Friday, September 03, 2010 11:52 AM

Macro Economic Theory: Accounting relationships

National Income Product Income Expenditure Main measure of economic activity in macro economics GDP (gross domestic product) Nominal GDP All the final goods and services produced within a countries borders during a particular calendar year measured at current market prices The measure of money GDP is a flow variable- only defined for a particular time period Stock variable- measured at a particular point in time -the amount of money you have is a stock variable there is no particular time period its a particular point in time GDP is everything that is produced within a countries borders, so even toyota's production in the US counts towards the US's GDP GDP DOES NOT INCLUDE: *Used goods are not counted as part of current GDP Except for the portion of their price that reflects something newly produced Capital gains are not counted Intermediate goods
GNP (gross national product) Measures all of the output anyware in the world (labor, capital, demand) GDP + net factor payments from abroad = GDP+NFP=GNP - Net= something minus something else Net factor payments (US) Payments to us - payments made by foreign Example:

Shoes Cow=$200
Leather=$300

Value Rancher= $200

Leather guy= $100 GDP should equal the income made by those involved - Output is income

Shoes=$500 Retail=$600

Shoe manufacturer= $200 Retailer=$100

Shoe GDP= $600 Income= $600

GDP- only includes goods and services for which a market transaction is recorded
Licit Market Transaction: these are not counted in GDP

GDP does include clean up costs

GDP 1) Nominal GDP i. Measured at current market prices Price X Q= GDPn 2009 - $1 100=$100 2010 - $2 100=$200

GDP deflator - Nominal GDP/ GDP deflator = real GDP National output in terms of ""constant" dollars = Y Per Capita GDP= Y/population
The degree of income equality/inequality= GINI Coefficient

Rate of Economic growth The rate of growth in real GDP= Y2010-Y2009/ Y2009= x% - In the long run it should be right around 3%

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Quarters in the year are in 3 month sets Example: 2010:3 (3rd quarter 2010) GDP over time

y
Slope= %3

The wave= the business cycle

Expansion: the period in which the rate of GDP growth is positive Resession: the period lasting at least 2 consecutive quarters during which the GDP is negative

1960

x 2010 Crunchy conservative www.frontporch.com

Calculating the pErcentage change in the product of 2 varaibles: % (AxB)= %A + %B % (A/B)= %A- %B= -3% -5%=-8% American Dream- upward mobility Every child will live a better life than their parents

National Expenditure
Look at the part of national income account and who ends up with the output
National income expenditure identity: Y=C+I+G+NX -> where all the output goes (who gets what) the division of national output) Ex post expenditures - after the fact spending must be the same as GDP

C= Consumer Expenditures 1- Consumer durables (last a long time) 2- Non durable I= Investment Expenditure Changes in the stock of capital [K] It has nothing to do with financial expenditures a) Residential Construction b) Business fixed investment c) Inventory Investment

Capital= produced goods that are intended to produce other goods for sale

Investment is spending that effect GDP No purely financial transactions are effected in the national income account

G= Government Purchases Purchases on goods and services Does not include transfer payments (TR) NX= Net Exports Exports of goods and services - imports of goods and services = the current account defficit (if NX<O) or Surplus (if NX>0) = trade deficit (surplus)
Expenditures within these categories: - Someone in hong kong buys a car from US= export - Someone buys a porche from italy= import - American staying at hotel in rome= import - Shares of stock and gov bonds dont count either way - Interest is counted in net exports

Inflation
An increase in overall level of prices (which are mesured in terms of money) -> which implies a decrease in the value of money.
Deflation: Implies a decrease in the overall level of prices, -> which corresponds an increase in the value of money

Changing the value of money: -> Friday, 4 beers @ $5 per beer On the way the the price of beer doubles Now you can only get 2 beers for $20 How are they measured? CPI= The Consumer Price Index Laspeyres Index= past weighted (the quantities used to weight the different prices are fixed) CPI Paasche Index= present weighted (the quantities used to weight different prices are variable) GDP deflator

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 GDP deflator Suppose 2 goods: Q^a and Q^b

CPI => P^(a)v(T+1) + P^(b)v(T+1) x Q^(B)v(T) P^avT+1 x Q^AvT+1 + P^A

GDP deflator
Generally the CPI equations overstate the rate of inflation

Quiz: All multiple choice 7 or 8 questions that specify a particular transaction

Major Reason why the CPI tends to overstate the actual rate of inflation: - It doesnt take into account changes in quality If the quality of the things purchased are improving in quality then the money spent is more valuable - When a goods price rises people tend to seek out substitutes The CPI might understate the rate of inflation because: When people substitute A for B because Pb^ then they move to a level of subjective well being

Unemployment Rate: = the unemployment rate= the preparation of the labor force that is currently not working: Labor force- employed Labor force = = 9.5% currently Some say it should be measured:

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Working age population-employed Working age population

= 18%

3 major types of Unemployment: 1) Frictional unemployment i. When people change or are in-between jobs (short duration) 2) Structural Uunemployment i. Long term unemployment due to changes in the employment market (long duration) ii. Usually caused by changes in technology or common practices 3) Cyclical unemployment i. Indeterminate termination ii. Example people layed off during a recession they wont be hired

CPI Systematically overstate the actual rate of inflation GDP Deflator Tends to understate both the impact and actual rate of inflation because: 1) it doesnt take into account reductions in welfare that result from changing consumption patterns when prices rise 2) It doesnt include impact prices Its used to convert nominal GDP to normal gdp

