2020 L1 Macroeconomics

Aggregate Output, Prices and Economic Growth
a. calculate and explain gross domestic product (GDP) using expenditure and income
approaches;
b. compare the sum-of-value-added and value-or-final-output methods of calculating

GDP;
c. compare nominal and real GDP and calculate and interpret the GDP deflator;
d. compare GDP, national income, personal income, and personal disposable income;
e. explain the fundamental relationship among saving, investment, the fiscal balance,
and the trade balance;
f. explain the IS and LM curves and how they combine to generate the aggregate
demand curve;
g. explain the aggregate supply curve in the short run and long run;
h. explain causes of movements along and shifts in aggregate demand and supply curve;
i. describe how fluctuations in aggregate demand and aggregate supply cause short-run
changes in the economy and the business cycle;
j. distinguish between the following types of macroeconomic equilibria: long-run full

employment, short-run recessionary gap, short-run inflationary gap, and short-run
stagflation;
k. explain how a short-run macroeconomic equilibrium may occur at a level above or

below full employment;
l. analyze the effect of combined changes in aggregate supply and demand on the
economy;
m. describe sources, measurement, and sustainability of economic growth;
n. describe the production function approach to analyzing the source of economic

growth;
o. distinguish between input growth and growth of total factor productivity as

components of economic growth.
Prepared exclusively for Matthew Maselle ,matthewmaselle@gmail.com

Transaction: 0066205454,
Aggregate Output, Prices, and Economic Growth
Aggregate output (AO) = Aggregate Income (AI) LOS a

-calculate
- value of all g/s produced - value of all payments
-explain
in a specified time period earned by the suppliers of the Pg-1
factors of production
wages, rent, interest, profit

Households
Indirect Direct - since households are the ultimate
Funds
Investment Investment owners of productive assets, plus
Companies the source of all labour, it is
Productive Assets standard to attribute all income
to the household sector
➞ Aggregate Expenditure (AE) ➞ total amount spent on g/s produced in
the domestic economy during a period
A0 = AI = AE = Y
➞ GDP – gross domestic product ➞ measures: LOS a

-calculate
a) the market value of all final g/s produced within
-explain
an economy in a given period of time (output definition)
Pg-2
- all g/s must be produced during the measurement period
- excluded ➞ previous period production, transfer pmts.
from gov’t to households, capital gains
- only g/s whose value can be determined by being sold
in a market
- only market value of final g/s are included
or/ b) the aggregate income earned by all households, all companies, and
the government within the economy in a given period of time
(income definition)
∴ Income approach ➞ GDP = total amt. of income earned (over a period)
Expenditure approach ➞ GDP = total amount spent (over a period)

➞ value of GDP based on expenditure ➞ 2 measurement LOS b
methods -compare
Pg-3
1/ value of final output
(Exhibit #2)
2/ sum of value added
(example #1)
Note: g/s whose market price cannot be determined:
- use imputed price
e.g. owner-occupied housing ➞ purchase/sale of houses not included
➞ estimate of ‘rent’ is included instead
government services ➞ included at cost with no value-added
➞ non-market transactions, barter and black market/illegal activities
are excluded
➞ Nominal vs. Real GDP/ LOS c

· real GDP ➞ removes the effect of changes in the -compare
-calculate
general price level
-interpret
Pg-4
· per capita real GDP ➞ real GDP/population ➞ measures the standard
of living in an economy
· nominal GDP ➞ value of g/s produced at current prices
e.g./
output Price nominal GDP
YR 1 300,000 18,750 5.625B
7% growth in nominal GDP
YR 2 300,000 20,062.50 6.01875B
Pt × Qt
- real GDP ➞ PB × Qt = 18,750 × 300,000 = 5.625B➞ 0% growth in real GDP
base year
- if YR 2 output = 309,000, real GDPYR2 = 18,750 × 309,000 = 5.79375 B
3% growth in GDPr

➞ GDP deflator (or implicit price deflator for GDP) LOS c
-compare
𝐧𝐨𝐦𝐢𝐧𝐚𝐥 𝐆𝐃𝐏 𝟏𝟎𝟎 × 𝐆𝐃𝐏𝐧 -calculate
𝐆𝐃𝐏 𝐝𝐞𝐟𝐥𝐚𝐭𝐨𝐫 = × 𝟏𝟎𝟎 5⇒ 𝐆𝐃𝐏𝐫 = 7 -interpret
𝐫𝐞𝐚𝐥 𝐆𝐃𝐏 𝐆𝐃𝐏 𝐝𝐞𝐟𝐚𝐥𝐭𝐨𝐫
Pg-5
- using YRZ data at 309,000 units, €20,062.50/unit
(𝟑𝟎𝟗, 𝟎𝟎𝟎 × 𝟐𝟎, 𝟎𝟔𝟐. 𝟓𝟎) 𝟐𝟎, 𝟎𝟔𝟐. 𝟓𝟎

= × 𝟏𝟎𝟎 = × 𝟏𝟎𝟎 = 𝟏𝟎𝟕
(𝟑𝟎𝟗, 𝟎𝟎𝟎 × 𝟏𝟖, 𝟕𝟓𝟎) 𝟏𝟖, 𝟕𝟓𝟎
e.g. output ↑ 3%
➞ also: 𝐧𝐨𝐦𝐢𝐧𝐚𝐥 𝐆𝐃𝐏 = [(𝟏 + 𝐆𝐃𝐏𝐫 )(𝟏 + 𝐢𝐧𝐟𝐥𝐚𝐭𝐢𝐨𝐧)] − 𝟏 prices ↑ 7%
GDPn = [(1.03)(1.07)] – 1
(example #2)
= 10.2%
➞ Components of GDP/ LOS d

-compare
Pg-6
GDP = C + I + G + (x – m)
C = consumer spending
G = government spending
= GC + GI
I = private domestic
investment
(capital goods + Inventory)
x = exports
m = imports
GDP = (C + GC) + (I + GI) + (x – m)

➞ household sector = C + S LOS d
➞ Investment (I) most volatile component of GDP -compare
➞ Government (G), next Taxes (T) = gross taxes – transfer payments Pg-7
if G > T ➞ fiscal deficit included in C

➞ External Sector ➞ (x – m) < 0 ➞ trade deficit
> 0 ➞ trade surplus
· GDP = C +I + G + (x – m)
statistical
= C + (bus.Inv. + 𝚫Inventories) + (GC + GI) + (x-m) +
discrepancy
data are more timely and reliable
statistical
· National Income = Y = net domestic Income + CFC +
discrepancy
e.g. NI = all income + what needs to be
consumption of fixed
reinvested to
wages capital
maintain the capital
return on capital (i.e. depreciation)
stock
sales tax
LOS d
➞ personal income = all income received by households -compare
= wages + net mixed income + net property income Pg-8
(whether earned or not)
➞ disposable income = personal income – net personal taxes
taxes paid transfers received
➞ personal savings = disposable income – C + 𝚫pension entitlements
some payroll taxes are

for gov’t sponsored
personal pensions

· IS ➞ Investment and Savings net taxes LOS e
-explain
Y = C + I + G + (X -M) ➞ subtract T from both sides Pg-9
(Y – T) = C + I + (G -T) + (X – M) ➞ (Y – T) = disposable income (Yd)
➞ subtract C from both sides
(Yd – C) = I + (G -T) + (X – M) ➞ (Yd – C) = S
∴ S = I + (G – T) + (X – M) - in words, domestic savings is used to

finance: · Investment
SB + SH · fiscal deficit
must hold for AE = AI · trade surpluses
Recall: AO = AE = AI ➞ G -T > 0 = fiscal deficit
if AE > AI, then AE > AO ➞ X – M > 0 = trade surplus
(example #4)
must borrow must import
➞ look ahead: economy LOS f

-explain
Demand Supply
Pg-10
goods money Labour market

market market
aggregate S
IS LM supply = Pe
+ = demand +
curve curve curve
curve D
1
Investment -Savings Liquidity-Money Ye
Q
real interest rate
influences both 2
- the interaction between the level of level of AD
goods and money market NI determines determines
Q
that determine the level of AD level of AS
level of NI
4
AE = C ➞ an increasing function of Yd LOS f
➞ a decreasing function of r (real interest rate) -explain
MPS = 1 – MPC ⇒ larger MPC is (i.e. C/Y), greater the impact Pg-11
+ I ➞ a decreasing function of r (cost of financing)
➞ an increasing function of AE (stronger demand = ↑ investment
spending)
+G ➞ G - T = G -t(Y) ➞ taxes are an increasing function of AE
gov’t expenditure treated as exogeneous
∴ fiscal balance will increase as AE decreases and decrease
as AE increases
∴ deficit
∴ surplus
+ (X - M) ➞ decreasing function of domestic income
➞ increasing function of foreign income
➞ negatively related to the fx-rate
increases as incomes rise (upward sloping) LOS f

-explain
for a given level of r
Pg-12
r
- combinations of
r0 ∼ AE = AI r and Y such that
AE = AI
r1 ∼ AE = AI
IS
Y
Y = b0 – b, r
(G -T) + (X – M)
decreases as
(downward sloping)
incomes rise

- LM curve (equilibrium in the money market) LOS f
- balancing supply and demand for money -explain
Pg-13
M = supply of money 𝐒 - assume a
𝐌
I K𝐏L = supply of real money
P = price level fixed nominal
➞ Demand for money balances ➞ as r rises, less supply
demand to hold money (demand for financial 𝐒
∴ I𝐌K𝐏L = N𝐌O K P𝐒
O
𝐏
assets increase)
both
- as Y ↑, more demand to hold money balances
r
supply r r exogenous
supply
demand < supply
equilibrium
L (r3, Y3)
L (r2, Y2)
demand L (r1, Y1)
-
M/P M/P Y1 Y2 Y3
r LOS f
-explain
Pg-14
equilibrium in the
LM1 money market
IS equilibrium in the
Y goods market
M/P3 M/P2 M/P1 M/P
- as P ↑ (price level) - AD curve will be

𝐒 P1 - flatter if
I𝐌K𝐏L ↓
· I is highly sensitive for
P2 -
· S is insensitive to Income
(example #6)
P3 - · money demand is
AD Insensitive to r or to income
Y

determined by potential LOS g
-explain
GDP
Pg-15
short-run ➞ wages and raw material
prices somewhat inflexible
deflationary - as price level rises, companies
increase output
inflationary
companies will +/- output

without changing prices
full employment all costs adjust higher, selling prices are higher, profit
or natural level margins revert to the mean ➞ AS is unaffected but
of output the price level is higher
➞ Shifts in AD/AS LOS h

-explain
long-run growth Pg-16
rate of GDP
SRAS2
SRAS1
SRAS2 expansion
business SRAS1
cycle
AD2 AD1
contraction AD2
AD1
Y1 Y2 Y2 Y1
expansion - business cycle is a contraction
direct result of
short-run fluctuations of
real GDP
- Shifts in AD/
1/ household wealth ➞ wealth effect: more wealth, less current savings,
more current consumption (AD ➞ right)
2/ consumer and business – confidence increases, MPC ↑, MPI ↑
expectation (AD ➞ right)

- Shifts in AD/ LOS h
3/ Capacity utilization > 82% to 85%, I ↑ (AD ➞ right) -explain
Pg-17
4/ Fiscal policy ➞ G ↑ or T ↓, C ↑ (AD ➞ right)
5/ Monetary policy ➞ increase money supply by:
a) buying securities from banks
b) lowering the required reserve ratio
c) reducing target interest rate
as M ↑, AD ➞ right
6/ Exchange rate – affect the price of X and M
↓ fx-rate ➞ ↑X, ↓ M AD ➞ right
7/ Global growth ➞ higher X, AD ➞ right
(example #8)
· Shifts in SRAS/ - factors that change cost of LOS h

production or expected profit margins will cause SRAS to shift -explain
Pg-18
plus: factors that shift LRAS will also shift SRAS in the same way
1/ changes in nominal wages ↑ W raises production costs ➞ SRAS ➞ left
↑ W may be offset by ↑ productivity no impact on LRAS
%𝚫 unit labour = %𝚫W - %𝚫productivity (example #9)
2/ changes in input prices ↑ RM prices raise cost of production SRAS ➞ left
3/ change in expectations about future prices ➞ expectations of being
able to increase prices in future SRAS ➞ right
- but temporary and small (difficult to predict impact)
4/ changes in business taxes and subsidies
↑ T and ↓ S raise production costs/unit SRAS ➞ left
5/ changes in fx-rate – higher fx-rate, ↓ Mp ➞ if those are RM, lowers
production costs SRAS ➞ right

· Shifts in LRAS/ LOS h
-explain
1/ Supply of Labour · population
Pg-19
· participation rate ↑ workforce, ↑ potential GDP
· net immigration LRAS ➞ right
2/ supply of natural resources – increased availability LRAS ➞ right

3/ supply of physical capital – increased capital stock, increase in
productive capacity LRAS ➞ right
4/ supply of human capital – higher quality of labour, ↑ potential GDP
· training · education LRAS ➞ right
· skills
5/ Labour productivity and technology – more efficient workforce, higher
output per hour worked, lower production costs/unit
- typically obtained through technological advances
LRAS ➞ right
(example #10, #11)
LRAS - long-run full employment equilibrium LOS i

P - AD intersects SRAS on the LRAS curve -explain
- economy is at potential GDP Pg-20
SRAS
SRhg LRg
← level
P1 → LRg expansion
growth
AD SRLg
rate contraction
Y1 Y
LOS j
P -distinguish
LRAS
Recessionary gap/
SRAS
AD ➞ left = lower Y, lower P
P1 - companies cut production, cut workforce
P2 (movement along SRAS)
AD1 - recessionary gap = (Y1 – Y2)
- equilibrium GDP < potential GDP
AD2
Y2 Y1 Y

- Recessionary gap ➞ Investment Implications LOS j, k
-distinguish
· corporate profits decline - reduce investments in cyclical
-explain
· commodity prices decline companies, commodities, or
Pg-21
· interest rates decline commodity – oriented companies, and
· demand for credit declines speculative equity companies
- increase investments in defensive
stocks, IG/gov’t long-term bonds
LRAS
Inflationary gap – economic expansion, real
GDP and employment increase
SRAS - higher output at higher prices
P2 - companies increase production, may have
AD2 to compete on wages to attract employees
- inflationary gap = (Y2 – Y1)
- equilibrium GDP > potential GDP
AD1
Y1 Y2
LOS j, k
- Inflationary gap ➞ Investment Implications
· corporate profits rise - increase investments in cyclical -distinguish
-explain
· commodity prices increase companies, commodities, or
Pg-22
· interest rates rise commodity – oriented companies, and
· inflationary pressure builds speculative fixed-income securities
- reduce investments in defensive
stocks, IG/gov’t long-term bonds
P
LRAS
SRAS2 Stagflation ➞ SRAS shifts to the left
- lower output at higher prices
SRAS1 - higher unemployment, higher inflation
P2
P1 - reduce exposure to both equities and
fixed income
- increase exposure to commodities
AD
Y2 ← Y1 Y

LOS l
-analyze
Pg-23
(example #13)
LOS m
- economic growth is calculated as %𝚫 in real GDP
-describe
has a limit ➞ sustainable growth
rate of increase in the economy’s

productive capacity or potential GDP
LRAS – the factors that

shift LRAS right also increase
potential GDP
- output depends on inputs L and K LOS n

· Y = AF (L, K)
-describe
Y = output and the level of technology (A)
Pg-24
L = labour
constant returns to scale ➞ double the inputs, double the outputs
K = capital
A = total factor productivity
➞ Diminishing returns to scale with respect to any individual input

· as K increases while holding L and A constant, output
increases at a decreasing rate
Y/L developing
economy growth
Y/LA developed rate
output economy
gap developed
economy
Y/LO developing
growth rate
economy
K/LO K/LA K/L

