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GDP is denoted as Y
Measuring GDP
Production method (or value added method) = the sum of the
incremental value added at each stage of the production process
Income method = the sum of the income generated from the sale of
domestically produced goods and services
o The income method is almost identical to the production method
Expenditure method = the sum of expenditures on all domestically
produced goods and services
Each method will provide the same answer
Example: A cotton farmer sells cotton to a fabric wholesaler for $5. The
wholesaler then processes it and sells it to a clothing retailer for $8. The
clothing retailer sews a shirt with the cotton, which they sell to
customers for $10. What is the GDP (Y) of this shirt?
Production method: Y = value added at each stage of the production
process = $5 + ($8 $5) + ($10 $8) = $5 + $3 + $2 = $10
Income method: Y = sum of income generated at each stage of the
production process = $5 + ($8 $5) + ($10 $8) = $5 + $3 + $2 = $10
Expenditure method: Y = money spent on the final product = market
value = $10
Components of GDP
GDP = consumption + investment + government purchases + net exports
Y = C + I + G + NX
Consumption = any goods and services purchased by households
o Consumption is divided into services (e.g. medical care, education),
durable goods (e.g. cars) and non-durable goods (e.g. food, clothes)
o Excludes purchases of new houses
Investment = new fixed capital (e.g. machinery, factories, offices, etc),
new inventory (goods that are produced but not sold) and new
residential houses
o Excludes depreciation of goods or purchases of financial securities
(e.g. shares this is merely a transfer of assets and no goods and
services are produced from buying and selling shares)
Government purchases = government spending on consumption and
investment items
o Excludes transfer payment (e.g. Centrelink benefits) as no goods
and services are receive in return for these payments
Net exports = Exports imports
o Spending on imports is excluded as GDP is only concerned with
spending on domestically produced goods and services
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GDP per capita is often seen as the average income per person
o This is clearly inaccurate as everyone earns a different income
GDP per capita is used as an indicator of wellbeing or standard of living
o If a country wants to increase their standard of living, their GDP
must increase faster than the population
o GDP per capita as an indicator of standard of living is inaccurate
because:
There are many other factors that impact ones
standard of living that is not considered when
determining GDP e.g. crime rate, distribution of wealth
across the population, leisure, quality of health care and
education, pollution
Gross National Happiness (GNH) has been suggested
as a new framework for measuring standard of living
GNH considers sustainable development, cultural
integrity, ecosystem conservation and good
governance
Some events may increase GDP but reduce wellbeing car
accidents, money spent on medical service, fires, etc
GDP deflator =
Example:
Production and Price Statistics of Futureland
2010
2011
Product
Quantity Price per Quantity
Price per
unit ($)
unit ($)
Wellington/
95
50
110
60
Gumboots
Raincoat
500
35
550
40
Toilet
500
35
550
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Paper
Nominal
$42, 650
$51, 100
GDP
(a) Using 2010 as the base year, calculate the value of real GDP in
2011:
Real GDP = 2011 quantity x 2010 quantity
Wellingtons: 110 x $50 = $5, 500
Raincoats: 550 x $35 = $19, 250
Toilet Paper: 1, 500 x $12 = $18, 000
Real GDP = $5, 500 + $19, 250 + $18, 000
= $42, 750
The real GDP in 2011 is $42, 750.
(b) Calculate (i) the GDP deflator; and (ii) the price change between
2010 and 2011, using 2010 as the base year.
(i)
GDP deflator =
=
=
= 119.53
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Example cont:
(ii)
Price change between 2010 and 2011= inflation
Inflation = %change in GDP deflator
= GDP deflator in 2011 GDP deflator in 2010
= 119.53 100
= 19.53
The price change between 2010 and 2011 is 19.52.
Example: Between 2009 and 2010, Greeces nominal GDP decreased by
6% and its GDP deflator increased by 1.7%. What is the change in
Greeces real GDP?
Inflation = %change in nominal GDP % change in real GDP
% change in real GDP = %change in nominal GDP Inflation
% change in real GDP = 6% 1.7%
= 7.7%
Greeces real GDP contracted by 7.7% in 2010.
