Final Exam Review

Supply:
Law of supply : there is a positive relationship between price and quantity produced .

 As price ↑= ↑ Quantity supply

 As price ↓=↓quantity supply

What shift supply?

1. Technological innovation: comes more efficient

2. Price and availability of inputs
3. Supply shock: any unexpected change that impacts production
4. Taxes and regulation

Demand:

Law of demand: Inverse relationship between price and quantity bought

 As price ↑=↓ quantity demand

 As price ↓=↑quantity demand
 ∆ demand: shift in demand
 ∆ quantity demand: move to another point on demand curve

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Why is demand downward sloping?

1- Income effect : as ↑P → consumer become relatively poorer(↓ purchasing power). So

we purchase less
2- 2- Substitution effect : as ↑P of one specific good →all other goods become relatively
cheaper so we buy them instead.

What causes demand to shift?

1- ∆Income
2- Price and availability of substitutes goods
3- Tastes/preferences/other factors
4- Change in population/market
5- Taxes and regulation
6- Consumer expectation
7- Price available of complementary goods.

Market Affect

In equilibrium:

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Why does equilibrium hold?

1- Quantity supply > Quantity demand:

 Surplus
 Get to equilibrium:↓P
2- Quantity Supply < Quantity demand:
 Shortage
 Get to equilibrium :↑ P

Questions related:

5. Use Supply and Demand to show the effects on price and quantity for each of the
following scenarios that occur in the market for McDonald’s Big Mac.

A. Consumer income falls.

Decrease demand, decrease price and decrease quantity
B. French fries become more expensive due to a potato famine.
Decrease demand, decrease price and decrease quantity
C. Mad cow disease afflicts the U.S. cattle population.
Decrease demand, decrease supply, decrease price , decrease quantity
D. A hillbilly revolt in Arkansas cuts off the supply of hot dogs.
Increase demand , increase quantity , increase price
E. Kentucky Fried Chicken increases the price of a bucket of fried chicken.
Increase demand, increase price and increase quantity
F. The government relaxes standards for handling raw meat.
Decrease demand, increase supply, decrease quantity and decrease price
G. Concerned about the obesity epidemic, Americans begin to diet more.
Decrease in demand , decrease in quantity , decrease in price
7. Recently, Shell disclosed that they overstated their proven oil reserves by 20%.
How might this affect the oil market? The gasoline market? The SUV market?
Alternative fuels? (HW#1)

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 Oil market: supply will shift back and the price will increase
Gasoline market: Supply will shift back and price will increase
SUV market: demand shift back, price decrease and increase quantity
Alternative fuels: demand increase, price increase, quantity increase

8. Demand for watermelons is typically highest during the summer and lowest during the
winter. Yet, watermelon prices are normally lower in summer than in winter. Use a
supply and demand diagram to illustrate why this happens. Be sure to clearly indicate
summer and winter equilibrium prices.(HW#1)
We have more quantity of the good during the summer, which means higher quantity
supply pushing the price down increasing quantity demanded

9. Briefly explain whether each of the following statements is true or false:

A. If both supply and demand for a product increase, the equilibrium quantity of the
product must also increase.
B. If both supply and demand for a product increase, the equilibrium price of the
product must also increase.(HW#1)

Answer:
a) True, people want more and there is more available
b) False, depends how much each other will increase

PRICE CONTROL: place limit on price

Price floor: sets minimum price

 Cause increase of price so quantity supply increase surplus of production and

quantity of buyers/people in willing able to buy decrease

Price ceiling: sets maximum price

 Causes decrease in price( good for some consumers) results in shortage because it
increase in quanity demand and decrease quantity supply.
 There is not so much available
 Make less money

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Questions related:

10. Assess the following argument:

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 A price floor reduces the amount of a product consumers buy, because it keeps the
price above the competitive market equilibrium price. On the other hand, a price
ceiling increases the amount people buy because it keeps the price below the
competitive market equilibrium.

Do you agree with the argument above? Use a supply and demand diagram to illustrate
your answer. Be sure to analyze the impact of these price controls in the short- and
long-run.(HW#1)

No, I do not agree. Because price ceiling is below the competitive market equilibrium price
people are willing to pay but how there is a shortage they don’t find the product, so people
buy less because firms are unwilling to produce the product at that low price.

5. Evaluate the following statement as true, false, or uncertain: “Raising the minimum
wage benefits unskilled workers by allowing them to earn a living wage so that they are
better able to support themselves.” Explain(Midterm#1)

False. While it may benefit those who keep their jobs, raising the minimum wage also
decreases the total amount of workers hired in the labor market as firms are unwilling to
hire those workers at that higher wage. These workers who are unable to find work at the
higher wage do not benefit from the higher wage.

PPF:

Production possibilities frontier

PPF: the maximum combination of outputs we can produce given a current level of
resources, labor(population, capital and technology

 Trade- off between two products(opportunity cost)

 In general amount of one good we must sacrifice to get one more unit of the other.
 Slope: rise/run
 PPF BOWED OUTWARDS: because increasing opportunity cost: the more of one
good produced, the more of the other good which must be given up to produce one
more unit.

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  A: Efficient: any point in PPF line( we are using all available resources)
 C: Inefficient point (not using all available resources)
 What causes inefficient? We are wasting at least one of resources
 PPF can shift: technology, new factory, increase labor force, economic growth has
increase in inputs.

 If we have a change in capital, technology or labor force or natural resources in

specifics is one industry

Base technological change:

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MARKET FAILURES:

What causes market to function inefficiently?

1. Imperfect competition: when a producer or consumer gains ability to influence

price(market power)
 Extreme example:
 Result: use market power to rise price and decrease production
 Inefficient because companies produce less to rise price.
2. Imperfect Information: have misleading or inaccurate information about a product
 Inefficient because cause consumers and producers to waste money and resources.
3. Public goods: have two characteristics
A )nobody can be excluded
B) does not cost extra if more people use it
 Example national defense
 Problem: free loaders/free rider
 Result: Is not enough produced
4. Externalities: a third part either pays some production costs of enjoys some of
benefits of the good.

Two types:

a)negative externalities: producer does not pay all costs of production, some of the costs
are paid by an unrelated part.

 Example: pollution

b)positive externalities: additional benefits of a good are enjoyed

 Example: education, exercise

Questions related:

8. Choose your favorite two market failures, define them and explain why each causes the
economy be inefficient.(Midterm#1)

Ask mine

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How/ why the government fights them?

INFLATION

 Inflation: rising prices, loss of purchasing power; money losing value

 Deflation: falling prices
 Disinflation: Falling inflation
 Hyperinflation: very high inflation at least 15 % a month
 Core inflation: excludes food and energy prices because more volatile and seasonal
 Expected inflation: generally is not a problem and doesn’t dispute economy

Problems/ effects of unexpected inflation:

1. Impacts income and wealth distribution:

 If we own money, inflation is good because payment worth less money paid back
is not as valuable as what was borrowed meaning real value of loans decrease
 Debtors gain at expense of lenders/ savors
 Silver lining: decrease government debt burden

What about deflation? Bad for borrowers, good for savers

a) Pay back loan with more valuable payments

b) Underlying collateral loses value

2.Impacts efficiency: companies see rise in price but need to determine cause: need to
know if increase in price is caused by overall rise in price or relative rise in up( this
good is becoming more valuable) so companies and government spend and tracking
price changes argue this leaves fewer resources for expansion innovation, also they
have the costs of changing price.

3.Impacts people on fixed income: income stays the same but prices rises, people
become poorer, or income doesn’t keep pace with inflation.

4. Distorts tax Burden and creates disincentive to save, another way to saves punished,
government taxes nominal (not real) gain

Questions related:

7. True/False/Uncertain: A rise in gas price is likely to be sign the economy is suffering

from cost push inflation. Explain (Midterm #1)

True. The term pushing inflation comes from that inputs are more expensive, which rise in
gas price may be a signal that the economy will suffer inflation, because gas is used as
input in many industries.

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 10. Explain how unexpected price changes impact the economy. If inflation is in line
with expectations, will it have the same type of impact on the economy? Justify.

Unexpected price changes impacts the economy;

1. Impacting income and wealth distribution because if we owe money, increase in price is
good because payment worth less money paid back is not as valuable as what was
borrowed, meaning that real value loan decreases.

