Econ test 3 Part 2

If a cup of coffee costs 2 euros in Paris and $6 in New York and purchasing-power parity holds, what is the exchange rate? 1/4 euro per dollar 1/3 euro per dollar 3 euros per dollar 4 euros per dollar

1/3 euro per dollar If purchasing-power parity holds, a dollar should buy the same quantity of goods in New York (where prices are measured in dollars) as it would buy in Paris if converted to euros. If P is the price level (or in this case, the price of a representative good, coffee), the purchasing power of $1 is 1/P , or 1/6. Abroad, when $1 is exchanged for e units of foreign currency, the purchasing power will be e/P (where P is again the price of the representative foreign good). The exchange rate e must therefore equalize the two expressions: 1/P = e/P* Rearranging the expression reveals that the nominal exchange rate equals the ratio of the foreign price level (measured in units of the foreign currency) to the domestic price level (measured in units of the domestic currency): e = P*/P = 2 euros / 6 dollars = 1/3 euro per dollar

3 facts about economic fluctuations

1: Irregular and Unpredictable 2. Most macroeconomic Quantities Fluctuate together Although many macroeconomic variables fluctuate together, they fluctuate by different amounts when economic conditions deteriorate, much of the decline is attributable to reductions in spending on new factories, housing, and inventories.. 3. As output Falls, Unemployment Rises Changes in the economy's output of goods and services are strongly correlated with changes in the economy's utilization of its labor force. In other words, when real GDP declines, the rate of unemployment rises

If business leaders in Great Britain become more confident in their economy, their optimism will induce them to increase investment, causing the British pound to and pushing the British trade balance toward . appreciate, deficit appreciate, surplus depreciate, deficit depreciate, surplus

A. appreciate, deficitAn increase in investment means increased demand for loanable funds, which increases the interest rate. A higher interest rate will decrease net capital outflow and increase demand for the British pound, causing it to appreciate. As the currency appreciates, imports become cheaper and British exports become more expensive to foreigners, so the trade balance moves toward deficit.

The Market For Loanable Funds

All savers go to this market to deposit their saving, and all borrowers go to this market to get their loans. In this market, there is one interest rate, which is both the return to saving and the cost of borrowing. Because S=I+NCO Whenever a nation saves a dollar of its income, it can use that dollar to finance the purchase of domestic capital or to finance the purchase of an asset abroad. The two sides of this identity represent the two sides of the market for loanable funds. The supply of loanable funds comes from national saving (S), and the demand for loanable funds comes from domestic investment (I) and net capital outflow (NCO). Loanable funds should be interpreted as the domestically generated flow of resources available for capital accumulation. When NCO > 0, the country is experiencing a net outflow of capital; the net purchase of capital overseas adds to the demand for domestically generated loanable funds. When NCO < 0, the country is experiencing a net inflow of capital; the capital resources coming from abroad reduce the demand for domestically generated loanable funds.

Inflation-Induced Tax Distortions

Almost all taxes distort incentives, cause people to alter their behavior, and lead to a less efficient allocation of the economy's resources. Many taxes, however, become even more problematic in the presence of inflation. The reason is that lawmakers often fail to take inflation into account when writing the tax laws. Economists who have studied the tax code conclude that inflation tends to raise the tax burden on income earned from savings. Thus, inflation exaggerates the size of capital gains and inadvertently increases the tax burden on this type of income. Another example is the tax treatment of interest income. The income tax treats the nominal interest earned on savings as income, even though part of the nominal interest rate merely compensates for inflation. Because the after-tax real interest rate provides the incentive to save, saving is much less attractive in the economy with inflation (Economy B) than in the economy with stable prices (Economy A). Lack of savings causes less economic productivity in the long run. One solution to this problem, other than eliminating inflation, is to index the tax system. That is, the tax laws could be rewritten to take account of the effects of inflation. the government could tax only real interest income by excluding that portion of the interest income that merely compensates for inflation.

inflation does not in itself reduce people's real purchasing power. Because... the inflation fallacy

As prices rise, so does income. EX: A worker who receives an annual raise of 10 percent tends to view that raise as a reward for his own talent and effort. When an inflation rate of 6 percent reduces the real value of that raise to only 4 percent, the worker might feel that he has been cheated of what is rightfully his due. In fact, as we discussed in the chapter on production and growth, real incomes are determined by real variables, such as physical capital, human capital, natural resources, and the available production technology. Nominal incomes are determined by those factors and the overall price level. If the Fed were to lower the inflation rate from 6 percent to zero, our worker's annual raise would fall from 10 percent to 4 percent. He might feel less robbed by inflation, but his real income would not rise more quickly.

Real exchange rate price index for a basket

By using a price index for a U.S. basket (P), a price index for a foreign basket (P*), and the nominal exchange rate between the U.S. dollar and foreign currencies (e), we can compute the overall real exchange rate between the United States and other countries as follows: This real exchange rate measures the price of a basket of goods and services available domestically relative to a basket of goods and services available abroad.

the business cycle

Fluctuations in the economy are often called the business cycle. As this term suggests, economic fluctuations correspond to changes in business conditions. The term business cycle is somewhat misleading because it suggests that economic fluctuations follow a regular, predictable pattern. In fact, economic fluctuations are not at all regular, and they are almost impossible to predict with much accuracy

real exchange rate

Formula the rate at which a person can trade the goods and services of one country for the goods and services of another we express the real exchange rate as units of the foreign item per unit of the domestic item. But in this instance, the item is a good rather than a currency. the real exchange rate depends on the nominal exchange rate and on the prices of goods in the two countries measured in the local currencies. Why does the real exchange rate matter? As you might guess, the real exchange rate is a key determinant of how much a country exports and imports. If you decide where to vacation by comparing costs, you are basing your decision on the real exchange rate

Pros and cons of deflation

Friedman- small deflation lowers the nominal interest rate and reduce the cost of holding money, shoeleather cost is reduced. However, deflation is rarely as steady and stable as inflation it comes as a surprise, resulting in the redistribution of wealth toward creditors and away from debtors. Because debtors are often poorer, these redistributions in wealth are particularly painful. falling prices result when some event, such as a monetary contraction, reduces the overall demand for goods and services in the economy. This fall in aggregate demand can lead to falling incomes and rising unemployment. In other words, deflation is often a symptom of deeper economic problems.

