Macro Flashcards
Define GDP
The value of total output of an economy in each period
Define economic growth
refers to the increase in the capacity of the economy to produce goods and services over time. It is measured by the rate of increase of real GDP
Define inflation rate
the percentage increase in the average price of goods and services
Gross debt
total liabilities owed to creditors
Net debt
total liabilities minus total assets that could be sold to raise money to pay creditors
Define Recession
a period of negative growth
growth calculation
Economic growth in poor countries
If poor countries are to catch up with the living standards of rich countries, they must grow at a faster pace.
what is a goal of macro policy
keep the economy as close to the straight line as possible, along the business cycle
Inflation calculation
Define a household
earn income which they use to purchase goods and services
Define a firm
produce goods and services which are sold in the market. Owned by households
how do the facotrs of production relate to economic activity
And all factors of production (e.g. labour and land) are owned by households, rented to firms.
- Further assume no savings, no surplus production, and no inter-firm sales.
explain the link between firms and households
- Revenue flows into the firm are divided up into wages, rents and profits.
- These wages, rents and profits are then taken back to households as incomes.
- The income is then used as expenditure on the goods that the firm produces.
- These expenditures are the firmโs revenue.
The circular flow of income holds:
- The value of output is equal to household income ๐ โก ๐.
- The value of output must equal the expenditure used to purchase ๐ โก ๐ธ.
- Expenditures must equal income ๐ธ โก ๐ .
What does y stand for
Output (the value of all production)
what does e stand for?
The value of all expenditure on goods and services
what does r stand for?
The value of all household income
Intermediate goods
goods which fully depreciate in the production process
Capital goods
goods purchased by firms from other firms, which do not depreciate in the production process. They are used many times.
Capital and intermediate goods in GDP
- Capital goods are final goods โ we do want to include this in GDP, but not the intermediate goods.
Define value added
the change in the value of a good as it moves through the production process.
what does total expenditure equal
C + I
What does Household income equal
C + S
How is investment for firms funded?
The savings of household
How does savings finance investment
- Loans through the banking system (using the savings of households).
- Issuing debt (bonds) which are sold to households in the financial market.
- Issuing equity (shares) which are sold to households in the financial market.
How do we account for unsold production?
- Unsold stocks of inventory are counted as part investment by firms,
- When these stocks are sold in the next year, they are counted as dis-investment (negative investment) by firms.
- Inventory counts towards GDP (as investment) in year 1, but not year 2.
two functions of government
- Providing income transfers (benefits, pensions etc) to households
- Providing final goods and services (education, police, bridges, etc) to households
How does government collect revenue
- Direct or income tax (wages, capital, rent, profits)
- Indirect, or expenditure tax
Define net taxes
tax minus benefit transfers:
NT โก Td โ B
Household disposable income
๐ โ ๐๐ โก ๐ถ + ๐
The leakages of the economy
๐ + ๐๐
The injections into the economy
๐ผ + ๐บ
what happends when ๐บ โ ๐๐ = 0
balanced budget so S = I
what happends when ๐บ โ ๐๐ > 0
Budget deficit so S > I โ> Households finance the deficit
what happends when ๐บ โ ๐๐ < 0
budget surplus so ๐ < ๐ผ โ> Government pays down the deficit
Imports
Goods purchased from foreigner firms by domestic households and firms.
- Imports are not part of domestic output. We need to account for them in final expenditure.
Exports
Goods sold to foreigners by domestic firms.
- Exports are part of domestic output.
Net Exports value
NX = X โ Z
What happens when ๐๐ > 0
trade surplus
What happens when ๐๐ < 0
trade deficit
Nominal GDP
GDP computed at current prices
Real GDP
GDP computed at the prices of a base year
GDP deflator
Gross National Product
the value of all income earned by citizens in a country.
example of german who works in london on GDP and GNP
- Contributes to UK, not German, GDP.
- Contributes to German, not UK, GNP.
Investment from foreign to domestic country
- Contributes to domestic GDP.
- Contributes to foreign GNP.
Full capacity output
The maximum level of output an economy can achieve at a given period by using all inputs at full capacity.
Potential output
The level of output the economy can achieve using all inputs at โnormalโ capacity.
Recession
A period of slow to negative economic growth for which the actual output starts to diverge from the potential output.
Boom
A period of rapid economic growth in which the difference between actual output and full capacity output becomes small.
Phases of the business cycle
- The upturn: the economy is below trend output but slowly recovering.
