CB2: Chapters 19-24

What is stagflation and natural rate of unemployment?

Stagflation = combo of stagnation (low growth/high unemployment) and high inflation

NRE = rate of unemployment consistent with market clearing (supply = demand) in labour market and long-run Phillip’s curve

How, according to monetarists, does an increase in money supply cause inflation in long run?

1. if money supply rises faster than potential output in long run, then inflation occurs

2. in terms of quantity of money, V and Y independent of M

3. So increasing money supply will lead to increases in P = inflation

How, according to monetarists, does an increase in money supply maybe result in lower unemployment in short run but not long run? State the implication of this for the slope of a long run Phillip’s curve

1. if money supply rises, AD rise will lead to higher output and employment in short run

2. but if firms and workers soon expect higher wages and prices

3. so extra demand taken up by inflation and so output and employment fall again

4. long run implication on Phillips curve is vertical

How, according to monetarists, does a decrease in rate of money supply growth reduce inflation without increasing unemployment in long run?

1. reducing rate of growth of money supply leads to temporary increase in unemployment as demand for goods/labour falls

2. but as price and wage inflation adjust down to new lower level of demand, unemployment falls

3. this process is hindered and high unemployment will persist if workers keep on demanding high wages or workers continue to expect high inflation

Why do monetarists suggest gov should set targets for rate of growth of money supply?

setting modest and well-publicised targets should help reduce

1. expected rate of inflation

2. uncertainty associated with inflation - which reduces investment and country’s competitiveness in international trade

Why should a gov use supply-side policies if it wishes to reduce natural level of unemployment?

1. in long run, increase in AD fully absorbed by higher inflation so it will have no long-run effect on output and unemployment

2. so if we want unemployment to be reduced in long run, the vertical long run Phillips curve needs to be shifted to the left by reducing natural rate of unemployment

3. to do this, supply-side policies should be used - increasing potential output by increasing quantity/productivity of factors of production

Define the new classical school of economists

1. body of economists who believe markets are highly competitive and clear very rapidly

2. so, any expansion in demand will instantly feed through higher prices, resulting in vertical Phillips curve in short run as well as long run

Define continuous market clearing and rational expectations (new classical school). State the implication of combining these.

CMC = all markets in economy clear continuously so economy in permanent equilibrium

RE = expectations based on current situation i.e. info people have atm. this info might be imperfect so people might make errors but these errors are random

Implication = change in AD will cause change in prices and not output/employment even in short run

Define policy ineffectiveness proposition and real business cycle theories (new classical school)

IP = conclusion that when economic agents anticipate economic changes in economic policy, output/employment remain at equilibrium

RBCT = explains fluctuations in real GDP in terms of economic shocks esp. tech shocks which have permanent effect on potential output

What is meant by monetary surprises? Why do they not occur in new classical model?

Monetary surprise models show how unexpected changes in monetary policy can result in firms and workers changing supply decisions so economy temporarily deviates from equilibrium

e.g. if unexpected rise in monetary supply leads to unexpected increase in inflation (higher prices and wages), firms and workers might mistakenly believe that real price of labour and output has increased so supply more

This will not occur in classical model due to continuous market clearing and rational expectations assumptions

What is the real business cycle theory? Give examples of supply side shocks/impulses

explains cyclical business cycles in terms of shifts in potential output due to supply side shocks rather than fluctuations around potential output (AS not AD)

e.g. improvements in IT, availability of raw materials (depletion of oil reserves)

the theory removes distinction from business cycles and long term economic growth

Define expectations-augmented Phillips curve. State formula relating actual and expected inflation

SR Phillips curve whose position depends on expected rate of inflation

pi = f(1/U) + pi^e + k where U=unemp, pi^e = expected inflation rate

Define adaptive expectations, natural rate hypothesis and misperceptions theory

AE = where people adjust expectations of inflation in light of what has happened in past

NRH = theory that after fluctuations in AD, unemployment will return to natural rate - determined by supply side factors

MT = theory that changes in economic activity are cause by people confusing changes in general prices with changes in relative prices

