FINAL EXAM MACRO

The Effects of a Shift in Aggregate Supply

- Shifts in aggregate supply can cause stagflation : a combination of recession (falling output) and inflation (rising prices) - Policymakers who can influence aggregate demand can potentially mitigate the adverse impact on output but only at the cost of exacerbating the problem of inflation

Important variables that influence Net Capital Outflow

- 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

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

- 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

The Four steps to analyzing Macroeconomic Fluctuations

1. Decide whether the event shifts the aggregate demand curve or the aggregate supply curve 2. Decide the direction in which the curve shifts 3. Use the diagram of aggregate demand and aggregate supply to determine the impact on output and the price level in the short run 4. Use the diagram of aggregate demand and aggregate supply to analyze how the economy moves from its new short run equilibrium to its new long run equilibrium

What are the Three Key Facts about Economic Fluctuations?

1. Economic Fluctuations are Irregular and Unpredictable - Fluctuations in the economy are often called the business cycle. As this term suggests, economic fluctuations correspond to changes in business conditions: When real GDP grows business is good, and when real GDP falls business have trouble. The team business cycle is somewhat misleading however, as it suggests that economic fluctuations follow a regular pattern. This is not true: economic fluctuations are not at all regular, and they are almost impossible to predict with much accuracy. 2. Most Macroeconomic Quantities Fluctuate Together -Real GDP is the variable most commonly used to monitor short-run changes in the economy because it is the most comprehensive measure of economic activity. However, it turns out that for monitoring short run fluctuations, it doesn't really matter which measure of economic activity one looks at. When real GDP falls in a recession, so do personal income, corporate profits, consumer spending, investment spending, industrial production, etc. 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. When real GDP declines, the rate of unemployment rises. This is because when firms choose to produce a smaller quantity of goods and services, they lay off workers, expanding the pool of unemployed.

How simultaneous equilibrium in the Market for Loanable funds and the Market for Foreign Currency Exchange Works

1. In the Market for Loanable funds, the equilibrium between the supply and demand for loanable funds determines the real interest rate 2. The real interest rate determines net capital outflow, which provides the supply of dollars in the market for foreign currency exchange -A higher interest rate at home makes domestic assets more attractive, and this in turn reduces net capital outflow, therefore, the NCO curve slopes down 3. The equilibrium between the supply and demand in the Market for Foreign currency exchange determines the real exchange rate -Because foreign assets must be purchased with foreign currency, the quantity of net capital outflow determined by the NCO curve determines the supply of dollars to be exchanged into foreign currencies.

Events that Shift the Aggregate Demand Curve

1. Shifts arising from Changes in Consumption - An event that causes consumers to spend more at a given price level (a tax cut, a stock market boom) shifts the aggregate demand curve to the right. - An event that Causes consumers to spend less at a given price level (a tax hike, a stock market decline) shifts the aggregate demand curve to the left 2. Shifts Arising from Changes in Investment - An event that causes firms to invest more at a given price level (optimism about the future, a fall in interest rates due to an increase in the money supply) shifts the aggregate demand curve to the right. - An event that causes firms to invest less at a given price level (pessimism about the future, a rise in interest rates due to a decrease in the money supply) shifts the aggregate demand curve to the left. 3. Shifts arising from changes in Government Purchases - An increase in government purchases of goods and services (greater spending on defense or highway construction) shifts the aggregate demand curve to the right. - A decrease in government purchases on goods and services (a cutback in defense of highway spending) shifts the aggregate demand curve to the left 4. Shifts arising from Changes in Net Exports - An even that raises spending on net exports at a given price level (a boom overseas, speculation that causes an exchange rate depreciation) shifts the aggregate demand curve to the right - An event that reduces spending on net exports at a given price level (a recession overseas, speculation that causes an exchange rate appreciation) shifts the aggregate demand curve to the left.

Aggregate Supply Curve

A curve that shows the quantity of goods and services that firms choose to produce and sell at each price level.

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.

