Real Variables in Macroeconomics

Real variables are measured in constant prices and can be considered to be measured in units of “goods and services.” In general nominal variables, such as the nominal wage rate and nominal GDP, are deflated to become real variables using the formula real variable = The exception to this rule is the nominal interest rate. (In two chapters the students see that the real interest rate = nominal interest rate - inflation rate.)

20. Financial Institutions and Financial Markets

Finance and money differ:

Finance refers to providing the funds used for investment.

Money refers to what is used to pay for goods and services.

Physical capital and financial capital differ:

Physical capital is the tools, instruments, machines, buildings, and other items that have been produced in the past and that are used to today to produce goods and services.

Financial capital is the funds that firms use to buy physical capital.

Financial Capital Markets

Financial markets transform saving and wealth into investment and capital.

Loan markets: Both businesses and households obtain loans from banks. Financing for inventories, purchasing houses, and so forth can be obtained in this market.

Bond markets: Businesses and governments can raise funds by issuing bonds. A bond is a promise to make specified payments on specified dates. One type of bond is a mortgage-backed security, which entitles its owner to the income from a package of mortgages. The failure of many mortgage-backed securities to make their specified payments was a factor leading to the financial crisis in 2007 and 2008.

Stock markets: Businesses can raise funds by issuing stock. A stock is a certificate of ownership and a claim to the firm’s profit.

Financial Institutions

A financial institution is a firm that operates on both sides of the markets for financial capital by being a borrower in one market and a lender in another market. Financial institutions include, commercial banks, government-sponsored mortgage lenders (Fannie Mae and Freddie Mac), pension funds, and insurance companies.

Insolvency and Illiquidity

A financial institution’s net worth is the total market value of what it has lent minus the market value of what it has borrowed. If the net worth is positive, the institution is solvent and can remain in business. If the net worth is negative, the institution is insolvent and might go out of business.

A firm is illiquid if it can not meet a sudden demand to repay what it has borrowed because it does not have enough available cash. A firm can be illiquid but solvent.

Interest Rates and Asset Prices

Stocks, bonds, short-term securities, and loans are financial assets.

The interest rate on a financial asset is equal to the interest paid on the asset expressed as a percentage of the asset’s price.

If the price of the asset rises, the interest rate falls. Conversely if the interest rate falls, the price of the asset rises.

21. The Market for Loanable Funds

The market for loanable funds is the aggregate of all the individual financial markets. In this market households, firms, governments, banks, and other financial institutions lend and borrow.

The funds that finance investment are from household saving, the government budget surplus, and international borrowing.

Households’ income is consumed, saved, or paid in net taxes (taxes paid to the government minus transfer payments received from the government): Y = C + S + T. GDP equals income and also equals aggregate expenditure, so Y = C + I + G + (X - M). Combining shows that C + S + T = C + I + G + (X - M), which can be rearranged to show how investment is financed:

I = S + (T - G) +(X - M).

This formula shows that investment is financed using private saving, a government budget surplus, (T - G) and borrowing from the rest of the world,(X - M).

The sum of private saving, S, plus government saving, (T - G), is national saving.

If we export less than we import, (X - M) is negative and we borrow (M - X) from the rest of the world.

If we export more than we import, (X - M) is positive and we loan (X - M) to the rest of the world.

The nominal interest rate is the number of dollars that a borrower pays and a lender receives expressed as a percentage of the number of dollars borrowed or lent. The real interest rate is the nominal interest rate adjusted to remove the effects of inflation on the buying power of money. The real interest rate is approximately equal to the nominal interest rate minus the inflation rate. The real interest rate is the opportunity cost of loanable funds.

22. The Demand for Loanable Funds

The quantity of loanable funds demanded is the total quantity of funds demanded to finance investment, the government budget deficit, and international investment or lending during a given time period. Business investment makes up the majority of the demand for loanable funds and so the initial focus is on investment.

Investment depends on the real interest rate and expected profit. Firms will make the investment only if they expect to earn a profit.

The demand for loanable funds is the relationship between the quantity of loanable funds demanded and the real interest rate when all other influences on borrowing plans remain the same.

The real interest rate is the opportunity cost of loanable funds, so there is a negative relationship between the quantity of loanable funds demanded and the real interest rate.

Investment is influenced by expected profit. The higher the expected profit, the more investment firms make. Expected profit rises during a business cycle expansion and falls during a business cycle recession; rises when technology advances; rises as the population grows; and fluctuates with swings in business optimism and pessimism.

The demand curve for loanable funds is downward sloping as shown in the figure. The demand for loanable funds increases when investment increases, so when expected profit increases, the demand for loanable funds increases and the demand for loanable funds curve shifts rightward.

23. The Supply of Loanable Funds

The quantity of loanable funds supplied is the total quantity of funds available from private saving, the government budget surplus, and international borrowing during a given time period. Saving makes up the majority of the loanable funds available, so the initial focus is on saving.

The supply of loanable funds is the relationship between the quantity of loanable funds supplied and the real interest rate when all other influences on lending plans remain the same.