Define fooling model and state 3 assumptions upon which it is based

where workers, as a result of imperfect info, can be fooled into believing a rise in money wages represents a rise in real wages

assumptions:

1. price and wages adjust relatively quickly to ensure supply demand equilibrium in goods and labour markets

2. actual rate of inflation can deviate from expected rate since people have imperfect info

3. people form adaptive expectations of inflation

what is accelerationist theory of inflation? and what are the implications?

in the long run, there is no trade off between unemployment and inflation so long run Phillips curve vertical at natural rate of unemployment

if gov want to hold unemployment below natural rate, it will be at the cost of continuously accelerating inflation

What is the political business cycle?

theory that after being elected, govs will engineer an economic contraction to reduce inflation and then later engineer a pre-election boom to get re-elected

What are 3 possible causes of stagflation?

1. increase in structural/frictional unemployment at the same time as increase in cost-push inflation

2. increase in structural/frictional unemployment at the same time as increase in AD (as increasing AD will not reduce these forms of unemployment but will raise inflation)

3. gov policy to reduce unemployment by increasing AD is reversed because it has caused inflation so unemployment will rise and inflation will continue to rise due to expectations of inflation rising

Outline implications of monetarist model for demand side policy, supply side policy and use of rules and targets

demand: have no long run effect on unemployment and output. Can only be used to influence inflation or temporary reductions in unemployment. but these policies can also be destabilising

supply: should be used to reduce unemployment and increase output permanently

rules and targets: should be set for inflation and growth of money supply to reduce both expected and actual inflation

Define “new Keynesians”

economists who want to explain how market imperfections and frictions can lead to fluctuations in real GDP and persistence of unemployment

Explain implications of price rigidity for new classical view that real output not affected by changes in AD

Price rigidity means changes in AD can have significant effects on actual output so when these frictions to market adjustment exist govs might need to intervene to affect level of AD

What are 6 sources of market imperfections?

1. price inelasticity of demand

2. anticipating other firms’ pricing strategies

3. sticky nominal wages

4. real wage rigidity

5. sources of finance

   1. attitudes towards debt

Explain efficiency wage hypothesis with reference to real wage rigidity

hypothesis that productivity of workers affected by wage they receive

suggests firms might pay higher than market levels to incentivise workers

so they might be reluctant to cut wages in downturn as it could decrease productivity

Define insiders and outsiders and outline what is suggested by insider-outside theories in the context of real wage rigidity

insiders = those in employment who can use privileged position (union members or skilled people) to secure pay rises/resist pay cuts despite excess supply of labour

outsiders = those out of work/employed on casual basis who have little/no power to influence wages

insider-outsider theories: suggests existing workers might be able to resist real wage cuts as they can prevent unemployed from competing wages down (so there is always unemployment)

What is the effect of menu costs on monopoly with decreasing demand?

it might delay lowering the price if the lost profit from selling fewer items is smaller than the cost to update the price

Define hysteresis and scarring effects. What is the relationship between them?

Hysteresis = persistence of effects on macroecon variables even when economic event that caused them no longer exists

SE = long lasting damage to economy and economic situations of people that can result from downturn

Define non-accelerating inflation rate of unemployment (NAIRU) and explain impact of hysteresis on NAIRU

rate of unemployment that is consistent with steady inflation in near term e.g. over next 12 months

long term unemp might cause unemployed to be deskilled, demoralised so firms more cautious about taking on workers even when demand increases. So employment and output might fail to recover following recession i.e. hysteresis occurs, resulting in decrease in potential output and increased in NAIRU

Describe Keynesian view of demand-management policies

1. targeted gov int might be needed to smooth AD and substantial increase in AD might be needed in there is recession danger

2. Could undertake infrastructure projects that has direct impact on potential output and relatively low import

3. in longer term, gov should help maintain high and stable AD to keep unemp low and create env for long term investment and growth

What are the aims of supply-side policies?