Depreciation of Currency

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

Depreciation in Real Exchange Rate

A depreciation in the US real exchange rate means that US goods have become cheaper relative to foreign goods.This change encourages consumers both at home and abroad to buy more US goods and fewer goods from other countries. As a result, US exports rise and US imports fall. both of these changes raise US net exports.

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 theory of the purchasing power parity is based on a principle called the law of one price. This law asserts the a good must sell for the same price in all locations, otherwise there would be opportunities for profit left unexploited. The Law of one price tells us that a dollar must buy the same amount of coffee in all countries. Parity means equality, purchasing power refers to the value of money in terms of the quantity of goods it can buy. According to the purchasing power parity, a unit of currency must have the same real value in every country.

Appreciation in Real Exchange Rate

An appreciation in the US real exchange rate means that US goods have become more expensive compared to foreign goods, so US net exports fall.

Appreciation of Currency

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

What is the macroeconomic impact of an increase in production costs on the aggregate demand and aggregate supply model?

Because production costs affect the firms that supply goods and services, changes in production costs alter the position of the aggregate supply curve. Because higher production costs make goods and services less profitable, firms now supply a smaller quantity of output for an given price level. The first two steps conclude that when production costs increase, the short run aggregate supply curve shifts to the left. In the short run, the economy moves to a point where output falls and price level rises, an event known as stagflation. According to the sticky wage theory, the key issue is how stagflation affects nominal wages. Firms and workers may at first respond to the higher level of prices by raising their expectations of the price level and setting higher nominal wages. In this case firms' costs will rise again, and the short run aggregate supply curve will shift farther and farther to the left, making the problem of stagflation even worse. This is known as the wage-price spiral. At some point the spiral will slow. As nominal wages fall, producing goods and services becomes more profitable and the short run aggregate supply curve shifts to the right. AS it shifts back towards the original equilibrium, the price level falls and the quantity of output approaches its natural level. In the long run, the economy returns to its original point, where the aggregate demand curve crosses the long run aggregate supply curve.

How Political Instability and Capital Flight Affect and Open Economy

Capital flight is a large and sudden reduction in the demand for assets located in a country, and often occurs after a country suffers political problems which make the world financial markets nervous and want to withdraw their assets out of a country. Consider Mexico Undergoing Capital flight: When investors around the world observe political problems in Mexico, they decide to sell some of their Mexican assets and use the proceeds to buy US assets. This increases Mexican NCO and therefore affects both the Market for foreign currency exchange and the market for loanable funds Because Mexican NCO increases, this affects the NCO curve and the demand curve for loanable funds (because the demand for loanable funds comes from Investment and NCO) THE DEMAND CURVE FOR LOANABLE FUNDS SHIFTS RIGHT because there is a greater demand for loanable funds to finance these purchases of capital assets abroad. Because NCO is higher for any interest rate, THE NET CAPITAL OUTFLOW CURVE SHIFTS RIGHT The increase in NCO raises the supply of pesos in the market for foreign currency exchange because 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 In the end: Capital flight from Mexico increases Mexican interest rates and decreases the value of the Mexican peso in the market for foreign currency exchange. ** Capital flight has its largest impact on the country from which the capital is fleeing, but it also affects other countries. When capital flows out of Mexico into the US, for instance, it has the opposite effect on the US economy as it has on the Mexican Economy. In particular, the rise in Mexican net capital outflow coincides with a fall in US net capital outflow. As the peso depreciates in value and Mexican interest rates rise, the dollar appreciates in value and US interest rates fall. ==> A nation that experiences an outflow of capital sees its currency weaken in foreign exchange markets, and this depreciation in turn increases the nation's net exports. The country into which the capital is flowing sees its currency strengthen, and this appreciation pushes its trade balance towards deficit GENERALLY: Political instability can lead to capital flight, which tends to increase interest rates and cause the currency to depreciate

What are the two forms of flow between the US Economy and the rest of the world?

