causing the short run aggregate supply curve to shift upward. The economy returns to a new long run equilibrium, where output is back at its natural level. - long run monetary neutrality and short run monetary non neutrality are perfectly compatible. Short run non-neutrality is represented here by the movement from point A to point B, and long run monetary neutrality is represented by the movement from point A to point C. We reconcile the short run and long run effects of money by emphasizing the adjustment of expectations about the price level

Okun's law

High output growth seems to be associated with a reduction in the unemployment rate, while low output growth seems to be associated with an increase in the unemployment rate - gy is the normal growth rate: rate of output growth needed to maintain constant unemployment - B coefficient: if output growth is 1 percentage point greater than normal growth, then in the simply model unemployment falls by 1 pp. however, actual data shows that unemployment falls by B< 1 pp - why is B less than one? - some workers are needed no matter what the level of output is (a given firm may require a minimum number of workers in order to produce): so if growth goes down, firms will reduce their number of employees to a lower extent - training new employees is costly: firms hoard labor; may keep them in bad times (intend of laying them off) in expectation of better times to come - changes in labor force participation: if growth goes down, some individuals will leave the labor market, so the increase in unemployment will be reduced

Income, money, and the LM curve

How does a change in the economy's level of income Y affect the market for real money balances? The answer is that the level of income affects the demand for money. When income is high, expenditure is high, so people engage in more transactions that require the use of money. Thus, greater income implies greater money demand. We can express these ideas by writing the money demand function as (M/P)d= L(r,Y) The quantity of real money balances demanded is negatively related to the interest rate and positively related to income Using the theory of liquidity preference, we can figure out what happens to the equilibrium interest rate when the level of income changes. As panel a illustrates, when income increases from Y1 to Y2, this increase in income shifts the money demand curve to the right. With the supply of real money balances unchanged, the interest rate must rise from r1 to r2 to equilibrate the money market. Therefore, according to the theory of liquidity preference, higher income leads to a higher interest rate

The response of the economy to a tax increase

How the economy responds to a tax increase depends on how the central bank responds. In panel a, the Fed holds the money supply constant. In panel b, the Fed holds the interest rate constant by reducing the money supply. In panel c, the Fed holds the level of income constant by increasing the money supply. In each case, the economy moves from point A to point B

Saving and investment in a small open economy (graph)

In a closed economy, the real interest rate adjusts to equilibrate saving and investment. In a small open economy, the interest rate is determined in world financial markets. The difference between saving and investment determines the trade balance. Here there is a trade surplus, because at the world interest rate, saving exceeds investment

The key macroeconomic difference between open and closed economies is that

In an open economy, a countrys spending in any given year need not equal its output of goods and services. A country can spend more than it produces by borrowing from abroad, or it can spend less than it produces and lend the difference to foreigners

International capital flows and trade balance

In an open economy, financial markets and goods markets are closely related. We must rewrite the national income accounts identity in terms of saving and investment: Y= C + I + G + NX Subtract C and G from both sides to obtain Y - C - G= I + NX Y - C - G is national saving S, which equals the sum of private saving and public saving, T - G, where T stands for taxes S= I + NX Subtracting I from both sides of the equation, we can write the national income accounts identity as S - I= NX This firm of the national income accounts identity shows that an economy's net exports must always equal the difference between its saving and its investment - NX, net exports of goods and services. Another name for net exports is the trade balance, because it tells us how our trade in goods and services departs from the benchmark of equal imports and exports

Economies experience short run fluctuations in economic activity, measured most broadly by real GDP. These fluctuations are associated with movement in many macroeconomic variables:

In particular, when GDP growth declines, consumption growth falls (typically by a smaller amount) and investment growth falls (typically by a larger amount) and unemployment rises. Although economists look at various leading indicators to forecast movements in the economy, these short run fluctuations are largely unpredictable

What is the Fed's policy- the money supply or the interest rate?

In recent years, the Fed has used the federal funds rate- the interest rate that banks charge one another for overnight loans- as its short term policy instrument. After a meeting in which the Fed open market committee votes on a target for this interest rate, the Fed's bond traders are told to conduct the open market operations necessary to hit that target. These open market operations change the money supply and shift the LM curve so that the equilibrium interest rate equals the target interest rate chosen. As a result, Fed policy is often discussed in terms of changing interest rates. Behind these changes in interest rates are the necessary changes in the money supply. Why has the Fed chosen to use an interest rate rather than the money supply as its short term policy instrument? - shocks to the LM curve are more prevalent than shocks to the IS curve- when the Fed targets interest rates, it automatically offsets LM shocks by adjusting the money supply, although this policy exacerbates IS shocks. If LM shocks are the more prevalent type, then a policy of targeting the interest rate leads to greater economic stability than a policy of targeting the money supply

Accommodating an adverse supply shock

In response to an adverse supply shock, the fed can increase aggregate demand to prevent a reduction in output. The economy moves from point A to point C. The cost of this policy is a permanently higher level of prices

What would happen to the trade balance, the real exchange rate, and the nominal exchange rate if the introduction of automatic teller machines that reduces the demand for money

In the model under consideration, the introduction of ATMs has no effect on any real variables. The amounts of capital and labor determine output white. The world interest rate determines investment. The difference between domestic savings and domestic investment determines net exports. The intersection of the NX schedule and the (S-I) schedule determines the real exchange rate. The introduction of ATMs by reducing money demand does affect the nominal exchange rate through its effect on the domestic price level. The price level adjusts to equilibrate the demand and supply of real balances. If M is fixed, then a fall in (M/P)d causes an increase in the price level. This reduces the supply of real balances and restores equilibrium in the money market

If expected inflation depends on recently observed inflation, then inflation has

Inertia, meaning that reducing inflation requires either a beneficial supply shock or a period of high unemployment and reduced output. If people have rational expectations, however, then a credible announcement of a change in policy might be able to influence expectations directly and therefore reduce inflation without causing a recession - most economists accept the natural rate hypothesis, according to which fluctuations in aggregate demand have only short run effects on output and unemployment. Yet some economists have suggested ways in which recessions can leave permanent scars on the economy by raising the natural rate of unemployment