When the real interest rate rises, saving increases so the supply of loanable funds increases. As illustrated in the figure, the supply of loanable funds curve is upward sloping.

Saving and hence the supply of loanable funds increases when disposable income increases, when wealth decreases, when expected future income decreases, and when default risk decreases. When the supply of loanable funds increases the supply curve of loanable funds curve shifts rightward.

24. Equilibrium in the Market for Loanable Funds

As the figure shows, the equilibrium real interest rate sets the quantity of loanable funds demanded equal to the quantity of loanable funds supplied

Changes in either demand or supply change the real interest rate and the price of financial assets.

If expected profit increases the demand for loanable funds increases. The equilibrium real interest rate rises and the equilibrium quantity of loanable funds and investment increase.

If the supply of loanable funds increases, the equilibrium real interest rate falls and the equilibrium quantity of loanable funds and investment increase.

Short-run changes in the demand and supply can be sharp so that changes in the real interest rate also can be sharp. But in the long run the demand and supply grow at the same pace so there is no upward or downward trend in the real interest rate.

 

25. Government in the Market for Loanable Funds

Changes in the government surpluscan shift the supply of loanable funds curve. In the figure, PSLF is the private supply of loanable funds curve. The government has a budget surplus equal to the length of the arrow. The surplus adds to private saving and so the supply of loanable funds curve becomes SLF.

Changes in the government deficit can shift the demand for loanable funds curve. In the figure, PDLF is the private demand for loanable funds curve. The government has a budget deficit equal to the length of the arrow. The deficit adds to private demand and so the demand for loanable funds curve becomes DLF.

The tendency for a government budget deficit to decrease investment is called a crowding-out effect.

The possibility that a budget deficit increases private saving supply in order to offset the increase in the demand for loanable funds is called the Ricardo-Barro effect. The reasoning behind this effect is that taxpayers will save to pay higher future taxes that result from the deficit. To the extent that the Ricardo-Barro effect occurs, it reduces the crowding-out effect because the SLF curve shifts rightward to offset the deficit.

26. A Government Budget Surplus ответ в предыдущем вопросе первый абзац первый график

27. A Government Budget Deficit то же самое ответ в том вопросе только уже второй абзац и второй график

28. The Global Loanable Funds Market

The loanable funds market is a global market. Lenders look worldwide to find the highest real interest rate; borrowers likewise look worldwide to find the lowest real interest. These actions bring the risk-adjusted real interest rate to equality throughout the world.

If a country’s net exports are negative, X < M, then the country finances the shortfall in exports by borrowing from the rest of the world. If a country’s net exports are positive, X > M, then the country uses the excess to loan to the rest of the world.

Demand and supply in the world global loanable funds market determines the world equilibrium real interest rate.

A country is a net foreign borrower if the world equilibrium real interest rate is less than what would be the no-trade interest rate in the country. The figure shows this situation.

With international trade, the real interest rate in the country becomes the world real interest rate. At this lower real interest rate, the quantity of loanable funds supplied decreases and the quantity of loanable funds demanded increases. The country has negative net exports, with X < M.

A country is a net foreign lender if the world equilibrium real interest rate exceeds what would be the no-trade interest rate in the country. The figure shows this situation.

With international trade, the real interest rate in the country becomes the world real interest rate. At this higher real interest rate, the quantity of loanable funds supplied increases and the quantity of loanable funds demanded decreases. The country has positive net exports, with X > M.

29. Three functions of Money

Money is any commodity or token that is generally acceptable as a means of payment. A means of payment is a method of settling a debt. Money has three functions:

Medium of exchange

Unit of account

Store of value

A medium of exchange is any object that is generally accepted in exchange for goods and services. Money acts as a medium of exchange. As a result, money eliminates the need for barter, which is the exchange of goods and services directly for other goods and services.

Money serves as a unit of account, which is an agreed measure for stating the prices of goods and services.

Money serves as a store of value because it can be held and exchange later for goods and services.

30. Depository Institutions

A firm that takes deposits from households and firms and makes loans to other households and firms is called a depository institution. There are three types of depository institutions whose deposits are money: commercial banks, thrift institutions, and money market mutual funds.

A commercial bank is a firm that is licensed to receive deposits and make loans.

Banks accept deposits and then divide these funds into reserves (cash in the vault plus its deposits at the Federal Reserve), liquid assets (such as Treasury bills and commercial bills), securities, and loans (made primarily to corporations for purchases of capital equipment and to households to finance homes, consumer durable goods, and credit cards). Loans are the riskiest of a bank’s assets.

The thrift institutions are savings and loan associations, savings banks, and credit unions.

A money market mutual fund is a fund operated by a financial institution that sells shares in the fund and holds liquid assets such as U.S. Treasury bills and short-term commercial bills.

Depository institutions make a profit from the spread on the interest rate at which they lend over the interest rate they pay on deposits. The spread reflects four services provided by depository institutions:

Create Liquidity: Most assets are less liquid than liabilities, so depository institutions turn less-liquid funds into more liquid funds.

Lower the Cost of Borrowing Obtaining Funds: Depository institutions lower transaction costs of matching borrowers and lenders.

