Exam #3 Flashcards
P = Overall price level aka…
1/p =
CPI or GDP deflator
1/p is the value of $1 (value of money) measured in goods
if p = $2, value of $1 is 1/2 candy bar
The quantity theory of money
David Hume, how the quantity of $ determines the value of money
What do we assume about the money supply
We assume the federal bank precisely controls MS and sets it at some fixed amount
The money demand is
Increase in P _______ value of money
How much wealth people want to hold in liquid form
reduces
The classical dichotomy
The theoretical separation of nominal and real variables that momentary developments affect nominal variables but not real variables
If the money supply doubles, prices will likely double, but the actual amount of goods and Services will not nesseciarly increase
What happens if the central bank doubles MS
All nominal variables - including prices - will double
All real variables - including relative prices - remain unchanged
Money neutrality define
The proposition that changes in the money supply do not affect real variables but only nominal variables
Velocity of money
The rate at which money changes hands
Nominal GDP =
P x y
Price level x real GDP
Velocity (v) =
(P x Y) / M
Money supply ( MS ) x velocity ( V ) =
Price level (P) X real GDP, quantity of production ( Y)
Inflation rate =
Change in price as a percentage
Money supply growth =
Change in money supply as a percentage
Economic growth =
Change in economic growth as a percentage
Hyperinflation is
how do prices rise
50% inflation per month or more
when the gov prints too much money
excessive growth leads to big social change
The fisher effect
Nominal interest rates adjust to changes in expected inflation to maintain a relatively stable real interest rate
nominal interest rates will rise with expected inflation to compensate lenders for the loss of purchasing power
Nominal interest rate =
Inflation rate + real interest rate
shoe leather costs
the resources wasted when inflation encourages people to reduce their money holdings
time and transaction costs of more frequent bank withdraws of cash
menu cost
the cost of changing prices
like new menus, mailing new catalogs, etc.
misallocation of resources from relative-price variability is when:
firms don’t raise prices at same time, so relative prices vary
this distorts allocation of resources because businesses and consumers struggle to make informed decisions about production and consumption ultimately leading to inefficient use of resources
confusion and inconvenience
inflation changes the measurements used to measure transactions
this complicates long-range planning and the comparison of dollar amounts overtime
inflation makes nominal income grow faster than real income, taxes are based on nominal income and some are not adjusted for inflation.
this leads to tax distortions where:
people pay more taxes even when their real incomes don’t increase
nominal variables are measured in
while
real variables are measured in
monetary units, like $20 for jeans, without adjusting for purchasing power
physical units or relative terms such as 2 t shirts per pair of jeans (relative price)
after-tax return =
nominal rate x (1 - tax rate) - inflation rate
net capital outflow (NCO) =
domestic residents’ purchases of foreign assets
minus
foreigners purchases of domestic assets
NCO is also called
net foreign investment
NCO: foreign direct investment:
domestic residents actively manage the foreign investment
such as the McDonalds in Moscow
NCO: Foreign portfolio investment
domestic purchases of foreign stocks or bonds that supply “loanable funds” to foreign firms
NCO measures the imbalance in a country’s trade in assets.
when NCO > 0 this is
“capital outflow”
where domestic purchases of foreign assets exceed foreign purchases of domestic assets
NCO measures the imbalance in a country’s trade in assets.
when NCO < 0 this is
“capital inflow” where foreign purchases of domestic assets exceed domestic purchases of foreign assets
Nominal exchange rate: =
we express all exchange rates as foreign currency per unit of domestic currency
Canadian dollar/ US dollar = 1.29/ 1.00
in this example the US dollar is buying more with less money
NCO (Net Capital Outflow) =
NX (Net Exports)
What is affected when a foreigner purchases a good from the US
US exports and NX increase
the foreigner pays with currency or assets
the US acquires some foreign assets causing NCO to rise
therefore, NX and NCO both rise
S (savings) =
I (investment) + NCO or NX
Appreciation:
strengthens/ increases the value of a currency as measured by the amount of foreign currency it can buy
Depreciation:
weakens/ decreases the value of a currency as measured by amount of foreign currency it can buy
Real Exchange Rate (RER) :
Real Exchange Rate (RER)=
the rate where goods and services of one country trade for the goods and services of another country
(e x P)/ P*
E = nominal exchange rate
P = domestic price
P* = foreign price
E (Nominal exchange rate) =
P*/ P
P* (Foreign Price) =
P x e
What does the Real Exchange Rate (RER) tell us if it’s
= 1
< 1
> 1?