Growth
Example: Real GDP per capita was $59, 629 in 2011 and $60, 839 in
2012. What was the income growth rate?
Income growth rate =
=
=
=
= 2.029%
To work out how long it would take for an investment to double, apply
the rule of 70
o This is used to estimate the speed at which real GDP per capita is
growing
A country with a higher growth rate will take less time for
that GDP per capita to double than a country with a slower
growth rate
(proof)
N = 17.5 years
It would take 17.5 years for the investment to double.
Financial System
All advanced economies have a well developed financial system
Financial system = the system of financial markets and financial
intermediaries through which firms acquire funds from households
o Financial markets = share and bonds market
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Because mortgage loans have a very long repayment duration (e.g. 2030
years), they are illiquid assets
o Banks developed mortgage-backed securities (MBS) to convert
this illiquid asset to liquid assets
MBS = a financial asset which the value is connected to
mortgage loans
Investors of MBS, what they expect to get is a long-term
stable high investment return
By selling a MBS to other investors for cash, banks not
only turn illiquid assets to liquid assets but also
transfer the risk associated with mortgage loans to MBS
holders
If a borrower defaults, the MBS holder bears the loss
this gives the bank less incentive to scrutinise
the quality of loan applications but more incentive
to make loans
o Borrowers with poor credit records are more
likely to get a loan with little or zero down
payments (liar loans)
This began the bloom of subprime
mortgages
The low interest rate in the early 2000s gave US households an
impression that they would be able to make the interest payments
o When interest rates went back to a more normal level, many
households failed to meet the interest payment obligations
Failure to make payments home foreclosures large
number of houses went on the market housing prices fell
as supply had increased
MBS values plummeted
o Because many US toxic MBSs were sold to foreign financial
institutions, the impact was global
Australian was not as negatively affected as the rest of the
world due to a timely resource boom, RBA lowered official
interest rates, fiscal stimulus package and strong
regulations
Mortgages:
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Business Cycle
Business cycle = alternative periods od expanding and contracting
economic activity
During the expansion phase production, employment and income are
increasing above the trend in growth that the economy experiences over
time
During the contraction phase production, employment and income are
falling below the trend in growth
o A contraction phase may be followed by a recession
Recession = when total production and employment
are decreasing and economic growth is negative
o Contraction or recession ends with a business cycle trough the
expansion period will begin again
Phases of the Business Cycle:
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Inflation rate:
o During economic expansions, the inflation rate usually
increases (particularly near the end of the expansion)
o During economic contractions, the inflation rate usually decreases
Exception: if expansion is due to rising productivity levels
and an expansion of potential GDP or if contractions is
caused by high prices for production inputs
Unemployment rate:
o During economic expansions, the unemployment rate will
decrease
o During economic contractions and recessions, the unemployment
rate will decrease
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Physical Capital:
o Physical capital includes manufacturing goods that are used to
produced other goods and services (e.g. computers, machines,
factories, etc)
o Accumulating more physical capital will lead to growth but as
physical capital increases, the amount of output gained will
decrease (law of diminishing returns)
Human Capital:
o Human capital is accumulated knowledge and skills that
workers acquire from education and training or from their life
experiences
o An increase in human capital will shift the production function
upwards
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Technological Progress:
o Technological progress (or change) refers to when firms can
produce more output using the same amount of inputs
o Technological change can occur due to:
Better machinery and equipment
Better organization and management method
o Technological progress will shift the production function upwards
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Catch-Up
The economic growth model predicts that poor countries will grow
faster than rich countries
o If this is correct, poor countries should be catching up with rich
countries this is not the case
The hypothesis is that poor countries will experience a higher level of real
GDP per capita growth than rich countries as developing countries are
not as greatly affected by diminishing marginal returns than
developed countries this will result in convergence in real GDP per
capita and standards of living throughout the world
Reasons for slow economic growth in poor countries:
o Failure to enforce the rule of law (e.g. property rights, contracts)
o Wars and revolutions
o Poor public education and health
o Slow technological developments
o Low rates of saving and investment
Poor countries can break out of a low-growth cycle through foreign
investment (easier for the country to get funds and technology)
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Example cont
2. If overseas market sales unexpectedly decline to 100, what is
Toyotas unplanned investment and actual investment?