Lower the Cost of Monitoring Borrowers: Depository institutions lower transaction costs by specializing in monitoring risky loans.

Pool Risk: The costs of defaults on loans are spread across all depositors, instead of being borne by individual lenders.

31. The Federal Reserve System

The central bank is the Federal Reserve System. A central bank is a bank’s bank and a public authority that regulates a nation’s depository institutions and controls the quantity of money. The Fed conducts the nation’s monetary policy, which means that it adjusts the quantity of money in circulation. By adjusting the quantity of money, the Fed can change interest rates.

The Federal Open Market Committee (FOMC) is the main policy-making group of the Fed. It is comprised of the members of the Board of Governors and the Presidents of the regional Federal Reserve Banks.

The Fed’s two main assets are U.S. government securities and loans to depository institutions.

The Fed’s two main liabilities are Federal Reserve notes (currency) and banks’ deposits.

The monetary base is the sum of coins, Federal Reserve notes, and depository institution deposits at the Fed. The major parts of the monetary base, Federal Reserve notes and depository institution deposits, are liabilities of the Federal Reserve. Changes in the monetary base lead to changes in the quantity of money.

32. The Federal Reserve Policy Tools

Required Reserve Ratios: The minimum percentage of deposits that depository institutions must hold as reserves are the required reserve ratios. The Fed sets the required reserve ratio. A decrease leads to an increase in the quantity of money and an increase leads to an increase in the quantity of money.

Last Resort Loans: The Fed is the lender of last resort, which means that if depository institutions are short of reserves, they can borrow from the Fed. The interest rate charged on these loans is the discount rate. A decrease in the discount rate leads to an increase in the quantity of money and an increase in the discount rate leads to a decrease in the quantity of money.

Open Market Operation: An open market operation is the purchase or sale of government securities by the Federal Reserve System in the open market. The Fed does not directly purchase bonds from the federal government because it would appear that the government was printing money to finance its expenditures. An open market purchase leads to an increase in the money supply.

33. How Banks Create Money

When a bank makes a loan, it makes a deposit to finance the loan. Because deposits are money, the bank has created money. The increase in deposits increases the quantity of money.

Three factors limit the amount of deposits that the banking system can create:

The monetary base: Banks have a desired amount of reserves they want to hold and people have a desired amount of currency. The monetary base sets a limit on the sum of these two. Both of these desired holdings depend on the quantity of money, and so the monetary base limits the amount of money that can be created. Alternatively, the monetary base limits the amount of the banking systems’ reserves.

Desired reserves: A bank’s actual reserves are the coin and currency in its vault and its deposits at the Federal Reserve. The fraction of a bank’s total deposits that are held in reserves is called the reserve ratio. The desired reserve ratio is the ratio of reserves to deposits that banks want to hold. Actual reserves minus desired reserves are excess reserves. Excess reserves can be loaned and can thereby create money.

Desired currency holding: The other use of the monetary base involves the public’s holding it as currency. When banks create new money by creating new deposits, the public wants to hold some of this money as currency. As a result, currency leaves the banking system when banks increase their loans, which limits the overall increase in loans. The currency drain is the ratio of currency to deposits.

Banks use excess reserves to make loans. In the process, banks create money.

For each dollar deposited, a bank keeps a fraction as reserves and lends out the rest. When a bank makes a loan, it creates a new deposit (new money) equal to the value of the loan. After the loan is spent by the borrower, the new money eventually ends up back as a new deposit in a bank. As new deposits are made, the process of money creation begins again, albeit with a smaller amounts each time because banks keep a fraction of each deposit in the form of reserves.

The total of amount of new money created by the entire banking system depends on the fraction of the deposits that banks loan at each step in the process.

34. The Money Creation Process

The monetary base increases and banks have excess reserves. Banks lend the excess reserves and thereby create new deposits, that is, create new money.

The new money is used to make payments. Some of the new money remains in the banking system as deposits and some of it is drained out of the banking system via the currency drain.

The funds that stay within the banking system are reserves for the banks. Because deposits have increased, banks’ desired reserves have increased. But the actual reserves have increased by more than desired reserves, so banks still have excess reserves to loan. Banks lend these excess reserves and the process continues.

Eventually the money creation process comes to a stop when the sum of additional currency holdings plus additional desired reserves equals the initial increase in the monetary base and banks’ reserves.

35. The money multiplier

The money multiplier is the ratio of the change in the quantity of money to the change in the monetary base. It determines the change in the quantity of money that results from a given change in the monetary base. A change in the monetary base has a multiplied effect on the quantity of money because banks’ loans are deposited in other banks where they are loaned once again. The formula for the money multiplier is derived in the Mathematical Note to the chapter (see the end of these lecture notes).

36. The Money Market

The demand for money refers to the choice to hold an inventory of money, not to the desire to receive money. The quantity of money that people plan to hold depends on:

The Price Level: The quantity of nominal money demanded is proportional to the price level so that, for example, when the price level doubles, the quantity of nominal money demanded doubles.

