In a flexible exchange regime what determines the exchange rate, E, and what determines the money supply?
In a flexible regime, MARKET deterimines exchange rate, and CENTRAL BANK sets money supply
What is the nominal exchange rate, E?
E is the price of foreign currency in terms of domestic currency
When foreign currency becomes stronger, or domestic currency becomes weaker, it is called ________
What is the UIP condition and what do they each term stand for?
Domestic interest rate= foreign interest rate + (expected exchange rate - nominal exchange rate)/ nominal exchante rate
What is the Marshall and Lerner condition?
ML states if export and import are elastic enough, then a real deprectiation improves the trade balance. (So... a positive relationship between e and NX)
What is the wage-setting relation?
W= F(u, z) OR W= F (1- Y/L, z)
P (− ,+ ) (-. +)
What is natural rate of unemployment?
natural rate of unemployment is the unemployment rate such that the real wage chosen in wage setting is equal to the real wage implied by price setting.
What are 2 major reasons why there's always unemployment?
- Problems in the matching process, time/resource consuming: imperfect information, different qualifications needed, worker's preference
- (Due to "real wage rigidities"= which is anything that dnt allow labor market to adjust freely, ex minimum wage required by law)
What are the 3 basic assumptions of medium run and how are they different from short run?
1. Price is endogenous, meaning it can change
2. Capital, K, is fixed
3. Labor, L, is fixed
What are the 3 types of structural unemployment? (HINT: real wage rigidities which dnt allow labor market to adjust freely)
1. Minimum Wage Laws
2. Labor Union & Collective Bargaining
3. Efficiency wages
What is the Efficiency Wage Theory?
The productivity of labor is increasing on the wage rate. Employers pay above market wages for higher productivity.
What are 4 examples of Efficiency Wages?
1. (For poor) "Health Issues"-> employer pay higher wage to improve quality of life
2. (For rich) "Reducing labor turnover rate"-> ex) when when Ford doubled workers income, turnover rate dropped
3. (Hidden Info), "Adverse Selection"= there's asymmetric info (1 side knows more), higher wages will increase mean quality of workers in the application pool
4. (Hidden Action), "Moral Hazard"= imperfect monitoring, employers can't monitor workers all the time, so employers pay higher wage to reduce slacking and fire those who do
What is turnover rate?
(number pf separations/ number of workers)
Whats the difference between u and μ?
u= unemployment rate, negative relation to real wage, in wage setting relation
μ= markup, shows how competitive the market is, in price setting relation
What does z represent?
- z represents all factors that affect structure of labor market and unemployment
- ex) stronger labor union, minimum wage, generous EI
Why is the price setting curve a horizontal line?
Because the price setting equation is independent of unemployment rate, (it's only affected by the markup rate, μ)
Why is wage setting curve negatively sloped?
Because as unemployment increases, workers have less bargaining power, so workers ok with lower wages
What does the aggregate supply curve represent?
AS represents the equilibrium in labor market.
What does the aggregate demand curve represent?
AD represents all equilibrium points in goods and financial market, since AD is derived from the IS/LM curves.
Why is UIP curve downward sloping?
Intuitively, as i increase, it makes domestic bonds more attractive, capital inflow, increase demand for domestic currency, which cause nominal app'n (E drop). Hence, as i increase, E drops.
Mathematically, E= fixed expected E/ (1+i +i*)
, if i increase, E drops
T/F At full employment, unemployment is zero.
- When economy at full employment, y= y-bar, which means, u=natural rate of unemployment
- unemployment is never zero
Starting at labor market equilibrium, what happens to W/P and u when EI increases? Provide intuition.
When EI increases
- job finding rate falls
job separation increases
- natural rate of unemployment increases
- output capacity falls, y-bar falls
Starting at labor market equilibrium, , if market becomes more competitive, what happens to W/P and u, intuitively and graphically please.
- μ drops
- firms set lower price (bc markup is now lower)
- real wage, W/P increases
- job separation drops
- natural rate of u falls
- output capacity increases
(PS curves shifts upwards)
Why is AS downward sloping?
HINT: start at P=Pe, play with Y, what does change in y always implicate
- think what market does AS represent?
Start with P=Pe, if Y<Y-bar, then...
- u > natural u
- nominal wage (w) drops
- production cost (w) drops
- price drops
- P> Pe
Why is AD upward sloping?
HINT: play with increase or decrease of price
- think what market/(s) does AD represent?
If price, P increases, (given fixed money supply)
- MS falls
- purchase power of money falls
- real MS shrinks(afford to buy less), people sell bonds
- Price of bonds fall
- i increase
-I, ZZ, Y will fall
What's a devaluation policy?
When CB increases (fixed exchange rate)E-bar, thus depreciating value of domestic currency
What's an revaluation policy?
When CB decreases (fixed exchange rate)E-bar, thus appreciating domestic currency
In a flexible exchange regime, who determines the exchange rate and who sets the money supply?
HINT: the answer is in the name
- market determines exchange rate
- CB determines money supply
In a FIXED exchange regime, who determines the exchange rate and who sets the money supply?
HINT: the answer is in the name
- market determines money supply
- CB determines exchange rate
How does a fixed regime make the exchange rate credible? E= E-bar
By buying or selling foreign exchange or bonds
When there is app'n pressure in a fixed exchange regime, should CB buy or sell foreign assets? Why?
CB should buy foreign asset.
- the reason there is app'n pressure is bc demand for domestic currency is higher
- so, the ppl want to sell foreign assets for domestic currency
- CB complies by buying up the ppl's foreign asset, since the ppl now have more domestic currency, money supply increases
Why is demand-side policies considered voodoo economics? What are the final result?
What's the Balance of Payments Accounts?
parts of Systems of National Accounts, which records a country's int'l transactions
What's a current account (CA)?
Keeps track of flow of goods, services, transfers, and factor payments
What's a Capital and Financial Account (KA)?
Keeps track of flow and assets
What is considered a credit item?
Any transaction that involves a FLOW of funds INTO the country
What is considered a debit item?
Any transaction that involves a FLOW of funds OUT of the country
What is the aggregate demand curve in rates?
gyt= gmt - πt
Growth rate of output= growth rate of money supply - inflation rate
What is Okun's Law?
It's the negative relationship between growth rate of real output and change in unemployment rate.
What is the normal growth rate? What is it's significance?
-part of okun's law
- it's the output growth rate needed to keep unemployment fixed
What is the Sacrifice Ratio?
(Total lost employment)/(Total reduction in inflation)
In what 3 ways can credibility reduce the cost of disinflation?
1. lower impact on unemployment
2. lower impact on output
3. faster reduction in inflation (shorter time)
Even if disinflationary policies are fully credible and politicians are honest, why are there still costs?
1. "Nominal Rigidities"
- many wages and prices are fixed in nominal terms and cannot be readjusted over time, so inflation is already built into the contract
2. "Staggering Wage Theory" (Contracts)
How does "Staggering Wage Theory" adds to the disinflationary cost?
- wage contracts are not signed at the same time, but staggered over time
- problem: too fast decrease in money supply doesn't lead to fast decrease in inflation, but to decrease of real money, u, and recession
Why is short run Philip's curve downward sloping while Medium run Philip's curve is a vertical line?
Context: Open economy, medium run (flexible vs. fixed)
Given expansionary fiscal policy, how does changes in price and exchange rate vary between flexible vs. fixed exchanged rate. Explain.
In flexible regime,
1. Price is fixed
2. Exchange rate goes down (appreciates)
In fixed regime,
1. Price goes down
2. Exchange rate is fixed
Why do we say IS shift LEFT and not UP?