What ensures that the quantity of money the Fed supplies balances the quantity of money people demand? The answer depends on the time horizon being considered

In the long run, money supply and money demand are brought into equilibrium by the overall level of prices.

The Market For Foreign-Currency Exchange

Participants in this market trade U.S. dollars in exchange for foreign currencies. NCO=NX Net capital outflow represents the quantity of dollars supplied for the purpose of buying foreign assets. Net exports represent the quantity of dollars demanded for the purpose of buying U.S. net exports of goods and services. What price balances the supply and demand in the market for foreign-currency exchange? The answer is the real exchange rate. an appreciation of the real exchange rate reduces the quantity of dollars demanded in the market for foreign-currency exchange.

import quota example

Suppose that the U.S. auto industry, concerned about competition from Japanese automakers, convinces the U.S. government to impose a quota on the number of cars that can be imported from Japan. In making their case, lobbyists for the auto industry assert that the trade restriction would shrink the size of the U.S. trade deficit. Although trade policies do not affect a country's overall trade balance, these policies do affect specific firms, industries, and countries. When the U.S. government imposes an import quota on Japanese cars, General Motors has less competition from abroad and will sell more cars. At the same time, because the dollar has appreciated in value, Boeing, the U.S. aircraft maker, will find it harder to compete with Airbus, the European aircraft maker. U.S. exports of aircraft will fall, and U.S. imports of aircraft will rise. The first step in analyzing the trade policy is to determine which curve shifts. The initial impact of the import restriction is, not surprisingly, on imports. Because net exports equal exports minus imports, the policy also affects net exports. And because net exports are the source of demand for dollars in the market for foreign-currency exchange, the policy affects the demand curve in this market. The second step is to determine the direction in which this demand curve shifts. Because the quota restricts the number of Japanese cars sold in the United States, it reduces imports at any given real exchange rate. Net exports, which equal exports minus imports, will therefore rise for any given real exchange rate. Because foreigners need dollars to buy U.S. net exports, there is an increased demand for dollars in the market for foreign-currency exchange. This increase in the demand for dollars is shown in panel (c) of Figure 6 as the shift from to . The third step is to compare the old and new equilibria. As we can see in panel (c), the increase in the demand for dollars causes the real exchange rate to appreciate from to . Because nothing has happened in the market for loanable funds in panel (a), there is no change in the real interest rate. Because there is no change in the real interest rate, there is also no change in net capital outflow, shown in panel (b). And because there is no change in net capital outflow, there can be no change in net exports, even though the import quota has reduced imports. It might seem puzzling that net exports stay the same while imports fall. This puzzle is resolved by noting the change in the real exchange rate: When the dollar appreciates in value in the market for foreign-currency exchange, domestic goods become more expensive relative to foreign goods. This appreciation encourages imports and discourages exports, and both of these changes work to offset the direct increase in net exports due to the import quota. In the end, an import quota reduces both imports and exports, but net exports (exports minus imports) are unchanged. Trade policies do not alter the trade balance because they do not alter national saving or domestic investment. For given levels of national saving and domestic investment, the real exchange rate adjusts to keep the trade balance the same, regardless of the trade policies the government puts in place. Although trade policies do not affect a country's overall trade balance, these policies do affect specific firms, industries, and countries. When the U.S. government imposes an import quota on Japanese cars, General Motors has less competition from abroad and will sell more cars. At the same time, because the dollar has appreciated in value, Boeing, the U.S. aircraft maker, will find it harder to compete with Airbus, the European aircraft maker. U.S. exports of aircraft will fall, and U.S. imports of aircraft will rise.

Fisher Effect Short Run (inflation)

The Fisher effect need not hold in the short run because inflation may be unanticipated If a jump in inflation catches the borrower and lender by surprise, the nominal interest rate they agreed on will fail to reflect the higher inflation. But if inflation remains high, people will eventually come to expect it, and loan agreements will reflect this expectation. To be precise, therefore, the Fisher effect states that the nominal interest rate adjusts to expected inflation.

why do countries experience hyperinflation?

The answer is that the governments of these countries are using money creation as a way to pay for their spending.

Saving, Investment, and Their Relationship to the International Flows

The economy's GDP (denoted Y) is divided among four components: consumption (C), investment (I), government purchases (G), and net exports (NX). We write this as Y= C+I+G+NX S= Y-C-G Which equal I+NX SO S= I + NX NX=NCO S=I+NCO This equation shows that a nation's saving must equal its domestic investment plus its net capital outflow. In other words, when a U.S. citizen saves a dollar of her income for the future, that dollar can be used to finance the accumulation of domestic capital or it can be used to finance the purchase of foreign capital. the financial system as standing between the two sides of this identity. When a nation's saving exceeds its domestic investment, its net capital outflow is positive, indicating that the nation is using some of its saving to buy assets abroad. When a nation's domestic investment exceeds its saving, its net capital outflow is negative, indicating that foreigners are financing some of this investment by purchasing domestic assets.

