Ec102 Notes
17.1:
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As the quantity of money increases, prices rise, value of money decreases
The demand for money reflects how much wealth people want to hold in liquid form
The quantity of money demanded depends on the interest rate a person could earn
by using money to buy an interest-bearing bond rather than leaving it in his wallet or
low-interest checking account
Higher prices, lower money value, more money demanded
In the long run, money supply and demand are brought to equilibrium by overall level
of prices
Money supply held fixed by central bank
More money supply, less money demand, more quantity of money, less value of
money, higher prices
Quantity theory of money: a theory of 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
Surplus in money supply leads to people trying to spend it on goods and services, but
labour, physical capital, human capital, natural resources, technological knowledge
have not changed, hence production of goods and services is the same, prices
increase
Classical dichotomy: dividing into nominal variables (measured in monetary units) and
real variables (measured in physical units)
Dollar prices are nominal variables, relative prices are real variables
Monetary neutrality: the irrelevance of changes to money supply to real variables
Valid in the long run, not completely in short run
Velocity: rate at which money changes hands
Velocity of money is relatively stable over time
Quantity equation :
 Money x Velocity = Price level (GDP deflator) x Real GDP
When CB increases money supply rapidly, result is a high inflation rate
Inflation tax: the revenue raised by government when it creates money, like a tax on
everyone who holds money
Nominal interest rate = real interest rate + expected inflation rate
Fisher effect: the one-for-one adjustment of the nominal interest rate to the inflation
rate
17.2
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Inflation does not decrease purchasing power if wages and prices increase by same
proportion
Later adjustment of wages is what hurts
Costs of inflation:
 Shoeleather costs: the resources wasted when inflation causes people to
decrease their money holdings (time and effort making more trips to bank,
converting money into stable currency, stocking up on goods)
 Menu costs: cost of updating prices (resources wasted on frequent updates)
 Relative price variability: variation in relative prices due to inflation causes
markets to inefficiently allocate their resources
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Inflation-induced tax distortion: inflation increases the tax burden on savings and
income from capital gain. Income tax treats nominal interest earned by savings as
part of income, even though part of it merely covers for inflation, savings become
less attractive
Confusion and inconvenience: dollars at different times have different values,
more difficult to compare real revenues, costs, and profits over time
Arbitrary redistribution of wealth: loans in economy are specified in unit of account
which is money
18.1:
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Closed economy: does not interact with other economies in the world
Open economy: interacts freely with other economies in the world (buys and sells
goods and services: NX, buys and sells capital assets: NCO)
NX/ Net exports/ Trade balance: exports – imports
If positive, trade surplus. If negative, trade deficit
Exports: produced domestically, sold abroad
Imports: produced abroad, sold domestically
Factors affecting NX: consumer tastes for foreign and domestic goods, prices at
home and abroad, currency exchange rates, transportation costs, government
policies
Net capital outflow = purchase of foreign assets by domestics – purchase of
domestic assets by foreigners
When positive, capital is flowing out of country. When negative, capital is flowing in
Assets include stocks, bonds, houses, currencies…
Factors affecting NCO: real interest rates on foreign assets, real interest rates on
domestic assets, perceived economical + political risks of holding assets abroad,
government policies affecting foreign ownership of domestic assets
NX = NCO because every transaction affecting one side must also affect the other by
the same amount
When country has positive NX, it uses the foreign currency it receives to buy foreign
assets
When country has negative NX, it must be selling domestic assets to finance the
purchase of foreign goods
Saving and investment are equal only in a closed economy: S = I = (Y-T-C) + (T-G) =
private saving + public saving
In an open economy, saving = domestic investments + net capital outflow:
 (Y-T-C) = I + NX then S = I + NX then S = I + NCO
Factors that tend to make negative NX: uncompetitive business, excessive desire for
consumption
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Factors that tend to make negative NCO: low saving rates, foreigners want to buy
your assets
18.2:
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Nominal exchange rate: the price at which a person can trade the currency of one
country for the currency of another
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
Appreciation/depreciation: an increase/decrease in value of currency as measured by
amount of foreign currency it can buy
A depreciation in real exchange rate of a certain country means that country’s goods
ave become cheaper relative to foreign goods, increasing NX
18.3:
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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 every country (all real
exchange rates equal exactly 1)
Law of one price: good must sell for same price in all locations, otherwise, there
would be unexploited opportunity for profit
Cheaper prices will increase and expensive prices will decrease until prices are equal