LOS n
➞ Growth in potential GDP = growth in technology
-describe
+ WL (growth in Labour)
Pg-25
+ WC (growth in capital)
𝐖𝐚𝐠𝐞𝐬
𝐖𝐋 =
𝐆𝐃𝐏 relative shares of capital 𝐜𝐨𝐫𝐩𝐨𝐫𝐚𝐭𝐞 𝐩𝐫𝐨𝐟𝐢𝐭𝐬, 𝐧𝐞𝐭 𝐢𝐧𝐭𝐞𝐫𝐞𝐬𝐭
and labour in national income 𝐢𝐧𝐜𝐨𝐦𝐞, 𝐧𝐞𝐭 𝐫𝐞𝐧𝐭𝐚𝐥 𝐢𝐧𝐜𝐨𝐦𝐞,
𝐖𝐂 = 𝐈 − 𝐖𝐋 𝐝𝐞𝐩𝐫𝐞𝐜𝐢𝐚𝐭𝐢𝐨𝐧
𝐆𝐃𝐏
e.g. U.S. ➞ WL = .7 ∴ ↑ in L will have a larger effect

➞ WC = .3 on GDP than an increase in K
➞ Growth in per capita GDP = growth in technology + WC (growth in K/L)
· daycare LOS o
➞ Sources of Economic Growth/ -distinguish
· child benefits immigration
1/ Labour Supply (quality variable) Pg-26
➞ labour force = participation rate × population
➞ potential size (quantity) = labour force × Avg. hours worked per
worker
2/ Human Capital (quality variable) business cycle
- education, training, experience sensitive
3/ Physical Capital Stock – increases from year to year as long as
net investment is positive
(gross Inv. – Dep.)
4/ Technology – most important factor
- allow economies to overcome the limits imposed by
diminishing marginal returns
TFP growth = growth in potential GDP – [WL (growth in labour) +
WC (growth in Capital)]
residual

➞ Sources of Economic Growth/ LOS o
renewable (forest) -distinguish
5/ Natural Resources imports can overcome
Pg-27
non-renewable (oil) these deficits
➞ Measures of sustainable growth/
- recall the growth accounting equation:

𝐆𝐫𝐨𝐰𝐭𝐡 𝐢𝐧 𝐠𝐫𝐨𝐰𝐭𝐡 𝐢𝐧 𝐠𝐫𝐨𝐰𝐭𝐡 𝐢𝐧 𝐠𝐫𝐨𝐰𝐭𝐡 𝐢𝐧
= + 𝐖𝐋 N P + 𝐖𝐂 5 7
𝐩𝐨𝐭𝐞𝐧𝐭𝐢𝐚𝐥 𝐆𝐃𝐏 𝐭𝐞𝐜𝐡𝐧𝐨𝐥𝐨𝐠𝐲 𝐋𝐚𝐛𝐨𝐮𝐫 𝐜𝐚𝐩𝐢𝐭𝐚𝐥

unobservable unobservable data may not be available

𝐑𝐞𝐚𝐥 𝐆𝐃𝐏
∴ focus on labour productivity =
𝐀𝐠𝐠𝐫𝐞𝐠𝐚𝐭𝐞 𝐇𝐨𝐮𝐫𝐬 both observable
depends on
· K/L · A
∴ growth in = LT growth rate of labour force + LT labour productivity growth
potential GDP rate

REVIEW

Aggregate Output, Price & Economic Growth
Aggregate Output = Aggregate Income = Aggregate Expenditure Pg-1

- MV/final g/s W/ - value of all
in
- total spending on g/s - review
an economy payments earned produced domestically
by land, labour, capital
produced during - all income is attributed to the
the measurement household sector
period - transfer pmts. from G ➞ C
excluded
- not included: used goods, illegal activity, barter, financial assets,
intermediate g/s
- owner-occupied housing ⇒ rent is assumed (i.e. imputed) to be paid in GDP
· Real GDP/ controls for price changes nominal GDPt = Pt × Qt
real GDPt = P0 × Qt
𝑵𝒐𝒎𝒊𝒏𝒂𝒍 𝑮𝑫𝑷 𝑷𝒕 × 𝑸𝒕
𝑮𝑫𝑷 𝑫𝒆𝒇𝒍𝒂𝒕𝒐𝒓 = × 𝟏𝟎𝟎 = × 𝟏𝟎𝟎
𝑹𝒆𝒂𝒍 𝑮𝑫𝑷 𝑷𝟎 × 𝑸𝒕
(𝐍𝐨𝐦𝐢𝐧𝐚𝐥 𝐆𝐃𝐏)
∴ 𝐑𝐞𝐚𝐥 𝐆𝐃𝐏 = s 𝐆𝐃𝐏 𝐃𝐞𝐟𝐥𝐚𝐭𝐨𝐫
N 𝟏𝟎𝟎
P
government Pg-2
GDP = Y = C + I + G + (x – m) + statistical discrepancy - review
· expenditure trade balance
consumption private domestic
approach investment
· GDP = NI + CCA (National Income + Capital Cost Allowance)
· income
approach
NI = Wages + Profit + Interest + Private Profit + rent + (Indirect Tax
- subsidies)
Corp. + Gov’t
(Div. + RE + Tax) sales tax, etc…
⇒ Personal Income = PI = NI – Indirect Bus. Tax – Corp. Tax – RE + Transfer
⇒ Personal Disposable Income = PDI = PI - personal tax Pmts.
⇒ Savings = S = PDI - C – interest paid – transfer pmts. to foreigners
⇒ Business Saving = RE + CCA


Pg-3
Y = C + I + G + (X – M) - subtract T - review
Y - T = C + I + (G -T) + (X – M) – subtract C
Y - C = I + G + (X – M) investment
key [S = I + (G – T) + (X – M)] – saving is used to finance gov’t details
S + gov’t surplus = I + (X – M) - good (G – T)
(T - G) trade surplus claims against
S + trade deficit = I + (G -T) - bad (unsustainable) foreigners
(M -X) gov’t def. (X – M)
S + gov’t surplus + trade deficit = I · objective is
Economy to determine
Demand Supply macro equilibrium
Money Market (Labour market)
Goods Market
r r P P
LM
IS curve AD AS
+ = + = (Ye, Qe)
curve - at a given
curve curve
price level
y y y y
⇒ IS Curve/ Pg-4
AI = AE Planned Exp. - review
AE
MPC
· savings
CA
· equilibrium in · inventories build ➞ production ↓
- autonomous employment ↓
the goods market
consumption incomes ↓
y
· dissaving production ↑, employment ↑, incomes ↑
· inventories are drawn down
AE = C + I + G + (X-M)
- as Yd ↑, C ↑ - as r ↑, I ↓ - treated as · X treated as
- as r ↑, C ↓ - as Y ↑, I ↑ exogenous exogenous
- as T ↑, Yd ↓, C ↓ - as Y ↑ t(Y) ↑ · as Y ↑, M ↑
MPS = 1 - MPC r - curve represents all the points
∴ 𝐘 = 𝐂𝐀 + 𝛃𝟏 𝐘 − 𝛃𝟐 𝐫 = (IS)
of equilibrium in the goods
y
market for a given price level

· LM Curve/ Liquidity & Money Pg-5
𝐒
transactional - review
I𝐌K𝐏L - supply of real money
𝐝
I𝐌K𝐏L liquidity precautionary
- assume M is fixed 𝐝 speculative
r as r ↑, I𝐌K𝐏L ↓
real supply - liquidity is a
interest
decreasing function
rate
of r
M/P – real money balance

supply
r r
LM curve
- all combinations
L (r, Y4) of r & Y in
L (r, Y3) which money
L (r, Y2) market is in
L (r , Y1) equilibrium
M/P Y
-
-
Y1 Y2 Y3 Y4
P0 Pg-6
r P2 P1 at - review
at at -
supply
monetary policy
rat P2 LM
rat P1
rat P0 f i s c al
policy
L (r, Y) IS
Y
M/P · as P ↑, real
P money supply ↓
- raise price level to P2 - r ↑
I𝐌K𝐏L↓ P2 -
- demand for
- raise price level of P1 P1 -
S increases
I𝐌K𝐏L↓ - Y decreases
P0 - as MPC ↓
AD (MPS ↑)
Y
- AD ↓ as P ↑

LRAS Y = F (K, L) Pg-7
- review
SRAS variable variable in the
in the short run
P1 long run
Y1 – full employment or natural level of output

⇒ Shifts in AD/
left AD right
a) household wealth wealth ↓, C ↓, S ↓ wealth ↑, C ↑, S ↓

b) Consumer/Business Expectations confidence ↓ confidence ↑
MPC ↓ MPS ↑ MPC ↑ MPS ↓
c) Capacity Utilization > 82-85% I ↑
d) Fiscal policy G ↓ or T ↑ G ↑ or T ↓
e) Monetary Policy
Reserve Requirements
Policy Rate
I ↓ C ↓ I ↑ C ↑
f) Exchange Rate FX ↑ X ↓ FX ↓ X ↑
M ↑ M ↓

Pg-8
⇒ Shifts in AD/ left SRAS right
- review
a) Shift in LRAS LRAS - left LRAS - right
b) Changes in nominal wages 𝐰
I K𝐮𝐧𝐢𝐭 L ↑ I𝐰K𝐮𝐧𝐢𝐭 L ↓
(no impact on LRAS)
c) Changes in Input Prices RM ↑ RM ↓
d) Changes in Expectations of ↓ own prices ↑ own prices
Future Prices (e.g. our selling price)
e) Changes in Business Taxes ↑ T, ↓ Subs. ↓ T, ↑ Subs.
and Subsidies
f) Changes in FX Rate ↓ FX ⇒ M ↓ ↑ FX ⇒ M ↑
but X ↑ X ↓
effect uncertain

left LRAS right Pg-9
⇒ Shifts in AS/ - review
a) Supply of Labour ↓ population ↑
participation rate
net immigration
b) Supply of Physical Capital ↓ net Investment ↑
c) Supply of human capital ↓ Quality of ↑
Labour
(training/education/ skills)
d) Labour Productivity and ↓ 𝐨𝐮𝐭𝐩𝐮𝐭K ↑

N 𝐋𝐇P
Technology ↓ ↑
Investments in
technology
(Recession Gap) Pg-10

LRAS - review
· real GDP growth < long-run GDP
SRAS
growth
P1 - supply contracts, unemployment ↑
commodity prices ↓
P2 recessionary gap
· fiscal & monetary intervention
G ↑, T ↓ int. rates ↓, M ↑
AD0
AD1
· investment action: low 𝜷 strategy, defensive stocks, lengthen duration
(Inflationary Gap)
LRAS · real GDP growth > long-run GDP growth

- higher wages, profits rise,
SRAS
commodity prices ↑
P2 inflationary gap · fiscal & monetary intervention
P1 G ↓, T ↑ r ↑
AD1 · investment action: high 𝜷 strategy,
cyclical/growth stocks, shorten duration
AD0

LRAS Pg-11
SRAS1 · higher inflation, higher unemployment - review
SRAS0 · Fiscal & monetary policy ?
P2 - boost AD = higher prices
- raise rates to combat
P1
inflation = lower output
AD0
SRAS shifts left

- output contracts, prices rise
⇒ Economic Growth/ LRAS = potential GDP
· additions to productive capacity shift LRAS to the right
neo-classical Y = A × F (L, K) · (L, K) ↑ · constant returns to
production function scale, diminishing
pace of technological
(Solow growth model) marginal productivity
change
(with any one input)
growth in pot. GDP = growth in A + growth in L + growth in k Pg-12

(WC) - review
exogenous (WL)
= .7 = .3
· sources of growth/ pop. growth
1/ Labour Supply – quantity immigration
Labour force
2/ Human capital - quality - education, training, experience

3/ Physical capital stock – net investment
4/ Technology – most important factor
5/ Natural Resources – renewable/non-renewable
➞ Measures of sustainable growth/
Y/L – level of Labour Productivity
Y/L = A × F (1, K/L)
𝐜𝐚𝐩𝐢𝐭𝐚𝐥K I𝒀K𝑳L − I𝒀K𝑳L - growth rate of
𝐨𝐮𝐭𝐩𝐮𝐭K 𝐥𝐚𝐛𝐨𝐮𝐫 𝟏 𝟎
LP
𝐰𝐨𝐫𝐤𝐞𝐫 N𝒀K𝑳 P
𝟎
(Potential GDP = agg. hrs. worked * Y/L) (Pot. g rate = LT g(pop) + LT growth
rate of LP)

Understanding Business Cycles
a. describe the business cycle and its phases;
b. describe how resource use, housing sector activity, and external trade sector activity
vary as an economy moves through the business cycle;
c. describe theories of the business cycle;
d. describe types of unemployment and compare measures of unemployment;
e. explain inflation, hyperinflation, disinflation, and deflation;
f. explain the construction of indexes used to measure inflation;
g. compare inflation measures, including their uses and limitations;
h. distinguish between cost-push and demand-pull inflation;
i. interpret a set of economic indicators and describe their uses and limitations.

Business Cycles
Pg-1
But: in reality
- not so symmetrical
Peak Expansion
- recurrent, but not periodic
Trough - vary in duration
& intensity
Contraction
Expansion Recession – general contraction

in output; broad-based; for
Recovery 2 consecutive quarters
Recovery Expansion Peak Contraction

Economic - show · show accelerating decelerating declines
Indicators expansion growth growth
Employment · Initial claims · Net new jobs · hiring · Avg. hrs.
drop rise slows worked ↓
· Net new jobs · unemployment ↓ · Initial · Net new
positive · participation claims slow jobs turn
· Avg. weekly hrs. rate ↑ negative
worked increase · Initial
claims ↑
Consumer & · housing, durable ·more broad- · I ↑ · first drops
Bus Spending good, equipment based demand · C ↑ slows in Ind.
(credit related) · construction ↑ (2nd der.) Prod.,
housing,
durables
and then I
Inflation moderate picks up a bit accelerates decelerates

Leads vs. Lags Pg-3
· financial markets lead the economy
· Monetary/Fiscal policy work with a lag
· Economic indicators
lag co-incident lead
Snag: releases are often subject to later

revisions (1-2 mos. up to 1 yr. later)
(preliminary vs. final)
Further complication: Behaviour may also lead or lag
economic conditions
LRAS inflationary gap ⇒ peak (boom) Pg-4

SRAS
AD1 ➞ AD2
P1 · Inventories start to build
- production slows (lag)
P3 · layoffs increase
AD1 (longer lag)
AD3 AD2
Y3 Y1
recessionary · sluggish Inventory turnover
gap = (delayed equipment purchases
contraction + reduced production
+ cute in overtime
+ shorter work weeks)
= increase in consumer precautionary

savings
AD2 ➞ AD3 (trough)

inflationary gap
Pg-5
LRAS SRAS1 · Low prices begin to induce
demand (movement along
SRAS2
demand curve)
P1
AD2 · Low interest rates increase
AD1
demand for credit ⇒ translates into
Y1 Y2
more housing
Expansion automotive demand
durable goods
AD1 ➞ AD2
· Production begins to rise - Late
· Investment shifts SRAS, ➞ SRAS2 Expansion
(Boom)
Fluctuations in Capital Spending
AD
Capacity expansion
· heavy equipment
· structures
· new orders
· Capacity
halted
utilization
(esp. IT & light equip.)
- IT investment picks-up of about
· efficiency investments 80-88% range
rather than
capacity
· major capital projects

on hold
· heavy equipment
demand drops

Fluctuations in Inventory
· Inventory/Sales ratio
· tends to move
AD
rapidly/forcefully
· Sales drop · Sales ↑, inventory stable
- inventories · ratio ↓
accumulate · surge in production
· ratio ↑ to above sales levels
· production cuts As inventories drop,
(if inventory low)
below sales levels ratio improves (↓)
· measured increase
· production rises – maybe
in production if
above sales levels
inventory levels OK!
(inventory rebuilding)
sales of inventory > production
Consumer Behavior
- greatest economic
impact
Retail Sales – durable goods (leading)
- non-durable goods
staples
- services
Consumer Confidence/Sentiment
Income (Yd) ⇒ better correlated with C (non-dur., services)
Saving ⇒ ↑ S may indicate future caution
⇒ stock of ‘Savings’ ⇒ future consumption potential
without a need for ↑ income