Adjustment process of monetary injection

The immediate effect of a monetary injection is to create an excess supply of money the quantity of money supplied now exceeds the quantity demanded. People try to get rid of this excess supply of money in various ways. (buying things, loaning it, putting it in a bank) the injection of money increases the demand for goods and services. The economy's ability to supply goods and services, however, has not changed. Thus, the greater demand for goods and services causes the prices of goods and services to increase. The increase in the price level, in turn, increases the quantity of money demanded because people are using more dollars for every transaction. Eventually, the economy reaches a new equilibrium

The Market for Loanable Funds Graph

The interest rate in an open economy, as in a closed economy, is determined by the supply and demand for loanable funds. National saving is the source of the supply of loanable funds. Domestic investment and net capital outflow are the sources of the demand for loanable funds. At the equilibrium interest rate, the amount that people want to save exactly balances the amount that people want to borrow for the purpose of buying domestic capital and foreign assets.

An increase in the money supply and equilibrium of money and price levels

The monetary injection shifts the supply curve to the right from to , and the equilibrium moves from point A to point B. As a result, the value of money (shown on the left axis) decreases from ½ to ¼, and the equilibrium price level (shown on the right axis) increases from 2 to 4. In other words, when an increase in the money supply makes dollars more plentiful, the result is an increase in the price level that makes each dollar less valuable. This explanation of how the price level is determined and why it might change over time is called the quantity theory of money.

If the value of a nation's imports exceeds the value of its exports, which of the following is NOT true? Net exports are negative. GDP is less than the sum of consumption, investment, and government purchases. Domestic investment is greater than national saving. The nation is experiencing a net outflow of capital.

The nation is experiencing a net outflow of capital. Net exports equal exports minus imports;When the value of a nation's imports exceeds the value of its exports, net exports are negative.Recalling that total income is equal to the sum of consumption, investment, government purchases, and net exports ( Y=C+I+G+NX ), GDP must be less than the sum of consumption, investment, and government purchases alone (imagine Y=100 and NX=-10 ); in order for Y=C+I+G+NX to be true, C+I+G=110 (spending is greater than GDP). Having determined that Y<C+I+G , you can rearrange to say that Y-C-G< I , or domestic investment is greater than national saving ( Y-C-G ). Because the country is investing more than it is saving, it must be financing some domestic investment by selling assets abroad (that is, it is not experiencing a net outflow of capital).

The Market For Foreign-Currency Exchange Graph

The real exchange rate is determined by the supply and demand for foreign-currency exchange. The supply of dollars to be exchanged into foreign currency comes from net capital outflow. Because net capital outflow does not depend on the real exchange rate, the supply curve is vertical. The demand for dollars comes from net exports. Because a lower real exchange rate stimulates net exports (and thus increases the quantity of dollars demanded to pay for these net exports), the demand curve slopes downward. At the equilibrium real exchange rate, the number of dollars people supply to buy foreign assets exactly balances the number of dollars people demand to buy net exports.

These five steps are the essence of the quantity theory of money. explain the equilibrium price level and inflation rate.

The velocity of money is relatively stable over time. Because velocity is stable, when the central bank changes the quantity of money (M), it causes proportionate changes in the nominal value of output (P × Y). The economy's output of goods and services (Y) is primarily determined by factor supplies (labor, physical capital, human capital, and natural resources) and the available production technology. In particular, because money is neutral, money does not affect output. With output (Y) determined by factor supplies and technology, when the central bank alters the money supply (M) and induces proportional changes in the nominal value of output (P × Y), these changes are reflected in changes in the price level (P). Therefore, when the central bank increases the money supply rapidly, the result is a high rate of inflation.

Why does the aggregate demand curve slope downward?

There are three distinct but related reasons a fall in the price level increases the quantity of goods and services demanded: Consumers are wealthier, which stimulates the demand for consumption goods. Interest rates fall, which stimulates the demand for investment goods. The currency depreciates, which stimulates the demand for net exports. It is important to keep in mind that the aggregate-demand curve (like all demand curves) is drawn holding "other things equal." A decrease in the price level raises the real value of money and makes consumers wealthier, which in turn encourages them to spend more. The increase in consumer spending means a larger quantity of goods and services demanded. Conversely, an increase in the price level reduces the real value of money and makes consumers poorer, which in turn reduces consumer spending and the quantity of goods and services demanded. A lower price level reduces the interest rate, encourages greater spending on investment goods, and thereby increases the quantity of goods and services demanded. Conversely, a higher price level raises the interest rate, discourages investment spending, and decreases the quantity of goods and services demanded. When a fall in the U.S. price level causes U.S. interest rates to fall, the real value of the dollar declines in foreign exchange markets. This depreciation stimulates U.S. net exports and thereby increases the quantity of goods and services demanded. Conversely, when the U.S. price level rises and causes U.S. interest rates to rise, the real value of the dollar increases, and this appreciation reduces U.S. net exports and the quantity of goods and services demanded.

