Econ Part Three

Does not interact with other economies in the world

Interacts freely with other economies around the world

Domestically-produced goods and services sold abroad

Foreign-produced goods and services sold domestically

• Aka, the trade balance
• = value of exports - value of imports

• Consumer's preferences for foreign and domestic goods
• Prices of goods at home and abroad
• Incomes of consumers at home and abroad
• The exchange rates at which foreign currency trades for domestic currency
• Transportation costs
• Govt policies

An excess of import over exports

An excess of exports over imports

When exports = imports

• Domestic residents' purchases of foreign assets
• minus
• foreigners' purchases of domestic assest
• NCO is also called net foreign investment

Domestic residents actively manage the foreign investment, (ie Second cup in Russia)

Domestic residents purchase foreign stocks or bonds, supply "loanable funds" to a foreign firm

• NCO measures the imbalance in a courntrys trade in assets:
• When NCO > 0, "capital outflow": Domestic purchases of foreign assets exceed foreign purchases of domestic assets (capital flowing out)
• When NCO < 0, "capital inflow": foreign purchases of domestic assets exceed domestic purchases of foreign assets

• Real interest rates paid on foreign assets
• Real interest rates paid on domestic assets
• Perceived risks of holding foreign assets
• Govt policies affecting foreign ownership of domestic assets

• An accounting identity: NCO = NX
• -arises because every transaction that affects NX also affects NCO by the same amount
• When a foreigner purchases a good from Canada; Canadian exports and NX increase; the foreigner pays with currency or assets, so that Canadian acquires some foreign assets, causing NCO to rise

• Y=C+I+G+NX
• S=Y-C-G so
• S=I+NCO (since NX =NCO)
• When S>I, the excess loanable funds flow abroad in the form of positive net capital outflow
• When S<I, foreigners are financing some of the country's investment, and NCO<0

• The rate at which one country's currency trades for another
• Looked at (for this course) in units of foreign currency per on Canadian dollar

(or "strengthing"): an increase in the value of a currency as measured by the amount of foreign currency it can buy

(or "weakening"): a decrease in the value of a currency as measured by the amount of foreign currency it can buy

• The rate at which the g&s of one country trade for the g&s of another
• (e x P)/P*
• When P = domestic price
• P* = foreign price (in foreign currency)
• e = nominal exchange rate (ie. foreign currency per unit of domestic currency

The notion that a good should sell for the same price in all markets

• A theory of exchange rates whereby a unit of any currency should be able to buy the same quantity of goods in all countries
• Based on the law of one price
• Implies that nominal exchange rates adjust to equalize the price of a basket of goods across countries
• e = P* / P

• PPP implies that the nominal exchange rate between 2 countries should equal the ratio of price levels
• If the 2 countries have different inflation rates, then e will change over time
• Thus, the greater a country's imflation rate, the faster its currency should depreciate (relative to a low-inflation country like Canada)

• Two reasons why the exchange rates do not always adjust to equalize prices across countries:
• -many goods cannot be easily traded
• Foreign, domestic goods not perfect substitutes

• "Small" means a small part of the world economy
• Canada is an economy with perfect capital mobility because: Canadians have full access to world financial markets, and the rest of the world has full access to the Canadian financial market
• This means that the real interest rate prevailing in the world: r = r^w

The theory that the real interest rate in Canada should equal that in the rest of the world is known as interest rate parity

• Real interest rate in Canada is not always equal to the real interest rate int eh rest of the world for 2 reasons:
• Financial assets carry with them the possibility to default
• Financial assets offered for sale in different tax regimes may result in different after-tax returns

Periods of falling real incomes and rising unemployment

Sever recessions (very rare)

Short-run economic fluctuations

• 1. EF are irregular and unpredictable
• 2. Most macroeconomic quantities fluctuate together
• 3. As output falls, unemployment rises

• A model used to explain short-run fluctuations in economic activity around its long-run trend
• Differs from the classical economic theories economists use to explain the long run
• In the short run, changes in nominal variable (like the money supply or P) can affect real variables (like Y or the u-rate).
• To study the short run, we use a new model

• The Classical Dichotomy, the separation of variables into two groups: real - quantities, relative prices; nominal - measured in terms of money
• The neutrality of money: changes in the money supply affect nominal but not real variables

• Shows the quantity of goods and services that households, firms, and the government want to buy at each price level
• ADC = Spending

• Shows the quantity of goods and services that firms choose to produce and sell at each price level
• ASC = output

Shows the quantity of all g&s demanded in the economy at any given price level

• Y = C+I+G+NX
• Assume G fixed by govt policy. To understand the slope of AD, must determine how a change in P affect C, I, and NX

• Suppose P rises
• -the dollars people hold buy fewer g&s, so real wealth is lower
• -people feel poorer
• Result: C falls

• Suppose P rises
• -Buying g&s requires more dollars.
• -To get these dollars, people sell bonds or other assets
• -This drives up interest rates
• Result: I falls (recall, I depends negatively on the interest rates)

