ECON Final Exam

fiscal policy

the levels of government spending and taxation set by the president and Congress

The Phillips Curve Equation

unemployment rate = natural rate of unemployment - a(actual inflation - expected inflation) •Short run -The Fed can reduce u-rate below the natural u-rate by making inflation greater than expected. •Long run -Expectations catch up to reality, u-rate goes back to natural u-rate whether inflation is high or low.

In the long run, inflation and unemployment are ...

unrelated -The inflation rate depends mainly on growth in the money supply. -Unemployment (the "natural rate") depends on the minimum wage, the market power of unions, efficiency wages, and the process of job search. In the short run, society faces a trade-off between inflation and unemployment.

What is a balanced trade

when exports = imports

The AS curve shows the

The AS curve shows the total quantity of goods and services firms produce and sell at any given price level. AS is: §upward-sloping in short run §vertical in long run

Trade policy

- Government policy that directly influences the quantity of goods and services a country imports or exports - Tariff: a tax on imported goods - Import quota: limit on the quantity of imports Some arguments for restricting trade: - Save jobs in domestic industry - Reduce the trade deficit

The model of the theory of the open economy

- Highlights the forces that determine the economy's trade balance and exchange rate - Looking simultaneously at two related markets: • The market for loanable funds • The market for foreign-currency exchange

Factors that might influence a country's exports, imports, and net exports:

- Consumers' tastes for foreign and domestic goods - Prices of goods at home and abroad - Exchange rates at which foreign currency trades for domestic currency - Incomes of consumers at home and abroad - Transportation costs - Government policies

Depreciation (or "weakening")

- Decrease in the value of a currency - As measured by the amount of foreign currency it can buy

Assumptions

- Economy's GDP is given • Real GDP is determined by factors of production and available technology - Economy's price level is given • Price level adjusts to bring the supply and demand for money into balance

The U.S. real exchange rate (E)

- Measures the quantity of foreign goods & services that trade for one unit of U.S. goods & services. - E is the real value of a dollar in the market for foreign-currency exchange. - E balances the supply and demand in the market for foreign-currency exchange

effects of a budget deficit

- National saving falls - The real interest rate rises - Domestic investment and net capital outflow both fall - The real exchange rate appreciates (E increases) - Net exports fall (or, the trade deficit increases) -As foreigners acquire more domestic assets, the country's debt to the rest of the world increases.

Implications of PPP

- Nominal exchange rates change when price levels change - When a central bank in any country increases the money supply • And causes the price level to rise • It also causes that country's currency to depreciate relative to other currencies in the world

1994: Political instability in Mexico made world financial markets nervous.

- People worried about the safety of Mexican assets they owned - People sold many of these assets, pulled their capital out of Mexico

Net capital outflow, NCO (net foreign investment)

- Purchase of foreign assets by domestic residents - Foreign direct investment - Foreign portfolio investment - Minus the purchase of domestic assets by foreigners

Nominal exchange rate:

- Rate at which one country's currency trades for another - We express all exchange rates as foreign currency per unit of domestic currency. •Some exchange rates,1 October 2019, per US$ - Canadian dollar: 1.32 - Euro: 0.91 - Japanese yen: 107.70 - Mexican peso: 19.82

A country running a trade surplus, NX > 0

- Selling more goods and services to foreigners than it is buying from them - Use the foreign currency it receives from the net sale of goods and services abroad to buy foreign assets - Capital is flowing out of the country NCO>0

market for foreign currency exchange

- Trade U.S. dollars in exchange for foreign currencies - Identity: NCO = NX - NX is the demand for dollars: foreigners need dollars to buy U.S. net exports. - NCO is the supply of dollars: U.S. residents sell dollars to obtain the foreign currency they need to buy foreign assets.

When a foreigner purchases a good from the U.S

- U.S. exports and NX increase - The foreigner pays with currency or assets, so the U.S. acquires some foreign assets, causing NCO to rise.

When a U.S. citizen buys foreign goods

- U.S. imports rise, NX falls - The U.S. buyer pays with U.S. dollars or assets, so the other country acquires U.S. assets, causing U.S. NCO to fall.

Arguments against discretion

-Allowing central bankers discretion could do great harm if they are incompetent. -Discretion allows the possibility of abuse. •Using monetary policy to affect election outcomes, causing fluctuations called "the political business cycle." -Central bankers who promise price stability may renege if a recession occurs. •Time-inconsistency: the discrepancy between actual policy and announced policy

Supply shock:

-An event that directly alters firms' costs and prices -Shifting the AS and PC curves -Example: large increase in oil prices •1974 and 1979, OPEC restricted the supply of oil: higher oil prices

Arguments against balancing the budget:

-Burden of the government's debt is exaggerated; it's only a tiny % of a person's lifetime income. -Cutting the deficit could do more harm than good: •Cutting education would reduce human capital accumulation and future living standards •Raising taxes reduces incentives to work and save -Divert attention from other programs that redistribute income across generations -Debt/income ratio more relevant than debt itself.

The Interest-Rate Effect (P and I) Suppose the price level, P, declines

-Buying goods and services requires fewer dollars: people buy bonds and other assets -Decrease in the interest rate -Increase spending on investment goods, I -Increase in quantity demanded of goods and services

A country is running a trade deficit, NX < 0

-Buying more goods and services from foreigners than it is selling to them. -Financing the net purchase of these goods and services in world markets by selling assets abroad. -Capital is flowing into the country, NCO < 0

Automatic stabilizers

-Changes in fiscal policy that stimulate aggregate demand when economy goes into recession -Occur without policymakers having to take any deliberate action

short run

-Changes in nominal variables (like the money supply or P ) can affect real variables (like Y or the u-rate). -We use a new model...