Our model of the open economy shows that the flow of goods and services measured by the trade balance is inextricably connected to the

International flow of funds for capital accumulation. The net capital outflow is the difference between domestic saving and domestic investment. Thus, the impact of economic policies on the trade balance can always be found by examining their impact on domestic saving and domestic investment. Policies that increase investment or decrease saving tend to cause a trade deficit, and policies that decrease investment or increase saving tend to cause a trade surplus Evaluating economic policies and their impact on the open economy is a frequent topic of debate among economists and policy makers. When a country runs a trade deficit, policy makers must confront the question of whether it represents a national problem. Most economists view a trade deficit not as a problem in itself, but perhaps as a symptom of a problem. A trade deficit could be a reflection of low saving. In a closed economy, low saving leads to low investment and a smaller future capital stock. In an open economy, low saving leads to a trade deficit and a growing foreign debt, which eventually must be repaid. In both cases, high current consumption leads to lower future consumption, implying that future generations bear the burden of low national saving Yet trade deficits are not always a reflection of an economic malady. When poor rural economies develop into modern industrial economies, they sometimes finance their high levels of investment with foreign borrowing. In these cases, trade deficits are a sign of economic development. The lesson is that one cannot judge economic performance from the trade balance alone. Instead, one must look at the underlying causes of the international flows

Measurement problem 4: the business cycle

Many changes in the government's budget occur automatically in response to a fluctuating economy. When the economy goes into a recession, incomes fall, so people pay less in personal taxes. Profits fall, so corporations pay less in corporate income taxes. Fewer people are employed, so payroll tax revenue declines. More people become eligible for government assistance, such as welfare and unemployment insurance, and government spending rises. Even without any change in the laws governing taxation and spending, the budget deficit increases - these automatic changes in the deficit are not errors in measurement because the government truly borrows more when a recession depresses tax revenue and boosts government spending. But these changes do make it more difficult to use the deficit to monitor changes in fiscal policy - to solve this problem, the government calculates a cyclically adjusted budget deficit based on estimates of what government spending and tax revenue would be if the economy were operating at its natural level of output and employment. The cyclically adjusted deficit is a useful measure because it reflects policy changes but not the current stage of the business cycle

Measurement problem 2: capital assets

Many economists believe that an accurate assessment of the government's budget deficit requires taking into account the government's assets as well as its liabilities - in particular, when measuring the govts overall indebtedness, we should subtract government assets from government debt. Therefore, the budget deficit should be measured as the change in debt minus the change in assets - a budget procedure that accounts for assets as well as liabilities is called capital budgeting because it takes into account changes in capital. - ex) suppose that the government sells one of its office buildings or some of its land and uses the proceeds to reduce the government debt. Under current budget procedures, the reported deficit would be lower. Under capital budgeting, the revenue received from the sale would not lower the deficit because the reduction in debt would be offset by a reduction in assets. Similarly, under capital budgeting, government borrowing to finance the purchase of a capital food would not raise the deficit - the major difficulty with capital budgeting is that its hard to decide which government expenditures should count as capital expenditures - opponents of capital budgeting argue that, although the system is superior in principle to the current system, it is too difficult to implement in practice

Interaction between monetary and fiscal policy

Model: monetary and fiscal policy variables are exogenous - real world: monetary policy makers may adjust M in response to changes in fiscal policy, or vice versa - such interaction may alter the impact of the original policy change

Monetary policy under the EMU

Monetary policy is independently decided by the ECB - monetary policy objectives - broad objectives established in the Maastricht treaty - main objective: to maintain price stability - without prejudice to the objective of price stability, the Eurosystem also supports the general economic policies of the community with a view to contributing to objectives as a high level of employment and non-inflationary growth - the governing council currently interprets "price stability" as harmonized consumer price index growth beneath 2% - monetary policy instruments - main instrument: open market operations: in order to increase the amount of money in the € area, the ECB buys bonds; in order to reduce the amount of money in the € area, the ECB sells bonds - main open market operations: repurchase - expansionary policy: the NCBs buy assets from commercial banks under a repurchase agreement (the commercial banks agree when the first transaction is implemented to buy back the asset from the ECB in the future at a fixed higher price) - contractionary policy: the NCBs sell assets and agrees to buy them back in the future - the difference between the initial price and the repurchasing price corresponds to the repo interest rate - the repo interest rate has in turn an impact on the interest rate at which commercial banks lend to consumers or firms: if the repo rate paid by commercial banks to the ECB is higher, commercial banks are more likely to raise the interest rate at which they lend money to consumers or firms - exchange rate policy - the euro fluctuates with respect to the most important currencies - the external value of the euro is determined by financial markets, so the exchange rate cannot be an instrument of economic policy

Trade surpluses and deficits

NX= EX-IM= Y - (C + I + G) - trade surplus: exports are greater than output/spending - trade deficit: exports are smaller than output/spending - as spending need not equal output, saving need not equal investment - the country may invest less than its savings: part of its savings will finance investment in other countries - or it may invest more than its domestic savings and borrow from abroad to finance it

The national income accounts identity shows how domestic output, domestic spending, and net exports are related:

NX= Y- (C + I + G) This equation shows that in an open economy, domestic spending need not equal the output of goods and services. If output exceeds domestic spending, we export the difference: net exports are positive. If output falls short of domestic spending, we import the difference: net exports are negative

Two lessons of the Lucas critique

Narrow lesson: economists evaluating alternative policies need to consider how policy affects expectations and thereby behavior Broad lesson: policy evaluation is hard so economists engages in this task should be sure to show the requisite humility

The determination of €

Neither S nor I depend on €, so the net capital outflow curve is vertical - € adjusts to equate NX with net capital outflow, S-I Supply and demand in foreign exchange market: - demand: foreigners need £ to buy domestic net exports - supply: net capital outflow (S-I) is the supply of £ to be invested abroad - NX downward sloping: the lower the exchange rate, the cheaper the domestic goods sold abroad, ie the higher the demand for £ to buy the exports

Fiscal policy and the multiplier: taxes

Now consider how changes in taxes affect equilibrium income. A decrease in taxes ΔT immediately raises disposable income Y-T by ΔT and therefore increases consumption by MPC x ΔT. For any given level of income Y, planned expenditure is now higher. The planned expenditure schedule shifts upward by MPC x ΔT. The equilibrium of the economy moves from point A to point B - just as an increase in government purchases has a multiplied effect on income, so does a decrease in taxes. As before, the initial change in expenditure, now MPC x ΔT, is multiplied by 1/(1- MPC). The overall effect on income of the change in taxes is ΔY/ΔT= -MPC/(1-MPC) This expression is the tax multiplier, the amount income changes in response to a $1 change in taxes.

