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· Inflation in Ukraine: calculate the Consumer Price Index (CPI) and rate of inflation and time series for the last 4 years. Give reasons for prices’ evolution in the country 

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Three Key Facts about Economic Fluctuations

Fact 1: Economic Fluctuations Are Irregular and Unpredictable

Fluctuations in the economy are often called the business cycle. As this term suggests, economic fluctuations correspond to changes in business conditions. When real GDP grows rapidly, business is good. During such periods of economic expansion, most firms find that customers are plentiful and that profits are growing. When real GDP falls during recessions, businesses have trouble. During such periods of economic contraction, most firms experience declining sales

Fact 2: Most Macroeconomic Quantities Fluctuate Together

Real GDP is the variable most commonly used to monitor short-run changes in the economy because it is the most comprehensive measure of economic activity. Real GDP measures the value of all final goods and services produced within a given period of time.

It turns out, however, that for monitoring short-run fluctuations, it does not really matter which measure of economic activity one looks at. Most macroeconomic variables that measure some type of income, spending, or production fluctuate closely together.

Fact 3: As Output Falls, Unemployment Rises

Changes in the economy’s output of goods and services are strongly correlated with changes in the economy’s utilization of its labor force. In other words, when real GDP declines, the rate of unemployment rises. When firms choose to produce a smaller quantity of goods and services, they lay off workers, expanding the pool of unemployed.

4

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.

The economy works quite differently when prices are sticky. In this case, as we will see, output also depends on the economy’s demand for goods and services.

Demand, in turn, depends on a variety of factors: consumers’ confidence about their economic prospects, firms’ perceptions about the profitability of new investments, and monetary and fiscal policy. Because monetary and fiscal policy can influence demand, and demand in turn 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 Assumptions of Classical Economics

Money does not matter in a classical world. If the quantity of money in the

Economy were to double, everything would cost twice as much, and everyone’s income

would be twice as high. But so what? The change would be nominal. The things that

People really care about—whether they can afford, and so on—would be exactly the same. have a job, how many goods and services

Most economists believe that, beyond a period of several years, changes in

the money supply affect prices and other nominal variables but do not affect real GDP,

unemployment, and other real variables—just as classical theory says.

The model of short-run economic fluctuations focuses on the behavior of two

variables.

1.The first variable is the economy’s output of goods and services, as

measured by real GDP.

2.The second is the average level of prices, as measured by the CPI or the GDP

deflator. Notice that output is a real variable, whereas the price level is a nominal

variable. By focusing on the relationship between these two variables, we are departing

from the classical assumption that real and nominal variables can be studied separately.

The aggregate-supply curve shows the quantity of goods and services that firms

produce and sell at each price level. According to this model, the price level and

the quantity of output adjust to bring aggregate demand and aggregate supply

into balance.

The Aggregate-Demand Curve

Why does a change in the price level move the quantity of goods and services

demanded in the opposite direction?

Y = C + I + G + NX.

The Price Level and Consumption: The Wealth Effect

A decrease in the price level raises the real value of money and makes

consumers wealthier, which in turn encourages them to spend more. The increase in

consumer spending means a larger quantity of goods and services demanded. Conversely, an increase in the price level reduces the real value of money and

makes consumers poorer, which in turn reduces consumer spending and the quantity

demanded.

The Price Level and Investment: The Interest-Rate Effect

When the price level falls, households try to reduce their

holdings of money by lending some of it out. For instance, a household might

use its excess money to buy interest-bearing bonds. as households try to convert some

of their money into interest-bearing assets, they drive down interest rates.

The Price Level and Net Exports: The Exchange-Rate Effect

When a fall in the country price level causes interest rates to fall, the real

value of the dollar declines in foreign exchange markets. This depreciation stimulates

U.S. net exports and thereby increases the quantity of goods and services demanded.

Example: As a mutual fund tries to convert its dollars into euros to buy the German

bonds, it increases the supply of dollars in the market for foreign currency exchange.

The increased supply of dollars to be turned into euros causes the dollar to depreciate relative to the euro.

Why the Aggregate-Demand Curve Might Shift

Shifts Arising from Changes in Consumption

Shifts Arising from Changes in Investment

Shifts Arising from Changes in Government Purchases

Shifts Arising from Changes in Net Exports

The Aggregate-Supply Curve

Unlike the aggregate-demand curve, which always slopes downward, the

aggregate-supply curve shows a relationship that depends crucially on the time

horizon examined. In the long run, the aggregate supply curve is vertical, whereas in the short run, the aggregate-supply curve slopes upward.

In the long run, an economy’s production of goods and services (its real GDP)

Depends on its supplies of labor, capital, and natural resources and on the available technology used to turn these factors of production into goods and services.

Why the Aggregate-Supply Curve Is Vertical in the Long Run

Since the amount of money does not affect technology or the supplies of labor, capital,

and natural resources, the output of goods and services in the two economies would be the same.

Why the Long-Run Aggregate-Supply Curve Might Shift

The potential output or full-employment output, or the natural level of output

because it shows what the economy produces when unemployment is at its

natural, or normal, rate. The natural level of output is the rate of production

toward which the economy gravitates in thelong run.

Shifts Arising from Changes in Labor

Shifts Arising from Changes in Capital

Shifts Arising from Changes in Natural Resources

Shifts Arising from Changes in Technological Knowledge

Using Aggregate Demand and Aggregate Supply to Depict

Long-Run Growth and Inflation

The two most important forces in practice are technology and monetary policy.

The short-run fluctuations in output and the price level that we will be studying should

be viewed as deviations from the long-run trends ofoutput growth and inflation.

Why the Aggregate-Supply Curve Slopes Upward in the Short Run

The quantity of output supplied deviates from its long-run, or natural, level when

the actual price level in the economy deviates from the price level that people expected

To prevail. When the price level rises above the level that people expected, output rises

above its natural level, and when the price level falls below the expected level,

output falls below its natural level.

The Sticky-Wage Theory

Nominal wages are slow to adjust to changing economic conditions.

In other words, wages are “sticky” in the short run. To some extent, the slow

adjustment of nominal wages is attributable to long-term contracts between

workers and firms that fix nominal wages

The Sticky-Price Theory

This slow adjustment of prices occurs in part because there are costs to adjusting

prices, called menu costs. These menu costs include the cost of printing and

distributing catalogs and the time required to change price tags. As a result of these

costs, prices as well as wages may be sticky in the short run.

The Misperceptions Theory

Suppose the overall price level falls below the level that suppliers expected. When

suppliers see the prices of their products fall, they may mistakenly believe that their

relative prices have fallen; that is, they may believe that their prices have fallen compared to other prices in the economy

Two Causes of Economic Fluctuations

The Effects of a Shift in Aggregate Demand

The Effects of a Shift in Aggregate Supply

Fiscal Policy

The government can influence the behavior of the economy not only with monetary policy but also with fiscal policy. Fiscal policy refers to the government’s choices regarding the overall level of government purchases and taxes.

Changes in Government Purchases

When policymakers change the money supply or the level of taxes, they shift the aggregate-demand curve indirectly by influencing the spending decisions of firms or households. By contrast, when the government alters its own purchases of goods and services, it shifts the aggregate-demand curve directly.

The Multiplier Effect

1. When the government buys $20 billion of goods from Boeing, that purchase has

repercussions. The immediate impact of the higher demand from the government is to raise employment and profits at Boeing.

2. Then, as the workers see higher earnings and the firm owners see higher profits, they respond to this increase in income by raising their own spending on consumer goods. As a result, the government purchase from Boeing raises the demand for the products of many other firms in the economy.

3. Because each dollar spent by the government can raise the aggregate demand for goods and services by more than a dollar, government purchases are said to have a multiplier effect on aggregate demand.

4. This multiplier effect continues even after this first round. When consumer

spending rises, the firms that produce these consumer goods hire more people and

experience higher profits. Higher earnings and profits stimulate consumer spending once again and so on.