Some argue that the Fed should be forced to follow a rule, such as

-Constant money growth rate -Inflation targeting: •Increase money growth rate if inflation is below target; decrease money growth rate if inflation is above target

The Exchange-Rate Effect (P and NX) Suppose the U.S. price level, P, declines

-Decrease in the U.S. interest rate -U.S. dollar depreciates (decline in the real value of the dollar in foreign-exchange markets) -Stimulates U.S. net exports, NX -Increase in quantity demanded of goods and services

Arguments for discretion

-Discretion allows flexibility to react to unforeseen events. -Political business cycles and time-inconsistency are theoretical possibilities but not that important in practice. -It is difficult to specify rules precisely and to determine what the best rule would be.

Arguments for fighting recessions with spending:

-Each $ of government spending adds directly to aggregate demand •But only part of each $ of a tax cut does because consumers save part of it. -Most states must keep balanced budgets, •Federal spending given to states can prevent states from laying off public workers, saving jobs.

The multiplier effect:

-Each $1 increase in G can generate more than a $1 increase in aggregate demand. -Also true for the other components of GDP (C, I, G, NX)

Arguments for balancing the budget:

-Government debt places a burden on future generations. -Budget deficits crowd out investment, reducing growth and future living standards. -While deficits may be justified during recessions or wars, the surging peacetime debt of recent decades is unsustainable and detrimental.

Suppose real income (Y) rises

-Households want to buy more goods and services, so they need more money - To get this money, they attempt to sell some of their bonds An increase in Y causes an increase in money demand, other things equal.

The wealth effect (P and C) Suppose the price level, P, declines

-Increase in the real value of money -Consumers are wealthier -Increase in consumer spending, C -Increase in quantity demanded of goods and services

tax cut

-Increases households' take-home pay -Households respond by spending a portion of this extra income, shifting AD to the right The size of the shift is affected by the multiplier and crowding-out effects

Arguments against active stabilization

-Monetary & fiscal policy work with long lags, so policy must act in advance of economic changes. -But the shocks that cause fluctuations are unpredictable, and forecasting is highly imprecise. -If policy takes effect too late, it will worsen fluctuations. -So, leave economy to its own devices.

The crowding-out effect

-Offset in aggregate demand -Results when expansionary fiscal policy raises the interest rate -Thereby reduces investment spending -Which reduces the net increase in aggregate demand. -So, the size of the AD shift may be smaller than the initial fiscal expansion. example: A $2b increase in G initially shifts AD right by $2b. But higher Y increases MD and r, which reduces AD.C

Arguments for tax reform to encourage saving:

-One of the Ten Principles: A nation's standard of living depends on its ability to produce goods and services. -Higher saving provides more funds for capital accumulation, which increases productivity and living standards. -Another principle: People respond to incentives -Current U.S. tax system discourages saving: •High marginal tax rates reduce return on saving •Some saving is taxed twice (as corporate income and again as personal income) -High tax rates on bequests (up to 40%!!!) -Better: replace income tax with a consumption tax to increase the incentive to save.

Sacrifice ratio

-Percentage points of annual output lost per 1 percentage point reduction in inflation -Typical estimate: 5 (to reduce inflation rate 1%, must sacrifice 5% of a year's output) -Can spread cost over time: to reduce inflation by 6%, can either •sacrifice 30% of GDP for one year •sacrifice 10% of GDP for three years

households perception

-Permanent tax cut - large impact on AD -Temporary tax cut - small impact on AD

Variables that influence NCO

-Real interest rates paid on foreign assets -Real interest rates paid on domestic assets -Perceived economic and political risks of holding foreign assets -Government policies affecting foreign ownership of domestic assets

Money demand, MD

-Reflects how much wealth people want to hold in liquid form -Assume household wealth includes only two assets: •Money - liquid but pays no interest •Bonds - pay interest but not as liquid -A household's "money demand" reflects its preference for liquidity

How an Adverse Supply Shock Shifts the PC

-SRAS shifts left, prices rise, output & employment fall. -Inflation & u-rate both increase as the PC shifts upward

Arguments against tax reform to encourage saving:

-Such tax reform would mainly benefit the wealthy, who need tax relief the least. -Estimates of the interest-rate elasticity of saving are low, so tax incentives may not increase saving much. -Reducing taxes on capital income may increase the government's budget deficit, negating the benefits of higher private saving. -Better: increase national saving directly by reducing the budget deficit.

Arguments for fighting recessions with tax cuts:

-Tax cuts increase households' disposable income and therefore increase consumption spending. -Tax cuts can increase aggregate demand with incentives—like the investment tax credit. -Tax cuts can increase aggregate supply by increasing the incentive to work and produce goods and services -Rapid spending increases may be wasteful ("bridges to nowhere") and will require future tax increases.

Since fiscal and monetary policy affect aggregate demand

-The PC appears to offer policymakers a menu of choices: •Low unemployment with high inflation •Low inflation with high unemployment •Anything in between •1960s: U.S. data supported the PC -Many believed the PC was stable and reliable

Arguments against a zero inflation target:

-The benefits of moving from moderate to zero inflation are small, but the costs are large: •Estimates: must sacrifice 5% of a year's GDP for each 1% reduction in inflation •A disinflation would leave permanent scars: -Investment falls, lowering the future capital stock -Workers' skills diminish while unemployed -Some of inflation's costs could be reduced through more widespread indexation.