The natural rate hypothesis vs hysteresis

Our analysis of the costs of disinflation is based on the natural rate hypothesis: - changes in aggregate demand affect output and employment only in the short run - in the long run, the economy returns to the levels of output, employment, and unemployment described by the classical model - natural rate hypothesis: fluctuations in aggregate demand affect output and unemployment only in the short run. In the long run, the economy returns to the levels of output, unemployment, and employment described by the classical model - the natural rate hypothesis allows macroeconomists to separately study short run and long run developments in the economy. It is one expression of the classical dichotomy - Hysteresis: the long lasting influence of history on variables such as the natural rate of unemployment - negative shocks may increase u', the economy may not fully recover - if that is true, hysteresis raises the costs of recessions and the sacrifice ratio as well

The economy in equilibrium- planned expenditure

PE= C + I + G C= Co + c1(Y-T) PE= Co + c1(Y-T) + I + G When actual expenditure (Y) equals planned expenditure (PE), then Y= Co + c1(Y-T) + I + G - the equilibrium condition is that production, Y, be equal to demand. Demand, Z, in turn depends on income, Y, which itself is equal to production If firms are producing at level Y2 - planned expenditure is more than production - firms are selling more than they expected - firms meet the high level of sales by drawing down their inventories - unplanned drop in inventories - hire more workers and increase production until reach equilibrium Algebra: Y= 1/(1-c1) x [Co + I + G - c1T] - increase in consumption: firms produce more, more employees are needed, income goes up, increase in consumption. Same qualitative effect when there are changes in I, G, or T

An increase in government purchases shifts the IS curve outward

Panel a shows that an increase in government purchases raises planned expenditure. For any given interest rate, the upward shift in planned expenditure of ΔG leads to an increase in income Y of ΔG/(1-MPC). Therefore, in panel b, the IS curve shifts to the right by this amount - this figure is drawn for a given interest rate r and thus for a given level of planned investment. The Keynesian Cross in panel a shows that this change in fiscal policy raises planned expenditure and thereby increases equilibrium income from Y1 to Y2. Therefore, in panel b, the increase in government purchases shifts the IS curve outward - we can use the Keynesian Cross to see how other changes in fiscal policy shift the IS curve. Because a decrease in taxes also expands expenditure and income, it too shifts the IS curve outward. A decrease in government purchases or an increase in taxes reduces income: therefore, such a change in fiscal policy shifts the IS curve inward. In summary, the IS curve shows the combinations of the interest rate and the level of income that are consistent with equilibrium in the market for goods and services. The IS curve is drawn for a given fiscal policy. Changes in fiscal policy that raise the demand for goods and services shift the IS curve to the right. Changes in fiscal policy that reduce the demand for goods and services shift the IS curve to the left

Economists often express aggregate supply in a relationship called the

Phillips curve - the Phillips curve says that inflation depends on expected inflation, the deviation of unemployment from its natural rate, and supply shocks. According to the Phillips curve, policy makers who control aggregate demand face a short run tradeoff between inflation and unemployment

Planned expenditure as a function of income

Planned expenditure PE depends on income because higher income leads to higher consumption, which is part of planned expenditure. The slope of the planned expenditure function is the marginal propensity to consume, MPC - the line slopes upward because higher income leads to higher consumption and thus higher planned expenditure. The slope of this line is the marginal propensity to consume: it shows how much planned expenditure increases when income rises by $1. The planned expenditure function is the first piece of the Keynesian Cross

Rules and discretion: basic concepts

Policy conducted by rule: - policymakers announce in advance how policy will respond in various situations, and commit themselves to following through Policy conducted by discretion: - as events occur and circumstances change, policymakers use their judgement and apply whatever policies seem appropriate at the time This debate is distinct from the debate over passive versus active policy. Policy can be conducted by rule and yet be either passive or active

The determinants of capital flows are easy to understand:

When saving falls short of investment, investors borrow from abroad; when saving exceeds investment, the excess is lent to other countries

Should policy be active or passive?

Policy makers in the federal government view economic stabilization as one of their primary responsibilities. - monetary and fiscal policy can exert a powerful impact on aggregate demand and thereby on inflation and unemployment - although the government has long conducted monetary and fiscal policy, the view that it should use these policy instruments to try to stabilize the economy is more recent - to many economists the case for active government policy is clear and simple. Recessions are periods of high unemployment, low incomes, and increased economic hardship. The model of aggregate demand and aggregate supply shows shocks to the economy can cause recessions. It also shows how monetary and fiscal policy can prevent recessions by responding to these shocks. These economists consider it wasteful not to use these policy instruments to stabilize the economy - other economists are critical of the government's attempts to stabilize the economy. These critics argue that the government should take a hands off approach to macroeconomic policy.