Housing Sector Behaviour
- very interest-rate
· New/Existing Home Sales sensitive
· HPI – Housing Price Index ⇒ median home prices
r 𝐈
5 7
r ↓ 𝐀𝐯𝐠 $
r ↑ · now works
HPI against higher
rate
𝐈 prices as rates
of · low rates support 5 7
𝐀𝐯𝐠 $ rise and
family prices · begins to life housing affordability
forma tion · low incomes keep prices ⇒ as Incomes wanes
a key prices down Rise · beware the ‘late
in flu enc e 𝐈
5 7 · rates still supportive buyer’
𝐀𝐯𝐠 $
(momentum & spec.)
Construction rises Construction drops
External Trade Sector Behavior
Domestic
Y
imports
ROW
imports rise
Y fall
exports
exports rise
fall
Net exports ⇒ may not track domestic business cycles
FX high rates low rates ⇒ ↑ exports

· encourage imports
↓ imports
· discourage exports

Theories of the Business Cycle
Neoclassical & Austrian Schools ⇒ (F. von Hayek, Ludwig von Mises) Pg-1
⇒
economy is self-correcting government intervention

(no theory of business cycle) (money supply/interest
· prices are flexible rates)
· no general gluts · attempts to engineer
· no persistent unemployment (steer) markets are the
cause of fluctuations
- distort market (price) signals
and lead to malinvestment
Both advocate ‘no’ or ‘limited’

gov’t role ⇒ theory of business
⇒ market will self-correct cycles – misguided
gov’t intervention

Keynesian & Monetarist (Mitton Friedman) Pg-2
⇒ money supply is far more

economy is NOT self-correcting important
⇒ sticky wages (Labour mkt.) · if M2 grows too fast
⇒ Low interest rates may ⇒ inflationary gap
not work if M2 grows too slow
∴ fiscal policy tools ⇒ recessionary gap
⇒ deficit spending to boost AD ∴ steady growth in money supply
⇒ lower taxes & limited gov’t intervention
Critiques: - does not proceed from - business cycle theory: exogenous
micro preferences/constraints shocks + wrong policy
· short-term focus on deficits
· timing lags

o ne Pg-3
New Classical Theory (Robert Lucas) price in
from: Static Partial Equilibrium market
n)
(adaptio
to: Dynamic Stochastic General Equilibrium prices in
models how the allows for random all markets
economy changes exogenous shocks (expectation)
over time
⇒ start from micro principles (preferences & constraints of decision makers)
rather than
correlations between aggregates
⇒ Models behaviour that leads to the aggregate versus modelling relationships
between aggregates
New Classical Theory Pg-4

A. Real Business Cycles (RBC) – modelled w/o money
· fluctuations in GDP are natural & efficient responses
to external real (i.e. non-monetary) shocks
⇒ has a hard time explaining persistent non-voluntary un-employment
But: a more prominent role for AS
el
B. Neo-Keynesians (modelled w/ money) i . e. mod
⇒
· dynamic GE models but advocate gov’t intervention
(since markets may not equilibrate)
(slow-to-adjust prices/wages)
Whatever you believe, it comes down to what the Central Bank/gov’t will do
– Period!

Unemployment
Pg-1
expansion – late expansion
⇒ low unemployment
recovery ‘tight labour market’
- potential for ‘price wage’
⇒ high unemployment inflationary spiral
trough
Terminology
Employed – those with a job
Labour Force – those with a job + those looking for a job
(Employed) (Unemployed)
Unemployed – those without a job but looking
Long-term unemployed ⇒ 3-4 mos. but still looking
Frictionally unemployed ⇒ natural movement from job-to-job
𝐔𝐧𝐞𝐦𝐩𝐥𝐨𝐲𝐞𝐝
Unemployment Rate =
𝐋𝐚𝐛𝐨𝐮𝐫 𝐅𝐨𝐫𝐜𝐞
Pg-2
Activity Ratio (Participation Rate) 𝐋𝐚𝐛𝐨𝐮𝐫 𝐅𝐨𝐫𝐜𝐞
(of working age)
𝐏𝐨𝐩𝐮𝐥𝐚𝐭𝐢𝐨𝐧
Underemployed – has a job below qualifications
Discouraged worker – person who has stopped looking for work
⇒ not counted as unemployed
Voluntarily unemployed – person who could get a job but refuses the work
Unemployment Rate ⇒ surveys
⇒ claims for UI
⇒ all working age regardless of willingness
ILO – International Labour Organization
⇒ lagging indicator ⇒ Labour responds to the environment
- unemployment rate can be paradoxical
⇒ Business response does not lead

Payroll/Productivity Indicators
Payroll ➞ Net new jobs F/T Productivity Pg-1

P/T = Output
· Hours worked Hrs. Worked
· Temporary workers · leading to coincident
indicator
Hrs./Overtime cut
P/T &
temporary Productivity F/T jobs cut
staff cuts (Payrolls drop)
drops
Payrolls
Increase Add F/T jobs
Productivity
rises Add P/T - temporary staff Recession
Increase hrs./overtime
Expansion
Pg-2
Inflation ⇒ pro-cyclical with a lag (a year or more)
a sustained rise in the overall level of prices
Inflation Rate = 𝐏𝐫𝐢𝐜𝐞 𝐈𝐧𝐝𝐞𝐱 𝟏 − 𝐏𝐫𝐢𝐜𝐞𝐈𝐧𝐝𝐞𝐱 𝟎
𝐏𝐫𝐢𝐜𝐞 𝐈𝐧𝐝𝐞𝐱 𝟎
· lagging indicator
Inflation Expectations – leading indicator
(esp. for Monetary Policy)
Terminology
Deflation – a sustained decrease in the aggregate price level
Hyperinflation – an extremely fast increase in the price level
Disinflation – a decline in the rate of increase
Ie. Ye1 – 3% YR2 – 2.5% YR3 – 1.5% YR – 1%

Measuring Inflation
⇒ Price Index – the average prices of a representative

basket of goods/services
Laspeyres Index
- composition of the representative basket held
constant as of base year (updated every 5 years)
i.e. Year 0 – WQ0 × P0
𝐖𝐐𝟎 × 𝐏𝐧 𝐈𝐧𝐟𝐥𝐚𝐭𝐢𝐨𝐧 𝐈𝐧𝐝𝐞𝐱 𝐧 × 𝐈𝐧𝐝𝐞𝐱 𝐧ƒ𝟏
Year 1 – WQ0 × P1 ➞ 𝐈𝐧𝐝𝐞𝐱 = =
𝐖𝐐𝟎 × 𝐏𝟎 𝐑𝐚𝐭𝐞 𝐈𝐧𝐝𝐞𝐱 𝐧ƒ𝟏
Year 2 – WQ0 × P2
Issues
① substitution effect (if not adjusted ⇒ upward bias in the Index)
chained price Index formula (i.e. Fisher
Index)
② quality (if not adjusted ⇒ upward bias) – adjustment ➞ hedonic pricing
③ New Products (not included until update ⇒ upward bias today)

Fisher Index
„𝐈𝐏 × 𝐈𝐋 chained attempt to solve

price Index substitution bias
Paasche Laspeyres
Index Index
𝐖𝐐𝟏 × 𝐏𝟏 𝐖𝐐𝟎 × 𝐏𝟏

𝐖𝐐𝟏 × 𝐏𝟎 𝐖𝐐𝟎 × 𝐏𝟎
changing at each constant at each

basket price level basket price level

Usage
Pg-1
· different names, weights, methodology
household survey
· CPI reflecting CPI - U (urban only
· HICP domestic conditions/ (IL) vs.
· PCE preferences/constraints urban + rural)
vs.
PCE – business survey
(IF) - all ‘C’ included
Producer Price Index
- measures price changes paid by
domestic producers
- may lead 𝚫CPI
⇒ fuels, farm products, machinery & equipment
by raw mat., intermediate goods, finished goods
· bonds, contracts, leases, pensions, labour contracts, etc… Pg-2

⇒ may be indexed to some price index
⇒ different Central Banks follow different measures

i.e. ECB – HICP India − WPI U.S. – PCE
⇒ Nominal GDP adjusted to real GDP by a price index
⇒ called the GDP deflator
C + I + G + (X – M) ?
CPI PPI CPI?/PPI?

⇒ Headline vs. Core
less energy & food

Explaining Inflation
Cost-Push Inflation: rising costs (usually wages) compel Pg-1

business to raise prices largest input cost
very little
wage
inflation
pressure
natural rate of unemployment (frictional)
or
rising 0% NAIRU – non-accelerating inflation
wage inflation rate of unemployment
pressure
Indicators hourly wages, weekly earnings, overtime
But: must include Productivity
𝐓𝐨𝐭𝐚𝐥 𝐖/𝐡𝐫.
𝐔𝐧𝐢𝐭 𝐋𝐚𝐛𝐨𝐮𝐫 𝐂𝐨𝐬𝐭 =
𝐎𝐮𝐭𝐩𝐮𝐭/𝐡𝐫.
Pg-2
Demand-Pull Inflation: Capacity utilization ⇒ better of the two
Actual vs. Potential GDP 80-85% ➞ ‘I’
r
o too much liquidity (i.e. M2)
𝐍𝐨𝐦𝐢𝐧𝐚𝐥 𝐆𝐃𝐏
= watch 𝐕𝐞𝐥𝐨𝐜𝐢𝐭𝐲 𝐨𝐟 𝐌𝐨𝐧𝐞𝐲 =
𝐌𝟐
- analyze +/- as to whether it was numerator or denominator
motivated
- if velocity ↓ due to M2 ↑ - may be inflationary
- if velocity ↑ due to Nominal GDP ↑ - may be disinflationary
or deflationary
Inflations Expectations:
· may become self-fulfilling

Economic Indicators
· lagging · coincident · leading
· Avg. Duration of · Payrolls · Avg. weekly hours

Unemployment · Personal Income worked
· Inventory/Sales · Industrial Production · Initial Claims
Ratio etc… · New Orders
· Ratio of Installment · Building Permits
Debt to Income · S & P 500
etc… · M2
· Spread of 10-year
- some are aggregated into Composites
over FFF
(Conference Board, OECD)
· Consumer Expectations
etc…
Diffusion Index
· tries to capture the proportion of a composite moving in the same direction

e.g.
n n +1 Rule
Ind1 2 1 -.8 0 if ≥ 0.05% ⇒ + 1
Ind2 1 1 .5 1 if < 0.05% ⇒ + .5
Ind3 - .5 .5 1 if < -0.05% ⇒ 0
Ind4 -.6 0 3.5 1
2.5 3
= .625 × 100 = 62.5 = .75 × 100 = 75
4 4
Others
Fed: Beige Book Case Shiller - HPI
ISM – PMI U of M – Consumer Sentiment

REVIEW

Understanding Business Cycles
- recurrent but not predictable fluctuations in economic activity Pg-1

- review
long- run trend growth
peak expansion
recovery
trough
contraction – may be a recession – broad based contraction, for 2

consecutive quarters
Recovery Expansion Peak Contraction

economic
· show · show · decelerating · decline
indicators
expansion accelerating growth
growth
lagging Leading
· monetary/fiscal policy work with a lag

coincident
· financial markets lead the economy
LRAS Pg-2
SRAS - review
inflationary gap (peak, boom)
AD0
AD2 AD0
recessionary gap (contraction, recession)
LRAS SRAS1 ① in a recession, low AD,
supply has constricted to SRASV
SRAS2
② Central Bank lowers rates
③
to induce demand
① ②
P1 ③ supply begins to expand
AD2 to meet demand
AD1
Y1

⇒ Fluctuations in Capital Spending/ Pg-3
- review
Agg. Demand

Capacity expansion

· heavy equip.
· new orders
· structures
halted
action IT investment
major
picks-up
capital projects
· more for efficiency
on hold
than for capacity
- heavy equipment

demand drops
⇒ Fluctuations in Inventory/
Agg. Demand
· Sales drop
- inventories Sales ↑, inventory stable
accumulate · Inventory/Sales ↓
· Inventory/Sales
- Inventory/Sales ↑ · production expands to
ratio improves
- production cuts above sales levels
· production begins
below sales levels
to increase

⇒ Consumer Behavior/ durable goods – leading Pg-4
Retail Sales - review
- indicators non-durable
Consumer
greatest services
Confidence
economic impact Income

Saving ➞ ↑ may indicate future caution
⇒ Housing Sector/ very interest rate sensitive
rate of
r
family r ↑
formation a r ↓ HPI – housing
driver price index
· as incomes rise,
- low rates support prices
housing prices - as rates rise,
- low incomes keep prices down housing prices
rise
new/existing home sales - rates still top out and
indicators building permits supportive begin to fall
HPI 𝐈
𝐤𝐞𝐲 𝐫𝐚𝐭𝐢𝐨 5 7
𝐀𝐯𝐠 $

⇒ External Trade Sector/ Pg-5
Domestic Y - review
imports rise
imports fall
ROW Y exports rise
exports fall
- net exports may not track domestic business cycles
FX ↑ imports,
↓ exports
⇒ Theories of the Business Cycle ↑ exports, ↓ imports

1) Neoclassical & Austrian Schools ➞ government interventions are
- economy is self-correcting the cause of fluctuations
- prices are flexible (int. rates, money supply)
- no theory of business cycle - theory of bus. cycle ⇒ misguided
- both advocate no or limited gov’t rule
Pg-6
⇒ Theories of the Business Cycle
- review
2) Keynesian - economy is NOT self-correcting (e.g. sticky wages)
- low interest rates may not work
· fiscal policy tools deficit spending

lower taxes
3) Monetarist - money supply growth
· too fast - inflationary gap
· too slow - recessionary gap
- advocate steady growth in money supply & limited
- business cycle theory ⇒ exogenous shocks/wrong policy
4) New Classical Theory - dynamic stochastic general equilibrium
allows for random shocks

- attempts to models behaviour that leads to the aggregate
like AD/AS, rather than modelling relationships between
aggregates

⇒ Theories of the Business Cycle/ Pg-7
4) New Classical Theory - review
a) Real Business Cycles - fluctuations in GDP are natural &
e lle d
mo d mone
y efficient responses to external real shocks
o u t
with - business cycles are natural & self-correcting
b) Neo-Keynesians - dynamic GE models but advocate gov’t
o d elled
m y intervention (since markets may not equilibrate)
i t h mo n e
w
⇒ Unemployment/
employed – those with a job
Labour Force – those with a job + those looking for a job
Unemployed – those without a job but looking
Unemployment Rate Unemployed/Labour force
- Long-term unemployed ⇒ 3-4 mos. but still looking
- Frictionally unemployed ⇒ natural movement from job-to-job
⇒ Unemployment/ Pg-8
𝐋𝐚𝐛𝐨𝐮𝐫 𝐅𝐨𝐫𝐜𝐞 - review
Participation Rate - of working age
𝐏𝐨𝐩𝐮𝐥𝐚𝐭𝐢𝐨𝐧
Underemployed – has a job below qualifications
Discouraged worker – person who has stopped looking for work
Voluntarily unemployed - could get a job but does not
surveys
· Unemployment Rate
claims for UI
lagging indicator
- others: Payrolls, Jobs Report, hours worked, temporary workers
Productivity = Output
Hrs. Worked
productivity
leading to
drops
coincident indicator
productivity
rises

⇒ Inflation/ pro-cyclical with a lag Pg-9
Inflation rate = 𝐏𝐫𝐢𝐜𝐞 𝐈𝐧𝐝𝐞𝐱 𝟏 − 𝐏𝐫𝐢𝐜𝐞𝐈𝐧𝐝𝐞𝐱 𝟎 - review
· lagging
𝐏𝐫𝐢𝐜𝐞 𝐈𝐧𝐝𝐞𝐱 𝟎 indicator
Inflation Expectations ➞ leading indicator
Deflation – a sustained decrease in the aggregate price level