The marginal propensity to consume (MPC)

Definition: The fraction of extra income that a household consumes rather than saves. For example, suppose that the marginal propensity to consume is 3 / 4

This means that for every extra dollar that a household earns, the household spends $0.75 (3/4 of the dollar) and saves $0.25.

With an MPC of 3/4, when the workers and owners of Boeing earn $20 billion from the government contract, they increase their consumer spending by :

¾ * $20 billion = $15 billion.

The process begins when the government spends $20 billion, which implies that national income (earnings and profits) also rises by this amount. This increase in income in turn raises consumer spending by MPC * $20 billion, which raises the income for the workers and owners of the firms that produce the consumption goods.

This second increase in income again raises consumer spending, this time by MPC * (MPC * $20 billion). These feedback effects go on and on.

To find the total impact on the demand for goods and services, we add up all

these effects:

Change in government purchases = $20 billion

First change in consumption = MPC . $20 billion

Second change in consumption = MPC2 . $20 billion

Third change in consumption = MPC3 . $20 billion

• •

• •

• •

Total change in demand

= (1 + MPC + MPC2+ MPC3 + . . .) . $20 billion.

Multiplier = 1 + MPC + MPC2 + MPC3 + . . . .

This multiplier tells us the demand for goods and services that each dollar of government purchases generates.

To simplify this equation for the multiplier, recall from math class that this expression is an infinite geometric series. For x between −1 and +1,

1 + x + x2 + x3 + . . . = 1 / (1 − x).

In our case, x = MPC. Thus,

Multiplier = 1/(1 − MPC).

For example, if MPC is 3 /4 the multiplier is 1/(1 − 3/4), which is 4. In this case, the

$20 billion of government spending generates $80 billion of demand for goods

and services.

This formula for the multiplier shows that the size of the multiplier depends on

the marginal propensity to consume. While an MPC of 3/4 leads to a multiplier of

4, an MPC of ½ leads to a multiplier of only 2.

The Crowding-Out Effect

The multiplier effect seems to suggest that when the government buys $20 billion of planes from Boeing, the resulting expansion in aggregate demand is necessarily larger than $20 billion.

Yet another effect works in the opposite direction. While an increase in government purchases stimulates the aggregate demand for goods and services, it also causes the interest rate to rise, which reduces investment spending and puts downward pressure on aggregate demand. aggregate demand that results when a fiscal expansion raises the interest rate is called the crowding-out effect.

Example:

To see why crowding out occurs, let’s consider what happens in the money

market when the government buys planes from Boeing. As we have discussed, this increase in demand raises the incomes of the workers and owners of this firm (and, because of the multiplier effect, of other firms as well). As incomes rise, households plan to buy more goods and services and, as a result, choose to hold more of their wealth in liquid form. That is, the increase in income caused by the fiscal expansion raises the demand for money.

Because the Fed has not changed the money supply, the vertical supply curve remains the same. When the higher level of income shifts the money demand

curve to the right from MD1 to MD2, the interest rate must rise from r1 to r2 to keep supply and demand in balance.

The increase in the interest rate, in turn, reduces the quantity of goods and services demanded. In particular, because borrowing is more expensive, the demand for residential and business investment goods declines. In other words, as the increase in government purchases increases the demand for goods and services, it may also crowd out investment.

This crowding-out effect partially offsets the impact of government purchases on aggregate demand, as illustrated in panel (b) of Figure 5. The increase in government purchases initially shifts the aggregate-demand curve from AD1 to AD2, but once crowding out takes place, the aggregate-demand curve drops back to AD3.

Changes in Taxes

The other important instrument of fiscal policy, besides the level of government

purchases, is the level of taxation. When the government cuts personal income taxes, for instance, it increases households’ take-home pay. Households will save some of this additional income, but they will also spend some of it on consumer goods. Because it increases consumer spending, the tax cut shifts the aggregate- demand curve to the right.

Similarly, a tax increase depresses consumer spending and shifts the aggregate-demand curve to the left. The size of the shift in aggregate demand resulting from a tax change is also affected by the multiplier and crowding-out effects. When the government cuts taxes and stimulates consumer spending, earnings and profits rise, which further stimulates consumer spending. This is the multiplier effect. At the same time, higher income leads to higher money demand, which tends to raise interest rates. Higher interest rates make borrowing more costly, which reduces investment spending. This is the crowding-out effect.

Using Policy to Stabilize the Economy

Should policymakers use these instruments to control aggregate demand and stabilize the economy? If so, when? If not, why not?

The level of taxation is one determinant of the position of the aggregate-demand

curve. When the government raises taxes, aggregate demand will fall, depressing

production and employment in the short run.

If the Central bank wants to prevent this adverse effect of the fiscal policy, it can expand aggregate demand by increasing the money supply. A monetary expansion would reduce interest rates, stimulate investment spending, and expand aggregate demand.

If monetary policy is set appropriately, the combined changes in monetary and fiscal policy could leave the aggregate demand for goods and services unaffected.

Keynes emphasized the key role of aggregate demand in explaining short-run economic fluctuations. Keynes claimed that the government should actively stimulate aggregate demand when aggregate demand appeared insufficient to maintain production at its full-employment level.

Keynes (and his many followers) argued that aggregate demand fluctuates because of largely irrational waves of pessimism and optimism. He used the term “animal spirits” to refer to these arbitrary changes in attitude. When pessimism reigns, households reduce consumption spending and firms reduce investment spending. The result is reduced aggregate demand, lower production, and higher unemployment.

Conversely, when optimism reigns, households and firms increase spending.

The result is higher aggregate demand, higher production, and inflationary pressure.

In principle, the government can adjust its monetary and fiscal policy in response to these waves of optimism and pessimism and, thereby, stabilize the economy. For example, when people are excessively pessimistic, the Fed can expand the money supply to lower interest rates and expand aggregate demand. When they are excessively optimistic, it can contract the money supply to raise interest rates and dampen aggregate demand.

Automatic Stabilizers

The lags in implementation reduce the efficacy of policy as a tool for short-run stabilization. The economy would be more stable, therefore, if policymakers could find a way to avoid some of these lags.

Automatic stabilizers are changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession without policymakers having to take any deliberate action.

The most important automatic stabilizer is the tax system. When the economy goes into a recession, the amount of taxes collected by the government falls automatically because almost all taxes are closely tied to economic activity.

The personal income tax depends on households’ incomes, the payroll tax depends on workers’ earnings, and the corporate income tax depends on firms’ profits. Because incomes, earnings, and profits all fall in a recession, the government’s tax revenue falls as well. This automatic tax cut stimulates aggregate demand and, thereby, reduces the magnitude of economic fluctuations.

Some government spending also acts as an automatic stabilizer.

In particular, when the economy goes into a recession and workers are laid off, more people apply for unemployment insurance benefits, welfare benefits, and other forms of income support.

This automatic increase in government spending stimulates aggregate demand at exactly the time when aggregate demand is insufficient to maintain full employment. Indeed, when the unemployment insurance system was first enacted in the 1930s, economists who advocated this policy did so in part because of its power as an automatic stabilizer.

45

Monetary Policy

What is Fiat Money?

Fiat money is government-issued currency that is not backed by a physical commodity, such as gold or silver, but rather by the government that issued it. The value of fiat money is derived from the relationship between supply and demand and the stability of the issuing government, rather than the worth of a commodity backing it as is the case for commodity money. 

The Functions of Money

Money has three functions in the economy: It is a medium of exchange, a unit of account, and a store of value. These three functions together distinguish money from other assets in the economy, such as stocks, bonds, real estate, art, and even baseball cards. Let’s examine each of these functions of money.

A. A medium of exchange is an item that buyers give to sellers when they purchase goods and services. When you go to a store to buy a shirt, the store gives you the shirt and you give the store your money. This transfer of money from buyer to seller allows the transaction to take place. When you walk into a store, you are confident that the store will accept your money for the items it is selling because

money is the commonly accepted medium of exchange.