2. Impacts efficiency; because companies see rise in price but they need to determine the
cause, if rise in price is caused by overall rise in price or relative use in up, so companies
and government spend and tracking price changes argue this leaves fewer resources for
expansion innovation and they also lead with costs of changing prices.

3. Impact people of fixed income; income stays the same but prices rises, people becomes
poorer, or income does not keep with inflation.

4. Distorts tax Burden and creates disincentive to save; another way savers punished,
government has taxes nominal gain and inflationary portion taxed too( not just real gain)

Generally expected change in price is not a problem and does not dispute economy,
because household can save money a producers do not leads with a mistake about the
answers of your product in market.

1. As we discussed in class, many economists feel the inflation rate is overstated. Analyze
the impact of the overestimated inflation rate on the economy; be sure to mention
which groups benefit and which groups are hurt by the inaccurate estimate of inflation.
How would the economic effects change if we used the PPI or the PCE to measure
inflation? (HW#3)
If the inflation is overstated, the economy expect lower growth, so we would expect higher
unemployment, and less investment, and increase in price level. Also, it increase interest rate
and affects taxes and transfer payments. These means that household would start to save
money and to consume less but they would do it more than actually they would if they had the
accurate information
Graph:

2. Should economic policymakers strive to achieve an inflation rate of zero percent?

Justify your answer and be sure to explain the implications this would have on the
economy. (hw#3)

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No, because it helps the labor market reach equilibrium . As the nominal wage stays the same
and we have increase of prices the real wage decreases, so is easy for workers entering into
new industries to contract for wages.

3. In what way can inflation be considered a tax? Upon whom is the tax levied? How is
the tax paid?(HW#3)
Inflation can be considered a tax if you think that both are drives from how the market
(taxes savers) is in that moment, both are revenue for the government . It is for the
government, which has the obligation to manage the money and direct it for the
development of the city as a whole.

Tax is a percentage of everything that you pay when you purchase a production or a
service. Also when we receive our salary one percentage is paid to the government.

What is the difference between anticipated and unanticipated inflation (and which are
we more concerned about?

o Anticipated inflation: When people are able to make accurate predictions of

inflation, they can take steps to protect themselves from its effects. For example,
trade unions may exercise their collective bargaining power to negotiate with
employers for increases in money wages so as to protect the real wages of union
members. Households may also be able to switch savings into deposit accounts
offering a higher nominal rate of interest or into other financial assets such as
housing or equities where capital gains over a period of time might outstrip general
price inflation. In this way, people can help to protect the real value of their financial
wealth. Companies can adjust prices and lenders can adjust interest rates.
Businesses may also seek to hedge against future price movements by transacting in
“forward markets”. For example, most of the major airlines buy their aviation fuel
several months in advance in the forward market, partly as a protection against
fluctuations in world oil prices.
o Unanticipated inflation: When inflation is volatile from year to year, it becomes
difficult for individuals and businesses to correctly predict the rate of inflation in the
near future. Unanticipated inflation occurs when economic agents (i.e. people,
businesses and governments) make errors in their inflation forecasts. Actual
inflation may end up well below, or significantly above expectations causing losses
in real incomes and a redistribution of income and wealth from one group in society
to another

We concerned more the anticipated inflation, considering that every year the
government predicts interest rate which directly influences in future percentages of
inflation.

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What is the dilemma of anti-inflation policies?

Define the Philips Curve

 Philips Curve: Inverse relationship between unemployment and inflation, so as

unemployment rises inflation decreases, as unemployment falls inflation increase.

How inflation measured?

1. Consumer price index(CPI) : tracks the price of the goods and services bought by
typical household.
 Fixed bundle representing goods bought by average person
2. Producer Price index(PPI): tracks cots of bundle goods bought by typical
business
 Example: wages raw material, etc
 Helps predict future changes in CPI
3. GDP deflator: tracks price of output produced domestically
 Measures what is actually produced
 Ignores import prices, includes export prices
4. Personal Consumption Expenditures(PCE): measures prices of goods and
services actually bought by households (more dynamic)

INFLATION IS PCI CHANGE IN PRICE INDEX

Why do economists argue that the inflation rate is not calculate correctly? If the
inflation rate is not calculated correctly, how would this impact the economy?

Why CPI measures inflation innacurately?

1. Substitution Bias: prices do not move together proportionally some goods rise
by more or less than others.
 So households react by buying goods that are relatively cheaper and do
not buy realively more expensive goods, but bundle of goods in CPI
unchanged.
 Assumes households do not respond to relative price changes
 PROBLEM: Household substitute similar good for expensive one but this
isn’t captured in CPI

2.Introduction of new goods: gives consumers more variety (more choices)

 so can make better decisions meanings each dollar spent has more purchasing
power and lower cost of living and get more out each one dollar spent.
 Also new goods may not have been included in CPI yet.

3. Quality changes: price may stay the same but quality features , etc. may change.

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  Could be positive or negative.
 Mismearing inflation is a problem because many things linked/indexed to
official inflation.

Sources of inflation: Use supply and demand

1st Demand pull inflation: rising price level caused by increase in demand

 Excess demand cause increase in price because shortage need increase price to
clear market .
 Economics at or above full employment .

2nd Cost push

 Caused by limit or constraint on supply ( negative supply shock)

Question related:

5. Why do economist argue that Consumer Price Index cause us to overstate the
inflation rate? Be sure to explain if this is beneficial or harmful to households.
(Midterm #1)

Consumer Price Index(CPI) tracks the price of the goods and services bought by typical
household, it has a fixed bundle representing goods bought by average person and also this is
static, which means that change in few in few years. The problems using this type of measure
are that it assumes that households do not respond to relative price changes. So, when
households substitute similar good and expensive one the CPI does not capture. Another
problem is when the market introduce new goods, the consumers have more choices ,
meaning that each dollar spend has more power, also, lower cost of living and get more out of
each dollar spent. Also new goods may not been included in CPI yet. In addition, prices may
stay the same but quality, features may change, it may not be computed in CPI. Mishearing
inflation is problem because many thing are linked/indexed to official as an example
government spend, investments and interest rate. So, if this mishearing causes decreasing in
investment and government spending leading to fluctuations in the interest rate this is
harmful for household.

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1. As we discussed in class, many economists feel the inflation rate is overstated. Analyze
the impact of the overestimated inflation rate on the economy; be sure to mention
which groups benefit and which groups are hurt by the inaccurate estimate of inflation.
How would the economic effects change if we used the PPI or the PCE to measure
inflation?(HW#3)

If the inflation is overstated, the economy expect slower economy growth, so, we would
expect higher unemployment, and less investment, and higher price level causing increase
in interest rate and affects taxes and transfer payments .These means that household
would start to save money and to consume less, but they would do it more than actually
they would if they had the accurate information.
The impacts using PCE would be more dynamic, once this measures using measures prices
of goods and services actually bought by households, resulting in less overstated.

Be able to explain the role financial institutions play in the economy, including the
importance of financial markets.

Principal role of the financial system: channeling savings from investors to investment

 payment system
 diversity manage risk
 Financial intermediation: how savings in converted into investment
 Happens in financial markets: connects borrowers and savers; always savers to
channel funds to borrowers.
 Primary finance market: for newly issued financial investment instrument, example:
1st time shake is sold
 Secondary Financial Market: already issued instruments bought and sold example:
NY stock exchange
 Money: anything you can use to buy something; anything accepted as payment
 Commodity money: backed by something of value (specie: usually gold)
 Flat money: has valued because government says it has value (and people believe)

Functions of money:

•store value

•medium of exchange breaks down in hyperinflation

•unit of account

Types of money:

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M1: cash, coins, traveler checks, demand deposits,(checking account);most liquid

M2: M1 and savings accounts, money market shares, and small denomination ( less than
250,000 dollars) time deposits

M3: M2 and large denomination ( more than 250, 000 dollars) time deposits

QUESTIONS RELATED:

2.What role financial institutions and the financial market play in the economy? Be
sure to also discuss the relationship between savings and investment. (Mid term#2)

Financial Institutions makes the economy work. For example when savers deposit
money in the bank this can makes loans for investor and lenders. The financial market is the
cycle of create money and how is administrate investment and savings. It converts savings to
investment.

 Savings> investment =shortage of savings

 Savings< investment= surplus of savings
 When savings=investment the economy is in equilibrium.