• Suppose P rises
• -Canadian interest rates rise (the interest-rate effect)
• -Foreign investors desire more Canadian bonds
• -Higher demand for $ in foreign exchange market
• -Canadian exchange rate appreciates
• -Canadian exports more expensive to people abroad, imports cheaper to Canadian residents
• Result: NX falls

• An increase in P reduces the quantity of g&s demanded because:
• -the wealth effect (C falls)
• -the interestrate effect I (falls)
• -the exchange-rate efect (NX falls)

• Any event that changes C, I, G, or NX - except a change in P - will shift the AD curve
• Changes in C (stockmarket boom/crash, tax hikes/cuts)
• Changes in I (firms by new computers, expectaions, optimism/ pessimism, interest rates, monetary policy, tax incentives)
• Changes in G (federal spending, provincial & municipal spending)
• Changes in NX (booms/recessions in countries that buy our exports, appreciation/depreciation resulting from international speculation in foreign exchange market)

• The AS curve shows the total quantity of g&s firms produce and sell at any given price level
• It is upward-sloping in the short-run and vertical in the long run

The natural rate of output (Y_N) is the amount of output the economy produces when unemployment is at its natural rate. Y_N is also called potential output or full-employment output

• Y_N determined by the economy's stocks of labour, capital, and natural resources, and on the level of technology.
• An increase in P does not affect any of these, so it does not affect Y_N (classical dichotomy)

• Any event that changes any of the determinants of Y_N will shift LRAS
• Changes in L or natural rate of unemployment: immigration, boby-boomers retire, govt policies reduce natural U-rate
• Changes in K or H: investment in factories, equipment; more people get college degrees; factories destroyed by a hurricane
• Changes in Natural resources: discovery of new mineral deposits, reduction in supply of imported oil, changing weather patterns that affect agricultural production
• Changes in technology: productivity improvements from technological progress

• Over the long run, tech. progress shifts LRAS to the right and growth in the money supply shifts AD to the right.
• Result: ongoing inflation and growth in output.

The SRAS curve is upward sloping: over the period of 1-2 years, an increase in P causes an increase in the quantity of G&S supplied

• If AS is vertical, fluctuations in AD do not cause fluctuations in output or employment
• If AS slopes up, then shifts in AD do affect output and employment
• (if shift causes less the Y_N - deflationary gap, and larger then Y_N - inflationary gap

• 1. The sticky-wage theory
• 2. The sticky-price theory
• 3. The misperceptions theory
• In each, some type of market imperfection
• Result: Output deviates from its natural rate when the actual price level deviates from the price level people expected
• Y = Y_N + a ( P - P_E)

• Imperfection: Nominal wages are sticky in teh short run, they adjust sluggishly (due to labour contracts and social norms)
• Firms and workers set the nominal wage in advance based on P_E, the price level they expect to prevail
• If P>P_E, revenue is higher, but labour cost is not.  Production is more profitable, so firms increase output and employment
• Hence, higher P caused higher Y, so the SRAS curve slopes upward

• Imperfection: many prices are sticky in the short run. Due to menu costs, the costs of adjusting prices.
• Firms set sticky prices in advance based on P_E
• Suppose BoC increases money supply unexpectedly.  In long run, P rises.  In short run, firms without menu costs can raise their prices immediately. Firms with menu costs wait to raise prices.  Meantime, their prices are relatively low, which increases demand for their products, so they increase output and employment. Hence, higher P is associated with higher Y, so the SRAS curve slopes upward

• Imperfection: Firms may confuse changes in P with changes in the relative price of the products they sell. 
• If P rises above P_E a firm sees its price rise before realizing all prices are rising. The firm may believe its relative price is rising and may increase output and employment. So, an increase in P can cause an increase in Y, making the SRAS curve upward-sloping

• The imperfections in these theories are temporary. Over time: stickey wages and prices become flexible, and misperceptions are corrected.
• In the LR, P_E = P
• AS curve is vertical

• Everything that shifts LRAS shifts SRAS, too
• Also, P_E shifts SRAS:
• If P_E rises, workers & firms set higher wages. At each P, production is less profitable, Y falls, SRAS shifts left

• In the long-run equilibrium
• P_E = P
• Y = Y_N
• and unemployment is at its natural rate

• Caused by events that shift the AD and/or AS curves
• 1. Determine whether the event shifts AD or AS
• 2. Determine whether curve shifts left or right
• 3. Use Ad-As diagram to see how the shift changes Y and P in the short run
• 4. Use AD-AS diagram to see how economy moves from new SR eq'm to new LR eq'm

A period of falling output and rising prices (when the SRAS shifts to the left)

• In the long run, we are all dead. 
• Governments need to play a role in bettering the economy, by shifting the AD to lessen the affect of stagnation

• The wealth effect
• The interest-rate effect (this is most important)
• The exchange-rate effect

• A simple theory of the interest rate (denoted r)
• r adjusts to balance supply and demand for money
• Money supply: assume fixed by central bank, does not depend on interest rate.
• Money demand reflects how much wealth people want to hold in liquid form
• For simplicity, suppose household wealth includes only 2 assets: Money- liquid but pays no interest; bonds - pay interest by not as liquid
• A household's "money demand" reflects its preference for liquidity
• The variables that influence money demand: Y, r, and P.