- The expansion: The economy experiences rapid economic growth.
- The peaking out: Growth slows down or even ceases.
- The recession: GDP starts to fall (negative growth).
Keynesian cross model - overview
- Aggregate output fluctuations are caused by changes in aggregate demand.
- In periods of recession or boom, the government can use policy to move the economy back to potential output.
Keynesian cross model - assumptions
- Prices, rents, and wages are all fixed.
- Firms always produce what demand requires.
- Workers are always available to work at current wage.
- Firms always have spare capacity that can profitably be used at current prices.
- There are always resources available at current rents.
- We start with two agents: households and firms
- Government and foreign trade will be added.
What does the Keynesian cross model consist of
Investment: Firms desired or planned additions to physical capital and inventories.
Consumption: Household demand for goods and services.
The Consumption Function
๐ถ = ๐ด + ๐๐
- ๐ด > 0
- 0 < ๐ < 1
What does the consumption function show
The desired aggregate household consumption at each level of aggregate income.
What is A in the consumption function
The part of consumption that does not depend on income, called autonomous consumption. This is the level of consumption at ๐ = 0.
What is c in the consumption function
The marginal propensity to consume. It is the amount of each additional pound in income that is
consumed (rather than saved.)
MPC in different households
- A very poor household is likely to immediately spend any extra income they earn. Their MPC is relatively high.
- A very wealthy household is likely to spend very little of a small income change. Their MPC is relatively low.
Marginal propensity to save
1 - c
Relationship between conumption and saving function
The steeper the consumption functions the flatter the saving function.
Savings function
๐ = ๐ โ ๐ถ
= ๐ โ ๐ด โ ๐๐
= โ๐ด + (1 โ ๐)๐
what is aggregate demand the sum of
consumption and investment
what does the 45degree line correspond to
the circular flow
In equilibrium
In equilibrium ๐โ = ๐ถ + ๐ผ
We know that ๐โ = ๐ถ + ๐
Therefore, in equilibrium it must be the case that ๐ = ๐ผ
autonomous spending and investment calculation
๐โ = ๐ด + ๐ผ/(1 โ ๐)
what is the multiplier
- A change in AD leads to a change in output which leads to a change in household income which leads to a change in AD.
multiplier calculation
1/1-c
what happens when desired savings fall
- At ๐0โ: ๐ < ๐ผ (not in equilibrium)
- As incomes rise from ๐0โ to ๐1โ, households increase their savings.
- This happens until ๐ = ๐ผ.
- Notice, there is no change in savings
Summarise an increase in A
- Decrease in C
- Decrease in Y
- No change in S
Consumer Confidence
- Shifts in A and I are often due to change in consumer and firm confidence.
- we assume that confidence about the future is independent of current income levels.
- If households and firms lack confidence in the outlook for the economy, they will increase savings (put off investment).
- If households feel less wealthy, they will increase savings (put off investment).
- The government will try and deter system-wide increases in savings during times of recession.
Fiscal policy
the governmentโs policy on spending and taxes
Stabilisation policy
refers to actions taken by the government to minimize movements in aggregate demand and output (keep it close to potential output).
Budget deficit
the excess of government spending over government receipts (taxes) each year.
national debt
the stock of outstanding government debt.
What are the two ways that government can finance spending?
- Tax (provide benefits) at a constant rate proportional to income.
- Collect taxes as a lump-sum (not conditional on income).
Tax (provide benefits) at a constant rate proportional to income.
- Let ๐ก be the net tax rate: the rate of taxation, less rate of benefit transfer.
- Tax revenues will be ๐ก๐, where 0 < ๐ก < 1.
- Disposable household income will be ๐๐ = (1 โ ๐ก)๐
Collect taxes as a lump-sum (not conditional on income).
- Let ๐๐ be the net tax: taxes less benefits transfer.
- Tax revenues will be ๐๐.
- Disposable household income will be ๐๐ = ๐ โ ๐๐
The consumption function written in terms of disposable income (PT)
C = ๐ด + ๐(1 โ ๐ก)๐
AD written in terms of disposable income (PT)
AD = ๐ด + ๐(1 โ ๐ก)๐ + ๐ผ + ๐บ
What does an increase in G do to the AD curve (PT)
Shift it up
what happen to the AD curve when t increases (PT)
AD curve pivots, becoming less
steep.
