Chap 9 Basic Macroeconomic Markets: Circular Flow of Income: Goods and Services Market: Businesses supply goods &

services in exchange for sales revenue. Households, investors, governments, and foreigners (net exports) demand goods. Resource Market: Highly aggregated market where business firms demand resources and households supply labor and other resources in exchange for income. Loanable Funds Market: Coordinates actions of borrowers and lenders. Foreign Exchange Market: Coordinates the actions of Americans that demand foreign currency (in order to buy things abroad) and foreigners that supply foreign currencies in exchange for dollars (so they can buy things from Americans). The resource market coordinates the actions of businesses demanding resources and households supplying them in exchange for income. The goods & services market coordinates the demand for and supply of domestic production (GDP). thte foreign exchange market brings the purchases (imports) from foreigners into balance with the sales (exports plus net inflow of capital) to them. The loanable funds market brings net household saving and the net inflow of foreign capital into balance with the borrowing of businesses and governments. Aggregate demand (AD) curve indicates the various quantities of domestically produced goods and services that purchasers are willing to buy at different price levels. The AD curve slopes downward to the right, indicating an inverse relationship between the amount of goods and services demanded and the price level. Other things constant, a lower price level will increase the wealth of people holding the fixed quantity of money, reduce the demand for money and lower real interest rates, and make domestically produced goods cheaper relative to foreign goods. Each of these factors tends to increase the quantity of goods & services purchased at the lower price level. Aggregate Supply curve include, Short-run: A period of time during which some prices, particularly those in resource markets, are set by prior contracts and agreements. Therefore, households and businesses are unable to adjust these prices when unexpected changes occur, including unexpected changes in the price level, and Long-run: A period of time of sufficient duration that people have the opportunity to modify their behavior in response to price changes. Short-Run Aggregate Supply (SRAS): various quantities of goods and services that domestic firms will supply in response to changing demand conditions that alter the level of prices in the goods and services market. The SRAS curve slopes upward to the right. The upward slope reflects the fact that in the short run an unanticipated increase in the price level will improve the profit margin of firms since many components of costs will be temporarily fixed as the result of prior longterm commitments. Firms respond to this increase in the price level with an expansion in output. Long-Run Aggregate Supply (LRAS) indicates the relationship between the price level & quantity of output after decision makers have had sufficient time to adjust their prior commitments where possible. LRAS is related to the economy's production possibilities constraint. A higher price level does not loosen the constraints imposed by the economy's resource base, level of technology, and the efficiency of its institutional arrangements and once people have time to adjust their long-term commitments, resource markets (and costs) will adjust to the higher levels of prices and thereby remove the incentive of firms to continue to supply a larger output. Thus, the LRAS curve is vertical. Full employment rate of output (YF) is at the vertical LRAS curve. Short-run equilibrium is present in the goods & services market at the price level P where the aggregate quantity demanded is equal to the aggregate quantity supplied. At this market clearing price, the amount that buyers want to purchase is just equal to the quantity that sellers are willing to supply during the current period: price were lower (higher) than P, general excess demand (supply). Long-run equilibrium requires that decision makers, who agreed to long-term contracts influencing current prices and costs, correctly anticipated the current price level at the time they arrived at the agreements. If NOT, buyers and sellers will want to modify the agreements when the long-term contracts expire. When Longrun equilibrium is present: Potential GDP is equal to the economys maximum sustainable output consistent with its resource base, current technology, and institutional structure. The Economy is operating at full employment. Actual rate of unemployment equals the natural rate of unemployment. Disequilibrium: Adjustments that occur when output differs from long-run potential. An unexpected change in the price level (rate of inflation) will alter the rate of output in the short-run. An unexpected increase in the price level will improve the profit margins of firms and thereby induce them to expand output and employment in the short-run. An unexpected decline in the price level will reduce profitability, which will cause firms to cut back on output and employment. Resources market: Demand for Resources: Business firms demand resources because they contribute to the production of goods the firm expects to sell at a profit. Supply of Resources: Households