1. increase potential output and rate of potential economic growth - maybe through encouraging R&D, education

2. reduce equilibrium unemployment by helping workers be more responsive to changes in job opportunities, reducing union powers to drive wages up

3. reduce cost-push inflation by reducing union power, increasing tax incentives, investment grants to firms

4. could also be used to improve balance of payments and/or correct regional imbalances

Distinguish between the 3 main approaches to supply side policy and the intermediate “Third Way” approach

New classical: want policies to free up market = encouraging private enterprise, provide incentives (market orientated supply side policies)

New Austrian/libertarian = wants maximum liberty for economic agents to pursue own interests and own property

Modern Keynesian: want interventionist policies e.g. training schemes, encouraging firms to set up in areas of high unemployment

Third way: want incentives, low taxes and free movement of capital, gov can provide support for individuals in need whilst improving economic performance of country by investing in infrastructure and social capital

Give examples that link between demand side and supply side policies

1. supply side policy involving increasing gov expenditure on retraining schemes will cause rise in AD

2. demand-management policy that involves cutting interest rates to increase investment (and national income) will also create increased productive capacity

What are market orientated supply side policies? How do they aim to increase potential output?

policies that increase AS by freeing up market (market forces can work freely)

aim to increase potential output by increasing role of markets (decreasing role of gov) and by removing impediments to market e.g. gov intervention by encouraging private enterprise and competition

What are 8 examples of market orientated supply side policies?

1. reducing G to encourage private sector investment without an increase in AD

2. reducing income taxes so more people work

3. reducing profit taxes and/or increasing tax reliefs to increase I

4. reducing monopoly power of trade unions - greater flexibility in wages

5. reducing automatic entitlement to welfare benefits

6. reducing red tape and other impediments to investment

7. encouraging competition through deregulation and privatisation

8. abolishing exchange control to free movement of capital

What are the aims and effectiveness of reducing G?

public sector often seen as more bureaucratic and less efficient than private sector

aims: to use public sector resources more efficiently and reduce the size of the public sector

hard in practice because they have choices concerning level of services and provision of infrastructure

What are 5 ways cutting marginal rate of income tax might have beneficial effect on output and discuss effectiveness in practice

1. people might work longer hours - but this might not be the case as substitution effect (workers substituting leisure for work) and income effect (workers are richer for same amount of hours worked) roughly cancel out

2. more people want to work

3. people work more enthusiastically

4. employment rises

5. unemployment falls - more difference between after tax wages and unemployment benefits

What are 2 market orientated policies that might be useful to encourage I and discuss effectiveness

1. cut in taxes on business profits - can be a potential problem as if all countries do the same, global taxes lower so all govs receive less in tax revenue

2. tax relief or other incentives for investment

What are 5 examples of market orientated policies designed to encourage competition?

1. privatisation = private firms competing with public sector can increase efficiency, more consumer choices and lower prices

2. deregulation = removal of monopoly rights

3. introducing market relationships in public sector

4. public private partnerships - funding public expenditure with private capital

5. free trade and capital movements - increases level of international competition

What is knowledge transfer?

sharing and discussion of knowledge between indivs, organisations and countries

Define interventionist supply-side policies, industrial policies and regional multiplier effects

ISSP = policies to increase AS by gov int to counteract market deficiencies

IP = policies to encourage industrial investment and greater industrial efficiency

RME = occur when change in injections/withdrawals in region causes a multiplied change in income to region

Why do people think interventionist policies are necessary? Why are there low levels of investment, R&D, education and training?

free market might fail to provide sufficient amounts as

1. firms free ride on investment of other firms

2. substantial external benefits so social rate of return on investments exceeds private rate of return but companies only take private benefits into account so under invest

3. firms consider these investments too risky

4. financing might be difficult

What are 6 examples of interventionist supply-side policies?

1. nationalisation

2. direct provision of capital

3. funding and support for R&D etc.