Equilibrium output with government spending (PT)
impact of tax on the multiplier (PT)
Household disposable income (LST)
๐๐ = ๐ โ ๐๐
The consumption function written in terms of disposable income (LST)
๐ถ = ๐ด + ๐(๐ โ ๐๐)
AD written in terms of disposable income (LST)
๐ด + ๐(๐ โ ๐๐) + ๐ผ + ๐บ
What does an increase in G do to the AD curve?
shift it up
What does an increase in NT do to the AD curve?
shift the AD curve down
NT and G increasing by the same amount
If ๐๐ increases by the same amount as ๐บ, the AD curve shifts down, but not all the way back.
Equilibrium output for LST
Multiplier for LST
1/1-c
- However, the shift in government spending is offset by the decrease in household
disposable income.
What is a balanced budget?
A balanced budget means that the government will set taxes such that government
spending is always covered.
How has taxation been adjested in a balanced budget?
so that NT = G
What happens when the government runs a balanced budget
government spending offset by a tax
increase will always increase in output.
why is using a balanced budget multiplier as a fiscal tool indefinetely not feasible
- It involves raising taxes for greater expenditures.
- It involves replacing some private spending (in the form of household consumption) with public spending.
- Once we include interest rates in the model, we will also see that government spending โcrowds outโ capital investment from firms.
Savings in equilibrium
๐ = ๐ผ + ๐บ โ ๐๐
How does household savings finance investment by firms
- Through the banking system
- Shares
- Bonds
- Government bonds.
Budget deficit
when total government spending is greater than total tax revenue ๐บ > ๐๐.
Budget surplus
when total government spending is less than total tax revenue ๐บ < ๐๐.
automatic stabilisers
used to dampen the response of the economy to shocks.
automated taxes and transfers
they work by offsetting the economyโs response to
contraction and expansion.
equlibrium when we have a proportional net tax
multiplier when we have a proportional net tax
a positve demand shock on output
A positive demand shock will cause output to increase above its potential level
a negative demand shock on output
A negative demand shock will cause
output to decrease below its
potential level
what is the policy objectives for shocks to AD
Our policy objective is to make the deviations from ๐bar as small as possible.
Investment shock without tax
Investment shock with a proportional tax
Discretionaty fiscal policy
decisions that are made, on a case-by-case basis, to change
spending/tax rates to stabilize aggregate demand.
fiscal stimulus
A discretionary increase in spending, or cut to taxes, is referred to as fiscal stimulus. An example of this is the furlough scheme used during the pandemic.
what does austerity mean
a reduction in ๐ฎ โ ๐ต๐ป.
Analysis of why a recession is the wrong time for austerity
- Austerity worsens economic output declines.
- Stabilization policy uses proportional taxes, deficits in downturns, and surpluses in booms.
- Full-capacity economy assumptions alter analysis conclusions.
- Full-capacity leads to government spending crowding out private spending.
trade deficit
When ๐ โ ๐ < 0
trade surplus
When ๐ โ ๐ > 0
import demand function
๐ = ๐ง๐
- little z is MPZ
what does a high domestic income mean for trade balance
trade deficit
what does a low domestic income mean for trade balance
trade surplus
Equilibrium including x and z
what does a small value of z do to the AD curve
pivot it up
what does a large value of z do to the AD curve
pivot it down
if exports are higher than imports
more is sold to foreigners than is purchased from them. This extra income is part of savings (holding all else constant).
if imports are higher than exports
more is purchased from foreigners than is sold to them. This suggests a decrease in savings (holding all else constant).
what is money
Money is any generally accepted means of payment for delivery of goods or settlement of debt.
functions of money
- Medium of exchange of goods and services
- Unit of account in which prices are quoted and accounts are kept
- Store of value.
- Standard of deferred payment (enables borrowing and lending)
what is fiat money
A currency without intrinsic value.
what is commodity money
the actual use of a valued commodity as a form of money.
what is representative money?
is money that represents a claim on a commodity.
what are commerical banks
Commercial banks are a financial intermediary, coordinating activities
between savers and borrowers.
bank reserves
the money that a bank has available to meet possible withdrawals from depositors.
reserve ratio
the percent of all deposits that banks keep on hand to meet
withdrawals.
money supply
the value of the stock of all money in circulation.
monetary base
the value of currency either in circulation or held in reserves.
monetary base function
๐๐๐ท + ๐๐๐ท
money supply function
๐๐๐ท + ๐ท
money multiplier
financial asset
a piece of paper entitling the owner to a stream of payments over a specified period.
liquidity
the speed at which an asset can be turned into money.
solvency crisis
when an institutionโs assets have become less than its liabilities.
liquidity crisis
when an institution is temporarily unable to meet immediate payment requests.
bills
- Short term asset with a known date of repurchase at the known price.
