Macroeconomics Midterm #2

Price of two year bond

A two year bond — a bond that promises one payment of $100 in two years. Price of the two year bond: $P2t = $100/((1+i1t)(1+i(1t+1)^e))

Aggregate private spending

Aggregate private spending (private spending, A) equals the sum of consumption and investment spending: A(Y, T, r, x) = C(Y-T) + I(Y, r+x)

Appreciation

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: One can buy more units of foreign currency with one unit of domestic currency; one can buy less domestic currency for one unit of foreign currency. It costs more foreign currency to but one unite of domestic currency.

Expectations and the IS Relation (Output)

An increase in output or expected output leads to an increase in aggregate private spending 1) An increase in Y^('e) will cause human wealth to be higher (because the expected present value of future income will increase). -Individuals will increase their current consumption -and the IS curve will shift right 2) An increase in Y^('e) will also cause firms to increase their expectations of future expected profits -When this occurs, the discounted present value of future profits is higher causing investment (I) to increase -As Investment (I) increases, the IS curve shifts right.

Interpreting the Yield Curve

An upward sloping yield curve means that long-term interest rates are higher than short-term interest rates. Meaning that financial markets expect short-term rates to be higher in the future. A downward sloping yield curve means that long-term interest rates are lower than short-term interest rates. Financial markets expect short-term rates to be lower in the future. Using the following equation, you can find out what financial markets expect the 1-year interest rate to be 1 year from now: i(1t+1)^e = 2i(2t) - i(1t)

How do bonds differ

Bonds differ in two basic dimensions: -Default risk, the risk that the issuer of the bond will not pay back the full amount promised by the bond. -Maturity, the length of time over which the bond promises to make payments to the holder of the bond. Bonds of different maturities each have a price and an associated interest rate called the yield to maturity, or simply the yield.

Corporate bonds

Bonds issued by firms

Government bonds

Bonds issued by the government (Risk free)

Discount bonds

Bonds that promise a single payment at maturity called the face value Present discounted value is the present value of a sequence of payments. Thus, it makes sense that a discount bond tells the buyer the present day value of the yield of the bond

Coupon bonds

Bonds that promise multiple payments before maturity and one payment at maturity

Indexed bonds

Bonds that promise payments adjusted for inflation

Junk bonds

Bonds with high default risk

Nominal exchange rate

E The price of the domestic currency in terms of the foreign currency. For example, 1 USD = 0.76GBP (it costs 0.76 pounds to buy 1 dollar) The nominal exchange rate is the price of the domestic currency in terms of the foreign currency

Bond ratings

Ratings for default risk

term premium

The premium associated with longer maturities

Returns from holding stock for one year

$D^e = expected dividends $Q = price of the stock Ex-dividend price: the stock price after the dividend has been paid this year

The new IS-LM curve

-The IS curve is steeply downward sloping -Other things equal, a change in the current interest rate has a small effect on output (steepness of IS curve) -The LM curve is flat -The equilibrium is at the intersection of the IS and LM curves

The production function: Diminishing returns

1) When the economy has a low level of capital, an extra unit of capital leads to a large increase in output. 2) When the economy has a higher level of capital, an extra unit of capital leads to a small increase in output. Increasing investment leads to increasing capital, and thus to increasing output in the long run. Here other determinants of output, including human capital, natural resources, and technology, are held constant. The curve becomes flatter as the amount of capital increases because of diminishing returns to capital.

Discount factor and Discount rate

1/(1+it) is the discount factor with the discount rate it The discount rate is used to compute the present discounted value of a dollar next year. The higher the nominal interest rate, the lower the value today of a dollar received next year. The higher the actual or expected payments, the higher the expected present discounted value.

Balance of Payments

A countries transactions with the rest of the world, including both trade flows and financial flows, are summarized by a set of accounts called the balance of payments. The table has two parts separated by a line. Transactions are referred to either as above the line (current account transactions) or below the line (capital account transactions)

Depreciation (open market)

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. One can buy more units of domestic currency with one unit of foreign currency. It costs less foreign units to buy one unit of domestic currency.

Movements in stock prices (fiscal consolidation)

A fiscal consolidation leads to a lower level of output. What happens to the stock market depends on what investors expect the fed to do. If investors expect that the Fed will not respond and will keep the policy rate unchanged, output will decrease, as the economy moves to A'. With an unchanged policy rate and lower output, stock prices will go down (since markets will expect firms to pay lower dividends if the firms are making less money due to output decreasing). If instead investors expect that the Fed will respond by reducing the policy rate, output may remain unchanged as the economy moves to A''. With unchanged output, and a lower policy rate, stock prices will go up.

