Must Learn

Question 1

The Ricardian Equivalence

Answer 1

Proposition that tax finance and bond finance have equivalent effects on private expenditure.
Is based on the alternative assumption to Keynesian Cross, that households base their expenditure decisions on the present discounted value of income and taxation into the infinite future.

Question 2

Why does it not matter if government spending in the current period is financed by debt or current taxes - according to the Ricardian equivalence?

Answer 2

It doesn’t matter if government spending is financed by debt or taxes because rational households anticipate that borrowing today means higher future taxes to repay the debt and interest. Assuming perfect markets, the present value of future taxes equals the borrowed amount, leaving lifetime disposable income unchanged. Households save to offset future taxes, neutralizing the effect of deficit financing on demand.

Question 3

According to the Ricardian Equivalence why is there a limited effect of fiscal policy on economic activity?

Answer 3

Private Saving (Y - C - T) + Public Saving (T - G) = Investment I
If taxes decrease by 1 unit, public saving falls by 1 unit. Private saving increases by 1 unit. Total savings therefore stay the same.
Consumption doesn’t respond to the fall in taxes
Investment doesn’t change as total saving stays the same

Question 4

Where does the Ricardian Equivalence break down?

Answer 4

• imperfections in financial markets
• if newly issued debt is assumed to last beyond current taxpayer’s lifetimes
• distortionary taxes

Question 5

What is the uncovered interest parity?

Answer 5

UIP displays the relationship between interest rates and exchange rate movements. UIP suggests that the returns on financial assets are the same when converted to domestic currency.

Question 6

What is Purchasing Power Parity (PPP)?

Answer 6

When we assume efficient markets with free and costless cross border movements of goods, 1 domestic set of goods can be exchanged for exactly 1 foreign set.
Equivalently, in an efficient market for goods, the real exchange rate equals 1

Question 7

What is the Balance of Payments (BoP)?

Answer 7

An open economy can interact with the RoW through both financial markets and international trade. Both are interlinked. the way to keep track of both financial assets and goods & services is through BoP. BoP records transactions between an economy and the RoW

Question 8

Monetary Policy trilemma

Answer 8

1. Monetary policy independence
2. Free movement of financial capital
3. Stability of exchange rates

Question 9

Current account (CA)

Answer 9

List exports, imports, income flows, CA balance = NX + NI

Question 10

Capital account (KA)

Answer 10

transactions in non produced non financial assets and capital transfers, FA balance = ΔNIIP

Question 11

Financial account (FA)

Answer 11

transactions in financial and liabilities, FA = CA + KA

Question 12

What is the Marshall Lerner Condition?

Answer 12

A concept that describes when a country’s currency depreciation will improve its trade balance.
For example when a country devalues its currency, exports may increase as foreigners choose to buy cheaper goods from us.
domestic customers may cut back on imports due to expensive foreign goods.
For the trade balance to improve, the combined response must result in an increase of the net export value.