Unemployment rate What is the full employment unemployment rate? The full employmet unemployment rate 0% some immutable constant There is a negative relationship between the unemployment rate and GDP Or between the unemployment rate and the rate of economic growth

Fresh Water Macroeconomics: (classical approach) How the economy behaves in the long run at full employment
The long run vs. the short run: Micro theory- long run theory of the firm: varaible short run : fixed Long run=> prices are completely flexible, and all markets clear Short run=> prices are sticky or fixed, and some markets if not all markets don't clear

Kains: short run Chapter 3: The long run Macro Economic Theory: self regulating economy The entire economy is always leading toward full employment In the long run what determines the full employment, potential level of GDP? The "Natural" full employment level of GDP:

Y*=AF(K,L)
*in the long run the full employment level of GDP is determined by the state of production technology (A), the shape of the production function (F), and the amount of capital (K), and labor (L) employed in the production process when the economy is at full employment It has entirely to do with the supply and productive capacity but nothing to do with spending

Exogenous= determined outside the theoretical framework Endogenous= determined within the theoretical framework
dY=Y*=AF(K,L) dL y y L = MPL= Marginal product of labor

(y) L

1) The MPL is positive 2) The marginal product of labor is decreasing - Each additional worker causes output to increase but the increase in output attributable to the last unit of labor is less than that attributable to the previous unit of labor

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The perfectly competitive firm: maximize profits by setting output such that MPL*P=W When a firm is maximizing profits they vary the number of employment
MPL*P= the marginal revenue product of labor w= the nominal wage

When: Labor increases=> MRP is decreasing Because MPL decreases => so I increses L as long as MRP > w=>

MPL*P=W=> MPL= W/P

Y*=F(K,L) W/P SL (income/leisure trade off)

DL (MPL)
L

Labor Market Framework W/P

SL W/P* W/P'

SL'
DL (MPL) L* L' L

Increase in immigration => Supply of Labor will increase => W/P decrease to W/P' and L increases to L'

^Y=AF(K,L^) => ^L in the long run causes ^Y => K/P ^ => %Y^

Increase in immigration increasing demand for labor drives down wages

W/P
W/P'

SL' SL

^ Mortality rate among working age adults => supply of labor would Decrease

W/P*
DL

L'

L*

=> ^K => ^labor redundancy => v DL=> v W/P until workers became so "immiserated" that they would eventually realize that "they had nothing to lose but their chains"

W/P SL

W/P'
W/P*

DL' (MPL') DL (MPL)

L* L' ^K => ^ MPL at all levels of employment L

GDP

K2 K1

^ Demand for Labor => W/P ^ to W/P' and L^ to L'

The amount by which output increases the income increases thus the standard of living increases

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Economics of Ten-year Professors Would eliminating ten-year drive down higher education costs?
W/P' SL'

W/P
W/P*

SL

Eliminating Ten-year would cause a decrease in supply

DL'
DL L* L' L Labor All different types of labor are substitutes

The real wage for labor type a to increase the demand for labor type b will increase and that will drive the W/Pb(real wages) to increase w/p(min) ^ => DL ^ =>w/p^
Arrogate Production function Y=A(K,L)

W/P W/P' W/p*

SL

DL' (MPL) DL L* L' L ^ A => ^ MPL => ^ DL=> ^ W?P => ^L

Section 3.2
r* (real interest rate) C,I,G,T,TR,S,SPUT, SGUT

In a closed economy: The National Income Expenditure Identity Y=C+I+G Given the long run output (Y*). What causes C+I+G = Y* C= a(r,w) +b(Y+TR-T) Consumption has an exogenous component (not dependent on income) a(r,w) => autonomous consumption r=money interest rate(i) - rate of inflation ()
b= the marginal propensity to consume => 0<b<1 c/disposable income= (Y+TR-T) TR(transfer payments) T(taxes) MPS= 1-MPC MPS(marginal propensity to save) =1-b MPC (marginal propensity to consume)

i= investment I=I(v,MPKf) I=K(t+1) - Kt

Two important reasons for negative relationship: 1) Real interest rate is the opportunity cost of investment spending

Mpkf= optimism of business Income tax law

Y=C+I+G C=a(r,w)+b(Y+TR-T) I= I(r, MPKf)

(Y+TR-T)= disposable income

Y= gdp Tr=transfer payments T= tax payments

T=tY were t= the average income tax rate

The marginal tax rate = the rate of tax you pay on the last dollar of income earned= change in tax

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payments / change in income T/Y Proportional taxation=> the average ta rate stays constant because the marginal tax rate is constant from dollar "one: Progressive taxation the average tax rate rises as income rises because of increasing marginal tax rates Regressive taxation-the average tax rate raises when income falls

$250,000=$250,000.00 the dividing line between the top 2% of distribution of income and everybody else. Proposed tax increase from 35% to 39% or increase above $250,000

Progressive tax code

Laugher curve: Y t(Marginal) t=marginal tax rate T=tax revenues

0-$23K
25k-50k 50k-125k 250-

0%
25% 30% 39%

125k-250k 35%
T

% (tY)= %t+%Y If tv by a smaller % then Y^, (tY)^

Government purchases: G=G Exogenous= determined outside the theoretical framework within which we're working (TR,T,G) Given Y=C+I+G, what causes people to want to buy what exactly is being produced? What causes long run equilibrium in the goods and services market? What determines the real interest rate in the long run? What determines the level of national saving in the long run? *Y=C+I+G (when the goods are in equilibrium)