Index of openness

A good index of openness is the proportion of aggregate output composed of tradable goods—or goods that compete with foreign goods in either domestic markets or foreign markets. Estimates are that tradable goods represent around 60% of aggregate output in the US today. Tradable goods: cars, computers, etc. Non-tradable goods: housing, medical services, haircuts, auto repairs, etc.

Movements in the stock market (Monetary expansion)

A monetary expansion decreases the interest rate and increases output. What it does to the stock market depends on whether of not financial markets anticipated the monetary expansion because real stock prices depend mainly on expected real interest rates. If the markets anticipated the monetary expansion, then the prices of stocks would go up. If the markets did anticipate the monetary expansion, then prices wouldn't really change.

Price of one year bond

A one-year bond—a bond that promises one payment of $100 in one year. Price of the one-year bond: $P1t=($100)/(1+i1t)

Statistical discrepancy

Capital account balance minus current account balance. (bottom minus top on balance of payments) The current account balance and the capital account balance should be equal (in absolute value), but because of data gathering errors they are not. For this reason, the account shows a statistical discrepancy.

Consumption

Consumption depends not only on total wealth but also on current after-tax labor income. Ct = C(Total wealth t, Ylt-Tt) Total wealth = Sum of non-human wealth and human wealth: Non-human wealth: financial wealth + housing wealth Human wealth: Expected present value of after-tax labor income (over whole life span) Current after-tax labor income = Y(Lt) -T(t) Y(Lt) = real labor income in year t. T(t) = real taxed in year t

Can exports exceed GDP?

Countries can have exports ratios larger than 1 (they export more than their GDP) because exports and imports may include exports and imports of intermediate goods, whereas GDP does not include this. -In 2014, the ratio of exports to GDP in Singapore was 188% Example: -A country imports intermediate goods worth $1 billion, and transforms them into final goods using $200 million worth of labor (assume no profits). It exports $1 billion worth of final goods and consumes the rest domestically. Then its GDP is $200 million (because GDP = total income in economy and firms make no income so only income was the $200 million in labor), and exports are 5 times the value of the country's GDP.

Equilibrium in the stock/bond market

Equilibrium requires that the expected rate of return from holding stocks for one year (left side) be the same as the rate of return on one-year bonds plus the equity premium x (right side):

How expectations affect consumption

Expectations affect consumption in two ways: Directly through human wealth, or expectations of future labor income, real interest rates, and taxes. If people expect labor income to increase, they consume more because human wealth increases. If people expect real interest rates to increase, they consume less because human wealth decreases. If people expect the percentage of income that goes to taxes to increase, they consume less because human wealth decreases. Expectations also affect consumption indirectly through nonhuman wealth (stocks, bonds, and housing). Expectations of the value of nonhuman wealth is computed by financial markets. This dependence of consumption on expectations has two main implications for the relation between consumption and income: 1) Consumption is likely to respond less than one for one to fluctuations in current income. 2) Consumption may move even if current income does not change, due to changes in consumer confidence, related to expectations about the future.

Static espectations

Firms expect both future profits and future interest rates to remain at the same level as today. Economists call such expectations — expectations that the future will be like the present—static expectations. Under these two assumptions, expected present value of profits is profits divided by (real interest rate + depreciation rate). You can put this equation together with investment by plugging the equation for expected present value of profits into the equation for investments. I=I(pi/(r+d)) When this occurs, the NPVt is greater than 0

A convenient special case investment

For static expectations, investment is

A convenient special case, NPV

For static expectations, net present value is

Movements in the stock market

For the most part, major movements in stock prices are unpredictable.

Zero interest rates

If i = 0, then 1/(1+i) equals one, and so does (1/(1+i)^n) for any power n. For this reason, the present discounted value of a sequence of expected payments is just the sum of those expected payments.

The price of a stock today is you expect to hold it infinitely long

If the interest rate is positive, then as n becomes larger, the last term goes to zero. The expression reduces to

Famous bubbles

In 1634, a "tulip bubble" began to take place as the price of rare bulbs started increasing, and speculators bought tulip bulbs in anticipation of even higher prices later. The price of a bulb called "Admiral Van d Eyck" jumped from 1,500 guineas in 1634 to 7,500 guineas in 1637 In 1994, a Russian "financier" created a company called MMM and promised shareholders a rate of return of at least 3,000% a year. Even though MMM was not involved in any type of production an held no assets, its share prices increased from 1,600 rubles in February to 105,000 in July.