•Arguments for a zero inflation target:

-The costs of inflation (shoeleather, menu, etc.) can be substantial even for low inflation. -Achieving zero inflation would have temporary costs (higher unemployment) but permanent benefits. •And these costs could be reduced if the commitment to zero inflation is credible (reduces the expected inflation rate).

Rational expectations

-Theory according to which people optimally use all the information they have •Including info about government policies, when forecasting the future -Early proponents: Robert Lucas, Thomas Sargent, Robert Barro. -Implied that disinflation could be much less costly.

Theories in chapter 22 teach us that inflation and unemployment are

-Unrelated in the long run -Negatively related in the short run -Affected by expectations, which play an important role in the economy's adjustment from the short-run to the long run

Effects of reducing MS

-the Fed can raise r by reducing the MS -an increase in r reduces the quantity of g&s demanded

Three facts about economic fluctuations

1. Economic fluctuations are irregular and unpredictable 2. Most macroeconomic quantities fluctuate together 3. As output falls, unemployment rises

Limitations of PPP

1. Theory of purchasing-power parity does not always hold in practice - Many goods are not easily traded - Price differences on such goods cannot be arbitraged away - Even tradable goods are not always perfect substitutes when they are produced in different countries - Price differences reflect taste differences 2. Purchasing-power parity - Not a perfect theory of exchange-rate determination - Real exchange rates fluctuate over time 3. Large and persistent movements in nominal exchange rates -Typically reflect changes in price levels at home and abroad

Four steps to analyzing economic fluctuations

1.Determine whether the event shifts AD or AS. 2.Determine whether curve shifts left or right. 3.Use AD-AS diagram to see how the shift changes Y and P in the short run. Use AD-AS diagram to see how economy moves from new SR equilibrium to new LR equilibrium

Real exchange rate = (e x P)/P*

= price of a domestic basket of goods relative to price of a foreign basket of goods •P = U.S. price level, e.g., Consumer Price Index, measures the price of a basket of goods •P* = foreign price level -If U.S. real exchange rate appreciates, U.S. goods become more expensive relative to foreign goods.

The multiplier effect diagram

A $2b increase in G initially shifts AD to the right by $2b. The increase in Y causes C to rise, which shifts AD further to the right. Multiplier effect: the additional shifts in AD that result when fiscal policy increases income and thereby increases consumer spending.

How the interest-rate effect works

A fall in P reduces money demand, which lowers r --> a fall in r increases I and the quantity of g&s demanded

Disinflation

A reduction in the inflation rate •To reduce inflation, -The Fed has to pursue contractionary monetary policy, which reduces AD -Short run: output falls and unemployment rises. -Long run: output & unemployment return to their natural rates.

Prices for International Transactions

Appreciation and depreciation

What do you think would happen to U.S. net exports if: A. Canada experiences a recession (falling incomes, rising unemployment) B. U.S. consumers decide to be patriotic and buy more products "Made in the U.S.A." C. Prices of goods produced in Mexico rise faster than prices of goods produced in the U.S.

A. Canada experiences a recession (falling incomes, rising unemployment) --> U.S. net exports would fall due to a fall in Canadian consumers' purchases of U.S. exports B. U.S. consumers decide to be patriotic and buy more products "Made in the U.S.A." --> U.S. net exports would rise due to a fall in imports C. Prices of goods produced in Mexico rise faster than prices of goods produced in the U.S. --> This makes U.S. goods more attractive relative to Mexico's goods. Exports to Mexico increase, imports from Mexico decrease, so U.S. net exports increase.

For each of the events below, •Determine the short-run effects on output •Determine how the Fed should adjust the money supply and interest rates to stabilize output A.Congress tries to balance the budget by cutting government spending. B.A stock market boom increases household wealth. C.War breaks out in the Middle East, causing oil prices to soar.

A. Congress tries to balance the budget by cutting government spending. -This event would reduce aggregate demand and output. -To stabilize output, the Fed should increase MS and reduce r to increase aggregate demand. B. A stock market boom increases household wealth. -This event would increase aggregate demand, raising output above its natural rate. -To stabilize output, the Fed should reduce MS and increase r to reduce aggregate demand. C. War breaks out in the Middle East, causing oil prices to soar. -This event would reduce aggregate supply, causing output to fall. -To stabilize output, the Fed should increase MS and reduce r to increase aggregate demand.

What is the exchange rate? Did the US dollar appreciated or depreciated? A. Last year, Khalid exchanged $1 for 100 Japanese yen, but this year he exchanged $1 for 105 Japanese yen. B. Last year, Amira exchanged $1 for 25 Mexican pesos, but this year she exchanged $1 for 20 Mexican pesos.

A. Last year's exchange rate = 100 yen per dollar This year's exchange rate = 105 yen per dollar -US dollar appreciation : $1 now can buy more yens than last year (Yen depreciation) B. Last year's exchange rate = 25 pesos per dollar •This year's exchange rate = 20 pesos per dollar -US dollar depreciation : $1 now can buy fewer pesos than last year (Peso appreciation)

What happens to the AD curve in each of the following scenarios? A. A ten-year-old investment tax credit expires. B. The U.S. exchange rate falls. C. A fall in prices increases the real value of consumers' wealth. D. State governments replace their sales taxes with new taxes on interest, dividends, and capital gains.