supply resources in exchange for income. Loanable Funds Market: The interest rate coordinates the actions of borrowers and lenders. From the borrower's viewpoint, interest is the cost paid for earlier availability. From the lenders viewpoint, interest is a premium received for waiting, for delaying possible expenditures into the future. The money interest rate is the nominal price of loanable funds. When inflation is anticipated, lenders will demand a higher money interest rate to compensate for the expected decline in the purchasing power of the dollar. The real interest rate is the real price of loanable funds. Money interest rate minus real interest rate is the inflationary premium. Foreign Exchange Market. Americans demand foreign currencies to import goods & services and make investments abroad. Foreigners supply their currency in exchange for dollars to purchase American exports and undertake investments in the United States. The exchange rate brings quantity demanded into balance with the quantity supplied and will bring (imports + capital outflow) into equality with (exports + capital inflow). The exchange rate will bring the quantity of foreign exchange demanded into equality with the quantity supplied. Imports - Exports (trade balance: deficit or surplus) = Capital inflow - Capital outflow (net capital flow: + or -). Trade deficits are generally indicative of something positive: a net inflow of capital because investors are confident about the future strength of the economy. Chap10 Dynamic Change, Economic Fluctuations, AD-AS Model: Anticipated changes are fully expected by economic participants and decision makers have time to adjust to them before they occur. Unanticipated changes catch people by surprise. The following factors will increase AD: an increase in real wealth (such as from a stock market boom), a decrease in the real interest rate, an increase in the optimism of businesses and consumers about future economic conditions (Consumer Sentiment Index), an increase in the expected rate of inflation, higher real incomes abroad, a reduction in the exchange rate value of the nations currency. A shift in LRAS (meaning production possibilities curve is altered) will cause SRAS to shift in the same direction. Changes that temporarily alter the productive capability will shift SRAS but not LRAS. Factors that increase LRAS: increase in the supply of resources, improvement in technology and productivity, institutional changes that increase the efficiency of resource use. Factors that increase SRAS: a decrease in resource prices, hence, production costs, a reduction in expected inflation, favorable supply shocks, such as good weather or a reduction in the world price of a key imported resource. Expansions in the productive capacity of the economy, like those resulting from capital formation or improvements in technology, will shift the economy's LRAS curve to the right. When growth of the economy is steady and predictable, it will be anticipated by decision makers. Anticipated increases in output (LRAS) need not disrupt macroeconomic equilibrium. In response to an unanticipated increase in AD for goods & services, prices rise to and output will increase, temporarily exceeding full-employment capacity. With time, resource market prices, including labor, rise due to the strong demand. Higher costs reduce SRAS. In the long-run, a new equilibrium at a higher price level and output consistent with original long-run potential will occur. A supply shock is an unexpected event that temporarily increases or decreases short-run aggregate supply. SRAS shifts to the right. Since the temporarily favorable supply conditions cannot be counted on in the future, the economys long-term production capacity will not be altered. If individuals recognize that they will be unable to maintain their current high level of income, they will increase their saving. Lower interest rates, and additional capital formation may result. If the adverse supply shock is temporary, resource prices will eventually fall in the future, shifting SRAS right and returning original equilibrium. If the adverse supply factor is permanent, the productive potential of the economy will shrink, LRAS shifts left and reaches a new equilibrium. When the actual and expected rates of inflation are equal: Inflation will be built into long term contracts and relative price is unchanged. An actual rate of inflation that is greater than anticipated is the equivalent of an increase in the price level -> Profits will be enhanced and firms will expand output. Recessions occur because prices in the goods and services market are low relative to the costs of production and resource prices. The two causes of recessions are: unanticipated reductions in AD, and, unfavorable supply shocks. Bring back to equilibrium of a recession, (1) real resource prices will tend to fall because the demand for resources will be weak and the rate of unemployment high, thus increases SRAS (2) real interest rates will tend to decline because of the weak demand for investment and will stimulate AD. An unsustainable boom occurs when prices in the goods and services market are high relative to resource prices and other costs. Economic expansions have been far more lengthy than recessions. Chap 11 Fiscal Policy: Keynesian View: Keynesian analysis