Net Exports and Net Capital Outflow are equal

We have seen that an open economy interacts with the rest of the world in two ways—in world markets for goods and services and in world financial markets. Net exports and net capital outflow each measure a type of imbalance in these markets. Net exports measure an imbalance between a country's exports and its imports. Net capital outflow measures an imbalance between the amount of foreign assets bought by domestic residents and the amount of domestic assets bought by foreigners. EX: Imagine that you are a computer programmer residing in the United States. One day, you write some software and sell it to a Japanese consumer for 10,000 yen. The sale of software is an export of the United States, so it increases U.S. net exports. What else happens to ensure that this identity holds? The answer depends on what you do with the 10,000 yen you are paid. First, let's suppose that you simply stuff the yen in your mattress. (We might say you have a yen for yen.) In this case, you are using some of your income to invest in the Japanese economy. That is, a domestic resident (you) has acquired a foreign asset (the Japanese currency). The increase in U.S. net exports is matched by an increase in the U.S. net capital outflow. More realistically, however, if you want to invest in the Japanese economy, you won't do so by holding on to Japanese currency. More likely, you would use the 10,000 yen to buy stock in a Japanese corporation, or you might buy a Japanese government bond. Yet the result of your decision is much the same: A domestic resident ends up acquiring a foreign asset. The increase in U.S. net capital outflow (the purchase of the Japanese stock or bond) exactly equals the increase in U.S. net exports (the sale of software). Let's now change the example. Suppose that instead of using the 10,000 yen to buy a Japanese asset, you use them to buy a good made in Japan, such as a Sony TV. As a result of the TV purchase, U.S. imports increase. Together, the software export and the TV import represent balanced trade. A final possibility is that you go to a local bank to exchange your 10,000 yen for U.S. dollars. But this doesn't change the situation because the bank now has to do something with the 10,000 yen. It can buy Japanese assets (a U.S. net capital outflow); it can buy a Japanese good (a U.S. import); or it can sell the yen to another American who wants to make such a transaction. In the end, U.S. net exports must equal U.S. net capital outflow.

Net Exports and Net Capital Outflow are equal Situations

When a nation is running a trade surplus (NX > 0), it is selling more goods and services to foreigners than it is buying from them. What is it doing with the foreign currency it receives from the net sale of goods and services abroad? It must be using it to buy foreign assets. Capital is flowing out of the country (NCO > 0). When a nation is running a trade deficit (NX < 0), it is buying more goods and services from foreigners than it is selling to them. How is it financing the net purchase of these goods and services in world markets? It must be selling assets abroad. Capital is flowing into the country (NCO < 0).

Positive and Negative Net capital outflow (net foreign investment)

When it is positive, domestic residents are buying more foreign assets than foreigners are buying domestic assets. Capital is said to be flowing out of the country. When the net capital outflow is negative, domestic residents are buying less foreign assets than foreigners are buying domestic assets. Capital is said to be flowing into the country.

aggregate-demand curve

a curve that shows the quantity of goods and services that households, firms, the government, and customers abroad want to buy at each price level The aggregate-demand curve tells us the quantity of all goods and services demanded in the economy at any given price level. aggregate demand fluctuates because of largely irrational waves of pessimism and optimism. the government can adjust its monetary and fiscal policy in response to these waves of optimism and pessimism and, thereby, stabilize the economy. For example, when people are excessively pessimistic, the Fed can expand the money supply to lower interest rates and expand aggregate demand. When they are excessively optimistic, it can contract the money supply to raise interest rates and dampen aggregate demand.

Why does Net Capital Outflow NOT depend on the exchange rate?

a higher exchange value of the U.S. dollar not only makes foreign goods less expensive for American buyers but also makes foreign assets less expensive. One might guess that this would make foreign assets more attractive. But remember that an American investor will eventually want to turn the foreign asset, as well as any profits earned on it, back into dollars. For example, a high value of the dollar makes it less expensive for an American to buy stock in a Japanese company, but when that stock pays dividends, those will be in yen. As these yen are exchanged for dollars, the high value of the dollar means that the dividend will buy fewer dollars. Thus, changes in the exchange rate influence both the cost of buying foreign assets and the benefit of owning them, and these two effects offset each other.

capital flight

a large and sudden reduction in the demand for assets located in a country If people decide that Mexico is a risky place to keep their savings, they will move their capital to safer havens such as the United States, resulting in an increase in Mexican net capital outflow. This is because NCO= foreign investments by domestic individuals- domestic investments by foreign individuals. If people are selling their investments/ not investing in mexico as much, then the domestic investments by foreigners will decrease leaving a bigger NCO. Consequently, the demand for loanable funds in Mexico rises from to , as shown in panel (a), and this drives up the Mexican real interest rate from to . Because net capital outflow is higher for any interest rate, that curve also shifts to the right from to in panel (b). At the same time, in the market for foreign-currency exchange, the supply of pesos rises from to , as shown in panel (c). This increase in the supply of pesos causes the peso to depreciate from to , so the peso becomes less valuable compared to other currencies. the increase in net capital outflow raises the supply of pesos in the market for foreign-currency exchange from to . That is, as people try to get out of Mexican assets, there is a large supply of pesos to be converted into dollars. This increase in supply causes the peso to depreciate from to . Thus, capital flight from Mexico increases Mexican interest rates and decreases the value of the Mexican peso in the market for foreign-currency exchange These price changes that result from capital flight influence some key macroeconomic quantities. The depreciation of the currency makes exports cheaper and imports more expensive, pushing the trade balance toward surplus. At the same time, the increase in the interest rate reduces domestic investment, slowing capital accumulation and economic growth. Capital flight has its largest impact on the country from which capital is fleeing, but it also affects other countries. When capital flows out of Mexico into the United States, for instance, it has the opposite effect on the U.S. economy as it has on the Mexican economy. In particular, the rise in Mexican net capital outflow coincides with a fall in U.S. net capital outflow. As the peso depreciates in value and Mexican interest rates rise, the dollar appreciates in value and U.S. interest rates fall. The size of this impact on the U.S. economy is small, however, because the economy of the United States is much larger than that of Mexico.