RER = 1, prices are equal
RER < 1, domestic prices are cheaper
RER > 1, foreign prices are cheaper
P :
US Price Level or Consumer Price Index
law of one price
the notion that a good should sell for the same price in all markets
like if coffee sold for $4/ pound in Seattle and $5/ pound in Boston, costlessly transported
this opens an opportunity for arbitrage making a quick profit buying coffee in Seattle and selling it in Boston
such arbitrage drives up the price in Seattle and drives down price in Boston, until prices are equal
Purchasing-Power Parity (PPP):
a theory of exchange rates whereby a unit of any currency should be able to buy the same quantity of goods in all countries
this theory doesn’t always hold in practice because some goods are not easily tradable, not always perfect substitutes, price differences reflect taste differences
or prices can’t be arbitraged away
what does the purchasing-power parity (PPP) imply about nominal exchange rates and real exchange rates
nominal exchange rates adjust to equalize the price of a basket across countries
while real exchange rates will equal 1
Arbitrage:
the practice of taking advantage of a difference in prices in two or more markets – striking a combination of matching deals to capitalize on the difference, the profit being the difference between the market prices at which the unit is traded.
PPP isn’t perfect but it does work well to explain…
the greater a country’s inflation rate…
long-run trends
the faster its currency should depreciate
a change in the money supply (MS) doesn’t affect __________ but does affect __________
doesn’t affect real variables
but
does affect nominal variables
Quantity of Money Theory =
M x V = P x Y
increase price means __________ interest rate
increase interest rate
Velocity and real GDP or quantity of production are
constant
mD is always _________ and mS is always ________
mD is always constant and mS is always variable
Purchasing power:
The value of A currency expressed in terms of the goods and services that it can be purchased with
The price level falls. This might be because the Federal Reserve
a.bought bonds which raised the money supply.
b.bought bonds which reduced the money supply.
c.sold bonds which raised the money supply.
d.sold bonds which reduced the money supply.
d.sold bonds which reduced the money supply.
According to the classical dichotomy, which of the following increases when the money supply increases?
a.the real interest rate
b.real GDP
c.the real wage
d.None of the above increases.
d.None of the above increases.
If the nominal interest rate is 7 percent and expected inflation is 4.5 percent, then what is the expected real interest rate?
a.11.5 percent
b.7 percent
c.4.5 percent
d.2.5 percent
d.2.5 percent
real interest rate = nominal interest rate - inflation rate
7 - 4.5 = 2.5
When inflation rises, people will desire to hold
a.less money and will go to the bank less frequently.
b.less money and will go to the bank more frequently.
c.more money and will go to the bank less frequently.
d.more money and will go to the bank more frequently.
b.less money and will go to the bank more frequently.
The nominal exchange rate is 30 Thai baht for one U.S. dollar. A sub sandwich combo deal in the U.S. costs $6 dollars in the U.S. and 120 bhat in Thailand.
The real exchange rate equation and answer is:
E (Nominal Exchange Rate) x P (US Price) / P* (Foreign Price)
6 x 30 / 120 =
180 / 120
3 / 2
Suppose that a country imports $75 million of goods and services and exports $100 million of goods and services. What is the value of net exports?
a.
$175 million
b.
$75 million
c.
$25 million
d.
-$25 million
c.
$25 million
Net Exports =
Exports - Imports
Definition of trade balance:
the value of a nation’s exports minus the value of its
imports, also called net exports.