Foreign Direct Investment : when the American Owner of a restaurant, for example, actively manages the investment Foreign Portfolio Investment : when the American Owner has more of a passive role, like when they have invested in a stock Because in both cases US residents are buying assets located in another country, both purchases increase US net capital outflow

How Government Budget Deficits Affect an Open Economy

Government budget deficits occur when government spending exceeds government revenue. Because a government budget deficit represents negative public saving, it reduces national saving. -Thus, a government budget deficit reduces the supply of loanable funds, drives up the interest rate, and crowds out investment Because a budget deficit represents negative public saving, it reduces national saving and SHIFTS THE SUPPLY CURVE FOR LOANABLE FUNDS TO THE LEFT When budget deficits raise interest rates, both domestic and foreign behaviors cause US net capital outflow to fall Because net capital outflow is reduced, Americans need less foreign currency to buy foreign assets and therefore spend fewer dollars in the market for foreign currency exchange. THE SUPPLY CURVE FOR DOLLARS SHIFTS TO THE LEFT In the end: In an open economy, government budget deficits raise real interest rates, crowd out domestic investment, cause the currency to appreciate, and push there trade balance towards deficit. GENERALLY: A policy that reduces national saving, such as a government budget deficit, reduces the supply of loanable funds and drives up the interest rate. The higher interest rate reduces NCO, which reduces the supply of dollars in the market for foreign currency exchange. The dollar depreciates, and net exports fall.

Why is the Aggregate Supply Curve Vertical in the Long Run?

In the long run, an economy's production of goods and services (its real GDP) depends on its supplies of labor, capital, and natural resources and on the available technology used to turn these factos of production into goods and services. Because the price level does not affect the long run determinants of real GDP, the long run aggregate supply curve is vertical. In other words, in the long run, the economy's labor, capital, natural resources, and technology supplied is the same regardless of what the price level happens to be.

What does the theory of purchasing power parity say about exchange rates?

It says that the nominal exchange rate between two currencies of two countries depends on the price level in those countries. 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. If the purchasing power of the dollar is always the same at home and abroad, then the real exchange rate - the relative price of domestic and foreign goods - cannot change P - Price of a bases of goods in the US P* - Price of a basket of goods in Japan e - nominal exchange rate ==> e = P*/P

Why does the Short Run Aggregate Supply Curve Slope Upward? / Why do changes in the Price Level affect output in the short run?

Macroeconomists have proposed three theories for the upward slope of the short-run aggregate supply curve. In each theory, a specific market imperfection causes the supply side of the economy to behave differently in the short run than it does in the long run. The common theme among the theories is this : ==> The quantity of the output supplied deviates from its long-run, or natural, level when the actual price level in the economy deviates from the price level that people expected to prevail. -MENU COSTS are relevant to the Sticky Wage Theory and the Sticky Price Theory 1. The Sticky Wage Theory - According to the Sticky Wage Theory, the short run aggregate supply curve slopes upward because nominal wages are based on expected prices and do not respond immediately when the actual price level turns out to be different from what was expected (this may be because of contracts with employees on their wages). This 'stickiness' of wages gives firms an incentive to produce less output when the price level turns out lower than expected, because production is less profitable, and to produce more when the price level turns out higher than expected because production is more profitable. 2. The Sticky Price Theory - According to the Sticky Price Theory, the short run aggregate supply curve slopes upward because the prices of some goods and services adjust sluggishly in response to changing economic conditions. This slow adjustment of prices occurs in part because there are costs to adjust prices, called menu costs. These menu costs include the cost of printing and redistributing catalogs and the time required to change price tags. As a result of these costs, prices as well as wages may be sticky in the short run. As a result, an unexpected fall in price level leaves some firms with higher than desired prices, and these higher than desired prices depress sales and induce firms to reduce the quantity of goods and services they produce. 3. The Misperceptions Theory - According to the Misperceptions Theory, changes in the overall price level can temporarily mislead suppliers about what is happening in the individual markets in which they sell their output. As a result of these short-run misperceptions, suppliers respond to changes in the level of prices, and this response leads to an upward sloping aggregate supply curve. For example, suppose the overall price level falls below the level that suppliers expect. When suppliers see the prices of their products fall, they may mistakenly believe that their relative prices have fallen compared to other prices in the economy. They may infer from this observation that the reward for producing is temporarily low, and they may respond by reducing the quantity of the product they supply. In this case, a lower price level causes misperceptions about relative prices, and these misperceptions induce suppliers to respond to the lower price level by decreasing the quantity of goods and services supplied.

