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the assets that economy regularly uses to buy G and S

Money Supply (Ms)

the amount of money available to households and firms

Money Demand (Md)

the amount of money households and firms want to hold to buy G and S

Price Level (P)

measure of the prices in the economy
*GDP Deflator


a general increase in the overall price level


a general decrease in the overall price levels

Quantity Theory of Money

used to explain the long run determinants of the price level and the inflation rate

monetary injection

the fed uses its tools to put money into the economy ( increase the money supply)
*causes inflation--> price level rises
* value of money falls

Quantity Theory of Money

the quantity of money available determines the value of money

nominal variables

measured in monetary units

real variables

measured in physical units

classical dichotomy

different factors affect nominal variables and real variables.
*changes in money supply ONLY affect nominal variables

Monetary Neutrality

money supply does not affect real variables ==> Y bar

Quantity Equation

M V= P Y

V ( velocity)

how many times money changes hands within a given period of time

Fisher Effect

the one to one adjustment of the nominal interest rate to the inflation rate

Cost of Inflation

inflation does not reduce people's real purchasing power
6 reasons

Shoe leather costs

cost and time needed to go to the bank

Menu costs

costs to firms of changing prices
comes from losing customers

Relative Price Variability

some prices increase faster than other prices

Inflation- Induced Tax Distortion

income tax on nominal savings so after tax real interest rate falls

Confusion and Inconvenience

developing countries
causes hoarding
lose customers

Arbitrary Redistribution of Wealth

lender of a loan can lose money when inflation rate causes value of the loan to decrease
*borrower wins

Closed Economy

no imports or exports

Net Exports

Exports (x)- Imports (M)

Country interacts economically with other country

1. imports and exports of goods and services
2. buying and selling capital assests

Factors that affect Net Exports

1. Tastes of consumers for foreign and domestic goods
2. Prices in domestic and foreign countries
3. Exchange rates at which people use domestic currency to buy foreign currency
4. Income of consumers home and abroad
5. Cost of transporting goods between countries
6. Policies of the government toward international trade

Net Capital Outflow NCO

purchase of foreign assets by domestic residents - purchase of domestic assets by foreign residents

Factors that Affect NCO

1. Interest rate paid on domestic assets
2. Interest rate paid on foreign assets
3. Perceived economic and political risk of holding assets abroad
4. Government policies that affect foreign ownership of domestic assets


Economy as a whole

nominal exchange rate

the rate at which a person can trade the currency of one country for the currency of another country

foreign/ domestic


increase in the value of a currency as measured by the amount of another currency it can buy


decrease in the value of a currency as measured by the amount of another currency it can buy

real exchange rate

the rate at which a person can trade the Goods and services of one country for the goods and services of another country

nominal exchange rate * US price/ foreign price

If our currency value goes up

makes domestic goods more expensive
lowers exports
raises imports

law of one price

a good must sell for the same price in all locations (internationally) If not same price, arbitrage


taking advantage of differences in prices to make a profit

Purchasing power parity

a theory of exchange rates where by a unit of any given currency should be able to buy the same amount of good in all countries
- law of one price assumed
- arbitrage assumed
-exchange rates move

Limitations to Purchasing Power Parity

1. many goods are not easily traded or shipped between countries
2. Trade-able goods are not always perfect subtitute

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