Real money is the quantity of money measured in constant dollars and equals nominal money divided by the price level. The quantity of real money demanded is independent of the price level.

The Nominal Interest Rate: The nominal interest rate is the opportunity cost of holding money, so an increase in the nominal interest rate decreases the quantity of real money demanded.

Real GDP: An increase in real GDP increases the quantity of money people plan to hold.

Financial Innovation: Some financial innovation decreases the quantity of money people plan to hold (ATM machines) and other financial innovation increases it (interest paid on checking accounts).

The Demand for Money Curve

The demand for money curve is the relationship between the quantity of real money demanded and the interest rate, holding all else equal. As the figure shows, the negative relationship between the interest rate and the quantity of money demanded means the demand for money curve is downward sloping.

A change in real GDP or financial innovation changes the demand for money and shifts the demand for money curve. An increase in real GDP increases the demand for money and shifts the demand for money curve rightward.

 

37. Money Market Equilibrium

Money market equilibrium occurs when the quantity of money demanded equals the quantity of money supplied. The quantity of money supplied is determined by the Federal Reserve.

Short Run: On any given day, the quantity of real money is fixed, so the supply of money curve is vertical. The nominal interest rate adjusts to establish equilibrium in the money market. The equilibrium nominal interest rate equates the quantity of real money demanded with the fixed quantity of real money.

The Short-Run Effect of a Change in the Supply of Money: Starting from a short-run equilibrium, if the Fed increases the quantity of money, people hold more money than the quantity demanded. With a surplus of money holding, people enter the loanable funds market and buy bonds. The increase in demand for bonds raises the price of a bond and lowers the interest rate.

Long Run: In the long run, supply and demand in the loanable funds market determines the equilibrium real interest rate. That, plus the expected inflation rate determines the nominal interest rate, so the nominal interest rate cannot adjust to restore equilibrium in the money market. The factor that adjusts in the long run is the price level: The price level adjusts to make the real quantity of money equal to the real quantity of money demanded. In the long run, an increase in the quantity of money raises the price level by the same proportion.

38. The Quantity Theory of Money

The quantity theory of money is the proposition that in the long run, an increase in the quantity of money brings an equal percentage increase in the price level.

The velocity of circulation is the average number of times a dollar of money is used annually to buy the goods and services that make up GDP. Nominal GDP equals real GDP, Y, multiplied by the price level, P, or GDP=PY. So the velocity of circulation, V, is given by V = PY/M.

The equation of exchange states that the quantity of money, M, multiplied by the velocity of circulation, V, equals GDP: MV = PY. The equation of exchange is a definition and so is always true. It becomes the quantity theory of money by adding two assumptions:

The velocity of circulation is not influenced by the quantity of money.

Potential GDP is not influenced by the quantity of money.

The equation of exchange can be rearranged as P = M(V/Y). This equation, together with the assumptions about velocity and potential GDP, implies that in the long run, the price level is determined by the quantity of money.

In growth rates, the equation of exchange is: (Money growth rate) + (Growth rate of velocity) = (Inflation rate) + (Real GDP growth rate). Rearranging this equation gives (Inflation rate) = (Money growth rate) + (Growth rate of velocity) - (Real GDP growth rate). If velocity does not grow, then in the long run the inflation rate equals the growth rate of the quantity of money minus the growth rate of potential GDP.

The predictions of the quantity theory can be tested using evidence on money growth and inflation across time. On the average, the money growth rate and the inflation rate are correlated, supporting the quantity theory. The predictions of the quantity theory also can be tested using the evidence on money growth and inflation across countries. As predicted, rapid money growth is correlated with high inflation.

39. The Exchange Rate and the Balance of Payments

International trade, borrowing, and lending, make it necessary to exchange currencies and the foreign exchange value of the dollar is determined in the foreign exchange market.

The exchange rates for currencies are determined by supply and demand in the foreign exchange market.

When a nation trades with other nations, the country’s balance of payments records the transactions.

40. The Foreign Exchange Market

International trade, borrowing, and lending, make it necessary to exchange currencies. Foreign currency is the money of other countries regardless of whether that money is in the form of notes, coins, or bank deposits. The foreign exchange market is the market in which the currency of one country is exchanged for the currency of another. The price at which one currency exchanges for another is called the exchange rate.

Over time, the U.S. dollar appreciates and depreciates against other currencies such as the Japanese yen or European euro. Currency depreciation is the fall in the value of one currency in terms of another currency. Currency appreciation is the rise in the value of one currency in terms of another currency.

A rise in the U.S. exchange rate is called an appreciation of the dollar; a fall in the U.S. exchange rate is called a depreciation of the dollar.

The exchange rate is determined by demand and supply in the (competitive) foreign exchange market. When people holding the money of some other country want to exchange it for U.S. dollars, they supply the other currency and demand dollars. When people holding U.S. dollars want to buy the currency of some other country, they supply U.S. dollars and demand the other currency.

41. Demand in the Foreign Exchange Market

The main factors that influence the dollars that people plan to buy in the foreign exchange market are the exchange rate, world demand for U.S. exports, interest rates in the United States and other countries, and the expected future exchange rate.