US housing prices: Fundamentals or bubble

In real time, there was little agreement whether the large increase in housing prices in the 2000s was a bubble. Pessimists argued that the increase in house prices was not matched by a parallel increase in rents (bubble). Optimists argued that the increasing price-to-rent ratio reflects the decreasing real interest rate and changing mortgage market (fundamentals) Pessimists were right

Deficit reduction

In the long run, a reduction in the budget deficit is likely to be beneficial for the economy. Recall the conclusions we reached in the core about the effects of a budget deficit reduction: -In the medium run, a deficit reduction has no effect on output. It leads, however, to a lower interest rate, to higher national savings, and to higher investment. -In the long run (to be covered) higher investment translates into higher capital stock and thus to a higher level of output. Then in the short run, a reduction in the budget deficit need not necessarily lead to lower spending and to a contraction in output.

Treasury Inflation Protected Securities (TIPS)

Indexed bonds introduced in the United States in 1997

Firms finance themselves through

Internal finance: Using their own earnings External finance: Bank loans Debt finance: bonds and loans Equity finance: by issuing stocks—or shares. Instead of paying predetermined amounts, as bonds do, stocks pay dividends in an amount decided by the firm.

Investment decisions

Investment decisions depend on current profits (as well as sales as a proxy of profits), the current real interest rate, and on expectations of future profits and future real interest rates. The decision to buy a machine depends on the present value of the profits the firm can expect from having this machine versus the cost of buying it (NPV = -I + expected present value of profits from buying the machine)

Estimating human wealth

Let's compute the present value of your labor income as the value of real expected after-tax labor income, discounted using real interest rates: **present value of total income you will make across your lifetime

The volatility of consumption and investment (similarities)

Let's look at the similarities between our treatment of consumption and of investment behavior: -Whether consumers perceive current movements in income to be transitory or permanent affects their consumption decisions. -In the same way, whether firms perceive current movements in sales to be transitory or permanent affects their investment decisions. changes in investment and consumption generally move in the same direction, but investment moves much more. In other words, investment is much more affected by changes in expected income, interest rates, etc. Consumption and investment usually move together. Investment is much more volatile than consumption. Because the level of investment is much smaller than the level of consumption, changes investment from one year to the next end up being the same overall magnitude as changes in consumption.

Nominal versus real interest rates and present values

Replacing nominal interest rates with real interest rates to obtain the present value of a sequence of real payments, we get: Vt = zt + 1/(1+rt)*z(t+1)^e + 1/((1+rt)(1+r(t+1)^e))*z(t+2)^e Which can be simplified to: $Vt/Pt = Vt

Stock prices as present values

Replacing the nominal interest rates with the real interest rates, then the real stock price is: Higher expected future real dividends lead to a higher real stock price Higher current and expected future one-year real interest rates lead to a lower real stock price A higher premium leads to a lower stock price

Yield curve

maturity vs. interest rates The relation between maturity and yield is called the yield curve, or the term structure of interest rates.

The effects of monetary policy depends on its effects on expectations

The effects of monetary policy depends on its effects on expectations: -If a monetary expansion leads to changes in expectations of future interest rates and output, then the policy effect on output may be large. -But if expectations remain unchanged, the policy effects on output will be limited

Effects of an expansionary monetary policy

The effects of monetary policy on output depend very much on whether and how monetary policy affects expectations

Expected present discounted value

The expected present discounted value of a sequence of future payments is the value today of this expected sequence of payments. Expected present discounted values are not directly observable, but must be constructed from information on the sequence of expected payments and expected interest rates. $Vt = $zt + 1/(1+it)*$zt+1 + 1/((1+it)(1+it+1^e))*$zt+2+.... present discounted value or present value is another way of saying "expected present discounted value." Expected present discounted value depends positively on today's actual payment or expected future payments. Present value depends negatively on current and expected future interest rates.

Domestic vs. foreign goods

When goods markets are open, domestic consumers must decide not only (i) how much to consume and save, but also (ii) whether to buy domestic goods or to buy foreign goods. Central to the second decision is the price of domestic goods relative to foreign goods, or the real exchange rate. The real exchange rate is not directly observable. What you see in newspapers is the nominal exchange rate.

