Unit 4: Foreign Trade and the Exchange Rate and The Monetary Policy Rule

Question 1

The Terms of Trade

Answer 1

the ratio of the price of exports to the price
of imports (TT=P<sub>X</sub>/P<sub>IM</sub>).

Question 2

When the price of exports rises or the price of imports falls,

Answer 2

the terms of trade for U.S. residents improves but the amount
of net exports fall.

Question 3

When the price of exports falls or the price of imports rises,

Answer 3

the terms of trade for U.S. residents worsens but the amount
of net exports rise.

Question 4

When the value of imports (price multiplied by quantity)
exceeds the value of exports,

Answer 4

Americans must finance the
difference abroad. This amount of foreign borrowing is called
direct foreign investment.

Question 5

The foreign exchange (FX) market

Answer 5

(FX) The foreign exchange market is where dollars and other
currencies are traded freely.

Question 6

The Exchange Rate

Answer 6

The exchange rate (E) is the amount of foreign currency
exchanged for one U.S. Dollar.

Question 7

Suppose the exchange rate between the Japanese Yen
and the U.S. Dollar is 95 Yen per Dollar, and you wanted to exchange $100 in the FX market, ___

Answer 7

you would receive 9,500 Yen.

Question 8

The U.S. Dollar appreciates (i.e., its value increases) when
E ____.

Answer 8

rises

Question 9

The U.S. Dollar depreciates (i.e., its value decreases)
when E ____.

Answer 9

falls

Question 10

The rest of the world is specified as a weighted average of
foreign countries so there is one ____ and ____

Answer 10

foreign output, (Y_W); foreign price level (P_W)

Question 11

The real exchange rate

Answer 11

(E_R) is an exchange rate measure that
adjusts for the difference in the price level between the U.S.
and the rest of the world

E_R = (E×P)/P_W

• (E×P) is the average price of U.S. goods in the foreign
  currency. (Ex., The average price of U.S. goods in the
  Japanese Yen.)
• P_W is the average price of foreign goods in the foreign
  currency. (Ex., The average price of Japanese goods in
  Japanese Yen.)

Question 12

When ER is high (ER > 1), ____

Answer 12

U.S. goods are expensive for
foreigners while foreign goods are inexpensive in the U.S.

Question 13

When ER is low (ER < 1), ____

Answer 13

U.S. goods are inexpensive for
foreigners while foreign goods are expensive in the U.S.

Question 14

Purchasing power parity (PPP)

Answer 14

says that prices of goods
across countries should be equal. That is, E_R = 1.

Question 15

Three things to note about PPP

Answer 15

a. Since goods across countries are not perfect substitutes,
prices do not have to be equal across countries.
b. PPP does not need to hold, especially in the short run.
c. PPP has an influence on ER and works well in the long run.

Question 16

Assumptions about the real exchange rate.

Answer 16

a. P and PW are fixed in the short run but flexible in the long run.
b. E is completely flexible in both the short and long run.

Question 17

Model of the Real Exchange Rate

Answer 17

Says that a higher R boosts foreign demand for U.S. assets, which increases demand for U.S. Dollars and drives up E and E_R.

Question 18

Real Exchange Rate (Alg.)

Answer 18

E_R = (E×P)/P_W = q + q_R×R,
where q and qR are constants.

Question 19

Higher E_R’s effect on NX

Answer 19

• This makes U.S. products more expensive overseas so exports (X) decline. [ER↑→ X↓]
• This makes foreign products cheaper in the U.S. so
  imports (IM) rise. [ER↑ → IM↑]

Question 20

A higher disposable income (Y_D)’s effect on NX

Answer 20

encourages consumers to spend more on imports (IM). [Y_D↑ → IM↑]

Question 21

Exports (Alg.)

Answer 21

Question 22

Imports (Alg.)

Answer 22

Question 23

Net Exports and E_R (Alg. and Graph)

Answer 23

Question 24

The NX function with R and E_R use the variables, respectively

Answer 24

g_ex, g_EIM, v_x, v_IM; and g_x, g_{IM, <span>n</span>x}, n_IM​

Question 25

If we take the net exports function with E_R and set gX=(gEX–q×vX), gIM=(gEIM+vIM×q), nX=(vX×qR), and nIM=(vIM×qR), we get____

Answer 25

the net export function from the shortrun
model

Question 26

Suppose output starts at its potential (Y*) and government
spending (G) increases.

