ECON Ch 27-30

Question 0

Who makes fiscal policy and what can they change?

Answer 0

Government. President, Congress.
Can change G and can change T
Changing G directly affects AD
Changing T changes income, affects consumption, indirect effect on AD

Question 1

Fiscal policy

Answer 1

Changes in federal taxes and purchases that are intended to achieve macroeconomic policy objectives
Tax reform and government budget

Question 2

Budget

Answer 2

With government, we care about spending and cost
The government budget is made up of costs (G) and revenue (tax revenue —T)
Short term. Annual or quarterly basis

Question 3

Budget deficit, balanced budget budget surplus

Answer 3

Budget is When G > T. Spends more than it collects.
Balanced is when G=T
Surplus is when G<T. Collects more than it spends.

Issue debt when has a budget deficit

Question 4

Debt

Answer 4

When in a deficit, treasury finances its activities by selling Treasury securities.
Total value of those securities outstanding is known as the national debt.
Government prints bond sells it. Use that money now. Debt is the sum of all outstanding US govt bonds, 20 trillion inu 2017
Debt : GDP ratio over 100%

Question 5

Debt ceiling

Answer 5

Raise debt ceiling to prevent government shut down.

When you hit debt ceiling, can raise taxes, lower spending, or ask Congress to borrow more money (sell more bonds)

Question 6

Why does debt go up?

Answer 6

Fiscal issue.
Budget is expansionary. G up, AE up, Y up or T down, C up, AE up, Y up
Other reason is deficit. G up, tax down increase deficit and debt.
The cost of increasing Y is increased debt and a greater deficit.

Question 7

What happens to government deficit during a recession?

Answer 7

It will automatically have a greater deficit. Y goes down, so this results in G going up as more poor people need government help. T goes down because with less income, less taxes.
So budget deficit automatically rises during recession.

Question 8

Discretionary federal policy

Answer 8

Intentional actions the government takes to change spending or taxes
During a recession, since Y goes down, do a stimulus package to increase Y. G up and T down.
But this causes further deficit

Question 9

Expansionary federal policy

Answer 9

Increase G and/or decrease T
Positives are that Y goes up and U goes down
Negatives are that prices go up, deficit goes up, crowding out effect (G goes up, causing I to go down)
If real GDP is below potential GDP, it will do expansionary FP to restore long run EQ, decreasing P
On the price vs GDP graph, shift AD to the right. P and GDP up, u down

Question 10

Contractionary fiscal policy

Answer 10

Decreasing government spending or increasing taxes.
If real gdp is too high, will do this to restore long run EQ
Shifts AD to the left.
P down, Y down, U up

Question 11

Countercyclical fiscal policy

Answer 11

Expansionary during recession to increase Y or contractionary when too much inflation to lower the price level.

Question 12

Problems with fiscal policy compared to monetary policy

Answer 12

Timing is harder due to legislative and implementation delay. And crowding out.

Question 13

Crowding out

Answer 13

G going up causes I to go down
The goods market (AE vs Y) and the money market (r and M) interact. When G goes up, AE goes up in the goods market, so Y goes up (multiplier). People are richer so there is an effect on the money market. Money demand increases, so r goes up. When r goes up, I goes down
So, G going up shrinks the other sectors. Can’t expand Y as much as we wanted to.
So, in the short run, AD doesn’t shift quite as far right as we’d like.
In the long run, increase in G has no effect on real GDP. reducing c, I, NX will offset increase in G. In long run, returns to potential GDP, even without government intervention. Long run effect is simply to increase size of government sector.

Question 14

Government spending multiplier

Answer 14

Government purchases multiplier = change in eq Y / change in G
Or 1/(1-MPC). If G up by $10, and say MPC =.8, then Y up by 1/(1-.8)= 5 Times. So Y = $50. 50/10=5 which is our multiplier.

Question 15

Tax cut multiplier

Answer 15

Change in eq Y / change in taxes.
Also MPC / (1-MPC). Say we decrease taxes by 10,and MPC = .8, then multiplier is .8/.2=4 so, Y up by 40. As c goes up by 10,then multiply by 5to get 40
C spends money slower, so the G going up increases Y more.

Question 16

Automatic stabilizers

Answer 16

System automatically has Y go up if In a recession (Y goes down) by increasing government spending automatically to poor people because more poor people and decreasing taxes because less income to tax off of.
If we get poorer, we lose Y. Y going down results in T going down which causes C to go up and Y to go up.

Question 17

Phillips curve

Answer 17

A curve showing the short run and long run relationship between the unemployment rate and inflation rate.
Trade off between price and unemployment in the short run.

Question 18

Short run Phillips curve

Answer 18

P on the Y axis, u on the x axis
Say we shift AD to the right in our AD frame work.
Then it causes lower unemployment but higher price.
So Phillips curve will be downward sloping. For low unemployment, higher price. For high U, lower P.

