Circular Flow Diagram

Flow of money

1)      hhlds spend $$$ (on goods & services)

2)      firms generate revenues and pay wages, rent, profit for use of FOP

3)      translates into income for households

Flow of FOP as well as goods and services

1)      hhlds provide FOP to and are hired by firms

2)      firms sell goods & services

3)      goods & services purchased by hhlds

Circular Flow Diagram

Production Possibilities Frontier (PPF)

Graph that depicts combinations of output that an economy can produce given: (1) available resources (FOP) and (2) technology.

Illustrates economic concepts of:

•            tradeoffs

•            opportunity cost

•            efficiency

•            economic growth*

Production Possibilities Frontier (PPF)

A, B, and C all represent the most efficient allocation of resources for the economy

Point X means that the country's resources are not being used efficiently 

- country is not producing enough cotton or wine given the potential of its resources 

Point Y represents an output level that is currently unreachable by this economy

- Change in technology

-new curve would represent the new efficient allocation of resources.  

Characteristics of Free Trade

With trade...

1)      Involvement is voluntary

2)      Parties are self-motivated (no intention to make others better off)

3)      Both parties gain (made “better off”)

Specialization

Comparative advantage implies there are gains to be had from trade (GFT)

•          Further, suggests specialization is appropriate.

Specialization: focus majority of resources on 1 good

•          don’t necessarily produce same bundle as whatconsume

•          complete specialization possible but rare

Absolute Advantages

•          based on productivity

Spain à  AA in Olive oil

Greece à AA in Cheese

Note: Producer can have AA in one, both, or neither good(s), but CA only in 1 good

The Gains From Trade

[  Consumption w/Trade  >  Autarky consumption  ]

Sources of extra Olive oil & Cheese...

1. “Vive la difference”: every difference creates oppty for trade and oppty to get “richer”
2. Specialize in what you’re better at producing (CA), i.e. low-cost

–        necessary but not sufficient!!!...

1. Must trade, otherwise won’t specialize

–        trade allows to reach preferred consumption bundle

1. Get more when specialize and trade w/o working harder

Production v. Consumption Possibilities

Production Possibilities (PP)

•          combo.s of output that an individual/firm/economy can produce (given available resources—i.e., FOP—and technology).

Consumption Possibilities (CP)

•          combo.s of output that an individual/firm/economy can consume (given available FOP and technology).

Systems of Production:

1. Autarky = self-sufficiency; consume only what you produce, somewhere on your PPF (PP = CP)
2. Trade = interdependent; can consume more than what you would have produced alone, beyond your PPF (CP > PP)

Absolute v. Comparative Advantage

Q: When we decide to trade, how do we know what to specialize in (e.g. what to export, and for that matter, what to import)?

Absolute advantage: comparison of producers based on their level of productivity

•          a producer is said to have an absolute advantage if s/he can produce (in total) more of a good than another producer, w/in the same amount of time

Comparative advantage: comparison of producers based on their opportunity costs of production (on efficiency)      

•          A producer has a comparative advantage if s/he has a lower opportunity cost of production, i.e. gives up less production of good B to produce good A.

Types of Markets

1.       Perfectly Competitive market:

-           many buyers and many sellers.

-          e.g., agricultural markets, retail services, stock market

-           Therefore NO single buyer(s) or seller(s) has control over market price.

2.       Monopoly market:

-          Many buyers

-         only one firm producing a given product

-          e.g., public utilities (cable), small town (gas or food stores)

-          As a result, the firm has market power or control over market price.

3.       Oligopolies:

-           fall somewhere in between in terms of the number of firms as well as their control over market price, i.e. they have some market power

-          e.g., manufacturing (steel, auto), pharmaceuticals, cereal, beverages (soft drinks, beer)

o   Cartels (a cooperative form of oligopoly) fall into this category.