Answer 26

In the short run, a rise in G pushes up Y to Y_B, which causes
the IS curve to shift rightward and R to increase. The higher
R increases demand for U.S. assets, which leads to an
increase in E_R. Since P and P_W remains at P_A and P_W′,
respectively, E must increase and the AD curve shifts
rightward from AD_A to AD_B.

In the long run, P rises from P_A to P_B, which causes M_D and R
to rise. The higher R further increases demand for U.S. assets,
which leads to a further increase in ER. A higher R and ER
force down I and (X – IM), which causes Y to return to Y*.
Therefore, in the long run an increase in G leads to a rise in R
and ER and a decline in I and (X – IM).

Question 27

Suppose output starts at its potential (Y*) and the money supply
(MS) increases.

Answer 27

In the short run, the rise in MS pushes down R. This leads a

decreased demand for U.S. assets, which causes ER to fall.
Since P and PW remain unchanged, the decline in ER forces
down E. The combination of a lower R and ER leads to an
increase in I and (X – IM), which forces up Y to YB. As a
result, the AD curve shifts rightward from ADA to ADB.

In the long run, P rises from PA to PC, which causes MD and R
to rise. R increases to its original level and in the process
raises the demand for U.S. assets. This leads to a complete
reversal of the decline in ER so that ER returns to its pre-shock
level. A higher R and ER lead to declines in I and (X – IM),
which causes Y to return to Y*. Since P has increased and ER
is unchanged, E must fall. Therefore, in the long run an
increase in MS causes P to increase and E to decrease, while
ER remains unchanged.

Question 28

Suppose the Federal Reserve decides to make targeting the
exchange rate the objective of monetary policy.

Answer 28

• Since E_R, responds to changes in R, the Federal Reserve must
  supply sufficient MS to keep R constant.
• The M^s and LM curve will be perfectly horizontal.

Question 29

If the spending line shifts up then

Answer 29

the shift in Md is accommodated by increasing money supply to keep R constant.

Question 30

In the event RW rises, (E_R as a target)

Answer 30

the Federal Reserve must increase its
target R from RA to RB in order to keep ER constant by decreasing the money supply.

Question 31

Types of protection measures

Answer 31

a. Tariffs, which are a tax on imports.
b. Quotas, which limit the quantity of imports.
c. Outright bans of certain products.

Question 32

Protection policies help domestic companies because they
____but these policies hurt consumers because _____

Answer 32

face less competition;
they pay higher prices.

Question 33

Suppose the government imposes protection policies [gIM↓]

Answer 33

1. In the short run, a decline in gIM (i.e., X – IM rises) forces
   consumers to buy more domestic goods, which causes Y to
   rise to YB. This causes the IS curve to shift rightward and R
   to increase. The higher R increases demand for U.S. assets,
   which leads to an increase in ER. Since P and PW remains at
   PA and PW′, respectively, E increases and the AD curve shifts
   rightward from ADA to ADB.
   [gIM↓ → Y↑ → MD↑ → R↑ → ER↑ → E↑]
2. In the long run, P rises from PA to PC, which causes MD and R
   to rise. The higher R further increases demand for U.S. assets,
   which leads to a further increase in ER. A higher R and ER
   combined force down I and moderate the increase in (X –
   IM), which causes Y to return to Y*. Therefore, in the long
   run protectionist policies lead to increases in R, ER, and (X –
   IM) and a decline in I. [Y > Y* → P↑ → MD↑ → R↑ → I↓ &
   (X–IM) ↓ → Y↓] & [R↑ → ER↑ → E↑]

Question 34

By enacting protectionist policies, the U.S. runs the risk of
our trading partners retaliating with protection policies of
their own, which would ____

Answer 34

prevent the exportation of our goods
[gX↓]. This action would reverse any benefits from
protectionism.

Question 35

Functions of Money

Answer 35

1. Medium of Exchange
2. Unit of Account
3. Store of Value

Question 36

Medium of Exchange

Answer 36

Money is any item that is universally accepted as a means
of payment.