6. Would a series of bank runs in a country decrease the total quantity of M1?
Wouldn’t a bank run simply result in funds moving from a checking account to currency in
circulation? How could that movement of funds decrease the quantity of money?(HW#4)
If people would start to prefer to hold money in their houses than to keep in the banks
accounts, the bank loans would decrease, because the process of money would be limited, as
we can see that one part of the cycle would be corrupted. The result would not be more in
circulation it would just have less money supply.

8. How does hyperinflation undermine each of the three functions of money? In spite of
this, why do governments sometimes allow hyperinflation?(hw#4)
Hyperinflation is caused by high volume of money. When hyperinflation happens the economy
is uncertain about the future, also, the value of the money is falling and the money supply
increase. Over time the unit account of the money may be revised, because this is not stable.
Government sometimes allows hyperinflation to inject money in their savers when they need
money for public projects or when the country is during a war for example.

List the functions of the Fed, explain what the FOMC does, and why Fed is considered
quacipublic.

FEDERAL RESERVE SYSTEM: founded by Federal Reserve Act (1913); established 12

federal reserve banks and board of governors in D.C. (Washington)

 Each bank operates independently

 Board of governors oversee everything

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  Shows that politics hasn’t changed much (locations of the banks are the same)
 POWERFULL SENATE WANTED ONE IN HIS CITY , SO THEY PUT ONE THERE

Quasi Public: Fed is “ Quasi Public” because established by act of congress and cab be shut
down by congress but has full independence in decision making

 FED DOES NOT RELY CONGRESS FOR MONEY

Seignorage: Revenue earned by printing money (legally)

ALL OPERATING PROFIT GOES BACK TO TREASURY

Functions of FED:
1. Conduct monetary policy: changing interest rate and money supply
2. Supervise and regulate financial institutions
3. Serve as “ lender of last resort” cannot borrow money for anyone on FED
4. Issue and maintain coin and currency put money into circulation
5. Provide payment system service’s: check clearing electronic payment, etc
6. Serve as bank for U.S. government

Who runs the FED?

 Seven governors : Serve staggered ( 14 years terms, 2 years)

 Chairman of Board of governors: Ben Bernake
 Seven governors plus 5 reserve bank presidents make up federal open market:
COMITTE(FOMC): set monetary policy meet 8 times a year

Questions related:

4.List the functions of the Federal Reserve Bank. What is the Federal Open Market
Committee and what does it do? Is the Fed a government agency or private business?
(Midterm#2)

Federal Reserve Bank(FED), control the quantity of money supply in the and drives inflation
but not growth in the economy; oversee the banks; is the last resource to borrow money for
banks(but just banks to keep stability to the economy) across the monetary policies created
by FOMC drives the interest rate in the economy; it also makes payment services, maintain
cash for government.

The Federal Open Market Comitte(FOMC) is a meeting that happens eight time per year in
Washington , DC. FOMC has the power to drive the monetary policies if this need to change
and the FED applies. FOMC is managed by the Seven board of governors from the Federal
Reserve plus 5 Federal reserve bank presidents make up federal open market.
Fed can be considered a “Quasi Public” because established by act of congress and cab be shut
down by congress but has full independence in decision making.

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What are the three instruments of Monetary Policies and how the Fed uses them to
increase or decrease money supply.

Three tools of monetary policy

1. Change reserve: requirement(percent of deposits banks must hold)

Set higher than banks would hold
Safety; sadness and control issue

 If Fed ↑ Reserve Requirement → ↓ Money supply because banks have less to loan
out so ↑interest rate
 If Fed ↓Reserve Requirement →↑ Money supply and ↓interest rate

GRAPH:

2. Change in discount rate or Fed fund rate discount rate: interest rate on overnight
loan from FED
 FED fund rate: interest rate on bank to bank loans (overnight)

How does it impact money supply?

 If ↑discount rate or Fed Funds rate→↓ Money Supply and ↑ interest rate
 If ↓discount rate or Fed Funds rate→↑ Money Supply and ↓ interest rate
3. Open Market Operations: Fed buys and sells treasury securities (done thru NY FED)
Impact on Money supply:
 If Fed buys securities→ Fed putting money into banking system→ ↑money
supply causing ↓interest rate
 If Fed sells security→ Fed pulls money out of banks system→↓ decreasing
money supply and ↑money demand
4. Quantitative Easing
 Fed starts buying others types of security
 Fed putting more: liquid over economy quantity into system

Questions Related:

3.Define Legal reserve requirement. In a fractional reserve syste, does the central
bank have complete control over the money supply? If there were no legal reserve

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 requirement, would banks choose to hold reserves, considering that reserves earn
no income for the banck Why or why not?(Midterm #2)

Legal reserve requirement is a percentage of money that the bank must hold from
deposits done by people. The central bank have the control over the money supply
because it has the power to “create money” using the reserve requirement. Also, using
the monetary policy the central bank can inject more money in the economy; buying
securities rises money supply and vice-versa; rising discount rate or Funds rates
decrease money supply and vice-versa, rising reserve requirement decrease money
supply and vice-versa, and also injecting money in the economy buying other types of
security. Banks would choose to hold reserve to make profit loan out and to prevent
the market from future expectations, also, it would be more security for them.

Be able to draw the money market, show how the three instruments affect the money
market (graphically) and also explain what can cause money demand to shift.

Also, be able to explain what will ultimately happen to output, consumption, employment,
investment, inflation, and interest rate because of the Fed’s policy( you do not need to go
through the entire Monetary Transmission Mechanism ) You should also be able to explain
what happens in long-run.

How does monetary policy impact the economy?

Monetary transmission mechanism(TRAD VIEW) assume: want to stimulate the economy.

1. Fed has policy options: want to inject reserves info Finance system:
3 tools:
1st - ↓ reserve requirement and
2nd-↓Fed fund rate by bond to put money into the system
rd
3 -↓discount rate
2. Banks have mre reserve and liquidity

FED BANK SYSTEM

Banks have more reserves and liquidity results in more lending so money creation
process begins , results in bigger money supply.

3. Go to money market

↑ Money supply →↓Interest rate

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 Graph:

4. Impact of ↓ interest → money is cheaper , both borrowing and spending cheaperr so

household and business respond :
 ↑Consumption
 ↑Investment
5. Recall→ GDP= C+ I+ G(X- M)
 So→ ↑ consumption ↑ investment mean ↑ GDP ↑output
 Causing →↓ unemployment ↓ employment ↑income

But ↑inflation to much money

Because more money in circulation and growth is demand side

6. A s move into long-run

 ↑ growth economy ↑ income ↑spending
 Causes: increase Money demand impact on money market
 Meaning: ↑ interest rate ( more expensive)
 ↓ Investment ↓ Consumption↓ GDP ↑ Unemployment ↓ employment ↓inflation

GRPH:

QUESTIONS RELATED:

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1. Assume that the government decides to use monetary policy to fight inflation. Be able
to trade out the effects of the new monetary policy in detail (this is called the ‘Monetary
Transmission Mechanism’). Don’t forget to draw the money market, plus be sure to
explain how (and why) money supply, interest rate, investment, consumption, GDP,
employment, income, and inflation change (plus any other variable that I’ve left out).
How do these short-run effects reflect the trade-offs of economic decision making?
What are the long-run effects of the change in monetary policy? Is it possible to
construct the business cycle using the analysis you just completed? If so, sketch out
how you could derive the business cycle from this analysis.(hw#5)

7. Use the Monetary Transmission mechanism to explain the effects on money supply,
interest rate, output, employment, consumption, investment, income, and the price
level (inflation) when the Feed uses monetary policy to fight inflation. Br sure to
discuss both the long-run and short- run effect of the policy. Do not forget any
relevant definition or to list the three instruments of monetary policy, what the Fed
would do to each one, and the instrument they will most likely use. Be sure to
include the money market and also clearly explain each step in the process.
(Midterm #2)

9. Assume that, rather than the Fed changing monetary policy, the money market is
impacted by a change in money demand(such households deciding to hold more
cash is impacted by don’t trust banks) How would the impact of the change in
money demand differ from the change in policy discussed in #7.Explain briefly
(Midterm #2)

7.How does the Fed's program to purchase Treasury securities, mortgage-backed securities
and debt issued by Fannie Mae and Freddie Mac differ from open market operations? Why
did the Fed make these purchases?(HW#5)

The difference is that open market operations influence money supply in another hand the
other operations do not affect money supply. The FED made these purchase to stabilize the
housing market, and to make sure that the federal funds rate is low enough also to prevent
the banks from fail.
ASK skelton

What is the Classical School’ response to the impact of monetary policy? Explain why/ how
they come different conclusion than that predicted by the Monetary Transmission
Mechanism.