indicated that fiscal policy could be used to maintain a high level of output and employment. Balanced presentation of current views on the potential and limitations of fiscal policy as a stabilization tool. Prior to the Great Depression, most economists thought market adjustments would direct an economy back to full employment rather quickly. Keynes argued that spending motivated firms to produce output. If spending fell because of pessimism and other factors, firms would reduce production. When an economy is in recession, Keynesians do not believe that reductions in either resource prices or interest rates will promote recovery. As a result, market economies are likely to experience recessions that are both severe and lengthy. In the Keynesian model, firms will produce the amount of goods and services they believe people plan to buy. Equilibrium occurs when total spending equals current output. When this is the case, producers have no reason to expand or contract output. If total spending (demand) is deficient (less than full employment output), inventories will rise and firms will reduce output and employment. In the Keynesian model, Total spending (AD) is key and fluctuations in total spending (AD) are the major source of economic instability. Keynes believed that the cause of the Great Depression was weak AD. The Multiplier Principle: an independent change in expenditures (such as investment) leads to an even larger change in aggregate output. It builds on the point that one individuals spending a portion of their additional earnings on consumption becomes the income of another. Growth in spending can expand output by a multiple of the original increase. The multiplier concept is based upon the proportion of additional income that households choose to spend on consumption: marginal propensity to consume (MPC). The term multiplier is also used to indicate the number by which the initial change in spending is multiplied to obtain the total increase in output. M = 1/(1-MPC). The multiplier concept also works in reverse reductions in spending will also be magnified and generate even larger reductions in income. Keynesians argue that the multiplier concept indicates that market economies have a tendency to fluctuate back and forth between excessive demand that generates an economic boom and deficient demand that leads to recession. An increase in government spending will require either higher taxes or additional government borrowing. This will often generate secondary effects, reducing spending in other areas. It takes time for the multiplier to work. The multiplier effect implies that the additional spending brings idle resources into production without price changes - this is unlikely to be the case during normal times. During normal times, the demand stimulus effect of additional spending is substantially weaker than the multiplier suggests. Budget deficit: present when total government spending exceeds total revenue from all sources. When the money supply is constant, deficits must be covered with borrowing. The U.S. Treasury borrows by issuing bonds. Budget surplus: present when total government spending is less than total revenue. Surpluses reduce the magnitude of the governments outstanding debt. Changes in the size of the budget deficit or surplus may arise from either a change in cyclical economic conditions or a change in discretionary fiscal policy. The federal budget is the primary tool of fiscal policy. Discretionary changes in fiscal policy: deliberate changes in government spending and/or taxes designed to affect the size of the budget deficit or surplus. Keynesian theory highlights the potential of fiscal policy as a tool capable of reducing fluctuations in AD. Rather than balancing the budget annually, Keynesians argue that counter-cyclical policy should be used to offset fluctuations in AD. This implies that the government should plan budget deficits when the economy is weak and budget surpluses when strong demand threatens to cause inflation. When recession, fiscal policy should be more expansionary: increase in government purchases of goods & services or reduction in taxes. Allowing the market to self-adjust may be a lengthy and painful process. Expansionary Fiscal Policy: At e1 (Y1), the economy is below its potential capacity YF. There are 2 routes to long-run full-employment equilibrium: Rely on lower resource prices to reduce costs and increase supply to SRAS2, restoring equilibrium at YF (E3).Alternatively, expansionary fiscal policy could stimulate AD (shift to AD2) and direct the economy back to YF (E2). When inflation is a potential problem, Keynesian analysis suggests fiscal policy should be more restrictive: reduction in government spending or increase in taxes. Why it is difficult to time fiscal policy changes in a manner that promotes stability: It takes time to institute a legislative change. There is a time lag between when a change is instituted & when it exerts significant impact. These time lags imply that sound policy requires knowledge of economic conditions 9 to 18 months in the future. But, our ability to forecast future conditions is limited. Therefore, discretionary fiscal policy is like a two-edged sword: If timed correctly (incorrectly), it may increase (reduce) economic instability. Automatic stabilizers: Without any delays