Question 37

Unit of Account

Answer 37

a. Money serves as a common unit to measure the value of
goods and services.
b. Ex. the U.S. dollar is the unit of account in the U.S. and
the Euro is the unit of account in the European Union.

Question 38

Store of Value

Answer 38

a. Money is an asset that people use to store their wealth.
b. People prefer to hold their wealth in currencies that they
believe will not fall in value.

Question 39

Currency

Answer 39

(CU) = paper money + coins

Question 40

Total reserves

Answer 40

(TR) = bank deposits held at the Fed + vault
cash (The Fed requires banks to hold a certain fraction of
their checking deposits as reserves; Required Reserves)

Question 41

Monetary base

Answer 41

(M^B) = CU + TR

Question 42

M₁

Answer 42

= CU + checking deposits (ChD) [For this class, M1 is
our definition of the money supply (M^S)]

Question 43

M₂

Answer 43

= M₁ + savings accounts + small time deposits (CDs)
+ money market mutual funds

Question 44

Total reserves (TR) are ___ plus ____

Answer 44

Required Reserves; Excess Reserves

TR = RR + ER

Question 45

Required reserves equal the ____
multiplied by _____

Answer 45

required reserves ratio (rr); checking deposits (ChD)

RR = rr×ChD

Question 46

Excess reserves equal the ____ multiplied by ____

Answer 46

excess reserves-to-deposit ratio
(e = ER/ChD)

checking deposits

ER = e×ChD.

Question 47

Total reserves as a
function of checking deposits:

Answer 47

TR = (rr + e)×ChD.

Question 48

Currency held outside of banks equals the ____ multiplied by _____:

Answer 48

currency-to-deposit
ratio (c = CU/ChD) ;

checking deposits:

CU = c×ChD

Question 49

The monetary base as a
function of checking deposits:

Answer 49

MB = (c + rr + e)×ChD.

Question 50

Balance Sheet Items (6)

Answer 50

1. Gold
2. Currency (CU)
3. Checking deposits (ChD)
4. Government bonds (B)
5. Reserves (TR)
6. Loans (L)

Question 51

The Fed’s balance sheet

Answer 51

Assets Liabilities
Bonds Currency
Gold Reserves

Question 52

Banks’ balance sheet

Answer 52

Assets Liabilities
Bonds Checking deposits
Reserves
Loans

Question 53

Individuals’ and firms’ balance sheets

Answer 53

Assets Liabilities
Bonds Loans
Currency
Checking deposits

Question 54

The balance sheet impact of an increase in the money supply. (Ex. M_B increases by $100)

[The Fed and Bank Balance Sheets]

Answer 54

Question 55

Bank makes a loan to Consumer with additional reserves

[The bank]

Answer 55

Question 56

Consumer makes a purchase and the firm deposits c =.25 to Bank B

[Bank Balance Sheet]

Answer 56

Question 57

Bank lends fraction of $80 deposit when rr=.10 and e=.5

What happens next?

Answer 57

Question 58

Money Multiplier Effect (Alg.)
Why does it change the way it does?

Answer 58

The bottom portion acts exponentially, the top is linear

Question 59

The Fed’s tools to conduct monetary policy

Answer 59

• Open-market operations (Fed’s main tool)
• Discount Rate
• Interest Rate on Reserves
• Required reserve ratio

Question 60

Open-market operations (2)

Answer 60

The Fed’s main policy tool

Open-market sale

a. The Fed sells bonds for reserves.
b. This action reduces the money supply.

Open-market purchase

a. The Fed buys bonds for reserves.
b. This action increases the money supply.

Question 61

Discount Rate

Answer 61

1. The Fed charges this interest rate on loans made to banks.
2. Higher rates discourage borrowing and lower the money
   supply.
3. This is an imperfect tool for monetary policy.

Question 62

Interest rate on reserves

Answer 62

1. In 2008, federal legislation gave the Fed the authority to pay
   interest on reserves.
2. The Fed usually sets the interest rate on reserves at or above
   the overnight interest rate (federal funds rate), so banks have
   an incentive to hold excess reserves.
3. Since 2008, the Fed has used excess reserves to fund its
   purchases of long-term bonds/mortgage-backed securities.

