Part 3 Flashcards
Price level P
The price of a basket of goods measured in money
1/p
The value of money measured in goods
As P increases, 1/P…
Decreases
Quantity theory of money
Asserts that the quantity of money determines the value of money
Has two approaches:
Supply demand diagram, (money market)
An equation
Money supply Ms (money market diagram)
Money supply in he real world determined by the fed, the banking system, and households
In this model, we assume that the Fed controls Ms and sets it at some fixed amount
Money demand Md (money market) and what does it depend on
Refers to how much wealth people want to hold in liquid form
Depends on P: an increase in P means to purchase the same amount of goods and services, one needs more money
The quantity of money demanded is positively related to P and negatively related to the value of money 1/p
Why might an increase in the money supply cause P to rise
An increase in Ms causes an excess supply of money
People get rid of excess money by spending it on goods and services or by loaning it to others who want to spend it
This increases a demand for goods but supply does not increase so prices must rise (bid up by those who demand them)
Real vs nominal variables
Nominal variables are measured in monetary units
Real variables: measured in physical units or measured excluding inflation
Relative price
The price of one good relative to another good
Real wage
W/P
W= nominal wage p= price level
Real wage is the price of labor relative to the price of output
Classical dichotomy
Theoretical separation of nominal and real variables
-states monetary developments affect nominal variables but not real variables
Money neutrality
The proposition that changes in the money supply do not affect real variables
Under classical dichotomy and money neutrality how does change in money supply affect W/P
The real W/P does not change because of money neutrality so when supply increases quantity of labor supplied does not change
Labor demanded does not change
Employment of labor does not change
And employment of capital and other resources does not change
Total output is not changed
Most economists believe the classical dishotomy and neutrality describe the economy in the short run or the long run??
Long run
The quantity theory equation
MV = PY
P*Y = nominal GDP (price level times real GDP
m = money supply
V = velocity of money
The quantity theory equation— how do P and M relate and what does this imply
MV= PY
usually assume V is stable
M Does not affect Y bc of neutrality (Y determined by technology and resources)
Sooo P must change by same amount as M to keep the equality
The equation implies rapid money supply growth causes rapid inflation
What is velocity and what is the formula
The rate at which money changes hands
V= PY/M
Lessons abt the quantity theory of money
If real GDP is constant then inflation rate = money growth rate
If real GDP is growing, then inflation rate < money growth rate
Inflation rate = money growth rate - output growth rate
Excessive money growth causes inflation
Economic growth increases # of transactions, and bc velocity stays constant, money growth is needed for these extra transactions
Inflation tax
The revenue the government raised by creating money (today the inflation tax only accounts for less than 3% of total revenue
The fisher effect
An increase in the rate of money growth raises the rate of inflation but does not affect any real variable
(An extensions of the principle of money neutrality)
Why does the fisher effect exist
Real interest rate= nominal interest rate -inflation rate
Nominal interest rate = real interest rate + inflation rate
One for one adjustment of nominal interest rate to inflation rate
If inflation rate goes up, nominal interest rate will go up, but no change in interest rate
When the fed increases the rate of money growth, the long run result is:
Higher inflation rate
Higher nominal interest rate
Inflation fallacy
When prices rise, buyers pay more, and sellers get more, so inflation does not itself reduce people’s real purchasing powers
Inflation causes CPI and nominal wage to rise together
Costs of inflation
Shoe leather costs, menu costs, misallocation lf resources from relative price variability, confusions dn inconvenientes, tax distortions, unexpected inflation
Shoe-leather costs (cost of inflation
Resources wasted when inflation encourages people to reduce thnjeir money holdings
This means they have to go to the bank to get money out for transactions to incur more transaction costs (hence wearing out their shoes)
Menu costs
Costs of changing prices (think having to print out me menus
Misallocation of resources
Firms don’t all raise prices at the same time, so relative prices can vary, distorts the allocation of resources
Tax distortions ( cost of inflation)
Inflation makes nominal income grow faster than real income, taxes are based on nominal income, inflation causes people to pay more taxes when their real incomes don’t increase
Unexpected inflation does what
Redistributes wealth among the population not by merit or by need
Redistributes wealth from debtors to creditors (debtors pay less in real terms while creditors receive less in real terms
How do costs of inflation affect diffeeent countries?