with legislative action, these tools will institute counter-cyclical fiscal policy: increase the budget deficit during a recession and increase the surplus during an economic boom. Examples: unemployment compensation, corporate profit tax, progressive income tax. When substantial idle resources are present, increases in AD will lead primarily to an expansion in output and the impact on the general level of prices will be small. When an economy is at or near full employment, increases in AD will lead primarily to a higher price level rather than a substantial increase in output. Chap 12 Fiscal Policy: Others: There are secondary effects of fiscal policy which undermine effectiveness of fiscal policy and maintenance of AD. It also ignores important incentive effects of fiscal changes. Crowding-out effect: an increase in borrowing to finance a budget deficit will increase the demand for loanable funds and push real interest rates up and thereby retard private spending, reducing the stimulus effect of expansionary fiscal policy. Restrictive fiscal policy will reduce real interest rates and "crowd-in" private spending. Crowding-out effect in an open economy: Larger budget deficits and higher real interest rates attract foreign capital and lead to an inflow of capital, demand for dollar increases and appreciation in the dollar, and a decline in net exports. The larger deficits and higher interest rates trigger reductions in both private investment and net exports, which offset the expansionary impact of a budget deficit. The New Classical view stresses that: debt financing merely substitutes higher future taxes for lower current taxes, and budget deficits affect the timing of taxes, but not their magnitude. New Classical economists argue that when debt is substituted for taxes: people save the increased income so they will be able to pay the higher future taxes, thus, the budget deficit does not stimulate aggregate demand. New Classical economists believe that the real interest rate is unaffected by deficits as people save more in order to pay the higher future taxes and thus increase the supply of loanable funds. Fiscal policy does not affect aggregate demand, output, employment, or real interest rates. Public choice analysis indicates that legislators are delighted to spend money on programs that directly benefit their own constituents but are reluctant to raise taxes because they impose a visible cost on voters. Given the political incentives, budget deficits will be far more attractive than surpluses. It is important to distinguish between the use of discretionary fiscal policy to: promote economic stability (most people agree) and combat a severe recession (hot debate). Agreement: Proper timing of discretionary fiscal policy is both difficult to achieve and crucially important. Automatic stabilizers reduce fluctuations in AD and help direct the economy toward full employment. Fiscal policy is much less potent than the early Keynesian view implied. Debate: Keynesians believe that increases in government spending financed by borrowing will speed recovery from a severe recession because: the expansion in government spending will offset reductions in private spending, interest rates will be extremely low during a severe recession and therefore crowding out of private spending will be minimal, and increased government spending will trigger a substantial multiplier effect when widespread unemployment is present. Non-Keynesian critics argue that because: The expansion in government debt will mean higher future interest payments and tax rates that will retard future growth. Recessions reflect a coordination problem and increases in government spending are likely to worsen this problem, thereby slowing the recovery process. More politically directed spending will lead to more rent-seeking and less productive activity. Some argue that increases in government spending will expand GDP by more than tax reductions, because 100% of an increase in government purchases will be pumped into the economy, whereas part of the tax reduction will be saved or spent abroad. Or tax reduction will expand GDP by more than spending because a tax cut will stimulate AD more rapidly; is less likely to increase structural unemployment and reduce the productivity of resources; will be easier to reverse once the economy has recovered, and increase the incentive to earn, invest, produce, and employ others. From a supply-side viewpoint, the marginal tax rate is of crucial importance. A reduction in marginal tax rates increases the reward derived from added work, investment, saving, and other activities that become less heavily taxed. High marginal tax rates will tend to retard total output because they will: discourage work effort and reduce the productive efficiency of labor, adversely affect the rate of capital formation and the efficiency of its use, and encourage individuals to substitute less desired tax-deductible goods for more desired non-deductible goods. So, changes in marginal tax rates, particularly high marginal rates, may exert an impact on aggregate supply because they influence the relative attractiveness of productive activity compared to leisure and tax avoidance. Supply-side policies are designed to influence long-run growth (not short-run fluctuations). Countries with high taxes grow more