The real exchange rate and the trade balance

Real exchange rate is nothing more than a relative price- the relative price of domestic and foreign goods affects the demand for these goods - real exchange rate is low: domestic goods are relatively cheap, so domestic residents will want to purchase fewer imported goods. For the same reason, foreigners will want to buy many of our goods. As a result of both of these actions, the quantity of our net exports demanded will be high - real exchange rate is high: opposite effect. Domestic goods are expensive relative to foreign goods, so domestic residents will want to buy many imported goods and foreigners will want to buy fewer of our goods. Therefore, quantity of our net exports demanded will be low We write this relationship between the real exchange rate and net exports as NX= NX(€) Net exports are a function of the real exchange rate

The determinants of the nominal exchange rate

Recall the relationship between the real and the nominal exchange rate: Real ER= nom ER x ratio of price levels € = e x (P/P*) We can write the nominal exchange rate as: e= € x (P*/P) This equation shows that the nominal exchange rate depends on the real exchange rate and the price levels in the two countries. - given the value of the real exchange rate, if the domestic price level P rises, then the nominal exchange rate e will fall: because a dollar is worth less, a dollar will buy fewer yen. However, if the Japanese price level P* rises, then the nominal exchange rate will increase: because the yen is worth less, a dollar will buy more yen It is instructive to consider changes in exchange rates over time. The exchange rate equation can be written: % change in e= % change in € + % change in P* - % change in P The percentage change in € is the change in the real exchange rate. The percentage change in P is the domestic inflation rate, and the percentage change in P* is the foreign country's inflation rate.

Fiscal policy at home

Suppose that the economy begins in a position of balanced trade. That is, at the world interest rate, investment I equals savings S, and net exports equal zero. Consider first what would happen to the small open economy if the government expands domestic spending by increasing government purchases. The increase in G reduces national saving, because S= Y - C - G. With an unchanged world real interest rate, investment remains the same. Therefore, saving falls below investment, and some investment must now be financed by borrowing from abroad. Because NX= S - I, the fall in S implies a fall in NX. The economy now runs a trade deficit The same logic applies to a decrease in taxes. A tax cut lowers T, raises disposable income Y-T, stimulates consumption, and reduces national saving (even though some of the tax cut finds its way into private saving, public saving falls by the full amount of the tax cut; in total, saving falls). Because NX= S-I, the reduction in national saving in turn lowers NX A fiscal policy change that increases private consumption C or public consumption G reduces national saving and therefore shifts the vertical line that represents saving to the left. Because NX is the distance between the saving schedule and the investment schedule at the world interest rate, this shift reduces NX . Hence, starting from balanced trade, a change in fiscal policy that reduces national saving leads to a trade deficit

If investment does not depend on the interest rate, the IS curve is vertical

The IS curve represents the relationship between the interest rate and the level of income that arises from equilibrium in the market for goods and services. It describes the combinations of income and interest rate that satisfy the equation: Y= C(Y-T) + I(r) + G If investment does not depend on interest rate, then nothing in the IS equation depends on the interest rate and we get the same level of equilibrium income no matter the level of the interest rate. For this reason, IS is vertical. When IS is vertical, monetary policy has no effect on output, because the IS curve determines Y

How fiscal policy shifts the IS curve

The IS curve shows us, for any given interest rate, the level of income that brings the goods market into equilibrium. The equilibrium level of income also depends on government spending G and taxes T. The IS curve is drawn for a given fiscal policy; that is, when we construct the IS curve, we hold G and T fixed. When fiscal policy changes, the IS curve shifts

Deriving the IS curve

The IS curve, shown in the graph, summarizes this relationship between the interest rate and the level of income. In essence, the IS curve combines the interaction between I and Y demonstrated by the Keynesian Cross. Each point on the IS curve represents equilibrium in the goods market, and the curve illustrates how the equilibrium level of income depends on the interest rate. Because an increase in the interest rate causes planned investment to fall, which in turn causes equilibrium income to fall, the IS curve slopes downward - the higher the interest rate, the lower the level of income

The IS-LM model in the short run and long run

The IS-LM model is designed to explain the economy in the short run when the price level is fixed. Yet, now that we have seen how a change in the price level influences the equilibrium in the IS-LM model, we can also use the model to describe the economy in the long run when the price level adjusts to ensure that the economy produces at its natural rate

The interest rate, investment, and the IS curve

The Keynesian Cross is only a stepping stone on our path to the IS-LM model, which explains the economy's aggregate demand curve - the Keynesian Cross is useful because it shows how the spending plans of households firms and the government determine the economy's income. Yet it makes the simplifying assumption that the level of planned investment I is fixed. An important macroeconomic relationship is that planned investment depends on the interest rate r - to add this relationship between the interest rate and investment to our model, we write the level of planned investment as I= I(r) - in the graph: because the interest rate is the cost of borrowing to finance investment projects, an increase in the interest rate reduces planned investment. As a result, the investment function slopes downward

Deriving the Philips curve from the aggregate supply curve

The Philips curve in its modern form states that the inflation rate depends on three forces: - expected inflation - the deviation of unemployment from the natural rate, called cyclical unemployment - supply shocks Expressed in the following equation: π= πe - B(u-u') + v π= inflation, πe= expected inflation, B= parameter measuring the response of inflation to cyclical unemployment, u-u'= cyclical unemployment, v= supply shock - other things equal, higher unemployment is associated with lower inflation Where does this equation for the Philips curve come from? Aggregate supply: 1. AS equation given by Y=Y' + a(P-Pe) 2. Rearranging the terms, P=Pe + (1/a)(Y-Y') 3. Consider now a more general equation in which an exogenous supply shock v is included: P= Pe + (1/a)(Y-Y') + v This may correspond to an exogenous change in world oil prices for example 4. Subtracting the lagged price level in both the RHS and LHS: (P-P(-1))= (Pe-P(-1)) + (1/a)(Y-Y') + v 5. Assuming that prices are in logarithms, the LHS corresponds to the inflation rate, and the first term in the RHS to the expected inflation rate: π= πe + (1/a)(Y-Y') + v 6. Using Okun's law, (1/a)(Y-Y')= -B(u-u') —> π= πe - B(u-u') + v Which is a philips curve relating the unexpected inflation to the deviations of the unemployment rate from the natural unemployment rate