Question 63

Required reserve ratio

Answer 63

1. This is the percentage of reserves a bank must hold against
   deposits.
2. A higher required reserves ratio contracts the money supply.
3. This tool is very disruptive to the banking system.
4. This tool is rarely changed.

Question 64

The total amount of reserves in the banking system is called
____

Answer 64

total reserves.

Question 65

The total amount of reserves in the banking system that are
required by the Fed is called ____

Answer 65

required reserves.

Question 66

____ are the difference between total reserves and
required reserves.

Answer 66

Excess reserves

Question 67

Banks that do not have a sufficient amount of reserves to meet
their requirements can acquire additional reserves in two ways.

Answer 67

• Banks can borrow reserves from other banks that have excess
  reserves in the federal funds market.
• Banks can also borrow reserves directly from the Fed at the
  discount window.

Question 68

Federal Funds Rate

Answer 68

the interest rate that one bank
charges another for borrowing reserves.

Primary place banks go to acquire reserves

Question 69

Discount Rate

Answer 69

• the interest rate that the Fed charges banks for borrowing reserves.
• The discount rate is almost always equal to or greater than
  the federal funds rate
• Restrictive regulations on the use of borrowed reserves
  strongly discourage banks from going to the discount
  window.

Question 70

Borrowed Reserves

Answer 70

Reserves borrowed directly from the Fed at the discount
window

borrowed reserves + nonborrowed
reserves = total reserves.

Question 71

Nonborrowewd Reserves

Answer 71

All reserves that weren’t borrowed.

borrowed reserves + nonborrowed
reserves = total reserves.

Question 72

Opportunity Cost of holding money

Answer 72

OC_M,
OC_M = R – R_M
R is the return on bonds that people forgo
when they hold their assets as money instead of bonds.

The own rate on money, RM, is the interest rate earned from
holding assets as money. (Above zero for ChD but 0 for CU)

Question 73

As the opportunity cost of money rises, _____.

Answer 73

the demand for
money falls

Question 74

Number of time transfers are made

Answer 74

z = YM/(2×M))

Question 75

Average Monthly Balance (Alg.)

Answer 75

M = Y_M/(2×z)

Question 76

Optimal level of money balances (Alg. and implications)

Answer 76

M = ((k×Y_M)/(2×OC_M))^1/2

As M rises so does Y, k, and a dec. in OC

Question 77

Demand for money as a store of wealth

Answer 77

1. People save some wealth in the form of money in case of an
   emergency need for liquid assets.
2. Some people save their wealth in the form of money because
   of the anonymity it provides the holder. (This case is
   especially true in criminal activities where individuals are
   seeking to avoid detection.)

Question 78

Recent trends in currency and checking deposits.

Answer 78

1. Currency holdings fell from the 1960s to the 1980s as new
   transactions technology reduced the need for currency.
2. Currency holdings since the mid-1980s have risen due to
   increased foreign demand for the U.S. dollar. (Foreigners in
   some politically unstable countries like to store their wealth in
   the U.S. dollar.)
3. The amount of money held in checking accounts declined
   from 1960-1980 as higher interest rates encouraged
   household to learn to economize on their checking balances.
4. The amount of money held in checking deposits has
   fluctuated with its opportunity cost since interest rates peaked
   in 1980.

Question 79

The demand for currency (D_CU) and checking deposits (D_ChD)

Answer 79

• 1. The DCU and DChD decline as the opportunity cost of money, OCM, rises.
     a. As R rises, OCM increases, which causes DCU and DChD to fall.

b. As RM rises, OCM falls, which causes DChD to increase.
(note: the own rate of currency is always zero)

• 2. DCU and DChD increases as output rises.
• 3. DCU and DChD increases as the price level rises.

Question 80

Monetary policy by money supply growth targets.

Approach and Problems.

Answer 80

• The Fed sets a M^S growth rate target and then estimates
  the money multiplier to determine how much the M^B
  needs to increase to reach its M^S growth rate target.
• One problem with this approach is that a bad estimate of
  MD or a shock to MD will cause fluctuations in R, which
  leads to undesirable movements in I and Y.
• Another problem is what measure of money growth
  should the Fed target? M1? M2?