*Y-C-G=I (National Saving) - Proof: Private Saving: Sp=T+TR-T-C Public Saving: SG=T-TR-G (when positive > government is running a surplus, when negative the gov is running a budget deficit)

S=Sp+ SG= Y+TR-T-C+T-TR-G =Y-C-G

**S=I (in the long run if saving= the goods market is in equilibrium)

Bear in mind: S>I => Y-C-G>I => Y>C+I+G =>then spending is lower than GDP S<I=> Y-C-G < I => Y<C+I+G =>spending is higher than GDP

Loan able Funds Framework V S

Anything that causes a change in saving at all real interest rates will shift the saving function.
Anything that causes a change in investment at all interest rates will shift the I function. i=r+ So if r=i

V*

If r ^ => PbV => DsV => PsV

I (S,I)* S,I

EX. Congress decides to increase taxes: ^T => Gov budget Deficit V (Sgov ^ but Spriv V)=> V C bc disposable income V => S^=> S=Y-C-G

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Fiscal Policy => undertaken by the executive and legislative brands of Gov. => G,TR, and/or T Monetary Policy is uncertain by the central bank (FED) => M

V
V* V'

S
S'

In the very long run => ^T => ^S => Vr => ^I =>K^ => Y^ b.c. Y=AF(K,L)

(S,I)*

S,I

Quiz on Monday: 10 multi choice 2 short answer 1 labor market 1 saving investment Fiscal policy Taxes Transfer payments Government spending

r
S

*Y= C+I+G Y-C-G=I

S=I

S' r* I
(S,I)* (S,I)' S,I

How will a decrease in the housing market effect this graph? Saving will increase as people's wealth goes down. vW=> Cv => S^ => S shifts to S' => (S,I)'

Crowding out: Means a decrease in private spending, especially investment, That results from higher real interest rates following a fiscal expansion.

r
r' r*

^G=> example of expansionary fiscal policy since, everything else held constant it will cause gov budget deficit to ^ => Sv=> r^ to r', (S<I)v to (S,I)'

I (S,I)' (S,I)*

(S,I)

Chapter 4: Money in the long run

Function of money1) Medium of exchange => reduces transactions costs, thereby greatly increasing the volume of exchange. (transaction costs, the pains of organizing trade) 2) Unit of account-> (the way we keep score) => reduces transactions costs 3) Standard of deferred payment (a way of nominating debts) 4) Store of Value => most of our obligations toward one another are expressed in nominal terms (in terms of money) and money is the only asset one can hold who's future nominal value can be known certainty

Money is always worth itself

3 types of money: 1) Commodity money i. Gold, platinum, silver ii. Problem: - Gold standard:

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 $20=$20.00 $.01 oz gold $2000=$2000.00 1 oz gold Price of gold falls to $1000 oz This would lead people to buy gold and sell it to the treasury which would increase the money supply and lead to inflation The value of money is what it is able to buy 2) Fiat Money i. Money that derives its value because of government proclamation 3) Credit Money i. Monetary system in which the liabilities of financial institutions function as the main medium of exchange 1) Checkable deposits Money Supply -role of the central bank Money stock is totally determined by the Federal Reserve (the fed) FOMC- centered in New York . The main tool the FED uses in monetary policy- changes in the money supply caused by the central bank action Open market operations Fed purchases or sales of short term US government debt securities (t-bills) Whenever the Fed engages in an open market purchase of anything it causes the money supply to increase Whenever the Fed engages in an open market sale of anything it causes the money supply to decrease
Equation of Exchange: MV=PY (M*V=P*Y)

Y= real GDP P=The price level P*Y= nominal GDP M= the money supply V= velocity (the velocity of money) A number that reflects the amount of times on average that each dollar in the money stock changes hands during the course of the year in the income determination process [the number of times the money stock changes hands] v= PY/m PY (1 billion)/ m(100 million) v=10

3 Major Monetary arrogates: M1= Currency in the hand of the public + checkable deposits at banks + nonbank issued travelers checks

M2= M1+ other less liquid forms of money (savings deposits in banksetc)
M3= M2 + other even less liquid forms of money (large CD's etc) Quantitative Easing: Increasing money supply Expansionary Monetary Policy: Increasing money supply Contractionary Monetary Policy: Decreasing money supply What changes in velocity signify? The quantity theory of money.

Equation of Exchange: MV=PY Velocity can be used as a "proxy" variable that implies changes in the demand for money V= PY/M M= 1/v PY = kPY where k=1/v= the Cambridge "K"

When the money market is in equilibrium: Qs= Qd => S=D The nominal money supply= M The nominal demand for money= kPY 1/V=k= the proportion of peoples income that they choose to hold in the form of money on average.
Suppose: V=3 Thus, 1/v=k=1/3

The demand for money= the demand to hold money not have money

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So, people are holding 1/3 of their income in the form of money -Suppose V^ to 5 => the demand for money goes down =Kv to 1/5 An increase in V is synonymous with a decrease in demand for money(md) A Decrease in V is synonymous with an increase in the demand for money (md) Oct 12 you predict a huge financial panic=> a huge v demand for securities=> P to decrease=> a flight to liquidity => k increases => v to decrease The nominal version: MV=PY The real version: (M/P)V=Y M/P= real money supply Y=real GDP

MV=PY V=exogenous (constant) Y= depends on 3 things *the price level is proportionate to the money supply. And a certain proportionate change in the money supply will cause an equiproportionate change in the price level
M= $1t V=4 P=1 Y=$4t $1t * 4=1*$4t