NCO: The Link between the Market for Loanable funds and the Market for Foreign Currency Exchange

Market for Loanable funds :S = I + NCO Market for Foreign Currency Exch: NCO = NX In the Market for Loanable funds, supply comes from national saving (S), demand comes from domestic investment (I) and net capital outflow (NCO), and the real interest rate balances supply and demand In the Market for Foreign Currency Exchange, supply comes from net capital outflow (NCO), demand comes from net exports (NX), and the real exchange rate balances supply and demand Net capital outflow is the variable that links these two markets. In the market for loanable funds, NCO is a piece of demand. In the market for foreign currency exchange, NCO is the source of supply. The key determinant of NCO is the real interest rate, and the NCO curve is the link between the market for loanable funds and the market for foreign currency exchange.

For an Economy as a whole, net capital outflow must always equal net exports

NCO = NX

Aspects of the Market for Foreign Currency Exchange

NCO = NX Net Capital Outflow (NCO) represents the quantity of dollars supplied for the purpose of buying foreign assets. Net Exports (NX) represents the quantity of dollars demanded for the purpose of buying US net exports of goods and services. When the US economy is running a trade surplus (NX > 0), foreigners are buying more US goods and services than Americans are buying foreign goods and services. Americans are using the foreign currency they are getting from the net sale of goods and services to buy foreign assets, so US capital is flowing abroad (NCO>0) When the US economy is running a trade deficit (NX < 0), Americans are spending more on foreign goods and services than they are earning from selling abroad. Some of this spending must be financed by selling American assets abroad, so foreign capital is flowing into the US (NCO < 0) The demand curve slopes downward because a higher real exchange rate makes US goods more expensive and reduces the quantity of dollars demanded to buy those goods The supply curve is vertical because the quantity of dollars supplied for net capital outflow does not depend on the real exchange rate. - This is because 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. At the equilibrium real exchange rate, the demand for dollars by foreigners arising from the US net exports of goods and services exactly balances the supply of dollars from Americans arising from US net capital outflow

Net Capital Outflow Equation

Net Capital Outflow = Purchase of foreign assets by domestic residents - Purchase of domestic assets by foreigners

When is Net Capital Outflow positive? When is it negative?

Net Capital Outflow is positive when domestic residents are buying more foreign assets than foreigners are buying domestic assets. Capital is said to be flowing out of the country. Net Capital Outflow is negative when domestic residents are buying less foreign assets than foreigners are buying domestic assets. Capital is said to be flowing into the country.

What does Net Capital Outflow measure?

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

Net Exports Equation

Net Exports = Exports - Imports If net exports are positive, exports are greater than imports, indicating that the country sells more goods and services abroad than it buys from other countries. If net exports are negative, exports are less than imports, indicating that the country sells fewer goods and services abroad than it buys from other countries. If net exports are zero, exports and imports are exactly equal, and the country is said to have balanced trade.

What do Net Exports measure?

Net Exports measure an imbalance between a country's exports and imports

What happens when policymakers "accommodate" a shift in aggregate supply due to an increase in production costs?