quantity theory of money

a theory asserting that the quantity of money available determines the price level and that the growth rate in the quantity of money available determines the inflation rate

purchasing-power parity

a theory of exchange rates whereby a unit of any given currency should be able to buy the same quantity of goods in all countries EX: The theory of purchasing-power parity is based on a principle called the law of one price. This law asserts that a good must sell for the same price in all locations. Otherwise, there would be opportunities for profit left unexploited. For example, suppose that coffee beans sold for less in Seattle than in Dallas. A person could buy coffee in Seattle for, say, $4 a pound and then sell it in Dallas for $5 a pound, making a profit of $1 per pound from the difference in price. The process of taking advantage of price differences for the same item in different markets is called arbitrage.

closed economy

an economy that does not interact with other economies in the world

open economy

an economy that interacts freely with other economies around the world

Relative-Price Variability and the Misallocation of Resources

because business's prices change only once in a while, inflation causes relative prices to vary more than they otherwise would. market economies rely on relative prices to allocate scarce resources. Consumers decide what to buy by comparing the quality and prices of various goods and services. Through these decisions, they determine how the scarce factors of production are allocated among industries and firms. When inflation distorts relative prices, consumer decisions are distorted and markets are less able to allocate resources to their best use.

Why does the real interest rate in a country affect that country's net capital outflow?

consider two mutual funds—one in the United States and one in Germany—deciding whether to buy a U.S. government bond or a German government bond. Each mutual fund manager would make this decision in part by comparing the real interest rates in the United States and Germany. When the U.S. real interest rate rises, the U.S. bond becomes more attractive to both mutual funds. Thus, an increase in the U.S. real interest rate discourages Americans from buying foreign assets and encourages foreigners to buy U.S. assets. For both reasons, a high U.S. real interest rate reduces U.S. net capital outflow.

The theory of purchasing-power parity says that higher inflation in a nation causes the nation's currency to , leaving the exchange rate unchanged. appreciate, nominal appreciate, real depreciate, nominal depreciate, real

depreciate, real The theory of purchasing power parity says that the nominal exchange rate equals the ratio of the foreign price level (measured in units of the foreign currency) to the domestic price level (measured in units of the domestic currency): e=P*/P . As the domestic price level increases (due to higher inflation), e decreases. This depreciation of the currency, however, does not affect the real exchange rate

Holding other things constant, an increase in a nation's interest rate reduces national saving and domestic investment. national saving and the net capital outflow. domestic investment and the net capital outflow. national saving only.

domestic investment and the net capital outflow. A higher interest rate makes borrowing to finance capital projects more costly; thus, it discourages domestic investment. It also makes that nation's domestic bonds and other interest-yielding assets more attractive, which discourages investing abroad, and encourages foreigners to buy more of the nation's assets as well. This decreases net capital outflow.

The government in an open economy cuts spending to reduce the budget deficit. As a result, the interest rate , leading to a capital and a real exchange rate . falls, outflow, appreciation falls, outflow, depreciation falls, inflow, appreciation rises, inflow, appreciation

falls, outflow, depreciationA reduction in government spending increases national saving, which, in turn, causes the interest rate to fall. Lower interest rates decrease the incentive to buy domestic assets (relative to foreign assets), which leads to a capital outflow. This increases the amount of currency a country supplies in foreign currency markets, causing a real exchange rate depreciation.

Limitations of Purchasing Power Parity

first reason-many goods are not easily traded(haircut more expensive in Paris than New York) 2.Even tradable goods are not always perfect substitutes when they are produced in different countries. (German vs. US cars) -Thus, both because some goods are not tradable and because some tradable goods are not perfect substitutes with foreign counterparts, purchasing power parity is not a perfect theory of exchange rate determination. For these reasons, real exchange rates fluctuate over time. Nonetheless, the theory of purchasing-power parity does provide a useful first step in understanding exchange rates. The basic logic is persuasive: As the real exchange rate drifts from the level predicted by purchasing-power parity, people have greater incentive to move goods across national borders. Even if the forces of purchasing-power parity do not completely fix the real exchange rate, they provide a reason to expect that changes in the real exchange rate are most often small or temporary. As a result, large and persistent movements in nominal exchange rates typically reflect changes in price levels at home and abroad.

The flow of capital between the U.S. economy and the rest of the world takes two forms.

foreign direct investment. foreign portfolio investment. If McDonald's opens up a fast-food outlet in Russia, that is an example of foreign direct investment. Alternatively, if an American buys stock in a Russian corporation, that is an example of foreign portfolio investment. In the first case, the American owner (McDonald's Corporation) actively manages the investment, whereas in the second case, the American owner (the stockholder) has a more passive role. In both cases, U.S. residents are buying assets located in another country, so both purchases increase U.S. net capital outflow.

Exports

goods produced domestically and sold abroad

Effects of import quota

import quota, a limit on the quantity of a good produced abroad that can be sold domestically. In the end, an import quota reduces both imports and exports, but net exports (exports minus imports) are unchanged. Trade policies do not affect the trade balance. That is, policies that directly influence exports or imports do not alter net exports. This conclusion seems less surprising if one recalls the accounting identity: NX=NCO=S-I Trade policies do not alter the trade balance because they do not alter national saving or domestic investment. For given levels of national saving and domestic investment, the real exchange rate adjusts to keep the trade balance the same, regardless of the trade policies the government puts in place The effects of trade policies are, therefore, more microeconomic than macroeconomic Trade restrictions interfere with these gains from trade and, thus, reduce overall economic well-being.