A.A ten-year-old investment tax credit expires. - I falls, AD curve shifts left. B.The U.S. exchange rate falls. -NX rises, AD curve shifts right. C.A fall in prices increases the real value of consumers' wealth. -Move down along AD curve (wealth-effect). D.State governments replace their sales taxes with new taxes on interest, dividends, and capital gains. -C rises, AD shifts right.

Suppose a structural change reduces the demand for university administrators, lowering their equilibrium real wage by 3%. A.If the actual real wage paid to university administrators remains constant, what would be the consequences? B.Would it be easier to achieve the 3% real wage reduction if the inflation rate is 0% or if it is 4%? Why?

A.If the actual real wage paid to university administrators remains constant, what would be the consequences? -Whenever the actual real wage exceeds the equilibrium real wage, there is a surplus of labor, which represents wasted resources. -A fall in the wage would alleviate the surplus: •It would encourage some administrators to switch to university teaching or private sector employment •It would increase the quantity of administrators demanded B.Would it be easier to achieve the 3% real wage reduction if the inflation rate is 0% or if it is 4%? Why? -To restore labor market equilibrium under 0% inflation, administrators would have to accept a 3% nominal wage cut. -Under 4% inflation, they would have to accept a 1% nominal wage increase. -The second scenario is more likely, as many people suffer from "money illusion" and focus on nominal variables rather than real ones.

What happens to money demand in the following two scenarios? A.Suppose r rises, but Y and P are unchanged. B.Suppose P rises, but Y and r are unchanged.

A.Suppose r rises, but Y and P are unchanged. -r is the opportunity cost of holding money. -An increase in r reduces the quantity of money demanded: households attempt to buy bonds to take advantage of the higher interest rate. -Hence, an increase in r causes a decrease in the quantity of money demanded, other things equal. B.Suppose P rises, but Y and r are unchanged. -If Y is unchanged, people will want to buy the same amount of goods and services. -Since P is higher, they will need more money to do so. -Hence, an increase in P causes an increase in money demand, other things equal.

The Equality of NX and NCO

An accounting identity: NCO = NX -every transaction that affects NX also affects NCO by the same amount (and vice versa)

Why the AD Curve Slopes Downward

An increase in P reduces the quantity of goods and services demanded because: •the wealth effect (C falls) •the interest-rate effect (I falls) •the exchange-rate effect (NX falls)

Natural rate of unemployment = 5%Expected inflation = 2%In PC equation, a = 0.5 A.Plot the long-run Phillips curve. B.Find the u-rate for each of these values of actual inflation: 0%, 6%. Sketch the short-run PC. C.Suppose expected inflation rises to 4%. Repeat part B. D.Instead, suppose the natural rate falls to 4%. Draw the new long-run Phillips curve, then repeat part B.

An increase in expected inflation shifts PC to the right. A fall in the natural rate shifts both curves to the left.

Money supply, MS

Assumed fixed by central bank, does not depend on interest rate

Net inflow of capital when NCO < 0

Capital resources coming from abroad reduce the demand for domestically generated loanable funds

Why the AD curve might shift

Changes in C - Stock market boom/crash - Preferences re: consumption/saving tradeoff - Tax hikes/cuts Changes in I - Firms buy new computers, equipment, factories - Expectations, optimism/pessimism - Interest rates, monetary policy - Investment Tax Credit or other tax incentives Changes in G - Federal spending, e.g., defense - State & local spending, e.g., roads, schools Changes in NX - Booms/recessions in countries that buy our exports - Appreciation/depreciation resulting from international speculation in foreign exchange market

The neutrality of money

Changes in the money supply affect nominal but not real variables

Classical Theory

Describes the world in the long run, but not the short run

The Breakdown of the Phillips Curve

Early 1970s: unemployment increased, despite higher inflation. Friedman & Phelps' explanation: expectations were catching up with reality.

Closed economy

Economy that does not interact with other economies in the world

Why the SRAS Curve Might Shift

Everything that shifts LRAS shifts SRAS, too. Also, PE shifts SRAS: If PE rises, workers & firms set higher wages. At each P, production is less profitable, Y falls, SRAS shifts left.

exports vs. imports

Exports: Goods and services that are produced domestically and sold abroad Imports: Goods and services that are produced abroad and sold domestically

•Real GDP over the long run, U.S.

Grows about 3% per year on average

The Federal Reserve

Has almost complete discretion over monetary policy

Why the Slope of SRAS Matters

If AS is vertical, fluctuations in AD do not cause fluctuations in output or employment. If AS slopes up, then shifts in AD do affect output and employment.

What the 3 theories have in common

In all 3 theories, Y deviates from YN when P deviates from PE.

The Vertical Long-Run Phillips Curve

In the long run, faster money growth only causes faster inflation. •1968, Milton Friedman, Edmund Phelps: -Argued that the tradeoff was temporary - Based on the classical dichotomy and the vertical LRAS curve

long run equilibrium

In the long-run equilibrium: •PE = P, •Y = YN , •and unemployment is at its natural rate.

Appreciation (or "strengthening")

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

How expected inflation shifts the PC

Initially, expected & actual inflation = 3%,unemployment = natural rate (6%). Fed makes inflation 2% higher than expected, u-rate falls to 4%. In the long run, expected inflation increases to 5%, PC shifts upward, unemployment returns to its natural rate.