Policymakers who control monetary and fiscal policy might attempt to offset some of the effects of a shift in short run aggregate supply by shifting the aggregate demand curve. In this case : the aggregate demand curve shifts right exactly enough to prevent the shift in the aggregate supply from affecting output. The economy moves directly to a point where output remains at its natural level and price level rises. **Accommodative policies accept a permanently higher level of prices to maintain a higher level of output and employment

Real Exchange Rate Equation

Real Exchange Rate = (Nominal Exchange Rate x Domestic Price / Foreign Price) - AKA: (e x P)/P* Ex: (80 yen/dollar) x (100/bushel of US Rice) / (16000 yen/bushel of Japanese Rice) = (8000 yen/bushel of Us Rice) / (16000 yen/bushel of Japanese rice) = 1/2 bushel of Japanese Rice/ bushel of American Rice

Aspects of the Market for Loanable funds

S = I + NCO The supply for loanable funds comes from national saving (S) and the demand for loanable funds comes from domestic investment (I) and net capital outflow (NCO) 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 The supply curve slopes upward because a higher interest rate increases the quantity of loanable funds supplied, and the demand curve slopes downward because a higher interest rate decreases the quantity of loanable funds demanded. At the equilibrium interest rate in the Market for Loanable funds, the amount that people want to save exactly balances the desired quantities of domestic investment and net capital outflow.

Equation for National Saving

S = Y - C - G so... Y - C - G = I + NX so... S = I + NX and NX = NCO so... S = I (Domestic Investment) + NCO Why? Because an open economy has two uses for its saving: domestic investment and net capital outflow. Because of this, all saving in the US Economy shows up as investment in the US economy or as US net capital outflow.

What does the Market for Foreign Currency Exchange do?

The Market for Foreign Currency Exchange coordinates people who want to exchange domestic currency for the currency of other countries Participants in this market trade US dollars in exchange for foreign currencies

What does the Market for Loanable funds do?

The Market for Loanable funds coordinates the economy's saving, investment, and flow of loanable funds abroad (NCO). 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. Loanable funds should be interpreted as the domestically generated flow of resources available for capital accumulation: - The purchase of a capital asset adds to the demand for a loanable fund, regardless of whether that asset is located at home (I) or abroad (NCO)

Limitations of the Purchasing Power Parity

The Purchasing Power Parity works well in explaining long term trends, such as historical appreciation and depreciation, and it can also explain the major changes in exchange rates that occur during hyper inflations The two reasons the theory of the purchasing power parity does not always hold in practice are: 1. Many goods are not easily traded 2. Even tradable goods are not always perfect substitutes when they are produced in different countries

Classica Dichotomy and Monetary Neutrality

The classical dichotomy is the separation of variables into real variables (those that measure quantities or relative prices) and nominal variables (those measured in terms of money). According to classical macroeconomic theory, changes in the money supply affect nominal variables but not real variables. This is monetary neutrality. In a sense, money does not matter in the classical world. If the quantity of money in the economy were to double, everything would cost twice as much, and everyone's income would be twice as high. This change would be nominal. The things people really care about - whether they have a job, how many goods and services they can afford, and so on - would be exactly the same. Most economists believe that the classical theory describes the world in the long run but not in the short run. When studying year to year changes in the economy, the assumption of monetary neutrality is no longer appropriate. In the short run, real and nominal variables are highly intertwined and changes in the money supply can temporarily push real GDP away from its long run trend.

The Effects of a Shift in the Aggregate Demand Curve

The long run effect of a shirt in aggregate demand is a nominal change (the price level is lower) but to a real change (output is the same) - In the short run, shifts in aggregate demand cause fluctuations in the economy's output of goods and services - In the long run, shifts in aggregate demand affect the overall price level but do not affect output - Because policymakers influence aggregate demand, they can potentially mitigate the severity of economic fluctuations

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 The Model of Aggregate Demand and Aggregate Supply focuses on the behavior of two variables : the economy's output of goods and services as measured by real GDP, and the average level of prices, as measured by the CPI or GDP deflator. -Output is a real variable, while Price level is a nominal variable. This allows us to study the relationship between both variables and to depart from the classical assumption that real and nominal variables can be studied separately In this model, the price level and the quantity of output adjust to bring aggregate demand and aggregate supply into balance

Nominal Exchange Rate

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) P - Price of a bases of goods in the US P* - Price of a basket of goods in Japan e - nominal exchange rate ==> e = P*/P If the nominal exchange rate changes so that a dollar can buy more foreign currency, that change is called an appreciation of the dollar. (strengthens) If the exchange rate changes so that a dollar buys less foreign currency, that change is called a depreciation of the dollar (weakens) For each country there are many nominal exchange rates (dollar/peso, dollar/euro, etc) ** nominal exchange rates change when price levels change - when a 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, so when the US government prints more money, US currency depreciates, affecting the nominal exchange rate

Arbitrage

The process of taking advantage of price differences for the same item in different markets. When arbitrage occurs, eventually prices will return to the same level in the places where it occurred.