4. provision of training/education

5. advisory services to help firms be more efficient, innovative

6. provision of info e.g. to bring firms together to create climate of more certainty

What are the causes of regional imbalances and what are the policies that could be used to reduce/correct them?

result from structural problems e.g. decline in certain industries concentrated in certain areas. regional multiplier effects then depress areas further. also, labour might be immobile - more unemployment in some areas

policies:

1. subsidies/tax concessions in depressed regions

2. provision of facilities in depressed regions

3. siting of gov offices in depressed regions - they employ lots of people

Define current expenditure, capital expenditure, final expenditure and transfers in context of G

Current = recurrent spending on goods and factor payments e.g. medicine, salaries, welfare payments

Capital = investment expenditure on assets e.g. schools, hospitals

Final = expenditure on goods and services which are part of GDP and AD (in the equation)

Transfers = payments from taxpayers to recipients of benefits

Define budget deficit, surplus and fiscal stance in context of government

Deficit = if in a given year, G > T

Fiscal stance = extent that fiscal policy across entire public sector is expansionary/contractionary

Define the following in terms of gov deficits and surpluses:

1. public sector net borrowing (PSNB)

2. public sector net cash requirement (PSNCR)

3. national debt

4. structural deficit (or surplus)

5. current budget deficit

PSNB = expenditure of public sector - tax receipts and revenues from public corporations

PSNCR = UK based measure of what public sector has to borrow - based on when cash is actually paid/received and takes into account financial transactions by public sector

ND = accumulated deficits of central government - represents total amount owed by central gov domestically and internationally

SD/S = public sector deficit/surplus that would occur if economy operating at potential level of national income (zero output gap)

CBD = amount by which gov or public sector current expenditures exceed public sector receipts

Describe main roles of fiscal policy wrt AD and AS

1. prevent fundamental disequilibria in AD i.e. by removing severe inflationary/deflationary gaps

2. stabilisation policies i.e. fine tuning policy to smooth out AD cyclical fluctuations

3. to influence AS e.g. by increasing G on education, training

What are 4 key fiscal indicators that can be used to assess the financial position of the public sector?

1. Public sector net borrowing

2. public sector net debt = gross public sector debt - liquid financial assets

3. current budget deficit

4. primary surplus/deficit = how much they are overspending this month/year excluding interest payments on debt

Explain the influence of the business cycle on public finances

economy booming then T high. Unemployment and unemployment benefits low

so PSNB lowers and there might be a surplus

What is the relationship between the size of the deficit/surplus and the govs financial stance?

the existence of public sector deficit/surplus does not mean that fiscal stance is expansionary/contractionary

this is because whether the economy expands/contracts depends on balance of total injections and withdrawals

so instead, we need to focus on change in size of deficit/surplus

Define automatic fiscal stabilisers and fiscal drag

AFS = forms of G and T that adjust automatically to the state of the economy (without gov int) and reduce size of fluctuations in Y e.g. unemp benefits, progressive tax brackets

FG = tendency of AFS to reduce recovery of an economy from recession

Define discretionary fiscal policy, pure fiscal policy and fiscal impulse

DFP = deliberate changes in T and/or G to influence AD

PFP = does not involve change in money supply

FI = measure of change in fiscal stance arising from DFP changes. Can be measured bottom up (based on fiscal measures) or top down (based on cyclically adjusted budget balance)

What are the pros and cos of automatic fiscal stabilisers?

+act instantly as AD fluctuates

-effect is to reduce size of fluctuations rather than eliminate them

-although higher tax rates provide more stability, they might discourage effort and initiative

-although high unemployment benefits provide more stability, they might increase equilibrium unemployment

-high income related benefits might create poverty trap i.e. lower paid people might be better off not working

What are 3 things that can be altered using discretionary changes in G and/or T?

1. overall AD

2. AS e.g. using tax incentives to encourage work

3. distribution of income - using taxes and benefits to redistribute incomes from rich to poor

Discuss relative merits of changing G and T with reference to tax multiplier

Increasing G has full multiplied rise in Y as all money gets spent and so all goes to boosting AD

cutting T by the same amount will have smaller effect on Y as only part of additional disposable income will be spent

(tax multiplier always one less than government spending multiplier)

What are the problems of magnitude and timing associated with use of discretionary fiscal policy?