Constant interest rates and payments

When the sequence of payments is equal—call them $z, the present value formula simplifies to: $Vt = $z[1 + 1/(1+i) + i/(1+i)^2 + 1/(1+i)^3 + .... + 1/(1+i)^(n-1)] $Vt = $z * (1-[1/(1+i)^n])/(1-[1/(1+i)]

Price of a stock today if you sell it n-years from now

You get paid dividends each year ($D) but you only get paid the price of the stock n years form now once ($Q)

Risk premium

The difference between the interest rate paid on a given bond and the interest rate on the bond with the best rating

Monetary policy revisited

The effects of monetary policy depend crucially on its effect on expectations: -If a monetary expansion leads financial investors, firms, and consumers to revise their expectations of future interest rates and output, then the effects of the monetary expansion on output may be very large. -But if expectations remain unchanged, the effects of the monetary expansion on output will be small. -Could it ever be the case that an increase money supply today can lead to lower output today? People form expectations about the future by assessing the likely course of future expected policy and then working out the implications of future activity. Economists refer to expectations formed in a forward-looking manner as Rational Expectations.

Fixed exchange rates

When countries operate under fixed exchange rates, that is, maintain a constant exchange rate between them, two other terms used are: Revaluations, rather than appreciations, which are increases in the exchange rate, and Devaluations, rather than depreciations, which are decreases in the exchange rate.

As n goes to infinity >> constant interest rates and payments

As n goes to infinity, we get: $Vt = $z/(1-1/(1+i)) >> $Vt=$z/i

Movements in real exchange rates

Like nominal exchange rates, real exchange rates move over time: -An increase in the relative price of domestic goods in terms of foreign goods is called a real appreciation, which corresponds to an increase in the real exchange rate. When this happens, domestic goods cost more relative to foreign goods (imports go up, exports go down) A decrease in the relative price of domestic goods in terms of foreign goods is called a real depreciation, which corresponds to a decrease in the real exchange rate. When this happens, domestic goods cost less relative to foreign goods (imports go down, exports go up)

Openness

Openness has three distinct dimensions: Openness in goods markets. Free trade restrictions include tariffs and quotas. Openness in financial markets. Capital controls place restrictions on the ownership of foreign assets. Openness in factor markets. The ability of firms to choose where to locate production, and workers to choose where to work. The North American Free Trade Agreement (NAFTA) is san example of this. We will ignore this for now.

The effects if a deficit reduction on current output

Since in the long run a deficit reduction leads to an increase in output, in the short run, a deficit reduction may not lead to a decrease in output. When account is taken of its effects on expectations, the decrease in government spending need not lead to a decrease in output. Deficit reduction may actually increase spending and output, even in the short run, if people take into account the future beneficial effects of deficit reduction. In response to the announcement of deficit reduction, -Current spending goes down—the IS curve shifts to the left. -Expected future output goes up—the IS curve shifts to the right. -And the expected future interest rate goes down — the IS curve shifts to the right The change is ambiguous, so it could increase output The net effect of the three shifts in the IS curve depends on: 1) Timing -Credibly backloading the deficit reduction program toward the future, with small cuts today and larger cuts in the future, is more likely to lead to an increase in output, is more likely to lead to an increase in output. -The program's credibility (the perceived probability that the government will do what it has promised when the time comes to it) decreases when the government announces the need for painful cuts in spending, and then leaving them to the future. 2) Composition -If some government spending programs are perceived as "wasteful," cutting these programs today will allow the government to cut taxes in the future. -Expectations of lower future taxes and lower distortions could induce firms to invest today, thus raising output in the short run. 3) Initial situation: -If government debt is increasing fast, then a credible deficit reduction program is more likely to increase output in the short run, as the program announcement may well reassure the people that the government has regained control of its budget. 4) Monetary policy matters -Even if the three previous argument .s cannot fully offset the effect of an adverse shift in the IS curve due to a deficit reduction, monetary policy can: a decrease in the policy rate can help reduce the adverse effects of the shift on output.

Current versus expected profit

Some of the reasons we used to explain the behavior of consumers also applies to firms: -Firms may be reluctant to borrow if current profit is low. But if current profit is high, the firm may not need to borrow to finance its investments. Even if the firm wants to invest, it might have difficulty borrowing. Potential lenders may not be convinced the project is as good as the firm says. Investment depends both on the expected present value of future profits and on the current level of profit. Investment does not always change in the same direction as profits, especially if firms expect future profits to be different.