Unplanned investment would be 70 (unplanned change in
inventory).
Actual investment = IP + IU
= 80 + 70
= 150
3. If domestic market sale unexpectedly rises to 800, what is
Toyotas unplanned investment and actual investment?
Unplanned investment would be 100 (unplanned change in
inventory).
Actual investment = IP + IU
= 80 100
= 20
Toyota would have to use old stock to fulfill demand.
o Consumption function:
The consumption function explains the relationship
between consumption and disposable income
A change in consumption depends on a change in
disposable income
C = a + bYd
a = autonomous consumption
bYd = induced consumption
o b = marginal propensity to consume (MPC)
o Yd = disposable income
Marginal Propensity to Consume:
MPC =
MPS =
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Investment
o Four important variables that determine the level of investment
Expectation of future profitability
A firm is likely (unlikely) to invest in new factories,
offices and equipment if they expect (do not expect)
that demand for their product to stay strong
Interest rate
An increase (decrease) in the interest rate will result
in less (more) investment spending as it would be
more (less) expensive for firms to borrow money
Taxes
An increase (decrease) in company income tax
would decrease (increase) the after-tax profitability
of investment spending
Cash flow = the difference between the cash revenues
received by the firm and the cash spending by the firm
The more (less) profitable a firm, the greater (lesser)
its cash flow and the greater (lesser) its ability to
finance investment
Government Purchases
o Main source of government revenue is taxation
The more (less) taxes the government receives, the more
(less) funds the government has to spend on government
purchases
Net Exports
o Three important variable that determine the level of net exports
The price level in Australia relative to the price level in
other countries
When the inflation rate is lower (higher) in Australia
that in other countries, the prices of Australian
products increase slower (faster) than the prices of
foreign products. This increases (decreases) the
demand for Australian products exports will
increase (decrease) and imports will decrease
(increase)
The economic growth rate in Australia relative to the
economic growth rate in other countries
If income rises faster (slower) in Australia than in
other countries, Australian purchases of foreign
goods and services increases faster (slower) that
foreign purchases of Australian goods and services
exports will decrease (increase) and imports will
increase (decrease)
The exchange rate between the Australian dollar and
other currencies
An increase (decrease) in the value of the AUD will
decrease (increase) exports as Australian goods are
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Multiplier =
=
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Equilibrium
Short-run equilibrium occurs when AEP = Y
In short-run equilibrium, Y is not necessarily equal to potential GDP
Short-run equilibrium:
If AEP > Y
o The economy demands more than the economy produces
(total spending > total production)
There will be an unplanned decrease in inventory (IU < 0)
Firms will increase production in the next period until
AEP = Y
Employment will rise to cater for the increase in
production
o Knock-on effect: Increase in demand from consumers
warehouse sells more goods warehouse orders more goods
from the producer producer increases production
employment rises increased spending in other areas of the
economy as individuals have more money
If AEP < Y
o The economy demands less than the economy produces (total
spending < total production)
There will be an unplanned increase in inventory (IU > 0)
Firms will decrease production in the next period until
AEP = Y
Employment will fall to cater for the decrease in
production
o Knock-on effect: Decrease in demand from consumers
warehouse sells less goods warehouse orders less goods from
the producer producer decreases production employment
falls decreased spending in other areas of the economy as
individuals have less money may lead to a recession
Increases and decreases in AEP cause the year to year fluctuations in GDP
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Macroeconomic Equilibrium
Equilibrium occurs at the intersection of the AD curve and the SRAS curve
In the long run, the AD curve and the SRAS curve will intersect on the
LRAS curve (the economy will be at potential GDP)
Expansion
o 1. The economy begins at point A
o 2. There is an increase in aggregate demand AD curve shifts to
the right
o 3. The economy will move along the SRAS curve to point B this
point is beyond potential GDP; thus, indicating that resources are
being over-utilised and there is upward pressure on wages
o 4. An increase in wages will increase the cost of production for
