Macro Exam 2

Closed Markets

no competition, ignore imports/exports in IS-LM, etc. Consumers chose between

Closed good market

consumers choose between saving and consuming

Closed financial market

no international borrowing/lending/investing

Open goods market

consumers choose between domestic and foreign goods

Restrictions on open goods market

tariffs (price-based) and quota (quantity-based)

Open financial market

enables investors to choose between domestic and foreign assets (e.g. foreign bonds, foreign direct investment)

Restrictions on open financial market

capital controls (restrictions on foreign assets domestic residents can hold and restrictions on domestic assets foreigners can hold), bilateral investment treaties (agreements between countries on rules/limits for foreign investment)

Open factor markets

enables firms to choose where to put production, and enables workers to choose where to work

Tradeable Goods

must compete with foreign goods (either in domestic or foreign markets)

Nontradeable goods

do not compete with foreign goods (e.g. haircuts, nail appointments)

Nominal Exchange Rates

denoted by letter E; comes in two forms…

1. Price of domestic currency in terms of foreign currency (e.g., how many dollars do I need to buy 1 euro?)

2. Price of foreign currency in terms of domestic currency (e.g., how many euros do I need to buy 1 dollar?)

Real Exchange Rates

denoted by letter ε; price of domestic goods relative to foreign goods

Real Exchange Rates formuka

Formula: =EPP*, where E is the nominal exchange rate, P is the price of domestic good, and P* is price of foreign good

• P and P* found via GDP deflator ($Y/Y)

Nominal Appreciation

appreciation ⇒ increase in price of domestic currency, which leads to an increase in price of domestic currency in terms of foreign currency, as well as an increase in the exchange rate

Nominal depreciation

decrease in price of domestic currency, which leads to a decrease in price of domestic currency in terms of foreign currency, as well as a decrease in the exchange rate

Real appreciation

decrease in price of domestic currency, which leads to a decrease in price of domestic currency in terms of foreign currency, as well as a decrease in the exchange rate

Real appreciation

increase in real exchange rate, i.e., increase in price of domestic goods in terms of foreign goods

Real depreciation

decrease in real exchange rate, i.e., decrease in price of domestic goods in terms of foreign goods)

Revaluation

increase in exchange rate (in fixed exchange rate scenario)

Devaluation

decrease in exchange rate (in fixed exchange rate scenario)

bilateral exchange rates

Exchange rates between two countries

Multilateral Exchange Rates

the real exchange rate between a country and its trading partners, computed as a weighted average of bilateral exchange rates

Weights for multilateral ER

 how much a foreign country trades with the domestic country and how much the foreign country competes with the domestic country elsewhere

Multilateral Real Exchange Rate

relative price of domestic goods in terms for foreign goods, accounting for weights referenced above

Floating exchange rate

the exchange rate is determined by supply and demand within the foreign exchange market. Currencies can appreciate or depreciate freely based on the market

Fixed Exchange Rate

the exchange rate for a country’s currency is set relative to another currency and maintained by the country’s central bank. Currency’s value is held constant by the central bank by selling their currency and/or buying foreign currency

Balance of payments

a set of accounts that summarize a country’s transactions with the rest of the world

above the line, below the line

In the balance of payments, the items in the current account are above the line drawn to divide them from the items in the financial account, which appear below the line

Current Accounts

summary of a country’s payments to and from the rest of the world

Current Account Balance

sum of net payments to and from the rest of the world

Current Account Surplus

a country is running this if net payments from the rest of the world are positive

Current account deficit

a country is running this is net payments from the rest of the world are negative

Capital Account

the account showing the financial transactions of a country with the rest of the world

Capital Account Balance

the difference between what a country borrows from the rest of the world and what it lends to the rest of the world. Also known as net capital flows

Capital Account Surplus

a positive capital account balance. The country borrows more from the rest of the world than it lends to the rest of the world. Having this means having a current account deficit

Capital Account Deficit

a negative capital account balance 

Gross National Product

=GDP + Net Income a measure of aggregate output the value added by domestic factors of production.