B. A unit of account is the yardstick people use to post prices and record debts. When you go shopping, you might observe that a shirt costs $50 and a hamburger costs $5. Even though it would be accurate to say that the price of a shirt is 10 hamburgers and the price of a hamburger is 1/10 of a shirt, prices are never quoted in this way. Similarly, if you take out a loan from a bank, the size of your future loan repayments will be measured in dollars, not in a quantity of goods and services. When we want to measure and record economic value, we use money as the unit of account.

C. A store of value is an item that people can use to transfer purchasing power from the present to the future. When a seller accepts money today in exchange for a good or service, that seller can hold the money and become a buyer of another good or service at another time. Money is not the only store of value in the economy: A person can also transfer purchasing power from the present to the future by holding nonmonetary assets such as stocks and bonds. The term wealth is used to refer to the total of all stores of value, including both money and nonmonetary assets.

The most obvious asset to include is currency—the paper bills and coins in

the hands of the public. Currency is clearly the most widely accepted medium of

exchange in our economy. There is no doubt that it is part of the money stock.

To measure the money stock, therefore, you might want to include demand deposits—balances in bank accounts that depositors can access on demand simply by writing a check or swiping a debit card at a store.

The two most commonly used, designated M1 and M2. M2 includes more assets in its measure of money than does M1.

The important point is that the money stock economy includes not only currency but also deposits in banks and other financial institutions that can be readily accessed and used to buy goods and services.

Central bank (CB)—

An institution designed to oversee the banking system and regulate the quantity of money in the economy. Other major central banks around the world include the Bank of England, the Bank of Japan, and the European Central Bank.

The first job of a CB is to regulate banks and ensure the health of the banking system. This task is largely the responsibility of the regional Banks.

It also acts as a bank’s bank. That is, the CB makes loans to banks when banks themselves want to borrow. When financially troubled banks find themselves short of cash, the CB acts as a lender of last resort—a lender to those who cannot borrow anywhere else—to maintain stability in the overall banking system.

The second and more important job is to control the quantity of money that is made available in the economy, called the money supply. Decisions by policymakers concerning the money supply constitute monetary policy.

Central Bank primary tool is the open-market operation—the purchase and sale of government bonds. A government bond is a certificate of indebtedness of the government.

If the government decides to decrease the money supply, the CB sells government bonds from its portfolio to the public in the nation’s bond markets. After the sale, the dollars the CB receives for the bonds are out of the hands of the public. Thus, an open-market sale of bonds by the CB decreases the money supply.

Central banks are important institutions because changes in the money supply can profoundly affect the economy.

The amount of money you hold includes both currency (the bills in your wallet and coins in your pocket) and demand deposits (the balance in your checking account).

Because demand deposits are held in banks, the behavior of banks can influence the quantity of demand deposits in the economy and, therefore, the money supply.

Reserve ratio

Let’s suppose that the total quantity of currency is $100. The supply of money is, therefore, $100. Now suppose that someone opens a bank, appropriately called First National Bank. First National Bank is only a depository institution—that is, it accepts deposits but does not make loans. The purpose of the bank is to give depositors a safe place to keep their money. Deposits that banks have received but have not loaned out are called reserves.

On the left side of the T-account are the bank’s assets of $100 (the reserves it holds

in its vaults). On the right side are the bank’s liabilities of $100 (the amount it

owes to its depositors). Because the assets and liabilities exactly balance, this

accounting statement is called a balance sheet.

Each deposit in the bank reduces currency and raises demand deposits by exactly the same amount, leaving the money supply unchanged. Thus, if banks hold all deposits in reserve, banks do not influence the supply of money.

Fractional-reserve banking.

The fraction of total deposits that a bank holds as reserves is called the reserve ratio. This ratio is influenced by both government regulation and bank policy. As we discuss more fully later in the chapter, the CB sets a minimum amount of reserves that banks must hold, called a reserve requirement

Let’s suppose that First National has a reserve ratio of 1/10, or 10 percent. This

means that it keeps 10 percent of its deposits in reserve and loans out the rest.

Now let’s look again at the bank’s T-account:

First National still has $100 in liabilities because making the loans did not alter the

bank’s obligation to its depositors. But now the bank has two kinds of assets: It has $10 of reserves in its vault, and it has loans of $90.

Once again consider the supply of money in the economy. Before First National makes any loans, the money supply is the $100 of deposits. Yet when First National lends out some of these deposits, the money supply increases. The depositors still have demand deposits totaling $100, but now the borrowers hold $90 in currency.

The money supply (which equals currency plus demand deposits) equals $190. Thus, when banks hold only a fraction of deposits in reserve, the banking system creates money.

Loans from First National give the borrowers some currency and thus the ability to buy goods and services. Yet the borrowers are also taking on debts, so the loans do not make them any richer. In other words, as a bank creates the asset of money, it also creates a corresponding liability for those who borrowed the created money.

At the end of this process of money creation, the economy is more liquid in the sense that there is more of the medium of exchange, but the economy is no wealthier than before.

The Money Multiplier:

Suppose the borrower from First National uses the $90 to buy something from someone who then deposits the currency in Second National Bank. Here is the T-account for Second National Bank:

After the deposit, this bank has liabilities of $90. If Second National also has a reserve ratio of 10 percent, it keeps assets of $9 in reserve and makes $81 in loans.

In this way, Second National Bank creates an additional $81 of money. If this $81 is eventually deposited in Third National Bank, which also has a reserve ratio of 10 percent, this bank keeps $8.10 in reserve and makes $72.90 in loans. Here is the T-account for Third National Bank:

It turns out that even though this process of money creation can continue forever, it does not create an infinite amount of money. If you laboriously add the infinite sequence of numbers in the preceding example, you find that the $100 of reserves

generates $1,000 of money.

The amount of money the banking system generates with each dollar of reserves is called the money multiplier. In this imaginary economy, where the $100 of reserves generates $1,000 of money, the money multiplier is 10.

What determines the size of the money multiplier? It turns out that the answer is simple: The money multiplier is the reciprocal of the reserve ratio. If R is the reserve ratio for all banks in the economy, then each dollar of reserves generates 1/R dollars of money. In our example, R = 1/10, so the money multiplier is 10.

If a bank holds $1,000 in deposits, then a reserve ratio of 1/10 (10 percent) means that the bank must hold $100 in reserves. The money multiplier just turns this idea around:

If the banking system as a whole holds a total of $100 in reserves, it can have only $1,000 in deposits. In other words, if R is the ratio of reserves to deposits at each bank (that is, the reserve ratio), then the ratio of deposits to reserves in the banking system (that is, the money multiplier) must be 1/R.

If the reserve ratio were only 1/20 (5 percent =0,05), then the banking system would have 20 times as much in deposits as in reserves, implying a money multiplier of 20. Each dollar of reserves would generate $20 of money. Similarly, if the reserve ratio were 1/4 (25 percent), deposits would be 4 times reserves, the money multiplier would be 4, and each dollar of reserves would generate $4 of money.

The higher the reserve ratio, the less of each deposit banks loan out, and the smaller the money multiplier. In the special case of 100-percent-reserve banking, the reserve ratio is 1, the money multiplier is 1, and banks do not make loans or create money.

In the bank balance sheets you have seen so far, a bank accepts deposits and either uses those deposits to make loans or holds them as reserves. More realistically, a bank gets financial resources not only from accepting deposits but also, like other companies, from issuing equity and debt. The resources that a bank obtains from issuing equity to its owners are called bank capital. A bank uses these financial resources in various ways to generate profit for its owners. It not only makes loans and holds reserves but also buys financial securities, such a stocks and bonds.

Here is a more realistic example of a bank’s balance sheet:

By the rules of accounting, the reserves, loans, and securities on the left side of the balance sheet must always equal, in total, the deposits, debt, and capital on the right side of the balance sheet.

The value of the owners’ equity is, by definition, the value of the bank’s assets (reserves, loans, and securities) minus the value of its liabilities (deposits and debt). Therefore, the left and right sides of the balance sheet always sum to the same total.