§  e.g. diamonds (DeBeers), oil (OPEC)

Shifters of Demand

1. Changes in Income (depends on whether good is normal or inferior)

Normal goods (e.g. wine, luxury cars, designer clothes)

•          are those for which an increase (decrease) in income raises (lowers) demand

•          (+) relation between income and demand

Inferior goods (e.g. cheap beer, Ramen noodles)

•          are those for which an increase (decrease) in income lowers (raises) demand

•          (-) relation between income and demand

1. Changes in the Price of Related Goods (depends on whether good under comparison is a substitute or a complement)

Substitute goods (e.g. beer and wine, pretzels and chips)

•          are those for which a rise (fall) in the price of one good raises (lowers) demand for the related good

•          (+) relation between the price of one good and the demand for the other

Complementary goods (e.g. PB&J, hot dogs and hot dog buns)

•          are those for which a rise (fall) in the price of one good lowers (raises) the demand for the related good

•          (-) relation between the price of one good and the demand for the other

3.  Changes in Tastes and Preferences (all other factors that impact demand—other than the own-price of the good, changes in income, and changes in the prices of related goods)

·         EX. reputed physicians confirm that eating dark chocolate will boost your life expectancy (+)

4.       Changes in Expectations

·         e.g., if you expect goods to be cheaper in the future, you may reduce your demand for those goods now

1. Change in the Number of Buyers (Consumers)

*changes in Demand SHIFT the entire demand curve

1. Changes in Input prices

•          e.g. changes in the cost of materials, wages paid to labor, rent paid on land, buildings, and machinery

•          market for pencils: the price of graphite falls (+)

•          market for tomatoes: the price of fertiziler rises (-)

1. Changes in Production Technology

•          e.g. invention of a new process that raises

        productivity (+)

1. Any other changes that could limit or boost production

•          market for Oil: new oil fields come on-line (+)

•          market for Oranges: cold snap in FL (-)

•          Change in the Number of Sellers (Producers)

4. Changes in Expectations

•          e.g., if producers expect the price of their good to rise next week, then they will hold back on production now

*changes in Supply SHIFT the entire supply curve

Market Equilibrium

1)      Where the value of a good (or service) to consumers is equal to the cost of production for producers

2)      Where Qs = Qd

3)      No tendency to want to move fm this point!

note: P*, Q* are the equilibrium market price and quantity prevailing in a competitive market

The market in Disequilibrium:

P > P*  à  Qs > Qd  (surplus)

P < P*  à  Qd > Qs  (shortage)

CPI and the inflation rate (be able to calculate)

Inflation (Π) demonstrates how fast prices for consumersare rising

•          the rate of inflation is percentage change in CPI (or prices)

•          expressed as a %

Π rate = [ (CPI₁₉₈₀ – CPI₁₉₅₀) / CPI₁₉₅₀ ] * 100%

CPI problems associated with fixed consumer basket (substitution bias / intro. new goods / quality changes)

1. Does not account for consumer substitution toward relatively cheaper goods over time

•          e.g., switch to cheaper soda from coffee, but quantities of goods in basket are fixed

1. Does not account for introduction of new goods

•          can choose b/w goods in and out of basket, but what’s included in basket overall is fixed

•          e.g., more goods à value of $ greater (raises purchasing power), can buy more things with same money

3             3.   Does not account for quality changes of goods and services

•          e.g., better quality à get more for your money

If counted, all of the above would lower the COL, but they are NOT… Thus CPI can overstate true inflation

Comparison with GDP Deflator

GDP deflator (G.D.) measures the average level of prices in the economy but differs from CPI:

•          G.D. includes all goods and services produced rather than consumed (CPI) and thus excludes imported goods

•          G.D. automatically changes group of goods and services over time as composition of GDP changes. CPI is consistent

Correcting for Inflation

Inflate 1985 salary…

                ( CPI₂₀₁₀ / CPI₁₉₈₅ ) x salary ₁₉₈₅

                ( 218 / 108 ) x $20,000 = $40,370

Between 1985 and 2010 prices nearly doubled (rose by a factor of two) and the value of your dad’s 1985 salary in 2010 would be $40,370.

What was the rate of inflation (from 1985 to 2010)?