firms this will shift the SRAS curve to the left
o 5. The economy will move along the AD curve to point C the
economy is back at potential GDP but the price level has risen
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Expansion:
Recession
o 1. The economy begins at point A
o 2. There is a decrease in aggregate demand AD curve shifts to
the left
o 3. The economy will move along the SRAS curve to point B this
point is below potential GDP; thus, indicating that resources are
being under-utilised and there is downward pressure on wages
(workers are willing to accept lower wages)
o 4. A decrease in wages will decrease the cost of production for
firms this will shift the SRAS curve to the right
o 5. The economy will move along the AD curve to point C the
economy is back at potential GDP but the price level has fallen
Expansion:
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Supply Shock
o 1. The economy begins at point A
o 2. A sudden change in the availability of a natural resource (e.g. oil)
will decrease supply SRAS curve will shift to the left
o 3. The economy will move along the AD curve to point B this
point is below potential GDP; thus, indicating that resources are
being under-utilised and there is downward pressure on wages
(workers are willing to accept lower wages)
o 4. After an extended period of time (years), the resulting fall in
wages will decrease the cost of production for firms this will
shift the SRAS curve to the right (back to the original positi on)
o 5. The economy will move along the AD curve to point A the
economy is back at potential GDP and at the same price level
Supply Shock:
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Topic 6 Unemployment
Unemployment Rate
Each month, the ABD conducts a labour force survey to calculate the
unemployment rate
To be classified by the ABS as unemployed, the person must have:
o Worked for less than one hour in paid employment in the
week before the survey;
o Actively looked for work in the previous four weeks; and
o Is currently available to start work
Unemployment rate = percentage of the labour force that is unemployed
Labour force = no. employed + no. unemployed (according to ABS)
Types of Unemployment
Cyclical Unemployment
o Unemployment caused by the business cycle
Economic expansion job creation lower
unemployment
Economic contraction job destruction higher
unemployment
o Cyclical unemployment will equal 0 when the economy id
producing at its potential output level (Y=Y*)
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Costs of Unemployment
Unemployment has negative personal and social impacts
The size of the impact depends on the duration of the unemployment (the
longer people are unemployed, the more they lose their skills and
workplaces contract and thus it is harder for them to get a job)
Costs of unemployment to the economy as a whole:
o Loss of GDP (people have less money to buy things)
o Loss of human capital
(skills deteriorate when people are
not using them)
o Retraining costs
o Costs to government
(due to unemployment benefits)
o Opportunity cost of funds being directed towards unemployment
benefits
Costs of Unemployment to the unemployed:
o Loss of income
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o
o
o
o
o
o
Loss of skill
Loss of self-esteem
Social costs on society (e.g. problems)
Health problems
Crime
Political unrest
Unemployment Benefits
Unemployment benefits are an important automatic stabiliser of an
economy
Unemployment benefits have the effect of:
o Lessening financial pressure on the unemployed allows more
time for job searching so they can find a job for which they are best
suited to (allows for increased labour market efficiency)
o Reducing the opportunity cost of unemployment (i.e. reducing the
incentive to work) as the unemployed are still receiving an income
(this leads to longer periods of unemployment)
o Reducing income inequality
With unemployment benefits, the shift of real GDP after a demand shock
will be less severe
Without unemployment benefits:
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Topic 7 Inflation
General
Inflation = the sustained increase in the price level
Price level = a measure of the average price of goods and services in
the economy
o The price level is unitless
Inflation rate (%) = the percentage increase in the price level from
one year to the next
o Note: Since 1990, the inflation rate in Australia has usually been
below 4% (with the exception of one-off spikes)
There are a number of ways to measure the price level:
o Consumer price index (CPI)
o GDP deflator
o Producer price index (PPI)
o Wholesaler price index (WPI)
o Retail price index (RPI)
Types of inflation:
o Inflation refers to an increase in price levels from year to year
o Deflation = negative inflation (decrease in the price level e.g.