Many businesses in the economy rely on leverage, the use of borrowed money to supplement existing funds for investment purposes. Indeed, whenever anyone uses debt to finance an investment project, she is applying leverage.

The leverage ratio is the ratio of the bank’s total assets to bank capital. In this example, the leverage ratio is $1,000/$50, or 20. A leverage ratio of 20 means that for every dollar of capital that the bank owners have contributed, the bank has $20 of assets. Of the $20 of assets, $19 are financed with borrowed money—either by taking in deposits or issuing debt.

Open-Market Operations are where the CB conducts open-market operations when it buys or sells government bonds. To increase the money supply, the CB instructs its bond traders to buy bonds from the public in the nation’s bond markets. The dollars the Fed pays for the bonds increase the number of dollars in the economy.

CB to Banks: CB can also increase the quantity of reserves in the economy by lending reserves to banks. Banks borrow from the CB when they feel they do not have enough reserves on hand, either to satisfy bank regulators, meet depositor withdrawals, make new loans, or for some other business reason.

Traditionally, banks borrow from the CB’s discount window and pay an interest rate on that loan called the discount rate.

Reserve Requirements One way the CB can influence the reserve ratio is by altering reserve requirements, the regulations that set the minimum amount of reserves that banks must hold against their deposits.

Unconventional monetary policy: quantitative easing

We can think of the premium on an asset as determined by supply and demand for the asset. If the demand for an asset decreases, whether because buyers become more risk averse, or because some investors just decide not to hold the asset, the premium will increase. If, instead, the demand increases, the premium will decrease. This is true whether the increased demand comes from private investors or from the central bank.

This is the logic which led central banks to buy assets other than short term bonds, with the intention of decreasing the premium on those assets, and thus decreasing the corresponding borrowing rates with the aim of stimulating economic activity. They did this by financing their purchases through money creation, leading to a large increase in the money supply. Although the increase in the money supply had no effect on the policy rate, the purchase of these other assets decreased their premium, leading to lower borrowing rates and higher spending. These purchase programs are known as quantitative easing, or credit easing, policies.

Debt:

Do not confuse the words deficit and debt. Debt is a stock—what the government owes as a result of past deficits. The deficit is a flow—how much the government borrows during a given year.

Suppose that, starting from a balanced budget, the government decreases taxes, creating a budget deficit. What will happen to the debt over time? Will the government need to increase taxes later? If so, by how much?

We can write the budget deficit in year t as:

deficit t = r Bt – 1 + Gt – Tt

Bt – 1 is government debt at the end of year t – 1, or, equivalently, at the beginning of year t; r is the real interest rate, which we shall assume to be constant here. Thus, rBt – 1 equals the real interest payments on the government debt in year t.

Gt is government spending on goods and services during year t.

Tt is taxes minus transfers during year t.

In words: The budget deficit equals spending, including interest payments on the

debt, minus taxes net of transfers.

The government budget constraint then simply states that the change in government debt during year t is equal to the deficit during year t:

Bt – Bt – 1 = deficit t

If the government runs a deficit, government debt increases as the government

borrows to fund the part of spending in excess of revenues. If the government runs a surplus, government debt decreases as the government uses the budget surplus to repay part of its outstanding debt.

Using the definition of the deficit we can rewrite the government budget constraint as:

Bt – Bt – 1 = rBt – 1 + Gt – Tt

The government budget constraint links the change in government debt to the initial level of debt (which affects interest payments) and to current government spending and taxes. It is often convenient to decompose the deficit into the sum of two terms:

1. Interest payments on the debt, rBt – 1.

2. The difference between spending and taxes, Gt – Tt . This term is called the primary deficit (equivalently, Tt – Gt is called the primary surplus).

Money Growth and Inflation

The Classical Theory of Inflation

We begin our study of inflation by developing the quantity theory of money. This theory is often called “classical” because it was developed by some of the earliest economic thinkers

The Level of Prices and the Value of Money

The economy’s overall price level can be viewed in two ways. So far, we have viewed the price level as the price of a basket of goods and services. When the price level rises, people have to pay more for the goods and services they buy. Alternatively, we can view the price level as a measure of the value of money. A rise in the price level means a lower value of money because each dollar in your wallet now buys a smaller quantity of goods and services.

Suppose P is the price level as measured by the consumer price index or the GDP deflator. Then P measures the number of dollars needed to buy a basket of goods and services.

Now turn this idea around: The quantity of goods and services that can be bought with $1 equals 1/P. In other words, if P is the price of goods and services measured in terms of money, 1/P is the value of money measured in terms of goods and services.

When the price of a cone (P) is $2, then the value of a dollar (1/P) is half a cone. When the price (P) rises to $3, the value of a dollar (1/P) falls to a third of a cone. The actual economy produces thousands of goods and services, so we use a price index rather than the price of a single good. But the logic remains the same: When the overall price level rises, the value of money falls.

Money Supply, Money Demand, and Monetary Equilibrium

The supply and demand for money determines the value of money.

First consider money supply. In the preceding chapter, we discussed how the Federal Reserve, together with the banking system, determines the supply of money. When the Fed sells bonds in open-market operations, it receives dollars in exchange and contracts the money supply. When the Fed buys government bonds, it pays out dollars and expands the money supply. In addition, if any of these dollars are deposited in banks, which hold some as reserves and loan out the rest, the money multiplier swings into action, and these open-market operations can have an even greater effect on the money supply.

We ignore the complications introduced by the banking system and simply take the quantity of money supplied as a policy variable that the CB controls.

Now consider money demand. Most fundamentally, the demand for money reflects how much wealth people want to hold in liquid form. Many factors influence the quantity of money demanded. The amount of currency that people hold in their wallets, for instance, depends on how much they rely on credit cards and on whether an automatic teller machine is easy to find.

The quantity of money demanded depends on the interest rate that a person could earn by using the money to buy an interest bearing bond rather than leaving it in his wallet or low-interest checking account.

What ensures that the quantity of money the CB supplies balances the quantity of money people demand?

The answer depends on the time horizon being considered. The long- run answer, however, is much simpler. In the long run, money supply and money demand are brought into equilibrium by the overall level of prices.

If the price level is above the equilibrium level, people will want to hold more money than the CB has created, so the price level must fall to balance supply and demand.

If the price level is below the equilibrium level, people will want to hold less money than the CB has created, and the price level must rise to balance supply and demand. At the equilibrium price level, the quantity of money that people want to hold exactly balances the quantity of money supplied by the Fed.

What Is Seigniorage?

Seigniorage is the difference between the face value of money, such as a $10 bill or quarter coin, and the cost to produce it. In other words, the economic cost of producing a currency within a given economy or country is lower than the actual exchange value, which generally accrues to governments who mint the money. If the seigniorage is positive, the government will make an economic profit; while a negative seigniorage will result in an economic loss.

Seigniorage is the difference in face value of money, such as a $0.25 quarter coin, and the cost to produce it.

Seigniorage may be counted as positive revenue for a government when the money it creates is worth more than it costs to produce.

In some situations, the production of currency can result in a loss instead of a gain for the government creating the currency (e.g. producing copper pennies).

The Effects of a Monetary Injection

Imagine that the economy is in equilibrium and then, suddenly, the CB doubles the supply of money by printing some dollar bills and dropping them around the country from helicopters. (Or the CB could inject money into the economy by buying some government bonds from the public in open-market operations.)

What happens after such a monetary injection? How does the new equilibrium compare to the old one?

The monetary injection shifts the supply curve to the right from MS1 to MS2, and the equilibrium moves from point A to point B. As a result, the value of money (shown on the left axis) decreases from 1/2 to 1/4 , and the equilibrium price level (shown on the right axis) increases from 2 to 4.

When an increase in the money supply makes dollars more plentiful, the result is an increase in the price level that makes each dollar less valuable.

This explanation of how the price level is determined and why it might change over time is called the quantity theory of money.

According to the quantity theory, the quantity of money available in an economy determines the value of money, and growth in the quantity of money is the primary cause of inflation. As economist Milton Friedman once put it, “Inflation is always and everywhere a monetary phenomenon.”

