govt. macroeconomic intervention (policies)

• The relationship between the internal value of money and the external value of money.
• The value of the money inside a country


  Is closely related to the value of its currency in the overseas markets
• If there is inflation inside the country

  The value of money falls
• The real value of money falls
• Each unit of currency will buy a person less in the domestic market
• If the value of our currency falls but other countries' currency falls by a larger amount

  Our exports to them become more expensive
• If we continue to import

  More of our currency will be supplied into the overseas market
• Reduced demand and increased supply


  Will cause the currency to depreciate
• Decreased demand for the currency will make the demand curve shift to D1
• More currency is supplied to the world market and supply rises to S1
• The combined effect


  Is that the currency will depreciate from P to P1
• A change in the exchange rate


  Will affect the purchasing power of money inside the country
• A fall in the exchange rate

  Will make imports more expensive and exports cheaper
• One unit of currency buys fewer imports when the exchange rate falls
• If the price of domestic goods rises rapidly because of inflation

  Our exports will fall
• Our products are no longer price competitive
• An increase in the current account surplus


  Means that more money is flowing into the country through increased exports
• This means aggregate demand will rise


  Which will lead to inflation
• In the long term a current account surplus


  Will make the currency appreciate
• An appreciation of the currency


  Will make imports cheaper and imports will rise
• The BOP surplus will become smaller and eventually disappear
• A fall in unemployment


  Will lead to higher aggregate demand
• Higher aggregate demand

  Leads to higher inflation
• Bill Phillips (1958) looked at the relationship between unemployment and inflation
• The Phillips curve suggests that govt. can select its best combination of unemployment and inflation
• If the current rate of unemployment is 8% and the inflation rate is 4%
• This view of the Keynesians

  Is challenged by the monetarists
• Friedman created the expectations-augmented Phillips curve
• The diagram shows that an increase in aggregate demand does succeed in reducing unemployment from 8% to 4%
• It will create inflation of 5%


  Firms increase output and more jobs are created
• When firms realise that their costs have risen and their real profit is unchanged


  They will cut back production
• Some workers realising that their real wages have not risen

  Will leave the firm
• Unemployment rises to 8% again


  But inflation of 5% has been created
• Govt. measures to stimulate aggregate demand


  Has resulted in a direct rise in inflation
• Workers will believe that inflation is 5%


  And demand more wages
• If govt. attempts to reduce unemployment to 4%


  The economy will move to SCP2 and push up inflation to 12%
• If we join the 3 points then we will obtain the long run Phillips curve
• Expansionary fiscal policy

  Can increase economic growth and reduce unemployment
• The negative is that demand pull inflation will result and lead to a deficit in the BOP since imports rise
• Contractionary fiscal policy


  Will help reduce aggregate demand and achieve lower inflation and improve BOP deficit