A. Which of the following statements about a country with a trade deficit is not true? a) Exports < imports b) Net capital outflow < 0 c) Investment < saving d) Y < C + I + G

Investment Saving •A trade deficit means: NX < 0; exports < imports; •Y < domestic spending (C + I + G); •and NCO < 0. •Since NX = S - I, a trade deficit implies I > S.

theory of liquidity preference

Keynes's theory that the interest rate adjusts to bring money supply and money demand into balance

Capital flight

Large and sudden reduction in the demand for assets located in a country

How r is determined

MS curve is vertical: Changes in r do not affect MS, which is fixed by the Fed. MD curve is downward sloping: A fall in r increases money demand.

Net exports

NX (Trade balance) = Value of exports - value of imports

net outflow of capital when NCO>0

Net purchase of capital overseas adds to the demand for domestically generated loanable funds

Using AD & AS to depict long-run growth & inflation

Over the long run, tech. progress shifts LRAS to the right •and growth in the money supply shifts AD to the right. •Result: ongoing inflation and growth in output.

Fiscal policy might affect aggregate supply

People respond to incentives •A cut in the tax rate -Gives workers incentive to work more, so it might increase the quantity of goods and services supplied and shift AS to the right. -People who believe this effect is large are called "Supply-siders" •Example: government increases spending on roads. -Better roads may increase business productivity, which increases the quantity of goods and services supplied, shifts AS to the right -This effect is probably more relevant in the long run: it takes time to build the new roads and put them into use

Recessions

Periods of falling real incomes and rising unemployment

real exchange rate equation

Rate at which the goods and services of one country trade for the goods and services of another Real exchange rate = e x P / P* -Where •P = domestic price •P* = foreign price (in foreign currency) •e = nominal exchange rate (foreign currency per unit of domestic currency)

NX = NCO

S = I + NCO Saving = Domestic investment + Net capital outflow

National saving

S = Y - C - G •Y - C - G = I + NX •S = I + NX

Depressions

Severe recessions (very rare)

The economy is in recession. Policymakers think that shifting the AD curve rightward by $200 billion would end the recession. A.If MPC = 0.8 and there is no crowding out, how much should Congress increase G to end the recession? B.If there is crowding out, will Congress need to increase G more or less than this amount?

Shifting the AD curve rightward by $200b would end the recession. A.If MPC = 0.8 and there is no crowding out, how much should Congress increase G to end the recession? -Multiplier = 1/(1 - .8) = 5 -Increase G by $40b to shift aggregate demand by 5 x $40b = $200b. B.If there is crowding out, will Congress need to increase G more or less than this amount? -Crowding out reduces the impact of G on AD. -To offset this, Congress should increase G by a larger amount.

Rational expectations example

Suppose the Fed convinces everyone it is committed to reducing inflation. -Then, expected inflation falls, the short-run PC shifts downward. -Result: disinflations can cause less unemployment than the traditional sacrifice ratio predicts.

Arbitrage

Take advantage of price differences for the same item in different markets

Amazon U.S. purchases $10,000,000 worth of goods from China (to sell to the American customers). •What is the effect on the U.S. net exports and net capital outflows if: A. China buys $10 million worth of U.S. government bonds B. China buys $10 million worth of goods from the U.S. C. China buys $10 million worth of stocks in U.S. companies

The $10 million worth of goods bought from China are imports for the U.S. Imports increase, NX decrease. A. and C. China buys $10 million worth of U.S. government bonds or stocks in U.S. companies Purchase of domestic assets by foreigners increase, so U.S. NCO decrease B. China buys $10 million worth of goods from U.S. U.S. imports increase (Amazon buys goods from China) and U.S. exports increase (U.S. sells goods to China). NX do not change. NCO do not change.

The 1970s Oil Price Shocks

The Fed chose to accommodate the first shock in 1973 with faster money growth. Result: Higher expected inflation, which further shifted PC. 1979: Oil prices surged again, worsening the Fed's tradeoff. Oil price per barrel went from $3.56 in 1973 to $38 in 1981 Supply shocks & rising expected inflation worsened the PC tradeoff.

short-run aggregate supply curve

The SRAS curve is upward sloping: Over the period of 1-2 years, an increase in P •causes an increase in the quantity of goods and services supplied.

monetary policy

The supply of money set by the central bank

If purchasing power of the dollar is always the same at home and abroad:

Then the real exchange rate cannot change

Trade Surplus vs. Trade Deficit

Trade surplus, NX > 0 - Exports are greater than imports - The country sells more goods and services abroad than it buys from other countries - Exports > Imports and Net exports > 0 - Y > Domestic spending (C+I+G) - S > I and NCO > 0 Trade deficit, NX < 0 - Imports are greater than exports - The country sells fewer goods and services abroad than it buys from other countries - Exports < Imports and Net exports < 0 - Y < Domestic spending (C+I+G) - S < I and NCO < 0

A shift in the LRAS

What is the effect of an increase in immigration on the LRAS curve? Immigration increases the economy's stock of labor, L, causing YN to rise. Any event that changes any of the determinants of YN will shift LRAS.

Open economy

Y = C + I + G + NX -Economy that interacts freely with other economies around the world -Buys and sells goods and services in world product markets -Buys and sells capital assets such as stocks and bonds in world financial markets

SRAS and LRAS

Y = Yn + a (P - PE) In the long run, PE = P and Y = YN.

Variables that influence money demand

Y, r, and P

Why LRAS is vertical

YN determined by the economy's stocks of labor, capital, and natural resources, and on the level of technology. An increase in P does not affect any of these, so it does not affect YN. (Classical dichotomy)

PPP (Purchasing Power Parity)

a currency must have the same purchasing power in all countries - A U.S. dollar must buy the same quantity of goods in the United States and Japan - And a Japanese yen must buy the same quantity of goods in Japan and the United States - A unit of a currency must have the same real value in every country.