The Classical Dichotomy and Monetary Neutrality

Economic variables should be divided into two groups. The first group consists of nominal variables—variables measured in monetary units. The second group consists of real variables— variables measured in physical units. For example, the income of corn farmers is a nominal variable because it is measured in dollars, whereas the quantity of corn they produce is a real variable because it is measured in bushels. Nominal GDP is a nominal variable because it measures the dollar value of the economy’s output of goods and services; real GDP is a real variable because it measures the total quantity of goods and services produced and is not influenced by the current prices of those goods and services. The separation of real and nominal variables is now called the classical dichotomy.

Nominal variables are influenced by developments in the economy’s monetary system, whereas money is largely irrelevant for explaining real variables.

Real variables, such as production, employment, real wages, and real interest rates, are unchanged. The irrelevance of monetary changes for real variables is called monetary neutrality.

When we say that the price of corn is $2 a bushel or that the price of wheat is $1 a bushel, both prices are nominal variables. But what about a relative price—the price of one thing compared to another? In our example, we could say that the price of a bushel of corn is 2 bushels of wheat. This relative price is not measured in terms of money. When comparing the prices of any two goods, the dollar signs cancel, and the resulting number is measured in physical units. Thus, while dollar prices are nominal variables, relative prices are real variables.

Velocity and the Quantity Equation

How many times per year is the typical dollar bill used to pay for a newly produced good or service? The answer to this question is given by a variable called the velocity of money: the rate at which money changes hands.

To calculate the velocity of money, we divide the nominal value of output (nominal GDP) by the quantity of money. If P is the price level (the GDP deflator), Y the quantity of output (real GDP), and M the quantity of money, then velocity is:

V = (P * Y)/M.

Suppose that the economy produces 100 pizzas in a year, that a pizza sells for $10,

and that the quantity of money in the economy is $50. Then the velocity of money is:

V = ($10 * 100)/$50

= 20.

In this economy, people spend a total of $1,000 per year on pizza. For this $1,000

of spending to take place with only $50 of money, each dollar bill must change

hands on average 20 times per year.

This equation can be rewritten as:

M * V = P * Y.

This equation states that the quantity of money (M) times the velocity of money (V) equals the price of output (P) times the amount of output (Y). It is called the quantity equation because it relates the quantity of money (M) to the nominal value of output (P * Y).

The quantity equation shows that an increase in the quantity of money in an economy must be reflected in one of the other three variables: The price level must rise, the quantity of output must rise, or the velocity of money must fall.

We now have all the elements necessary to explain the equilibrium price level and inflation rate. They are as follows:

1. The velocity of money is relatively stable over time.

2. Because velocity is stable, when the central bank changes the quantity of

money (M), it causes proportionate changes in the nominal value of output

(P* Y).

3. The economy’s output of goods and services (Y) is primarily determined by

factor supplies (labor, physical capital, human capital, and natural resources)

and the available production technology. In particular, because money is

neutral, money does not affect output.

4. With output (Y) determined by factor supplies and technology, when the

central bank alters the money supply (M) and induces proportional changes in

the nominal value of output (P * Y), these changes are reflected in changes in

the price level (P).

5. When the central bank increases the money supply rapidly, the result is a high rate of inflation.

The Inflation Tax

If inflation is so easy to explain, why do countries experience hyperinflation? That is, why do the central banks of these countries choose to print so much money that its value is certain to fall rapidly over time ?

The answer is that the governments of these countries are using money creation as a way to pay for their spending. When the government wants to build roads, pay salaries to its soldiers, or give transfer payments to the poor or elderly, it first has to raise the necessary funds. Normally, the government does this by levying taxes, such as income and sales taxes, and by borrowing from the public by selling government bonds. Yet the government can also pay for spending simply by printing the money it needs. When the government raises revenue by printing money, it is said to levy an inflation tax.

When the government prints money, the price level rises, and the dollars in your wallet become less valuable. Thus, the inflation tax is like a tax on everyone who holds money.

The Fisher Effect

To understand the relationship between money, inflation, and interest rates, recall the distinction between the nominal interest rate and the real interest rate. The nominal interest rate is the interest rate you hear about at your bank. If you have a savings account, for instance, the nominal interest rate tells you how fast the number of dollars in your account will rise over time.

The real interest rate corrects the nominal interest rate for the effect of inflation to tell you how fast the purchasing power of your savings account will rise over time. The real interest rate is the nominal interest rate minus the inflation rate:

Real interest rate = Nominal interest rate – Inflation rate.

For example, if the bank posts a nominal interest rate of 7 percent per year and the inflation rate is 3 percent per year, then the real value of the deposits grows by 4 percent per year. We can rewrite this equation to show that the nominal interest rate is the sum of the real interest rate and the inflation rate:

Nominal interest rate = Real interest rate – Inflation rate.

Consider how growth in the money supply affects interest rates. In the long run over which money is neutral, a change in money growth should not affect the real interest rate. The real interest rate is, after all, a real variable.

For the real interest rate not to be affected, the nominal interest rate must adjust one-for one to changes in the inflation rate. Thus, when the Fed increases the rate of money growth, the long-run result is both a higher inflation rate and a higher nominal interest rate. This adjustment of the nominal interest rate to the inflation rate is called the Fisher effect, after Irving Fisher (1867–1947), the economist who first studied it.

The Costs of Inflation

A Fall in Purchasing Power? The Inflation Fallacy:

When prices rise, buyers of goods and services pay more for what they buy. At the same time, however, sellers of goods and services get more for what they sell. Because most people earn their incomes by selling their services, such as their labor, inflation in incomes goes hand in hand with inflation in prices. Thus, inflation does not in itself reduce people’s real purchasing power.

A worker who receives an annual raise of 10 percent tends to view that raise as a reward for his own talent and effort. When an inflation rate of 6 percent reduces the real value of that raise to only 4 percent, the worker might feel that he has been cheated of what is rightfully his due. In fact, as we discussed in the chapter on production and growth, real incomes are determined by real variables, such as physical capital, human capital, natural resources, and the available production technology. Nominal incomes are determined by those factors and the overall price level. If the Fed were to lower the inflation rate from 6 percent to zero, our worker’s annual raise would fall from 10 percent to 4 percent. He might feel less robbed by inflation, but his real income would not rise more quickly.

Why then is inflation a problem?

Several costs of inflation: persistent growth in the money supply does, in fact, have some adverse effect on real variables:

Shoe leather Costs: How can a person avoid paying the inflation tax? Because inflation erodes the real value of the money in your wallet, you can avoid the inflation tax by holding less money. One way to do this is to go to the bank more often. For example, rather than withdrawing $200 every four weeks, you might withdraw $50 once a week. By making more frequent trips to the bank, you can keep more of your wealth in your interest-bearing savings account and less in your wallet, where inflation erodes its value. The cost of reducing your money holdings is called the shoe leather cost of inflation because making more frequent trips to the bank causes your shoes to wear out more quickly.

Menu Costs

Most firms do not change the prices of their products every day. Instead, firms often announce prices and leave them unchanged for weeks, months, or even years. One survey found that the typical U.S. firm changes its prices about once a year. Firms change prices infrequently because there are costs to changing prices. Costs of price adjustment are called menu costs, a term derived from a restaurant’s cost of printing a new menu. Menu costs include the costs of deciding on new prices, printing new price lists and catalogs, sending these new price lists and catalogs to dealers and customers, advertising the new prices, and even dealing with customer annoyance over price changes.

Inflation increases the menu costs that firms must bear. In the current U.S. economy, with its low inflation rate, annual price adjustment is an appropriate business strategy for many firms. But when high inflation makes firms’ costs rise rapidly, annual price adjustment is impractical. During hyperinflations, for example, firms must change their prices daily or even more often just to keep up with all the other prices in the economy.