The theory and the law imply that the nominal exchange rate is proportional to the
ratio of price levels (currency exchange rate reflects price levels in both countries)
CB doubles Turkish money supply: price levels increase, nominal exchange rate
depreciates to reflect changes in price levels
Arbitrage: taking advantage of price differences to make profit
PPP is limited: real exchange rate is not always equal to 1
 Many goods are not easily tracked
 Tradable goods are not always perfect substitutes
 Trade restrictions
These reasons provide low arbitrage
19.1:
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Positive NCO: capital sent overseas creates more demand for domestically generated
loanable funds (investment)
Negative NCO: capital brought in from overseas decreases demand for domestically
generated loanable funds
In open economy, loanable funds go towards investment and NCO
Increase in a country’s real interest rate reduces its NCO, domestics more likely to
keep their money in the country and foreigners are more likely to buy domestic assets
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A macroeconomic model takes GDP and price level as a given
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Lower real exchange rates leads to more net exports, in turn leading to more quantity
of dollars needed to pay for these exports
Real exchange rate increase leads to domestic goods being expensive, lower NX
At the equilibrium exchange rate, demand for dollars by foreigners to buy net exports
balances the supply of dollars by domestics coming from NCO
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19.2:
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19.3:
In the market for loanable funds, NCO is a source of demand, domestic must demand
a fund to buy foreign asset
In the market for foreign currency exchange, NCO is a source of supply, domestic
must supply dollars to exchange them so they can buy foreign asset
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Government deficit shifts supply of loanable funds left, drives real interest rate higher,
private savings increase, in turn reduces NCO, increasing real exchange rate
(appreciating currency)
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Trade policy: a government policy that directly influences the quantity of goods and
services a country imports and exports
 Tariff: tax on an imported good
 Import quota: limit on the quantity of goods produced abroad and sold
domestically
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When US government sets import quota, real exchange rate and in turn dollar
appreciates
NX and NCO do not change
Capital flight: a large and sudden reduction in the demand for assets located in a
country
When a country is deemed risky, funds are moved from it, NCO increases, demand
for loanable funds increases, interest rate increases, NCO increase causes supply of
domestic currency to increase, causing it to depreciate
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20.1:
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Recession: period of declining real incomes, investment, and rising unemployment.
Depression: severe recession
Economic fluctuations / business cycles are irregular and unpredictable
Most macroeconomic variables and quantities fluctuate together but in different
amounts
20.2:
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Long run variables do not affect real GDP while short run variables do
The model of aggregate demand and aggregate supply is what economists use to
explain short-run fluctuations around long-run trend
aggregate demand: quantity of goods and services that households, firms, the
government, and customers abroad want to buy
aggregate supply: quantity of goods and services that firms choose to produce
aggregate supply-demand curves show those quantities at each price level,
equilibrium output, equilibrium price level
20.3:
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decrease in economy’s price level leads to increase in goods and services demanded
theories on why aggregate demand curve slopes downwards:
 Wealth effect: increase in price levels makes people feel poorer, consumption
goes down, GDP goes down
 Interest rate effect: a lower price level decreases interest rate, encourages
spending on investment, increases goods and services demanded. Higher prices,
higher interest, lower investment, GDP goes down
 Exchange rate effect: higher prices, higher interest rate, currency appreciation,
less NX and NCO, GDP goes down
Why demand curve might shift:
 Less consumption: shift left. Policy variable: taxes. Less taxes: more consumption
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More investment: higher demand, shift right. Policy variable: money supply. More
money supply, lower short run interest rates, more investment
More government spending: more demand, shift right
Less net exports: lower demand, shift left
20.4:
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In the long run, economy’s production of goods and services depends on physical
and human capital, labour, natural resources, technological advancements, not on
nominal price level
Price level is GDP deflator
Long run aggregate supply curve is vertical because price level does not affect long
run determinants
Long run aggregate supply curve is vertical at natural rate of output (this represents
classical dichotomy and monetary neutrality)
The natural rate of output is the production level of goods and services an economy
reaches in the long run when its unemployment is at its normal rate
An increase in any of physical and human capital, labour, natural resources,
technological advancements, shifts the aggregate supply curve right
Short run aggregate supply curve is upwards sloping. Why?