- High liquidity.
bonds
- Longer-term
- Medium liquidity
perpetuities
- A type of a bond which is never repurchased by the issuer. Interest payments made forever.
- Medium liquidity
equities
- Company shares, entitling the owner to receive corporate dividends.
- Low liquidity.
role of the central bank
- Issue bank notes (ยฃยฃยฃยฃ).
- Lender of last resort
- Banker to the government
- It may also be the job of the Central Bank to police the financial system.
- Monitoring and controlling the money supply, interest rates & inflation.
How can the central bank influence the money supply
- Reserve requirements
- Setting the bank rate
- Open market operations
The yield calculation
relationship between price and interest rate
inverse
real money supply
M/P
why do we hold money
- Transaction - we do not buy and sell things at the same time.
- Precautionary - we hold money for unexpected costs that may arise.
- Asset - money has very low risk, but also very low return.
what is the primary benefit to holding money
- Higher consumption means higher money demand.
- Money demand is increasing with income (ceteris paribus).
the cost of holding money
- All wealth held in money rather than bonds forgoes the interest that bonds earn.
- The cost of holding money is greater when the interest on bonds is greater.
- Money demand is decreasing with interest rates (ceteris paribus).
What happens to the cost of borrowing money following an increase in the return on bonds
increase
what happens to the demand for money when the rate of interest decreases
decrease
What happens to demand as income increases
- Households need more cash for consumption transactions.
- Holding all else constant, the demand for real balances
increases.
demand equation for real money balances
๐ฟ๐ฟ = ๐ผ + ๐ฝ๐ โ ๐พ(๐ โ ๐๐)
Given the money demand schedule ๐ฟ๐ฟ, the Central Bank can either:
- Set the interest rate and let the money supply adjust.
- Set the money supply and let the interest rate adjust.
Endogenous variables in the money market - moves along the curve
Interest rates, ๐
Exogenous variables in the money market - shift curves
Income/output, ๐
Nominal money balances, ๐
Price level, ๐
how does changing the interest rate effect households?
- Lower interest rates imply higher price of bonds โ Households feel wealthier, consumption increases.
- Lower interest rates imply lower cost of borrowing, increasing spending on consumer durables (housing, cars, furniture) , consumption increases.
how does changing the interest rate effect investment by firms?
Lower interest rates imply lower cost of borrowing, increasing investing by firms.
goods market equilibrium
defined by output level ๐โ, such that aggregate demand and actual income (output) are equal.
money market equilibrium
defined by interest rate ๐โ, such that money demand is equal to money supply.
IS schedule
combinations of ๐ and ๐ for which the goods market is in equilibrium.
MP schedule
combinations of ๐ and ๐ for which the money market is in equilibrium.
Shifts in the IS curve
- Anything that shifts the AD curve for a given interest rate will shift the IS curve.
- Changes in ๐บ.
- Exogenous changes in ๐ถ or ๐ผ that are not due to changes in ๐.
Shifts in the MP curve
- Changes in the money supply (๐ฟ) for a given income level will shift the MP curve.
impact of increase government spending on spending
- Public spending has crowded out private spending โ investment spending has decreased.
Quantitive easing
refers to action taken by the central bank to increase the
money supply.
quantitive tightening
refers to action taken by the central bank to decrease the money supply.
monetary financing
Monetary financing refers to an arrangement whereby the central bank creates money to finance a government deficit.
what effects the slope of the MP curve?
- The slope of the Monetary Policy (MP) curve represents the change in interest rates resulting from changes in output.
- This slope is determined by the responsiveness of money demand to output fluctuations.
Flat MP curve
- Money demand is not
very responsive to changes in output. - Fiscal policy is effective.
- Little change in ๐, large change in ๐.
- Minimal crowding out of private spending.
Steep MP curve
- Money demand is very
responsive to changes in output. - Fiscal policy is largely ineffective.
- Large change in ๐, little change in ๐.
- Government spending has a large crowding out effect on private spending โ small increase in output is at the expense of a reduction in investment.
what effects the slope of the IS curve?
- The IS curveโs slope reflects how output changes with interest rate variations.
- This depends on how sensitive aggregate demand is to interest rate changes, specifically investment and consumption.
- High sensitivity (large AD shifts) leads to a flat IS curve.