Relative-Price Variability and the Misallocation of Resources

Suppose that the Eatabit Eatery prints a new menu with new prices every January and then leaves its prices unchanged for the rest of the year. If there is no inflation, Eatabit’s relative prices—the prices of its meals compared to other prices in the economy—would be constant over the course of the year. By contrast, if the inflation rate is 12 percent per year, Eatabit’s relative prices will automatically fall by 1 percent each month. Prices change only once in a while, inflation causes relative prices to vary more than they otherwise would.

Inflation-Induced Tax Distortions

Almost all taxes distort incentives, cause people to alter their behavior, and lead to a less efficient allocation of the economy’s resources. Many taxes, however, become even more problematic in the presence of inflation. The reason is that lawmakers often fail to take inflation into account when writing the tax laws. Economists who have studied the tax code conclude that inflation tends to raise the tax burden on income earned from savings.

A Special Cost of Unexpected Inflation: Arbitrary Redistributions of Wealth

Suppose that Sam Student takes out a $20,000 loan at a 7 percent interest rate from Bigbank to attend college. In 10 years, the loan will come due. After his debt has compounded for 10 years at 7 percent, Sam will owe Bigbank $40,000. The real value of this debt will depend on inflation over the decade. If Sam is lucky, the economy will have a hyperinflation. In this case, wages and prices will rise so high that Sam will be able to pay the $40,000 debt out of pocket change. By contrast, if the economy goes through a major deflation, then wages and prices will fall, and Sam will find the $40,000 debt a greater burden than he anticipated.

A hyperinflation enriches Sam at the expense of Bigbank because it diminishes the real value of the debt.

Inflation Is Bad, but Deflation May Be Worse

Some economists have suggested that a small and predictable amount of deflation may be desirable. Milton Friedman pointed out that deflation would lower the nominal interest rate (via the Fisher effect) and that a lower nominal interest rate would reduce the cost of holding money. The shoeleather costs of holding money would, he argued, be minimized by a nominal interest rate close to zero, which in turn would require deflation equal to the real interest rate. This prescription for moderate deflation is called the Friedman rule.

Moreover, in practice, deflation is rarely as steady and predictable as Friedman recommended. More often, it comes as a surprise, resulting in the redistribution of wealth toward creditors and away from debtors. Because debtors are often poorer, these redistributions in wealth are particularly painful.

Open Economy. Balance of payments. Imbalances. CA. FA. Sovereign debt. Foreign Exchange rates.

In balance of payments accounting, we need to keep track of flows of value both in

and out of the country and assign a positive sign to one direction and a negative sign to the other direction:

• A credit item (measured with a positive sign) is an item for which the country must be paid. It sets up the basis for a payment by a foreigner into the country—that is, it creates a monetary claim on a foreigner.

• A debit item (measured with a negative sign) is an item for which the country must pay. It sets up the basis for a payment by the country to a foreigner—that is, it creates a monetary claim owed to a foreigner.

Balance of payments accounting is just an international application of the fundamental accounting principle of double entry bookkeeping .

Double-entry bookkeeping has a key implication. If we add up all the positive items (credits) and all the negative items (debits) in a country’s balance of payments, the total will be— zero .

A balance that is positive is called a surplus, and negative balance is called a deficit .

Current Account

The current account includes all debit and credit items that are exports and imports of goods and services, income receipts and income payments, and gifts.

Exports and imports of goods (also called merchandise) are easy to understand. But what are the major services that are exported and imported? Tourism or travel services include the expenditures of foreign visitors on such items as hotel rooms, meals, and transportation. In addition, nations trade transportation, insurance, education, financial, technical, telecommunications, and other business and professional services.

Nations also pay each other royalties for use of technologies or brand names. If we add up all the items for exports and imports of goods and services, we get the goods and services balance, an important balance within the current account.

The balance on goods and services measures the country’s net exports.

The net value of flows of goods, services, income, and unilateral transfers is the

current account balance. As shown, the current account balance for 2013 is a deficit of $379 billion. Most of this current account deficit was the deficit in the goods and services balance.

Financial Account

The net value of flows of financial assets and similar claims (excluding official

international reserve asset flows) is the private financial account balance.

The values reported in the financial account are for the principal amounts only of assets traded—any flows of earnings on foreign assets are reported in the current account. Here are four possible items:

A U.S. resident increasing his holding of a foreign financial asset (a stock, a bond, or an IOU from a loan) is a debit. The U.S. individual is making a payment now (or extending a loan now) to the foreigner, so funds are flowing out of the United States now (negative item).

2. A foreign resident increasing her holding of a U.S. financial asset (a stock, a bond, or an IOU from a loan) is a credit. The U.S. seller (or borrower) is receiving payment now (or getting a loan now) from the foreigner, so funds are flowing into the United States now (a positive item).

3. A U.S. resident decreasing her holding of a foreign financial asset (a stock, a bond, or an IOU from a loan) is a credit. The U.S. individual is receiving a payment now (or receiving repayment of a previous loan) from the foreigner, so funds are flowing into the United States now (positive item).

4. A foreign resident decreasing his holding of a U.S. financial asset (a stock, a bond, or an IOU from a loan) is a debit. The U.S. buyer (or borrower) is making a payment now (or repaying a previous loan) to the foreigner, so funds are flowing out of the United States now (a negative item).

Official International Reserves

The third major part of the balance of payments keeps track of changes in official holdings of international reserves. Official international reserve assets are

money-like assets that are held by governments and that are recognized by governments as fully acceptable for payments between them.

The majority of countries’ official reserve assets are now foreign exchange

assets, financial assets denominated in a foreign currency that is readily acceptable in international transactions. For the United States, these foreign exchange assets are euro and Japanese yen assets.

For other countries these foreign exchange assets are often U.S. dollar assets. Two other small categories of official reserve assets are claims that a country has on the International Monetary Fund (IMF)—the country’s reserve position in the fund and the country’s holdings of special drawing rights (SDRs), a reserve asset created by the IMF.

Statistical Discrepancy

At the bottom of the accounts comes the suspicious item statistical discrepancy. If the flows on the two sides of every transaction were correctly recorded, there would not be any statistical discrepancy. In fact, as shown in the table, the statistical discrepancy for the balance of payments for 2013 was a credit of $28 billion, meaning that the credit items for the United States were less fully measured than its debit items.

The accountants add the statistical discrepancy to make the accounts balance and to warn us that something was missed. In fact, the statistical discrepancy understates what was missed. It is the net result of errors and omissions on both the credit and debit sides.

The current account balance (CA) has several meanings. The first meaning comes from the fact that all of the items in a country’s balance of payments must add to zero (because it is double-entry bookkeeping). All of the items other than the current account items are flows of international financial investments, both private or nonofficial (in the financial account) and official (changes in official international reserve assets).

• If the country has a current account surplus, then its foreign assets are growing faster than its foreign liabilities. Its net foreign investment is positive —it is acting as a net lender to the rest of the world.

• If the country has a current account deficit, then its foreign liabilities are growing faster than its foreign assets. Its net foreign investment is negative —it is acting as a net borrower from the rest of the world.

Examples of Paired Transactions:

You buy an ink-jet fax machine from the Italian company Olivetti and pay for your purchase with a $1,000 check. Your payment to buy a good (the fax machine) from a foreign resident enters the U.S. current account as a debit. But where is the offsetting balance of payments credit? Olivetti’s U.S. salesperson must do something with your check—let’s say he deposits it in Olivetti’s account at Citibank in New York. In this case, Olivetti has purchased, and Citibank has sold, a U.S. asset—a bank deposit worth $1,000—and the transaction shows up as a $1,000 credit in the U.S. financial account.

Suppose that during your travels in France, you pay $200 for a fine dinner at the Restaurant. Lacking cash, you place the charge on your Visa credit card. Your payment, which is a tourist expenditure, will be counted as a service import for the United States, and therefore as a current account debit. Where is the offsetting credit? Your signature on the Visa slip entitles the restaurant to receive $200 (actually, its local currency equivalent) from First Card, the company that issued your Visa card. It is therefore an asset, a claim on a future payment from First Card. So when you pay for your meal abroad with your credit card, you are selling an asset to France and generating a $200 credit in the U.S. financial account.