Question 81

Money growth targets were used primarily by the Fed in
___ when the money demand function was
____ and when inflation expectations were ____.

Answer 81

the early 1980s; predictable; volatile

Question 82

Monetary policy by interest rate targets

Answer 82

• The Fed sets a nominal interest rate target and then
  estimates the money multiplier to determine how much
  the MB needs to increase to reach its nominal interest rate
  target.
• One problem with this approach is that a bad estimate of
  inflation expectations causes an unintentional change in
  the real interest rate. Unplanned changes in the real
  interest rate leads to undesirable movements in I and Y.
• c. Interest rate targets have been used primarily by the Fed
  since the mid-1980s because inflation expectations have
  been low and predictable while the money demand
  function has been volatile.

Question 83

Interest rate targets have been used primarily by the Fed
since ___ because inflation expectations have
been ____while the money demand
function has been ____.

Answer 83

the mid-1980s; low and predictable; volatile

Question 84

Objectives of the Fed

Answer 84

a. Keep inflation low and stable
b. Keep deviations of real GDP from its potential, [(Y–
Y*)/Y*], small

Question 85

Monetary Policy Rule

Answer 85

describes how the Fed sets the money
growth rate or the interest rate in response to variables in the
economy.

Question 86

The Taylor Rule

Answer 86

A monetary policy rule describing an interest rate target

R = π + β_π×(π – π*) + β_Y×[(Y – Y*)/Y*] + r^e*

^{where<br></br>π is the actual inflation rate.<br></br>π* is the target inflation rate.<br></br>(Y–Y)/Y is the percent deviation of Y from Y.<br></br>re is the Fed’s belief of the value of the real interest rate<br></br>when Y is at Y*.<br></br>βπ and βY are constant coefficients that are greater than zero. The sensitivity of R to those factors.}

Question 87

The Taylor rule does a good job of explaining Fed behavior since _____

Answer 87

the mid to late 1980s.

Question 88

the inflation rate rises if ___ increases and the Fed
does not increase ___.

Answer 88

r; r^e*

Question 89

Theories as to why P does not adjust as fast as M^S in the short run

Answer 89

A. Imperfect Information
B. Sticky Prices
C. Sticky Wages

Question 90

The Imperfect Information Theory

Answer 90

• Prices are completely flexible.
• Firms, however, have imperfect information on whether a
  shift in its demand curve is due to
  
  • a. a change in M^S or
    b. a shift that is product specific (ex. increased consumer
    demand for that firm’s product)
• Specifically, this model assumes firms have a difficult time
  observing P so they must form expectations of P in order to
  interpret the source of a change in Pi.
• The effect of this informational problem is that P will slowly
  adjust after a change in MS if firms believe the source of the
  shift in its demand curve maybe product specific.

Question 91

A firm’s change of P_i in reponse to a demand curve shift depends not he source of the shift.

Answer 91

• If a MS change is the source, a firm does not adjust its output, Yi, because the change in Pi is economy wide. (i.e., the price level, P, changes)
• If the shift is product specific, the firm adjusts Yi because
  the change in Pi is product specific. (i.e., P does not
  change)

Question 92

Theory of Supply

Answer 92

a firm will increase Yi if its relative price, (Pi – P),
rises.

Question 93

Derivation of the supply curve in a model with imperfect
information

Answer 93

1. It is assumed there are n identical firms.
2. Firm i’s (where i E [1,n]) supply curve is given by

Yi = h×(Pi – P) + Yi* (1)

where
Yi is firm i’s output.
Yi* is firm i’s potential output.
Pi is firm i’s price.
P is the aggregate price level.
h is a constant coefficient such that h > 0.

Question 94

Firm i’s expectation of P (alg.)

Answer 94

Pe = P^f + b×(Pi – P^f)

where Pf is firm i’s forecast of P at the start of the year
(before Pi changes), while b is a constant coefficient such that
0 ≤ b ≤ 1 {The Level of Certainty]

Question 95

Aggregate Supply Curve (AS)
How does it look with perfect information?
How does it look with imperfect information?