 Sticky wage theory: firm agrees with workers on a wage for a couple years,
inflation happens (higher price level), workers receiving lower real wage, costs of
production down, firm can hire more labour and produce more, supplies more
 Sticky price theory: not all prices adjust to inflation, low relative prices attract
customers, firms need to produce more
 Misperceptions theory: price level increasing unexpectedly leads suppliers to
believe it’s an increase in the relative price of their products, they supply more
These theories suggest that output deviates from natural rate when nominal price
levels deviate from expected price levels
In long run, technology shifts supply right, growth in money shifts demand right,
increasing output and prices, ongoing inflation
20.5:
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A shock to equilibrium for demand occurs when companies and individuals become
pessimistic about the future
When investment falls, demand shifts left
In the short run: output falls, price level falls, recession
In the long run: people will correct the three theories, short run aggregate supply
shifts right, output eventually returns to long run supply, original level of production
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Government implements policies to shift aggregate demand back right sooner
Fiscal policy: increasing government spending increases aggregate demand
Monetary policy: increasing the money supply decreases interest rates which
increases demand for loanable funds
Decrease in stocks or exports leads to decrease in wealth, decrease in demand,
lower price levels in short run
Shocks to equilibrium for supply occurs when firms experience an unexpected and
temporary increase in cost of production
Supply curve shifts left
In the short run, output and price levels rise, stagflation and inflation
21.1:
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Wealth effect, interest rate effect and exchange-rate effect all explain why
aggregate demand curve shifts downwards, but interest rate effect has greatest
importance
Exchange-rate effect has more prevalence in smaller countries where NX and
NCO make up larger fraction of GDP
When prices are up, demand for money is up, interest rates are up, investment
and consumption down
Theory of liquidity preference: the interest rate adjusts to bring money supply and
money demand into balance
In short run, expected inflation is stable, so nominal and real interest rates differ
by same amount
Fed controls money supply by buying and selling government bonds
Fed also increases/decreases discount rate to discourage/encourage banks from
borrowing, decreasing/increasing bank reserves decreases/increases money
supply
Fed can also change reserve requirements and interest rate it pays banks on
reserves they hold
Since money supply is controlled and fixed by Fed, money supply graph is a
vertical line
Liquidity of an asset: the ease by which it can be converted to economy’s medium
of exchange
Holding money has an opportunity cost of losing interest of other forms of assets,
therefore when interest rate decreases demand for money increases
At the equilibrium interest rate, money supplied = money demanded
Higher prices lead to more money demanded, more money demanded
raises interest rates, higher interest rates reduces aggregate demand of
goods and services
When fed increases money supply, they decrease interest rates, increasing
investment and aggregate demand
Central bank raising money supply = central bank decreasing interest rates
CB chooses to shift AD to return output to its natural rate: output less, AD right,
interest rate down and vice versa
20.2:
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Fiscal policy: setting of levels of government spending and taxation by government
policy makers
In the short run, fiscal policy changes shift the aggregate demand curve directly
without the need to influence firms or households
In the long run, it influences saving, investment, and growth
Increasing gov spending increases output/GDP, shifts aggregate demand right and
vice versa
The size of impact of government spending on GDP could be larger due to multiplier
effect or smaller due to crowding out effect
multiplier effect: additional shifts in aggregate demand when expansionary fiscal
policy increases income and thereby consumer spending
investment accelerator: positive feedback from demand to investment
marginal propensity to consume (mpc): for every dollar I earn, I save 75 cents if mpc
=¾
multiplier = 1 / (1 – MPC)
crowding out effect: the offset in aggregate demand when expansionary fiscal policy
raises interest rate thereby reducing spending
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Increase in government spending, more aggregate demand (shifts right) and also
more money demand, increase in eqb interest rate, AD shifts left
This partly offsets original right shift of AD
Crowding out increases MPC
21.3:
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Should the government try to intervene in short run fluctuations?