1. impossible to predict sizes of effects of changes in G and T on Y

2. will take long time for full effect of changes to occur during which economic conditions could have changed

List 7 reasons why size of effect of fiscal policy on Y is difficult to predict

1. rise in G might replace private sector expenditure

2. pure fiscal expansion might cause crowding out as higher I decreases private sector borrowing and spending

3. effects of tax cuts depends on confidence in economy and who gets the cuts

4. multiplier effect depends on size of marginal propensity to consume

5. accelerator and pump-priming effects depend on business, bank and consumer confidence

6. multiplier/accelerator interactions virtually impossible to estimate

7. economy subject to unpredictable random shocks

What are 5 possible time lags associated with fiscal policy, which means it takes time to work?

1. time lag of recognition of problem

2. time lag between recognition and action

3. time lag between action and changes taking effect e.g. some taxes paid in arrears

4. time lags between changes in G and T and resulting change in Y, prices and employment - accelerator (change in national income leads to change in investment) and multiplier (initial injection of spending leads to more leads to larger final increase in Y) effects take time

5. consumption might respond slowly to changes in T

What are the requirements of:

1. EU’s Stability and Growth pact (SGP)

2. EU’s fiscal compact

SGP = required govs adopting euro to balance budgets over business cycle and also to make sure deficits did not exceed 3% of GDP in any year

EU fiscal compact = required govs to not only abide by deficit requirements of SGP but also to keep structural deficits no higher than 0.5 of GDP

What are the 2 main arguments against discretionary (fiscal and monetary) policy?

1. political behaviour - politicians might overstimulate economy prior to election so growth is strong at election time without considering later inflation

2. time lags - can make policies ineffective or destabilising

What are the 4 arguments in favour of discretionary (fiscal and monetary) targets and rules?

1. if firms unprotected from adverse market conditions by discretionary demand management (i.e. gov bailing them out), they will improve efficiency

2. setting and sticking to rules will influence people’s expectations - making targets easier to get to

3. having stable monetary and fiscal framework makes it easier for firms to make long term planning decisions - leading to more I and growth

4. rules work well if different countries follow mutually consistent rules e.g. similar inflation targets as global stability

What are the 3 arguments in favour of discretionary policy?

1. active intervention lets gov respond appropriately to unpredictable shocks that continually affect economy

2. without discretionary stabilisation policies, uncertainty of shocks would be damaging to I and long term growth

3. sticking to inflation target could require excessive fluctuations in interest rates - which could discourage I and growth

What are the problems with targets and rules?

1. difficult to decide whether to stick to rules or come what may

2. difficult to decide what degree of flexibility to design into rules

3. difficult to decide whether policy makers should have some discretion to change the rules e.g. when target becomes inappropriate due to current circumstance

4. inflation target will be the same even if economy is in a boom or recession i.e. Phillips curve might become horizontal so they might not create stable long term growth

5. targeting one variable can have adverse effects elsewhere

What are the 5 factors influencing choice between discretion and rules?

1. degree of confidence people have in effectiveness of discretion/rules

2. degree of inherent stability of economy

3. size and freq of exogenous shocks to demand e.g. financial crashes

4. ability and determination of gov to stick to rules and confidence people have that they will be effective

5. ability of gov to adopt and speedily execute discretionary policies

What is internal and external balance in foreign exchange policy?

internal = domestic economy at eqm = operating at full potential output

external = country’s international accounts at eqm = balance of payments sustainable

What are the potential conflicts between attaining internal and external balance in foreign exchange policy?

if economy in recession and GDP below potential level (internal imbalance) but current account of balance of payments in balance (external balance), gov might expand AD by increasing G to close output gap and restore internal balance

Increasing GDP will increase imports so will introduce external imbalance

What is the relationship between balance of trade and public finances?