What is the natural level of output?

The production of goods and services that an economy achieves in the long run when unemployment is at its normal rate

Real Exchange Rate

The rate at which a person can trade the goods and services of one country for the goods and services of another The real exchange rate depends on the nominal exchange rate and on the prices of goods in the two countries measured in local currencies, and it matters because it is the key determinant of how much a country exports and imports.

What price balances the supply and demand in the market for Foreign Currency Exchange?

The real exchange rate. the real exchange rate is the relative price of domestic and foreign goods and, therefore, is the key determinant of net exports. When the US real exchange rate appreciates, US goods become more expensive relative to foreign goods, making US goods less attractive to consumers both at home and abroad. As a result, exports form the US fall, and imports into the US rise. For both reasons, net exports fall. ==> Hence, an appreciation of the real exchange rate reduces the quantity of dollars demanded in the market for foreign currency exchange.

What do the quantity of loanable funds supplied and the quantity of loanable funds demanded depend on?

The real interest rate A higher real interest rate encourages people to save and therefore raises the quantity of loanable funds supplied. It also makes borrowing to finance capital projects more costly, thus, it discourages investment and reduces the quantity of loanable funds demanded. A high US real interest rate reduces US net capital outflow, because an increase in the US interest rate discourages Americans from buying foreign assets and encourages foreigners to buy US assets.

What does the real interest rate determine? What does the real exchange rate determine?

The real interest rate determines the price of goods and services in the present relative to goods and services in the future. The real exchange rate determines 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.

Why is the long run aggregate supply curve a representation of the classical dichotomy and monetary neutrality?

The vertical long-run aggregate supply curve is a graphical representation of the classical dichotomy and monetary neutrality. As we have already discussed, classical macroeconomic theory is based on the assumption that real variables do not depend on nominal variables. The long run aggregate supply curve is consistent with this idea because it implies that the quantity of output (a real variable) does not depend on the level of prices (a nominal variable).

Why does the Aggregate Demand Curve Slope Downward?

To understand the downward slope of the aggregate demand curve, we must examine how the price level affects the quantity of goods and services demanded for consumption, investment, and net exports. Three reasons why the Aggregate Demand Curve Slopes Downward: 1. The Price Level and Consumption: The Wealth Effect - 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 demanded. -Basically, consumers are wealthier when the price level falls, which stimulates the demand for consumption goods. OR -Basically, when the price level rises, decreased wealth depresses consumer spending 2. The Price Level and Investment: The Interest-Rate Effect - 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 - Basically, interest rates fall, which stimulates the demand for investment goods. OR - Basically, higher interest rates depress investment spending 3. The Price Level and Net Exports: The Exchange-Rate Effect - When a fall in the US price level causes US interest rates to fall, the real value of the dollar declines in foreign exchange markets. This depreciation stimulates US net exports and thereby increases the quantity of goods and services demanded. Conversely, when the US price level rises and causes US interest rates to rise, the real value of the dollar increases, and this appreciation reduces US net exports and the quantity of goods and services demanded. - Basically, The currency depreciates, which stimulates the demand for net exports. OR - Basically, currency appreciation depresses net exports

Trade Deficit

When net exports are negative, exports are less than imports, indicating that the country sells fewer goods and services abroad than it buys from other countries. 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) Exports < Imports Net Exports < 0 Y < C + I + G Saving < Investment Net Capital Outflow < 0

Trade Surplus

When net exports are positive, exports are greater than imports, indicating that the country sells more goods and services abroad than it buys from other countries. 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) Exports > Imports Net Exports > 0 Y> C + I + G Saving > Investment Net Capital Outflow > 0

Why is it when price level is low interest rates are low?