Financial system

The broad term for the institutions in the economy that facilitate the flow of funds between savers and investors - in this simple model, there is a single interest rate that adjusts to bring saving and investment into balance - the actual financial system is more complicated than this description - one piece of the financial system is the set of financial markets through which households can directly provide resources for investment - two important financial markets are the market for bonds and the market for stocks. A bond represents a loan from the bond holder to the firm; a share of stock represents an ownership claim by the shareholder in the firm. A person who buys a bond becomes a creditor of the company, while a person who buys newly issued stock becomes a part owner of the company - raising investment funds by issuing bonds is called debt finance, and raising funds by issuing stock is called equity finance. Debt and equity are forms of direct finance because the saver knows whose investment project his funds are financing - another piece of the financial system is the set of financial intermediaries through which households can indirectly provide resources for investment. A financial intermediary stands between the two sides of the market and helps move financial resources toward their best use. Commercial banks are the best known type of financial intermediary. They take deposits from savers and use these deposits to make loans to those who have investment projects they need to finance. When an intermediary is involved, the financing is considered indirect because the saver is often unaware of whose investments his funds are financing

Net Capital Outflow (NCO)

The difference between domestic saving and domestic investments S- I - net capital outflow equals the amount that domestic residents are lending abroad minus the amount that foreigners are lending to us - if net capital outflow is positive, the economy's saving exceeds its investment, and it is lending the excess to foreigners - if net capital outflow is negative, the economy is experiencing a capital inflow: investment exceeds saving, and the economy is financing this extra investment by borrowing from abroad. Thus, net capital outflow reflects this international flow of funds to finance capital accumulation. The national income accounts identity shows that net capital outflow always equals the trade balance. That is, S - I = NX Net capital outflow = trade balance If S - I and NX are positive, we have a trade surplus. In this case, we are net lenders in world financial markets, and we are exporting more goods than we are importing. If S - I and NX are negative, we have a trade deficit. In this case, we are net borrowers in world financial markets, and we are importing more goods than we are exporting. If S - I and NX are exactly zero, we are said to have balanced trade because the value of imports equals the value of exports The equality of net exports and net capital outflow is an identity

A reduction in aggregate demand graph

The economy begins in long run equilibrium at point A. A reduction in aggregate demand, perhaps caused by a decrease in the money supply, moves the economy from point a to point B, where output is below its natural level. As prices fall, the economy gradually recovers from the recession, moving from point B to point C

The Keynesian Cross

The equilibrium in the Keynesian cross is the point at which income (actual expenditure) equals planned expenditure - how does the economy get to equilibrium? In this model, inventories play an important role in the adjustment process. Whenever an economy is not in equilibrium, firms experience unplanned changes in inventories, and thus induces them to change production levels. Changes in production in turn influence total income and expenditure, moving the economy toward equilibrium

The net capital outflow is

The excess of domestic saving over domestic investment. The trade balance is the amount received for our net exports of goods and services. The national income accounts identity shows that the net capital outflow always equals the trade balance

The national income accounts identity shows that

The international flow of funds to finance capital accumulation and the international flow of goods and services are two sides of the same coin. If domestic saving exceeds domestic investment, the surplus saving is used to make loans to foreigners. Foreigners require these loans because we are providing them with more goods and services than they are providing us. That is, we are running a trade surplus. If investment exceeds saving, the extra investment must be financed by borrowing from abroad. These foreign loans enable us to import more goods and services than we export. We are running a trade deficit

Equilibrium in the IS-LM model

The intersection of the IS and LM curves represents simultaneous equilibrium in the market for goods and services and in the market for real money balances for given values of government spending, taxes, the money supply, and the price level

What would happen to the trade balance, the real exchange rate, and the nominal exchange rate if the introduction of a stylish line of Toyota's makes some consumers prefer foreign cars over domestic cars

The introduction of a stylish line of Toyota's that makes some consumers prefer foreign cars over domestic cars has no effect on saving or investment, but it shifts the NX(€) schedule inward. The trade balance does not change, but the real exchange rate falls from €1 to €2. Because prices are not affected, the nominal exchange rate follows the real exchange rate

Net exports and the real exchange rate graph

The lower the real exchange rate, the less expensive are domestic goods relative to foreign goods, and thus the greater are our net exports.

The IS curve represents

The negative relationship between the interest rate and the level of income that arises from equilibrium in the market for goods and services. The LM curve represents the positive relationship between interest rate and the level of income that arises from equilibrium in the market for real money balances. Equilibrium in the IS-LM model- the intersection of the IS and LM curves- represents simultaneous equilibrium in the market for goods and services and in the market for real money balances

Labor migrations

The question is then whether this adjustment mechanism is likely to work at the € area level: do we observe high migration levels across € area counties? - currently, quite a low migration level observed - other possible adjustment mechanism: redistribution towards the country experiencing the shock - currently, the EU budget for this purpose is limited - this is probably linked to the weakness of the European identity: if negative asymmetric shock experiences by Liverpool, the London electorate may favor a transfer of resources from London to Liverpool. Less likely to be the case if the shock is experienced by the Paris region

Purchasing power parity and real exchange rate

The quick action of international arbitrageurs implies that net exports are highly sensitive to small movements in the real exchange rate. A small decrease in the price of domestic goods relative to foreign goods- that is, a small decrease in the real exchange rate- causes arbitrageurs to buy goods domestically and sell them abroad. Similarly, a small increase in the relative price of domestic goods causes arbitrageurs to import goods from abroad. Therefore, the net exports schedule is very flat at the real exchange rate that equalizes purchasing power among countries; any small movement in the real exchange rate leads to a large change in net exports. This extreme sensitivity of net exports guaranteed that the equilibrium real exchange rate is always close to the level that ensures purchasing power parity

The nominal exchange rate is

The rate at which people trade the currency of one country for the currency of another country. The real exchange rate is the rate at which people trade the goods produced by the two countries. The real exchange rate equals the nominal exchange rate multiplied by the ratio of the price levels in the two countries Because the real exchange rate is the price of domestic goods relative to foreign goods, an appreciation of the real exchange rate tends to reduce net exports. The equilibrium real exchange rate is the rate at which the quantity of net exports demanded equals the net capital outflow The nominal exchange rate is determined by the real exchange rate and the price levels in the two countries. Other things equal, a high rate of inflation leads to a depreciating currency