Suppose ^M by 100% $2t * 4=?*$4t ?=P=2

The money supply relative to velocity and real GDP determines the price level Money determines the level of prices

M=kPY $1t= 1/4*1*$4t But if M ^ to $2t => $2t>1/4*1*$4t=> Ms/Md => The thing that causes the money market to get back into equilibrium in the long run is to increase prices

The neutrality of Money hypothesis: Proponents of money neutrality believe: the changes in M only effect nominal variables (like the price levels) Opponents of money neutrality believe the changes in money can effect real aggregates, like GPD, real exchange rate, the equilibrium real investment rate, real usages etc. The dynamic terms: %M+%V =%P+ %Y =Rate of money growth + rate of change in velocity= The rate of inflation/deflation + rate of growth of real gdp Whenever you see inflation or deflation, in the long run its always up to one thing This is to show you what determines the rate of inflation in the long run The rate of economic growth is determined by the supply side factor
%M=20% %V =3% %P=17%

20%+0%-3%=17%

Inflation is always a monetary phenomena

There are three ways that government can deal with a budget deficit: 1) Decrease government purchases, decrease transfer payments, increase taxes => lower deficit 2) Borrow from public => potential problem is very high interest rates to compensate for default risk 3) Borrowing from the central bank => central bank buys government bonds => ^M => debt monetization The nominal interest rate= r+=I
During periods of inflation, borrowers tend to benefit and lenders suffer because the value of money borrowed is higher than the value of money repaid

Real interest rate= nominal interest rate - rate of inflation (r=i-) Test ch. 2-5 The Key difference between open and closed economy Open economy= international trade, capital flows Y=C+I+G+NX Y-C-G=I+NX S=I+NX
NX=net exports(exports-imports)

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S=I+NX

*S-I=NX

NX<0 => CA deficit or a trade deficit, i.e. imports are greater than exports => net international borrowing (a trade deficit country is always a net international debter-capital inflows) NX>0 => CA surplus or a trade surplus, ie. Exports are greater than imports => net international lending (a trade surplus country is always a net international creditor- net capital outflows)

Perfect capital mobility => any country can engage in as much international borrowing or lending as it wishes at rw=the world real interest rate rw rw S global

rw*

I global
S,I* S,I

Every country is a "small open economy" => no country by itself can affect rw
If a countries net exports is greater than zero then Y> C+I+G => a countries GDP or income is greater than domestic spending =>it exports the difference => a country is living well within its means => it is earning more than its spending

If NX<0 => Y<C+I+G => a countries GDP is less than domestic spending => its imports the difference => a country is living beyond its means
Ex. What one of the major things that started the US to have trade deficit to the rest of the world? S' rw A B S At rw, S=I, NX=0 => decrease in taxes => saving to go down =>A->B = (S-I) <0 since at rw, I>S => NX<0 =>net intl borrowing

rw*

I
S=I* (S-I),NX

S S'

This country is running a trade deficit

S-I=NX at rw S-I>0 => NX>0 => CA surplus S-I<0 => NX<0 => CA deficit T, TR and G that will increase NX ^T => v C=> ^ S => now S' => at rw, S=I=> NX=0 => CA=0

r* Rw

s
b

i
I L* y

When we were running a trade deficit, were we engaged in net international borrowing or lending? Borrowing => capital inflows => a trade deficit country is a net debter

Trade Deficit: S<I Y-C-G<I *Y<C+I+G=> spending is higher than GDP/income => we must be importing the difference

What was Bush trying to persuade the Japanese to do with respect to fiscal policy? Japan (1989) is running a large trade surplus - Request them to run a more expansionary fical policy => v T => v S => Sv relative to I => S-Iv =>

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NX v => the trade surplus goes down

Ben Bernanky blamed the US deficit on "Foreign Savings glut" -> foreigners were saving too much r I' S As rw decreases, S-I gets more negative => NX decreases => CA deficit grows

Rw~* rw

I
I S-I

Theory of Purchasing Power Paridy (PPP)

Long run: In theory a unit of countries money should be worth the same in terms of goods and services evry ware in the world.

The nominal exchange rate: F/$1 or foreign price of one unit of domestic money $1/F or the domestic price of one unit of foreign money
- When F/$1 ^ => e^ => domestic money has appreciated (increased in value relative to foreign exchange) - When F/$1 v => e v=> domestic money has depreciated (decreased in value relative to foreign exchange) Flexible or floating Exchange rates

- Id e changes E1.3/$1 to e1.4/$1 => the dollar has appreciated to one euro has appreciated Real Exchange Rate Real exchange rate= e^x PD/PF roughly measures how expensive domestic goods are relative to foreign goods E=real exchange rate => E^ => a real appreciation => domestic goods have become relatively more expensive to foreigners The real echnage rate is always tending towards the value of 1 at which point purchasing power parody holds %e=f-d

Quiz review:
v T=> C^ => Sv => at rw 1 I >S => (s-I) v => NX v => the current account deficit increases

CA deficit => (S-I) <0 => net capital inflow => not intl borrowing, so when (S-I) v => borrowing from abroad
%De=f - d Flexible Exchange rates: E is constantly changing to cause the balance of payments to equal zero (BOP=0): - If a country is running a current account deficit that means its citizens are trying to make more payments to foreigners than foreigners are trying to make to them =>e v (domestic money depreciates )