Based on the law of one price

a good should sell for the same price in all locations

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

The exchange rate is e = 20 pesos per $ The price of a tall Starbucks Latte is: P = $3 in U.S. and P* = 40 pesos in Mexico A. What is the price of a U.S. latte measured in pesos? B. Calculate the real exchange rate, measured as Mexican lattes per U.S. latte.

e = 20 pesos per $; P = $3 in U.S., P* = 40 pesos in Mexico A. What is the price of a U.S. latte measured in pesos? e x P = (20 pesos per $) x (3 $ per U.S. latte) = 60 pesos per U.S. latte B. Calculate the real exchange rate, measured as Mexican lattes per U.S. latte. e x P / P* = 60 pesos per U.S. latte / 40 pesos per Mexican latte = 1.5 Mexican lattes per U.S. latte

Theory of purchasing-power parity

e = P*/P -Nominal exchange rate between the currencies of two countries must reflect the price levels in those countries •P = domestic price level •P* = foreign price level •And e = exchange rate (foreign currency per $)

A Big Mac costs $4 in U.S., 380 yen in Japan. The exchange rate is 110 yen per dollar. •Compute the real exchange rate.

e x P = price in yen of a U.S. Big Mac = (110 yen per $) x ($4 per Big Mac) = 440 yen per U.S. Big Mac Real exchange rate = e x P / P* = 440 yen per U.S. Big Mac / 380 yen per Japanese Big Mac = 1.16 Japanese Big Macs per U.S. Big Mac

GDP in the short run

fluctuates around its trend

classical dichotomy

separation of real and nominal variables •Real - quantities, relative prices •Nominal - measured in terms of money

natural rate of output

the amount of output the economy produces when unemployment is at its natural rate Also called the potential output or employment output

Natural-rate hypothesis:

the claim that unemployment eventually returns to its normal, or natural, rate, regardless of the rate of inflation

Effects of Investment Incentives

• A tax incentive for investment has similar effects as a budget deficit: - r rises, NCO falls - E rises, NX falls • But one important difference: - Investment tax incentive increases investment, which increases productivity growth and living standards in the long run. - Budget deficit reduces investment, which reduces productivity growth and living standards.

The Market for Loanable Funds

• In an open economy, S = I + NCO Saving = Domestic investment + Net capital outflow • Market for loanable funds: - Supply of loanable funds: from national saving (S) - Demand for loanable funds: from domestic investment (I) and net capital outflow (NCO)

The Greenspan Era

•1986: Oil prices fell 50%. •1989-90: Unemployment fell, inflation rose. -Fed raised interest rates, caused a mild recession •1990s: Unemployment and inflation fell. •2001: -Negative demand shocks created the first recession in a decade. -Policymakers responded with expansionary monetary and fiscal policy.

Arguments for active stabilization:

•Arguments for active stabilization: -Left on their own, economies tend to fluctuate •Pessimism of households and firms causes a fall in AD, which causes a recession -Policymakers can "lean against the wind" •Use monetary & fiscal policy to stabilize AD, output, and employment -A more stable economy benefits everyone

The Role of Interest-Rate Targets in Fed Policy

•Because -The MS is hard to measure with sufficient precision and MD fluctuates over time -Leads to fluctuations in interest rates, AD, output •Fed policy: set a target for federal funds rate -Accommodates the day-to-day shifts in MD by adjusting the MS accordingly Monetary policy can be described either in terms of the money supply or in terms of the interest rate.

Assume the government buys $2 billion of military trucks from Oshkosh Corporation. •What is the effect of this purchase on the aggregate demand?

•Because G increases by $2 billion, the AD curve shifts to the right by $2 billion •Oshkosh's revenue increases by $2 billion -Distributed to Oshkosh's workers (as wages) and owners (as profits or stock dividends). -These people are also consumers and will spend a portion of the extra income: C increases so AD increases

Why the LRAS Curve Might Shift

•Changes in L or natural rate of unemployment -Immigration -Baby-boomers retire -Government policies reduce natural u-rate •Changes in K or H -Investment in factories, equipment -More people get college degrees -Factories destroyed by a hurricane •Changes in natural resources -Discovery of new mineral deposits -Reduction in supply of imported oil -Changing weather patterns that affect agricultural production •Changes in technology -Productivity improvements from technological progress

Conclusion

•Economics teaches us "there's no such thing as a free lunch." -There are few easy answers and many unresolved questions. •Crafting the best policy -Requires knowing the pros and cons of every alternative. •Being an informed voter -Requires the ability to evaluate the candidates' policy proposals.

Reconciling Theory and Evidence

•Evidence (from 1960s): -PC slopes downward •Theory (Friedman and Phelps): -PC is vertical in the long run. •Friedman and Phelps, bridge the gap between theory and evidence -Introduced a new variable, expected inflation: a measure of how much people expect the price level to change

The Volcker Disinflation

•Fed Chairman Paul Volcker -Appointed in late 1979 under high inflation & unemployment -Changed Fed policy to disinflation •1981-1984: Fiscal policy was expansionary -So Fed policy had to be very contractionary to reduce inflation. -Success: Inflation fell from 10% to 4%,but at the cost of high unemployment. Disinflation turned out to be very costly

How Fiscal Policy Influences AD

•Fiscal policy: -Setting the level of government purchase (G) and taxation (T) by government policymakers -An increase in G and/or decrease in T, shifts AD right -A decrease in G and/or increase in T, shifts AD left

Marginal Propensity to Consume

•How big is the multiplier effect? -Depends on how much consumers respond to increases in income. •Marginal propensity to consume, MPC=ΔC/ΔY -Fraction of extra income that households consume rather than save •Example -If MPC = 0.8 and income rises $100, C rises $80.