Answer 95

Add up all supply curves for all n firms in the economy
Y = n×h×(1 – b)×(P – P^f) + Y*

When b=1, it is perfectly vertical, and a Ms change has no effect on output.

When b<1, it is upward sloping.

Question 96

AD in terms of Ms and P

Answer 96

Y = k₀ + k₁×(M^S – P)
where k0 and k1 are constant coefficients.

Question 97

LRAS

Answer 97

Firms have perfect information so it is a vertical line at potential output.

Question 98

Inc. in M^S on the AD/AS Curve

Answer 98

Question 99

An anticipated increase in the money supply in the Short-run

Answer 99

Question 100

An unanticipated increase in the money supply

Question 101

Sticky Prices

Answer 101

Studies have shown that prices tend to be “stuck” at a
particular U.S. dollar value for a long time.

Question 102

In some economies, prices are set in terms other than its
domestic currency (ex. Chile sets prices in terms of the UF
and not it currency: the peso). In these economies, _____

Answer 102

price
stickiness, as observed in the U.S., is not present.

Question 103

Menu costs

Answer 103

Firms incur a cost to print new catalogs, price sheets, and menus every time they adjust their prices.

It is a source of price stickiness.

Question 104

Sticky Wages

Answer 104

Wages tend to be sticky because
a. the wage bargain is made in monetary terms.
b. it is complicated and costly to index wages based on some
measure of the average wage rate.

Spreads to price stickiness

Question 105

If wages are sticky, then prices are sticky. Why?

Answer 105

A profit-maximizing firm sets its price in relation to its
marginal cost.
b. Since wages are a key component of marginal cost, wage
stickiness is transferred to prices through the marginal
cost. As a result, prices become sticky.​

Question 106

The length of a wage contract depends, in part, on whether
____ [Details]

Answer 106

there is a union or not.
a. Union contracts tend to last for several years. (Three-year
contracts are especially popular.)
b. Non-union workers tend to receive salary and wage
adjustments once a year. While there usually is not a
formal contract, the wage rate is rarely changed before the
next adjustment period.

Question 107

Wage contracts, whether formal or informal, tend to be
_____

Answer 107

staggered, which means that at any one time only a small
number of workers are signing contracts.

Question 108

Factors influencing the outcome of wage negotiations.

Answer 108

a. One factor is the state of the labor market. That is, low
unemployment favors the employee, while high
unemployment favors the employer.
b. Another factor is the wage rate paid to comparable
workers at other companies and in other industries. This
includes both recently signed wage contracts and expected
wage contracts to be signed in the near future.
c. A final factor is the expected inflation rate pi^e.

Question 109

Why are wage contracts set for long periods without indexing
them to P?

Answer 109

1. The time and resources for employees and employers to
   acquire information on labor market conditions is substantial.
2. In unionized industries, there is always possibility of a costly
   strike. In addition, it is expensive to prepare for that strike
   regardless of whether or not it occurs.
3. Since firms choose labor where W/P=MPL, indexing the wage
   (W) to P would prevent W/P from falling. In the event there is
   a negative technology shock that shifts down the MPL, the
   inability to adjust W/P forces the employer to push up the
   MPL by decreasing their labor input.
4. Indexing contracts to P adds complexity to the contract,
   which could make it harder to sell to some union members.
5. Some workers object to indexing because it adds uncertainty

to future wages, even though economists argue that the
workers are better off with it.

Question 110

A Model with Staggered Wage-Setting (Assumptions)

Answer 110

1. All wage contracts last 2 years.
2. ½ of all contracts are signed at the start of even-numbered
   years and the other ½ are signed at the start of odd-numbered
   years.
3. There is no indexing in the contract.

Question 111

Average Wage Rate

Answer 111

W = ½×(X + X_-1)
X denotes the contract wage negotiated this year. (X_-1 is the
contact wage negotiated last year)

Question 112

Determining the Value of X

Answer 112

X = ½×(X_-1+X₊₁)–d×[(U–U*)+(U+1–U*)]

1. X_-1 reflects the influence of last year’s contract and is
   what makes inflation persist from year to year.
2. X₊₁ reflects the influence of next year’s contract and is
   what makes expectations about future monetary policy
   important.