31 - Terms of Trade (macro)

29 - Specialization & Trade (macro & micro)

Absolute v. Comparative Advantage

Absolute Advantage v. Comparative Advantage

·         Absolute Advantage

o   Faster, more, more efficient

·         Comparative Advantage

o   Low opportunity cost

Specialization – producing according to comparative advantage

Comparative advantage – Opposite Product / Product 

Changes in Exchange Rates

Changes in Exchange Rates

• Exchange rates (e) are a function of the supply and demand for currency.
• An increase in the supply of a currency will decrease the exchange rate of a currency
• A decrease in supply of a currency will increase the exchange rate of a currency
• An increase in demand for a currency will increase the exchange rate of a currency
• decrease in demand for a currency will decrease the exchange rate of a currency

Appreciation and Depreciation

• Appreciation of a currency occurs when the exchange rate of that currency increases (e↑)
• Depreciation of a currency occurs when the exchange rate of that currency decreases (e↓)
• Ex. If German tourists flock to America to go shopping, then the supply of Euros will increase and the demand for Dollars will increase. This will cause the Euro to depreciate and the dollar to appreciate.

Exchange Rate Determinants

·         Consumer Tastes

o   Ex. A preference for Japanese goods creates an increase in the supply of dollars in the currency exchange market which leads to depreciation of the Dollar and an appreciation of Yen

·         Relative Income

o   Ex. If Mexico’s economy is strong and the U.S. economy is in recession, then Mexicans will buy more American goods, increasing the demand for the dollar, causing the Dollar to appreciate and the Peso to depreciate

·         Relative Price Level

o   Ex. If the price level is higher in Canada than in the United States, then American goods are relatively cheaper than Canadian goods, thus Canadians will import more American goods causing the U.S. Dollar to appreciate and the Canadian Dollar to depreciate.

·         Speculation

o   Ex. If U.S. investors expect that Swiss interest rates will climb in the future, then Americans will demand Swiss Francs in order to earn the higher rates of return in Switzerland. This will cause the Dollar to depreciate and the Swiss Fran to appreciate.

Tips

·         Always change the D line on one currency graph, the S line on the other currency’s graph

·         Move the lines of the two currency graphs in the same direction (right or left) and you will have the correct answer.

·         If D on one graph increase, S on the other will also increase

·         If D moves to the left, S will move to the left on the other graph

Balance of Payments

Balance of Payments:

·         Measure of money inflows and outflows between the United States and the Rest of the World (ROW)

o   Inflows are referred to as CREDITS

o   Outflows are referred to as DEBITS

·         The Balance of Payments is divided into 3 accounts

o   Current Account

o   Capital/Financial Account

o   Official Reserves Account

Double Entry Bookkeeping:

·         Every transaction in the balance of payments is recorded twice in accordance with standard accounting practice.

o   Ex. U.S. manufacturer, John Deere, exports $50 million worth of farm equipment to Ireland.

§  (-$50 million worth of farm equipment or physical assets)

§  (+$50 million worth of Euros or financial assets)

o   Notice that the two transactions offset each other. Theoretically, the balance payments should always equal zero… Theoretically.

Current Account:

·         Balance of Trade or Net Exports

o   Exports of Goods/Services – Imports of Goods/Services

o   Exports create a credit to the balance of payments

o   Imports create a debit to the balance of payments

·         Net Foreign Income

o   Income earned by U.S. owned foreign assets – Income paid to foreign held U.S. assets

o   Ex. Interest payments on U.S. owned Brazilian bonds – Interest payments on German owned U.S. Treasury bonds

·         Net Transfers (tend to be unilateral)

o   Foreign Aid → a debit to the current account

o   Ex. Mexican migrant workers send money to family in Mexico

Capital /Financial Account:

·         The balance of capital ownership

·         Includes the purchase of both real and financial assets

·         Direct investment in the United States is a credit to the capital account

o   Ex. The Toyota Factory in San Antonio

·         Direct investment by U.S. firms/individuals in a foreign country are debits to the capital account

o   Ex. The Intel Factory in San Jose, Costa Rica

·         Purchase of foreign financial assets represents a debit to the capital account.

o   Ex. Warren Buffet buys stock in Petrochina.

·         Purchase of domestic financial assets by foreigners represents a credit to the capital account.

o   The United Arab Emirates sovereign wealth fund purchases a large stake in the NASDAQ.

What causes Capital/Financial Flows?