Rational speculative bubbles

Stock prices increase just because investors expect them to.

Fads

Stocks become high prices for no reason other than its price has increased in the past.

The LM relation with expectations

The LM relation is not modified because the opportunity cost of holding money today de3pends on the current nominal interest rate, not on the expected nominal interest rate one year from now. **The real interest rate that enters the LM relation is the current real interest rate The LM curve is a horizontal line at r

Net Present Value

The Net Present Value, or simply NPV, is the expected present value of profit per unit of capital (or per machine) minus aggregate investment

Life

The amount of time left until the bond matures

Exports and Imports in the US

The behavior of exports and imports in the US is characterized by the following facts: -The US economy is becoming more open over time, and trades more than twice as much (relative to its GDP) with the rest of the world as it did just 40 years ago. -Although imports and exports have followed broadly the same upward trend, imports have consistently exceeded exports (the US has been running a trade deficit) since the early 1980s

Depreciation

The depreciation rate measures how much usefulness the machine loses from one year to the next. Reasonable values for the depreciation rate are between 4 and 15% for machines, and between 2 and 4% for buildings and factories.

Capital Account

The fact that the US had a current account deficit of $389 billion in 2014 implies that it had to borrow $389 billion from the rest of the world—or equivalently, that net foreign holdings of US assets had to increase by $389 billion. The numbers below the line describe how this was achieved. Foreign investors buy US stocks, US bonds, and US assets. Increases in foreign holdings of US assets is incorporated. If US buys foreign stocks, foreign bonds, or other foreign assets, we include this in increase in US holdings of foreign assets. Capital Account balance is increase in foreign holdings of US assets minus increase in US holdings of foreign holdings. Positive net capital flows are called a capital account balance. Negative net capital flows are called a capital account deficit Capital account balance is also known as net capital flows

The internal rate of return

The internal rate of return of an investment project is the rate above which the investment is worse (that not investing), is the rate that makes NPV = 0, is the expected annual return of the project

Why do some countries export more than others?

The main factors behind differences in export ratios are geography and country size: -Distance from other markets (if you have many neighbors, it's easier to trade) -Size also matters: The smaller the country, the more it must specialize in producing and exporting only a few products and rely on imports for other products.

The new IS curve

The new IS curve is much steeper than the IS curve in previous chapters, so a decrease in the current policy rate is likely to have only a small effect on equilibrium output. A decrease in the current real policy rate, given unchanged expectations of the future real policy rate, does not have much effect on private spending. The multiplier is likely to be small because a change in current income, given unchanged expectations of future income, is unlikely to have a large effect on spending.

The new IS curve (with expectations)

The new IS curve is steeper because you must increase or decrease the current interest rate (r) by more to have the same change in current output (Y). In other words, changes in expectations affect output more than changes in current output/interest rates. Given expectations, -A decrease in the real interest rate leads to a small increase in output: The IS curve is steeply downward sloping. -Increases in government spending or in expected future output shift the IS curve to the right. -Increases in taxes, in expected future taxes, or in the expected future real interest rate shift the IS curve to the left.

Coupon payments

The payments before maturity **Coupon bond promises multiple payments before maturity and one payment at maturity

Fundamental value

The present value of expected dividends given in previous equations — stocks are sometimes underpriced or overpriced. Sometimes stocks cost more or less because people expect the companies to pay more or less dividends

Real exchange rate

The price of domestic goods relative to foreign goods (backwards 3 symbol) Changes in the real exchange rate are informative but the real exchange rate for one year on its own is not that informative.

Openness in Financial Markets

The purchase and sale of foreign assets implies buying or selling foreign currency— sometimes called foreign exchange. Openness in financial markets allows: -Financial investors to diversify—to hold both domestic and foreign assets and speculate on foreign interest rate and exchange rate movements. -Allows countries to run trade surpluses and deficits, A country that buys more than it sells must pay for the difference by borrowing from the rest of the world

Current yield

The ratio of the coupon payment to the price of the bond

Coupon rate

The ratio of the coupon payments to the face value **coupon payments are the payments before maturity **coupon bonds promise to pay multiple payments before maturity and one payment at maturity

User cost or the rental cost of capital

The sum of the real interest rate and the depreciation rate is called the user cost or the rental cost of capital

The theory of consumption

The theory of consumption was developed by Milton Friedman in the 1950s, who called it the permanent income theory of consumption, And by Franco Modigliani, who called it the life cycle theory of consumption.