2%)
Deflation expectation (occurs in countries with a long
trend of deflation e.g. Japan) = consumers expect there to
be deflation, meaning that the price of goods and services
will decrease. Thus, consumers hold off their spending.
Aggregate
demand
continues
to
contract
and
unemployment increases.
o Disinflation = a reduction in the inflation rate (i.e. the price
level is increasing but at a slower rate than the year before e.g. a
change in the inflation rate from 3% to 2%)
o Hyperinflation = very high inflation (no specific threshold as to
what constitutes very high usually where inflation > 100%)
Hyperinflation tends to occur in periods of war or political
unrest when the government spends more than it has. The
government will order more money to be supplied in the
economy
Consumer Price Index (CPI)
The CPI is the most commonly used price index for measuring inflation
CPI= a measure of how much a typical family of four in a capital city
needs to spend on a representative basket of goods and services in a
particular year relative to the base year
o Based upon the ABS market basket (i.e. what the ABS has
determined is what a typical household would purchase)
CPI is also referred to as the cost-of-living index
The inflation rate is the % increase in CPI from year to year
The CPI overstates the true inflation rate due to:
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o Substitution bias the CPI does not take into account consumer
substitution between products as the price of products change
o Increase in quality bias the CPI does not take into account the
percentage of the increase in price that is due to an increase in
quality of the good or service
o New product bias the ABS only updates its market basket every
6 years; thus, new products will not be immediate included
o Outlet bias the ABS does not take into account the prevalence of
discount stores and online shopping. Basing prices on full-price
stores will overstate the cost of the market basket.
Measuring Inflation (using CPI)
Method:
o Step 1: Calculate the cost of the basket of goods and services
($)
Costs = (price of good 1 x quantity of good 1) + (price of
good 2 x quantity of good 2) + + (price of good n x
quantity of good n)
Costs = P1Q1 + P2Q2 + + PnQn
o Step 2: Calculate the CPI
Note:
o Any year can be used as the base year changing the base year
will change the CPI values but will not change the inflation rate
between two years
o CPI of the base year = 100
Example: Use the information in the following the table to calculate the
annual rate of inflation for 2009 as measure by the CPI (where 2006 is the
base year)
Product
Quantity
Haircuts
Hamburgers
DVDs
1
9
2
Price
(2006)
$20
$4
$15
Price
(2008)
$22
$4.20
$15
Price
(2009)
$25
$4.50
$14
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CPI (2009) =
=
=
= 4.12%
The inflation rate in 2009 was 4.12%.
Nominal vs. Real variables
Nominal variable are not adjusted for inflation
Real variable are adjusted for inflation
The purchasing power of the dollar falls over time as the price level rises
(i.e. you could buy more stuff for $1 in 1960 than you can in 2013)
Comparing dollar value over time:
o Real value =
o
Exact equation:
Approximated equation:
o Where:
r = real interest rate
i = nominal interest rate
= inflation rate
o Note: in the exact equation: r, i and are expressed in decimal
form not as a % (e.g. 0.03 not 3%). In the approximated equation,
they can be expressed as a %
The real interest rate represents the true cost to borrowers and the
trust (before tax) return to lender
o Banks and other financial institutions forecast the inflation rate in
order to obtain the best return. If the actual inflation rate differs
from the expected inflation rate, the trust cost and return will be
different from the expected cost and return
If actual inflation < expected inflation
Lenders gain and borrowers lose
If actual inflation > expected inflation
Borrowers gain and lenders lose
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Costpush inflation:
Price wage spiral = demand-pull inflation will raise the price level;
thus, triggering cost-push inflation
o Process = demand-pull inflation cause an increase in the price level
real wages decrease workers bargain for higher wages to
compensate for inflation nominal wages will increase
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negative supply shock (SRAS curve moves to the left) as the cost of
production has increased cost-push inflation causes another
increase in the price level real wages decrease etc
Price wage spiral:
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o Liabilities include:
Deposits = money that households deposit with banks
This is a liability as the bank is liable to pay savers