·         Differences in rates of return on investment

·         Ceteris Paribus, savings will flow toward higher returns

·         Debit to the Chinese Capital Accounts shifts to the left

·         Credit to the U.S. Capital Account shifts to the right

Relationship between Current and Capital Accounts:

·         The Current Account and the Capital Account should zero each other out

·         If the Current Account has a negative balance (deficit), then the Capital Accounts should then have a positive balance (surplus).

Official Reserves:

·         The foreign currency holdings of the United States Federal Reserve System

·         When there is a balance of payments surplus the Fed accumulates foreign currency and debits the balance of payments.

·         When there is a balance of payments deficit the Fed depletes its reserves of foreign currency and credits the balance of payments.

·         The Official Reserves zero out the balance of payments.

Foreign Exchange (FOREX)

·         The buying and selling of currency

o   Ex. In order to purchase souvenirs in France, it is first necessary for Americans to sell (supply) their Dollars and buy (demand) Euros.

·         The exchange rate (e) is determined in the foreign currency markets.

o   E. The current exchange rate is approximately 77 Japanese Yen to 1 US dollar

·         Simply put. The exchange rate is the price of a currency.

·         Do not try to calculate the exact exchange rate.

Ex. Increase in the Demand of Euros relative to the U.S. Dollar:

Demand of Euro →:

Credits vs. Debits

Credits: additions to a nation’s account

Debits: subtractions to a nation’s account

How to calculate the following:

1)      Balance on trade:

a.       (Merchandise + service exports) – (merchandise + service imports)

2)      Trade deficit occurs when the balance on trade is negative. (Imports > Exports)

Trade surplus occurs when the balance on trade is positive. (Exports > Imports))

3)      Balance on current account:

Balance on trade (Exports & Imports) + Net investment income + Transfer Payments

4)      Official Reserves

a.       Nationally: Change in Current Account + Change in Financial Account + Change in official reserves = 0

UNIT 5

Chapter 16: AD/AS

I.                   From Short Run to Long Run

·         AS curve doesn’t shift in response to changes in the AD curve in the short run.

-          Nominal wages do not respond to price-level changes

-          Workers may not realize impact of the changes or may be under contract.

·         Long Run – period in which nominal wages are fully responsive to previous changes in price level

·         When changes occur in the short run they result in either increased or decreased producer profits – not changes in wages paid.

·         Nominal wages – money getting paid, Real wages – actual value of money, actual gross pay

Ø  In the long run, increases in AD result in a higher price level, as in the short run, but as workers demand more money the AS curve shifts left to equate production at the original output level, but now at a higher price.

Ø  In the long run, the AS curve is vertical at the natural rate of unemployment (NRU), or full employment (FE) level of output. Everyone who wants a job has one & no one is enticed (tempt) into or out of the market.

Ø  Demand-pull inflation will result when an increase in demand shifts the AD curve to the right, temporarily increasing output while raising prices.

Ø  Cost-push inflation results when an increase in input costs that shifts the AS curve to the left. In this case, the price level increase is not in response to the increase in AD, but instead the cause of price level increasing.

The Philips Curve

–        represents the relationship between unemployment and inflation

–        The trade-off between the inflation and the unemployment occurs in the short run

–        Each point on the Philips curve corresponds to a different level of output

Long Run Philips Curve

-             It occurs at the Natural Rate of Unemployment (NRU)

-             It is represented by a vertical line

-             There is no trade-off between unemployment and inflation in the long run

-             The economy produces at the full-employment output level

-             The nominal wages of workers fully incorporate any changes in price level as wages adjust to inflation over the long run.

-             LRPC only shifts if the LRAS curve shifts

-             Same determinants for the shift

-             Increases in u_n will shift LRPC →

-             Decreases in u_n will shift LRPC →

Increase in AD = Up/left movement along SRPC

Determinants ↑: AD →, GDP_R↑ & PL↑: u%↓ & π%↑: up/left along the curve

Decrease in AD = Down/right movement along SRPC

Determinants ↓: AD ←, GDP_R↓ & PL↓: u%↑ & π%↓: down/right along the curve

SRAS → = SRPC ←

Determinants (Inflationary Expectations, Input Prices, Productivity, Business Taxes, and/or Deregulation) ↓: SRAS →, GDP_R↑ & PL↑: u%↓ & π%↓: SRPC ←

Supply shock - a rapid and significant increase in resource cost which causes the SRAS curve to shift

Natural Rate of Unemployment (NRU) = frictional + structural + seasonal

-             The natural rate at fewer worker benefits creates a lower NRU

Misery Index – the combination of inflation and unemployment in any given year

-             Single digit misery is good

If the inflation rate persists and the expected rate of inflation rises, then the entire SRPC moves upward.