Flat IS curve
- ๐ผ and ๐ถ are very sensitive to changes in the interest rate.
- Monetary policy is effective.
- Output is highly responsive to changes in the interest rate.
Steep IS curve
- ๐ผ and ๐ถ are not very
sensitive to changes in the interest rate. - Monetary policy is relatively ineffective.
- Output does not respond to changes in the interest rate.
Fiscal Policy - increase in government spending
- Increase in government spending increases AD โ IS shifts right
- Output increases, which leads to an increase in interest rates, which decreases investment spending.
- This adjustment stops when we arrive at the new equilibrium.
- Output has increase, interest rates have increased.
- Government spending has crowded out some investment spending.
Monetary policy increase in money supply
- Central bank increases the money supply โ MP curve to the right.
- Interest rates decreases, as a result firms want to increase their investment spending.
- There is a feedback between the goods market and money market as output and interest rates adjust.
- This adjustment stops when we reach the new general equilibrium.
- Output has increase, interest rates have decreased. Investment spending has increased.
Pros of monetary policy to stimulate the economy
- Works by stimulating private investment andconsumption.
Cons of monetary policy to stimulate the economy
- Zero (nominal) lower-bound!
- May be slow to work.
- Cannot be โtargetedโ.
Pros of fiscal policy to stimulate the economy
- Can work fast (e.g. job retention scheme).
- Can be targeted.
Cons of fiscal policy to stimulate the economy
- May lead to a crowding out of private consumption.
- Lots of disagreement about the size of the multiplier.
When should we use fiscal policy versus monetary policy to simulate the economy?
The answer depends on the shape of these curves!
- If the MP curve is steep (households and firms are sensitive to interest rate changes) use monetary policy - The fiscal spending multiplier will be low, lots of crowding out.
- If the MP curve is flat (households and firms are not sensitive to interest rate changes) use fiscal policy - The fiscal spending multiplier will be high.
Small open economy
- Small means that the countries decisions will not affect world prices (world prices are exogenous).
- An open economy has trade and financial links to other countries (foreign economies) which will impact the domestic economy.
foreign exchange market
This is where the currency of one country is exchanged for the currency of a different country.
exchange rate
The price (in units of domestic currency) at which a foreign can be purchased
exchange rate calculation
appreciation
Appreciation of domestic currency refers to an increase in the exchange rate
Depreciation
Depreciation of domestic currency refers to a decrease in the exchange rate
market for foreign exchange
- A higher exchange rate (USD/GBP) means pounds are more expensive for foreigners.
- This makes domestic goods and services pricier.
- Consequently, the foreign demand for pounds decreases.
Impact on foreign demand as ER decreases
Foreign demand increases - demand for pounds is decreasing with exchange.
UK demand for foreign goods, when ER decreases
UK demand for iPhones foreign goods when the exchange rate decreases โน supply of pounds is increasing with exchange.
Where can the supply of the pound in the foreigne exchange market come from?
- Firms, households and government purchases of foreign goods and services.
- Central monetary authority for the purpose of influencing the exchange rate.
If the central bank wishes to decreases the exchange rate what should they do
shift the supply curve right
If the central bank wishes to increases the exchange rate what should they do
shift the supply curve left
exchange rate regime
refers to the governmentโs policy with respect to how exchange rates are determined.
fixed exchange rate
actions are taken by the central bank to fix exchange rates at a pre-determined level.
floating exchange rate
the exchange rate is determined by the market for foreign exchange equilibrium.
benefits of a fixed regime
- A fixed exchange rate regime provides stability.
- This is attractive to foreign and domestic investors.
- Can be used to avoid inflation (i.e. gives the central bank a money-supply target)
cost of a fixed regime
- Central bank must always keep a large stock of foreign reserve.
- If capital is perfectly mobility in and out of country, country will lose control of its interest rate.
Nominal exchange rtae vs purchasing power
Nominal exchange rates reflect the exchange rate between different currencies, but they do not tell us about the purchasing power of different currencies.
the real exchange rate
reflects the relative price of actual goods and services when measured in different currencies.
real exchange rate calculation
Purchasing power parity
the hypothetical nominal exchange rate that makes the same โbasket of goodsโ in two countries cost the same.
balance of payments
a record of all transactions between the residents of one
country and the rest of the world.
current account
measures the real value of trade balances (Exports-Imports). This was previously denoted by ๐๐ = ๐ โ ๐ โ ๐ถ๐ด.
increasing and decreasing of the capital account
The current account is increasing in foreign income, decreasing in domestic income, and decreasing with the exchange rate.
capital account
the difference between the value of domestic assets purchased by foreign investors and the value of foreign assets purchased by domestic investors.
what does the capital account depend on
The capital account depends positively on the difference between the domestic interest rate and the foreign interest rate.