back when savers wish to receive their money)
o Shareholders equity = the value of the bank
Shareholders equity = Total assets total liabilities
A bank will be solvent when assets > liabilities
(equity will be positive)
A bank will be insolvent when assets < liabilities
(equity will be negative)
o When a bank becomes insolvent, it has three
options:
Declare bankruptcy
Bail-out external investors inject
new capital into the bank
Bail-in bank creditors convert loans
into shares
Total assets must equal total liabilities & shareholders equity
A bank balance sheet allows one to understand where a bank receives its
funding and how it uses those funds
Example bank balance sheet:
Assets
Reserves
10
Securities
50
Loans
90
Total Assets
150
150
+20
Creation of Money
Banks create money by issuing credit (loans) through the multiplier
effect
o E.g. If a bank receives $500 in deposits and the reserve ratio is
10%, it will keep $50 as reserves and lend $450. This $450 will be
deposited within another bank; thus, increasing its reserves. The
money supply has been increased from $500 to $950 (and so on)
Reserve ratio = the ratio of deposits that a bank keeps as reserves
o Reserve ratio =
o A banks reserve ratio is often 10%
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Inflation Targeting
Arguments in favour inflation targeting:
o The RBA can have an impact on inflation but not on real GDP (in
the long run, real GDP returns to its potential level and potential
GDP is not affected by monetary policy)
o An inflation target makes it easier for households and firms to
form accurate expectation of future inflation; thus, improving their
planning
o Helps institutionalise good Australian monetary policy
o Promotes accountability
Arguments against inflation targeting:
o Reduces the flexibility of monetary policy to address other goals
o Assumption that the RBA can accurately forecast future inflation
rates is not always correct
o Holding the RBA accountable only for an inflation goal may make it
less likely that the RBA will achieve other important goals
Independence of the RBA
The RBA is independent of the government; however, as the RBA is
created under legislation, the RBA would not conduct monetary policy
that strongly opposed the government
Reasons for independence:
o Avoid inflation
o Avoid the government using the central bank for political purposes
Reasons against independence:
o No accountability as members are not elected
The Governor of the RBA is second only to the Treasurer of Australia
in their ability to affect the Australian economy
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Crowding Out
Crowding out = a decline in private expenditure as a result of an
increase in government purchases which has diverted financial and
real resources away from the private sector
Financial crowding out = if the government finances it spending by
borrowing, it will increase the demand for funds and thus, push the
interest rates up. Higher interest rates will reduce private consumption
and investment and may cause the AUD to appreciate, causing net export
to decline.
Resource crowding out = the government competes with the private
sector for labour, land, intermediate goods and other real resources,
putting upward pressure on wages and prices. Higher wages and prices
reduce private consumption, investment and net exports.
There will be partial crowding out in the short run and possibly complete
crowding out in the long run (no increase in Y)
Crowding out effect:
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Time Lag
Fiscal policy is subject to time lags
o Recognition lag = the time it takes for policy-makers to recognise
there is a problem to be addressed
o Legislative lag = the time it takes for policy to be approved by
both Houses of Parliament
o Implementation lag = the time it takes to implement the policy
and for it to take effect
Budget Balance
There will be a:
o Budget surplus when the governments tax revenue is
greater than the expenditures (T G TR > 0)
Occurs in an economic boom
o Budget deficit when the governments tax revision is smaller
than its expenditure (T G TR < 0)
Occurs in an economic slump
The federal budget acts an automatic stabiliser as taxes and transfer
payments can change automatically due to business cycle
o In an expansion: real GDP increases so income and company taxes
increase. Unemployment decreases so transfer payments
decreases. Government debt is likely to decrease.
o In a recession: real GDP decreases so income and company taxes
decrease. Unemployment increases so transfer payments
increases. Government debt is likely to increase as the government
will have to finance their expenditure through borrowing.