If inflation expectations drop (new technology, efficiencies), then the SRPC moves downward.

Stagflation occurs when you have high unemployment and high inflation at the same time.

Disinflation – when inflation decreases over time:

-             Nominal

-             Business profits fall

-             Firms reduce employment, thus unemployment increases

Laffer Curve – Tradeoff between tax rates and government revenue; As tax rates increase from 0, tax revenues increase from 0 to some maximum level and then decline.

The higher the tax rate you set, the less money you will collect. Laffer Curve is controversial and debatable.

Criticisms on the Laffer Curve

1.      Where the economy is located on the curve is difficult to determine.

2.      Tax cuts also increase demand which can fuel inflation

3.      Empirical evidence suggests that the impact of tax rates on incentives to work, save, and invest are small

Supply-side economics or Reaganomics:

They support policies that support GDP growth by arguing that high marginal tax rates along with the current system of transfer payments (unemployment compensation and social security) provide disincentives to work, invest, innovative, and undertake entrepreneurial ventures. They believe that the AS curve will determine levels of inflation, unemployment, and economic growth.

Trickle-down effect: Rich → Poor

Marginal Tax-Rate: The amount paid on the last dollar earned or on each additional dollar earned

Supply-side economists believe that if you reduce the marginal tax rate then more people will be able to work longer thus forgoing leisure time.

UNIT 4

Unit 4

I.                   Uses of Money

a.       Medium of Exchange

b.      Unit of Account – Establishes worth

c.       Store of Money – Money holding value over a period of time (Bank)

II.                Types of Money

a.       Fiat money – Money because the government says so

b.      Commodity money – No physical money is exchanged, Ex. Gold & Silver coins

c.       Representative money – Money that is backed up by something tangible; Ex. IOU

III.             Characteristics of Money

a.       Durability – Money is durable

b.      Portability – Money can be carried in a multiple of ways, and it is very portable

c.       Divisibility – Many different combinations of money

d.      Uniformity – Our money is in uniform, it should not look any different from one state to another

e.       Scarcity – Scarce types of money

f.       Acceptability – Money is accepted everywhere

IV.             Money Supply

a.       M1 money

-          Consists of currency in circulation: Physical dollar as well as the coin

-          Checkable deposits

-          Travelers checks

b.      M2 money

-          Consists of M1 money plus saving accounts + money market accounts + deposits held by banks outside the US

Fractional Reserve System:

-          It is a process by banks upholding a small portion of their deposits in reserve and loaning out the excess

-          Banks keep cash on hand (required reserves)

-          Banks must keep reserve deposits in their vaults or at the federal reserve bank

Total reserves:

-          Total funds held by a bank

-          TR (Total reserves) = RR (Required reserves) + ER (Excess reserves)

-          Banks can legally lend only to the extent of their excess reserves

Reserved Ratio = RR / TR

Significance of a Fractional Reserve System

1.      Banks can create money by lending more than their reserves

2.      Required reserves don’t prevent bank panics because banks must keep their required reserves (FDIC)

3.      Reserve requirements give the Feds control over how much money banks can create

Function of the FED (Federal Reserve Bank):

1.      Control the nation’s money supply through monetary policy

2.      Issue paper currency

3.      Serve as a clearing house for checks

4.      Regulates banking activities

5.      Serves as a bank for banks

Balance Sheet – a statement of assets and claims summarizing the financial position of a firm or a bank at some point in time; MUST balance

Assets – what you own

Liabilities – what you owe

Net Worth – a claim of the owners against the firm’s assets

Assets + Net Worth = Liabilities

Multiple Deposit Expansion

How Banks Work

Assets

Liabilities + Equity

·         Reserves: -    Required Reserves (rr) - % required -                                                          By Fed. To keep on hand to meet -                                                          Demand -    Excess Reserves (er) - % reserves Over and above the amount needed to satisfy the minimum reserve ratio set by Fed. ·         Loans to firms, consumers, and other banks (earn interest) ·         Loans to govt. = treasury securities ·         Bank property – (if bank fails, you could liquidate the building/property)

·         Demand Deposits ($ in the bank) ·         Timed Deposits ·         Loans from: Federal Reserve & other banks ·         Shareholders Equity – (to set up a bank, you must invest your own money in it to have a stake in the banks success or failure)

Reserve Requirement

·         The Fed requires banks to always have some money readily available to meet consumers’ demand for cash.

·         The amount, set by the Fed, is the Required Reserve Ratio.

·         The Required Reserve Ratio is the % of demand deposits (checking account balances) that must not be loaned out.