Money growth and inflation

What causes inflation

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 1. Rise money supply led to increase in price level and rise in inflation (“ too much
money yo few goods)
2. Expectation of inflation lead to inflation (self- fullfiling prophecy)

How do households and business form expectations?

1. Adaptive Expectations: base decisions only what has happened in past.

Show to change decisions slow to realty to policy.
2. Rational Expectations: base decisions on all available information

CLASSICAL VIEW: Quantity Theory

M . V = P.Q (nominal GDP spending)

 M= Money supply
 V= velocity ( number of times 1 dollar changes hands; how quickly money
circulates)
 P= Price-level
 Q= Output

Assume :

 Constant velocity;
 Output depends only on level of inputs( output driven by tech, capital, resources,
labor force)
 Apply assumptions to Quantity Theory:AND our monetary policy easing
 So Fed ↑ Money Supply;
 Q theory : ↑M .V = P. Q

Quantity and velocity do not respond to change in Money supply only effect is :

 ↑ price level and ↑inflation

 According to classical school :
 ∆ Money supply =∆ Price level (inflation)

Result : Monetary Neutrality : changes in monetary policy have no real effect on economic ,
it has only nominal effect because does not impact real variables such as unemployment,
output and real wages, etc.

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8. Questions related: Would a Classical economist differently to the analysis you
presented in #7. Explain. Is the Classical viewpoint more consistent with adaptive
expectations or nominal expectations?. (Midterm #2)
Yes, they would say that change in money supply is equal change in price level. Using
the equation of quantity theory, so would decrease inflation but no impact on real
variable.
M.V=P.Q where M= money supply; P=price level; Q= output V= velocity of money.
They do not think that change in input matters for economy.
This is a rational expectations because they use a mathematical expression for this
where if we consider that velocity and quantity are constant change in money supply
needs to change at the same rate that price level changes for a growth in their view.

5. How would a classical economist (using the Quantity Theory) respond to #4? In
other words, would the classical economist feel that contractionary monetary
policy (decreasing the money supply – note: expansionary policy means
increasing the money supply) has the same impact on the economy as the
Monetary Transmission Mechanism discussed in the previous question? In what
ways (and why) would the classical economist agree and disagree with the analysis?
( hw # 5)

For the classical economist, prices would decrease immediately after the policy and while
inflation would come down, there would be no increase unemployment. The concept using
the Quantity theory assumes that change in money supply just has affect in change of
price level. In contrast, the Monetary Transmission Mechanism assumes that change in
money supply can influence output and price level and the velocity of money. Also,
classical economist agree that price level would fall with decrease in money supply, but
they disagree about interest rate because classical economist think that interest rate is
affect by productivity and the Monetary Transmission Mechanism think that the
contractionary. monetary policy (decreasing the money supply) which is decrease in
money supply would increase the interest rate.

6. At times, people will suggest that the Fed should try and achieve an inflation rate of
zero percent. If we assume that velocity is constant, does this goal of zero inflation
require that the rate of money growth equal zero. If yes, explain why. If no, explain
what the rate of money growth should equal.(HW #5)
No, if the velocity is constant, and the price level is constant, we can have the goal of
zero inflation, so, for zero rate of inflation, money supply need to change at same rate
as output change.

9. The following statement appeared in a Federal Reserve publication:

In practice, monetary policymakers do not have up-to-the minute, reliable
information about the state of the economy and prices. Information is limited

22
 because of lags in the publication of data. Also, policymakers have less-than-
perfect understanding of the way the economy works, including the knowledge
of when and to what extent policy actions will affect spending and output. The
operation of the economy changes over time, and with it the response of the
economy to policy measures. These limitations add to uncertainties in the policy
process and make determining the appropriate setting of monetary policy . . .
more difficult.

If the Fed itself admits there are many obstacles in the way of effective monetary
policy, why does it still engage in active monetary policy rather than using a monetary
growth rule, as suggested by Milton Friedman with the Quantity Theory? Do you think
the Fed should be able to pursue active monetary policy, or should this freedom be
constrained (economists refer to this debate as ‘Rules vs. Discretion’)? Justify your
answer.(hw #5)

Because that business cycle have some risks, as an example unemployment. Also, FED
policies are for the future, it keeps economy more stable by stimulation breaking it in a
deceleration into a recession.

Why is the monetary policy more effective in fighting inflation and/or recession?

Discretionary Fiscal POLICY HAS TO LAGS

1. Inside Lag: time it takes policy makers to

 Pass law: recognize nee to respond, write law, debate law, pass law(political
process).
 Implement effect: time for law to actually go into effect
2. Time it takes to see results of policy
 How long we have to wait for policy effect GDP, growth , unemployment,
 (dangerous for the government because try to figure out to know how long it
will take)

Monetary policy

Is more responsive:

Virtually no inside Lag but there is more outside Lag because had to be thru financial
system and to see how market works.

Questions Related:

23
3. Is discretionary Fiscal or Discretionary policy better suited to respond to
fluctuations in the economy ? Justify your answer (midterm#3)

6. Suppose that the economy is in a recession. If policymakers take no action, how

will the economy evolve over time? Explain in words and using an aggregate
supply/aggregate demand diagram.(HW#6)
If the economy is in a recession we would have less output, this influence aggregate
demand to decline, it means decreases in wages fall the firms hire more works
producing more output, increasing aggregate supply until unemployment and output
rate arrives to the natural rate. If the policy makers take no action, the price level will
keep below what it should be .

7. Contrast your answer to #6 with what would happen if the Fed decided to stimulate
monetary policy in response to the recession. Be sure to put your answer within the
context of aggregate supply and demand rather than the Monetary Transmission
Mechanism analysis.
If the FED decides to stimulate monetary policies in response to the recession, they
would basically be pumping money into the economy bonds, changing reserve rate,
changing discount rate). The Fed is purchasing the economy to produce more and
growth faster than is sustainable in the long-run.
 Price- level would increase due to the stimulated in aggregate demand
 Total quantity produced would increase
 Unemployment would decrease because more workers are needed to produce
goods
 Wages: increase with the lowered unemployment
 Input costs rise as inputs become more expensive with the higher price level
 Inflation: increases( each dollar now can buy less because goods are more
expensive)
 Savings (wealth: decreases in real value because of inflation
 Interest: now that goods are more expensive due to the increase in prices, you
now have to hold more money to purchase the same amount of stuff because
goods are more expensive
 Investment is down as well

Eventually a decrease in production would happen because cost as are too high
and they impact short-run aggregate supply. Eventually we return to equilibrium
at a higher price level

It’s also possible to construct a scenario where we start below equilibrium output,
but the Fed’s action causes to aggregate demand to rise and get us back to
equilibrium output more quickly, meaning with shorter and less severe recession.

24
 In essence it’s possible for the Fed action to allow us to return to long-run
equilibrium quickly.

3. Explain why expansionary fiscal policy causes an increase in aggregate

demand. (hw#6)

The key Is that expansionary fiscal policy means that there is either a decrease in
taxes or rise in government spending (or both). Since Aggregate demand=
Consumption+ Investment + Government spending then the rise in government
spending obviously causes a direct rise in Aggregate demand. With the tax cut,
household keep more of their income (disponsable income) so consumption will
rise because people have more money to spend.

What happens to the interest rate, employment, output, consumption, profits, stock
price, labor demand, inventory, and wages in a recession or expansion? Define
automatic stabilizers and explain how they ease fluctuations in the business cycle. What
should happen to the government budget deficit over the business cycle.

Automatic Stabilizers: Fiscal policy, already in place that work counter cyclically

 No policy change necessary

 Idea: Taxes and transfer payments ease fluctuations in business cycle

Transfer payments: direct payment from government to individuals ( unemployment,

social security, welfare, etc)

Assume we are in a recession

 ↓ spending/ output →↓sales tax revenue ( o que pagamos quando compramos na

loja) + excise tax revenue ( especifica, quando voce compra bebida alcoolica ou
gasoline)
 ↑unemployment → ↑transfer payments because more collect social security
welfare, unemployment insurance
 ↓Income/ stock →less income tax + capital gains tax revenue
 On net → government pays out more in benefits and transfer payments while
receiving less tax revenue so government pumps money into economy
expansionary fiscal policy without makers passing new discretionary policy

(It happens in no change in policy, it happens naturally )

 At same time : ↑increasing borrowing( treasury securities from other countries)

because collecting less tax revenue and spending more money in transfer
payments

25
 What should happen to the government budget deficit during business cycle?

In a recession is when automatic stabilizers are happening, the government is paying out
money to ease the recession( by the transfer payments). In expansionary of business cycle
the government should be get in with money and taxes. The idea is that automatic
stabilizers are counter -cyclical. (memorize this word) lembrar que quando eles estao
colocando dinheiro pra fora o pais esta passando por uma recession, e quando eles estao
colocando dinheiro pra dentro o pai esta passando por expansao.