Actual injections must always equal actual withdrawals so if public sector runs budget surplus, it is possible trade balance is in surplus too

If I=S, a budget surplus/deficit would be exactly matched by trade surplus/deficit

Define real exchange rate. What is the formula for real exchange rate index (RERI) in terms of nominal exchange rate index (NERI)?

nominal exchange rate (at which currencies exchanged) adjusted for changes in domestic currency prices of exports relative to foreign currency prices of imports

RERI = NERI *Px/Pm where Px = domestic currency price index of exports and Pm = foreign currency weighted price index of imports

Define totally fixed exchange rate, freely floating exchange rate, intermediate exchange rate regime

Totally fixed = where gov/cb takes whatever measures to maintain exchange rate at fixed level (against another currency/basket of currencies)

Freely floating = exchange rate determined by market forces in foreign exchange market without gov int

Intermediate = gov intervenes to influence movements in exchange rate

What is the need for central bank intervention in currency markets under a fixed exchange rate regime?

unless demand/supply for/of currency are equal at fixed rate, central bank will have to buy/sell to make up the difference

e.g. if excess supply of currency, cb will need to buy up excess supply by selling its foreign currency reserves/borrow foreign currency from foreign banks to sell to stop currency depreciating

What is the effect on money supply (hence domestic economy) of central bank intervention in currency markets under fixed exhcange rate regime?

if fixed rate too high then there is balance of payments deficit and excess supply of domestic currency so cb will buy up excess domestic currency

This currency is withdrawn from circulation so domestic money supply reduced and interest rates rise

this attracts foreign inflows and financial account of balance of payments. also decreases AD, reducing imports and improving current account

Will also reduce GDP and possibly lead to recession

What is sterilisation and what is its use when there is excess supply of domestic currency?

where cb uses OMOs to neutralise effects of balance of payments surpluses/deficits on domestic money supply

e.g. if excess supply, buying domestic currency would cause reduction in money supply - this can be countered by buying gov bonds to inject money back into economy - this would avoid rise in interest rates and possible recession

but not allowing money supply to change means excess of dom currency exists which cannot continue indefinitely as foreign currency reserves are finite

How do we correct a persistent balance of payments deficit under a fixed exchange rate/

gov could use contractual fiscal/monetary policy

contractual - reduces expenditure incl imports to reduce GDP but also leads to fall in growth in rise in unemployment

if it reduces inflation, there would be increase in net exports - would also counteract adverse effect on growth and employment

or, restrictions on imports/subsiding exports can be used

What is the correction of a balance of payments deficit under a free-floating exchange rate regime?

freely floating exchange rate should automatically adjust to correct balance of payments surplus/deficit

deficit results in excess supply of dm currency so currency depreciates. exports cheaper so net exports should increase which corrects deficit

but rise in net exports increases GDP so more demand for imports which reduces the effectiveness

also, the GDP increase will reduce unemployment and might lead to higher inflation - which makes it less effective too

What is the effectiveness of monetary policy under fixed exchange rates?

if inflation high, cb will cut monetary growth. this increase interest and reduces GDP and demand-pull inflation

this will reduce imports leading to current account surplus

the higher interest rate will also lead to financial inflows and financial account surplus

balance of payments surplus will increase money supply and reduce interest, increase GDP back to original

so monetary policy not effective under fixed exchange rates

What is the effectiveness of fiscal policy under fixed exchange rates?

In a recession, gov might increase G and/or cut T to increase AD

This increases GDP and inflation - leading to higher imports so current account deficit

The GDP increase will also increase money demand hence interest rates - leads to financial inflows and financial account surplus

CB must increase money supply to stop interest rates rising too much (as lots of foreign investors want to put money into economy which would put upward pressure on exchange rate)

this monetary expansion reinforces expansionary fiscal policy (pushes interest rates back down) and prevents crowding out

Fiscal policy much more effective under fixed exchange rates

What are 4 causes of long term balance of payment problems under fixed exchange rates?

1. different inflation rates between countries

2. different growth rates between countries - imports tend to grow faster than exports for countries with higher growth rates

3. income elasticity of demand for imports higher than exports

4. long term structural changes e.g. emergence of trading blocs (agreements between countries to reduce/eliminate trade barriers for members), countries exercising monopoly power, development of substitute products

What are 4 advantages of fixed exchange rates?