                [ (218 – 108) / 108 ] x 100% ~ 102 percent

Interest rates (nominal vs. real) bond rates (corporate and government)

Nominal rate of interest (i)                          i = r + Π

•          usually reported (e.g. earn on savings accounts, pay on credit cards)

•          includes inflation rate

•          can change due to changes in r or Π

•          rate at which number of $s in account increases over time

Real rate of interest (r)                  r = i – Π

•          excludes inflation rate

•          based on the level of savings and investment in an economy

•          accounts for changes in value of the $

Corporate Bonds

•          i_c = r +Π + ρ*                  (entail risk)

Government Bonds   (ρ = 0)        (no risk)

•          non-indexed:    i_n = r        (short-term)

•          indexed:          i_i = r +Π      (longer-term)

* ρ = default / risk premium

Factors of production (K, L, H, N, A)

1. Natural Resources (N)

–      inputs provided by nature (e.g., land, wind, solar, water)

1. Labor (L)

–      workers

1. Physical Capital (K)

–      stock of equipment and structures (e.g., machines, tools)

1. Human Capital (H)

–      worker knowledge and skills acquired thrutraining and education

1. Technology (A)

–      understanding of how to most efficientlyproduce goods (e.g., Henry Ford invents assembly-line process)

Productivity and economic growth (relation to real GDP)

·      Similarly, it is important to note that the growth rate of the economy (an indicator of how productive an economy is) is measured as the growth rate or % change in specifically real GDP.

• When we calculate the growth rate of the economy it tells us whether we are being more/less productive(producing more or less) over time
• A productive economy--one that is producing and selling more g&s--is an indicator of economic growth
• As the economy grows it means that it is generating ahigher level of income (remember GDP is a measure of an economy’s income and expenditures) and we enjoy a higher standard of living

 Savings and Investment (S = I in closed economy)

(Solve for) Investment…

I = Y – C – G

I = total income – consumption - gov’t purchases

I = national savings

I = S

*(for a closed economy, investment is equal to savings)*

We can break down national savings (S)…

I = S = private savings + public savings

Public (federal budget) vs. private saving… calculate

I = S = (Y – T – C) + (T – G)

Private savings : Y – T – C

•          total income left after taxes and expenditures on consumption

Public savings : T – G

•          tax revenues to the government net of government purchases

•          More on public savings and the budget (next slide)

Budget surplus : T > G                   

•          gov’t generates more in revenues than it spends

•          c.p., as public savings (rises) à S (rises)

Budget deficit : T < G

•          gov’t spends more than it obtains in tax revenues

•          c.p., as public savings (falls) à S (falls)

Balanced budget : T = G

•          gov’t breaks even in terms of revenues and expenditures

•          c. p., if public savings (remains constant) à S (no change)

Financial system

·         savers channel funds to borrowers so that they can invest (in physical capital)

·         Matters because it encourages savings and investmentas a government policy aimed at raising inputs, thereby promoting economic growth.

Stock Markets 

New York Stock Exchange (orig. 1792)

•          lists close to 2,800 companies

•          listed companies are among the world’s best and range from “blue-chip” companies, to world-leaders in technology, to young, high-growth enterprises

•          Blue chip: stock of a large, national company with a solid record of stable earnings and/or dividend growth and a reputation for high quality management and/or products. More generally, anything of very high quality. (http://www.investorwords.com/505/Blue_Chip.html)

American Stock Exchange (est’d 1921)

•          lists over 700 companies

•          bulk of trading consists of index options (computer technology index, institutional index, major market index) and shares of small to medium-size companies is predominant

•          1998 merger between the NASD and the AMEX resulted in the Nasdaq-Amex Market Group (oversees both NASDAQ and AMEX but still operate as separate markets)

National Association of Securities Dealers Automated Quotations (est’d 1971)

•          largest U.S. electronic stock market (approx. 3,300companies)

•          it lists more companies and, on average, trades more shares per day than any other U.S. market

•          home to category-defining co.s that are leaders across all areas of business including technology, retail, communications, financial services, transportation, media and biotechnology.

•          carries securities for newer and smaller companies

Loanable funds market (6 cases)

…effects of changes in policies toward interest income & corporate tax breaks

Loanable funds market (6 cases)

Case 1: Taxes and effect on Savings

1. taxes on interest income rise

•          lowers incentive to save, S_LF or S (falls)

2.       “ r ”  rises (otherwise have a shortage of funds in the market)

•          lowers incentive to borrow, quantity funds borrowed (for investment) drops

Case 2: Taxes and effect on Investment

1. corporate tax break increases

•          raises incentive to borrow, D_LF or I (rises)

2.       “ r ”  rises (otherwise have a shortage of funds in the market)

•          raises incentive to save, quantity funds saved increases

Case 3: State of the Federal Budget

–        note: affects only the S_LF through public savings, b/c this is what we use to measure the budget

Deficit : government is dissaving, S_LF or S (falls)

1. r (rises), otherwise have a shortage of funds in the market

•          lowers incentive to borrow, quantity funds borrowed (for investment) drops

Surplus : government is saving more, S_LF or S (rises)

1. r (falls), otherwise have a surplus of funds in market

•          raises incentive to borrow, quantity funds borrowed (for investment) increases 

Identify (3) types of UE

Frictional Unemployment

Unemployment that is always present, resulting fromtemporary transitions made by workers.