·         Typically the Required Reserve Ration = 10%

Practice Calculating Reserve Ratios

The reserve ratio is 5%. You deposit $1000 into a bank. How much is the bank required to add to its reserves?

0.5 * $1000 = $50 in reserve ratio

How much money can the bank now loan out?

$1000 (deposited) – 50 (reserve ratio) = $950

100% Reserve Banking has no impact on size of money supply.

Thus, in a fractional-reserve banking system, banks create money.

·         The % of demand deposits that must be stored as vault cash or kept on reserve as Federal Funds in the bank’s account with the Federal Reserve.

·         The Required Reserve Ratio determines the money multiplier (1/Reserve Ratio)

·         Decreasing the reserve ratio increases the rate of money creation in the banking system and is expansionary

·         Increasing the reserve ratio decreases the rate of money creation in the banking system and is Contractionary.

·         Changing the required reserve ratio is the least used tool of monetary policy and is usually held constant at 10%.

The Money Multiplier

·         The money multiplier shows us the impact of a change in demand deposits on loans and eventually the money supply.

·         The money multiplier indicates the total number of dollars created in the banking system by each $1 addition to the monetary base (bank reserves & currency in circulation)

·         To calculate the money multiplier, divide 1 by the required reserve ratio.

o   Money Multiplier = 1/ Reserve Ratio

o   Ex. If the reserve ratio is 25%, then the multiplier = 4

The Four types of Multiple Deposit Expansion Question

·         Type 1: Calculate the initial change in excess reserves

o   a.k.a. the amount a single bank can loan from the initial deposit

·         Type 2: Calculate the change in loans in the banking system

·         Type 3: Calculate the change in the money supply

o   Sometimes type 2 and type 3 will have the same result (i.e. no Fed involvement

·         Type 4: Calculate the change in demand deposits

·         We built this city. We built this city on rock & roll - BU

Review

·         Required Reserve = Amount of deposit X required reserve ratio

·         Excess Reserves = Total Reserves – Required Reserves

·         Maximum amount a single bank can loan = the change in excess reserves caused by a deposit

·         The money multiplier = 1/required reserve ratio

·         Total Change in Loans = amount single bank can lend X money multiplier

·         Total Change in the money supply = Total Change in Loans + $ amount of Fed action

·         Total Change in demand deposits = Total Change in Loans + any cash deposited

Fiscal Policy	Monetary Policy
·         Congress ·         Tax ·         Spend	·         Fed ·         OMO (Open Market Operations) ·         Required Reserves ·         Discount Rate ·         Federal funds rate

Monetary policy option	Expansionary (“easy” $)	Contractionary (“tight” $)
Open market operation (OMO)	Buy bonds from the public	Sell bonds to the public
Required Reserves	Decrease reserve ratio	Increase reserve ratio
Discount Rate	Decrease discount rate	Increase discount rate
Federal funds rate	Decrease federal funds rate	Increase federal funds rate

Monetary policy options

Open Market operation (OMO)

Required Reserves - Vault cash, reserve banks, percentage of the banks total deposits that they must hold on to. Government has control of.

Discount Rate – The interest rate charged by the Feds for overnight loans to commercial banks, and does not change money supply directly

Federal funds rate – The interest rate charged by one commercial bank for overnight loans to another commercial bank, FOMC sets a federal fund rate and then uses OMO to guide the effective rate to the target rate

Loanable Funds Market

-          The market where savers and borrows exchange funds (Q_lf) at the real rate of interest (r%).

-          The demand for loanable funds, or borrowing comes from households, firms, government and the foreign sector. The demand for loanable funds is in fact the supply of bonds.

-          The supply of loanable funds, or savings comes from households, firms, government and the foreign sector. The supply of loanable funds is also the demand for bonds.

Changes in the Demand for Loanable Funds

-          Remember that demand for loanable funds = borrowing (i.e. supplying bonds)

-          More borrowing = more demand for loanable funds

-          Less borrowing = less demand for loanable funds

-          Examples

1.      Government deficit spending = more borrowing = more demand for loanable funds: D_LF→.:r%↑

2.      Less investment demand = less borrowing = less demand for loanable funds: D_LF←.:r%↓

Changes in the Supply of Loanable Funds

-          Remember that supply of loanable funds = savings (i.e. demand for bonds)

-          More saving = more supply of loanable funds (→)

-          Less saving = less supply of loanable funds (←)

-          Example

1.      Government budget surplus = more saving = more supply of loanable funds: S_LF→.:r%↓

2.      Decrease in consumers’ MPS = less saving = less supply of loanable funds: S

3.       _LF←.:r%↑