The law of demand in the foreign exchange market is: Other things remaining the same, the higher the exchange rate, the smaller is the quantity of dollars demanded in the foreign exchange market. There are two reasons for the law of demand:

Exports Effect: Dollars are used to buy U.S. exports. The lower the exchange rate, with everything else the same, the cheaper are U.S. exports so the greater the quantity of dollars demanded on the foreign exchange market to pay for the exports.

Expected Profit Effect: The lower the exchange rate, with everything else the same (including the expected future exchange rate), the larger the expected profit from buying dollars so the greater the quantity of dollars demanded on the foreign exchange market.

The law of demand means that the demand curve for U.S. dollars is downward sloping, as illustrated in the figure below.

42. Supply in the Foreign Exchange Market

The main factors that influence the dollars that people plan to sell in the foreign exchange market are the exchange rate, U.S. demand for imports, interest rates in the United States and other countries, and the expected future exchange rate.

The law of supply in the foreign exchange market is: Other things remaining the same, the higher the exchange rate, the greater is the quantity of dollars supplied in the foreign exchange market. There are two reasons for the law of supply:

Imports Effect: Dollars are used to buy U.S. imports. The higher the exchange rate, with everything else the same, the cheaper are foreign produced imports so the greater the quantity of dollars supplied on the foreign exchange market to buy these imports.

Expected Profit Effect: The higher the exchange rate, with everything else the same (including the expected future exchange rate), the smaller the expected profit from holding dollars so the larger the quantity of dollars supplied on the foreign exchange market.

The law of supply means that the supply curve for U.S. dollars is upward sloping, as shown in the figure.

43. Market Equilibrium

Demand and supply in the foreign exchange market determine the exchange rate. In the figure, the equilibrium exchange rate is 100 yen per dollar, where the demand and supply curves intersect.

If the exchange rate is higher than the equilibrium exchange rate, a surplus of dollars drives the exchange rate down.

If theexchange rate is lower than the equilibrium exchange rate, a shortage of dollars drives the exchange rate up.

The market is pulled to the equilibrium exchange rate at which there is neither a shortage nor a surplus.

44. Exchange Rate Fluctuations

45. Changes in the Demand for U.S. Dollars

A change in any relevant factor other than the exchange rate changes the demand for dollars and shifts the demand curve for dollars.

World Demand for U.S. Exports: An increase in the world demand for U.S. exports increases the demand for U.S. dollars because U.S. producers must be paid in U.S. dollars. The demand curve for U.S. dollars shifts rightward.

U.S. Interest Rate Differential: The U.S. interest rate differential is the U.S. interest rate minus the foreign interest rate. The larger the U.S. interest rate differential, the greater is the demand for U.S. assets and the greater is the demand for U.S. dollars on the foreign exchange market. An increase in the U.S. interest rate differential shifts the demand curve for U.S. dollars rightward.

Expected Future Exchange Rate: The higher the expected future exchange rate, the greater is the expected profit from holding U.S. dollars. As a result, the demand for U.S. dollars increases and the demand curve shifts rightward.

46. Changes in the Supply of U.S. Dollars

A change in any relevant factor other than the exchange rate changes the supply of dollars and shifts the supply curve of dollars.

U.S. Demand for Imports: An increase in the U.S. demand for imports increases the supply of U.S. dollars because U.S. importers offer U.S. dollars in order to buy the foreign currency necessary to pay foreign producers. The supply curve of U.S. dollars shifts rightward.

U.S. Interest Rate Differential: The larger the U.S. interest rate differential, the greater is the demand for U.S. assets and the smaller is the supply of U.S. dollars on the foreign exchange market. An increase in the U.S. interest rate differential shifts the supply curve for U.S. dollars leftward.

Expected Future Exchange Rate: The higher the expected future exchange rate, the greater is the expected profit from holding U.S. dollars. As a result, the supply of U.S. dollars decreases and the supply curve shifts leftward.

47. Changes in the Exchange Rate

The exchange rate changes when the demand for and/or the supply of foreign exchange change.

When the expected future U.S. exchange rate increases, the demand for U.S. dollars increases and the supply decreases. As the figure shows, the demand curve shifts rightward, from D0 to D1, and the supply curve shifts leftward, from S0 to S1. The exchange rate rises, and quantity traded does not change by much, indeed in the figure it does not change at all.

48. Exchange Rate Expectations

Exchange rate expectations depend on deeper economic forces that influence the value of money:

Interest Rate Parity: Interest rate parity, which means equal rates of return, is the idea that the real interest on equally risky assets is the same in different countries. Adjusted for risk, interest rate parity always prevails. Market forces achieve interest rate parity very quickly.

Purchasing Power Parity:Purchasing power parity, which means equal value of money, is the idea that, at a given exchange rate, goods and services should cost the same amount in different countries. Purchasing power parity is an important force affecting prices and exchange rates in the long run and influences exchange rate expectations.

The exchange rate market responds instantly to news about changes in the factors that influence the demand and supply in the foreign exchange market.