1. certainty - international trade and investment less risky as profits not affect by exchange rate fluctuations

2. little/no speculation

3. automatic correction of monetary errors (from cb buying/selling domestic currency)

4. preventing govs from pursuing irresponsible macro policies - e.g. resulting balance of payments from wanting to expand G excessively to gain popularity puts a constraint on the demand

What are 2 new classical criticisms of fixed exchange rates?

1. they make monetary policy ineffective

2. they contradict the objective of having free markets

What are 4 problems with fixed exchange rates identified by Keynesian economists?

1. balance of payments deficits can lead to recession - e.g. if they result in persistent high interest rates

2. competitive deflations leading to world recession

3. international liquidity problems - supply of each currency depends on domestic economic factors not needs of international economy

4. speculation - can lead to devaluation/revaluation if currency thought to be overvalued/undervalued

Explain purchasing power parity PPP theory

PPP = nominal exchange rates will adjust to offset differences in countries’ inflation rates and make sure relative prices are unchanged (real exchange rate stays the same)

Explain why high real interest rates might lead to breakdown of PPP theory

If rise in AD leads to higher interest rates and inflation, higher AD and inflation leads to current account deficit (downward pressure on currency) and higher real interest rates leads to financial inflows (upward pressure on currency).

Overall result depends on which effect larger but either way, financial account effect means exchange rate will be above the rate according to PPP

Why might the carry trade lead to breakdown of PPP theory?

countries with current account deficits usually have high interest rates so it’s profitable to deposit cash to earn a high interest rate in a deficit country and vice verse (carry trade).

This has the effect of making currencies of deficit countries appreciate rather than depreciate accounting to PPP

How might floating exchange rates protect the domestic economy from world economic fluctions?

e.g. if rest of world goes into recession with no change in international interest rates then exports will fall, reducing domestic demand and GDP

But the exchange rate will depreciate, which means more exports so net exports increases, increasing AD and GDP so reducing effect of world recession

What are the possible effects of stabilising and destabilising speculation on exchange rate?

stabilising - occurs when people believe any exchange rate movement will soon be reversed so they make the exchange rate move as expected

destabilising - occurs when people believe exchange rate movements will continue in same direction - leads to exchange rate overshooting

What are the 4 advantages of free-floating exchange rates?

1. automatic correction of balance of payments surplus/deficit

2. no problem of international liquidity and reserves - no central bank intervention = no reserves needed

3. insulation from external economic events

4. govs free to choose domestic policy - free to target whatever demand is best for economy

Explain 3 disadvantages of free-floating exchange rates

1. speculation can lead to high levels of volatility

2. uncertainty for international trade and investors - but this can be reduced by forward exchange market

3. lack of discipline on domestic economy - gov can pursue irresponsible policies, unions can push up wages, firms can push up prices

What is the effectiveness of monetary policy under free-floating exchange rates?

e.g. recession so interest rates cut to increase AD

lower interest rates causes currency depreciation - leads to increase net exports and reinforcing AD increase

also, speculation might lead to exchange rate overshooting causing further fall in exchange rate and further increase in AD

So monetary policy very strong

What is the effectiveness of fiscal policy under free-floating exchange rates?

e.g. recession so gov cuts T and increases G to increase AD

AD rise increases imports so current account deficit depreciates currency

But increased money demand raises interest rates - causes financial inflows and appreciates currency

if the overall effect is appreciation on exchange rate, net exports decrease so AD decreases

so fiscal policy weak

Describe the following types of intermediate exchange rate regimes:

1. adjustable peg system

2. managed floating system

3. crawling peg system

4. joint float

5. exchange rate band

1. fixed exchange rate for period of time but can be de/revalued if deficit/surplus becomes substantial

2. floating exchange rate with gov/cb intervening from time to time to prevent large fluctuations or achieve unofficial target exchange rate

3. midway between - involves small but frequent adjustments

4. group of countries fix own currencies together but jointly float against all other countries

5. upper and lower limits between which exchange rate can freely float

What is the operation of the Bretton Woods system?

adjustable peg system where currencies were pegged to US dollar, which was convertible into gold at price of $35 per ounce

to prevent short term temporary fluctuations in exchange rate (more than +-1%), CBs intervened using foreign currency reserves

if disequilibrium, became more serious, govs supposed to pursue de/reflationary policies. they could also borrow from international monetary fund IMF to help maintain their exchange rate

if deficit severe (structural disequilibrium), countries could devalue currency in consultation with IMF to keep peg

What are the 3 ways by which Bretton Woods system contributed to world growth?

