Wk 5 part 2+week 10+week 11

What does the AD and AS model graph look like and what is AD and AS and what is it determined by

AD: describes downward sloping relationship between inflation and output

• inflation leads to nominal interest rates increasing which increases real interest rates which decreases Y (ie. cuz its more expensive for firms to invest)

• AD is determined by monetary policy, fiscal policy and demand shocks

AS: describes upwards sloping relationship between inflation and output

• as output increases, this leads to less unemployment which leads to more inflation.

  • relationship between Y and u=okuns law

  • relationship between u and pi=phillips curve

• AS is determined by inflation expectations and supply shocks.

New consumption function

C = ¯C + c(Y − ¯T ) − γC r, γc > 0

γC=interest sensitivity of consumption

• as r (real interest rate) increases, savings becomes more appealing to households and they consume less.

New investment function

I = ¯I − γI r, γI > 0

γI > 0 measures interest-sensitivity of investment

How to get real interest rate

just subtract pi from both sides since r=i-pi

what is goods market equation/AD curve

shocks to AD curve

they shift the curve either inwards or outwards

• could be changes to ed=shocks to aggregate demand

• increased optimism would increase ED=hence AD shifts right and vice versa

what does phillips curve represents and what are its components

• phillips curve represents relationship between u and pi

• πe =inflation expectations

• ϕ =inflation’s sensitivity to labour market tightness

• εS = supply shocks

Natural rate hypothesis

• in long run inflation expectations become inflation, shocks to supply are 0 and natural rate of unemployment becomes unemployment, can’t determine inflation.

• so there is a long run phillips curve at u=u*

okuns law

• what we learnt ages ago

• connect unemployment gap with output gap

• 
  

short run AS curve

plug okuns law into phillips curve

long run AS curve

inflation=inflation expactations

Es=0

long run AD and AS curve equlibirium

short run equilbrium

example of negative ad shock.

so we started at long run equilbibrium, then negative shock moves srad curve in so we get lower output and inflation leading to a negative output gap and inflation gap

What is bilateral nominal exchange rate and what is a direct and indirect quote

bilateral nominal exchange rate= relative price of one currency relative to another.

• direct quote: how many aus dollars to buy 1 avocado (how many aud to by one unit foreign currency)

• indirect quote: how many foreign dollars to buy 1 aud.

  • how many foreign dollars does 1 aud buy

  • E=0.75Y/1aud= indirect exchange rate

RER

• an increase in RER means the currency has appreciated THEREFORE NET EXPORTS DECREASE

• an decrease in RER means the currency has appreciated THEREFORE NET EXPORTS INCREASE

RER=P/PfE=EP/Pf

gRER=GE+GP-GPf

gRER=Ge+pi-piF

What is purchasing power parity

there is the law of one price suggests that goods should sell for one price across the world once they are denominated in one currency

• can have absoulte PPP=RER=1

• relative PPP=RER= constant. means growth in RER=0, so growth in exchange rate just depends on inflation differental pi-pif

  • means dom currency appreciates when foreign currency inflation exceeds domestic currency inflation

long run vs short run implications of PPP

• in long run, E just basically relects price level differences since rer is constant

• in short run changes in E are mostly bc of changes to nominal exchange rate so less useful for short run

how does interest rate effect excahnge rates

domestically:

• increasing r leads to foreigners investing here (so demand for dom currency increases) and supply of domestic currency reducing. demand right, supply left. so we get an appreication of currency. net exports decrease and gdp falls. and vice versa

• this means MP is only more effective in open economies where exchange rates are flexible.

what does current account consist of

trade balance+net foreign income+net foreign transfers

National income accounting indentity + savinsg equation

S+ (T-G)-I=X-M

• having a trade surplus means total dom savings is more than I and vice versa for deficit

what does capital account consist of

• purchase and sales of assets

are current account deficits a problem

yes: becuase it means I is greater than S, so we are accumulating debt and C will have to fall in future

No: because implies KAS surplus. we are a good place to invest but there is a risk of sudden stops of we depend on foreign capital inflow

what determines net capital inflow

1. real return on domestic assets

2. real returns on foreign assets

3. risk premia

what does a higher domestic r do for net capital inflow (KA)

• makes domestic assets more attractive to foreign investors leading to more capital inflow

• foreign assets become less attractive for us leading to less capital outflow.

• this increases net capital inflow

what does a higher foreign r do for net capital inflow (KA)

• makes foreigners investing here less attractive so they invest less. decreasing capital inflow

• makes us attractive outside more attractive so they invest more and increase capital outflow

• overall decreases net capital inflow.

what does a higher international risk premia do for net capital inflow (KA)

• international investing has country specific risks such as exchange rate risk and soverign irsk

• risk premia is compensation for risk averse investors

• increase in risk premia decreases capital inflow cuz it seems more risky

floating vs fixed excahnge rates

floating

• determined by demand and supply

• can have clean or dirty

fixed

• determined by policy makers

• fixed or pegged to a strong commodity or major currency

how to maintain a fixed exchange rate

policy makers must be willing to take the other side of the transaction

what happens if epeg>efun

it means exchange rate is overvalued

• it means there is too much supply of aud relative to demand

• so they will buy some of aud and sell international reserves which can be a problem

what happens if epeg<efun

• exchange rate is undervalued

  • it means too much demand relative to supply

  • so policy makers will supply aud by buying international reserves

  • this builds up its international reserve

what are speculative attacks

mass selling and increase in supply of currency bc. people think policy makers don’t have enough international reserve.

supply curve shifts right leading to an ever lower efun

puts extra pressure on policy makers to buy even more aud and sell remaining international reserve

once we run out peg disappears and exchange rate drops to efun and devaluation has occurred.

constraints on mp

• can use mp to avoid speculative attacks but means it can’t be used domestically anymore

• can increase interest rate to increase investment here and shift demand right.

policy trilemma

can only pursue 2/3 goals

1. free capital flow

2. independent monteary policy

3. fixed exchange rate