49. The Real Exchange Rate

The nominal exchange rate is the value of the U.S. dollar expressed in units of foreign currency per U.S. dollar. It tells how many units of a foreign currency one U.S. dollar buys. The real exchange rate is the relative price of U.S-produced goods and services to foreign-produced goods and services. It tells how many units of foreign GDP one unit of U.S. GDP buys. The real exchange rate, RER, is equal to

RER = (E ´ P)/P*

where E is the nominal exchange rate, P is the U.S. price level, and P* is the foreign price level.

The Nominal and Real Exchange Rates in the Short Run and in the Long Run

Nominal and real exchange rates are linked by the equation RER = E ´ (P/P*).

Short Run: In the short run, this equation determines the real exchange rate. The nominal exchange rate is determined in the foreign exchange market by the supply and demand for dollars. Price levels do not change rapidly and so any change in the nominal exchange rate translates into a change in the real exchange rate.

Long Run: In the long run, rewrite the equation as E = RER ´ (P*/P). In the long run, the real exchange rate is determined by the supply and demand for imports and exports and the price level in each nation is determined by the quantity of money in that nation. So in the long run, a change in the quantity of money changes the price level and thereby changes the nominal exchange rate

50. Exchange Rate Policy

Because the exchange rate is the price of a country’s money, governments and central banks must have a policy toward the exchange rate. Three possible exchange rates policies are.

A flexible exchange rate policy permits the exchange rate to be determined by demand and supply with no direct intervention by the central bank. Even so, the exchange rate is influenced by the central bank’s actions

A fixed exchange rate policy pegs the exchange rate at a value determined by the government or the central bank and blocks the unregulated forces of supply and demand by direct intervention in the foreign exchange market. A fixed exchange rate requires direct and frequent intervention by the central bank.

If the demand for dollars decreases or the supply of dollars increases, to fix the exchange rate the Fed buys U.S. dollars. By so doing the Fed increases the demand for dollars and raises the exchange rate. But the Fed cannot pursue this policy forever because it eventually will run out of the foreign reserves it is using to purchase the dollars.

In the figure the demand for dollars has decreased from D0 to D1.

If the demand for dollars increases or the supply of dollars decreases, with no intervention the exchange rate will rise. To fix the exchange rate the Fed sells U.S. dollars so that it increases the supply of dollars and lowers the exchange rate.

51. Crawling Peg policy

A crawling peg policy selects a target path for the exchange rate with intervention in the foreign exchange market to achieve that path. A crawling peg works like a fixed exchange rate only the target value changes. The target changes whenever the central bank changes. China is now currently using a crawling peg exchange rate policy for the yuan.

52. The People’s Bank of China in the Foreign Exchange Market

From 1997 until 2005, the People’s Bank of China fixed the Chinese exchange rate by selling yuan and buying dollars to offset the effects of increases in the demand for yuan. China accumulated foreign currency reserves of almost $1 trillion by mid-2006, and by the end of 2007 was fast approaching $2 trillion.

Since 2005, the People’s Bank has allowed the yuan to crawl upward. Even so the yuan has not risen to its equilibrium level, hence the People’s Bank must buy U.S. dollars to hold the yuan/dollar exchange rate down.

China most likely fixed its exchange rate to anchor its inflation rate so that it does not deviate much from the U.S. inflation rate. The Chinese inflation rate departs from the U.S. inflation rate by an amount determined by the speed of the crawl.

53. Financing International Trade

54. Balance of Payments Accounts

A country’s balance of payments accounts records its international trading, borrowing, and lending. There are three balance of payments accounts:

The current account records payments for imports of goods and services from abroad, receipts for exports of goods and services sold abroad, net interest income paid abroad, and net transfers (such as foreign aid payment). The current account balance equals exports plus net interest income plus net transfers minus imports.

The capital account records foreign investment minus investment abroad. Any statistical discrepancy is included in this account.

The official settlements account records the change in U.S. official reserves, which are the government’s holdings of foreign currency. An increase in foreign reserves corresponds to a negative official settlements account balance. This occurs because holding foreign currency is like (but not the same as) investing abroad, which is a negative entry in the capital account.

The sum of the balances always equals zero:

current account + capital account + official settlements account = 0.

55. Current Account Balance and Net Exports

The current account balance (CAB) is:

CAB = X − M + Net interest income + Net transfers

The main item in the current account balance is net exports (X − M). The other two items are much smaller and don’t fluctuate much.

The national accounts show that Y = C + I + G + X - M and also that Y = C + S + T. These two relationships can be equated and rearranged to give (X - M) = (S - I) + (T - G). In this formula,

(X - M) is net exports, exports of goods and services minus imports of goods and services.

(S - I) is the private sector balance, saving minus investment.

(T - G) is the government sector balance, net taxes minus government expenditures on goods and services.

The formula shows that net exports equal the sum of the private sector balance and the government sector balance. There is a strong tendency for the private sector balance and the government sector balance to move in opposite directions, which means that the relationship between net exports and the other two sectors taken individually is not a strong one.

56. Aggregate Supply and Aggregate Demand

The aggregate supply-aggregate demand (AS-AD) model explains how real GDP and the price level are determined.

