Macroeconomics Chapter 4-6

The connection between money demand and the quantity equation

k = 1/V

Sectoral shift

A change in the composition of demand among industries or regions.

The classical view of inflation

A change in the price level is merely a change in the units of measurement.

Relative price distortions

Firms facing menu costs change prices infrequently, causing microeconomic inefficiencies in the allocation of resources.

The determinants of the nominal exchange rate

For a given value of nominal exchange rate, the growth rate of e equals the difference between foreign and domestic inflation rates.

Two types of unemployment

Frictional unemployment and structural unemployment.

Fiscal expansion

Reduces national saving.

The Fisher equation

i = r + pi

How does i and Y affect money demand

i negatively, Y positively.

ex ante real interest rate

i-Epi, the real interest rate people expect at the time they buy a bond or take out a loan.

ex post interest rate

i-pi, the real interest rate actually realized.

Trade surplus

output > spending and exports > imports. Size of the trade surplus = NX.

Assumptions about capital flows

1. Domestic and foreign bonds are perfect substitutes; 2. Perfect capital mobility: no restrictions on international trade in assets; 3. Economy is small: cannot affect the world interest rate.

Why doesn't PPP hold in the real world?

1. International arbitrage is not possible: 1) nontraded goods; 2) transportation costs; 2. Different countries' goods are not perfect substitutes.

The social costs of expected inflation

1. Shoeleather cost; 2. Menu costs; 3. Relative price distortions; 4. Unfair tax treatment; 5. General inconvenience.

Causes of structural unemployment

Real wage rigidity caused by minimum-wage laws, unions and efficiency wages.

Hyperinflation

All the costs of moderate inflation become huge. Money ceases to function.

The Fisher effect

An increase in inflation rate causes an equal increase in nominal interest rate.

Additional cost of unexpected inflation

Arbitrary redistribution of purchasing power.

Unions

Conflicts between insiders and outsiders.

What causes hyperinflation?

Hyperinflation is caused by excessive money supply growth.

Additional cost of high inflation

Increased certainty.

General inconvenience

Inflation makes it harder to compare nominal values from different time periods.

The quantity equation

M x V = P x Y

Classical dichotomy

Money is neutral. Does not affect real variables.

Net capital outflow

NX = S - I. Trade balance = Net capital outflow. When S > I, trade surplus, country is a net lender. When S < I, trade deficit, country is a net borrower.

Benefit of inflation

Nominal wages are rarely reduced, even when the equilibrium real wage falls. This hinders labor market clearing. Inflation allows the real wages to reach equilibrium levels without nominal wage cuts. There, moderate inflation imporvs the functioning of labor markets.

The quantity theory of money

Normal economic growth requires a certain amount of money supply growth to facilitate the growth in transactions. Money growth in excess of this amount leads to inflation.

The inflation tax

Printing money to raise revenue causes inflation. Inflation is like a tax on people who hold money.

M/P

Real money balances, the purchasing power of the money supply.

Unfair tax treatment

Some taxes are not adjusted to account for inflation.

Supply and demand in the foreign exchange market

Supply: Net capital outflow = S - I; Demand: Foreigners need dollars to buy U.S. net exports.

Shoeleather cost

The costs and inconveniences of reducing money balances to avoid the inflation tax.

Menu costs

The costs of changing prices.

Purchasing Power Parity

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 must have the same purchasing power in every country. Purchasing-power parity has to important implicattions. First, changes in saving or investment do not influence the real or nominal exchange rate. Second, because the real exchange rate is fixed, all changes in the nominal exchange rate result from changes in price levels.

Velocity

The number of times the average dollar bill changes hands in a time period.

Nominal exchange rate

The relative price of domestic currency in terms of foreign currency.

Frictional unemployment

The unemployment caused by the time it takes workers to search for a job.

Seigniorage

To spend more without raising taxes or selling bonds, the government can print money. The revenue raised from printing money is called seigniorage.

Causes of frictional unemployment

Unemployment insurance and sectoral shifts.

Why governments create hyperinflation?

When a government cannot raise taxes or sell bonds, it must finance spending increases by printing money.

How the price level is determined

With V constant, the money supply determines nominal GDP. Real GDP is determined by the economoy's supplies of K and L and the production function. The price level is nominal GDP/real GDP.

The nominal interest rate relevant for money demand

r+Epi

Trade deficit

spending > output and imports > exports. Size of the trade deficit = -NX.