CH 16+18 Flashcards
classical model of the price level (definition)
a simplified model in which the real quantity of money is always at its LR equilibrium level
- assumes that economy moves directly from one LR equilibrium to another
- assumes aggregate output (aka real GDP) never changes in response to a change in money supply
- analyses the effects of money supply changes as if the SR as well as the LR aggregate supply curves were vertical
when is the classical model of price level a good approximation of reality of economy?
when economy is facing persistently high inflation
–> short run stickiness of nominal wages+prices tends to vanish–> because used to inflation–> respond to changes in price level quicker–> so SRAS curve shifts quicker than if not used to adjusting quickly–> therefore more rapid return to potential output, only now with higher inflation
seigniorage (definition)
the difference between the value of currency/money and the cost of producing it
–> aka amount of money government actually captures by printing (more) money
inflation tax (definition)
the reduction in the value of money held by the public as a result of inflation
–> because inflation erodes the purchasing power of people’s money holdings
–> 5% inflation rate–> results in 5% inflation tax rate on value of all money held by the public
seigniorage (equation)
the change in money supply over the same period of time that the seigniorage is collected
real seigniorage (equation)
rate of rgowth of money supply X real money supply
how does hyper inflation happen?
- in face of high inflation–> public reduces real amount of money it holds
- this reduces the real money supply
- government needs to print more money to pay for G+S and its debt
- but because people hold less real money–> government has to respond by accelerating rate of growth of money supply because money worth less so need more to pay for things–> even higher levels of inflation
- people respond to this higher inflation by again reducing their money holdings
- this reinforces this process–> can spiral out of control
output gap (definition)
the percentage difference between actual level of real GDP (aggregate output) and potential output
unemployment rate=
cyclical+natural unemployment
the 2 rules that define the relationship betweenunemployment rate and output gap:
- when the actual aggregate output is equal to the potential output–> the actual unemployment rate is equal to the natural rate of unemployment
- when output gap is positive (inflationary gap) –> economy temporarily using resources higher than normal amounts–> unemployment rate below natural rate
- when output gap negative (recessionary gap) –> not full use of productive resources–> unemployment rate above natural unemployment rate
short-run philips curve (SRPC) (definition)
the negative SR relationship between unemployment rate and inflation rate
- when unemployment is low–> inflation high
- when inflation low–> unemployment high
a negative supply shock shifts SRPC…
upwards–> because inflation rate increases for every level of unemployment
a positive supply shock shifts SRPC…
downwards–> because inflation falls for every level of unemployment
expected rate of inflation (definition)
the inflation rate that businesses and workers are expecting in the near future
–> changes in expected rate of inflation affects SR trade-off between unemployment and inflation & shift the SRPC
stagflation (definition)
the combination of high inflation and high unemployment
how to avoid accelerating inflation over time:
unemployment must be high enough that the actual rate of inflation matches the expected rate of inflation
–> aka at the Nairu
non accelerating inflation rate of unemployment (NAIRU)
the unemployment rate at which inflation doesn’t change over time
Long-Run Philips Curve (LRPC) (definition)
shows the relationship between unemployment and inflation after expectations of inflationhave had time to adjust to experience
–> vertical line–> because no LR trade off between unemployment and inflation
natural rate of unemployment (definition)
portion of unemployment unaffected by swings of business cycle
deflation (definition)
fall in aggregate price level
deflation repercussions lenders+borrowers:
- lenders–> are owed money–> gain under deflation–> because real value of borrower’s payments increases
- borrowers–> owe the money–> lose–> burden of their debt rises
debt deflation (definition)
the reduction in aggregate demand arising from increase in real burden of outstanding debt caused by deflation
–> because borrowers are usually ones that spend that money, lenders are not–> therefore decrease in disposable income borrowers leads to less aggregate demand
liquidity trap (definition)
when in economy conventional monetary policy is ineffective because the nominal interest rate is up against the zero lower bound
–> can occur when there’s a sharp reduction in demand for loanable funds–> like during the Great Depression
international macroeconomics (definition)
branch of macroeconomics that deals with the relationship between national economies
balance of payments accounts (definition)
a summary of the country’s transaction with other countries over a year
factor income (definition)
the income that foreigners pay to US residents for the use of US owned factor sof production & income paid by US to foreigners for use of foreign owned factors of production
international transfers (definition)
funds send by US residents to residents of other countries and vice versa
(balance of Payments on) Current Account (definition)
country’s balance of payments on G+S+net international transfer payments+factor income
balance of payments on goods and services (definition)
the difference between country’s exports and imports during given period of time
(merchandise) trade balance (definition)
the difference between country’s exports and imports EXCLUDING services
–> economists sometimes focus on this 9even though not complete measure) because data on international trade in service isn’t as accurate as that of trade of goods
(balance of payments on) financial account (definition)
the difference between country’s sales of assets to foreigners and its purchases of assets from foreigners for given period
current account deficit (definition)
amount paid to foreigners for G+S+Factors+Transfers–> more than amount received
financial account account surplus (definition)
value of assets it sold to foreigners was more valuable than assets bought from foreigners
what is the basic rule of balance of payment accounting?
current account and financial account must sum up to zero!!!!
aka: CA+FA=0
by what is the financial account determined?