Balance of payments equation
๐ต๐ = ๐ถ๐ด + ๐๐ด
If ๐ถ๐ด > 0
then the country is in a current account surplus, income from foreign spending exceeds spending on foreign goods.
If ๐ถ๐ด < 0
then the country is in a current account deficit, income from foreign spending is less than spending on foreign goods.
In equilibrium the balance of payments must sum to
0
what happends to the current account when domestic income increases
CA decrease
what happends to the current account when foreign income increases
CA increases
what happends to the current account when exchange rate increases
CA decreases
what happens when the domestic interest rate is greater than the foreign interest rate
capital flows into the domestic economy and the capital account increases
what happens when the domestic interest rate is less than the foreign interest rate
capital flows out of the domestic economy and the capital account decreases
capital mobility
how easily can an investor move funds (financial capital) in and out of a country.
perfect capital mobility means ..
that there are no impediments to funds flowing from one
currency to another.
An increase in domestic income will increase import demand, leading to a โฆ
current account deficit
To solve the CA deficit and return to equilibrium what must happen
- Interest rates must rise.
- Foreign investment flows in, increasing the capital account.
Slope of the BP curve reflects the mobility of capital:
- Perfect capital mobility is reflected by a horizontal BP curve.
- Perfectly immobile capital is reflected by a vertical BP curve.
What happens when domestic interest rates are higher than foreign interest rates
demand for domestic currency increase, which leads to currency appreciation
What happens when domestic interest rates are lower than foreign interest rates
demand for domestic currency decrease, which leads to currency depreciation.
what happens to goods when the curency depreciaties e.g. ER decreases
domestic goods become relatively inexpensive
what happens to goods when the curency appreciates e.g. ER increases
domestic goods become relatively expensive
what happens to NX when the curency depreciaties
NX increases, AD shifts up
what happens to NX when the curency depreciaties
NX decreases, AD shifts down
When the domestic currency depreciates (e decreasing) - imports and exports
- Imports are becoming expensive relative to domestic goods
- Foreigners find exports relatively cheap.
- The IS curve shifts right.
WIDEC
When the domestic currency appreciates (e increasing) - imports and exports
- Imports are becoming cheap relative to domestic goods
- Foreigners find exports relatively expensive.
- The IS curve shifts left.
Fiscal policy with a fixed ER
Consider an increase in government spending:
- The domestic economy moves to point B.
- At B, ๐ > ๐๐.
- Demand for domestic currency leads to currency appreciation (๐ โ).
- To stop the appreciation, the Bank increases the supply of domestic currency.
- The MP curve shifts to new equilibrium C.
- Fiscal policy is effective in increasing output
Monetary policy with a fixed ER
- Does not work.
expansionary fiscal policy on a floating exchange rate
- The government increases spending, which shifts the IS curve right.
- At domestic equilibrium B, ๐ > ๐๐.
- This increase in domestic interest rates leads to an appreciation in the domestic currency.
- Currency appreciation shifts the IS curve left (as net exports fall).
- The economy shifts back to equilibrium A.
- Fiscal policy is completely ineffective (crowds out exports).
expansionary monetary policy on a floating exchange rate
- The money supply increases shifting the MP curve right.
- At domestic equilibrium B, ๐ < ๐๐.
- Reduction in the demand for domestic currency (for investment) โ devaluation of currency.
- The currency devaluation means that net exports increase โ IS curve shifts right.
- This happens until the new equilibrium at C is reached.
- Monetary policy is effective.
A decrease in foreign exchange rate (fixed)
- ๐๐ decreases, (holding ๐ and ๐๐ constant)
- Domestic currency starts to appreciate (currency demand increase in foreign exchange).
- Central bank responds by increasing the funds in foreign exchange market.
- Domestic interest rate falls to foreign interest rate.
- Investment and household spending increases in response to the lower interest.
- Output increases
A decrease in foreign exchange rate (floating)
- ๐๐ decreases, (holding ๐ and ๐๐ constant)
- Domestic currency starts to appreciate (currency demand increase in foreign exchange).
- Domestic goods are becoming expensive relative to foreign goods.