Structural (aka cyclically adjusted) budget surplus or deficit = deficit
or surplus when real GDP is at potential GDP (Y=Y*)
o This provides a more accurate indicator of whether governments
policy is expansionary or contractionary
o When Y=Y*, the cyclical component of a budget surplus or
deficit = 0. Therefore, at Y*, all of the budget surplus/deficit is
structural
o Structural budget surplus the government is engaging in
contractionary fiscal policy (taxes increase, government or
transfer payments decrease)
o Structural budget deficit the government is engaging in
expansionary fiscal policy (Taxes decrease, government or transfer
payments increase)
Maintaining a balanced budget every year is not a good idea as this
could lead to destabilising policies:
o In a recession, it is likely there will be a budget deficit. To balance
the budget, the government must increase taxes and decreases
government purchases and transfer payments through
discretionary contractionary fiscal policy. This would lead to a
further decrease in real GDP.
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Shifts in demand:
o During an economic expansion in another country, the
demand for $AUD will increase. E.g. If there is an economic
expansion in Japan, the income of Japanese households will rise
and the demand by Japanese consumers and firms for Australian
goods and services will rise. Also, the demand for Japanese goods
and services will rise, causing extra demand for Australian
minerals and energy. The demand for $AUD will increase.
o If interest rates in Australian are relatively higher than
interest rates in other countries, the demand for $AUD will
increase as the desirability of investing in Australian financial
assets will increase
o If currency traders think that the $AUD will appreciate, the
demand for $AUD will increase
Shifts in Supply:
o During an economic expansion in Australia, the supply of
$AUD will increase as Australian consumers and firms will spend
more in other countries. $AUD must be supplied in order to
exchange for other currency.
o If interest rates in another country are relatively higher than
interest rates in Australia, the supply id $AUD will increase as
the desirability of investing in foreign financial assets will increase.
o If currency traders think that a foreign currency will
appreciate, the supply of $AUD will increase as currency
traders will be purchasing other currencies
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Appreciation/Depreciation vs Revaluation/Devaluation
Appreciation = the value of a floating currency rises relative to another
currency
Depreciation = the value of a floating currency falls relative to another
currency
Revaluation = the value of a fixed/pegged currency is raised relative to
the anchor currency
Devaluation = the value of a fixed/pegged currency is lowered relative to
the anchor currency
Fixed/Pegged Exchange Rate System
Benefits of a fixed/pegged exchange rate system:
o Facilitate international investment and trade, especially with the
anchor currency
o Fix foreign debt levels and repayments
o Reduce fluctuations in import prices
o Prohibit the central bank from printing money excessively
Costs of a fixed/pegged exchange rate system:
o Countries lose monetary policy independency (e.g. if the US
increases interest rates, Malaysia will have to increase interest
rates (even if the conditions in the country do not warrant it)
o Countries are open to speculative currency attack when the
currency overvalues
Currency Attack
Traders can make money from speculating
o E.g. Thailand/USA before the peg is broken, the trader will
borrow 25 baht and sell the 25 baht in the FX market for $1. After
the peg is broken, the trader will sell the $1 in the FX market and
get 33 baht. The borrower will repay 25 baht and make an 8 baht
profit. This not the complete story selling the 25 baht increases
the money supply in the FX market. This leads to an excess supply
of baht. The central bank needs more foreign reserves to increase
the demand for baht. This raises interest rates, which causes the
baht to depreciate more. This means that the profits of the trader
will be even larger. This creates an incentive to attack currency.
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Currency Attack:
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=1
o If this was to hold, in the long run, a basket of goods and services
that costs $520 USD in the USA and that $520 USD were then
converted into Yuan, thus amount would buy the same goods and
services in China
Factors that affect the relative price levels affect the long run nominal
exchange rate:
o Relative money supply growth
o Relative productivity
PPP does not hold in reality because:
o Some goods and services are not traded internationally by nature
(e.g. house) or due to high transportation costs (e.g.. car repairing
services)
o Product and consumer preferences are different across countries,
so the basket of goods and services are identical
o Countries impose barriers to trade (e.g. tariffs and quotas)
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