Costs are high to economies experiencing hyper inflation
Low for economies with low inflation
Closed economy
Economy that does not interact with other economies
Open economy
Economy that interacts with other economies around the world, buys and sells goods and services in the world product market, and buys and sells assets such as stocks and bonds in world financial market
Trade surplus
Exports greater tan imports
Trade deficit
Imports are greater than exports
Balanced trade
Exports = imports
Factors that might influence a country’s exports and imports
Incomes of consumers at home and abroad
Consumers preferences for foreign and domestic goods
Prices of goods at home and abroad
Exchange rates at which currency traded for domestic currency
Government policies
Transportation costs
NCO
Net capital outflow
Amount of foreign assets held by domestic residents — amount of domestic assets held by foreigners
When NCO > 0
Capital outflow
When NCO < 0
Capital inflow
Variables that influence NCO
Real interest rates paid in foreign assets
Real interest rates paid on domestic assets
Perceived risk of holding foreign assets
Government policies affecting ownership of domestic assets
Accounting identity relating to NCO and NX
NCO = NX
Open economy identity including saving, investment and NCO
S= domestic investment + NCO
Nominal exchange rate
Rate at which one country’s currency trades for another
Units of foreign currency per unit of domestic currency
Appreciation
Increase in the value of currency as measured by the amount of foreign currency it can buy
Depreciation
Decrease in the value of a currency as measured by the amount of foreign currency it can buy
Real exchange rate
Rate at which the goods and services of one country trade for the goods and services of another
Real exchange rate = q= eP*/ P
P = domestic price P* = foreign price E = nominal exchange rate (foreign currency per unit of domestic currency)
Law of one price
Assumes trade is frictionless around the world —
Says a good should sell for the same price in all markets when the prices are expressed in the same currency
Arbitrage
The act of taking advantage of price differences for the same item in different markets
Equalizes prices and ensures Law lf one price holds
Purchasing power parity
A unit of any given currency should be able to buy the same quantity of goods in all countries (based on the law of one price)
If ppp holds, then q=
1
If ppp holds, e =
P*/P
When central bank increases money supply: price level will… and that country’s currency will
Price level will rise and the country’s currency will depreciate relative to other currencies
Why light ppp not hold
Transaction costs
Some goods are non-tradable
Imperfect competition and legal obstacles
Price stickiness (prices may not adjust right away when supply and demand changes
The business cycle
Irregular fluctuations in GDP and corresponding fluctuations in other macroeconomic variables
Booms
Happens from trough to peak and are periods of increasing real incomes and decreasing unemployment
Recessions
Happen from peak to trough, are periods of falling real incomes and rising unemployment
Depressions
Severe recessions
The classical dichotomy
The separation of variables into two groups (real vs nominal)
The neutrality of money
Changes in money supply affect nominal but not real variables
AD curve
Shows the quantity of all goods and services demanded in the economy at any given price level
Why does AD slope downward
The wealth effect (C), the interest effect (I) and the exchange rate effect (NX)
An increase in P decreases, output (Y) increases for all of these
The wealth effect
Price level P declines—
Increase in the real value of money, consumers are wealthier, increase in consumer spending C, increase in quantity demanded of goods and services , y goes up
The interest rate effect
If P declines,
Buying same amount of goods and services requires fewer dollars
People reduce monetary holdings and instead hold interest bearing assets like bonds
Higher demand for assets like bonds drive down the interest rate
Lower interest rate cheaper to borrow so investment increases
Increase in quantity demanded of goods and services
So as price level goes down, output goes up
The exchange rate effect
Suppose the price level P declines Real exchange rate declines Is dollar depreciates in real terms Stimulates US net exports NX Increase in quantity demanded of goods and services So as P decreases, Y increases
What shifts AD
Any event that changes C, I, G, NX except for a change in P or Y will shift the AD curve
AS
The AS curve shows the quantity of all goods and services firms produce and sell in the economy at any given price level (can be upward sloping or vertical)
Upward slipping in short run vertical in long run
LRAS
The potential level of output (Y bar) is the amount of output the economy produced when all available resources are employed
Productivity (L, K, H, N, A)
It is the maximum amount of output the economy can produce given existing resources
Any change in P does not affect productivity
What shifts LRAS
Any event that changes any of the determinants of potential output (productivity) (l k h n a) will shift LRAS
SRAS
The SRAS is upward and it is over the short run.
An increase in P will cause an increase in the quantity of goods and services supplied
Why is SRAS upward sloping?