Question Related:

8. Define automatic stabilizers. Explain how automatic stabilizers help fight

inflation during an expansion. Include an explanation of how the automatic
stabilizers will impact the government budget during the expansion? ( midterm#3)

Automatic Stabilizer is define by Fiscal policy, already in place that work counter
cyclically , Is not necessary change in policy and the mean idea is use taxes and transfer
payments ease fluctuations in business cycle. The impact in the government budget during
the expansion is that they will get in with money and taxes, because automatic stabilizers
works counter-cyclical

2. Give an example of a policy that works as an automatic stabilizer. Explain how this
policy works countercyclically over the business cycle and the impact on the
government budget deficit/surplus.( HW#6)
An example of a policy that works as an automatic stabilize is whenever government
makes household keep more money, it can happen when they make direct payments to
individuals , it can be social security and unemployment. The way that it works is when
people hold more money they consumption more, and as an automatic stabilizer it is a
tool for the government if the country passes by a recession or slow growth economy. The
impact in the government budget deficit, is that if they make more direct payments they
will have less money available which may means budget deficit or government borrowing
money.
If the government starts giving less transfer payments people would have less money and
the government more, this means budget surplus on the government.
On the net, the government is paying more benefits that it is receiving in taxes, which
means it creates deficit. However, even though it is considered natural to run a deficit
during a recession, we should be running a surplus during an expansion.

Aggregate supply and demand: Be able to use aggregate supply a demand to

demonstrate long run equilibrium in the economy and also explain hole the economy
adjusts to short term fluctuations and returns to long-run equilibrium.

26
  Aggregate Supply and demand: analyze long-run fluctuations around long-run
equilibrium
 Aggregate Demand(AD): relationship between price level and total quantity
purchased( C+I+G+ (X-M)

Price-level: essentially a price index; measures composite price of all goods.

Similary to CPI, PCE, PPI

Law of Aggregate demand: negative (inverse) relationship between price level and total
quantity purchased

Graph: downward sloping

What does this holds

1.Wealth (money supply) effect: as ↑ price-level→ money supply constant → each

dollar worth less (↓ purchasing power)→ ↓spending

 Also nominal value of savings and wealth unchanged

 So ↑ price level →↓real value ↓wealth so ↓purchasing
 Make households relatively poorer so canst buy as much

2.Interest rate effect : As ↑ price level → becomes more expensive so households

keep more money (↑ money demand)

 This ↑ money demand caused by higher prices so ↑interest rates

causes ↓consumption ↓investment ↓spending

3.Exchange rate effect:

What causes shift on AD?

Think of C+I+G+(X-M)

27
A change in any of these variables causes shift in AD

1. ∆consumption: caused by real income, expectations: lifecycle/ consumption

smoothing
 Change in wealth/ savings
2. ∆Investment: cost of investment(interest rate +investment tax credit), expectations,
growth, opportunities
3. ∆government spending: anything that changes government purchases of goods and
services
4. ∆in exports and imports: how international trade impacts economy

Aggregate Supply:Relationship between price level and quantity produced

Short- run: positive relationship between price level and quantity produced(upward
sloping)

1. Stick wages and prices: argue wages and prices slow to adjust (means all wages and
prices do not move together proportionally) and wages slower to adjust than price

 Idea: if we have general↑ price-level → wages and other input price unchanged
initially
 So as ↑ price →costs( initially) unchanged → so profit higher and respond by
↑production
 ↑ Price-level→ Costs unchanged →↑ profit and profit margin →↑production and
output

2. Misperceptions theory: change in price level misleads producers (in short-run) and
respond to price change by ∆quantity confuse change in overall price with change in
relatively price

 Example: If ↑price-level → producers may think good is coming more valuable so

respond by ↑production
 Also : similarly workers experience ↑ nominal wage and think there is a great
incentive to work
 So: ↑labor supply

Graph:

28
As move into long-run economy (prices, costs, households, firms,) has time to adjust

Using ↑price example (↑price→↑production)

2 things happens

1. Get shortage in labor market:

 Because ↑ quantity →↑labor demand , hire more works

 Results in ↑wages

2. Get shortage in input market

 As time passes… everyone has time to adjust

 So wages and input price start to rise
 And overall production costs rise
 Cost and price move together
In sum result: Cost and price move together in long-run one optimal quantity and
the output is independent of price.
Graph:

What does influence Long- run aggregate supply?

Our inputs: labor technology, natural resources, capital

Look at long-run equilibrium:

In long-run equilibrium:

AD= SHORT RUN =AS =LONG RUN AS

AD ~ SPENDING

AS ~PRODUCTION

29
How we get to equilibrium?

1. If AS > AD→ producing goods faster than being purchased

 Surplus so ↑investors and ↓production

2. If AS < AD →purchasing faster than being produced

 So ↓Investors and response is ↑production

Questions Related:

4. Suppose the economy is operating above long-run output. Do you think it’s better for
policy makers to take action or should they leave the economy alone? Justify your answer
and be sure to use AD/AS diagram to back up your explanation.(Midterm#3)

If the policy makers take an action they should sell bonds to decrease money supply shifting
back aggregate demand , that would decrease price level and decrease output, increasing
interest rate. The result of increasing interest rate is decrease in investment which leads to
decline in future growth. I think that they should leave the economy alone because if they take
an action they would influence in decline of investment because selling bond would decrease
money supply which would increase interest rate. And, whatever we have increase in interest
rate and decrease in investment we are slowing down long- term growth. It is better to have
higher future growth rates.

5. Suppose the FED begin worry about inflation and consequently takes steps to fight
inflation. Use AS/AD model to explain the short-run and the long-run implications of this
pessimism, assuming the economy starts in long-run equilibrium.(Midterm#3)

If the FED starts get worry about inflation and they want to fight they would start selling
bond to decrease money supply, this would shift back aggregate demand decreasing price
level and decreasing quantity, also, the interest rate increase so the investment decrease this
explain why economy growth is slow in the future .

GRAPH:

6. Define aggregate demand. Explain why aggregate demand is downward sloping.

Aggregate Demand(AD): relationship between price level and total quantity

purchased( C+I+G+ (X-M)
It has downward sloping because of the Law of Aggregate demand which is negative
(inverse) relationship between price level and total quantity purchased.
What does this holds

30
1.Wealth (money supply) effect: as ↑ price-level→ money supply constant → each dollar worth
less (↓ purchasing power)→ ↓spending
Also nominal value of savings and wealth unchanged
So ↑ price level →↓real value ↓wealth so ↓purchasing
Make households relatively poorer so canst buy as much
2.Interest rate effect : As ↑ price level → becomes more expensive so households
keep more money (↑ money demand)
This ↑ money demand caused by higher prices so ↑interest rates causes ↓consumption
↓investment ↓spending
3.Exchange rate effect:
What causes shift on AD?
Think of C+I+G+(X-M)
A change in any of these variables causes shift in AD
1. ∆consumption: caused by real income, expectations: lifecycle/ consumption
smoothing
Change in wealth/ savings
2. ∆Investment: cost of investment(interest rate +investment tax credit), expectations,
growth, opportunities
3. ∆government spending: anything that changes government purchases of goods and
services
4. ∆in exports and imports: how international trade impacts economy

7. Assume that a large number of workers go on strike. If the Fed were only interested in
price stability, how would the central bank respond to the strike? Use an aggregate supply
and demand diagram as part of your explanation. (Midterm#3)

If FED is only interest in price stability with large numbers of workers on strike, the FED
should start selling bonds to decrease money supply and shift back aggregate demand what
would decrease price-level to the original price-level.

What is the difference between government debt and government deficit ? Be able to
compare and contrast the traditional (“crowding out) view of government debt with the
Ricardin Equivalence view.