When price level falls, households try to reduce their holdings of money by lending some of it out. As households try to convert some of their money into interest-earning assets, they drive down interest rates.

Stagflation

a period of falling output and rising price level - a combination of recession and inflation

What shifts the Aggregate Supply Curve (both long run and short run)?

any change in the economy that alters the natural level of output shifts the long-run aggregate supply curve. FOR LONG AND SHORT RUN AGGREGATE SUPPLY CURVE : 1. Shifts Arising from Changes in Labor - An increase in the quantity of labor available (perhaps due to a fall in the natural rate of unemployment) shifts the aggregate supply curve to the right. -A decrease in the quantity of labor available (perhaps due to a rise in the natural rate of unemployment) shifts the aggregate supply curve to the left 2. Shifts Arising from Changes in Capital - An increase in physical or human capital shifts the aggregate supply curve to the right -A decrease in physical or human capital shifts the aggregate supply curve to the left 3. Shifts Arising from Changes in Natural Resources - An increase in the availability of natural resources shifts the aggregate-supply curve to the right - A decrease in the availability of natural resources shifts the aggregate supply curve to the left 4. Shifts Arising from Changes in Technology - An advance in technological knowledge shifts the aggregate supply curve to the right - A decrease in the available technology (perhaps due to government regulation) shifts the aggregate supply curve to the left ONLY FOR SHORT RUN AGGREGATE SUPPLY CURVE : ***5. Shifts Arising from Changes in the Expected Price level - A decrease in the expected price level shifts the short-run aggregate-supply curve to the right - An increase in the expected price level shifts the short-run aggregate-supply curve to the left

What is the macroeconomic impact of a wave of pessimism on the aggregate demand and aggregate supply model?

because a wave of pessimism affects spending plans, it affects the aggregate demand curve. Because households and firms now want to buy a smaller quantity of goods and services for any given price level, the even reduces aggregate demand. This first two steps conclude that during a wave of pessimism, the aggregate demand curve shifts left. In the short run, the economy moves to a point where output and price level fall, suggesting the economy is in a recession. This results in firms responding with lower sales and production by reducing employment. Thus, the pessimism that caused the shift in aggregate demand is self fulfilling as : ==> Pessimism about the future leads to falling incomes and rising unemployment Over time, as the expected price level adjusts, the short run aggregate supply curve shifts to the right and the economy reaches point C, where the new aggregate demand curve crosses the long run aggregate supply curve. This is the economy correcting itself. In the long run, the price level falls and output returns to its natural level. ***Theoretically, as soon as the economy heads into a recession, policymakers could take action to increase aggregate demand. Because an increase in government spending or an increase in the money supply would increase the quantity of goods and services demanded at any price and therefore would shift the aggregate-demand curve to the right. If policymakers acted with sufficient speed and precision, they could offset the initial shift in aggregate demand, and return the economy to the natural level.

How Trade Policy Affects an Open Economy

trade policy is a government policy that directly influence the quantity of goods and services that a country exports or imports. Trade policy takes many 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 The initial impact of an important restriction is 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 Because the quota restricts the number of Japanese cars sold in the US, it reduces imports at any given real exchange rate, therefore increasing net exports. The increase in the demand for dollars causes the real exchange rate to appreciate. Because nothing has happened in the market for loanable funds here, there is no change in the real interest rate. Because there is no change in the real interest rate, there is no change in net capital outflow. Because there is no change in net capital outflow, there can be no change in ent exports, even though the import quota has reduced imports. The reason there is no change is because 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 next exports (exports - imports) are unchanged. Trade policies do not affect the trade balance ! - or : policies that directly influence exports or imports do not alter net exports/the trade balance because they do not alter national saving or domestic investment -The effects of trade policies are more microeconomic than macroeconomic