If a country is running a trade surplus (NX>0) Foreigners are trying to make more payments to it then they are trying to make to foreigners => domestic money should appreciate Test: Short answer Output in the long run Saving investment Long run monetary framework
Ricardian Equivalence: Changes in taxes will have no effect on saving because they will have no affect on

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Ricardian Equivalence: Changes in taxes will have no effect on saving because they will have no affect on consumption If taxes are increased=> gov saving ^, but private saving goes down by the exact same amount. So only if consumption decreases will saving increase

Laugher Curve : Tax rate

If tv => ^ Ls => ^ L* and v w/p => since Y* = AF(K,L) => ^ Y* => ^ t* Y=taxes

Taxes
Its possible that a decrease in taxes can cause an increase in tax revenues

Short Run One of the things not able to explain in the long run is the business cycle The key feature of short run: In the short run, assume that prices are fixed LRAS P Y*=AF(K,C)

A
P* SRAS

C
ADC (M*) Y* y

Arrogate demand (AD) is drawn for a particular money supply(m) and therfore for a particular real money supply(m.p), given P=> at P*, M/P= M*/P*
=>vP =>(M*/P)^=> "real balance effect"=>^spending => for goods market to be in equilibrium if (C+I+G)^ =>Y^ =>B => C

In the short run aggregate demand determines GDP If Y<Y* => prices will begin to fall => Short run aggregate shift (SRAS) shifts down until Y=Y* If output rises above full employment level prices will begin to rise and SRAS shifts up until output equals full employment level

Resession: P
P1 P2 P3 LRAS

SRAS

vAD in roughly 2007=> Yv to Y' => Y'<Y* => a recession => P should fall =>delation =>P1 to P2 to P3 =>Y ^ back to Y*

AD'
Y' Y*

AD
Y

Stabilization Policy The use of fiscal and/or monetary policy to "manage" AD

Supply Shocks: Favorable supply shock: LRAS LRAS'

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LRAS LRAS' SRAS SRAS'

AD
Y* Y** Q

Ch 10: Aggregate Demand (determines the level of GDP in the short run)
LRAS Keynesian Cross Theory: how planned spending determines/causes the level of GDP P ISLM Planned Spending Y=C+I_G Cp=a+b(Y-T+TR) P B A But need not be Ip=I SRAS Gp=G true that C AD Y=Cp+Ip+Gp AD* Ep=planned spending Y' Y* E=actual spending Ep>E => Ip>I =>unplanned inventory dissimulations =>Ep>y Ep<E=>Ip<I => unplanned inventory accumulations => Ep<y

E=expendetures Y=GDP

E
E=Y (slope=1)
F

Slope=b

E*
A
B A

When the economy is in short run equilibrium, Ep=y Y=Ep y=a+b(Y-T+TR)+I+G y=a+bY-bT+bTR+I+G

450

YA
Suppose YA => B>A => Ep<Y => unplanned invantory decumulations = (Ip-I)<0 => Y^ until Y=Y* where Y=Ep at C Suppose YB => D<F Ep<Y => unplanned inventory accumulations => (Ip-I)>0 => Yv until Y=Y* where Y=Ep at c

Y*

YB

y=bY+A *Y=A+bY

A=a-bT+bTR+I+G

At Y*, Ep=Y*, so Y* is the short run equilibrium level of GDP

Y= E but when Ep >E, the difference is that Ip>I => an unplanned decrease in I

Ip<I but E=Y If people don't want to buy all of the output that is being produced what happens to it? It's added to inventories I>Ip

The Spending multiplier

Slope=1
E

E*

Y=A+bY Y-bY=A (1-b)Y=A Slope=b Y*=A * 1/1-b => [1/1-b] is the basic Keynesian spending multiplier
- Even small changes in planned spending can cause large changes on the equal level of GDP

45o
Y* Y

b=.8 b=.9

1/1-b = 1/1-.8 =1/.2 =5 1/1-b = 1/1-.9 =1/.1 =10

Gv by $100b and b=.9 => multiplier = 10 so when G=-$100b, in the short run, y=-$1 trillion

Theory of Purchasing Power Parody Long Run: In theory a unit of countries money should be worth the same in terms of goods and

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services every ware in the world.

The nominal echange rate=* F/$1 or the foreign price of one unit of domestic money *$/F or the domestic price of one unit of foreign money e=nominal exchange rate When F/$1 ^ => e^ => domestic money has appreciated (increased in value relative to foreign exchange) When F/$1 v => ev => domestic money has depreciated (decreased oin value relative to foreign exchange) Flexible or floating exchange rates If e changes 1.3/$1 to 1.4/$1 => the dollar has appreciated to euro has appreciated
Real Exchange Rate Real exchange rate= e x PD/PF roughly measures how expensive domestic goods are relative to foreign goods =real exchange rate => ^ => a real appreciation => domestic goods have become relatively more expensive If e^ => domestic goods are more expensive to foreigners The real exchange rate is always tending towards the value of 1 at which point purchasing power parody holds %e=F-D Advantages to QE2 1) QE2 could significantly decrease borrowing costs => ^ spending 2) QE2 could boost other asset prices => ^w => ^consumption spending 3) QE2 could cause the dollar to depreciate => ^D relative to F => ev => dollar depreciates => ^ NX

IS-LM curve B

r
A E>Y=>y^

C IS''
IS' IS

Anything direct spending disturbances that causes Ep^ at all r's and Y's shift IS out (vS =>IS out) Any direct spending disturbance that causes Epv at all r's and Y's shift IS in. (S^ => IS in)