Government deficit: when government spending exceeds government revenue(taxes)

 More money flow out than flows in

 It looks at revenue vs expense for one year
 (fixed period of time)

Surplus: revenue exceeds expense

31
  Government debit: total amount owed
 Sum all previous deficit/surplus

STOCK( debt) VS FLOWS(deficit)

If ↓Deficit→ still borrowing and ↑debt but debt is rising at slower rate

“Crowding out”→ ↑ Government spending deficits and government borrowing all work to
crowd out private investment

How this works?

1. Increasing government spending→ expansionary fiscal policy so works to stimulate

economy →↑Aggregate demand meaning ↑spending ↑ output ↑employment

 Effect on money market→ ↑Money demand (need more money available for
spending
 So expensive to invest and borrow interest rate
 Money becomes more expensive
 Consuming more today and investing less

2.↑Government spending, ↑ deficits ↑debts→ government must finance debt

 Deficit taxes revenue does not cover so they make bonds or borrow money they
earn less than what they spend
 So issue bonds (treasury securities) to finance debt
 And : at some point →must ↑interest rate to entice people to buy more bonds
 Also: →the more the government borrows →less funding is available for everyone
else

Since government borrows

 It does not means less money supply

 Since government borrow less →less loanable fund available for firms and
household

Bottom line: Funding is more expensive and more scarce investment so less funding is
available for private investment

(remember what private investment represents: future growth)

Higher taxes receive less benefit from government , at long-run hurts aggregate supply

Alternative explanation:

Ricardin Equivalence: assume forward looking households

32
  Idea: understand implications of government debt and that government borrowing
today implies higher taxes in future
 So: Tax cut ( or increase in government spending) funded by debt not change long-
run perspective only creates long-run liability
 In sum: Value of tax cut is offset by implied future tax liability
 So: consumption unchanged because household save tax cut to pay future taxes (if
tax cut)
Basically: Household save more disposable income to pay for future higher taxes
 And: increase private savings offsets public borrowing so government borrowing
has no net impact on economy
 Also: crowding out makes no distinction for how government uses the money
 Keep in mind: Ricardin Equivalence not arguing fiscal policy can not impact the
economy
 But, that government borrowing must be accompanied by credible plan to balance
budget

Essence of Ricardin

When households choose spending level: consider both current disposable income and
implied future tax liability and future disposable income

Basic difference:

Assumption about house time horizon

Example : crwoind out counter government:

1-miopia: Ricardin assumes household long-run view/ perspective

On the other hand crowing out argues household short sighted and think tax rates will stay
low forever or don’t understand implications of government debt

2. Future generations

 Consumers expect higher taxes to fall on the next generation

 Transfer wealth from young generation to old generation

Ricardin counter: people do not necessarily spend at expense of future generations

 Example: trusts, inherent

 Argue relevant decisions making unit is family or community

Questions Related:

33
9. Use the concept of “ crowding out” to illustrate the traditional view of the implications of
a budget deficit and large government debt on economic growth. Be sure to explain why is
crowed out and why. Would this increase in debt effect long-run aggregate supply? Explain
why or why not?(Midterm #3)

Crowed out can be defined whenever increase in aggregate demand influences increase in
interest rate which leads that firms will invest less having less output. This influences directly
the economic growth once investment implies future growth.

10. Contrast the Ricardian Equivalence argument concerning the impact of the government
debt on the economy with the traditional view discussed in #9. Do you agree with the
Ricardin viewpoint or the traditional viewpoint? Explain briefly.(Midterm#3)

The contrast between both vies is that Ricardian Equivalence says that with the government
borrowing money today will imply higher taxes in the future, so household save money to pay
future taxes meaning less consumption and more investment because we would have less
interest rate because the increased of savings. The tradition view says that the increase in
aggregate demand influences increase in interest rate leading to less investment. Which
implies less future growth. I agree with Ricardin Equivalence because at some point it means
more investment implying long term growth.

8. How do household and business expectations impact the ability of policymakers to

influence the economy? Hint: Think in terms of inflation expectations or what they expect
to happen to the price level.( Hw #6)

According Ricardin Equivalence; If household is expecting rises in price level or a recession

they influence decision of the policy makers, because whenever household expect increase in
price in the future they will save more in short-run to have enough in long-run, this means
less consumption, less investment, affecting price level which rises. Also they shift aggregate
demand if they spend more, whenever they expect higher income. This is the idea that the
economy is largely a self-fulling prophecy so the better policy makers can convince the public
the more successful their policies will be.(By the fisher equation if people are expecting higher
inflation then the real interest rate falls)
ASK SKELTON

7. How do proponents of Ricardian equivalence respond to the ‘crowding out’ argument?

In your opinion, do you think that increased government borrowing leads to future
declines in economic growth? (HW#7)

Ricardin Equivalence argues that household has a long-run view/ perspective, which is that if
the government borrowing today or government debt means higher taxes in the future. So,

34
tax cut or increase in government spending funded by debt does not change long-run
perspective only creates liability, which is that the value of tax cut if offset but implied future
liability, the result is that the household consumption will not change if they had a tax cut,
they will save the money to pay future taxes. So, the increase in household savings leads to
decrease in public savings. Assuming that there is no change in interest rate is no crowing out
effect as a result of cut in taxes.

I think that increasing government borrowing leads to future declines in economy growth,
because interest rate would increase we would have less investment and less consumption,
and also, it would not be attractive for international investors to apply their money with high
interest rate.

List an explain three reasons we gave as the economic basis for trade

INTERNATIONAL TRADE: Open vs closed (Robinson Cruso economy; no exports or

imports)economy

Economic reasons: Why?

1. Efficiency and lower cost: find cheaper resources or goods

2. Other countries have resources we don’t; technology or traditions
or culture (ex: corn into tortilla)
3. tastes/preferences; German corns, alcohol

Explain the idea of Comparative advantage, including an example of which type of goods
two countries should import and export

Comparative Advantage: each country benefits if they focus on producing the goods they
can produce relative more efficiently (lower opportunity cost)

 What should rule economic trade

 Do what you do best and trade for the rest
 Don’t want to waste resources when you could get in somewhere else for better
quality
 Focus scarce resources on what you do most efficient

Basic terms:

 Exports: produces in U.S., sold somewhere else.

 Imports: produced somewhere else, sold in U.S.
 The Trade Balance: exports- imports; how quickly goods flow
 Trade surplus: exports>imports
 Trade deficit: imports>exports

35
Questions related:

1. Explain the idea of comparative advantage. Use the idea of comparative advantage to
describe what types of goods the U.S. should import from and export to Mexico.(HW#5)

The idea of comparative advantage is that each country would have benefits if each one
produced the goods relative more efficiently, meaning lower opportunity cost.

Using this idea it is possible to explain why U.S. imports petroleum from Mexico, which has
natural resources providing it to U.S. since it does not produce enough for the demand, in
addition due to cheaper labor U.S. imports cars from Mexico. Also the comparative
advantage explains Mexico imports anything which requires higher skills of labor , as an
example software for computers.

Define exchange rate. Be able to explain the difference between a strong dollar and a weak
dollar, including what will happen to the price of imports and exports for each. Be able to
explain appreciation, depreciation, devaluation, revaluation. Understand how economic
conditions in one country (specifically in regards to inflation, income and interest rates)
affect its exchange rate and the capital account.

Exchange rate: price of foreign currency in dollars; “relative value of dollar”, price of dollar
in other countries; determined by supply and demand

 Importers demand foreign currency and supply dollars

 Exporters demand dollars and supply foreign currency
 Foreign buying U.S asset →demand dollars and supply foreign currency
 U.S. citizen buying foreign asset → supply dollar and demand foreign currency

EXCHANGE RATE AND FALL:

 Appreciation: dollar gets stronger;

 US dollar buy more foreign currency→ causes ↓ import prices, ↑export prices; good
for other countries.
 Depreciation: dollar gets weak;

US dollar buys less foreign currency→ causes ↓ export prices ,↑import prices; exports
cheaper, inputs more expensive; goods produced in U.S. more competitive, goods produced
elsewhere less competitive.

Devaluation: Manage currency value, when you depreciate your currency

36
Revaluation: Manage currency value, when appreciate your currency

Questions Related:

1. All else being equal, how would a weakening of the dollar impact the trade balance?
What would be the impact on capital flows?

A weakening of the dollar impact the trade balance in a trade surplus, which is explained
as whenever the dollar has less power the accuracy power from the others countries
increase, because they would not need as that same amount of money if the dollar would
not have weak. Basically, a weak dollar makes U.S. exports cheaper and foreign goods
more expensive.