Inflation - a sustained rise in the overall price level
Disinflation – a decline in the rate of increase
Hyperinflation – an extremely fast increase in the price level
- Price Index/ - avg. prices of a representative basket of goods
Laspeyres Index - composition of the representative basket held
constant as of base yr.
𝐖𝐐𝟎 × 𝐏𝐧 𝐈𝐧𝐟𝐥𝐚𝐭𝐢𝐨𝐧 𝐈𝐧𝐝𝐞𝐱 𝐭 − 𝐈𝐧𝐝𝐞𝐱 𝐭ƒ𝟏
Year 2 – WQ0 × P1 ➞ 𝐈𝐧𝐝𝐞𝐱 = =
𝐖𝐐𝟎 × 𝐏𝟎 𝐑𝐚𝐭𝐞 𝐈𝐧𝐝𝐞𝐱 𝐭ƒ𝟏
- Price Index/ Pg-10

- review
Laspeyres Index (updated every 5 years)
issues: substitution effect ➞ upward bias in the index
quality ➞ upward bias (adjust w/ hedonic pricing)
new products - not included until update year)
solution: Fisher Index = Š𝑰𝒑 𝐱 𝑰𝑳 - called a chained

Paasche price index
Laspeyres
Index Index
changing
𝐖𝐐𝟏 × 𝐏𝟏 𝐖𝐐𝟎 × 𝐏𝟏 constant
basket at
𝐖𝐐𝟏 × 𝐏𝟎 𝐖𝐐𝟎 × 𝐏𝟎 basket at
each price
chained
level each price
price
level
CPI
CPI – U (urban only)
PCE – personal consumption expenditure
PPI – producer price index

- Price Index/ Pg-11
- many contracts are indexed to CPI/PCE - review
- nominal GDP is adjusted to real GDP by a price index
(called the GDP deflator)
- headline vs. core ➞ (less energy & food)
- Cost-Push Inflation/ - rising costs compel business to raise prices
most likely wages

very little
non-accelerating
wage pressure
- natural rate of unemployment (NAIRU – inflation rate of
unemployment
wage pressure
· Indicators - hourly wages, weekly earnings
𝐔𝐧𝐢𝐭 𝐋𝐚𝐛𝐨𝐮𝐫 𝐂𝐨𝐬𝐭
· 𝐓𝐨𝐭𝐚𝐥 𝐰𝐚𝐠𝐞𝐬/𝐡𝐫.
- Demand-Pull Inflation/ =
𝐎𝐮𝐭𝐩𝐮𝐭/𝐡𝐫.
Indicators · Capacity utilization
Actual vs. Potential GDP
Pg-12
- Inflation Expectations/ - may become self- fulfilling
- review
- Diffusion Index/ - captures the direction of a Composite
(Leading Indicators)
rule: Ind n
if ≥ 0.05% ⇒ + 1 1 2 1
if < 0.05% ⇒ + .5 2 1 1
if < -0.05% ⇒ 0 3 - .5
4 -.6 0
- ranges between 0 – 100 2.5/4 = .625 × 100 = 62.5
· anything > 50 indicates growth
- Indicators/ lagging - Avg. Duration of Unemployment, Inv./sales ratio,
Installment Debt/Income
coincident – Payrolls, Personal Income, Industrial Production
leading - Avg. hours worked, Initial claims, new orders,
building permits, S & P 500, M2, Spread of
10yr. - FFF

Monetary and Fiscal Policy
a. compare monetary and fiscal policy;
b. describe functions and definitions of money;
c. explain the money creation process;
d. describe theories of the demand for and supply of money;
e. describe the Fisher effect;
f. describe roles and objective of central banks;
g. contrast the costs of expected and unexpected inflation;
h. describe tools used to implement monetary policy;
i. describe the monetary transmission mechanism;
j. describe qualities of effective central banks;
k. explain the relationships between monetary policy and economic growth, inflation,
interest, and exchange rates;
l. contrast the use of inflation, interest rate, and exchange rate targeting by central
banks;
m. determine whether a monetary policy is expansionary or contractionary;
n. describe limitations of monetary policy;
o. describe roles and objectives of fiscal policy;
p. describe tools of fiscal policy, including their advantage and disadvantages;
q. describe the arguments about whether the size of a national debt relative to GDP
matters;
r. explain the implementation of fiscal policy and difficulties of implementation;
s. determine whether a fiscal policy is expansionary or contractionary;
t. explain the interaction of monetary and fiscal policy.

Monetary & Fiscal Policy
Pg-1
Central Banks Government
interest money spending Taxation

rates supply
attempt to engineer an economy where:
1) growth is stable and positive
2) inflation is stable and low (pos)
Money
qualities must:
functions
· medium of exchange · be readily acceptable
· store of value · have a known value
· unit of account · be easily divisible
· have a high value: weight ratio
· be difficult to counterfeit
definitions what constitutes money? Pg-2
narrow def’n broad def’n

- coins/notes in circulation - narrow +
- demand deposits - savings/money market accts.
- chequing account balances - time deposits < 100k
- traveller’s cheques of - retail money – market/ mutual fund
non-bank issuers (M2) accts
(M1)
Money Creation
promissory exchange
note
exchange
exchange
Gold
goldsmith

Pg-3
promissory exchange
note
exchange
exchange
Gold
loan
goldsmith
money now: more promissory notes than

creation there is gold for
process ⇒ fractional reserve banking
Example: Reserve Requirement = 10%
Bank 1 Bank 2 Bank 3
res 10 100 dep. res 9 90 dep. 81 dep.
loan 90 loan 81 etc…
purchases seller purchases seller
𝐧𝐞𝐰 𝐝𝐞𝐩𝐨𝐬𝐢𝐭 𝟏𝟎𝟎 Pg-4

Σ of money created = i.e. = $𝟏𝟎𝟎𝟎
𝐫𝐞𝐬. 𝐫𝐞𝐪. .𝟏
money multiplier = 𝟏 𝟏
= 𝟏𝟎
set by central bank ⇒ ∴ Monetary Policy tool
Quantity Theory of Money
M × V = P× Y - in words: the amount of money

real output used to buy stuff = the
quality of price monetary value of output
money level - since we assume V is constant:
then spending (P × Y) is proportional
velocity of money
to M (money supply)
Money neutrality ⇒ is M ↑, only P ↑ (Monetarist Theory)

Demand for Money
transactions precautionary speculative

· pro-cyclical · rainy day fund · inversely related to
· 𝐭𝐫𝐚𝐧𝐬. 𝐛𝐚𝐥. ⇒ fairly asset yields
𝐆𝐃𝐏 stable (counter-cyclical)
· positively related to
perceived risk
Supply and Demand
I MS
@ I1 - excess MS (M0 – M1)
∴ less speculative demand
I1
- demand for yield drives prices up
and I ↓
I0
@ I2 – excess MD (M2 – M1)
I2 MD ∴ more speculative demand
M1 M0 M2 M - less demand for yielding assets
drives I ↑
The Fisher Effect
⇒ in words first: the real rate of interest is stable over time

∴ changes in normal rates are the result of changes
in expected inflation
Rnom = Rreal + πe
But: who knows?

uncertainty = risk
a required real return
∴ Rnom inflation expectation premium
risk premium

Role of Central Banks
⇒ Monopoly supplier of the currency (capacity to print money) Pg-1

from gold to fiat money
- non-convertible
- legal tender
∴ guardians of the - gov’t decree
value of the currency (inflation control)
⇒ in order to maintain confidence
⇒ Banker to the gov’t and other banks
drawdowns lender of the last resort
redeposits (if interbank loans can’t
be secured)
⇒ Supervisor of the Banking System (perhaps)

⇒ Regulator/supervisor of the payments system Pg-2
generates revenue i.e. Fed ～ $20B/yr.
⇒ Manage foreign reserves & gold reserves
* ⇒ Operation of Monetary Policy
quantity of money & credit
Objectives
Promote stable/sustainable growth by:

⇒ maintaining price stability - single
⇒ maximizing employment mandate
dual mandate
(ECB)
(Fed)


Costs of Inflation
High Inflation Unexpected

Expected & Predictable Unpredictable
⇒ wages could increase by ⇒ lagging incomes
the expectation - shoe leather costs
⇒ nominal interest rates would (unwillingness to hold cash
be set to the expectation balances)
⇒ prices would reflect the ⇒ borrowers benefit at expense
expectation of lenders (too high)
(so rates will include
· Expectations would become an uncertainty premium)
reality ⇒ frequent price changes
- menu costs
⇒ reduces the information
content of prices
Policy Tools
1) Open Market Operations Pg-1

- buy/sell gov’t securities from/to commercial banks
increase decrease reserves

reserves (contractionary)
(expansionary)
the
from tive
erspec Purchase & Resale
CB p rate
repo
Agreement Bank rate (discount rate) - lend
25 bps
target rate (policy rate)
25 bps
Overnight rate - borrow
Repurchase
f ro m interbank market
Agreement
bank’s
ive
perspect

2) Policy Rate ⇒ raising - contractionary Pg-2
⇒ lowering - expansionary
3) Reserve Requirements - already discussed
Transmission Mechanisms
Direct Effects Indirect Effects
Market
Rates Domestic
Demand
Asset Inflationary
Policy Total
Prices Pressure
Rate Demand
Expectations/
External Inflation
Confidence
Demand
Exchange Import
Rate Prices
Policy
1) Inflation Targeting Qualities of Effective Central Banks

Target: 1-3% usually ① Independence: from gov’t
Horizon: 1-2 years · operationally: to target rates
- most common except: without influence
BO5 Fed · target ind. free to define
2) Exchange Rate Targeting inflation
- setting a fixed level or ② Creditability: no competing
bound of values for the incentives
exchange rate vs. a major ③ Transparency
currency ⇒ one with a good - the indicators watched
track record with inflation - their forecast for
- domestic interest rates & M2 must inflation & growth
adapt to the FX rate instead!

The Neutral Rate
r contractionary
neutral ⇒ neither spurs on nor

rate slows down the economy
expansionary
the avg.
policy rate
over a
cycle ⇒ 2 components
1) real ⇒ real trend growth of the
+ underlying economy
2) inflation ⇒ long-run expected inflation

(usually the CB’s inflation target)
Limitations
Pg-1
1) Problems with transmission
⇒ Credit loosens @
long end of curve
· rise in s.t. rates met with belief of looming

recession
Credit tightens @
⇒ long end of curve
· drop on s.t. rates met with belief that inflation

will not be controlled

2) Deflation · raises real value of debt Pg-2
policy rate · may cause delays of consumption
(i.e. AD ↓)
0%
leads to more deflationary

pressure
r MS
money
demand curve ⇒ liquidity trap
D
horizontal

M0
⇒ use of quantitative easing
to lower long rates
buy securities here

10-yr to lower long rates
Fiscal Policy Taxation - wealth re-dist.

Spending - agg. demand
Roles and Objectives
A. influence aggregate demand
(Keynesian) · Expansionary ⇒ cut personal income taxes
⇒ cut sales taxes
⇒ cut corporate taxes
⇒ infrastructure spending
· Contractionary
raise taxes opposite of
contractionary discretionary
lower spending
budget
pay down debt
surplus
↑ U.I budget add to debt
automatic deficit expansionary
lower taxes
stabilizers
raise spending

Fiscal Policy Tools
Exp. Pg-1
A) Transfer Payments ⇒ automatic (i.e. UI, welfare, etc…)
B) Government Spending ⇒ discretionary (i.e. health, education,
defence)
C) Capital Expenditure ⇒ infrastructure
- enhances capital stock productivity
⇒ innovation investments
Rev.
A) Direct Taxes ⇒ on incomes
B) Indirect Taxes ⇒ fuel, alcohol, tobacco, sales tax, etc…
Taxes should be: 1. Simple (easy to both calculate & pay)
2. Efficient (should not affect decisions)
3. Fair - horizontal equity - those in the
same situations pay the same tax
- vertical equity - richer pay more
(progressive rates)
4. Revenue sufficient ⇒ should be enough
Adv: Pg-2
⇒ Indirect Taxes can be adjusted immediately
⇒ influence spending instantly may all
⇒ generate revenue efficiently have
⇒ discourage undesirable behavior expectational
Dis: effects
⇒ Direct Taxes take time to change
⇒ Cap. Ex. takes even longer
Fiscal Multiplier
Recall: ∴ household spending c (1 -t) Y

Yd = Y - NT - (1 - t) Y so if G ↑, Yd ↑ (1 - t) G
MPS = 1 MPC and C ↑ C (1 - t) G
(c)
𝟏 (1 -t) c (1 - t) G etc…
⇒ multiplier 𝟏
𝟏−𝐂 𝟏 − 𝐂 (𝟏 − 𝐭 ) ⇒ fiscal multiplier

(.9) (.1) Pg-3
e.g. Income tax Yd C S

100 20 80 72 8
𝟏 𝟏 𝟏
Fiscal multiplier = = = 𝟑. 𝟓𝟕
𝟏−. 𝟗(𝟏−. 𝟐) 𝟏−. 𝟕𝟐 . 𝟐𝟖
Balanced Budget Multiplier

Y = C + I Introduce a gov’t sector with t = 20%
1000 = 900 + 100 and spending = $200
C = .9 if MPC < 1, Y increase
S = .1
net change
savings = investment
[200 - 200(.9)] 𝟏
= 20 × 3.57 𝟏 − 𝐂 (𝟏 − 𝐭 )
= 71.40
Implementation
surplus Pg-1
just as a result
non-active
of automatic
fiscal policy
stabilizers
deficit
⇒
expansionary fiscal stance?

- deficit may not be discretionary
∴ structural deficit (cyclically adjusted)
current budget full

@
deficit balance employment
+
observable unobservable
i.e. Assume automatic stabilizers reduce taxes and increase
transfer payments by $1B
∴ structural deficit
current deficit = ($1.2B)
= ($1.2B) + 1B = ($200M)

Recognition Action Impact Pg-2
Lag Lag Lag
· imperfect · imperfect · imperfect
information decisions execution
imperfect transmission
⇒ will ↑ G lead to inflation?

⇒ if deficit/GDP is large, extra deficits may not be possible
⇒ full employment is not static
⇒ i.e. 5% unemp. may be 7% today
⇒ gov’t borrowing may crowd out more productive private borrowing
Pg-3
growing public - high exp. Fiscal
& private sectors tight
easy
rise in fall in
AD AD shrinking public sector
easy growing private sector
lower r lower r - mixed
Monetary
rise in fall in
AD AD
tight
higher r higher r
fall in public &

growing public sector
private sector
shrinking private sector
- highly cont.
- mixed

Deficit vs. Debt Pg-4
Rev - Exp < 0 accumulation of all
- financed by selling bonds unpaid deficits
𝐃𝐞𝐛𝐭
𝐈𝐧𝐭. 𝐩𝐚𝐲𝐦𝐞𝐧𝐭𝐬 · measure
𝐆𝐃𝐏 vs.
this ratio gets 𝐆𝐃𝐏 serviceability
worse · if real GDP
< real int. rate
Not a problem: growth
⇒ majority of debt is then 𝚫tax
< int. exp.
owned internally rev.
⇒ debt may have been used to Problem
raise public productivity ⇒ higher future tax rates
⇒ opportunity to rationalize tax = disincentives
system ⇒ printing press to pay
⇒ Ricardian equivalence debt
⇒ raises employment in slack ⇒ crowds out other debt
resources issues

REVIEW

Monetary & Fiscal Policy
Pg-1
Central Banks Government - review
interest rates money supply taxes spending

- seek stable & positive growth, stable & low inflation
Money ⇒ medium of exchange, store of value, unit of account
- must be - readily acceptable
- have a known value
- be easily divisible
- have a high value: weight ratio
- be difficult to counterfeit
- Definition of Money/
- narrow (M1) Broad (M2)
- coins/notes in circulation - narrow +
- demand deposits - savings/money market accts.
- chequing account balances - time deposits < $100k
- traveller’s cheques - retail money – market/ MF accounts
- Fractional Reserve Banking/ Pg-2

- review
Bank 1 Bank 2 Bank 3
reserve 10 100 dep. Res. 9 90 dep. R. 8.1 81 dep.
Loans 90 Loan 81 Loan 72.90
purchase ➞ seller purchases ➞ seller
Σ of money created = 𝐧𝐞𝐰 𝐝𝐞𝐩𝐨𝐬𝐢𝐭 𝟏𝟎𝟎