Tends to be shorter term on an individual level.

e.g., normal labor turnover (people moving between jobs, careers, locations)

Structural Unemployment

Unemployment resulting from major changes in the basic composition of the economy. Tends to have long termconsequences (and is more painful than frictional UE).

e.g., Evolution from an industrial to technological based economy…

•          mid-20^th century, US textile companies discover cheaper labor South of the Border (US textile workers out of luck)

•          introduction of computers eliminates many jobs

Cyclical Unemployment

Unemployment that varies with the business cycle--particularly economic downturns.

•          Occurs due to inadequate demand for goods and services. Low (C) and/or (I) and/or (G)

…or possibly a severe (-) production shock

e.g. economy-wide shock: we experience a recession (decline in economic activity... on average, production and incomes are falling) which         results in layoffs and cutbacks

Responsible for actual UE deviating from its natural rate

CPS categories when gathering data for UE stats

Employed:

•          includes only “adult” population (age 16 and older)

•          those who have worked some of previous workweek at a paid job (exception: unpaid work in family business)

•          considered part of the labor force

Unemployed:

•          without a job… but searching and available for employment (within the last month; otherwise considered “marginally attached” or “discouraged”, see slide 15)

e.g. temporarily laid off or waiting to start new job

•          considered part of the labor force

Not in Labor Force:

NILF: neither employed nor unemployed

•          have taken themselves out of the labor market for various reasons…

e.g. homemakers, retirees, full-time students, active duty military, institutionalized (nursing homes & prisons) 

Special cases of marginally attached and discouraged workers

•          Marginally attached: not looking but would like to work & available (worked or looked sometime in the last year, but more than month ago)

–        A subset of this group is…

•          Discouraged workers: not looking because…

–        Nothing available in line of work

–        Lack necessary human capital

–        Discriminatory reasons

–        Just plain old couldn’t find a darn thing

Q: Should they be counted as UE rather than NILF?

–        If so, then NILF is overstated & UE is significantly understated

UE stats: LF, LFPR, UE rate (be able to calculate)

LF = employed + unemployed

Labor Force Participation Rate: proportion of the adultpopulation that is part of the labor force

LFPR = ( LF / Pop. ) * 100 = %

Unemployment Rate: proportion of the labor force that isunemployed

UE rate = ( UE / LF ) * 100 = %

Underemployment and U-3 vs. U-6

•          U-3 is the “official” UE rate (8.8%) and includes…

–        Total UE as percent of civilian labor force

–        U-4 also includes discouraged workers (9.4%)

•          U-5 also includes remaining marginally attached (10.3%)

•          U-6 also includes the underemployed (15.7%)

Job creation (# jobs necessary per month)

Even in good times, approximately 150,000 jobs must be created each month simply to keep up with population growth

–        Various government economists estimated that in January 2011 about 145,000 jobs would be created

–        However, only 36,000 new jobs were added

Things that worsen UE

Wages paid above the market equilibrium (wage) in the labor market result in UE, or a surplus of workers...

Minimum wage laws (labor market)

•          a price control (i.e., price floor) that raises UE

2.     

Unions

•          collective bargaining: unions w/ firms re:wages and conditions

•          raises the cost of labor (w) above what it would be in a perfectly competitive labor market (10-20% higher on avg.)

•          balances market power of firms but raises UE

3.       

Efficiency Wage Theory

•          some firms pay above market wage to gainbetter quality workers and promote greater productivity

Implications of minimum wage (+/-)

Pros...   (social benefits)

•          reduces exploitation (e.g., from monopsonies)

•          allows people to afford basic necessities

•          could raise consumption and thus demand for g&s, increasing employment over longer term

Cons...