The model also helps explains the factors that determine inflation and the business cycle.

Aggregate Supply

The quantity of real GDP supplied is the total quantity of goods and services, valued in constant dollar prices, that firms plan to produce in a given time period. This amount depends on the quantity of labor employed, the capital stock, and the state of technology. In the short run, only the quantity of labor can vary, so fluctuations in employment lead to changes in real GDP.

Aggregate Demand

The quantity of real GDP demanded is the sum of consumption expenditure (C), investment (I), government expenditure (G), and net exports (X - M), or Y = C + I + G + (X - M).

Buying plans depend on many factors including:

The price level

Expectations

Fiscal policy and monetary policy

The world economy

57. Long-Run Aggregate Supply

The long-run aggregate supply curve is the relationship between the quantity of real GDP supplied and the price level in the long run when real GDP equals potential GDP. As illustrated in the figure, the LAS curve is vertical at the level of potential GDP ($13 trillion in the figure), showing that potential GDP does not depend on the specific price level.

In the long run, the wage rate and other resource prices change in proportion to the price level. So moving along the LAS curve both the price level and the money wage rate change by the same percentage.

58. Short-Run Aggregate Supply

The short-run aggregate supply curve is the relationship between the quantity of real GDP supplied and the price level in the short run when the money wage rate, the prices of other resources, and potential GDP remain constant.

As illustrated in the figure, the SAS curve is upward sloping. This slope reflects that a higher price level combined with a fixed money wage rate, lowers the real wage rate, thereby increasing the quantity of labor firms employ and hence increasing the real GDP firms produce.

59. Movements Along the LAS and SAS Curves and Changes in Aggregate Supply

When the price level, the money wage rate, and other resource prices change by the same percentage, real GDP remains at potential GDP and there is a movement along the LAS curve.

When the price level changes and the money wage rate and other resource prices remain constant, real GDP departs from potential GDP and there is a movement along the SAS curve.

When potential GDP increases, both long-run and short-run aggregate supply increase and the LAS and SAS curves shift rightward. Potential GDP increases when the full employment quantity of labor increases, the quantity of capital increases, or technology advances.

Short-run aggregate supply changes and the SAS curve shifts when there is a change in the money wage rate or other resource prices. A rise in the money wage rate or other resource prices decreases short-run aggregate supply and shifts the SAS curve leftward.

60. The Aggregate Demand Curve

Other things remaining the same, the higher the price level, the smaller is the quantity of real GDP demanded. The relationship between the quantity of real GDP demanded and the price level is called aggregate demand. As the figure shows, the AD curve is downward sloping.

The negative relationship between the price level and the quantity of real GDP demanded reflects the wealth effect (when the price level rises, real wealth decreases and so people decrease consumption) and substitution effects (first, the intertemporal substitution effect: when the price level rises, real money decreases and the interest rates rises so that consumption expenditure and investment decrease; and, second, the international price substitution effect: when the price level rises, domestic goods become more expensive relative to foreign goods so people decrease the quantity of domestic goods demanded).

61. Changes in Aggregate Demand

Any factor that influences buying plans other than the price level brings a change in aggregate demand and a shift in the aggregate demand curve. Factors that change aggregate demand are:

Expectations: Expectations of higher future income, expectations of higher future inflation, and expectations of higher future profits increase aggregate demand and shift the AD curve rightward.

Fiscal policy and monetary policy: The government’s attempt to influence the economy by setting and changing taxes, making transfer payments, and purchasing goods and services is called fiscal policy. Tax cuts or increased transfer payments increase disposable income (aggregate income minus tax payments plus transfers) and thereby increase consumption expenditure and aggregate demand. Increased government expenditures increase aggregate demand. Monetary policy consists of changes in interest rates and in the quantity of money in the economy. An increase in the quantity of money and lower interest rates increase aggregate demand.

The world economy: Exchange rates and foreign income affect net exports (X - M) and, therefore, aggregate demand. A decrease in the exchange rate or an increase in foreign income increases aggregate demand.

62. Short-Run and Long-Run Macroeconomic Equilibrium

Short-run macroeconomic equilibrium occurs when the quantity of real GDP demanded equals the quantity of real GDP supplied. This equilibrium is determined where the AD and SAS curves intersect.

If the quantity of real GDP supplied exceeds the quantity demanded, inventories pile up so that firms will cut production and prices.

If the quantity of real demanded exceeds the quantity supplied, inventories are depleted so that firms will increase production and prices.

Long-run macroeconomic equilibrium occurs when real GDP equals potential GDP—equivalently, as the figure shows, when the economy is on its long-run aggregate supply curve.

63. Economic Growth and Inflation

Economic growth occurs when potential GDP increases so that the LAS curve shifts rightward.

Inflation occurs when the AD curve continually shifts rightward at a faster rate than the LAS curve. In the long run, only growth in the quantity of money makes the AD curve continually shift rightward

64. The Business Cycle

65. Macroeconomic Schools of Thought

The Classical View

A classical macroeconomist believes that the economy is self-regulating and that it is always at full employment. A new classical view is that business cycle fluctuations are the efficient responses of a well-functioning market economy that is bombarded by shocks that arise from the uneven pace of technological change.