= $𝟏𝟎𝟎𝟎
- set by Central
money multiplier = 𝟏 𝟏 Bank
= = 𝟏𝟎
𝐫𝐞𝐬. 𝐫𝐞𝐪. .𝟏 - policy tool
- Quantity Theory of Money/
price P × Y = nominal GDP
level V - assume constant
real
M × V = P× Y Money neutrality ⇒ if M ↑, only
output
P ↑ in the long-run; in the
money
velocity of short-run, M ↑ can affect output
supply
money
- Demand for Money/ · transactions - pro-cyclical Pg-3
- review
· precautionary - pro-cyclical
· speculative - counter-cyclical (inversely
related to asset yields, positively
related to perceived risk of other assets)
- Supply & Demand/
I1 - excess MS, high I, ∴ less speculative
MS
int. demand for cash, more
ra te demand for yield assets,
I1
drives down rates
I2 – excess MD, low I ∴ opposite effect
I0
I2 MD
M - real interest rate
M1 M0 M2
is stable over time
- The Fisher Effect Rnom = Rreal + πe
a required real return
Rnom
inflation expectation
risk premium (regarding inflation uncertainty)
· Role of Central Banks Pg-4

· Monopoly supplier of the currency - fiat currency - review
· banker to the gov’t and other banks

· drawdowns · redeposits lender of the last resort
· supervisor of the banking system (not always, not alone)
· regulator/supervisor of the payments system
· manage foreign reserves/gold reserves
· operation of monetary policy
Objectives/
· maintain price stability ➞ single mandate
· maximizing employment dual mandate
Costs of Inflation/
Expected vs. Unexpected
- wages, interest rates - lagging incomes, borrowers
and prices would benefit, frequent price
reflect the expectation changes, information content
(expectations become reality) of prices reduced

- Policy Tools/ Pg-5
1) Open Market Operations - buy/sell gov’t securities from/to - review
buy - increase reserves commercial banks
sell = opposite (repo rate)
Purchase & Resale B - bank rate (discount rate)
25 bps ↑
Agreement T - target rate (policy rate)
25 bps ↓
Repurchase 0 - overnight rate
Agreement
interbank market
2) Policy Rate - raising = contractionary
- lowering = expansionary
3) Reserve Requirements
- Transmission Mechanism/
Direct Effects Indirect Effects
Market Rates Domestic
Policy Rate Asset Prices Demand Total Inflationary
Expectations/Confidence Demand Pressure
Exchange Rate External
Demand Import Inflation
Prices
- Qualities of Effective Central Banks/ Pg-6

operational - target rates without influence review
-
1) Independence
target - free to determine inflation
2) Creditability - no competing incentives
3) Transparency
- Inflation Targeting ➞ 1-3% over 1-2 yr. horizon
- Exchange Rate Targeting ➞ set a fixed level or bond of values
- Neutral Rate - neither spurs on nor slows down the economy
real rate (real trend growth)
- 2 components
inflation expectation (long run expectation)
- lower than neutral rate = expansionary policy
- higher contractionary policy
- Limitations of Monetary Policy/
1) transmission - rise in s.t. rates be met with belief of looming recession
(credit loosens at long end of curve)
- drop on s.t. rates met with belief that inflation will not
be controlled (credit tightens at long end curve)

- Limitations of Monetary Policy/ Pg-7
- review
2) Deflation - policy rate has a lower bound of 0%

taxation
⇒ Fiscal Policy/
spending
- Influence Aggregate Demand (Keynesian)
cut taxes
- expansionary - contractionary - opposite
increase spending
budget pay down debt
surplus
budget
add to debt
deficit
- Fiscal Policy Tools/
· Transfer Payments - automatic · Direct Taxes - on income
· Government Spending - discretionary · Indirect Taxes - fuel, alcohol, tobacco
· Capital Expenditure - infrastructure (taxes should be simple,
fair (horizontal equity, vertical
equity or progressive tax), efficient
(should not affect decisions) and
revenue sufficient)
Pg-8
Advantages/ · indirect taxes can be adjusted quickly
- review
- influences spending immediately
- generate revenue
- discourage undesirable behavior
Disadvantages/ direct taxes take time to change
CapEx takes even longer
𝟏
Fiscal Multiplier/ MPS = 1 - MPC ⇒ multiplier
𝟏 − 𝐌𝐏𝐂
so if G ↑, Yd ↑ (1 - t)G and C↑ by MPC (1 - t) G
𝟏
∴ fiscal multiplier = 𝟏 − 𝐌𝐏𝐂 (𝟏 − 𝐭 )
𝟏
e.g./ gov’t spending ↑ $1B, t = 30%, MPC = .90 = 𝟐. 𝟕𝟎𝟐

𝟏−. 𝟗(. 𝟕)
∴ gov’t spending of $1B adds $2.702B to GDP

Deficit vs. Debt/ - Σ of all deficits Pg-9
- review
Rev - Exp < 0 𝐈𝐧𝐭. 𝐩𝐚𝐲𝐦𝐞𝐧𝐭𝐬
𝐃𝐞𝐛𝐭
vs 𝐆𝐃𝐏
𝐆𝐃𝐏
. - measures serviceability
- high GDP/Debt not an issue if:
- majority of debt is owned internally
- debt was used to raise public productivity
- raise employment in slack resources
but// · higher future tax rates
· crowds out other debt issues
- Due to automatic stabilizers, surpluses/deficits may not be discretionary
current

⇒ Structural deficit budget full

@
+
deficit balance employment
⇒ Implementation/ Pg-10
- review
Recognition Lag ➞ Action Lag ➞ Impact Lag
- ↑ G may lead to inflation
- if deficit/GDP is large, extra G may not be possible
growing public &
Fiscal
private sectors
easy tight
easy - rise in AD - fall in AD
- lower r - lower r
Monetary
tight - rise in AD - fall in AD
- higher r - higher r
shrinking public &
private sector

International Trade and Capital Flows
a. compare gross domestic product and gross national product;
b. describe benefits and costs of international trade;
c. distinguish between comparative advantage and absolute advantage;
d. compare the Ricardian and Heckscher-Ohlin models of trade and the source(s) of
comparative advantage in each model;
e. compare types of trade and capital restrictions and their economic implications;
f. explain motivations for and advantages of trading blocs, common markets, and
economic unions;
g. describe common objectives of capital restrictions imposed by governments;
h. describe the balance of payments accounts including their components;
i. explain how decisions by consumers, firms, and governments affect the balance of
payments;
j. describe functions and objectives of the international organizations that facilitate

trade, including the World Bank, the International Monetary Fund, and the World
Trade Organization.

International Trade
GDP vs. GNP Pg-1

(more in use) · the market value
· of final g/s
· produced by factors of supplied by
located within
production citizens of a country
a country/economy
(either in or out of
country)
∴
· production of g/s by
in foreigners in the out
country
· production outside the

out in
country by its citizens
country Pg-2
Terms of trade:
ROW 𝐞𝐱𝐩𝐨𝐫𝐭 𝐩𝐫𝐢𝐜𝐞 𝐢𝐧𝐝𝐞𝐱
imports 𝐢𝐦𝐩𝐨𝐫𝐭 𝐩𝐫𝐢𝐜𝐞 𝐢𝐧𝐝𝐞𝐱
(Y) set to 100 in same
exports
(X) base year
> 100 ⇒ fewer exports

Net exports = X - M needed to pay for the
= 0 ⇒ balanced same level of imports
> 0 ⇒ surplus · terms of trade improved
< 0 ⇒ deficit <100 ⇒ more exports needed
Closed open to pay for the same level
· autarky vs. of imports
· terms of trade worsened
⇒
autarkic prices · world prices

Free trade ⇒ no gov’t restrictions on trade Pg-3
vs. ⇒ global AD & AS determine Eq & Ep of X/M
Trade Protection ⇒ tariffs, quotas, etc…

Dom. S · trade @ P1 excess supply Dom. S · trade @ P2
trade-off P2
PA
PA trade-off
· lower P
P1 Dom. D · lower dom. · higher P
Dom. D · higher dom.
production prod. & empl.
Gj GA Gk · lower dom. GC GA GD
employment exports
excess demand
· if the trade affected sector is
• imports
labour intensive:
exports - positive imports - negative
Benefits: Pg-4
exports occur @ higher prices
· countries gain from
imports occur @ lower prices
exchange & specialization
· industries experience
greater economies of scale
reduces monopoly power of
· households/firms have
domestic firms
greater product variety
efficient allocation
· competition is increased +
trade GDP higher productivity
· resources allocated more
knowledge spillovers
efficiently
pace of innovation
Costs: · potential for greater income
inequality comp. necessity incentives
· loss of jobs in developed countries
= structural unemployment (most difficult to fix)

Gains from Trade
Absolute Advantage ⇒ make it cheaper than other trading partners Pg-1
Comparative Advantage ⇒ opportunity cost of making output is lower

than opportunity cost of trading partners
Mach. Cloth Mach. Cloth
U.K. 4 8 U.K. 4 8
India 2 16 Abs. Adv. India 2 6
U.K. 2-cloth 𝟏K mach. U.K. 2-cloth 𝟏K mach.

𝟐 𝟐
India 8-cloth 𝟏K mach. Comp. Adv. India 3-cloth 𝟏K mach.
𝟖 𝟑
· if U.K could sell 1 mach. > 2 cloth U.K wins a bit
& India could buy 1 mach. < 8 cloth @3 India wins a lot
win - win
U.K wins a low
@7 India wins a bit
Cloth Pg-2
PA PG CA C 1600 -
F
U.K. ia PP
~ Ind
Machines 200 400 200 240 1200 -
Cloth 400 0 400 640
India 800 -
Machines 100 0 100 160
Cloth 800 1600 800 960 400 -
World PPF
~ UK
Machines 300 400 300 400
-
Cloth 1200 1600 1200 1600 100 200 400 Machines
U.K. (200, 400) 1 mach. = 2 cloth

India (100, 800) 1 mach. = 8 cloth

Cloth m = opp. cost of Pg-3
P - world price line
t
X in terms of
- new consumption possibilities line Y in the
120 -
a.k.a trading possibilities world market
Pline
A
90 -
I1
Autarkic A 𝐏𝐱
60 - 𝐐𝐲 = 𝐈K𝐏 − 𝐐 ∴ @ Pt A
Price (60, 60) 𝐲 𝐏𝐲 𝐱
Line
30 - B −𝐏𝐱 = opp. cost of

(120, 30) 𝐏𝐲 x in terms of
Y in the
-
30 60 90 -120 Machines
Competitive Advantage Pg-4

1. Ricardian ⇒ trade is based 2. Hecksher-Ohlin ⇒ trade is
on technological differences based on endowment of factors
⇒ results in of production
differences in labour ⇒ comp. adv. lies in goods
productivity (comp. adv.) produced with relatively abundant
Assumptions: factor
𝐊 𝐊 X - cap. int.
· Labour is the only 5 7 > 5 7
𝐋 𝐀 𝐋 𝐁 Y - Lab. int.
variable factor input
· Technology varies cap. abundant labour abundant
across countries country (X) country (Y)
# of hours to make X/Y Assumptions:
aLX ≠ bLX if aLX > bLX · Identical technologies within
b make X industries across countries
aLY ≠ bLY if aLY < bLY · Both L & K are variable
a make Y factor inputs

Trade and Capital Flows
Restrictions Pg-1
· Tariffs (tax on imports) · protect domestic industries
· Import quotes (restrict Q) (established & new)
· Voluntary export restraints (VER) · protect domestic employment
· Export subsidies · national security
· Embargoes (economic weapon) · generate revenue
· Domestic content requirements · close trade deficits
Capital Restrictions ⇒ restrict foreign ownership of

domestic assets (limits openness of
financial markets)
Pg-2
Tariffs - protect industries, generate revenues, reduce trade deficits
Dom S. · consumer loses surplus

value
A + B + C + D
· producer gains surplus
Pt value
t
A B C D A
P*
gov’t revenue
Dom D.
C
d.w.l
Q1 Q2 Q3 Q2
- (B + D)
imports
imports

Tariffs - protect industries, generate revenues, reduce trade deficits Pg-3
South
Africa:
Dom S.
·
produces 110k tons
·
demand 200k tons
@ p*
= $5
6 · impose 20% tariff
t prod. ⇒ 130k
5 A B C D
cons. ⇒ 170k
40k Dom D. cons. surplus
imports
(1 × 170k) + 𝟏K𝟐(30k) = $-185k
110k 130k 170k 200k prod. surplus
90k imports (1 × 130k) + 𝟏K𝟐(20k) = $120k
gov’t revenue Dwl. -185 + 120 + 40 = $-25k

1 × 40k = $40
Pg-4
Quota
Dom S.
captured by exporting
quota rent country
dwl = B + C +D
captured by importing
A B C D country
P*
e.g. selling import
40k Dom D.
licenses
dwl = B +D
Q1 Q4
Voluntary Export Restraint (VER)
imports · decision made by the exporter
90k · same effect as quota but
exporter captures quota rent
· reduce imports
to 40k

Export Subsidy · encourages exports Pg-5
· direct payment form gov’t ➞ producer
Producer ➞ shifts sales to export market

- get p* + subsidy
⇒ no incentive to sell domestically for
less than (p* + subsidy)
small country large country effect

effect - efforts depress world price
prod. ⇒ (lower p* + subsidy)
prod. cons. ⇒ (p* + subsidy)
p* + subsidy
cons. ∴ some part of subsidy is
transferred to ROW
Pg-5
Tariff Import Quota Export Subsidy VER
Impact on: Imp. Country Imp. Country Exp. Country Imp. Country
Prod. sur. + + + +
Cons. sur. - - - -
Gov’t rev. + mixed - ∅
dwl - (small) - (small) -
-
may + (large) may + (large)
Price + + + +
D. Cons. - - - -
D. Prod. + + + +
Trade imports - imports - export + imports -

Regional Trading Agreements
Regional Trading Bloc Pg-1
⇒ a group of countries that have signed an agreement to

reduce and progressively eliminate barriers to trade and
movement of factors of production among members
Free-trade
agreement (FTA) common trade free movement of
- barriers to the flow + policy towards + factors of production
of g/s eliminated non-members among members
- each member
= customs = common market
maintains its own
policy to non-members union
+ common economic institutions economic common monetary

= + =
+ co-ordination of economic policy union currency union as well
- regional integration · quicker, easier than WTO process Pg-2

results in preferential treatment for members
vs. non-members
Before After
X
A E - low cost A E
producer barrier to
D B
D B trade
C
C
higher cost
producer Trade diversion ⇒ lower cost imports
from non-members are replaces
with higher cost imports from
member countries

- regional integration · quicker, easier than WTO process Pg-3
results in preferential treatment for members
vs. non-members
Before After
barriers
A A
D B
D B
C
C
Trade creation: the replacement of

higher cost domestic production
for lower cost imports from
member countries
· All the benefits from L02 Pg-4

+ reduced potential for conflict
(higher levels of integration)
+ greater member bargaining power with ROW
+ spillover growth (convergence in living standards)
2 way high
lowered
process raised
low
Costs · adjustment costs
⇒ some production & jobs leave
temporary (i.e. one-time)

- but longer duration than otherwise
Contagion ⇒ problems in one country may spread to
other members

Challenges to Implementation Pg-5
1) Cultural/historical differences
⇒ integration @ economic level will
require some social/political integration
(esp. common market)
2) higher levels of integration may result in loss
of independent economic control
- difficult to control
· relative prices
· level of imports
less challenging more challenging
FTA custom common economic monetary

union market union union
Capital Restrictions
Pg-1
⇒ Free flow: adv. - investment can occur @ a rate higher
· long term than domestic savings
· relatively - achieve higher economic growth rate
fixed - FDI may bring new technology, skills, processes
‘Direct’ - induce domestic firms to become more efficient
disadv. - if investment is short-term in nature

i.e. indirect investing (stocks, bonds, etc…)
may inflate local currency (overvaluation) ‘hot
- when hot money leaves ⇒ capital flight money’
real estate
· value destruction
equity markets
· currency devaluation
inflation engine

why restrict? Pg-2
· protect domestic industries
· preserve domestic ownership
· minimize the export of profit
· control currency value
· if economy has a fixed-rate currency (i.e. a peg)
inflows - push - will most likely need capital restrictions
up a currency · limits on inflows/outflows make it
easier to hold the peg
outflows - push · interest rates can be used to steer
down a currency the domestic economy and not the
exchange rate
How? Pg-3
· prohibition ⇒ outright elimination
punitive
· taxes (in & out)
· price controls special taxes on investment returns

transaction - with holdings
taxes - loss of special
· quantity controls ⇒ small allowances
relaxations on prohibition i.e. Cap. gains. exem.
Div. Tax Credit
⇒ Costly to administer/monitor
⇒ May have long-term costs - isolation from global
capital markets