- Net exports fall.
- Money demand decreases, until domestic and foreign interest rates are equal.
- Output falls overall.
An increase to foreign exchange rate
- increase ๐๐, holding ๐ and ๐๐ constant.
- At interest rate ๐1we are in a BP deficit.
- Capital begins to leave the UK seeking the higher foreign interest rate, ๐1๐.
- Domestic currency depreciates.
- Currency depreciation leads to an increase in the demand for domestic goods and services, as well as an increase in the domestic interest rate.
The quantity theory of money
The quantity theory of money states that the price level is directly proportional to the
nominal money supply.
what does the quantity theory of money suggest about nominal money supply and price level
A % change in nominal money supply โ same % change in the price level.
what is velocity
The speed at which the stock of money passes around the economy.
what is the equation of exchange
๐๐ = ๐๐
how do we calculate velocity
where PY is the nominal value of transactions and M is the money supply
Why is inflation bad
- Shoe leather costs: The negative effects of inflation can be avoided by holding less money. This means that people will make more frequent trips to the bank to change their savings into cash.
- Menu costs: It is costly for firms to change their prices.
- Misallocation costs: If some businesses find it easier to change their prices than others, then inflation distorts the role of prices in reflecting the relative value of different goods and services.
winners and losers from inflation
- Consider a mortgage. I borrow money from my bank and agree to pay back the nominal amount + interest in the future.
- I use that money to purchase a house.
- If there is unanticipated inflation the nominal value of the money, I pay back remains unchanged, however the real amount decreases.
- My house maintains its real value (its nominal value increases).
- Inflation benefits borrowers but hurts lenders.
what happens if inflation is bad
a) The lending system can break down entirely, as lenders become unwilling to agree to nominal contracts.
b) People want to change their nominal holdings into real holdings. This leads to more inflation.
fisher equation
What does the AD curve reflect
The AD curve reflects the quality of output demanded by the economy at any given price level.
How does the price level effect aggregate demand - Consumption
Wealth effect.
- Simple economy in which the only goods are food and clothing.
- Individuals have a fixed nominal wealth.
- Inflation increases the price of food and clothing by the same amount, but does not affect nominal wealth.
How does the price level effect aggregate demand - Investment
Real interest rates
How does the price level effect aggregate demand - Net exports
Exchange rate effect.
- Foreign demand is increasing when the real value of domestic goods and services decreases.
AS curve
The AS curve shows the total supply of goods and services in the economy at each price level (inflation).
Where does supply come from?
- Firms making production decisions.
- Individuals supplying labour.
- Resources and production technologies available in the economy.
On the AS curve, at low levels of output, below potential output:
- Capital is underutilized at current rents,
- Labour is underutilized at current wages,
- Firms and workers are always willing to provide more output with no effect on inflation.
How does supply change with changes in the general price levels?
- If a firm that experiences a doubling in the cost of production and a doubling in the price of its goods will not change production.
- Workers that experience a doubling of wages and a doubling of all prices will not change labour supply.
Fiscal policy, Classical model - increase in government spending
- The increase in ๐บ causes aggregate demand to shift right.
- Now ๐ด๐ท > ๐ด๐, therefore the general price level starts to increases.
- The increase in the general price level means households reduce their spending (negative wealth effect), net exports decreases.
- At the new equilibrium, the general price level has increased, and government spending has lead to full crowding out of private spending (no change in ๐).
monetary policy in the classical model - when inflation is greater than the bankโs target
- If ๐0 > ๐โ then the central bank can tighten its monetary policy (shift ๐๐ up).
- This increases the real interest rate at all levels of inflation.
- This will lead to a leftward shift in the AD curve.
What is the output gap
Output gap reflects the deviation of output from its long-run trend (potential).
Sticky wages
The classical model assumes that inflation reflects a uniform change across all prices and wages in the economy.
- No relative price changes.
- It must be that all prices are changing by the same amount at the same time.
Reasons to question the assumption that wages adjust instantly:
Employees find it costly to leave their employer, even for higher wages elsewhere.