by the supply and demand market for loanable funds
–> capital moves from places where would be cheap in absence of international capital flows to where it would be expensive in absence of such flows
how does capital tends to flow?
from slowly growing economies to rapidly growing economies
–> because faster growing economies offer higher interest rates
reasons for 2-way capital flows:
- investors seeking to diversify against risk by investing in different countries
- corporations often engage in international investment as part of their business strategy–> eg: auto company might be better off to compete overseas if assemble cars overseas etc
- some countries are international banking centres–> people form all over world put money in US financial institutions–> which then fund those funds overseas
result of 2-way flows of capital:
moderne conomies are typically both debtors and creditors
foreign exchange market (definition)
market where currencies can be traded for one another
exchange rate (definition)
the price at which currencies trade
–> set by foreign exchange market
appreciates (definition)
when currency becomes more valuable in terms of other currencies
depreciates (definition)
when currency becomes less valuable in terms of other currencies
how is the exchange rate determined?
by the supply and demand in the foreign exchange market
equilibrium exchange rate (definition)
the exchange rate at which the quantity of a currency demanded in foreign exchange market is equal to the quantity supplied
real exchange rate (definition)
exchange rate adjusted for international difference in aggregate price level (inflation)
equation real exchange rate
real exchange rate= Mexican pesos per US dollar X PUS : PMex
PUS/PMex= indexes of aggregate price levels in US and mexico
purchasing power parity (definition)
the purchasing power parity between two currencies is the nominal exchange rate at which a given basket of G+S would cost the same amount in each country
effective exchange rate (definition)
measure of average value of dollar against other currencies
real net exports (definition)
exports-imports
exchange rate regime (definition)
a rule governing policy toward the exchange rate
2 main types of exchange rate regimes (definition):
- fixed exchange rate
- floating exchange rate
fixed exchange rate (definition)
when country’s government keeps exchange rate against some other currency at or near particular target
floating exchange rate (definition)
when country’s government lets market forces determine the exchange rate
3 ways government can keep value of EXR higher than equilibrium EXR:
- exchange market intervention–> use foreign currency to buy own currency
- try shift S+D curves for currency in foreign exchange market–> by raisinginterest rates–> more capital inflow+less capital outflow–> increased demand+reduced supply–> worth more because scarce
- government can support their currency by reducing supply of genos to foreign exchange market–> using foreign exchange control–> limiting its residents yo buy foreign currency
foreign exchange reserves (definition)
stocks of foreign currency that governments maintain to buy their own currency on foreign exchange market
foreign exchange controls (definition)
licensing systems that limit right of individuals to buy foreign currency
3 things government can do to keep EXR lower than equilibrium price (shortage):
- intervene foreign exchange market–> selling their currency+buying foreign currency
- reduce interest rates–> increased supply of their cureency and reduced demand
- impose foreign exchange controls–> limit ability of foreigners to buy their currency
2 benefits o fixed exchange rate:
- certainty about future value of currency–> beneficial to know for international trade, amount of money agreed on stays the same worth
- by committing itself to a fixed rate–> country also committing itself not to engage in inflationary policies
4 costs of fixing the exchange rate:
- to stabilise EXR through intervention–> country must keep large quantities of foreign currencies on hand–> (usually low return of investment)
- even largest reserves can be quickly exhausted when large amount capital flows out of country
- if country chooses to stabilise EXR by adjusting monetary policy instead of intervention–> must divert monetary policy from other goals–> like stabilising economy+managing inflation rate
- foreign exchange controls–> like import quota’s+tariffs–> distort incentives for importing+exporting G+s
3 policy issues raised by international aspects of macroeconomics (definition):
- devaluation and revaluation of fixed exchange rates
- monetary policy under floating exchange rates
- international business cycle
devaluation (definition)
a reduction in the value of a currency that is set under fixed exchange rate regime
–> makes domestic goods cheaper compared to foreign goods–> increase in exports and reduces imports–> this effect increases the balance of payments on the current account
revaluation (definition)
an increase in value of a currency that set under fixed exchange rate regime
–> makes domestic goods more expensive–> reduced exports+increase imports–> this effect reduces the balance of payments on the current account
2 purposes of devalutions+revaluations under fixed exchange rates:
- can be used to eliminate shortages/surpluses in foreign exchange market
- can be used as tools of macroeconomic policy:
- devaluation–> increases exports+reduces imports–> can be used to reduce/eliminate recessionary gap
- revaluation–> reduces aggregate demand by increasing imports–> can be used to reduce/eliminate inflationary gap
monetary policy under floating exchange rates (explanation)
even though floating exchange rate regime–> country’s monetary policy can still affect the EXR:
- lower interest rate–> higher investment+consumer spending–> but also causes less incentives foreigners to move their funds to that country–> so decline in demand for that currency–> at same time increased supply because residents want to get rid of their currency–> leads to depreciation in their currency exchange rate
–> this leads to increased aggregate demand because imports too expensive
–> so this monetary policy is working double: not only results the reduction in interest rate to increased spending, but also leads to increase in aggregate demand
international business cycle (explanation)
changes in aggregate demand affect demand G+S produced abroad as well as domestically
recession+imports relation:
recession leads to fall in imports
expansion+imports relationship:
expansion leads to rise in imports