slowly. U.S. Budget deficits generally increased during recessions and shrank during expansions, primarily as the result of automatic stabilizers rather than discretionary policy changes. Chap 13 Money and Banking: Money: A medium of exchange: an asset used to buy and sell goods and services; A store of value: an asset that allows people to transfer purchasing power from one period to another; A unit of account: a unit of measurement used by people to post prices and keep track of revenues and costs. Money is valuable because of the demand (for money) relative to its supply and it reduces the cost of exchange. If the purchasing power of money is to remain stable over time, its supply must be limited. When the supply of money grows rapidly relative to goods and services, its purchasing power will fall. Money supply includes M1 and M2. M1 are: currency, checking deposits (including demand deposits and interest-earning checking deposits) and traveler's check. M2 (a broader measure of money) includes: M1, savings, time deposits, and money market mutual funds. Money is an asset however the use of a credit card is merely a convenient way to arrange for a loan thus credit card balances are a liability. The banking industry includes: commercial banks, savings and loans, and credit unions. Banks accept deposits and use part of them to extend loans and make investments. Income from these activities is their major source of revenue. Banks play a central role in the capital market (loanable funds market): They help to bring together people who want to save for the future with those who want to borrow for current investment projects. Banks provide services and pay interest to attract checking, savings, and time deposits (liabilities). The U.S. banking system is a fractional reserve system; banks are required to maintain only a fraction of their assets as reserves against the deposits of their customers (required reserves): Vault cash and deposits held with the Federal Reserve count as reserves. Excess reserves (actual reserves in excess of the legal requirement) can be used to extend new loans and make new investments. Under a fractional reserve system, an

increase in deposits will provide the bank with excess reserves and place it in a position to extend additional loans, and thereby expand the money supply. Banks can increase money supply by lending money to other banks (like multiplier effect). The lower the percentage of the reserve requirement (ceiling on potential money creation), the greater the potential expansion in the money supply resulting from the creation of new reserves. The actual deposit multiplier will be less than the potential because: some persons will hold currency rather than bank deposits and some banks may not use all their excess reserves to extend loans. The Federal Reserve is responsible for the creation of a stable monetary climate for the entire U.S. economy. It regulates monetary policy: controls the money supply of the U.S., serves as a bankers bank or bank of last resort for U.S. banks, and regulates the banking sector. The Board of Governors (@ DC) is at the center of Federal Reserve operations. The board sets all the rates and regulations for the depository institutions. The seven members of the Board of Governors also serve on the Federal Open Market Committee (FOMC).The FOMC is a 12-member board that establishes Fed policy regarding the buying and selling of government securities (7 governors, NY president, 4 rotating president). 12 Federal Reserve District Banks. The independence of the Federal Reserve system is designed to strengthen the ability of the Fed to pursue monetary policy in a stabilizing manner. Fed independence stems from: the lengthy terms of the members of the Board of Governors (14 years) and the Feds revenues are derived from interest on the bonds that it holds rather than allocations from Congress. Fed four tools to increase money supply: Reserve requirements: setting the fraction of assets that banks must hold as reserves against their checking deposits; when the Fed lowers the required reserve ratio, it creates excess reserves for commercial banks allowing them to extend additional loans and expands the money supply; Open market operations: (the primary tool used by the Fed, U.S. Treasury bonds held by the Fed are part of the national debt) the buying and selling of U.S. government securities and other assets in the open market, When the Fed buys bonds the money supply expands because bond sellers acquire money and bank reserves increase, placing banks in a position to expand the money supply through the extension of additional loans; Extension of Loans: control of the volume of loans to banks and other financial institutions, a lower discount rate (the interest rate the Fed charges banks for short-term loans needed to meet reserve requirements) will make it cheaper for banks to borrow from the Fed and increase money supply; furthermore: the discount rate is related to federal funds (interest) rate in the federal funds market, a private loanable funds market where banks with excess reserves extend short-term loans to other banks trying to meet their reserve requirements; FOMC can reduce the fed funds rate by buying bonds, which will inject additional reserves into the banking system; longer-term loan: term auction facility (TAF) which created an auction procedure for credit provided by the Fed for an 84 day period and 5-10 year L/T loan to insurance companies and brokerage firms. Interest paid on bank reserves: setting the interest rate paid banks on reserves held at the fed to very low, possibly even zero to increase money supply. The U.S. Treasury is concerned with the finance of the federal expenditures and issues bonds to the general public to finance the budget deficits of the federal government. It does not determine the money supply. The Federal Reserve is concerned with the monetary climate of the economy, does not issue bonds, and is responsible for the control of the money supply and the conduct of monetary policy. CHAP 14. Monetary Policy. Keynesians argued that the money supply did not matter much. Monetarists argued that changes in the money supply caused both inflation and economic instability. Modern Keynesians and monetarists agree that monetary policy exerts an important impact on the economy. The quantity of money people want to hold (the demand for money) is inversely related to the money rate of interest, because higher interest rates make it more costly to hold money instead of interest-earning assets like bonds. The supply of money is vertical because it is established by the Fed and, hence, determined independently of the interest rate. Equilibrium: The money interest rate gravitates toward the rate where the quantity of money people want to hold (demand) is just equal to the stock of money the Fed has supplied. Transmission of Monetary Policy: Assume the Fed expands the supply of money by buying bonds, which will increase bank reserves, pushing real interest rates down, which leads to increased investment and consumption, a depreciation of the dollar leading to increased net exports, an increase in the general level of asset prices (and with the increased personal wealth, increased investment and consumption), an increase in the price level inflation. So, an unanticipated shift to a more expansionary monetary policy will stimulate aggregate demand and, thereby, increase both output and employment. If expansionary monetary policy leads to an in increase in AD when the economy is below capacity, the policy will help direct the economy toward LR full-employment output (LR change). Alternatively, if the demand-stimulus effects are imposed on an economy already at full-employment, they will lead to excess demand, higher product prices, and temporarily higher output. In the long-run, the strong demand pushes up resource prices, shifting short run aggregate supply left. The price level rises and output falls back to fullemployment output again. Suppose the Fed shifts to a more restrictive monetary policy by selling bonds, which will: depress bond prices and drain reserves from the banking system, which places upward pressure on real interest rates. As a result, an unanticipated shift to a more restrictive monetary policy reduces aggregate demand and thereby decreases both output and employment. Restrictive monetary policy will reduce aggregate demand. If the demand restraint occurs during a period of strong demand and an overheated economy, then it may limit or prevent an inflationary boom. If the reduction in aggregate demand takes place when the economy is at full-employment, then it will result in a recession. Proper timing of monetary policy is not easy: While the Fed can institute policy changes rapidly, there will be a time lag (6 to 18, even 36 months) before the change exerts much impact on output & prices. Given our limited ability to forecast the future, these lengthy time lags clearly reduce the effectiveness of discretionary monetary policy as a stabilization tool. Quantity theory of money: Money * Velocity = Price * Income, thus If V and Y are constant, then an increase in M will lead to a proportional increase in P. Thus, in the long run, money supply growth will lead primarily to higher prices (inflation) since decision makers eventually anticipate the higher inflation rate and build it into their choices and thus real interest rates, wages, and real output will return to their long-run normal level. The impact of monetary policy differs between the short and long-run. In the short-run, shifts in monetary policy will affect real output and employment. A shift toward monetary expansion will temporarily increase output. In the long-run, monetary expansion will only lead to inflation, consistent with the quantity theory of money. Shifts in monetary policy will influence the general level of prices and real output only after time lags that are long and variable. Given our limited forecasting ability, these time lags will make it difficult for policy-makers to institute changes in monetary policy that will promote economic stability. Constant shifts in monetary policy are likely to generate instability rather than stability. Movements of short-term interest rates (decrease -> expansion) have emerged as a reliable monetary policy indicator. Taylor rule provides an estimate of the federal funds rate (ffr)that would be consistent with both price stability and full employment: f = r + p + 0.5 * (p - p*) + 0.5 * (y - yp): target ffr = equilibrium real interest rate (assumed 2.5%) + actual inflation rate + 0.5 * (actual inflation rate - desired inflation rate, assumed 2%) + 