•Calculate the spending multiplier when MPC is 0.5, 0.75, and 0.9. •What is the relationship between the MPC and the simple multiplier?

•If MPC = 0.5, multiplier = 1 / (1-MPC) = 2 •If MPC = 0.75, multiplier = 4 •If MPC = 0.9, multiplier = 10 •The bigger the MPC, the bigger the multiplier. A bigger MPC means changes in Y cause bigger changes in C, which in turn cause bigger changes in Y.

Would you be more likely to support active stabilization policy if wages, prices, and expectations adjust quickly in response to economic changes, or if they adjust slowly?

•If wages, prices, and expectations adjust slowly, it will take longer for the economy to return to its natural rates of output and employment. •In that case, there's a better chance that expansionary policy will act in time to alleviate the recession, rather than push the economy into an inflationary boom.

The misperception theory

•Imperfection: -Firms may confuse changes in P with changes in the relative price of the products they sell. •If P rises above PE -A firm sees its price rise before realizing all prices are rising. •The firm may believe its relative price is rising, and may increase output and employment. So, an increase in P can cause an increase in Y, making the SRAS curve upward-sloping.

The sticky-wage theory

•Imperfection: -Nominal wages are sticky in the short run, they adjust sluggishly. •Due to labor contracts, social norms •Firms and workers set the nominal wage in advance based on PE, the price level they expect to prevail. •If P > PE, -Revenue is higher, but labor cost is not. -Production is more profitable, so firms increase output and employment. Hence, higher P causes higher Y, so the SRAS curve slopes upward. •Imperfection: -Many prices are sticky in the short run. •Due to menu costs, the costs of adjusting prices. •Examples: cost of printing new menus, the time required to change price tags -Firms set sticky prices in advance based on PE •Suppose the Fed increases the money supply unexpectedly -In the long run, P will rise -In the short run: •Firms without menu costs can raise their prices immediately •Firms with menu costs wait to raise prices. With relatively low prices: increase demand for their products: increase output and employment Hence, higher P is associated with higher Y.

Suppose a recession overseas reduces the demand for U.S. net exports by $10 billion. •What is the initial change in AD? •If MPC = 0.8, what is the change in output?

•Initially, AD falls by $10 billion •The spending multiplier = 5 •The decrease in Y is 5 * $10 billion = $50 billion

The Case for Active Stabilization Policy

•Keynes: "Animal spirits" cause waves of pessimism and optimism among households and firms, leading to shifts in aggregate demand and fluctuations in output and employment. •Also, other factors cause fluctuations, -Booms and recessions abroad -Stock market booms and crashes •If policymakers do nothing -These fluctuations are destabilizing to businesses, workers, consumers. •Proponents of active stabilization policy -Government should use policy to reduce these fluctuations: •When GDP falls below its natural rate, use expansionary monetary or fiscal policy to prevent or reduce a recession. •When GDP rises above its natural rate, use contractionary policy to prevent or reduce an inflationary boom

The zero lower bound

•Liquidity trap -If interest rates have already fallen to around zero -Monetary policy may no longer be effective, since nominal interest rates cannot be reduced further -Aggregate demand, production, and employment may be "trapped" at low levels •A central bank continues to have tools to expand the economy: -Forward guidance: raise inflation expectations by committing to keep interest rates low -Quantitative easing: buy a larger variety of financial instruments (mortgages, corporate debt, and longer-term government bonds) (The Fed, 2008)

The Case for Active Stabilization Policy continuted

•Monetary policy affects economy with a long lag: -Firms make investment plans in advance, so I takes time to respond to changes in r -Most economists believe it takes at least 6 months for monetary policy to affect output and employment •Fiscal policy also works with a long lag: -Changes in G and T require acts of Congress. -Legislative process can take months or years •Due to these long lags -Critics of active policy argue that such policies may destabilize the economy rather than help it: •By the time the policies affect aggregate demand, the economy's condition may have changed. •Contend that policymakers should focus on long-run goals like economic growth and low inflation.

Kiara is a web designer living in Illinois. She creates and sells a website to Gabrielle who is living in Germany. Gabrielle pays Kiara 5,000 euros for the website. •What is the effect on the U.S. net exports and net capital outflows if: A. Kiara keeps the 5,000 euros at home B. Kiara buys 5,000 euros worth of stocks in a German company C. Kiara spends the 5,000 euros on shoes made in Germany D. Kiara exchanges the 5,000 euros into U.S. dollars

•NX = Exports - Imports •NCO = Purchases of foreign assets by domestic resident - Purchases of domestic assets by foreigners The website sold to Gabrielle is an export for the U.S., so U.S. exports and net exports increase. A. Kiara keeps the 5,000 euros at home Kiara (a domestic resident) acquired a foreign asset (5,000 euros from Germany), so U.S. NCO increases B. Kiara buys 5,000 euros worth of stocks in a German company Kiara (a domestic resident) acquired a foreign asset (5,000 euros worth of stocks in a German company), so U.S. NCO increases C. Kiara spends the 5,000 euros on German shoes Kiara purchase of shoes made in Germany is an import for the U.S.: overall, exports increase by 5,000 euros (website sale to Germany), and imports increase by 5,000 euros (shoes bought from Germany), so U.S. Net exports do not change; NCO do not change. D. Kiara exchanges the 5,000 euros into U.S. dollars Now the bank has to use the 5,000 euros (keep in the vault, or purchase German assets, or sell the euros to an American that wants to purchase a good or service for euros) The change in NX is matched by the change in NCO.