According to the quantity theory of money and the Fisher effect, if the central bank increases the rate of money growth, inflation and the nominal interest rate both increase. inflation and the real interest rate both increase. the nominal interest rate and the real interest rate both increase. inflation, the real interest rate, and the nominal interest rate all increase.

inflation and the nominal interest rate both increase

The Model of Aggregate Demand and Aggregate Supply

the model that most economists use to explain short-run fluctuations in economic activity around its long-run trend classical theory works in the long run but not the short run ex he behavior of buyers and sellers depends on the ability of resources to move from one market to another. When the price of ice cream rises, the quantity demanded falls because buyers will use their incomes to buy products other than ice cream. Similarly, a higher price of ice cream raises the quantity supplied because firms that produce ice cream can increase production by hiring workers away from other parts of the economy. This microeconomic substitution from one market to another is impossible for the economy as a whole. After all, the quantity that our model is trying to explain—real GDP—measures the total quantity of goods and services produced by all firms in all markets.

Nominal V Real Interest Rates

the nominal interest rate tells you how fast the number of dollars in your account will rise over time. The real interest rate corrects the nominal interest rate for the effect of inflation to tell you how fast the purchasing power of your savings account will rise over time.

inflation tax

the revenue the government raises by creating money When the government prints money, the price level rises, and the dollars in your wallet become less valuable. Thus, the inflation tax is like a tax on everyone who holds money. The massive increases in the quantity of money lead to massive inflation. The inflation ends when the government institutes fiscal reforms—such as cuts in government spending—that eliminate the need for the inflation tax.

The Real Equilibrium in an Open Economy

the supply and demand for loanable funds determine the real interest rate. In panel (b), the interest rate determines net capital outflow, which provides the supply of dollars in the market for foreign-currency exchange. In panel (c), the supply and demand for dollars in the market for foreign-currency exchange determine the real exchange rate. The two markets shown in Figure 4 determine two relative prices: the real interest rate and the real exchange rate. The real interest rate determined in panel (a) is the price of goods and services in the present relative to goods and services in the future. The real exchange rate determined in panel (c) is the price of domestic goods and services relative to foreign goods and services. These two relative prices adjust simultaneously to balance supply and demand in these two markets. As they do so, they determine national saving, domestic investment, net capital outflow, and net exports.

What determines the value of money (and their determinants)

the supply and demand for money Money Supply: (fed and banking determine supply) Money Demand: the demand for money reflects how much wealth people want to hold in liquid form. Depends mostly on the average level of prices in the economy. Other dependents (how much they rely on credit cards and on whether an automatic teller machine is easy to find. the quantity of money demanded depends on the interest rate that a person could earn by using the money to buy an interest-bearing bond rather than leaving it in his wallet or low-interest checking account.)

net exports

the value of a nation's exports minus the value of its imports; also called the trade balance influencers The tastes of consumers for domestic and foreign goods The prices of goods at home and abroad The exchange rates at which people can use domestic currency to buy foreign currencies The incomes of consumers at home and abroad The cost of transporting goods from country to country Government policies toward international trade

flow of goods v flow of capital

A U.S. resident with $25,000 could use that money to buy a car from Toyota or, instead, to buy stock in the Toyota Corporation. The first transaction would represent a flow of goods, whereas the second would represent a flow of capital.

Confusion and Inconvenience (inflation)

Because inflation causes dollars at different times to have different real values, computing a firm's profit—the difference between its revenue and costs—is more complicated in an economy with inflation. Therefore, to some extent, inflation makes investors less able to sort successful from unsuccessful firms, which in turn impedes financial markets in their role of allocating the economy's saving to alternative types of investment. Because firms earnings are incorrectly measured.

The Prices for International Transactions: Real and Nominal Exchange Rates

In addition to the flow of goods and services and the flow of capital across a nation's border. macroeconomists also study variables that measure the prices at which these international transactions take place.

An open economy interacts with other economies in two ways:

It buys and sells goods and services in world product markets, and it buys and sells capital assets such as stocks and bonds in world financial markets.

Implications of Purchasing-Power Parity

It tells us that nominal exchange rate between the currencies of two countries depends on the price levels in those countries **For the purchasing power of a dollar to be the same in two countries this must be the case 1/P=e/P* with rearrangement it becomes 1=eP/P* left side is constant and the right side is the real exchange rate so **** IF the purchasing power of the dollar is always the same at home and abroad, then real exchange rate-the relative price of domestic and foreign goods-cannot change e=P/P* According to the theory of purchasing-power parity, the nominal exchange rate between the currencies of two countries must reflect the price levels in those countries. A key implication of this theory is that nominal exchange rates change when price levels change. ***When the central bank prints large quantities of money, that money loses value both in terms of the goods and services it can buy and in terms of the amount of other currencies it can buy

Inflation is more about the value of ......... Than the value of ...........

Money Goods

In the Open Market economy, what links The Market For Foreign-Currency Exchange and The Market for Loanable Funds?