The impact in capital flows is that capital flows outside the country causing decreasing
inflation, increasing price, increasing wages, meaning that output is more competitive so
decrease imports, increase exports, and domestic good are relatively less expensive.
Careful—this is only true if countries are using the gold standard.

List and explain the three exchange rate system. Also be able to explain how/why balanced
trade is an equilibrium condition for the fixed exchange rate system (and why this holds)

How exchange rate is determined

3 exchange rate systems:

1. Floating Exchange rate ; determined by market, supply and demand

 If U.S. buys more imports →↑supply dollars (↓demand foreign currency)→weaker

dollar

2. Fixed Exchange rate: one world currency(gold standard); peg each currency inn terms of
fixed amount of gold (or whatever specie is)

37
  When buy foreign goods→pay in gold
 Exchange rate can’t change
So: flows do not affect exchange rate
Also: money supply determined by amount of gold in a country
So: trade causes money supply to change
 Outsourcing monetary policy to trade flows, causing wages and prices and output to
change
Result: balanced trade in an equilibrium condition
Why does this hold?
1- If X>M→ trade surplus so gold flows into country causing ↑ money supply→
↑inflation means our output is less competitive so ↑ imports ↓exports domestic
↑price relatively more expensive
↑wages
2- If M>X→ trade deficit so gold flows outside the country causing↓ money supply→
↓inflation means our is more competitive so ↓imports ↑export domestic
↓price relatively less expensive
↓wages

3. Managed Exchange Rate: mostly determined by supply and demand but

government intervenes from time to time
 Generally market based but some government intervention
Exchange rate policies: Government buys and sells foreign currency
Ex: China
Buy foreign currency to weaken exchange rate

Questions related:

2. Assume that relative economic prosperity causes the U.S. to purchase more foreign
goods. How would you expect this to impact the exchange rate?(HW#8)
If we assume that relative economic prosperity causes the U.S. to purchase more foreign
goods we would expect causes decrease in import prices and increase in export prices,
which is good for the other countries. So, the impact in exchange rate is the weakness of
the dollar, increasing supply dollars and decreasing demand foreign currency.

4. Assume that every country is on the gold standard. Explain how the gold standard (the
fixed exchange rate) works to eliminate either a trade deficit or a trade surplus. In other
words, with a fixed exchange rate, explain why imports will be equal to exports in
equilibrium and why that equilibrium holds.(hw#8)

38
 Whenever a country buys foreign goods using gold as a currency, exchange rate
cannot change. So, this transaction does not affect exchange rate. Also, money supply
determined by amount of gold in a country. So, trade causes money supply to change;
outsourcing monetary policy to trade flows causing wages and prices and output to
change. Resulting balance trade in an equilibrium condition.Explain how this works.
The easiest way to do this is to assume that we have a trade surplus (or deficit) and
then explain how the trade surplus will impact money supply and therefore prices,
wages and exports and imports.

List the determinants of net exports and be able to explain how each determinant can affect
the trade deficit. Be able to explain why a trade deficit may not be a bad thing

Determinants of Trade Balance:

1. Foreign countries’ income and output: exports are positively related to foreign
income and output
2. U.S. income and output: imports positively related to U.S. income/output

1 and 2 show how relative economic prosperity influence trade balance

3. Exchange rate:
 If ↑Exchange rate means strong dollar →can buy more currency per dollar spend
 So ↓ price imports and ↑price exports
 Foreign goods in U.S. become cheaper and U.S. goods in other countries more
expensive
 strong dollar →expect bigger trade deficit

Questions related:

5.What is the relationship between national saving and the trade deficit? Explain.(hw#8)
Trade deficit is defined when a country buy more than sells, so money flows more outside the
country. Differently from national saving, that is the amount of money that remains after the
national income to spend on consumption and government procurement.

So, the trade deficit will not happen with the country remains a higher national savings,
although the opposite may happen if they have a trade deficit.

6 .List and explain the floating and the managed exchange rate systems we discussed in
class. For each one, explain (at least) one advantage and disadvantage it has.(hw#8)
A floating exchange rate is one in which the domestic central bank allows to change in response
to changing economic conditions and economic policies.
A managed exchange rate is one in which the domestic central bank buys and sells
domestic/foreign currencies in an effort to target (alvo, objetivo) a specific exchange rate.

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When an exchange rate is floating, risk is introduced to investments which are made by the
international community as the value of the investment returns is linked to the value of the
domestic currency in which the investment is made.
While this might be a disadvantage of a floating exchange rate, a managed exchange rate
implies that the domestic central bank cannot influence the money supply (in order to influence
aggregate demand) as its purchases of domestic/foreign currency are used solely for the purpose
of targeting (alvo) its desired exchange rate.
An advantage for each exchange rate system is (of course) the counter-argument for each
exchange rate regime presented above.
That is to say, a benefit of a fixed/managed exchange system is the stability in returns to
investment that investors from the international community can expect on its returns in
the domestic economy. An advantage of the floating exchange rate system is that the domestic
central bank can exercise monetary policy to influence aggregate demand, and hence output
and price levels of the economy.

Be able to explain net capital flows, including two types of capital flow. Also, we can
cause increase/decrease in capital inflows (outflows)? Lastly why must net capital flow
be equal to the trade balance?

Net flow capital: purchase of foreign assets by domestic residenst less purchase of U.S.
assets by foreign residents

Looks ar flow of money/capital:

2 forms of capital flow:

1. Foreign direct investment: Long-term best way to flow capital

 actively manage foreign asset

 buy and operate a business or factory or whatever

2. Foreign portfolio investment(FPI): investor has passive role in foreign asset

Example: German buying U.S. mutual fund or treasury security

 stock in home biuldes

Important factors influencing capital flow:

 Real interest rate (return) on foreign v.s. domestic assets

 Economic health and potential
 Legal system→ perceived economic and legal risk
 Government politicies about foreign ownership

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 Relationship between trade balance and capital flows

Net exports= net capital outflow

Accounting identify: if goods flow one way →money flow other way and buys
foreign asset

(quando os estados unidos compra produto chines pagam com dollar entao a china
usa esse dinheiro para comprar u.s. assets)
Example: China→ Big trade surplus with U.S. used to buy U.S. government bonds

GDP : C+I+G(X-M)

It does not drive economic growth direct drive by consumption

wrong way of cause and consequence

Questions related:

8.Holding all else equal, what should happen to the exchange rate if the interest rate on U.S.
securities rises more rapidly than the interest rate on Mexican securities (i.e. should the
dollar get stronger, weaker, or remain unchanged)? Explain. How would your answer
change if inflation in the U.S. were higher than inflation in Mexico? (HW#8)

The dollar would get stronger because whenever another country needs more quantity of
money to get the same amount of dollar, the dollar is overvalued, and with the rises in the
interest rate the dollar would be more expensive. If the inflation would be higher in U.S. than
in Mexico, U.S. dollar would get weaker than in Mexico, because the purchasing power in
Mexico would be higher than in U.S.

Define protectionism. List and explain the two protectionism policies we discussed in
class(tariff and quota) Also be able to give the economic effects of tariffs.

Protectionism : laws that resttrct trade

1. tariff: tax on imports

 ↑price, ↓quantity
 Prohibitive tariff: set tariff so high that imports eliminated (makes imports
prohibitively expensive)

2. Quota: limit on number of imports allowed into a country

 Impact same for consumers ;↑ price ↓quantity

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  But: with tariff; government receives extra revenue

With quota; lucky importers get higher revenue and profit

Extreme case: Embargo no imports allowed in country

 Example: Cuba

Effects of tariffs

1. Inefficient: cannot buy lowest priced inputs or goods.

 Also: less competition for domestic producers
 Consumers pay higher prices and buy less output; bad for consumers
 Raises revenue for government

Questions related:

3. What are the effects of protectionist trade policies on the economy? Briefly explain how
each of these effects helps or hurts the economy. In spite of this, why are protectionist
measures passed from time to time?(HW#8)

Protectionism is defined as laws that restrict trade providing equilibrium in the price between
the imported good and the national good. They use two tools; one of them is tariff that is tax
on imports increasing price, decreasing quantity of the good; the second tool is called quota,
this one inputs limit on numbers of imports allowed into a country, the effect for the
consumers is the same (increase in price and decrease in quantity purchased) but, with tariff
the government receives extra revenue and with quota lucky importer if it gets higher
revenue and profit The economy helps the economy making providing equilibrium between
the prices for the country whose imported (careful—generally speaking, tariffs hurt the
economy but can be good for specific industries), however it may hurt the economy if they set
the prohibitive tariff; which set tariff so high that imports eliminated(makes imports
prohibitively expensive) so, if the country stops exporting determined product the country
who set the prohibitively may get hurt because it may have a shortage of the product.