How the real exchange rate is determined

The real exchange rate is determined by the intersection of the vertical line representing saving minus investment and the downward sloping net exports schedule. At this intersection, the quantity of dollars supplied for the flow of capital abroad equals the quantity of dollars demanded for the net export of goods and services The line showing the relationship between net exports and the real exchange rate slopes downward because a low real exchange rate makes domestic goods relatively inexpensive. The line representing the excess of saving over investment, S-I, is vertical because neither saving nor investment depends on the real exchange rate. The crossing of these two lines determines the equilibrium real exchange rate is - this diagram represents the supply and demand for foreign currency exchange - the vertical line S-I represents the net capital outflow and thus the supply of dollars to be exchanged info foreign currency and invested abroad. The downward sloping line represents the net demand for dollars coming from foreigners who want dollars to buy our goods. At the equilibrium real exchange rate, the supply of dollars available from the net capital outflow balances the demand for dollars by foreigners buying our net exports

Nominal exchange rate

The relative price of the currencies of two countries - if the exchange rate between the US dollar and the Japanese yen is 80 yen per dollar, then you can exchange one dollar for 80 yen in world markets for foreign currency- a Japanese who wants to obtain dollars would pay 80 yen for each dollar he bought - when people refer to the exchange rate between two countries, they usually mean the nominal exchange rate - an exchange rate can be reported in two ways: if one dollar buys 80 yen, then one yen buys 0.0125 dollar. We can say the exchange rate is 80 yen per dollar, or we can say the exchange rate is 0.0125 dollar per yen - we express the exchange rate in units of foreign currency per dollar. With this convention, a rise in the exchange rate is called an appreciation of the dollar. A fall in the exchange rate is called a depreciation. When the domestic currency appreciates, it buys more of the foreign currency; when it depreciates, it buys less. An appreciation is sometimes called a strengthening of the currency, and a depreciation is sometimes called a weakening of the currency

Growth in consumption and investment

When the economy heads into a recession, growth in real consumption and investment spending both decline. Investment spending is considerably more volatile than consumption spending. When the economy heads into a recession, households respond to the fall in their incomes by consuming less, but the decline in spending on business equipment, structures, new housing, and inventories is even more substantial

The real exchange rate

The relative price of the goods of two countries - the real exchange rate tells us the rate at which we can trade the goods of one country for the goods of another. The real exchange rate is sometimes called the terms of trade Real exchange rate= (nominal exchange rate x price of domestic good) / price of foreign good - the rate at which we exchange foreign and domestic goods depends on the prices of the goods in the local currencies and on the rate at which the currencies are exchanged - this calculation of the real exchange rate for a single good suggests how we should define the real exchange rate for a broader basket of goods. Let e be the nominal exchange rate (the number of yen per dollar), P be the price level in the US (measured in dollars), and P* be the price level in Japan (measured in yen). Then the real exchange rate € is Real exchange rate = nom x ratio of PL € = e x (P/P*) PL= price level Nom= nominal exchange rate The real exchange rate between two countries is computed from the nominal exchange rate and the price levels in the two countries. If the real exchange rate is high, foreign goods are relatively cheap, and domestic goods are relatively expensive. If the real exchange rate is low, foreign goods are relatively expensive and domestic goods are relatively cheap.

The theory of liquidity preference graph

The supply and demand for real money balances determines the interest rate. The supply curve for real money balances is vertical because the supply does not depend on the interest rate. The demand curve is downward sloping because a higher interest rate raises the cost of holding money and thus lowers the quantity demanded. At the equilibrium interest rate, the quantity of real money balances demanded equals the quantity supplied - the theory of liquidity preference posits that the interest rate is one determinant of how much money people choose to hold. The underlying reason is that the interest rate is the opportunity cost of holding money: it is what you forgo by holding some of your assets as money, which does not bar interest, instead of as interest-bearing bank deposits or bonds. When the interest rate rises, people want to hold less of their wealth in the form of money. We can write the demand function for real money balances as (M/P)d= L(r) where the function L(r) shows that the quantity of money demanded depends on the interest rate. The demand curve slopes downward because higher interest rates reduce the quantity of real money balances demanded

Okun's law

This figure is a scatterplot of the change in the unemployment rate on the horizontal axis and the percentage change in real GDP on the vertical axis, using data on the US economy. Each point represents one year. The figure shows that increases in unemployment tend to be associated with lower than normal growth in real GDP. - if the unemployment rate remains the same, real GDP grows by about 3%; this normal growth in the production of goods and services is due to growth in the labor force, capital accumulation, and technological progress. In addition, for every percentage point the unemployment rate rises, real GDP growth typically falls by 2% - Okun's law is a reminder that the forces that govern the short run business cycle are very different than those that shape long run economic growth. Long run growth in GDP is determined primarily by technological progress. The long run trend leading to higher standards of living from generation to generation is not associated with any long run trend in the rate of unemployment. By contrast, short run movements in GDP are highly correlated with the utilization of the economy's labor force. The declines in the production of goods and services that occur during recessions are always associated with increases in joblessness

Inflation differentials and the exchange rate

This scatterplot shows the relationship between inflation and the nominal exchange rate. The horizontal axis shows the country's average inflation rate minus the US average inflation rate over the period 2000-2013. The vertical axis is the average percentage change in the country's exchange rate (per US dollar) over that period. This figure shows that countries with relatively high inflation tend to have depreciating currencies and that countries with relatively low inflation tend to have appreciating currencies

Model of a small open economy

Three assumptions: 1. The economy's output Y is fixed by the factors of production and the production function: Y= F(K,L) 2. Consumption C is positively related to disposable income Y - T. We write the consumption function as C= C(Y-T) 3. Investment I is negatively related to the real interest rate r. We write this investment function as I= I(r) These are the three key parts of our model We can now return to the accounting identity and write it as: NX= (Y - C - G) - I NX= S - I Substituting the assumptions above and the assumption that the interest rate equals the world interest rate, we obtain: NX= [Y - C(Y-T) - G] - I(r*) NX= S - I(r*) This equation shows that the trade balance NX depends on those variables that determine saving S and investment I. Because saving depends on fiscal policy (lower government purchases G or higher taxes T raise national savings) and investment depends on the world interest rate r*, the trade balance depends on these variables as well

How big is the multiplier?