•          raises UE among low wage (less skilled) workers (e.g., teenagers)

•          higher “input” prices (i.e., wages) causes inflation and slows economic growth

Things that help to reduce UE

Gov’t Policies that help to lessen UE over time…

            UE insurance (or benefits)

–        protects workers’ incomes so they can spend time searching for a job and get back to work sooner

Employment agencies

–        helps with “job search”, matching a worker’s particular skills to the “right” job

Public training programs

–        helps workers to learn new skills

How Monetary System evolved …and why?

Barter: direct exchange of g&s

–        requires coincidence of wants

Commodity Money: intermediate good with intrinsic valueused in transactions

–        e.g. sea shells, boulders...

Fiat Money: intermediate item used in transactions lacking market value in other uses

–        faith in legal tender

–        fiduciary monetary system

* Trend… to simplify and thus increase volume of transactions *

·        

(3) Basic Functions of money (those things that are not considered money …and why?)

To be called “money” an asset needs to fulfill all three functions…

  Medium of Exchange

–        readily acceptable as final payment in exchange for g&s

2.       

Unit of Account

–        common measure of relative value of g&s

–        can vary according to country (e.g., $, euro, peso)

3.       

Store of Value

–        not perishable (i.e., apples wouldn’t work!)

–        although can deteriorate due to inflation

DEBIT AND CREDIT CARDS AND CHECKS not considered money

Money is the most liquid asset

•          immediately available to spend in exchange for g&s (without additional expense)

More liquid than (from least to most)…

•          real estate; stocks & bonds; jewelry; gold; [associated w/brokerage fees, time delays, etc.]

Monetary Aggregates, i.e., official measures of the money supply (and how related to one another)

Monetary aggregates (official measures)…

M0: Physical Currency (the “monetary base”)

–        currency (C): paper bills and coins in the hands of the public

M1: Currency + Deposits (therefore includes M0) $1.6 trillion

–        deposits (D): checkable deposits that can be converted to currency “on demand”

–        traveler’s checks also included (but miniscule)

M2: includes M1 + savings and time deposits (cds), money market and retirement accounts, etc.

Background and purpose of the Fed

The U.S. central bank...Federal Reserve

–        According to the U.S. Constitution (Article I, Section 8), Congress has the power “to coin money” and “regulate the value thereof.” However, the Fed was est. in 1913

–        Private entity; operates independent of the government

Its purpose...

    “Lender of Last Resort”

–        Established to ensure liquidity and to help maintain solvency

Performs Monetary Policy

–        Monopoly on money creation

–        Supervises and regulates (sets standards for) member banks

liquid: bank has enough money on hand to meet the demands of its depositors

solvent: assets at least cover liabilities (insolvent suggests that a bank is “bankrupt”)

 Fed organization, details of… and who’s responsible for what (slides 12-16 in ch11 pwpt lecture)

FED ORGANIZATION

1. Board of Governors

Chairman Bernanke

1)      Presides over board meetings

2)      Directs Fed staff

3)      Testifies about Fed policy to Congress

Governors

–        7 members appt’d by Pres. and confirmed by Senate

–        14-year terms (except chairman… 4-yearterm)

–        oversee district banks

Functions: set reserve requirements & approvediscount rates

1. Federal Reserve District Banks

o   12 district banks (mostly eastern part of US)

o   Presidents chosen by regional bank board (from local banking / business community)

Functions: propose discount rates, provide currency,hold reserve balances and lend @ discount window, clear checks

1. Federal Open Market Committee

o   Includes 7 BOG members + regional bankpresidents

o   Only 5 bank presidents vote (rotating basis)

o   President of NY Fed is always a voting member

Functions: makes monetary policy & in charge of open market operations (OMOs)

1. Depository Institutions

Examples…

•          Commercial banks

–        about 1/3 of which are members of the Federal Reserve System

•          Credit Unions

–        Savings and Loan Institutions

How Fractional Reserve Banking system functions… reserve requirements (RR) and money creation through loans

All banks required to hold fraction of deposits as reserves(not loanable)

reserve ratio (RR): portion of deposits held in reserve (bank vault or with Fed)

money multiplier (MM): factor by which money supply expands for each dollar held in reserve

–        inversely (-) related to reserve ratio à MM = 1 / RR

Important: (initial deposit * MM) = total money “created”

                                                                     (including initial deposit)

·         Determine level of money created given initial deposit and RR, used to find money multiplier (MM) 

Q1: Given a RR of 10 percent and an initial deposit of$100, how much money was created via the fractional reserve banking system?