The uneven pace of technological advancement are the main source of business cycle fluctuations. There is no distinct short-run aggregate supply curve because the economy is always producing at potential GDP.

Classical economists emphasize that taxes blunt people’s incentives to work, so the most the government should do to affect the business cycle is to keep taxes low.

A Keynesian macroeconomist believes that left alone, the economy would rarely operate at full employment and that to achieve and maintain full employment, active help from fiscal policy and monetary policy is required.

Aggregate demand fluctuations driven by changes in expectations (“animal spirits”) about business conditions and profits are the main source of business cycle fluctuations. Because money wages are sticky (slow to adjust), especially in the downward direction, the economy can remain mired in a recession.

A modern version of the Keynesian view known as the new Keynesian view holds that not only is the money wage rate sticky but that the prices of some goods and services are also sticky.

Keynesians believe that fiscal policy and monetary policy should be used actively to stimulate demand to end recessions and restore full employment.

A monetarist macroeconomist believes that the economy is self-regulating and that it will normally operate at full employment provided that monetary policy is not erratic and that the pace of money growth is kept steady.

Aggregate demand fluctuations driven by monetary policy mistakes are the main source of business cycle fluctuations.

There is a short-run aggregate supply curve because money wages are sticky.

The monetarist view of policy is that tax rates should be kept low and the quantity of money should be kept growing on a steady path. Beyond these policies, however, the government should not undertake active stabilization policy.

66. The Keynesian View versus The Monetarist View

A Keynesian macroeconomist believes that left alone, the economy would rarely operate at full employment and that to achieve and maintain full employment, active help from fiscal policy and monetary policy is required.

Aggregate demand fluctuations driven by changes in expectations (“animal spirits”) about business conditions and profits are the main source of business cycle fluctuations. Because money wages are sticky (slow to adjust), especially in the downward direction, the economy can remain mired in a recession.

A modern version of the Keynesian view known as the new Keynesian view holds that not only is the money wage rate sticky but that the prices of some goods and services are also sticky.

Keynesians believe that fiscal policy and monetary policy should be used actively to stimulate demand to end recessions and restore full employment.

A monetarist macroeconomist believes that the economy is self-regulating and that it will normally operate at full employment provided that monetary policy is not erratic and that the pace of money growth is kept steady.

Aggregate demand fluctuations driven by monetary policy mistakes are the main source of business cycle fluctuations.

There is a short-run aggregate supply curve because money wages are sticky.

The monetarist view of policy is that tax rates should be kept low and the quantity of money should be kept growing on a steady path. Beyond these policies, however, the government should not undertake active stabilization policy.

67. Time Horizons in Macroeconomics

68. The Model of Aggregate Supply and Aggregate Demand

In classical macroeconomic theory, the amount of output depends on the economy’s ability to supply goods and services, which in turn depends on the supplies of capital and labor and on the available production technology. Flexible prices are a crucial assumption of classical theory. The theory posits, sometimes implicitly, that prices adjust to ensure that the quantity of output demanded equals the quantity supplied.

The economy works quite differently when prices are sticky. In this case output also depends on the demand for goods and services. Demand, in turn, is influenced by monetary policy, fiscal policy, and various other factors. Because monetary and fiscal policy can influence the economy’s output over the time horizon when prices are sticky, price stickiness provides a rationale for why these policies may be useful in stabilizing the economy in the short run.

The model of aggregate supply and aggregate demand

This macroeconomic model allows us to study how the aggregate price level and the quantity of aggregate output are determined. It also provides a way to contrast how the economy behaves in the long run and how it behaves in the short run.

Although the model of aggregate supply and aggregate demand resembles the model of supply and demand for a single good, the analogy is not exact. The model of supply and demand for a single good considers only one good within a large economy. By contrast, as we will see in the coming chapters, the model of aggregate supply and aggregate demand is a sophisticated model that incorporates the interactions among many markets.

69. Shifts in the Aggregate Demand Curve

70. Stabilization Policy

71. Shocks to Aggregate Demand

72. Shocks to Aggregate Supply

73. Expenditure Multipliers: The Keynesian Model

74. Consumption Function and Saving Function

75. Marginal Propensities to Consume and Save

76. Consumption as a Function of Real GDP and the Import Function

77. Aggregate Planned Expenditure and Real GDP

78. Equilibrium Expenditure and Convergence to the Equilibrium

79. The Multiplier GDP

80. The Multiplier and the Marginal Propensities to Consume and Save

81. The Effect of Imports and Income Taxes on the Multiplier

82. The Multiplier and the Price Level

83. The Aggregate Expenditure Curve and the Aggregate Demand Curve

84. Equilibrium Real GDP and the Price Level

85. Supply-Side Effects of Fiscal Policy

86. Taxes and the Incentive to Save and Invest

87. Tax Revenues and the Laffer Curve

88. Generational Effects of Fiscal Policy

89. The Social Security Time Bomb

90. Generational Imbalance