1. fixing exchange rates for long period of time reduced uncertainty - encouraged world trade

2. pegged rates plus oversight of IMF prevented govs from pursuing irresponsible policies - international harmonisation of economic policy and kept world inflation in check

3. ability to devalue when faced with severe deficit prevented govs being forced in deflationary/protectionist policies. IMF also ensure orderly process of devaluation

What is the difference between devaluation and depreciation of currency?

devaluation = deliberate attempt to make currency worth less in fixed/semi-fixed exchange rate system

depreciation = currency worth less due to market forces (supply and demand) due to free-floating exchange rate

What are the 3 problems of adjustment to balance of payments disequilibria and international liquidity that led to collapse of Bretton Woods system?

1. difficult to identify whether a deficit was fundamental - govs frequently optimistic about future balance of payments position

2. devaluation could be very disruptive - altered costs and revs of importers/exporters substantially. If devaluation felt as imminent, international traders reluctant to take on new commitments

3. devaluation could initially make current account deficit worse before better = J curve effect

Describe the operation of the managed floating system since early 1970s

has allowed adjustments required to inevitable shifts in supply/demand to be gentler - avoided large swings in exchange rates, exacerbated by speculation

some minor currencies pegged to USD whilst others to each other but float jointly against rest of world e.g. exchange rate mechanism ERM which operated prior to euro

although some countries allow their currency to float freely, most have sometimes attempted to stabilise their rate = manged flexibility. they have used two main methods to prevent depreciation: using reserves/foreign currency loans to buy domestic currency or raising interest to attract short term deposits

What are 3 problems with managed floating since 1972?

1. predicting what long term eqm exchange rate should be - as this will reflect PPP, oil crises, trade barriers, change in tech/tastes

2. growth in speculative financial flows - so more emphasis have been placed on interest rates

3. but using interest rates to control exchange rates might conflict with internal policy objectives e.g. meeting an inflation target

List 9 reasons for increased volatility in exchange rates

1. inflation/money supply targets - requiring interest rate changes

2. huge growth in international financial markets

3. widespread abolition of exchange controls

4. IT growth - facilitated international flows

5. preference for liquidity

6. growing speculation by trading companies to take advantage of currency movements

7. growth of speculation by banks

8. growth of speculative mentality - leads to destabilising depculation

9. growing believe govs are powerless to prevent currency movements

Define:

1. international trade multiplier

2. international harmonisation of econ policies

3. convergence of economies

1. effect on Y of a country due to changes in exports/imports of another country

2. where countries attempt to coord macro policies to achieve common goals

3. when countries achieve similar levels of econ growth, inflation and budget deficits as a % of GDP and similar balance of payments positions etc.

What is meant by interdependence of economies through international trade?

trade between countries means econ policies will affect each other e.g. inflation too high in US so they adopt deflationary measures to reduce AD so these will reduce imports and have deflationary effect in other economies via international trade multiplier

the more open to trade an economy is, the more susceptible it is to changes in econ activity around world

increasing volume of international trade as % of world GDP means more interdependence

What are the causes of financial interdependence of economies?

1. increase in international flows of money seeking higher interest

2. incresase in financial institutions/indivs holding assets in other countries

3. increase in financial deregulation/innovation

What are the implications of the financial interdependence of economies e.g. rise in US interest rates

This will:

1. reduce US GDP and hence exports from, and GDP in, other countries

2. interest rate rises in other countries so falls in GDP

3. inflow of funds into US, leading to rise in USD and fall in other currencies which will increase their GDP

What is the meaning of international business cycles?

trade and financial interdependence of economies means world economy tends to experience fluctuations in econ activity i.e. international business cycles

as a result, indiv econs tend to move together and experience similar econ conditions/problems at same time