Net Capital Outflow Because NCO+I=S and NCO=NX In the market for loanable funds, net capital outflow is a piece of demand. An American who wants to buy an asset abroad must finance this purchase by obtaining resources in the U.S. market for loanable funds. In the market for foreign-currency exchange, net capital outflow is the source of supply. An American who wants to buy an asset in another country must supply dollars to exchange them for the currency of that country. The key determinant of net capital outflow, as we have discussed, is the real interest rate. When the U.S. interest rate is high, owning U.S. assets is more attractive, and U.S. net capital outflow is low

price level = GDP deflator or CPI (depending on method) Formula

Nominal/Real

Inflation issues/costs

Shoeleather cost Menu Costs Fisher Effect relative price variability and the misallocation of resources Inflation-induced Tax Distortions confusion and inconvenience unexpected inflation causes arbitrary redistrubution of wealth

Money Supply and Demand

The horizontal axis shows the quantity of money. The left vertical axis shows the value of money, and the right vertical axis shows the price level. The supply curve for money is vertical because the quantity of money supplied is fixed by the Fed. The demand curve for money slopes downward because people want to hold a larger quantity of money when each dollar buys less. At the equilibrium, point A, the value of money (on the left axis) and the price level (on the right axis) have adjusted to bring the quantity of money supplied and the quantity of money demanded into balance. This equilibrium of money supply and money demand determines the value of money and the price level.

Supply and Demand for Loanable Funds and for Foreign-Currency Exchange

To understand the forces at work in an open economy, we focus on supply and demand in two markets. The first is the market for loanable funds, which coordinates the economy's saving, investment, and flow of loanable funds abroad (called the net capital outflow). The second is the market for foreign-currency exchange, which coordinates people who want to exchange the domestic currency for the currency of other countries.

A Special Cost of Unexpected Inflation: Arbitrary Redistributions of Wealth

Unexpected inflation redistributes wealth among the population in a way that has nothing to do with either merit or need. These redistributions occur because many loans in the economy are specified in terms of the unit of account—money. EX: Consider an example. Suppose that Sam Student takes out a $20,000 loan at a 7 percent interest rate from Bigbank to attend college. In 10 years, the loan will come due. After his debt has compounded for 10 years at 7 percent, Sam will owe Bigbank $40,000. The real value of this debt will depend on inflation over the decade. If Sam is lucky, the economy will have a hyperinflation. In this case, wages and prices will rise so high that Sam will be able to pay the $40,000 debt out of pocket change. By contrast, if the economy goes through a major deflation, then wages and prices will fall, and Sam will find the $40,000 debt a greater burden than he anticipated. This example shows that unexpected changes in prices redistribute wealth among debtors and creditors

According to the quantity theory of money, which variable in the quantity equation is most stable over long periods of time? money velocity price level output

Velocity

depreciation

a decrease in the value of a currency as measured by the amount of foreign currency it can buy

trade policy

a government policy that directly influences the quantity of goods and services that a country imports or exports Trade policy takes various forms, usually with the purpose of supporting a particular domestic industry. One common trade policy is a tariff, a tax on imported goods. Another is an import quota, a limit on the quantity of a good produced abroad that can be sold domestically.

recession depression

a period of declining real incomes and rising unemployment a severe recession

balanced trade

a situation in which exports equal imports

trade surplus

an excess of exports over imports

trade deficit

an excess of imports over exports

appreciation

an increase in the value of a currency as measured by the amount of foreign currency it can buy

The nation of Ectenia has long banned the export of its highly prized puka shells. A newly elected president, however, removes the export ban. This change in policy will cause the nation's currency to , making the goods Ectenia imports expensive. appreciate, less appreciate, more depreciate, less depreciate, more

appreciate, lessRemoving a ban on exports will increase the quantity of goods exported at any real exchange rate, causing net exports to rise as well. Net exports are the source of the demand for a nations currency; therefore, there is an increase in the demand for the nation's currency, which causes the currency to appreciate. A stronger currency makes it less expensive to import goods from other countries.

If a nation's currency doubles in value on foreign exchange markets, the currency is said to , reflecting a change in the exchange rate. appreciate, nominal appreciate, real depreciate, nominal depreciate, real

appreciate, nominal An increase in the value of a currency on foreign exchange markets is known as appreciation.The rate at which one currency is exchanged for another is the nominal exchange rate.

If an economy always has inflation of 10 percent per year, which of the following costs of inflation will it NOT suffer? shoeleather costs from reduced holdings of money menu costs from more frequent price adjustment distortions from the taxation of nominal capital gains arbitrary redistributions between debtors and creditors

arbitrary redistributions between debtors and creditors

Hyperinflations occur when the government runs a large budget , which the central bank finances with a substantial monetary . deficit, contraction deficit, expansion surplus, contraction surplus, expansion

deficit, expansion

Comparing the U.S. economy today to that of 1950, one finds that today, as a percentage of GDP, exports and imports are both higher. exports and imports are both lower. exports are higher, and imports are lower. exports are lower, and imports are higher.

exports and imports are both higher In the 1950s, imports and exports of goods and services were typically between 4 and 5 percent of GDP. In recent years, they have been about three times that level. These increases can be attributed to improvements in transportation, advances in telecommunications, changes in the types of goods being transported, and increasing openness of government trade policies

Holding other things constant, an appreciation of a nation's currency causes exports to rise and imports to fall. exports to fall and imports to rise. both exports and imports to rise. both exports and imports to fall.

exports to fall and imports to rise.When a currency appreciates in value in the market for foreign-currency exchange, domestic goods become more expensive relative to foreign goods. This appreciation encourages imports and discourages exports

Imports

goods and services that are produced abroad and sold domestically

Effects of Government budget deficit on open economy equilibrium

in an open economy, government budget deficits raise real interest rates, crowd out domestic investment, cause the currency to appreciate, and push the trade balance toward deficit. Loanable funds are reduced interest rates rise higher interest rates reduces net capital outflow. Reduced net capital outflow reduces the supply of dollars in the market for foreign currency exchange This fall in supply of dollars causes the real exchange rate to appreciate the appreciation of the exchange rate pushes the trade balance toward 0

A civil war abroad causes foreign investors to seek a safe haven for their funds in the United States, leading to U.S. interest rates and a U.S. dollar. higher, weaker higher, stronger lower, weaker lower, stronger

lower, strongerWhen foreign investors increase the amount of U.S. assets they purchase, this decreases capital outflow, which, in turn, decreases the demand for loanable funds and leads to lower U.S. interest rates. As foreigners demand more U.S. assets, they also must demand more dollars to buy those assets, which causes the dollar to appreciate (grow stronger).