The Meaning of "Natural"

•Natural rate of unemployment -Unemployment rate toward which the economy gravitates in the long run -Is not necessarily the socially desirable rate of unemployment -Is not constant over time •This unemployment is natural because it is beyond the influence of monetary policy

If coffee beans sell for $4/pound in Seattle and $5/pound in Boston; and coffee beans can be costlessly transported, how will the two markets reach equilibrium?

•Opportunity for arbitrage: making a quick profit by buying coffee in Seattle and selling it in Boston. •Seattle: increase demand drives up the price •Boston: increase supply drives the price down •Until the two prices are equal.

The imperfections in these theories are temporary

•Over time, -Sticky wages and prices become flexible -Misperceptions are corrected •In the LR, -PE = P -AS curve is vertical

B. A Ford Escape SUV sells for $24,000 in the U.S. and 720,000 rubles in Russia. If purchasing-power parity holds, what is the nominal exchange rate (rubles per dollar)?

•P* = 720,000 rubles •P = $24,000 •e = P*/P = 720000/24000 = 30 rubles per dollar

Using the theory of purchasing-power parity, find the exchange rate if a bushel of apples sells for $30 in the U.S. and 300 krona in Sweden.

•PPP: a dollar buys the same quantity of goods in the United States (prices in $) as in Sweden (prices in krona) •The number of krona per dollar must reflect the prices of goods in the U.S. and Sweden. •Nominal exchange rate = 300 krona / 30 dollars = 10 krona per dollar

Suppose the income tax were replaced with a consumption tax, and the tax rate was chosen carefully to ensure the average person's tax burden remains unchanged. •Who would benefit? •Who would be worse off?

•People with higher incomes save a bigger percentage of their incomes, so would benefit most from this change. •People with low incomes use most or all of their incomes for consumption and would be worse off. This is why most consumption tax proposals include exemptions for necessities, like groceries, which comprise a larger share of the budgets of low-income persons.

Origins of the Phillips Curve

•Phillips curve, PC: -Short-run trade-off between inflation and unemployment •1958: A.W. Phillips -Nominal wage growth was negatively correlated with unemployment in the U.K. •1960: Paul Samuelson & Robert Solow -Negative correlation between U.S. inflation & unemployment -Named it "the Phillips Curve."

Aim for Zero Inflation?

•Prices rise when the government prints too much money. •Society faces a short-run tradeoff between inflation and unemployment. •How much inflation should the central bank accept? Is zero the right target?

Chapter 20 in a nutshell

•Short-run economic fluctuations around long-run trends are irregular and largely unpredictable. •When recessions occur, real GDP and other measures of income, spending, and production fall, while unemployment rises. •Classical economic theory assumption: nominal variables such as the money supply and the price level do not influence real variables such as output and employment. •Accurate in the long run but not in the short run •Model of aggregate demand and aggregate supply" the output of goods and services and the overall level of prices adjust to balance aggregate demand and aggregate supply. •The aggregate-demand curve slopes downward due to: the wealth effect, the interest-rate effect, and the exchange-rate effect. •Any event or policy that raises consumption, investment, government purchases, or net exports at a given price level increases aggregate demand. •Any event or policy that reduces consumption, investment, government purchases, or net exports at a given price level decreases aggregate demand. •The long-run aggregate-supply curve is vertical. The quantity of goods and services supplied depends on the economy's labor, capital, natural resources, and technology but not on the overall level of prices. •Three theories explain the upward slope of the short-run aggregate-supply curve: Sticky-wage theory, Sticky-price theory, Misperceptions theory •All three theories imply that output deviates from its natural level when the actual price level deviates from the price level that people expected. •Shifts of short-run aggregate supply curve: events that alter the economy's ability to produce output •Causes of economic fluctuations: shifts in aggregate demand and aggregate supply.

Monetary Policy and the AD

•The Fed uses monetary policy to shift the AD curve -Policy instrument: the money supply (MS) -Targets the interest rate: the federal funds rate •Banks charge each other on short-term loans -Conducts open market operations to change MS

Phillips Curve During the Financial Crisis

•The early 2000s -Housing market boom turned to bust in 2006 -Household wealth fell, -Millions of mortgage defaults and foreclosures -Heavy losses at financial institutions •Result: -Sharp drop in aggregate demand, steep rise in unemployment

Automatic Stabilizers: Examples

•The tax system -In recession, taxes fall automatically,which stimulates aggregate demand •Government spending -In recession, more people apply for public assistance (welfare, unemployment insurance) •Government spending on these programs automatically rises, which stimulates aggregate demand

NCO measures the imbalance in a country's trade in assets:

•When NCO > 0, "capital outflow" -Domestic purchases of foreign assets exceed foreign purchases of domestic assets •When NCO < 0, "capital inflow" -Foreign purchases of domestic assets exceed domestic purchases of foreign assets

The AD curve slopes downward for three reasons

◦ wealth effect ◦ interest-rate effect ◦ exchange-rate effect