[IS']: ^ T =>(v gov budget deficit) => v (Y-T+TR)= disposable income => Ep(vC) =>IS in
C-> A = 1/1-b * A = 1/1-b*-bT

[IS'']: ^optimism within the business community= ^MPKF => ^I at all r's => IS out
LM Curve r

r2
r1 IS Y2 Y1

L=money demand M=money supply

Money Market: M=M~ (open mkt. purchases => ^M open mkt. sales => vM) Md=Md ( I , Y+ +) i=r with (i.e. if P~)

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i
i*

m m

(i.e. if P~) =a measure of the perceived riskiness of non monetary assets

I'
m~m'

Md(I,y,)
m

Bonds: Debt instruments (IOU's) Most bonds are associated with a fixed stream of payment(s) in the future=> those payments represent interest
**Bond prices and interest rates are negatively related Consider a consol= a bond that pays interest forever but which never matures(the principle value is never paid off) Pc= coupon payment/nominal interest rate i=coupon payment/ Pc 10%=$10/$100

-suppose interest on newly issued bonds decrease to 5% if you purchase a $100 consol, it will pay $5/year forever -demand increases for 10% bonds -> PB increase until it is no longer more desireable than a newly issued %5 bond, i.e. P B increase until = $200
PB=$50 = 10/I => $50(i)=$10 => i=20% ^DB at $50 => PB^ to $100 => $100 = $10/I => I => 10%

Suppose only 2 Financial assets: Money & Bonds (M and B) Supply of financial wealth= MS+BS Demand of financial wealth=Md+Bd When the financial system is in equilibrium: Ms+Bs=Md+Bd => **Ms-Md=Bd-Bs

3 key relationships: Ms=Md then Bd=Bs Ms-Md=Bd-Bs Ms>Md=Bd>Bs (if there is excess supply in the money market at I then there is Ms<Md=Bd<Bs excess demand in the bond market) (if there is excess demand in the money market there is excess supply in the bond market)

How does the fed affect interest rates through monetary policy? The only interest rate the fed directly controls is the discount rate

MS

Ms'

i
i* i'

A ----> B

Md

m/p
^Ms=> at i*, Ms>Md (excess supply in the money market) => this suggests Bd>Bs => PB^ => I decreases until Bd=Bs => in the money market the interest rate falls to I* until the demand for money = the supply of money (Md=Ms)

When the fed monetary policy becomes expansionary: All securities are more or less substitutes for one another: ^PB what will happen to the demand for corporate stock? => Ds^ => Ps^ ^Ps, ^PB=> ^D real estate => P^ real estate

Macro Economics Page 16

Financial Panics

1800

1915 Time

A financial Panic=> a flight to liquidity => decrease in (V)velocity => ^Md =>Md> Ms= Bs>Bd =>P Bv => i^ by enough to cause Bs=Bd=Md=Ms

MS

i
15%=I" 5% = i*

In this case, Buy securities=> ^Ms as a result of Fed open market purchases => Iv to I"

Md'
Md

m/p

MS
i vMs=>i^=>PBv I"

=> Dsv =>Psv =>D houses v =>Phouses v

i*
Md

m/p

Liquidity preference framework: Bond Market Money Market vT=> ^ gov. budget deficit => ^ borrowing => ^Bs => Bs>Dd => PBv => i^ (Md>Ms) => ^ Ms s.t. Md=Ms (by buying bonds)=> then, interest rates don't have to change Big players dont like it bc: vPB => ^I =>vDs=> vPs - Bc stocks are a substitute for bonds

LM Curve: I i2 Md=Md(i*Y*) Ms Md(Y2)

i1
i0 Md(Y1) Md (Y0) m/p

The LM curve shares all combinations of r and Y at which the money market is in equilibrium, everything else held constant

IS-LM r R2 R1 R0 LM

Y0

Y1

Y0 Y Ms Ms' LM

Strange cases:

Macro Economics Page 17

Md(yo) Md(y1) Md(Y2)

i Md(yo)

LM (liquidity trap)
m/p The interest elasticuty of Md=0 The interest elasticoity of Md= m/p

y
i=r+e^=>^i

What Causes the LM curve to shift? LM''

LM LM'

Anything that causes the money market to be in equilibrium at a lower interest rates, at every level of Y will shift LM down:
1)^Ms, vMs Ms Ms'

r0

Y0

I0
ir Md(Y0)

M/P 2)vMd, ^Md

If it effects: Spending- IS shifts Monetary-LM shifts

Using the IS-LM framework:

YF

vSpending => Yv LM

vG=> v Budget Deficit => IS curve shifts in=> r v to r' and y v to y''

r* r'
IS Y'' Y* YF IS y

Daniel,
It will be much easier after you watch me work through a bunch of problems on Friday. Still, getting it takes some practice. Try working through these:

Use the IS-LM framework to show and explain what will happen to the interest rate and GDP under each of the following scenarios:
1) The Bush tax cuts are allowed to expire, resulting in a large tax increase.

2) An increase in stock prices causes a large increase in private wealth (remember that wealth affects Consumption).
3) The Fed increases the Money Supply, as Quantitative easing Pt.2 kicks in. 4) You hear on the news that for some unknown reason, the velocity of money has increased dramatically.

Also, try this one:

Which would likely cause GDP to increase by the most.

a) An increase in taxes and a cut in Government purchases.

b) A tax increase coupled with an increase in the Money Supply. c) An increase in Government purchases combined with an increase in the Money Supply.