Current Account

The transactions above the line record payments to and from the rest of the world. They are called current account transactions. -The first two lines record the exports and imports of goods and services/ Exports lead to payments from the rest of the world, imports lead to payments to the rest of the world. The difference between exports and imports is the trade balance. (If negative, trade deficit; if positive, trade surplus). (Trade balance = exports - imports). -US residents receive income on their holdings of foreign assets and foreign residents receive income on their holdings of US assets. Income balance (income received - income paid to foreigners) -Finally, countries give and receive foreign aid; the net value of these payments is recorded as net transfers received. The sum of net payments to and from the rest of the world is called current account balance. It net payments are positive, current account surplus (you are receiving more than giving). If net payments are negative, current account deficit (you are giving more than receiving).

Total wealth

The value of his nonhuman wealth plus the value of his human wealth Nonhuman wealth = financial wealth + housing wealth The value of his human and nonhuman wealth together gives an estimate of his total wealth: Ct = C(Total wealth t) Consumption depends on total wealth.

Yield to maturity

The yield to maturity on an n-year bond, or the n-year interest rate, is the constant annual interest rate that makes the bond price today equal to the present value of future payments of the bond i2t ~ 1/2 (i1t + i(1t+1)^e)

Multilateral real exchange rates

These are all equivalent names for the relative price of US goods in terms of foreign goods: The US trade-weighted real exchange rate We weight a country by how much it trades with the US and how much is competes with the US in other countries. Given each weight and each exchange rate between US and another country, we can find the weighted average of all the real exchange rates to construct the multilateral real exchange rate.

Investment

To compute the present value of expected profits the firm must first estimate how long the machine will last or the depreciation rate. Investment depends positively on the "present value of expected profits from buying the machine in year t)

Shifts in the IS curve

To the right: Increase in government spending Increase in expected output Decrease in expected real interest rate Decrease in expected taxes Decrease in current taxes To the left: Increase in current taxes Increase in expected taxes Increase in expected real interest rates Changes in T (current taxes) or G (current government spending) shift the IS curve. Changes in expected future variables also shift the IS curve

Treasury notes

US government bonds with a maturity of 1 to 10 years

Treasury bonds

US government bonds with a maturity of 10 or more years

Treasury bills (t-bills)

US government bonds with a maturity up to a year

expectations (Including rational)

Until the 1970s, macroeconomists thought of expectations as: -Animal spirits assumed that expectations were simply random - the Keynesian treatment of expectations, which considers them important but unexplained -Backward-looking rules (Adaptive expectations)— either static or adaptive expectations which assumed that individuals formed expectations by looking at past changes in a variable. Rational expectations assumed that individuals form expectations by using all currently available information and an understanding of the model and policy. The assumption of rational expectations is one of the most important developments in macroeconomics in the last 25 years.

Fiscal multipliers

Views about the fiscal multipliers (the net effects of fiscal consolidation once direct and expectation effects are taken into account): -Those in favor of strong fiscal consolidation argue that fiscal multipliers are likely to be negative, and thus smaller deficits would lead to an increase in output -Those against strong fiscal consolidation argue that fiscal multipliers are likely to be positive and possibly large, thus smaller deficits would lead to a decrease in output.

Movements in Real exchange rate and nominal exchange rate

nominal and real exchange rates can move in opposite directions: While the nominal exchange rate went up during the period, the nominal exchange rate went down. The large fluctuations in the nominal exchange rate also show up in the real exchange rate. How could there be both a nominal appreciation and real depreciation in the USD/GDP exchange rate over this period? Two things have happened since 1970: -First, E has increased (nominal exchange rate increases). The dollar has gone up in terms of pounds — appreciation -Second, P/P* has decreased. (The price of domestic goods in terms of foreign goods (real exchange rate) has decreased). The price level has increased less in the US than in the UK: average inflation was lower in the US than in the UK. — real depreciation

Expectations and the IS relation (real interest rates)

r or r^('e) ^ > A v (Increase in r or expected r leads to an increase in aggregate private spending) 1) An increase in the future expected interest rate will cause: -A reduction in the present value of future disposable income and, therefore, a reduction in human wealth. 2) This causes: -current consumption (C) to decrease and the IS curve to shift left. 3) The increase in the future expected rate will also cause: -A reduction in the present value of future profits. -This will cause a reduction in investment -and another leftward shift in the IS curve.

Quantitative Easing

when the Fed buys longer-term government bonds or other securities The fed wants to decrease interest rates.