Balance of Payments
Double Entry Pg-1

Debits Credits
· increases in real assets · decreases in real assets
· increases in financial assets · decreases in financial assets
· decreases in financial liabilities · increases in financial liabilities
· exports · imports · financial transactions · transfer payments
Components
1. Current Account - measures the flow of g/s
2. Capital Account - measures the transfer of capital
3. Financial Account - records investment flows
BOP identity: 1 = 2 + 3 A = L + OE
Pg-2
Current Account
1. Merchandise trade - all commodities and manufactured goods bought, sold,
given away
2. Services e.g.- tourism, transportation, engineering, business services
- fees on patents, copyrights (software, books, movies)
3. Income Receipts - dividends, interest
4. Unilateral transfers - one-way transfer of assets
- foreign direct aid
- income earned from abroad sent back home
Capital Account
1) Capital transfers ⇒ debt forgiveness, migrants transfers, gift/inheritance
taxes, death duties, transfer of funds linked to the sale/purchase of fixed
assets
2) Sale and purchase of non-produced, non-financial assets
- rights to natural resources, sale/purchase of
intangible assets

Financial Account official reserve assets Pg-3
gold
1) financial assets abroad government assets forex
private assets securities
2) foreign owned financial assets within the country
official assets other foreign assets

bonds, stocks, - direct inv.
MBS - foreign liabilities
Examples
sell $50M of goods ($1M in transp. costs)
terms: 90 days
(Acts. Rec.) Financial Account $50M goods $49M
(Inv.) Current Account $50M
services $1M
Pg-4
Examples
2) import $45M, terms of 90-days
(Inv.)
Current Account $45M
(Acts. Pay.)
Financial Account $45M
3) Buy $100M in bonds from foreign country (same currency)
Financial Account $100M (Invest)+
Financial Account $100M (cash)-
4) Switzerland
$20 local so, instead
sell German
EUR bank replace
EUR Bank
SNB
CHF CHF deposits rather
buy EUR than sells
will affect EUR. CHF
(foreign reserves)
(Cash) Fin. Act. $20M
(st. Liab.) Fin. Act. $20M

Recall: Y = C + I + G + (X - M) Pg-5
equals the current account balance

· measures the size and direction of
international borrowing (lending)
𝐜𝐮𝐫𝐫𝐞𝐧𝐭
– – = –𝐜𝐚𝐩𝐢𝐭𝐚𝐥 + 𝐟𝐢𝐚𝐧𝐧𝐜𝐢𝐚𝐥 –
𝐚𝐜𝐨𝐮𝐧𝐭 𝐚𝐜𝐜𝐨𝐮𝐧𝐭
· hence the term ‘balance’ of payments
So, Y = C + I + G + (X - M)
(X - M) = Y - C - I - G if CA < 0, then must borrow
or from abroad
CA = Y - (C + I +G) if CA > 0, must be lending
abroad
CA = Y - [(Y - (T + R) - Sp) + I + G] Pg-6

Recall:
= Y - (Y + R + T - Sp + I + G)
Yd = Y - (T + R)
= Y - Y - R + T + Sp - I - G)
and Yd = C + Sp
= Sp + T - R - I - G
or
= Sp - I + (T - G - R)
C = Yd - Sp = Y - (T + R) - Sp
gov’t surplus
Sg
CA = Y - (C + I + G)
CA = Sp - I + Sg
CA + I = Sp + Sg
dom I
or Sp = I + CA - Sg
or CA = Sp + Sg - I
If CA <0, dom I dom I CA < 0 If Sp to low
Can be > Sp + Sg I is too high
Sy < 0

Trade Organizations
International Monetary Fund (IFM) Pg-1

· oversees the fixed exchange rate agreements
between countries
· help gov’ts manage their exchange rates
· provide short-term capital to aid balance of
payments (prevent the spread of crises)
World Bank · help developing countries fight poverty and
enhance environmentally sound economic growth
not
International Bank for for International Development
Reconstruction & Dev. profit Association
borrows @ ‘supranational org’
AAA rates provide low/no interest loans
& grants to countries with
pass on
no/few/bad options
policy-based lending
Pg-2
World Trade Organization (WTO)
· regulates cross-border trade relationships
globally (reviews/monitors trade policies)
· implements, administers & operates individual
agreements
· settles disputes

REVIEW

International Trade & Capital Flows
Pg-1
GDP - final MV of all final g/s produced
- review
- within a country (including foreigners within the country,
excluding citizens outside the country
GNP - excludes foreigners within the country, includes citizens outside
the country
Net exports X - M > 0 = surplus < 0 = deficit
𝐞𝐱𝐩𝐨𝐫𝐭 𝐩𝐫𝐢𝐜𝐞 𝐢𝐧𝐝𝐞𝐱
Terms of trade: set to 100 in same base yr.
𝐢𝐦𝐩𝐨𝐫𝐭 𝐩𝐫𝐢𝐜𝐞 𝐢𝐧𝐝𝐞𝐱
> 100 - fewer exports needed
Closed economy: Autarky
to pay for imports
- autarkic prices
- terms of trade improved
Open economy - world prices < 100 - opposite
Free Trade - no gov’t restrictions on trade
⇒ global AD/AS determine Ep & Eq of X/M
Pg-2
Trade Protection - tariffs, quotas, etc…
- review
- moving from closed to open economy, winners & losers
Losers Winners
- lower m prices vs. Domestic prices - higher X prices vs. domestic prices
- lower domestic production - higher domestic production
- lower employment - higher employment
excess demand filled trade-off - excess supply exported

by imports
exports - positive
- if the trade affected sector is labour intensive
imports - negative
Benefits of Trade/
· countries gain from exchange & specialization
· great economies of scale (business)
· greater product variety (consumer)
· more efficient allocated of resources
· competition increased - can increase the pace of innovation

Costs of Trade/ Pg-3
- review
- potential for greater income inequality
- loss of jobs in developed countries ⇒ structural unemployment
Absolute Advantage - make it cheaper than other trading partners
Comparative Advantage - opportunity cost of making output is lower
than the opp. cost of trading partners
than opp. cost of trading partners
X Y X Y
Country A 4 8 Country A 4 8
Absolute
Country B 2 16 Country B 2 6
Country A 2Y 𝟏K X Country A 2Y 𝟏K X
𝟐 𝟐 Relative
Country B 8Y 𝟏K X Country B 3Y 𝟏K X
𝟖 𝟑
Ricardian Model/ - trade is based on technological differences

∴ results in differences in labour productivity
· labour is the only variable factor
· technology varies across countries
Pg-4
Hecksher-Ohlin/ - trade is based on a country’s endowment of all the - review
factors of production ⇒ comparative advantage lies in goods produced
with relatively abundant factor
· Both labour and capital are variable
· technology is identical across countries
Restrictions on Trade/
· protect domestic
· tariffs -tax on imports
industries
· import quotes
· protect domestic
· voluntary export restraints (VER)
employment
· export subsidies
· national security
· embargoes
· close trade deficits
· domestic content requirements
Capital Restrictions - restrict foreign ownership of domestic assets

Tariffs - protect industries, generate revenues, reduce trade deficits Pg-5
- review
(raise domestic prices)
- consumer loses surplus value
- producer gains surplus value + government earns revenue
- will be deadweight loss · large country - may be
- small countries ⇒ loss of national welfare a gain
Quota - increases domestic production, domestic prices rise, imports drop
- consumer loses surplus value
- producer gains surplus value
- quota rent - if captured by exporting country - larger deadweight
- if captured by importing country - same loss than with tariff
deadweight loss as tariff + gov’t revenue
- small country ⇒ loss of national welfare · large country - may be a
Voluntary Export Restraint/ decision made by the exporter gain
- same effect as quota, but exporter captures
entire quota rent (generates no gov’t revenue)
Pg-6
Export subsidy/ direct payment form gov’t to producer
- review
- sell on world market for p*, get p* + subsidy
- no motivation to sell domestically for less than p* + subsidy
- large country exporters ⇒ can depress world prices
- producer gets lower p* + subsidy
∴ some of the subsidy gets transferred to ROW
- all forms/ · increase domestic price, decrease domestic consumption,
increase domestic production, create producer surplus, reduce
consumer surplus
Regional Trading Bloc - group of countries, agree to reduce and eliminate
barriers to trade

Regional Trading Bloc Pg-7
- review
Free-Trade Agreement + common trade policy + free movement of
- elimination of trade towards non-members factors of production
barriers
- each member maintains its = customs = common market
own policy towards non-members union
+ common economic intuitions economic common monetary

= + =
+ co-ordination of economic policy union currency union
Regional Integration/ preferential treatment for members vs. non-members
Before: After: X E
A E low cost A - barrier to trade
D B producer
D B
C
higher C
cost producer - trade diversion - lower cost
imports from non-members are replaced by
higher cost imports from members
Regional Integration/ Pg-8

- review
Before/ - trade creation - replacement
After
A barriers A of higher cost domestic
D B production with lower cost
D B
C imports from member
C
- benefits of integration: - all the benefits of trade

+ reduced potential for conflict
+ greater member bargaining power with ROW
+ convergence in living standards
- costs of integration:
· adjustment costs (will be losers)
· contagion - problems in one country may spread to another
· challenges to integration · cultural/historical differences
· some loss of independent economic control

· Capital Restrictions/ higher level of investment vs. domestic Pg-9
· free flow - review
savings alone
higher economic growth rate
FDI may bring new tech/skills/processes
negatives/
induce domestic firms to become more efficient
· short-term flows may inflate local currency (e.g. - stocks)
· capital flight can destroy value, devalue currencies (inflation engine)
(real estate, equities)
- why restrict capital? · protect domestic industries
· preserve domestic ownership
· control currency value (fixed rate regime most
How? likely needs cap. restrictions)
- prohibition ∴ interest rates can be used to steer the
- taxes (in & out) economy and not the exchange rate
- price controls taxes on investment returns withholdings
transaction taxes loss of special allowances
- quantity controls
Balance of Payments/ Pg-10

- review
Current Account = Capital Account + Financial Account
- flow of g/s · transfer of capital · investment flows
· merchandise trade + sale and purchase · financial assets
· services of non-produced, non- abroad
· income receipts (div, int.) financial assets · foreign owned fin.
· unilateral transfers (rights to nat. resources) assets within the
(foreign direct aid) country
- if CA < 0, then must borrow from abroad
CA > 0, must be lending abroad
CA + I = Sp + Sg CA = Sp + Sg - I
- if CA < 0, dom. I Sp too low
if CA < 0
can be > (Sp + Sg) Sg < 0
dom. S. I too high

· International Monetary Fund Pg-11
- oversees the fixed exchange rate agreements - review
- helps gov’ts manage their exchange rates
- provide short-term capital to aid balance of payments
· World Bank - help developing countries fight poverty and
enhance economic growth
International Bank for International

Reconstruction & Development Development Association
· World Trade Organization
- regulates cross border trade globally
- settles disputes
- slow & inefficient vs.
(replaced GATT)
regional trading blocs

International Trade and Capital Flows
a. define an exchange rate and distinguish between nominal and real exchange rates and
spot and forward exchange rates;
b. describe functions of and participants in the foreign exchange market;
c. calculate and interpret the percentage change in a currency relative to another

currency;
d. calculate and interpret currency cross-rates;
e. convert forward quotations expressed on a points basis or in percentage terms into an

outright forward quotation;
f. explain the arbitrage relationship between spot rates, forward rates, and interest rates;
g. calculate and interpret the forward rate consistent with the spot rate and the interest
rate in each currency;
h. calculate and interpret the forward rate consistent with the spot rate and the interest
rate in each currency;
i. describe exchange rate regimes;
j. explain the effects of exchange rates on countries’ international trade and capital
flows.

FX - Market
Pg-1
USD AUD RVB EUR. USD
EUR NZD SGD USD. CAD EUR. USD = 1.0950
GBP NOK etc… GBP. USD
JPY SEK USD. JPY
CAD CHF USD. CAD = 1.3925
exchange
individual rates
currencies in terms of A/B
𝐔𝐒𝐃K price
So… EUR. USD = 𝐄𝐔𝐑 𝐔𝐒𝐃
= 𝟏. 𝟎𝟗𝟓𝟎
if 𝐔𝐒𝐃K et1 = 1.0950 𝐄𝐔𝐑
base (1) buys
𝐄𝐔𝐑
et2 = 1.0900
𝐂𝐀𝐃 need
USD appreciated = 𝟏. 𝟑𝟗𝟐𝟓
or 𝐔𝐒𝐃
(1) to get
EUR depreciated
· Nominal exchange rate EUR. USD or 𝐔𝐒𝐃K𝐄𝐔𝐑

Pg-2
Now, let’s assume spot rates 5𝐒𝒅K 7

𝒇
1) a world of homogenous g/s d - domestic
direct
2) no market frictions f - foreign
3) no trade barriers (i.e. capital restrictions) indirect 5𝐒𝒅K 7
if an iPad cost £ 500 or $750, we would expect 𝒇
𝐔𝐒𝐃K [GBP. USD = 1.5000]
𝐆𝐁𝐏 = 𝟏. 𝟓𝟎𝟎𝟎
called Purchasing Power Parity (theory)
rarely satisfied (if ever) for ∀ goods/baskets
Reality Check: nominal exchange rates exhibit persistent
deviations from PPP

Real Exchange Rates Pg-3
if 𝐀K𝐁 ↑ (B.A)
A B
or if 𝐂𝐏𝐈𝐁 ↑
you live in · A - lander will suffer a
A - land… and want to buy loss of PP in terms of
from B - land B - land g/s
① foreign price But: if 𝐂𝐏𝐈𝐀 ↑ (and I & CPI
level in domestic = 𝑺𝑨K𝑩 × 𝑪𝑷𝑰𝑩 move together)
currency
· A - lander will gain PP
and if CPIA = price level in
in terms of B - land g/s
A - land
real exchange 𝑪𝑷𝑰𝑩
rate = 𝑺𝑨K ×
𝑩 𝑪𝑷𝑰𝑨
Pg-4
Real Exchange Rates
Example/ want to
GBP EUR
buy g/s
𝐂𝐏𝐈𝐄𝐔𝐑
real fx-rate = 𝑺𝑮𝑩𝑷K ×
𝑬𝑼𝑹 𝐂𝐏𝐈𝐆𝐁𝐏
so, if 𝑺𝑮𝑩𝑷K ↑ 10%, 𝐂𝐏𝐈𝐄𝐔𝐑 ↑ 5%, 𝐂𝐏𝐈𝐆𝐁𝐏 ↑ 2%

𝑬𝑼𝑹
- what is the change in the real fx-rate?
𝟏 + %𝚫𝐂𝐏𝐈𝐄𝐔𝐑 𝟏. 𝟎𝟓
N𝟏 + %𝚫𝐒𝑮𝑩𝑷K P× ¡ − 𝟏 = 5𝟏. 𝟏𝟎 × 7 = 𝟏𝟑. 𝟐𝟑
𝑬𝑼𝑹 𝟏 + %𝚫𝐂𝐏𝐈𝐆𝐁𝐏 𝟏. 𝟎𝟐
shortcut ∼ 10% + 5% - 2%
∴ real fx-rate is 13.23% higher = 13%
- means ⇒ need 13.23% more £ to buy same g/s in £