Sticky wage theory, misperception theory, sticky price theory
Sticky wage theory
Says that nominal wages are sticky in the short run, they adjust sluggishly
(When firms set nominal wages in advance, they do not take into consideration changing price level)
If price level remains the same as the equilibrium price level then output is at potential
How ever, in the future, if Price level is higher than Price equilibrium, workers are still getting paid the same nominal wage while the firm is receiving more profit from the higher price level (same cost but more profit means firms increase output so Y increases
The misperception theory
Firms may confuse changes in P with changes in the relative price of the products they sell
If P = Pe, output is st potential
I P rises above Pe, a firm is not sure if price for its own product has gone up or if general price level has gone up
If firm believes that the price increase may be indicative of a rise in demand, it’ll increase production and employment
Hence, an increase in P can cause an increase in Y so SRAS slopes upward
Sticky price theory
Assume firms get to set their own prices based on expectation of what their competitors will charge and the level of demand
Assume economy starts off at potential with two types of firms:
Flexible price firms adjust prices immediately to changing economic conditions
Sticky price firms set prices in advance based on Pe and then prices will stay the same for some time
Reasons for sticky prices (menu costs, cost of adjusting prices)
General P is a weighted avg of prices set by these two types of firms
If Y deviated form potential output,
Flexible price firms raise their prices immediately
Sticky price firms will wait to raise prices
P> Pe (bc flexible raises immediately)
Higher P is associated with higher Y, SRAS slopes upward
SRAS Equation
Y = Y bar (potential LRAS) + a (P -Pe)
Y= output Y bar= potential output (long run) a > 0 measures how much Y responds to undexpected changes in P (price elasticity of supply) P= actual price level Pe = expected price level
Pe shifts SRAS, if Pe rises, workers and firms set higher wages
What happens overtime
To sticky wages and misperceptions
Sticky wages and prices become flexible
Misperceptions are corrected
In the long run, Pe = P and Y = Y bar
How do LRAS and SRAS shifters relate
Everything that shifts LRAS shifts SRAS too, but not everything that shifts SRAS shifts LRAS
The general theory of employment, interest, and money
Argued recessions and depressions can result form inadequate demand, policy makers should shift AD
Famous critique of classical theory: the long run is a misleading guide to current affairs
fiscal policy
Setting the level of government spending and taxation by government policy makers
Expansionaryfiscal policy
An increase in G and/ or decrease in T (which stimulates C, shifts AD
Contractionary fiscal policy
A decrease in G and or increase in T, shifts AD left (less consumption)
Fiscal policy has two effects on AD
The multiplier effect and the crowding out effect
Multiplier effect on AD
The additional shifts in AD that result when fiscal policy increases Y and then C increases from the increase in Y
The crowding out effect
Government budget deficits reduced supply of loanable funds in the loanable funds market which lead to an increase in interest rate and a reduction in investment
Marginal propensity to consume
MPC = change in C/ change in Y
Fraction of extra income that households consume rather than save
Relates to the multiplier effect Bc the multiplier effect depends on how much consumers respond to increases in income
How to calculate the multiplier
It is the Chang in Y divided by the change in government spending
Change in y / change in G
Also,
1/ 1-MPC
Tax policy: tax cut vs tax hike
Tax cut is expansionary tax hike is contractionary
Tax cut effect on AD
Tax cut increases households take home pay, respond by spending a portion of this extra income, shifting AD to the right (affected by the multiplier effect and crowding out effects)
Permanent tax cut is large impact on AD temporary tax cut is small impact on AD
Case for active stabilization policy
Pessimism and optimism among households and firms lead to shifts in AD and fluctuations in output and employment
(Fluctuations also cause by booms and recessions and supply side disturbances)
If policy makers do nothing, these fluctuations are destabilizing to businesses, workers, consumers
Governments should use policy to reduce these fluctuations
When GDP fall below potential, gov should use what types of policies
Expansionary monetary or fiscal policy
When GDP rises above potential, what kinds of Policies should gov implement
Contractionary policy
The case against active stabilization policy
Firms make investment plans in advance, takes time to respond to changes in real interest rates
It takes at least 6 months for monetary policy to affect output and employment
Fiscal policy works with lag Bc of politics (require acts of congress legislative processs)
Critics say Bc of these lags, active policy could actually destabilize the economy Bc by the time these policies affect AD, the economy’s condition may have changed
What should congress consider when cutting taxes
Should consider the short run effects on AD and employment
And the long run effects on saving and growth
When the fed reduces the rate of money growth, must take into account not only long run effect on inflation but also the short run effects on output and employment