National Income

Income that originates from the production of goods and services by residents of a country

Net Income

= Factor Income Received From Abroad - Factor Income Paid abroad

Demand Equation (Goods Market)

Z=C+I+G-IM/Ɛ+X

IM/Ɛ

Used because foreign goods aren’t identical to domestic goods. Dividing by Ɛ, the real exchange rate, puts the value of imports in terms of domestic goods

Imports

=IM(Y, Ɛ). A function of output and the real exchange rate

Exports

=X(Y*,Ɛ) a function of foreign income and the real exchange rate, as shown by the equation

DD Curve

A curve in the goods market for a close economy

AA

DD-IM, smaller intercept because autonomous spending is decreased (because some goes to imports)

ZZ

AA+X difference between ZZ and AA is constant because exports are dependent on foreign income, which is constant in this model

Net Exports (NX)

balance between imports and exports; they’re positive if exports>imports and negative if exports<imports. NX is a decreasing function of Y because IM is an increasing function of Y

Increases in Government Spending (Open Economy)

• ZZ shifts up by an amount larger than the increase in spending itself because of the multiplier effect

• A trade deficit is created because imports increase at the higher level output 

• The net effect of the government spending is smaller than it would be in the closed economy because some of it and the increase in other spending it induces through the multiplier will go towards imports

Increases in Foreign Demand (Open Economy)

• An increase in foreign demand shifts the ZZ curve up by an amount larger than the increase in spending itself because of the multiplier effect

  • One way to measure NX is to subtract DD from ZZ at Y because ZZ is just DD+NX. This is represented by A’C above

• Foreign income is exogenous from domestic output, so an increase in foreign demand from higher foreign income shifts the NX curve right instead of moving along it

  • This means that NX will be smaller than the increase in foreign demand, because some amount of the increase in Y will go towards imports

Implications of the Open Economy for Policymakers

• Countries’ economies are interconnected, and their success is dependent on each other. This is more true the more trade ties countries have

• Policymakers will often prefer increases in foreign demand to increases in domestic demand—increased foreign demand improves the trade balance whereas increased domestic demand worsens it, and a long-term trade deficit means accumulated debt to other countries and more than likely, rising interest rates on it. However, if all countries prefer foreign demand to domestic demand, none of them will pursue expansionary fiscal policy, so none of them will benefit from other countries increasing demand.

  • Policy coordination, where countries coordinate their fiscal policy to avoid this collective action problem, is one solution. But even if countries agree to coordination, there’s still an incentive to freeride to avoid a problematic trade deficit.

Open Economy Multiplier

1/(1 - c1 - i1 + m). Smaller than closed economy multiplier holding other factors constant

IP

Interest parity between domestic and foreign bonds

Short Run Assumptions

• Domestic and foreign prices (P and P*) are fixed.

• Therefore, nominal and real exchange rates move proportionally.

• Foreign output (Y*), foreign interest rates (i*), and the expected future exchange rate (Eᵉ) are treated as given in the basic model.

Investment Channel

 i ↓ → Investment ↑ → Demand ↑ → Y ↑

Exchange Rate channel

i ↓ → E ↓ → Domestic currency depreciates → NX ↑ → Demand ↑ → Y ↑.

i ↑ → E ↑

Domestic currency appreciates. IP slopes upwards because higher i means higher E

i ↓ → E ↓

Domestic currency depreciates

i* ↑

IP shifts left

E^e ↑

IP shifts right

Expansionary Monetary Policy (Floating E)

• Investment: i ↓ → I ↑ → Y ↑.

• Net exports: i ↓ → E ↓ → Depreciation → NX ↑ at a given Y → Y ↑.

Expansionary Fiscal Policy (fixed Ms)

• G ↑ → Y ↑ → Money demand ↑ → i ↑.

• i ↑ → E ↑ → Domestic currency appreciates.

• Appreciation reduces net exports.

• Higher interest rates discourage investment

Fixed Exchange Rate

Under a fixed exchange rate system, the central bank commits to maintaining a specific exchange rate, so i=i*

Monetary Policy under a peg

• The central bank cannot independently lower interest rates while maintaining the peg.

• Monetary expansion creates depreciation pressure.

• To defend the peg, the central bank must intervene and reverse the expansion.

• Therefore, monetary policy loses independence under a credible fixed exchange rate.

Fiscal Policy under a peg

• G ↑ → IS shifts right → Y ↑.