Delays: by the time firms adjust to shift in AD after implemented laws, crisis is already
over
Automatic stabilizers: changes in fiscal policy that stimulate aggregate demand during
a recession but occur without policymaker intervention:
 People lose jobs, government pays unemployment insurance, stimulates
spending
 Output falls, taxes also fall
Ricardian equivalence: any action taken by policymakers will be counteracted by
rational individuals.
22.1:
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Phillips curve: shows short run trade-off between inflation and unemployment
In 1958, AW Phillips
In short run, negative relation between inflation and unemployment
In long run, no relation
In short run, more aggregate demand, more output, more employment but higher
prices (positive demand shock)
22.2:
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Since monetary growth has no effect on real/long run outputs or employment rates, in
the long run, there is no link between inflation and unemployment
Long run Phillips curve is then vertical
In short run, expansionary policy moves economy up SRPC, increasing inflation
But in long run, expected inflation then rises, shifting SRPC right
Monetary policy cannot influence natural rate of unemployment
Policies improving labour market functionality can
22.3:
22.4:
Supply shock: event that directly alters firms’ costs and prices, shifts SRAS and
SRPC
Short run negative supply shock raises prices, decreases output, shifts Phillip curve
right, giving policymakers less favourable inflation vs unemployment tradeoff
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Reducing inflation comes at a cost of increasing unemployment in short run
However, if short run aggregate supply shifts accordingly to the left, and people
adjust their inflation expectations to lower inflation, can be reduced without a cost
Sacrifice ratio: number of percentage points of annual output lost in process of
reducing inflation by one point
Favourable SRAS shocks: SRAS shifts right, SRPC shifts left
23.1:
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Should government/policymakers try to stabilize the economy?
 Pro: economics fluctuate when left on their own
 Pro: pessimism of households and firms causes decline in investment, production,
GDP, rise in unemployment
 Pro: monetary and fiscal policy can be used to stabilize economy
 Con: fiscal policy implementation takes time
 Con: monetary policy implementation is fast but its effects take time to show, if
effects too late, fluctuations worsen
 Con: shocks are difficult to predict
23.2:
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Should the government fight recessions with spending hikes rather than tax cuts
(since both shift aggregate demand right)?
 G: government spending is more potent, more money from tax cuts may be saved
by households than spent
 G: government projects can increase employment
 G: more money is spent on jobless, who will spend all of their income
 T: tax cuts can be specific, like could specifically encourage investment which is
most volatile component of AD
 T: lower taxes, more incentive to work, more AS
 T: tax cuts decentralize spending decisions
23.3:
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Should monetary policy be made by rule or discretion? (example of a rule is inflation
targeting)
 Rule: incompetence or abuse by central bankers
 Rule: if time discrepancy of policy occurs, lower public trust in CB, higher inflation
 Discretion: discretion allows flexibility to react to difficult to predict events
 Discretion: political abuse and time inconsistencies are not that relevant in
practice
23.4:
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Should central bank aim for 0 inflation?
 Pro: costs of inflation (shoe leather, menu) quite substantial
 Pro: temporarily higher unemployment, permanent benefits
 Con: disinflation by 1% could cost GDP decrease by 5%
 Con: fall in investment, unemployment for a while could diminish worker skills
 Con: some inflation allows negative real interest rates, lower real wages without
lower nominal wages
23.5:
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Should government balance its budget:
 Pro: debt burdens future generations
 Pro: deficit leads to lower national saving, lower investment, higher interest, lower
growth
 Against: debt/gdp is more relevant than debt itself, burden of debt is exaggerated
 Against: cutting deficit means cutting education, reducing taxes reduces work
incentive
23.6:
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Should the government tax income or consumption?
 Consumption: income is already highly taxed, sometimes twice as personal and
corporate
 Consumption: more saving, more capital accumulation, more productivity
 Income: people may not save more with higher rates of return, due to income
effect(working less), and substitution effect(working more)
 Income: wealthier people can save more and would get the most relief when they
need it least, less wealthy consume more, are worst off