Work contracts restrict the ability of firms to adjust employee hours and wages
when market conditions change
In the short-run, output is only affected by inflation when
๐๐๐ก๐ข๐๐๐๐ฆ ๐๐๐๐๐๐ก๐๐๐ โ ๐๐ฅ๐๐๐๐ก๐๐ ๐๐๐๐๐๐ก๐๐๐
๐๐๐ก๐ข๐๐ ๐๐๐๐๐๐ก๐๐๐ > ๐๐ฅ๐๐๐๐ก๐๐ ๐๐๐๐๐๐ก๐๐๐
output prices grow faster than wages. Firms increase output โน positive output gap.
a๐๐ก๐ข๐๐ ๐๐๐๐๐๐ก๐๐๐ < ๐๐ฅ๐๐๐๐ก๐๐ ๐๐๐๐๐๐ก๐๐๐
output prices grow slower than wages. Firms decrease output โน negative output gap.
what happens to wages in the long-run
In the long-run wages adjust to new inflation expectations and output returns to the
potential output.
aggregate labour marketโs ability to clear depends on the time frame - SR
- Fluctuations in labour supply come largely from hours (as opposed to employment).
- Employees can be asked to work more or fewer hours.
- Wages are unlikely to change.
aggregate labour marketโs ability to clear depends on the time frame - MR
- Firms begin to adjust their permanent work force.
- Employment contracts come up for renegotiation.
- This puts pressure on wages.
aggregate labour marketโs ability to clear depends on the time frame - LR
- All contacts are renegotiated.
- Wages fully adjust to new labour demand.
The SAS curve can shfit fro two reasons
- A change in the inflation expectations, ๐๐.
- A supply shock.
What does the SAS curve show
The relationship between the output gap and inflation.
When output deviates from potential output, we see
a movement along the SAS curve.
The slope of the SAS curve, ๐, reflects
how responsive prices/wages are to changes in inflation.
When ๐ is close to 0
wage stickiness is high.
A larger value of ๐ suggests
that wages are less sticky (close to the classical model).
What happens following a negative demand shock
- AD falls and firms respond by lowering prices (but not wages) and output.
- As time passes, inflation expectations change; firms and workers begin to renegotiate wage contracts.
- After enough time, all wage contracts are renegotiated in line with new lower inflation expectations.
Short run: Output falls (and employment) and then gradually increases, prices and wages gradually fall.
Long-run: No change to output, lower prices and wages.
What happens following a positive demand shock
- AD increases and firms respond by increasing prices (but not wages) and output.
- As time passes, inflation expectations change; firms and workers begin to renegotiate wage contracts.
- After enough time, all wage contracts are renegotiated in line with new higher inflation expectations.
Short run: Output increases (and employment) and then gradually decreases, prices and wages gradually increase.
Long-run: No change to output, higher prices and wages.
A temporary shock to supply
Shift in short-run supply, but not long-run supply.
- SAS shifts right, inflation falls below target at the current level of output.
- Excess demand at lower prices drives up prices. Positive output gap (C).
- Eventually, short-run supply shifts back to its original position (A).
permanent shocks to supply
- Technology increase leads to higher productivity.
- Both AS and SAS curves shifts right.
- Inflation and output move to short-run equilibrium, B.
- In the short run there is a negative output gap.
- Firms and workers adjust their inflation expectations downwards, shifting the SAS curve right.
- Inflation and output move to C.
what are the banks 3 choices following a temporary shock in supply
- Stabilize inflation.
- Stabilize output.
- Something in-between.
what is the taylor rule
A Taylor rule describes this more complicated monetary policy - how responsive are nominal interest rates (๐) to deviations in inflation versus output.
taylor rule in terms of nominal interest rates
๐ โ ๐โ = (1 + ๐)( ๐ โ ๐โ) + ๐(๐ โ ๐โ)
What happens following an increase in government spending.
- AD increases - this leads to a positive output gap and increases inflation.
- However, prices for output are increasing faster than wages.
- Over time, inflation expectations change, and workers and firms renegotiate wages.
- The output gap shrinks.
- Eventually, all wages are renegotiated, so wage growth is back in line with inflation.
The adjustment process when the central bank wishes to lower its target rate of inflation.
- Output falls as does inflation. Now growth in wages is greater than growth in output prices.
- Overtime, workers and employers revise their inflation expectations and renegotiate wage contracts.
- Eventually, when all wages are renegotiated, we return to the long run equilibrium, with a new lower inflation rate.
- The adjustment to the new inflation rate necessitates a decline in output.
What happens following a decrease in interest rate policy.
- Business investment and household consumption increase, shifting aggregate demand.
- In the short-run, output and inflation both increases.
- Over time, output begins to fall, but inflation continues to increase.
- Eventually, output returns to its potential level, but inflation is much higher.
- Cutting interest rates will exacerbate inflation!