Real Exchange Rates Pg-5
Example/ real
CNY USD
fx-rate
of to get 1 so, CNY
𝐂𝐍𝐘K USD. CNY ↓ 𝟑%
𝐔𝐒𝐃 ↓ 𝟑% needs appreciated
(1) buys against USD
CPIUSD = 1.5% CPICNY = 4.5%
𝟏. 𝟎𝟏𝟓 𝟏. 𝟎𝟏𝟓
real fx rate 𝟏 + (−. 𝟎𝟑) × ¡ − 𝟏 = 5. 𝟗𝟕 × 7 − 𝟏 = −𝟓. 𝟕𝟖%
𝟏. 𝟎𝟒𝟓 𝟏. 𝟎𝟒𝟓
(shortcut -3% + 1.5% - 4.5% = -6%)
means ⇒ need 6% less CNY to
buy same g/s in USD
𝑺 Pg-5b
e.g./ Setup: hold bonds in HKD, live in AUD N𝐒𝐀𝐔𝐃K P = N 𝒅K𝐟P
𝐇𝐊𝐃
1) if 𝐒𝐀𝐔𝐃K ↑, HKD bonds ↑ in AUD terms?
𝐇𝐊𝐃
yes, if 𝐒𝐀𝐔𝐃K ↑, HKD buys more AUD

𝐇𝐊𝐃
2) if 𝐒𝐀𝐔𝐃K ↑, relative purchasing power in HKD ↑
𝐇𝐊𝐃
no, HKD buy more AUD, but they do not buy
more g/s denominated in HKD
① ②
3) if CPIAUD ↑, then 𝐫𝐞𝐚𝐥𝐀𝐔𝐃K ↑ ⇒ implies that relative
𝐇𝐊𝐃
purchasing power of AUD income is higher

𝐂𝐏𝐈𝐇𝐊𝐃 𝐂𝐏𝐈𝐇𝐊𝐃
① no 𝐒𝐀𝐔𝐃K × (if CPI ↑, ↓, 𝐫𝐞𝐚𝐥𝐀𝐔𝐃K ↓)
𝐇𝐊𝐃 𝐂𝐏𝐈𝐀𝐔𝐃 𝐂𝐏𝐈𝐀𝐔𝐃 𝐇𝐊𝐃
② no if 𝐫𝐞𝐚𝐥𝐀𝐔𝐃K ↑, purchasing power of AUD ↓

𝐇𝐊𝐃

e.g./ Setup: hold bonds in HKD, live in AUD Pg-5c
𝐒
N𝐒𝐀𝐔𝐃K P = N 𝐝K𝐟P
𝐇𝐊𝐃
4) if 𝐒𝐀𝐔𝐃K ↓, then 𝐫𝐞𝐚𝐥𝐀𝐔𝐃K ↓ & increase the
𝐇𝐊𝐃 𝐇𝐊𝐃
relative purchasing power of AUD income
𝐂𝐏𝐈𝐇𝐊𝐃
yes:5𝐒𝐀𝐔𝐃K × 7 = 𝐫𝐞𝐚𝐥𝐀𝐔𝐃K - implies AUD is
𝐇𝐊𝐃 𝐂𝐏𝐈𝐀𝐔𝐃 𝐇𝐊𝐃
strengthening
against HKD
5) 𝐒𝐀𝐔𝐃K ↑ 5%, CPIHKD ↑ 5%, CPIAUD ↑ 2%
𝐇𝐊𝐃
(HKD bonds in AUD ↑ or ↓?) ↑ 5%
6) change in relative purchasing power of AUD income
𝟏. 𝟎𝟓
𝐫𝐞𝐚𝐥𝐀𝐔𝐃K = 5(𝟏+. 𝟎𝟓) × 7¡ − 𝟏 = 𝟖. 𝟎𝟖𝟗%
𝐇𝐊𝐃 𝟏. 𝟎𝟐
FX - Market Products
Pg-6
spot rates ⇒ for immediate delivery (i.e. on the spot)
(24 hours/day - on business days) (T + 2 settlement)
forward exchange rates ⇒ delivery at a future date agreed upon today
(OTC)
futures ⇒ exchange-traded forwards
(standardized)
Fx-swap · rolling an existing, but expiring forward, to a future date
- requires simultaneous spot transaction + new
forward agreement
original/ sell £100M
@ 𝐔𝐒𝐃K𝐄𝐔𝐑 = 𝟏. 𝟐𝟓𝟎𝟎
-
6 mos. 12 mos.
swap/ spot-buy sell £ 100M

£100M @ 𝐔𝐒𝐃K𝐄𝐔𝐑 = 𝟏. 𝟐𝟒𝟎𝟎

FX - Market Participants
Pg-7
· facilitate trade in g/s
· facilitate capital flows (FDI of indirect Inv.)
· hedge forex risk
· speculate
⇒ Participants
· Corporations ⇒ hedging, capital flows
· Funds ⇒ insurance, mutual, pension, endowments, ETFs
(a.k.a. non-leveraged institutional or real money funds)
· Leveraged Funds ⇒ hedge funds, prop. traders, leveraged ETFs, etc…
· Retail ⇒ Individual Account
· Government/Quasi-Gov’t
· Central Banks - manage foreign reserves, currency intervention
· Sovereign Wealth Funds (SWFs)
FX- Rate Calculations
price Pg-8
e.g./
𝐀K 𝐝K 𝐂𝐀𝐃K
Direct 𝐁 𝐟 𝐔𝐒𝐃 = 𝟏. 𝟑𝟑𝟎𝟎
base
𝐔𝐒𝐃K 𝟏
𝐁K 𝐟K 𝐂𝐀𝐃 = 𝟏. 𝟑𝟑𝟎𝟎 = 𝟎. 𝟕𝟓𝟏𝟗
Indirect 𝐀 𝐝
Quote Conventions
EUR euro 𝐔𝐒𝐃K EUR. USD

𝐄𝐔𝐑
JPY dollar-yen 𝐉𝐏𝐘K USD. JPY
𝐂𝐀𝐃
GBP sterling 𝐔𝐒𝐃K GBP. USD Major
𝐆𝐁𝐏
CAD loonie 𝐂𝐀𝐃K USD. CAD Pairs
𝐔𝐒𝐃
AUD aussie 𝐔𝐒𝐃K AUD. USD
𝐀𝐔𝐃
NZD kiwi 𝑼𝑺𝑫K NZD. USD
𝑵𝒁𝑫
CHF swissie 𝐂𝐇𝐅K USD. CHF
𝐔𝐒𝐃

𝐀K B.A. Pg-9
Quote Conventions 𝐁
EURJPY euro-yen 𝐉𝐏𝐘K EUR. JPY

𝐄𝐔𝐑
EURGBP euro-sterling 𝐆𝐁𝐏K EUR. GBP
𝐄𝐔𝐑
EURCHF euro-swiss 𝐂𝐇𝐅K EUR. CHF
𝐄𝐔𝐑
GBPJPY sterling-yen 𝐉𝐏𝐘K GBP. JPY cross pairs
𝐆𝐁𝐏
EURCAD euro-cad 𝐂𝐀𝐃K EUR. CAD
𝐄𝐔𝐑
CADJPY cad-yen 𝐉𝐏𝐘K CAD. JPY
𝐂𝐀𝐃
USD. CAD some quotes

1.39025
Sell Buy
pips 100 pips = 1 cent
1.39 02
1.39 06 dollar
cents
16.8M 19.2M
Yen 110.63
Bid Offer
Sell USD Buy USD
(Buy CAD) (Sell CAD)
t0 𝐔𝐒𝐃K t1 𝐔𝐒𝐃K Pg-10

𝐄𝐔𝐑 = 𝟏. 𝟐𝟓𝟎𝟎 𝐄𝐔𝐑 = 𝟏. 𝟑𝟎𝟎𝟎
𝟏. 𝟑𝟎 − 𝟏. 𝟐𝟓 ⇒ interpreted from the point of

= 𝟒%
𝟏. 𝟐𝟓 view of the base
∴ the EUR has appreciated relative
to the USD by 4%
Inverse/
𝐄𝐔𝐑K 𝟏
𝐄𝐔𝐑K 𝟏 Identical
𝐔𝐒𝐃 𝟏. 𝟐𝟓𝟎𝟎 = 𝟎. 𝟖𝟎𝟎𝟎
=
𝐔𝐒𝐃 = K𝟏. 𝟑𝟎𝟎𝟎 = 𝟎. 𝟕𝟔𝟗𝟐 Statements
. 𝟕𝟔𝟗𝟐 − . 𝟖𝟎𝟎𝟎
= −𝟑. 𝟖𝟓% ∴ the USD has
. 𝟖𝟎𝟎𝟎
depreciated 3.85%
relative to the EUR

𝟏 Pg-11
USD. CAD = 1.3900 CAD. USD = = 𝟎. 𝟕𝟏𝟗𝟒
𝟏. 𝟑𝟗𝟎𝟎
USD. CAD as this CAD. USD

Sell Buy rises
Buy Sell
1.3898 1.3902 .7196 .7192
Bid Ask -offer Ask Bid

⇒ offer this falls
⇒
Buy USD Sell CAD
Sell CAD Buy USD
Payoff: in CAD in USD
(gains/losses)
FX Cross - Rate Calculations
e.g. 1/ 𝐔𝐒𝐃K Pg-12

𝐂𝐀𝐃K 𝐄𝐔𝐑 = 𝟏. 𝟎𝟗𝟓𝟎
𝐔𝐒𝐃 = 𝟏. 𝟑𝟗𝟖𝟎
Find 𝐂𝐀𝐃K𝐄𝐔𝐑
𝐂𝐀𝐃K 𝐔𝐒𝐃K 𝐂𝐀𝐃K
𝐔𝐒𝐃 × 𝐄𝐔𝐑 = 𝐄𝐔𝐑
1.3980 × 1.0950 = 1.5308 (corrected from screen)
e.g. 2/ 𝐂𝐀𝐃K𝐔𝐒𝐃 = 𝟏. 𝟑𝟗𝟖𝟎 𝐉𝐏𝐘K

𝐔𝐒𝐃 = 𝟏𝟐𝟏. 𝟏𝟎
𝐉𝐏𝐘K
Find 𝐂𝐀𝐃 e.g. 3/ Decompose
𝟏
- first 𝐔𝐒𝐃K 𝐂𝐇𝐅K
𝐂𝐀𝐃 𝟏. 𝟑𝟗𝟖𝟎 = 𝟎. 𝟕𝟏𝟓𝟑
= 𝐄𝐔𝐑
𝐂𝐇𝐅K 𝐔𝐒𝐃K
𝐉𝐏𝐘K 𝐔𝐒𝐃K 𝐉𝐏𝐘K 𝐔𝐒𝐃 × 𝐄𝐔𝐑
𝐔𝐒𝐃 × 𝐂𝐀𝐃 = 𝐂𝐀𝐃
121.10 × 0.7153 = 86.62

Forward Calculations
pips Pg-13
- forward rates typically quoted as spot + points
(pos./neg.)
spot + points = forward, premium (base)
spot - points = forward discount (base)
e.g./ 𝐔𝐒𝐃K𝐄𝐔𝐑 = 1.2875 discount

1-yr. forward rate = 1.28485
1-yr forward points = -26.5
e.g./ spot 1.2875
1 week -.3
1.2875
1 mos. -1.1 -
13.3
3 mos. -5.5
1.28617
6 mos. -13.3
12 mos. -26.5
also called swap points
Pg-14
$1000 CAD
invest @ id for t1 convert to USD at 𝐒𝐟K
𝐝
t =0 t1
invest at if for ti
-
-1000 1000 (1 + id)

t0 t1
So, for there to be no
-
-
-1000 𝐒𝐟K 1000 𝐒𝐟K (𝟏 + 𝐢𝐟 )
arb. opp. 𝐝 𝐝
𝟏𝟎𝟎𝟎 𝐒𝐟K (𝟏 + 𝐢𝐟 ) amount in USD

𝐝
𝟏𝟎𝟎𝟎(𝟏 + 𝐢𝐝 ) =
𝐅𝐟K convert back to × 𝐒𝐝K
𝐝 𝐟
𝐒𝐟K (𝟏 + 𝐢𝐟 ) CAD
𝐝
(𝟏 + 𝐢𝐝 ) = 𝟏𝟎𝟎𝟎 𝐒𝐟K (𝟏 + 𝐢𝐟 ) 𝐒𝐟K
𝐅𝐟K 𝐝
𝐝 if (𝟏 + 𝐢𝐝 ) < 𝐒𝐟K (𝟏 + 𝐢𝐟 ) 𝐝
𝐝 𝐅𝐟K
𝐅𝐟K 𝐝
𝐒𝐟K (𝟏 + 𝐢𝐟 ) 𝐝
𝐅𝐟K = 𝐝 buy CAD, sell USD
𝐝 (𝟏 + 𝐢𝐝 )

Pg-15
𝐒𝐟K (𝟏 + 𝐢𝐟 ) e.g. 𝐒𝐟K = 𝟏. 𝟔𝟓𝟑𝟓 𝐢𝐝 = 𝟑. 𝟓% 𝐢𝐟 = 𝟓%
𝐝 𝐝
𝐅𝐟K =
𝐝 (𝟏 + 𝐢𝐝 )
𝟏. 𝟔𝟓𝟑𝟓(𝟏. 𝟎𝟓)
𝐅𝐟K = = 𝟏. 𝟔𝟕𝟕𝟓 240 pips
𝐝 𝟏. 𝟎𝟑𝟓
(points)
If 𝐅𝐟 = 𝟏. 𝟔𝟗𝟎𝟎 - what would we do?
K 𝐝 i.e. 2.4¢
Simple Rule: Buy low, Sell high
𝐒𝐟K (𝟏 + 𝐢𝐟 )
𝐝
(𝟏 + 𝐢𝐝 ) =
𝐅𝐟K
𝐝
Borrow 1.6535 o (f), convert to 1 unit of (d), Sell 𝐅𝐟K @ 1.69

𝐝
𝟏. 𝟔𝟓𝟑𝟓(𝟏. 𝟎𝟓)
𝟏. 𝟎𝟑𝟓 > = 𝟏. 𝟎𝟐𝟕𝟑
𝟏. 𝟔𝟗
Pg-16
𝐒𝐟K (𝟏 + 𝐢𝐟 )
𝐅𝐟K = 𝐝 ⇒ 𝐅𝐟K𝐝 (𝟏 + 𝐢𝐟 )
𝐝 (𝟏 + 𝐢𝐝 ) =
(𝟏 + 𝐢𝐝 ) if num > den
𝐒𝐟K
𝐝
𝐅𝐟K > 𝐒𝐟K

𝐝 𝐝
But 𝐅𝐝K (𝟏 + 𝐢𝐝 )
𝐟
= den > num General Rule:
𝐒𝐝K (𝟏 + 𝐢𝐟 )
𝐟
- if the base currency
𝐅𝐝K < 𝐒𝐝K is the higher yielding currency
𝐟 𝐟
⇒ forwards will be at a discount
- if the base currency is the lower
yielding currency
⇒ forwards will be at a premium

Exchange Rate Regimes
fixed-rate floating-rate Pg-17
· reduces uncertainty · exchange-rate

risk
· uncertainty
fully convertible capital restrictions
· unrestricted capital flows · inefficient

· efficient allocation of allocation
capital of capital
effective monetary
weak to no monetary
policy
policy effectiveness
· fully independent
Pg-18
Historical Evolution:
Gold Standard Bretton Woods Flexible fx
· up to 1930s · fixed fx regime · market
· money supply tied to · inflation of 1970s determined
trade balance surplus/deficit - most countries · fx rates much
· drop in global trade during leave fixed for more volatile
1930s - countries abandoned floating fx regime than expected
the standard
Midway ➞ limited flexibility
EU (79-92)

1) No separate legal tender Pg-19
dollarization monetary union (EU)

· countries use the currency of another nation
· imposes fiscal discipline since
country cannot monetize debt
· renders domestic monetary policy unless
2) Currency Board System

- commitment to exchange domestic for foreign
at a fixed rate
· limits printing press obviously
· 100% foreign currency reserves against the monetary base
3) Fixed parity · no legislative commitment Pg-20
- can be abandoned
· does not require 100% fx reserves
· some central bank flexibility
USD or trade-weighted basket of currencies
+/- 1% bond
excess demand results in > 1%
inflationary ➞ · must sell domestic & buy foreign to keep peg
deficient demand results in < 1%
deflationary ➞ · must sell foreign reserves and buy domestic
4) Target zone - as above but +/- 2%

5) Active & Passive Crawling Pegs Pg-21
static peg ⇒ fixed
passive ⇒ peg adjusted to inflation (passive crawl)
active peg ⇒ fx-rate pre-announced with changes in
small steps
- rather than react to inflation, the announcement
was meant to influence expectations (active crawl)
6) Fixed Parity with Crawling Bands
fixed rate with +/- 1%
then +/- 2%
then +/- 3% etc…
7) Managed Float - fx-rate based on policy targets
i.e. trade balance, price stability, etc…
Pg-22
8) Independently Floating Rates
· market determined fx-rates
· central bank enjoys full independence
· most common (esp. among the majors)
· Central Banks will ‘regime switch’ as it suits their objectives

FX, International Trade, Capital Flows
surplus Cap. + Fin. deficit Pg-23

trade offset by
Acct.
deficit surplus
CA Cap. Act.