• Suppose real income (Y) rises. Other things equal, what happens to money demand?
• If Y rises: households want to buy more g&s, so they need more money; to get this money, they attempt to sell some of their bonds.
• An increase in Y causes and increase in money demand, other things equal.

• MS curve is vertical: changes in r do not affect MS, which is fixed by the BoC
• MD curve is downward sloping: a fall in r increases money demand
• A fall in r increases I and the quantity of g&s demanded

• To achieve macroeconomic goals, the BoC can use monetary policy to shift the AD curve
• The BoC can change the money supply by buying and selling government bonds by conducting open market operation
• This changes the interest rate and shifts the AD curve

• A monetary injection by the BoC
• -causes the dollar to depreciate in value
• -the dollar depreciation causes net exports to rise
• -there is an addtional increase in demand for Canadian-produced goods and services not realized in a closed economy; and
• -in the end, a monetary injection in an open economy shifts the aggregate-demand curve farther to the right than in a closed economy

• The setting of the level of govt spending and taxation by govt policymakers
• This has 2 effects on AD
• 1. The multiplier effect
• 2. The crowding out effect

• An increase in G and/or decrease in T
• Shifts AD right

• A decrease in G and/or increase in T
• Shifts AD left

The additional shifts in AD that result when fiscal policy increases income and thereby increases consumer spending

• the fraction of extra income that households consumer rather than save
• If MPC = 0.8 and income rises $100, C rises $80

• Delta Y = 1/(1-MPC) x delta G
• A bigger MPC means changes in Y cause bigger changes in C, which in turn cause more changes in Y

• Fiscal policy has another effect on AD that works in the opposite direction
• A fiscal expansion raises r, which reduces the investment, which reduced the net increase in agg demand
• So the size of the AD shift may be smaller than the initial fiscal expansion

• Canada's interest rate must equal the world interest rate
• The interest rate increased as a result of the increased government spending
• Higher interest rate increases demand for Canadian assets and therefore the Canadian dollar

• If the BoC allows the exchange rate to be flexible, the dollar appreciates, which makes Canadian-produced goods and services relatively more expensive, and Canada's net exports fall
• This is an additional crowding out effect (on net exports) that reduced the demand for Canadian-produced goods and service
• In the end, fiscal policy has no lasting effect on aggregate demand
• To prevent the appreciation of the dollar: the BoC increases the money supply by selling dollars in the market for foreign currency exchange; this increase in the money supply also prevents the interest rate from changing
• As a result, both forms of crowding out are avoided
• In the end, the fiscal expansion has a large effect on aggregate demand

• A tax cut increases household's take-home pay.
• Households respond by spending a portion of this extra income, shifting AD to the right.
• The size of the shift is affected by the multiplier and crowding-out effects
• The change in the position of the AD curve will depend on the BoC's decision to let the exchange rate to change

• Deficit reduction can be accomplished with reduced government spending, increased taxes, or a combination of the two
• Deficit reduction can have a minimal impact on the level of aggregate demand if the central bank adopts the appropriate exchange-rate policy

• Changes in fiscal policy that stimulate agg demand when economy goes into recession, without policymakers having to take any deliberate action
• Ie, the tax system, govt spending

depends mainly on growth in the money supply

(the "natural rate") depends on the minimum wage, the generosity of EI, the market power of unions, efficiency wages, and the process of job search

• Shows the short-run trade-off between inflation and unemployment
• Downward sloping

• The claim that unemployment eventually returns to its normal or "natural" rate, regardless of the inflation rate
• Based on the classical dichotomy and the vertical LRAS curve

A measure of how much people expect the price level to change

• Short run: BoC can reduce u-rate below the natrual u-rate by making inflation greater than expected
• Long run: expectation catch up to reality, u-rate goes back to natrual u-rate whether inflation is high or low

• An event that directly alters firms' costs and prices, shifting the AS and PC curves
• Example: large increase in oil prices

• A reduction in the inflation rate
• To reduce inflation, BoC must slow the rate of money growth, which reduced agg demand
• Short run: output falls and unemployment rises
• Long run: output & unemployment return to their natural rates

• Percentage points of annual output lost per 1 percentage point reduction in inflation
• Typical estimate of the sacrifice ratio 2 : 5
• Reducing inflation 1% requires a sacrifice of 2% to 5% of a year's output (or 1% to 2.5% percentage points of unemployment = Okun's law)

• A theory according to which people optimally use all the information they have, including info about govt policies, when forecasting the future
• Expected inflation explains why there is a tradeoff between inflation and unemployment in the short run, but no in the long run.
• Implied that disinflation could be much less costly...

• Some economists believe that if the central bank makes a credible statement of its intention to deflate, that lower rates of inflation can be obtained at smaller cost
• Keeping inflation close to zero, from 1-2%

The stability in the rate of inflation is indicative of how over this period, expectations had become firmly "anchored" around the BoC's inflation target