Imagine next that your Uncle Sid from Los Angeles buys a newly issued share of stock in the U.K. oil giant British Petroleum (BP). He places his order with his U.S. stockbroker, Go-for-Broke, Inc., paying $95 with funds from his Go-for-Broke money market account. BP, in turn, deposits the $95 Sid has paid into its own U.S. bank account at Second Bank of Chicago. Uncle Sid’s acquisition of the stock creates a $95 debit in the U.S. financial account (he has purchased an asset from a foreign resident, BP), while BP’s $95 deposit at its Chicago bank is the offsetting financial account credit (BP has expanded its U.S. asset holdings). The mirror-image effects on the U.S. balance of payments therefore both appear in the financial account

How the U.S. balance of payments accounts are affected when U.S. banks forgive (that is, announce that they will simply forget about) $5,000 in debt owed to them by the government of the imaginary country of Bygonia. In this case, the United States makes a $5,000 capital transfer to Bygonia, which appears as a $5,000 debit entry in the capital account. The associated credit is in the financial account, in the form of a $5,000 reduction in U.S. assets held abroad (a negative acquisition” of foreign assets, and therefore a balance of payments credit):

A country’s current account balance also is linked to domestic production, income,

and expenditure. A country’s current account balance is the difference between its

domestic production of goods and services and its total expenditures on goods and services. Recall from basic macroeconomics that domestic production of goods and services ( Y ) equals the demand for the country’s production,

Y = C + I d + G + X – M

where:

C = domestic household consumption of goods and services

I d = domestic real investment in buildings, equipment, software, and inventories

G = government spending on goods and services

X = foreign purchases of the country’s exports of goods and services

M = the country’s purchases of imports of goods and services from other

countries

CA = EX – IM.

The total value of its consumption, investment, and government purchases, at 110 bushels of wheat, is greater than its output of 100 bushels. This inequality would be impossible in a closed economy; it is possible in this open economy because Agraria now imports 40 gallons of milk, worth 20 bushels of wheat, but exports only 10 bushels of wheat. The current account deficit of 10 bushels is the value of Agraria’s borrowing from foreigners, which the country will have to repay in the future.

When a country’s imports exceed its exports, we say the country has a current account deficit. A country has a current account surplus when its exports its imports.

Y – (C + I + G) = CA.

It is only by borrowing abroad that a country can have a current account deficit and use more output than it is currently producing. If it uses less than its output, it has a current account surplus and is lending the surplus to foreigners.

The GNP identity has many illuminating implications:

In a closed economy, national saving always equals investment. This tells us that the closed economy as a whole can increase its wealth only by accumulating new capital Let S stand for national saving:

S = Y – C – G.

Since the closed-economy GNP identity, Y = C + I + G, may also be written as

I = Y – C – G, then

S = I

120

In a closed economy, saving and investment must always be equal, in an open economy they can differ. Remembering that national saving, S, equals Y – C – G and that CA = EX – IM, we can rewrite the GNP identity:

S = I + CA.

Unlike a closed economy, an open economy with profitable investment 0pportunities does not have to increase its saving in order to exploit them. The preceding expression shows that it is possible simultaneously to raise investment and foreign borrowing without changing saving.

Example: If New Zealand decides to build a new hydroelectric plant, it can import the materials it needs from the United States and borrow American funds to pay for them. This transaction raises New Zealand’s domestic investment because the imported materials contribute to expanding the country’s capital stock. The transaction also raises New Zealand’s current account deficit by an amount equal to the increase in investment. New Zealand’s saving does not have to change, even though investment rises. For this to be possible, however, U.S. residents must be willing to save more so that the resources needed to build the plant are freed for New Zealand’s use. The result is another example of inter temporal trade, in which New Zealand imports present output (when it borrows from the United States) and exports future output (when it pays off the loan).

Private and Government Saving

Unlike private saving decisions, however, government saving decisions are often made with an eye toward their effect on output and employment.

Private saving is defined as the part of disposable income that is saved rather than consumed.

Sp = Y – T – C.

Government saving is defined similarly to private saving. The government’s “income” is its net tax revenue, T, while its “consumption” is government purchases, G.

Sg = T – G.

S = Y – C – G = (Y – T – C) + (T – G) = Sp + Sg

Because S = Sp + Sg = I + CA,

Sp = I + CA – Sg = I + CA – (T – G) = I + CA + (G – T).

A country’s private saving can take three forms: investment in domestic capital (I), purchases of wealth from foreigners (CA), and purchases of the domestic government’s newly issued debt (G – T)

These meanings are using the U.S. current account deficit.

What would they mean for a country with a current account surplus ?

The country has positive net foreign investment (that is, the country is acting as a net lender to or investor in the rest of the world).

The country is saving more than it is investing domestically.

The country is producing more (and has more income from this production) than it is spending on goods and services.

Sovereign debt is a central government’s debt. It is debt issued by the national government in a foreign currency in order to finance the issuing country’s growth and development. The stability of the issuing government can be provided by the country’s sovereign credit ratings. Sovereign debt is also called government debt, public debt, and national debt.

Debt restructuring refers to two types of changes in the terms of debt:

• Debt rescheduling changes when payments are due, by pushing the repayments

schedule further into the future. The amount of debt is effectively the same, but the

borrower has a longer time to pay it off.

• Debt reduction lowers the amount of debt.

When a financial crisis hits a country because the country has more debt than it is willing or able to service, resolution of the crisis often requires debt restructuring.

By stretching out payments or reducing debt, the borrowing country gains a better chance of meeting a more manageable stream of current and future payments for debt service. A key issue is the process of reaching a restructuring agreement among creditors and borrowers.

There is a free-rider problem here. Each individual creditor has the incentive to hold out, hoping that others restructure their lending agreements, but not altering its own.

Exchange rates

Floating Exchange Rates

The simplest system is the floating exchange-rate system without intervention by governments or central bankers. The spot price of foreign currency is market driven, determined by the interaction of private demand and supply for that currency. The market clears itself through the price mechanism.

What makes the demand curve slope downward?

As the pound declines below $1.98, a sweater selling for £50 in London would cost

American tourists $99 (5 50 3 $1.98).

If the pound suddenly sank to $1.60, the same £50 wool sweater would cost American tourists only $80.

Fixed Exchange Rates

Here, officials strive to keep the exchange rate virtually fixed (or pegged) even if the rate they choose differs from the current equilibrium rate. Their usual procedure under such a system is to declare a narrow “band” of exchange rates within which the rate is allowed to vary. If the exchange rate hits the top or bottom of the band, the officials must intervene.

Example:

Consider an officially declared “par value” of $2.00, at which the pound is overvalued relative to its market-clearing rate of $1.60 per pound. British officials have announced that they will support the pound at 1 percent below par (about $1.98) and the dollar at 1 percent above par (about $2.02). They are forced to make good on this pledge by officially intervening in the foreign exchange market, buying £50 billion (and selling $99 billion, equal to £50 billion times $1.98 per pound). This intervention fills the gap AB between nonofficial supply and demand at the $1.98 exchange rate. 7 Only in this way can they bring the total demand for pounds, private plus official, up to the 320 billion of sterling money supplied.

Changes in exchange rates are given various names depending on the kind of exchange-rate regime prevailing. Under the floating-rate system a fall in the market price (the exchange-rate value) of a currency is called a depreciation of that currency; a rise is an appreciation.

We refer to a discrete official reduction in the otherwise fixed par value of a currency as a devaluation; revaluation is the antonym describing a discrete raising of the official par. Devaluations and revaluations are the main ways of changing exchange rates in a nearly fixed-rate system, a system where the rate is usually, but not always, fixed.

The Goods Market and the IS Relation

The equilibrium condition is given by

Y = C (Y – T) + I + G

Investment, Sales, and the Interest Rate

Investment depends primarily on two factors:

1. The level of sales. Consider a firm facing an increase in sales and needing to

Increase production. To do so, it may need to buy additional machines or build an

Additional plant. In other words, it needs to invest. A firm facing low sales will feel no

such need and will spend little, if anything, on investment.