0.5 * (output target output) => when inflation is low and current output well below its potential, more expansionary monetary policy and a lower ffr would be used. The Taylor rule is important because it provides both a guide for the conduct of monetary policy and a tool for the evaluation of how well it is being conducted. If the actual ffr is below the target rate implied by the Taylor rule, this indicates monetary policy is overly expansionary. The Feds low interest rate policy (2002-2004), followed by its more restrictive policy (2005-2006), contributed to the boom and bust in housing prices, and the Crisis of 2008. As the recession worsened during the second half of 2008, the Fed shifted toward a highly expansionary monetary policy. CHAP 15. Stabilization Policy. While economic ups and downs continue, note that the swings have been more moderate during the last 60 years in U.S. All economists favor the following goals: a stable growth of real GDP; a relatively stable level of prices; a high level of employment. Activists believe that policy-makers can respond to changing economic conditions and institute policy in a manner that will promote economic stability. Non-activists argue that discretionary use of monetary and fiscal policy in response to changing economic conditions is likely to do more harm than good. The time lag problem: It takes time to identify when a policy change is needed, additional time to institute the policy change, and still more time before the change begins to exert an impact on the economy. The forecasting problem: Because of the time lag problem, policy makers need to know what economic conditions will be like 12 to 24 months in the future. But, our ability to forecast future economic condition is limited (e.g. index of leading indicators). The political problem: Policy changes may be driven by political considerations rather than stabilization needs. The Index of Leading Indicators is a composite statistic for forecast based on 10 key variables that generally turn down prior to a recession and turn up before the beginning of an expansion. Adaptive Expectations: Individuals form their expectations about the future on the basis of data from the recent past => What actually occurs during the most recent period (or set of periods) determines an individuals future expectations and the expected future rate of inflation lags behind the actual rate by one period as expectations are altered over time. Rational Expectations: assumes people use all pertinent information, including data on the conduct of current policy, in forming their expectations about the future => People also consider the expected effects of changes in policy. With rational expectations, the forecasts of individuals will not always be correct, but people will not continue to make the same type of errors. Thus, the errors of rational decision makers will be random and not show a consistent pattern. Comparison: If adaptive expectations theory is correct, people will adjust more slowly. Systematic errors will occur under adaptive expectations, but not rational expectations. Under adaptive expectations: a shift to a more expansionary policy will increase aggregate demand and lead to a temporary increase in GDP and modest increase in prices. Under rational expectations, while the more expansionary policy does increase aggregate demand, resource prices and production costs rise just as rapidly and thus prices increase but real output does not. The relationship between the rates of inflation and unemployment is known as the Phillips curve: a lower rate of unemployment could be achieved if we were willing to tolerate a little more inflation (view in 60s). The early Phillips curve view was fallacious because it ignored the role of expectations. It is the actual rate of inflation relative to the expected rate that will influence both output and employment. When the actual rate is greater than (less than) the expected rate, unemployment will be less than (greater than) its natural rate. Macroeconomics is a relatively new area of study. Real world experience, research, and developments in economic theory have vastly expanded our knowledge of both the potential and limitations of fiscal and monetary policy. Areas of Agreement: Proper timing of monetary and fiscal policy changes is difficult. Therefore, constant policy swings are likely to do more harm than good. Expansionary policies that generate strong demand and inflation will not reduce the rate of unemployment below the natural rate at least not for long. Price stability is the proper goal of monetary policy. When the Fed keeps the inflation rate at a low and therefore easily predictable rate, it lays the groundwork for the smooth operation of markets and long-term healthy growth. Monetary policy that provides approximate price stability (persistently low rates of inflation) is the key to sound stabilization policy. Price stability will facilitate the smooth operation of the pricing system and the realization of these gains. Debates: Does fiscal policy exert much impact on AD? K (Yes), Non-K (No); During a severe recession, will an increase in government spending be more effective than a reduction in taxes to promote recovery? K (Yes), Non-K (No); Is economic instability the result of the natural tendencies of a market economy? K(Yes), Non-K (No, its policymakers fault). CHAP 17. International Trade. Reductions in transport and communication costs, as well as lower trade barriers have contributed to trade growth. Canada, China, Mexico, and Japan are the leading trading partners. International trade occurs because both the buyer and the seller expect to gain, and generally do. With international trade, a countrys residents can gain by specializing in the production of goods they can produce economically. Law of Comparative Advantage: A group of individuals, regions, or nations can produce a larger joint output if each specializes in the production of goods in which it is a low-opportunity cost producer and trades for goods for which it is a high opportunity cost producer. International trade leads to mutual gain because it allows each country to specialize more fully in the production of those things that it does best. Trade makes it possible for each country to use more of its resources to produce those goods and services that it can produce at a relatively low cost. International trade and specialization result in lower prices (and more domestic consumption) for imported products and higher prices (and less domestic consumption) for exported products. Trade makes it possible for domestic producers to obtain higher prices for the items they export and for domestic consumers to buy imported items at lower prices. International trade also leads to gains from: Economies of Scale: International trade allows both domestic producers and consumers to gain from reductions in per-unit costs that often accompany large-scale production, marketing, and distribution. More Competitive Markets: International trade promotes competition in domestic markets and allows consumers to purchase a wider variety of goods at economical prices. Trade restrictions: Tariff and Quota (Areas U & V are deadweight losses from reduction in allocative efficiency.) Proponents of trade restrictions often use the following arguments in an effort to justify their position: National defense argument: domestic industry is needed for national defense purposes. Dumping: the sale of goods abroad at a price below the cost of production (and below the domestic market price of the exporting nation). Dumping is illegal under U.S. law. Infant Industry argument: new industry needs protection so it can mature. When considering the merits of anti-dumping restrictions, remember that: Firms with large inventories (either domestic or abroad) may find it in their interest to offer goods at prices below their original cost of production. Domestic firms are legally allowed to engage in this practice. Lower prices benefit domestic consumers. The special interest effect provides the primary explanation for trade restrictions. Trade restrictions almost always provide highly visible, concentrated benefits for a small group of people, while imposing widely dispersed costs that are often difficult to identify on the general citizenry. Politicians have a strong incentive to favor special interest issues, even if they conflict with economic efficiency. Trade fallacy 1:Trade restrictions that limit imports save jobs for Americans. This view is false because if foreigners sell less to us they will have fewer dollars with which to buy things from us. Thus, restraints on imports will also restrain exports => reshuffle jobs. Trade fallacy 2: "Free trade with low-wage countries, such as Mexico and China, will reduce the wages of Americans." Both high- and low-wage countries will gain when they are able to focus more of their resources on those productive activities that they do well. Propelled by technological advancements, lower transport costs, and more liberal trade policies, international trade has approximately doubled. More open economies both achieved higher income levels and grew more rapidly. NAFTA: U.S. trade with both Canada and Mexico grew rapidly. Today, less developed countries are often at the forefront of those pushing for greater trade openness, while highincome countries often impose restrictions in order to protect various domestic industrial interests and preserve their farm subsidy programs. CHAP18 International Finance. Foreign Exchange Market. An appreciation of a nations currency will make domestic goods more expensive. Under a flexible rate system, the exchange rate is determined by supply and demand. The dollar demand for foreign exchange originates from U.S. purchases for foreign goods, services, and assets (real and financial). The supply of foreign exchange originates from sales of goods, services, and assets from Americans to foreigners. Factors that cause a currency to depreciate (demand decrease): a rapid growth of income (relative to trading partners) that stimulates imports relative to exports; a higher rate of inflation than one's trading partners (impair export); a reduction in domestic real interest rates (relative to rates abroad)(less investment); a reduction in the attractiveness of the domestic investment environment that leads to an outflow of capital. Effects of fiscal policy (expansion) on currency: GDP up (dep), price up (dep), interest rate up (app) = > final: appreciate since capital moves faster than goods and services; monetary policy (expansion): GDP up (dep), price up (dep), interest rate down (dep) => final: depreciate.