Trace through each step of the change in income - process begins when expenditure rises by ΔG, which implies that income rises by ΔG as well. This increase in income in turn raises consumption by MPC x ΔG, where MPC is the marginal propensity to consume. This increase in consumption raises expenditure and income once again. This second increase in income of MPC x ΔG again raises expenditure and income, and so on. This feedback from consumption to income continued indefinitely. The total effect on income is: ΔY= (1 + MPC + MPC2 + ...) ΔG The government purchases multiplier is ΔY/ΔG= (1 + MPC + MPC2 + ...) This expression for the multiplier is an example of an infinite geometric series: ΔY/ΔG= 1/(1- MPC)

Why doesn't capital flow to poor countries?

US trade deficit represents a flow of capital into the US from the rest of the world- what countries were the source? The capital must have been coming from those countries that were running trade surpluses: many nations far poorer than US such as Nigeria and Venezuela. In these nations, saving exceeded investment in domestic capital. These countries were sending funds abroad to countries like the US, where investment in domestic capital exceeded saving Capital does not seem to flow to those nations where it should be most valuable- instead of capital rich countries like the US lending to capital poor countries, we often observe the opposite. There are important differences among nations other than their accumulation of capital; poor nations have lower levels of capital accumulation per worker but also inferior production capabilities (less access to advanced technologies, lower education levels, less efficient economic policies). Could mean less output for given inputs of capital and labor. In addition, property rights may not be enforced in poor nations. Corruption is more prevalent, revolutions and expropriation of wealth is common, governments often default

In the long run, the aggregate supply curve is ______. Therefore, shift in aggregate demand affect the ________ but not _______. In the short run, the aggregate supply curve is _______. Therefore, shifts in aggregate demand affect __________.

Vertical, because output is determined by the amounts of causal and labor and by the available technology, but not by the level of prices; price level but not output or employment Horizontal, because wages and prices are sticky at predetermined levels; output and unemployment

Rational expectations

Ways of modeling the formation of expectations: - adaptive expectations: people base their expectations of future inflation on recently observed inflation - rational expectations: people base their expectations on all available information, including information about current and prospective future policies - because monetary and fiscal policies influence inflation, expected inflation should also depend on the monetary and fiscal policies in effect. According to the theory of rational expectations, a change in monetary or fiscal policy will change expectations, and an evaluation of any policy change must incorporate this effect on expectations. If people do form their expectations rationally, then inflation may have less inertia than first appears - if the government tries to influence inflation, people anticipate that, which affects the expected inflation - thus, the economy is on average at u= u' - there is no longer a systematic trade off between inflation and unemployment that economic post can exploit - advocates of rational expectations argue that the short run Phillips curve does not accurately represent the options that policymakers have available. They believe that if policymakers are credibly committed to reducing inflation, rational people will understand the commitment and will quickly lower their expectations of inflation. Inflation can then come down without a rise in unemployment and fall in output. According to the theory of rational expectations, traditional estimates of the sacrifice ratio are not useful for evaluating the impact of alternative policies. Under a credible policy, the cost of reducing inflation may be much lower than estimates of the sacrifice ratio suggest

The short run and long run equilibria

We can compare the short run and long run equilibria using either the IS-LM diagram or the aggregate supply/ aggregate demand diagram. In the short run, the price level is stuck at price P1. The short run equilibrium of the economy is therefore point K. In the long run, the price level adjusts so that the economy is at the natural level of output. The long run equilibrium is therefore point C IS curve, LM curve, and natural level of output are necessary for understanding short and long run equilibria - the LM curve is drawn for a fixed price level P. In the short run equilibrium, the economy's income is less than its natural level - at the existing price level, there is insufficient demand for goods and services to keep the economy producing at its potential - eventually, the low demand for goods and services causes prices to fall, and the economy moves back toward its natural rate. When the price level reaches P2, the economy is at point C, the long run equilibrium. The diagram of aggregate supply and aggregate demand shows that at point C, the quantity of goods and services demanded equals the natural level of output. This long run equilibrium is achieved in the IS-LM diagram by a shift in the LM curve: the fall in the price level raises real money balances and therefore shifts the LM curve to the right.

Summary: two models of aggregate supply

We have seen two models of aggregate supply and the market imperfection that each uses to explain why the short run aggregate supply curve is upward sloping - one model assumes the prices of some goods are sticky - the second assumes information about prices is imperfect Keep in mind that these models are not incompatible with each other - the two models of aggregate supply differ in their assumptions and emphases, but their implications for aggregate output are similar. Both can be summarized by the equation Y= Y' + a(P-Pe) This equation states that devotions of output from the natural level are related to deviations of the price level from the expected price level. If the price level is higher than the expected price level, output exceeds its natural level. If the price level is lower than the expected price level, output falls short of its natural level - graph: notice that the short run aggregate supply curve is drawn for a given expectation Pe and that a change in Pe would shift the curve

The Philips curve: what is going on post 1970s

We need to understand two main stylized facts: 1. Philips curve pre 1970: a negative relation between the unemployment rate and the inflation rate 2. Philips curve post 1970: no visible relation between the unemployment rate and the inflation rate

How policies influence the real exchange rate: abroad

What happens to the real exchange rate if foreign governments increase government purchases or cut taxes? Either change in fiscal policy reduces world saving and raises the world interest rate. The increase in the world interest rate reduces domestic investment I, which raises S-I and thus NX. That is, increase in the world interest rate causes a trade surplus