LOOK MIKE HW 8

Be able to explain the sound and unsound grounds of tariff. This will probably be in the
form f a true/false/uncertain question with explanation.

Unsound (Economcally) reasons for tariff

1. Mercantilism: country wants to sell more goods than buy

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  Because allows to accumulate wealth (money flows into country if run trade
surplus)
 “Buy America” →Roots in gold stander
 Flaw: goal is not to accumulate money
 Also: ignores cause and effect

Bottom line: consumers bet off and economic growth in long-run we follow comparative
advantage and are efficient

2. Tariffs for special interest groups;

 Pass tariff to protect specific industry
 So: very concentrated benefit while cost widely distributed

3. Protect from cheap foreign labor;

 With free trade, U.S. workers must compete with cheap foreign labor

So there will be 2 effects:

a) U.S. will losw jobs for foreign labor

b) U.S. workers will see wages drop
 Flaw: only look at hourly wage relevant measure is labor price cost per unit
produced
 Ignores productivity, transportation, cost, legal/political environment,
infrastructure, etc.
 High wages come from higher productivity(Idea of comparative advantage in
production)

4. Retalatory Tariff:

Another country puts tariff on our goods so we showed put tariff on theirs

 Negative: both countries less competitive, nobody has benefits

Sound Argument for tariffs:

1. Optimal tariff: Optimal because imposes cost of tariff on other countries while protecting
domestic industries

 Idea: very large country dominates market for specific goods

 Pass tariff; causing ↑ domestic price ↓quantity

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  This drop in purchases causes big ↑quantity supply to rest of world (flood world
market)
 Causes ↓world price and ↓revenue as world
 ↓Price → U.S. ↓ price causing foreign producer to bear burden off tariff ( thru
↓revenue and ↓profit)

 Example: Assume U.S. dominates dry erase market and puts tariff on
 Dry erase markes:
 In U.S. → Initial ↑ Price ↓quanitty
 Since U.S. sales ↓→big global surplus of markers causing ↓world price
 So: U.S. price starts to fall also hurts foreign company while generating revenue for
U.S. government

2. Tariff on infant industry

 Protect industry when it first starts out give time for training, develop knowledge /
experience necessary to become more competitive
 Problem : can turn into special interest tariff.

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Definitions and Concepts:

ECONOMICS: study of how society scarce resources to officially propriety of distribute

goods and services

SCARCITY: when wants are bigger than what are available resources

EFFICIENCY: no waste, to use stuff efficiency as possible

CPI: Consumer Price Index, tracks the price of the goods and service bought by typical
households

 Fixed bundle representing goods bought by average person

 Measure official inflation

MONEY SUPPLY/ DEMAND:

Money supply: amount of money available in economy

 Fixed at any one point in time (set by FED)

Money Demand: amount of money people are willing and able to hold (measure of
liquidity)

Determined by : future expectations, income wealth

Graph:

STAGLATION: High inflation and high unemployment at same time

It is recession when you have a high inflation caused by supply shock because with
decrease in supply, increase in price lease to decrease in quantity which leads to fewer
works

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TIGHT MONEY: Contractionary in any monetary policy decrease in money supply increase
in interest rate

MONETARY POLICY: Economic strategy chosen by a government in deciding expansion or

contraction in the country's money-supply. Applied usually through the central bank, a
monetary policy employs three major tools: (1) buying or selling national debt, (2)
changing credit restrictions, and (3) changing the interest rates by changing reserve
requirements. Monetary policy plays the dominant role in control of the aggregate-demand
and, by extension, of inflation in an economy. Also called monetary regime. See also
monetarism.

TRANSFER PAYMENTS: direct payment from government to individuals (unemployment,

social security, welfare, etc)

DISPOSABLE INCOME: The amount of income left to an individual after taxes have been
paid, available for spending and saving. TOTAL INCOME- DIRECT TAXES

CONSUMPTION SMOOTHING: people look at long-run income to make spending decisions

EQUILIBRIUM: When the money market, the market for loanable funds, and the foreign
exchange market all clear.

INVISIBLE HAND: Has the idea if everyone pursues their own best interest then everyone’s
best interest is achieved

INFRASTRUCTURE: Everything that helps firms conduct business ( roads

telecommunication)

STICK PRICES: Prices are slow to adjust meaning that in the short run changes in aggregate
demand only affect output in the economy, and not prices. In the long run, (horizontal)
SRAS curve shifts to change the price level.

NATURAL RATE OF UNEMPLOYMENT:

 Unemployment rate of economy fully efficient

 Lowest unemployment rate economy can maintain
Some coments:
 Discourage workers not included
 Unemplyment insurance and impact on incentives
 People with more than one job count as one worked
 Part time workers count same as full time

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DISCRETIONARY FISCAL POLICY: Taxes and government expenditures policies

Discretionary Fiscal POLICY HAS TO LAGS

1. Inside Lag: time it takes policy makers to

 Pass law: recognize nee to respond, write law, debate law, pass law(political
process).
 Implement effect: time for law to actually go into effect
2. Time it takes to see results of policy
 How long we have to wait for policy effect GDP, growth , unemployment,
 (dangerous for the government because try to figure out to know how long it
will take)

HUMAN CAPITAL: Education, skills, training ets… possessions by workers

Idea: as skilss and knowledge increase they become more productive ( we take food, health
and literacy for granted)

GDP ( Gross Domestic Product): Total dollar value of all final goods and services produced
in a country in a given period of time

GDP= C+I+G+(X-M)

GNP( Gross National Product): Total dollar value of all final goods and services produced by
a country in a given time period

Real Vs Nominal (interest rate, GDP):

NOMINAL GDP: Value at prevailing (current) price

Nominal Interest rate: states rate on loans and bonds

REAL GDP: Value at constant (historical ) prices

Real interest rate: Nominal interest rate minus expected inflation

 Use base year

 Correct for price fluctuations

EXCHANGE RATE: Price for which the currency of a country can be exchanged for another
country's currency. Factors that influence exchange rate include (1) interest rates, (2)
inflation rate, (3) trade balance, (4) political stability, (5) internal harmony, (6) high degree

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of transparency in the conduct of leaders and administrators, (7) general state of economy,
and (8) quality of governance.

EXCHANGE RATE POLICY:

Policy of government towards the level of the exchange rate of its currency. It may want to
influence the exchange rate by using its gold and foreign currency reserves held by its
central bank to buy and sell its currency. It can also use interest rates (monetary policy) to
alter the value of the currency.

SPECIE: Coins, normally including only those made of precious metal.

TRADE BALANCE:

exports- imports; how quickly goods flow

Determinants of Trade Balance:

1.Foreign countries’ income and output: exports are positively related to foreign income
and output

2.U.S. income and output: imports positively related to U.S. income/output

1 and 2 show how relative economic prosperity influence trade balance

3. Exchange rate:
 If ↑Exchange rate means strong dollar →can buy more currency per dollar spend
 So ↓ price imports and ↑price exports
 Foreign goods in U.S. become cheaper and U.S. goods in other countries more
expensive
 •strong dollar →expect bigger trade deficit

FREE TRADE: A situation in which there are no artificial barriers to trade, such as tariffs
and NTBs. Usually used, often only implicitly, with frictionless trade, so that it implies that
there are no barriers to trade of any kind. For a traded homogeneous product, it follows
that domestic and world price must be equal.

PROHIBITIVE TARIFF: set tariff so high that imports eliminated (makes imports
prohibitively expensive)

EMBARGO: no imports allowed in country Example: Cuba

EFFICIENCY WAGE:

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A higher than market-clearing wage set by employers to, for example:

 discourage shirking by raising the cost of being fired

 encourage worker loyalty
 raise group output norms
 improve the applicant pool
 raise morale

Labor productivity in efficiency wage models is positively related to wage.

By contrast, consider models in which the wage is equal to labor productivity in

equilibrium, or models in which wages are set to reduce the likelihood of unionization
(union threat models). In these, productivity is not a function of the wage.

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