Macro Economics Page 18

Open Economy IS-LM Mondell Flemming Model: Assume perfect capital mobility => balance of payments is in equillibrium at the world real interest rate

Balance of Payments is a way of keeping track of all international transactions BP=0 at Vw.
BoP must = 0 What causes this? Under flexible exchange rates, e will occur until BoP=0 Under fixed exchange rates, official reserve transactions (ORT) occur until BoP=0 BoP= CA + KFA + ORT => under fixed exchange rates - CA (current account)= NX= net sales of domestic goods and services to foreigners => Domestic payment to foreigners (-), If it involves a foreign payment to domestic residents (+) - KFA (capital and financial account)= Net sales of securities to foreigners by domestic residents= sales of domestic securities abroad (domestic borrowing) - purchases of foreign securities by domestic residents (domestic lending abroad). Capital inflows-capital outflows - ORT(official reserve transactions) = Sales of foreign exchange reserves by the domestic central bank- purchases of foreign exchange reserves by the domestic central bank

BoP=0=CA+KFA+ORT US is running a, CA deficit= KFA surplus (net borrowing from abroad) - If CA+KFA<0, then ORT=positive From Chinas Persective: CA surplus but (CA+KFA)>0 ORT must be negative e=F/$1 BoP>0=> excess demand for domestic money in foreign exchange markets=> exchange rate money appreciates=> exports go down and imports go up=> net exports decrease until BoP=0 BoP<0=>excess supply of domestic money in foreign exchange markets =>exchange rateis going to go down => domestic money depreciates=> exports increase and imports decrease=> NX^ until BoP=0
Good Market equilibrium condition Open economy: Y=C+I+G+NX C=a(r,w) + b(Y+TR-T) I=I(r[-], MPKf[+]) G=G NX=NX(e,y)

Inflation, deflation= value of money for goods and services Appreciation, depreciation= value of money compared to other currencies

E= F/$ * P D/ PF = the price of one unit of domestic goods in terms of foreign goods: E>1=> foreign goods inexpensive E<1=> foreign goods expensive ^ E => real appreciation => v net exports v E=> real depreciation => ^NX

Perfect Capitol Mobility: NX= NX(e)

r rw

BP surplus bc KFA surplus (foreigners buying higher yielding domestic securities => e^ ($ appreciates)
BP=0 BP deficit bc KFA deficit (domestic residents buying higher foreign securities) => e v (domestic money will depreciate)

y
Under flexible exchange rates changes in the nominal exchange rate occur that cause the balance of payments (BP) to equal zero

Example: monetary

Macro Economics Page 19

Example: monetary policy >>>

r A C

LM

LM'
r*=rw BP=0

B IS' IS
Y* Y' y'' Y

^Ms=> LM shifts down and to the right=> A->B (rV and y^) => BP deficit because KFA deficit (more foreign lending) =>e V (domestic money depreciates) => NX^ => IS curve shifts out=> Y^ stil further until C at Y''

Fiscal Policy >>> r A LM BP=0 >>^T, e V

r=rw*

B
IS' Y* Y

IS

^T => IS shifts down and to the left =>r'<rw => BP deficit bc a KFA deficit => e V (domestic money depreciates) => NX^ => IS up=> eventually returns to initial position A

Under flexible exchange rates changes in fiscal policy will not permanently change anything

Fixed Exchange Rates: the central bank pegs the value of money compared to foreign
Gov sets a fixed exchange and whenever there is pressure on it to change the central bank must intervene in order to maintain the fixed exchange They require central bank intervention in order to maintain a fixed rate Pressure to; ^e=>CA^ or KFA^ => ORTV=> more central bank purchases of foreign exchange=> ^Ms Pressure to; Ve=> CAV or KFAV so ^ORT => central bank sales of foreign exchange =>Ms V

BP surplus => pressure on e to appreciate b.c. excess demand for domestic money =>foreigners trying to make more payments to us then we to them: Flexible: e (exchange rate) actually does increase Fixed: buy foreign currency and sell domestic money => ^Ms until pressure on e^ ceases BP deficit=> pressure on e to depreciate b.c. excess (-ORT) supply of domestic money =>Domestic residents are trying to make more payments to foreigners than foreigners making to domestic residents Flexible: e actually does decrease Fixed: Sell foreign currency => v Ms until pressure to e v ceases=> (+ORT)

Gold Standard: Requires Fixed exchange rate. Gold content of =.02oz/ Fixed exchange rates cause a necessity to fix a price of a key commodity(gold)
Gold content of $=.01/$

e= 1/gold content of =.5/1$ gold content of $ Setting up a gold standard requires fixed exchange rates It does not require of imply the value of money will be stable
^ the value of gold in the commodity market => ^ the value of domestic money => deflation V the value of gold in the commodity market=> v the value of domestic money => inflation

When you fix the value of money in the terms of a commodity doesnt make the value of money stable. If the value of money in fluctuating bc of the central bank moving then the gold standard can be a more stable type of way to use money Suspension: closed the doors and changed the exchange rate

Fixed exchange in IS-LM framework

Macro Economics Page 20

LM LM' BP=0

r* r' IS Y*

^Ms => rv to r', Y^ to Y' => Capital inflow (KFA deficit) => pressure on e to V => the Fed sells foreign currency => Ms V => LM shifts back up until pressure on e V is eliminated i.e. until LM returns to its former position

y'

How fiscal policy is Potent and Monetary policy is Not Potent r r' r* B LM

c BP=0 IS'
IS

^G=> IS out =>r^ and Y^ but now r>rw, BP surplus => Pressure on e^ => buy foreign exchange ^MS=> until LM=IS=BP => so A->B->C