Shifts in investment demand

What happens to the real exchange rate if investment demand at home increases? At the given world interest rate, the increase in investment demand leads to higher investment. A higher value of I means lower values of S-I and NX. That is, increase in investment demand causes a trade deficit

According to the theory of liquidity preference, the supply and demand for real money balances determine

What interest rate prevails in the economy. That is, the interest rate adjusts to equilibrate the money market. At the equilibrium interest rate, the quantity of real money balances demanded equals the quantity supplied How does the interest rate get to this equilibrium of money supply and money demand? The adjustment occurs because whenever the money market is not in equilibrium, people try to adjust their portfolios of assets and, in the process, alter the interest rate. If the interest rate is above the equilibrium level, the quantity of real money balances supplied exceeds the quantity demanded- individuals holding the excess supply of money try to convert some of their non-interest bearing money into interest bearing bank deposits or bonds. Banks and bond issuers, which prefer to pay lower interest rates, respond to this excess supply of money by lowering the interest rates they offer. If the interest rate is below the equilibrium level, so that the quantity of money demanded exceeds the quantity supplied, individuals try to obtain money by selling bonds or making bank withdrawals. To attract now-scarcer funds, banks and bond issuers respond by increasing the interest rates they offer. Eventually, the interest rate reaches the equilibrium level, at which people are content with their portfolios of monetary and non monetary assets

Optimal currency areas

Which are the conditions under which eliminating the exchange rate as an adjustment variable does not entail significant costs? - intuitively, these will be situations in which the exchange rate was not a very important adjustment mechanism - according to this theory, a group of countries or regions constitute an optimal currency area if: i. The shocks experienced by these economies are symmetric ii. There are alternative adjustment mechanism when shocks are asymmetric Symmetric shocks: - a group of countries are said to face symmetric shocks if they face shocks that are similar in their extent and their nature (ex. A shock to the productivity of a particular sector in both countries) - shocks are more likely to be symmetric across countries if: • the productive structures of the counties are similar • the countries have similar degrees of openness • there is not too much specialization across countries Asymmetric shock - consider the case of a country specialized in the production of one good - assume Syldavia exports wood towards the other countries of the € area - assume also that the Syldavian labor market is characterized by the existence of a minimum wage - we will compare the impact of a negative shock on the demand for wood when Syldavia belongs to the € area and when Syldavia remains out of the € area - if Syldavia does not belong to the € area: - negative shock to the demand for wood leads to a drop in Syldavian exports, decrease in the demand for the Syldavian currency by importers, depreciation of the currency with respect to €, reduction in price of Syldavian wood in the € area, increase in wood exports, increase in labor demand Optimal currency area if there are alternative adjustment mechanisms: - flexibility of markets for inputs, and in particular labor market flexibility - the economy can adjust to an asymmetric shock through a reduction in the wage, instead than through an increase in unemployment - labor migrations across regions or countries - migration from the country which experiences the negative shock to countries that do not experience such a shock - for instance, in the presence of labor market rigidities in the country experiencing the shock, this can be a way of avoiding a rise in unemployment

Some advantages from the EMU

Will the € become a vehicle currency? - vehicle currency: currency used in the trad actions between two countries that do not have this currency as their national currency - currently this role is played by the USD - since the creation of the €, the $ has lost some ground with respect to the € as a vehicle currency (but it still dominates) Advantages from the € becoming a vehicle currency include seigniorage revenue: if the € is widely used, more € will be printed, and the ECB will get an income from that Reduction in transaction costs - elimination of national currencies: the costs associated to exchanging one national currency into another disappear - however, the gains are not so easy to estimate - individuals making transactions in a different national currency do not have to pay an exchange rate commission: easy to measure - the EMU has probably reduced the size of the exchange rate business sector, in order to get an idea of the gains from this, we would need to know the new activities of the employees/ firms that were providing these services Micro-efficiency gains - elimination of exchange rate fluctuations risks: there were inefficiencies associated to exchange rate fluctuations (unexpected changes in the prices of imported goods and inputs relative to home produced goods) - consider for instance a French firm that can buy its inputs in either France or in Spain. Before the EMU, the price of the input in Spain relative to France may have varied because of fluctuations in the exchange rate between the French franc and the Spanish peseta, and is not because of changes in the relative costs of production of the input in both countries - assume that Spain has an advantage in the production of this input: the efficient choice for the French firm is then to import this input from Spain - however assume that the French franc depreciates with respect to the peseta, and that this depreciation is not related to changes in the market for this particular input. Then, the French input will become cheaper, and the firm will start buying the input in France. This will entail an efficiency loss, since the input is still produced more efficiently in Spain. Other micro efficiency gains include prices becoming perfectly comparable across countries - this is likely to increase competition in some sectors Political stability - monetary union—> more integration—> more political stability—> Lower or less frequent nationalistic tensions - individual European countries are relatively small in size with respect to the world economy and are quite open. Instead, the euro area as a whole is much bigger and much more closed.

Bilateral trade balance

nation's trade balance with a specific other nation - the overall trade balance is inextricably linked to a nation's saving and investment. That is not true of a bilateral trade balance. Indeed, a nation can have large trade deficits and surpluses with specific trading partners while having balanced trade overall - bilateral trade deficits receive more attention in the political arena than they deserve. This is in part because international relations are conducted country to country, so politicians and diplomats are naturally drawn to statistics measuring country to country economic transactions. Most economists believe that bilateral trade balances are not very meaningful; It is a nation's trade balance with all foreign nations put together that matters

The crucial difference between how the economy works in the long run and how it works in the short run is

that prices are flexible in the long run and sticky in the short run. The model of aggregate supply and aggregate demand provides a framework to analyze economic fluctuations and see how the impact of policies and events varies over different time horizons

The Philips curve states that

π depends on: - expected inflation, πe - cyclical unemployment: the deviation of the actual rate of unemployment from the natural rate - supply shocks, v π= πe - B(u-u') + v where B>0 is an exogenous constant