Exam 3

• The exam will cover chapters 13, 18 and 20
• Aggregate Demand (AD) curve


  Shows that short-run output is a function of the rate of inflation

  
• Aggregate Supply (AS) curve


  The price-setting equation used by firms

  
• The AS curve is simply the Phillips curve with a new name
• Expected inflation is assumed to be equal to last period's inflation
• Event #1: An Inflation (unexpected cost) Shock

  1. Shifts AS curve when shock occurs

  2. Recovery back to potential output occurs gradually because AS shifts back as expected inflation slowly adjusts
• Event #2: Target Inflation Change

  1. Shifts AD curve when central bank alters R to achieve desired result to inflation

  2. Long run equilibrium happens because AS gradually shifts and moves the economy towards zero output gap as expected inflation adjusts to the change in AD
• Event #3: An AD Shock

  1. Shifts AD curve to new SR equilibrium

  2. AS later gradually shifts and moves economy back to potential output at new stable inflation rate

  3. If the new stable inflation rate isn't at central bank target, they will conduct a policy to shift AD curve in the other direction, THEN AS gradually responds, and economy reaches second stable inflation rate (at zero output gap) at central bank target
• Budget balance


  The difference between tax revenues and spending
• Budget surplus


  Taxes exceed spending
• Budget deficit


  Spending exceeds taxes
• Balanced budget


  Spending equals taxes
• Government borrowing


  Selling government bonds (Treasury securities) to lenders in the United States and abroad
• Borrowing to finance a budget deficit is not monetary policy and does not, by itself, imply a change in money supply
• Fiscal policy for stabilizing business cycles

  • Increased G and/or tax cuts to alter AD is usually not as good for stabilization as monetary policy due to difficulty predicting effect on AD, large lags in policy implementation
  • Fiscal policy can be crucial in addressing an unusual recession in which AD is expected to stay very low for a long time despite monetary policy keeping interest rates extremely low
• Debt/GDP


  If debt/GDP is constant or falling, then it is easily sustainable
• Sustainable debt


  • Depends on deficits, interest on debt, and economic growth (fuels tax revenue)
  • If average real interest rate on the debt exceeds LR growth rate of GDP, then it is unsustainable
• Intergenerational equity


  How the costs and benefits of government borrowing are distributed across generations
• Crowding out


  Higher borrowing from deficit spending might push up interest rates, which might lower investment demand and eventually slow long run growth
• Nominal exchange rate (E)

  The price of one currency in terms of another, determined by the trading of foreign exchange in the global market
• Real exchange rate (ε)


  The nominal exchange rate adjusted by the relative price level at home and abroad
• How a rise in US interest rates affects the exchange rate


  1. Foreign investors are attracted to purchase US interest-bearing assets, increasing demand for dollars and causing the nominal exchange rate to appreciate

  2. The real exchange rate rises in the short run because prices are sticky
• Net exports (NX) function


  Determined by the medium-run trade balance and by short-run deviations that depend on the real interest rates
• Policy trilemma


  At most only two of the three goals can be achieved simultaneously: stable exchange rates, free capital flows, and independent monetary policy

  
• Fixed exchange rates


  The central bank trades in the foreign currency market to maintain a target exchange rate, which influences domestic interest rates
• A currency crisis can result when a central bank does not have enough foreign exchange reserves to defend its peg
• Capital controls are restrictions on financial flows and on trading of the currency in order to maintain a fixed price
• Use the AD/AS model to demonstrate what happens when there is an increase in consumption due to optimism about the economy.
• The increase in (C) will cause AD to shift right (AD = C + I + G + NX, so more consumption directly raises demand for goods and services).
• In the following periods firms will look back in time and see that inflation has risen. In addition, the fact that output is above potential output level suggests that demand is high, so firms will raise inflation each period until the economy returns to potential output at point C. (higher inflation causes AS to shift left).
• The central bank's target inflation has not changed so they will want to conduct a monetary policy to cause inflation to stabilize back at point A.
• The economy is not in a recession at point D. Then, in later periods, firm will continue to lower inflation as their expectations of inflation adjust down (contracts (like employment, materials, and goods contracts) will be negotiated at lower inflation rates as the continue to expire) and they will eventually return to profit maximization where output equals potential output (shifts AS and moves D back to A).
• Explain what "crowding out" means, how it can occur from higher government spending, and why it could be a problem for an economy in the long run.
• Explain why debt/GDP (ratio) is a more useful measure than just the total debt level alone.
• 3 goals of any monetary system: stable exchange rates, monetary policy autonomy, & free financial flows.
• Explain why an economy must give up fixed exchange rates if it chooses to have monetary autonomy and have financial capital flow freely across borders.
• If this country wishes to maintain monetary policy autonomy and it is facing high inflation then the central bank will raise real interest rates. If they do not restrict exchange of assets and currency across borders (free financial flows), they this increase in real interest rates domestically will cause foreign savers to seek this country's interest-bearing assets (as they are earning relatively more than other countries assets).
• If an economy sees its real exchange rate appreciate what will happen to net exports as a result?
• Suppose we know that output in the economy is given by the production function: Y=AK0.3Lx.
• Derive the equation for the growth rate of output (Y).