• MM = 1/RR = 1/.10 = 10
• (initial deposit * MM) = amount of money created
• $100 * 10 = $1000

(3) Monetary Policy Tools of the Fed (what they are, how they are used, and relative likelihood of use)

Target the Federal Funds Rate (FFR) via Open Market Operations (OMOs)         

–        FFR applies when banks borrow money from ea. other

–        OMPurchase or OMSale of U.S. government bonds

–        Target the federal funds rate (FFR)

–        Most frequently used tool

Discount Rate (DR)

–        Applies when banks borrow money from the Fed

–        Usually 1 bp or basis point (i.e., 1 percent) higher than FFR

3.     

  Reserve requirements (RR)

–        Regulated min. amount of reserves that banks must hold

CASES

                                I.            Targeting a lower FFR…

–        Assume that the current FFR* is 5% and the target is 2%

Q: What should the Fed do? Expand the money supply

–        creates surplus of money at current FFR*

–        Banks eliminate surplus by cutting FFR (to stimulate borrowing)

Options…

•          OMP:                    purchase bonds

•          Lower DR:            cheaper to borrow from Fed

•          Lower RR:            banks have more money to loan

II.            Objective is to maintain target FFR given unexpected decrease in demand for money…

–        creates surplus of money at current FFR*

M.P. Responses (contract the money supply)

•          OMS:                     sell bonds

•          Raise DR:             discourages borrowing from the Fed

•          Raise RR:             banks have less money to loan

Variables beyond Fed’s control …how Excess Reserves and Currency (vs. Deposits) also affect the money supply (M)

Things the Fed can’t control (that can affect M)...

1. Amount of money households choose to hold as currency v. deposits (in banks)

•       The more held as currency, the less money “created”

1. Amount of excess reserves banks hold

•       The more held in reserve, the less loaned out and the less money “created”

Difference btw Inflation, Deflation, Hyperinflation

Inflation

·         the price level rises while the value of money falls

·         [ U.S. since 1945, 1970s, 1990s ]

·         continued rise in overall P-level

Deflation

·         the price level falls

·         [ late 1800s (Ind. Rev. 1750 – 1830) ]

·         continued decline in overall P-level

Hyperinflation

·         the price level rises dramatically, more than 50% a month

·         [ Germany, 1923 (post WWI 1914-18) ]

[ NIS after fall of Soviet Union (1990s) ]

Relation btw P-level and Value of Money (VOM)

The value of money is inversely related to the overall P-level in the economy..

·         consumers require more money to buy sameamount of goods and services

·         value of $$$ = 1 / P

Understand that Quantity Theory of Money allows us to quantify (assign values to) the changes we see in the money market diagram (and therefore is related)

(1) How P-level determined.

•         due to changes in M

(2) Why P-level changes over time...

•         growth in M leads to growth in P-level (inflation)

Why does M*V = P*Q?

M * V

·         The amount of money in circulation and how quickly it changes hands (due to transactions) must

Equals

P * Q

·         The level of expenditures (or income generated) in the economy

What is the assumption of “Monetary Neutrality”? …and why is it important?

changes in M à only nominal NOT real variables

(i.e., money is “neutral”)

Be able to identify some of the real costs to society of inflation (e.g., shoeleather, …etc.)

Shoeleather costs

·         the resources wasted when inflation encourages people to reduce their money holdings. (keep money in bank to accrue interest)

Menu costs

·         the costs of price adjustments. The cost of deciding on new prices, the cost of printing new price lists, the cost of sending the new prices out…

Relative-price variability and the misallocation of resources

·         when inflation distorts relative prices, consumer decisions are distorted, and markets are less able to allocate resources to their best use.

Inflation-induced tax distortions

·         inflation tends to raise the tax burden  on income earned from savings

Confusion and inconvenience

·         because inflation causes dollars at different times to have different real values it is difficult to compute a firm’s…

Arbitrary redistributions of wealth

·         unexpected changes in prices redistribute wealth among debtors and creditors

What is an inflation tax and how does it work?