In an open economy, national saving equals domestic investment plus the net outflow of capital abroad. minus the net exports of goods and services. plus the government's budget deficit. minus foreign portfolio investment.

plus the net outflow of capital abroad. National saving is the nation's income that is left after paying for current consumption and government purchases, that is: S = Y-C-G . This can be rewritten as S=I+NX , which can be further rewritten as S=I+NCO , since the value of net exports must be equal to the value of net capital outflow. Thus, national saving equals domestic investment plus the net outflow of capital abroad.

The classical principle of monetary neutrality states that changes in the money supply do not influence variables and is thought most applicable in the run. nominal, short nominal, long real, short real, long

real, long

menu costs

the costs of changing prices Firms change prices infrequently because there are costs to changing prices.

Fisher Effect - Long Run (inflation)

the effect of money on interest rates the one-for-one adjustment of the nominal interest rate to the inflation rate when the Fed increases the rate of money growth, the long-run result is both a higher inflation rate and a higher nominal interest rate. In the long run over which money is neutral, a change in money growth should not affect the real interest rate. The real interest rate is, after all, a real variable. For the real interest rate not to be affected, the nominal interest rate must adjust one-for-one to changes in the inflation rate.

quantity equation

the equation , M x V = P x Y which relates the quantity of money, the velocity of money, and the dollar value of the economy's output of goods and services The quantity equation shows that an increase in the quantity of money in an economy must be reflected in one of the other three variables: The price level must rise, the quantity of output must rise, or the velocity of money must fall.

2 ways to view price levels

the price level as the price of a basket of goods and services. When the price level rises, people have to pay more for the goods and services they buy the price level as a measure of the value of money. A rise in the price level means a lower value of money because each dollar in your wallet now buys a smaller quantity of goods and services. if P is the price of goods and services measured in terms of money, 1/P is the value of money measured in terms of goods and services. The quantity of goods and services that can be bought with $1 equals 1/P. The actual economy produces thousands of goods and services, so we use a price index rather than the price of a single good. But the logic remains the same: When the overall price level rises, the value of money falls.

If nominal GDP is $400, real GDP is $200, and the money supply is $100, then the price level is ½, and velocity is 2. the price level is ½, and velocity is 4. the price level is 2, and velocity is 2. the price level is 2, and velocity is 4.

the price level is 2, and the velocity is 4

Relative Price

the price of one thing compared to another example, we could say that the price of a bushel of corn is 2 bushels of wheat. price of corn is $2 a bushel or that the price of wheat is $1 a bushel, both prices are nominal variables.

monetary neutrality

the proposition that changes in the money supply do not affect real variables Changes in the supply of money, according to classical analysis, affect nominal variables but not real ones. The dollar, like the yard, is merely a unit of measurement, so a change in its value should not have real effects.

net capital outflow

the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners NCO = purchase of foreign assets by domestic residents - purchase of domestic assets by foreigners Influencers The real interest rates paid on foreign assets The real interest rates paid on domestic assets The perceived economic and political risks of holding assets abroad The government policies that affect foreign ownership of domestic assets

nominal exchange rate

the rate at which a person can trade the currency of one country for the currency of another When economists study changes in the exchange rate, they often use indexes that average these many exchange rates. Just as the consumer price index turns the many prices in the economy into a single measure of the price level, an exchange-rate index turns these many exchange rates into a single measure of the international value of a currency. express the nominal exchange rate as units of foreign currency per U.S. dollar, such as 80 yen per dollar.

velocity of money

the rate at which money changes hands Calculate divide the nominal value of output (nominal GDP) by the quantity of money. If P is the price level (the GDP deflator), Y the quantity of output (real GDP), and M the quantity of money, then velocity is

shoeleather cost (inflation)

the resources wasted when inflation encourages people to reduce their money holdings Taxes cause people to change their behaviors to avoid the tax. How can a person avoid paying the inflation tax? Because inflation erodes the real value of the money in your wallet, you can avoid the inflation tax by holding less money. So people put more money in the bank. This makes it so that people have to make more frequent trips to the bank, it takes time and convenience that you must sacrifice to keep less money on hand compared to if there wasn't inflation.

classical dichotomy

the theoretical separation of nominal and real variables

trade balance

the value of a nation's exports minus the value of its imports; also called net exports

Nominal Variables

variables measured in monetary units the income of corn farmers is a nominal variable because it is measured in dollars Nominal GDP is a nominal variable because it measures the dollar value of the economy's output of goods and services; Dollar sign prices

Real Variables

variables measured in physical units the quantity of corn farmers produce is a real variable because it is measured in bushels. real GDP is a real variable because it measures the total quantity of goods and services produced and is not influenced by the current prices of those goods and services. relative prices