2. The interest rate. Consider a firm deciding whether or not to buy a new machine.

Suppose that to buy the new machine, the firm must borrow. The higher the interest

rate, the less attractive it is to borrow and buy the machine. At a high enough interest

rate, the additional profits from using the new machine will not cover interest

payments, and the new machine will not be worth buying.

To capture these two effects, we write the investment relation as follows:

I = I(Y, i)

(+, -)

Determining Output

Taking into account the investment relation , the condition for equilibrium in the goods market becomes

Y = C(Y – T) + I(Y, i) + G

Production (the left side of the equation) must be equal to the demand for goods (the right side). This equation is our expanded IS relation.

What Happens to output when the interest rate changes?

For a given value of the interest rate i, demand is an increasing function of output, for two reasons:

1- An increase in output leads to an increase in income and thus to an increase in disposable income. The increase in disposable income leads to an increase in consumption.

2- An increase in output also leads to an increase in investment. This is the relation

between investment and production.

In short, an increase in output leads, through its effects on both consumption and

investment, to an increase in the demand for goods. This relation between demand

And output, for a given interest rate, is represented by the upward-sloping curve ZZ.

Deriving the IS Curve

The increase in the interest rate decreases investment. The decrease in

investment leads to a decrease in output, which further decreases consumption and

investment, through the multiplier effect.

(a) An increase in the interest rate decreases the demand for goods at any level of output, leading to a decrease in the equilibrium level of output.

(b) Equilibrium in the goods market implies that an increase in the interest rate

leads to a decrease in output.

The IS curve is therefore downward sloping.

Shifts of the IS Curve

We have drawn the IS curve taking as given the values of taxes, T, and government spending, G. Changes in either T or G will shift the IS curve.

The IS curve gives the equilibrium level of output as a function of the interest rate.

Now consider an increase in taxes, from T to T. At a given interest rate, say i,

disposable income decreases, leading to a decrease in consumption, leading in turn to

a decrease in the demand for goods and a decrease in equilibrium output: shift to the

left for a given interest rate, increases the equilibrium level of output—a decrease in

taxes, an increase in government spending, an increase in consumer confidence—causes the IS curve to shift to the right. drawn for given values of taxes and spending.

Remember that:

Nominal GDP = Real GDP multiplied by the GDP deflator:

$ Y = YP.

Equivalently:

Real GDP = Nominal GDP divided by the GDP deflator:

$ Y / P = Y.

Financial Markets and the LM Relation

Let’s now turn to financial markets. The interest rate is determined by the equality of the supply of and the demand for money:

M = $Y L(i)

Real Money, Real Income, and the Interest Rate

The equation M = $Y L(i) gives a relation between money, nominal income, and the

interest rate.

Recall that nominal income divided by the price level equals real income, Y. Dividing

both sides of the equation by the price level P gives:

M /P = Y L(i)

The advantage of writing things this way is that real income, Y, appears on the right

side of the equation instead of nominal income, $Y.

To make the reading lighter, we will refer to the left and right sides of

equation simply as “money supply” and “money demand” rather than the more

accurate but heavier “real money supply” and “real money demand.”

Deriving the LM Curve

In deriving the IS curve, we took the two policy variables as government spending, G,

and taxes, T. In deriving the LM curve, we have to decide how we characterize

Monetary policy, as the choice of M, the money stock, or as the choice of i, the interest rate.

If we think of monetary policy as choosing the nominal money supply, M, and, by

implication, given the price level which we shall take as fixed in the short run,

Choosing M/P, the real money stock, equation tells us that real money demand, the

right hand side of the equation, must be equal to the given real money supply, the left-

hand side of the equation.

If real income increases, increasing money demand, the interest rate must increase so

as money demand remains equal to the given money supply. In other words, for a

given money supply, an increase in income automatically leads to an increase in the interest rate.

Although, in the past, central banks thought of the money supply as the monetary

policy variable, they now focus directly on the interest rate. They choose an interest

rate, call it i, and adjust the money supply so as to achieve it.

We shall think of the central bank as choosing the interest rate (and doing what

it needs to do with the money supply to achieve this interest rate). This will make for an extremely simple LM curve, namely, a horizontal line.

Putting the IS and the LM Relations Together

The IS relation follows from goods market equilibrium. The LM relation follows from

financial market equilibrium. They must both hold.

IS relation: Y = C(Y – T) + I(Y, i) + G

LM relation: i = i

Together they determine output. Next figure plots both the IS curve and the LM

curve on one graph. Output is measured on the horizontal axis. The interest rate is measured on the vertical axis.

Any point on the downward-sloping IS curve corresponds to equilibrium in the goods

market. Any point on the horizontal LM curve corresponds to equilibrium in financial

markets.

Point A, with the associated level of output Y and interest rate iQ is the overall equilibrium.

Used properly, it allows us to study what happens to output when the central

bank decides to decrease the interest rate, or when the government decides to increase

taxes, or when consumers become more pessimistic about the future, and so on.

Fiscal Policy

Suppose the government decides to reduce the budget deficit and does so by

increasing taxes while keeping government spending unchanged. Such a reduction in

the budget deficit is often called a fiscal contraction or a fiscal consolidation. (An

increase in the deficit, either due to an increase in government spending or to a

called a fiscal expansion.) What are the effects of this fiscal contraction on

output, on its composition, and on the interest rate?

When you answer this or any question about the effects of changes in policy (or,

more generally, changes in exogenous variables), always go through the following

three steps:

1. Ask how the change affects equilibrium in the goods market and how it affects

equilibrium in the financial markets. Does it shift the IS curve and/or the LM curve, and, if so, how?

2. Characterize the effects of these shifts on the intersection of the IS and the LM

curves. What does this do to equilibrium output and the equilibrium interest rate?

3. Describe the effects in words.

Monetary Policy

Suppose the central bank decreases the interest rate.

Recall that, to do so, it increases the money supply, so such a change in monetary

Policy is called a monetary expansion. Conversely, an increase in the

interest rate, which is achieved through a decrease in the money supply, is called a

monetary contraction or monetary tightening.

Using a Policy Mix

The combination of monetary and fiscal policies is known as the monetary-fiscal

policy mix, or simply the policy mix.

Sometimes, the right mix is to use fiscal and monetary policy in the same direction.

Suppose for example that the economy is in a recession and output is too low. Then,

Both fiscal and monetary policies can be used to increase output.

The initial equilibrium is given by the intersection of IS and LM at point A, with

corresponding output Y. Expansionary fiscal policy, say through a decrease in taxes, shifts the IS curve to the right, from IS to IS.

Expansionary monetary policy shifts the LM curve from LM to LM. The new equilibrium is at A, with corresponding output Y. Thus, both fiscal and monetary policies contribute to the increase in output.

Higher income and lower taxes imply that consumption is also higher. Higher output

And a lower interest rate imply that investment is also higher.

1. A fiscal expansion means either an increase in government spending, or an

Increase in taxes, or both. This means an increase in the budget deficit (or, if the

Budget was initially in surplus, a smaller surplus). Running a large deficit and

increasing government debt may be dangerous. In this case, it is better to rely, at least in part, on monetary policy.

2. A monetary expansion means a decrease in the interest rate. If the interest

rate is very low, then the room for using monetary policy may be limited. In this case,

Fiscal policy has to do more of the job. If the interest rate is already equal to zero, the

case of the zero lower bound then fiscal policy has to do all the job.

3. Fiscal and monetary policies have different effects on the composition of output. A decrease in income taxes for example will tend to increase consumption

relative to investment. A decrease in the interest rate will affect investment more than consumption. Thus, depending on the initial composition of output, policy makers

want to rely more on fiscal or more on monetary policy.

4. Finally, neither fiscal policy nor monetary policy work perfectly. A decrease in

Taxes may fail to increase consumption. A decrease in the interest rate may fail to

investment. Thus, in case one policy does not work as well as hoped for, it is better to

use both.

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