Ec102 Notes 17.1: - - - - 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 - 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 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: - - - - 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 - Factors that tend to make negative NCO: low saving rates, foreigners want to buy your assets 18.2: - - 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: - - - 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: - 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 - A macroeconomic model takes GDP and price level as a given - 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 - 19.2: - 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 - 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) - 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 - 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 - 20.1: - 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: - 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: - - 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 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: - - - 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: - 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 - 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: - - - - 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: - 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 - 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: - - 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: - 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: - 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 - 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: 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: - 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: - 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: - 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: - 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: - 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