·         an indirect tax, it is like a tax on everyone who holds money. No one receives a bill for inflation tax

·         gov’t prints money à M rises à P-level rises àΠ

How it’s possible to get into a hyperinflationary situation

•         a common cause is the result of government attempting to raise money to cover G.

•          (1) borrow, (2) tax, or (3) print money

Fisher Effect (how does inflation affect nominal interest rates?)

·         adjustment of the nominal interest rate to the inflation rate

·         Nominal interest rate = real interest rate + inflation rate ( I = r + π )

 When the P-level rises (i.e. there is Π)

·         nominal interest rate, “i” rises by same amount (1:1)

·         no effect on r

When the Fed increases the rate of money growth

·          the long-run result is both a higher inflation rate and a higher nominal interest rate

Which group benefits when expected is greater than actual inflation (and vice-versa)? 

Creditor-buyer

Debtor- seller

Inflation actual < inflation expected

·         Creditor benefits, knows they’re going to get money

·         Debtors overestimates,

Open vs. Closed economy 

Closed economy...         (no interaction w/ROW*)

•         unemployment

•         inflation

Open economy...           (interacts w/ROW)

•         ex/imports

•         trade balance

•         exchange rates

Different measures of the trade balance (NX), e.g. surplus, …etc.

Nix closed economy assumption (NX=0) such that...

Y = C + I + G + NX

Given: Net Exports = (X – M)...     [ Trade Balance ]

1. If NX > 0 or (+) à       X > M   trade surplus
2. If NX < 0 or (-)  à       X < M   trade deficit
3. If NX = 0           à       X = M   balanced trade

(6) factors that can affect the trade balance (NX) …including particularly, gov’t restrictions on trade (what is a quota, tariff, embargo?)

1. Relative prices (P_d v. P_f)

–        P_d falls relative to P_f : M / X more goods?

2.      Relative incomes

–        Incomes relatively higher in U.S. : more likely to M / X more?

1. Exchange rates

–        Nominal and real

1. Transportation costs

–        The higher they are...

–        Also, can affect who trade partners are

5.      Tastes and preferences

–        e.g., champagne (France) v. sparkling wine (U.S.)

6.      Government policies re: international trade

–        Restrictions lessen trade (e.g., quotas, tariffs, all-out embargo)

Nominal or currency (F/$) vs. Real exchange (G_F/G_D) rates …also, what it means to Appreciate vs. Depreciate

Nominal rate...

•         “currency rate of exchange”

•         rate can trade currency of one country for another

            (F / $1)

 Real rate...

•         “rate of exchange of physical goods”

•         rate can trade goods and services of one country for another

units of forn good / unit of dom good or ( G_F / G_D )

Appreciation: one unit of a currency now trades for agreater number of units of another currency

–        $1 buys more euro      ($ gained value;strengthened)

Depreciation: one unit of a currency now trades for fewerunits of another currency

–        $1 buys fewer euro     ($ lost value; weakened)

Be able to calculate G_F/G_D using Purchasing Power Parity (PPP) relation

Links the real and nominal exchange rates...

Real rate = (nominal rate * $-price)  /  F-price

G_F / G_D = [ (F / $) * P_d ]   /  P_f

What two things does PPP relation allow us to do?

(1)    solve for the real exchange rate (what you can afford to buy in “real” terms)

(2)    explain the variation that we see in nominal exchange rates

What does PPP Theory say? How is it related to Law of One Price (what is this?)?

Says

·         a unit of currency should buy (afford) the samequantity of goods in all countries

Related by

·         extension of the Law of One Price: that a good must sell for the same price everywhere

·         goods were not the same price, then a profit opportunity would exist and arbitrage* would occur.

o   *arbitrage: prices will adjust until they are equal

Aggregate Demand and Aggregate Supply (AD-AS) model of the economy

Market for all goods and services produced and consumed in an economy

Aggregate Demand (AD)

•         Depicts various quantities of goods and services thathhlds, firms, gov’t, and foreigners want to buy at each price-level

Aggregate Supply (AS)

•         Depicts various quantities of goods and services firmschoose to produce and sell at each price-level

Price-level (P)

•         average price-level

Real output (Q)

•         (natural rate of) output ; full employment

What constitutes a short run (SR) vs. Long run (LR) equilibrium?

SR equilibrium is where SRAS = AD

LR equilibrium is where LRAS = SRAS = AD