• Higher output raises money demand.

• The central bank increases money supply to maintain i = i*.

• E remains fixed, so fiscal expansion does not cause appreciation-induced crowding out of net exports.

• However, higher income still increases imports, reducing NX.

Expected Future Exchange Rate

expectations of future devaluation can cause domestic interest rates to rise above foreign interest rates even before any official exchange-rate change.

Non institutional civilian population

number of people potentially available for civilian employment

Sclerotic labor marke

a labor market with few separations/hires and a stagnant unemployment pool

Collective bargaining

 bargaining between firms and unions

What bargaining power depends on

• How costly it would be for the firm to find other workers were they to leave the firm

• How hard it would be for them to find another job were they to leave the firm

Reservation Wage

wage where a person would be indifferent between employment and unemployment. The opportunity cost of leisure time becomes 0

Efficiency wage theories

theories that link the productivity or the efficiency of workers to the wage they are paid

Unemployment insurance

the payment of unemployment benefits to workers who lose their jobs

Impcat of unemployment rate on welfare of workers and wages

1. Unemployed workers have a lower probability of becoming employed. 2. Employed workers face a higher probability of becoming unemployed

Determinants of wage

1. Workers are typically paid a wage that is greater than their reservation wage. 2. Wages depend on labor market conditions.3. bargaining power

Wage Setting equation

W= P^eF(u,z)

z in wage setting equation

level of unemployment benefits (such as unemployment insurance) z↑ reservation wage↑ bargaining power↑ nominal wage↑

Price Setting equation

P= (1+m)W

AS Relation

P= P^e(1+m)F(1-Y/L, Z)

First Property

given the expected price level, an increase in output leadsto an increase in the price level

Steps of First Property

1. An increase in output leads to an increase in employment.

2. The increase in employment leads to a decrease in unemployment and therefore to a decrease in the unemployment rate.

3. The lower unemployment rate leads to an increase in the nominal wage.

4. The increase in the nominal wage leads to an increase in the prices set by firms and therefore to an increase in the price level.

Second Property

given unemployment, an increase in the expected price level leads, one for one, to an increase in the actual price level.

Second Property Steps

1. If wage setters expect the price level to be higher, they set a higher nominal wage.

2. The increase in the nominal wage leads to an increase in costs, which leads to an increase in the prices set by firms and a higher price level.

Three Properties of AS curve

• The aggregate supply curve is upward sloping. Put another way, an increase in output Y leads to an increase in the price level P. You saw why earlier.

• The aggregate supply curve goes through point A, where Y = Yn and P = P^e. Put another way: When output Y is equal to the natural level of output Yn, the price level P turns out to be exactly equal to the expected price level P^e.

• An increase in the expected price level P e shifts the aggregate supply curve up. Conversely: A decrease in the expected price level shifts the aggregate supply curve down

Actual and Expected inflation

An increase in expected inflation raises actual inflation one for one.

The logic runs through price levels:

1. Wage setters expect a higher price level.

2. They set a higher nominal wage.

3. Firms pass this on, so the actual price level rises

Linear Wage Setting Function

F(u, z) = 1 − αu + z

Impact of u on wage

Higher unemployment means less bargaining power, so workers have a lower wage

Impact of z on wage

z is a catch-all for anything else that pushes wages up, such as more generous unemployment benefits or stronger employment protection

Impact of α on wage

A higher α means wages are more flexible. Measures how strongly unemployment affects the wage

Inflation and unemployment

Given expected inflation, an increase in unemployment lowers inflation.

The chain:

1. Unemployment rises.

2. The nominal wage falls.

3. The price level falls.

4. Given last year's price level, inflation is lower.

Original Phillips Curve Equation (θ=0)

π_t = (m + z) − αu_t

Wage Price Spiral

Given expected price level, lower unemployment → a higher nominal wage → price level. Lower unemployment → higher inflation

Expectation Parameter

θ_t = θπ_t-1+m+z-αu_t

θ

Effect of last years inflation rate on this years expected inflation rate  Higher value means the more last years inflation leads workers and firms to revise their expectations of what inflation will be this year so higher expected inflation

π_t-1

Last years inflation rate

π_t^e

this years expected inflation

Original Phillips Curve (θ=1)