∴ if fx-rates affect, they must affect

Recall (X - M) = (S - I) + (T - G)
CA = SP - I + Sg
or SP + Sg = CA + I Short to
intermediate effect L.T.
So, take country effect
trade surplus Capital Flows Trade surplus
A · places upward
⇒ enter ⇒ shrinks
pressure on · drive up currency · may even
currency & fin. assets become negative
elastic Pg-24
Recall from Micro: 𝑬 = − %𝚫𝐐 unit elastic
%𝚫𝐏 inelastic
Marshall-Lerner Condition
⇒ if this condition holds, then fx-rate
𝐖𝐗 𝐄𝐗 + 𝐖𝐌 (𝑬𝐌 − 𝟏) > 𝟎 management will have an effect
on the trade balance
𝐗 𝐌
𝐖𝐗 = 𝐖𝐌 =
𝐗+𝐌 𝐗+𝐌
price elasticity of domestic demand for M
- assumes imports are billed in
price elasticity of
the foreign currency
foreign demand for X
So, if 𝐖𝐌 > 𝐖𝐗 ⇒ trade deficit
- assumes exports are billed
then fx-rate deval./deprec. will
in the domestic currency and
help 𝐖𝐌 = 𝑾𝑿
that Pd is unchanged

𝐖𝐗 𝐄𝐗 + 𝐖𝐌 (𝐄𝐌 − 𝟏) > 𝟎 Pg-25
· the more elastic demand is for X
larger as if 𝐄𝐌 < 𝟏, this
and M, the more likely deval./deprec.
𝐄𝐗 increases term negative
will improve a trade balance
𝐖𝐌 > 𝐖𝐗 𝐖𝐗 > 𝐖𝐌
-
𝐄𝐌 becomes more 𝐖𝐌 = 𝐖𝐗
critical for success
Initial condition met?
e.g. X M 𝐖𝐗 𝐄𝐗 + 𝐖𝐌 (𝐄𝐌 − 𝟏) > 𝟎
𝑬𝐝 .75 .65 .4(.75) + .6(.65-1)
dep. € 10% .30 + (-.21) = .09 > 0
𝐏𝐝 ∅ 10% new x 430M
𝐏𝐟 -10% ∅ y 621M (𝟏 − 𝐄 ) %𝚫𝐏
X = 400M M = 600M (191M) (𝟏− . 𝟔𝟓 ) 𝟏𝟎%
U.S. (200M) 𝟑. 𝟓%
𝐖𝐗 𝐄𝐗 + 𝐖𝐌 (𝐄𝐌 − 𝟏) > 𝟎 Pg-26

fx- rate changes will be more effective for trade
adjustment if X & M
· have substitutes
· trade in competitive markets
· are luxury goods, rather than necessities
· are goods that represent a large portion of
consumer expenditures
J-curve +
· in the short run: in the long run
fx-rate ↓, but 𝐄𝐝 < 1 ep · consumers
devld
· consumers need time respond to the
to change behavior 0 change in
-
t =0 1 2 3 4 etc…
relative prices
∴ deficit worsens CA -

Absorption Approach Y = C + I + G + (X - M) Pg-27
A = total
A B absorption
⇒ Y = A + B
B = trade balance
(Y - A) > 0 = surplus
or B = Y - A
(Y - A) < 0 = deficit
∴ to improve trade balance, increase incomes/output
and/ or reduce absorption
a lower fx-rate will shift
a lower fx-rate may cause demand to domestic g/s
a wealth effect (if there is excess capacity)
⇒ lower purchasing power of · if MPC < 1, output rises faster
domestic currency denominated than absorption
assets may boost MPS ⇒ trade balance improves
(weak argument)

REVIEW

Currency Exchange Rates
buys Pg-1
⇒ Exchange Rate 𝐩𝐫𝐢𝐜𝐞 e.g. 𝐂𝐀𝐃 ↑ = base app. - review
= 𝟏. 𝟐𝟓𝟑𝟓
𝐛𝐚𝐬𝐞 𝐔𝐒𝐃 ↓ = base dep.
(1)
nominal
𝐒𝐝K - direct 𝐒𝐟K - indirect
𝐟 𝐝
· Purchasing Power Parity: assumes ① a world of homogenous g/s

② no market frictions
③ no trade barriers/capital restrictions
⇒ Real Exchange Rate 𝐂𝐏𝐈𝐝 rarely satisfied
𝐂𝐏𝐈𝐟
𝐒𝐝K × or 𝐒𝐟K ×
𝐟 𝐂𝐏𝐈𝐝 𝐝 𝐂𝐏𝐈𝐟
- if %𝚫𝐒𝐝K ↑ 10% 𝟏 + %𝚫𝐂𝐏𝐈𝐟
𝐟
𝟏 + %𝚫𝐒𝐝K × ¡−𝟏
𝐂𝐏𝐈𝐟 ↑ 5% 𝐟 𝟏 + %𝚫𝐂𝐏𝐈𝐝
- need 13.23%
𝐂𝐏𝐈𝐟 ↑ 2% 𝟏+ . 𝟎𝟓
(𝟏+ . 𝟏𝟎) × ¡ − 𝟏 = 𝟏𝟑. 𝟐𝟑% more d. to buy
𝟏+. 𝟎𝟐
same goods in f.
- spot rates - for immediate delivery Pg-2

- forward exchange rates - delivery at a future date, agreed on today review
-
- Fx-swap - rolling a forward, forward - requires a simultaneous
spot transaction + new forward agreement
⇒ Participants in FX-markets
- Corporations, Financial Institutions, Retail Investors,
Governments, Central Banks
⇒ Major Pairs - very liquid currency pairs (include the USD)
e.g. 𝐔𝐒𝐃K𝐄𝐔𝐑

⇒ Cross Pairs - less liquid currency pairs e.g. 𝐆𝐁𝐏K

𝐄𝐔𝐑
- Calculations/ 𝐔𝐒𝐃K 𝐔𝐒𝐃K
𝐄𝐔𝐑 = 𝟏. 𝟐𝟓𝟎𝟎 𝐄𝐔𝐑 = 𝟏. 𝟑𝟎𝟎𝟎
𝟏. 𝟑𝟎𝟎𝟎 − 𝟏. 𝟐𝟓𝟎𝟎
-
= 𝟒% 𝐄𝐔𝐑K 𝟏 𝐄𝐔𝐑K 𝟏
𝟏. 𝟐𝟓𝟎𝟎 𝐔𝐒𝐃 = K𝟏. 𝟐𝟓 =. 𝟖𝟎𝟎𝟎 𝐔𝐒𝐃 = K𝟏. 𝟑𝟎 =. 𝟕𝟔%
EUR ↑ 4% But . 𝟕𝟔𝟗𝟐−. 𝟖𝟎𝟎𝟎
= −𝟑. 𝟖𝟓% USD ↓ 3.85%
. 𝟖𝟎𝟎𝟎
identical statements

- Cross Rate Calculations/ Pg-3
eg. 1/ 𝐂𝐀𝐃 - review
𝐔𝐒𝐃K
K𝐔𝐒𝐃 = 𝟏. 𝟑𝟗𝟖𝟎 𝐄𝐔𝐑 = 𝟏. 𝟎𝟗𝟓𝟎
𝐂𝐀𝐃K 𝐂𝐀𝐃K 𝐔𝐒𝐃K
𝐄𝐔𝐑 = 𝐔𝐒𝐃 × 𝐄𝐔𝐑 = 𝟏. 𝟑𝟗𝟖𝟎 × 𝟏. 𝟎𝟗𝟓𝟎 = 𝟏. 𝟓𝟑𝟎𝟖
eg. 2/ 𝐂𝐀𝐃K 𝐉𝐏𝐘K

𝐔𝐒𝐃 = 𝟏. 𝟑𝟗𝟖𝟎 𝐔𝐒𝐃 = 𝟏𝟐𝟏. 𝟏𝟎
𝐉𝐏𝐘K 𝐉𝐏𝐘K 𝟏 𝟏
𝐂𝐀𝐃 = 𝐔𝐒𝐃 × sI𝑪𝑨𝑫K = 𝟏𝟐𝟏. 𝟏𝟎 ×
𝟏. 𝟑𝟗𝟖𝟎
= 𝟏𝟐𝟏. 𝟏𝟎 ×. 𝟕𝟏𝟓𝟑 = 𝟖𝟔. 𝟔𝟐
𝑼𝑺𝑫L

⇒ Forward Rate Calculations/ spot + points = forward, premium
e.g./ 𝐔𝐒𝐃K𝐄𝐔𝐑 = 1.2875 spot - points = forward discount
spot 1.2875 also called

1 week -.3 swap points when only
1 mos. -1.1 1 point quote is given
3 mos. -5.5
6 mos. -13.3 1.2875
12 mos. -26.5 13.3 typically given in bid/offer form
1.28617 e.g. -13.0/-13.6
⇒ Arbitrage Pricing for forwards/ 𝐒𝐟K (𝟏 + 𝐢𝐟 ) Pg-4

𝐝
(price) (base) 𝐅𝐟K =
(𝟏 + 𝐢𝐝 ) - review
𝐝
- if if > id ➞ forward premium 𝐝K
𝟏 + 𝐢𝐟 𝐟
if < id ➞ forward discount 𝐒𝐟K
𝐣 𝟏 + 𝐢𝐣
⇒ Exchange Rate Regimes/ 𝐟K
𝐣
· fixed-rates vs. floating rates
- reduces uncertainty - exchange-rate risk
· fully convertible vs. capital restrictions
- unrestricted capital flows - inefficient allocation of capital
- efficient allocation of capital
- types/
① No separate legal tender - countries use the currency of
another nation
② Currency Board System - commit to exchange d for f at a fixed rate
- 100% foreign currency reserves
against the monetary base

types/ Pg-5
- review
③ fixed parity - just a peg, does not require 100%
(+/- 1% bands) foreign curr. reserves
e.g./ ➞ to USD or to trade-weighted basket of currencies
④ Target zone - as above but +/- 2% (e.g.)
⑤ Active & Passive Crawling Pegs
static peg - fixed
passive - peg adjusted to inflation
active peg - changes in fx-rate announced, typically
in small steps - meant to influence inflation
⑥ Fixed Parity with Crawling Bands
fixed w/ +/- 1%, then +/- 2%, etc…
⑦ Managed Float - fx-rate based on policy targets
- types/ Pg-6
⑧ Fully Floating Rates - market determined - review
- most common
= FX, International Trade, Capital Flows
· trade surplus ➞ capital flows enter ➞
↑ pressure on currency ➞ trade surplus shrinks
- trade surplus is offset by a capital account deficit
deficit surplus
- Marshall-Lerner condition/
𝐖𝐗 𝐄𝐗 + 𝐖𝐌 (𝐄𝐌 − 𝟏) > 𝟎 if 𝐖𝐌 > 𝐖𝐗 - trade deficit
- then fx-rate devaluation
𝐗 𝐌
will help ➞ 𝐖𝐌 = 𝐖𝐗
𝐗+𝐌 𝐗+𝐌
(the more elastic X & M,
price price elasticity
the more likely intervention
elasticity of of domestic
will improve trade balance)
foreign demand demand for M
- assumes more billed in
for X
the foreign currency
- assumes X are billed
in domestic currency (Pd is constant)

- Marshall-Lerner condition/ Pg-7
Initial condition/
e.g. X M - review
𝐖𝐗 𝐄𝐗 + 𝐖𝐌 (𝐄𝐌 − 𝟏) > 𝟎
𝐄𝐗 = .75 𝐄𝐌 =.65 .4(.75) + .6(.65 - 1)
X = 400M M = 600M .30 - .21 = .09 > 0
∴ intervention will work
- Intervention will be more effective for trade adjustment if X & M:
· have substitutes
· trade in competitive markets
· are luxury goods, rather than necessities
· are goods that represent a large portion of
consumer expenditures
J-curve/ +
Short-run: Long-run:
fx-rate ↓, 𝐄𝐝 < 1 - consumers respond
- consumers need time to changes in
to adjust CA 0 relative prices
-
-
∴ deficit worsens changes
- X at lower prices
M at higher prices
Pg-8
- Absorption Approach/ Y = C + I + G + (X - M) - review
A = total
A B
absorption
∴ Y = A + B
Y - A > 0 = surplus B = trade balance
or B = Y - A
Y – A < 0 = deficit
- improve trade balance:
① increase incomes/output ② reduce absorption
(make Y larger in (Y - A)) (make A smaller in (Y - A))
- a lower fx-rate will switch - lower fx rate may cause
demand to domestic g/s a wealth effect
- trade balance improves ⇒ lower purchasing power of
dom. curr. denominated assets
may boost MPS


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Aggregate Output, Prices and Economic Growth

b. compare the sum-of-value-added and value-or-final-output methods of calculating

j. distinguish between the following types of macroeconomic equilibria: long-run full

k. explain how a short-run macroeconomic equilibrium may occur at a level above or

m. describe sources, measurement, and sustainability of economic growth;

n. describe the production function approach to analyzing the source of economic

o. distinguish between input growth and growth of total factor productivity as

Prepared exclusively for Matthew Maselle ,matthewmaselle@gmail.com

Aggregate output (AO) = Aggregate Income (AI) LOS a

wages, rent, interest, profit

➞ GDP – gross domestic product ➞ measures: LOS a

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➞ Nominal vs. Real GDP/ LOS c

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(𝟑𝟎𝟗, 𝟎𝟎𝟎 × 𝟐𝟎, 𝟎𝟔𝟐. 𝟓𝟎) 𝟐𝟎, 𝟎𝟔𝟐. 𝟓𝟎

➞ Components of GDP/ LOS d

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if G > T ➞ fiscal deficit included in C

taxes paid transfers received

➞ personal savings = disposable income – C + 𝚫pension entitlements

some payroll taxes are

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∴ S = I + (G – T) + (X – M) - in words, domestic savings is used to

➞ look ahead: economy LOS f

goods money Labour market

increases as incomes rise (upward sloping) LOS f

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demand < supply

- as P ↑ (price level) - AD curve will be

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companies will +/- output

➞ Shifts in AD/AS LOS h

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· Shifts in SRAS/ - factors that change cost of LOS h

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2/ supply of natural resources – increased availability LRAS ➞ right

LRAS - long-run full employment equilibrium LOS i

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rate of increase in the economy’s

LRAS – the factors that

- output depends on inputs L and K LOS n

➞ Diminishing returns to scale with respect to any individual input

K/LO K/LA K/L

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e.g. U.S. ➞ WL = .7 ∴ ↑ in L will have a larger effect

➞ Growth in per capita GDP = growth in technology + WC (growth in K/L)

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Aggregate Output = Aggregate Income = Aggregate Expenditure Pg-1

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M/P – real money balance

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Y1 – full employment or natural level of output

a) household wealth wealth ↓, C ↓, S ↓ wealth ↑, C ↑, S ↓

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d) Labour Productivity and ↓ 𝐨𝐮𝐭𝐩𝐮𝐭K ↑

(Recession Gap) Pg-10

LRAS · real GDP growth > long-run GDP growth

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SRAS shifts left