Y*

Y'

IS-LM, Kansian Cross, Multiplier, Understand self adjusting tendencies at work in the economy

Fixed Exchange Rate Flexible exchange rates: ^e => appreciation Ve=> depreciation "Dirty" Float -> exchange rates are aloud to float but the central bank can effect the exchange rate when it wants Fixed: ^e=> reduction Ve=>devaluation r
r=rw

LM
LM

A B
Y* Y

BP=0 IS IS'

Devaluation involves increasing the money supply until the exchange rate falls to the new desired level and them maintaining the exchange rate at that level Fixed=> Flexible => Fixed ^Ms=> A->B => BP deficit => Pressure on e V, but the central bank lets it fall (devaluation) => NX^ => IS out => Y^ to Y

Y=full employment ODP

Devaluation enables a country to use expansionary monetary policy under fixed exchange rates

Why is China so resistant to revaluing its money? The way china keeps a fixed exchange rate is by pegging the value of the Yuon to the dollar If the Chinese revalue its currency the Chinese goods will become more expensive

r B

LM' LM BP=0

r=r*

A
IS' IS Y* Y

For the Chinese to revalue the Yuon, VMs until their e($/1Y)^ to the new "desired" level => LM up => but as e^ => NX V => IS in until YV to Y' BP is horizontal at rw + (risk premium on borrowing from abroad)

Macro Economics Page 21

LM

BP=0
r* BP=0

IS

Y*

=0 and ^ to 5%=> BP shifts up=> At A1 new BP deficit=> e V massive depreciation as a result of capital flight, which should ^ NX, but VMs in order to keep e from falling to practically "0"

Using Supply and demand analysis to understand e e=f/$1 S' e e* QD QS S (imports of goods and services, foreign lending)

D (exports, foreign borrowing) Q* Q=$ in the foreign exchange market

Suppose e fixed at e=>Qs> QD (of domestic may in the foreign exchange market: excess supply) => over valued => VMs => S shifts, or QS-QD=ORT

BP=Payments to us- payments by US Capital inflows=> foreigners are paying us for IOU's
KFA=capital inflows-capital outflows CA=$200b KFA=$200b Foreign lending= purchases of foreign IOU's by US residents

Self adjusting tendencies If output is greater than full employment output If out falls below the sras down

Crowding out: Refers to the decrease in private spending especially investment that results from an increase in the interest rate when expansionary fiscal policy is adopted(^G, ^TR, VT)

If interest rate is constant if ^g then ^Y= 1/1-b * ^G i.e. if b=.9 then change in Y=10* change in G IS-LM
LM r' r* LM' ^G=>IS out=> A->B= (1/1-b*^G)=>but at B1 Were "off" LM (excess demand in money market i.e Md>Ms=Bs>Bd PBv and r^ => so Y only ^ to Y'

IS'

IS

Prevent crowding out? =>debt monetization =>the fed buys the government bonds that were issued in connection with ^G=>Ms^=>LM out=> if r, no crowding out

Tying together the ISLM and the economy self adjusting theory

FE
r LM' LM(M/P) Y>YF=>since M<MF,w^=>P^

But when the price level increases the real money supply decreases (Pigu effect) r* IS
Y* What happens when the fed increases the real money supply? =>LM curve shifts out bc. (M/P)^ => r V and Y^ => y>Yf=>w^=>P^=>(M/P)v=>usP^, LM shifts back to where it was befoee IS=LM=FE

Macro Economics Page 22

The economy is in the midst of a recession:

FE r LM
V w=>IS in=>Y to

LM'
r* r' IS' IS Y

Y' and rV to r' =>y<Yf =>M>MF=> w v =>Pv =>m/p^ =>LM gradually out until Y=Yf)

y' Y*

STagflation:

FE r FE' LM
BP=0

Adverse supply shock temporarily reduces Yf =>Yv to y' => but y>y', so p^=> m/p V=> lm back =>y V

r*

IS

**Anything that ^y in IS-LM ^AD by the same amount

Y*

Expectations Adjusted Philips curve

5%

=e+(M-) =(-)

%(w/p)=%w-%P so if %p=3% and w, then %(w/p)=-3% 4% = 5.5% 6%

=e+(M-) If M= then =e

T+2

T+1
e=T T+1 T

Policy:Mt+1=Mt+1+ In order to get to Mt+1, ^ to t+1 => assuming adoptive expectations eT+n=T+N-1 If =T+1 this period, then next period eT+2=T+1, so T+1 is associated with a higher rate of inflation that before (T+2)

In order to get rid of inflationary expectations, has to rise above M (recession)

Test question: Return to the gold standard: What would happen with a private sector spending disturbance effect the fixed exchange rate. Would it have been worse and how and why?

Fed's hands tied under fixed exchange:

Macro Economics Page 23

LM LM' BP=0

r=rw*

IS

Y*

Suppose the central bank wants to stimulate the economy: In the short run they buy bonds to increase the money supply=> lm out=> rV and Y^ Under fixed exchange since r<rw=> capitol outflows (KFA deficit=BP deficit)=> pressure on exchange rate to fall (on domestic money to depreciate below the fixed nominal exchange rate) The money supply is too high and r is to low there is pressure to decrease the exchange rate=> v MS and continue to do so until LM returned to its former position Net result is no change
Screen clipping taken: 1/17/2011, 10:29 PM

Macro Economics Page 24