Question 19

Long run Phillips curve

Answer 19

P on Y axis and U on the x axis.
Will be a vertical line. In the long run, employment determined by output, which in the long run, doesn’t depend on the price level.
So, same unemployment, natural rate, regardless of the price. No chclical u, but still structural and friticional.

Question 20

Open economy vs closed economy

Answer 20

Open economy has interactions with other countries. Closed economy is closed, no interactions in trade or in finance.

Question 21

Balance of payments

Answer 21

A good way to understand economic interactions with other countries is by examining the balance of payments. This is the record of a country’s trade with other countries in goods, services, and assets.
Sum of current account, financial account, and capital account
Must equal zero.
In 2014, US spent 389billion dollars more on goods, services,a Nd other current account items than it received. Money must have been used to buy us assets or to keep as us currency holdings oversees. This difference is called statistical discrepancy.

Question 22

Current account

Answer 22

Part of the balance of payments that records the country’s NX (sum of balance on trade and balance of services), net income on investments and net transfers.

Question 23

Financial account

Answer 23

Part of the balance of payments that records purchases of assets a country has made abroad and foreign purchases of assets in the country.
Records long term flows.
Capital outflows are purchases of assets overseas by Americans
Capital inflows are purchases of American assets by foreigners.
Net capital flows. Net foreign investment. Capital outflows - inflows.

Question 24

Capital account

Answer 24

Part of the balance of payments that r cords relatively minor transactions such as migrants transfers and sales and purchases of non produced, non financial assets.

Question 25

Balance of trade

Answer 25

Part of the current account.
Difference between value of the goods a country exports and the value of the goods a country imports

If positive, trade surplus. If negative, trade deficit. Negative in the US.

Question 26

How do countries interact

Answer 26

They each have their domestic market with three markets. The market for goods and services (AE VS Y),market for money (r vs Qm), and labor market. The three markets together interact with another country’s 3 markets using NX and exchange rate (e).

Question 27

Nominal exchange rate

Answer 27

Value of one country’s currency in terms of another countries currency.
How many units of yen does the dollar buy?

Question 28

Appreciate

Answer 28

Dollars point of view:
Dollar can afford more yen. Y/$

E is too low. Causes the dollar to appreciate. Increase in market value relative to the other currency.
On the Q vs exchange rate graph, we are too low. We have a shortage of dolllars. Need to increase the exchange rate to get to eq.

Question 29

Depreciate

Answer 29

If we have excess supply of the dollar from the dollars point of view.
Exchange rate is too high, more people will want to sell their dollar for a yen than want to buy dollars. So we have a surplus. Exchange rate will depreciate. Value of the dollar will fall relative to the value of the yen.

Question 30

Foreign exchange market

Answer 30

Graph between the demand and supply for a currency. Say we have the dollar point of view and trading with the yen.
Then the Y axis is Yen/ dollar and the X axis is the quantity of the dollar in the forex.
Downward sloping demand and positive sloping supply.

Question 31

Demand in forex

Answer 31

Downward sloping
Comes from:
1. Foreign firms and households wanting to buy us goods and services.
2 foreign firms and households wanting to invest in us physics or financial assets.
3. Currency traders believing the value of the US will rise
This is Japanese demand for the dollar. When the exchange rate is high, won’t want as much dollar. So it is downward sloping.

Question 32

Supply of dollar in forex

Answer 32

Dollar point of view.
Upward sloping. Caused by firms, households, and speculators wanting to obtain the other currency and pay with US dollars.
Selling the dollar in exchange for yen.
Eq exchange rate is the exchange rate when quantity of dollar supplied is equal to quantity of dollars demanded.

Question 33

Shift in demand or supply in forex

Answer 33

Demand changes could come from:
1. Changes in demand for US produced goods and services relative to foreign produced goods and services
2. Changes in the desire to invest in the US relative to foreign countries
3. Changes in the expectations of currency traders about likely future value of the dollar relative to foreign currencies
Changes in supply is same factors.

Question 34

When would demand increase in the forex from dollar point of view?

Answer 34

If foreigners demand more dollar, then the demand for the dollar will increase.
Jap want to buy more American goods
Quality of American goods up or price down relative to japan meaning inflation is relatively higher in japan
Since demand shifts right, intersection higher, so Y/$ goes up. So this means the dollar appreciates.

Question 35

When would supply shift to the left in the forex

Answer 35

From the dollars point of view. Means fewer Americans are selling the dollar in the forex. Causes appreciation
Americans want to buy American products, not those from foreign companies.

Question 36

How do interest rates affect the demand and supply in forex (from us point of view)

Answer 36

Suppose 120 yen = 1 dollar
Us incomes rise, our demand for Japanese imports goes up, so supply of dollar shifts right.
Same time, interest rates in the us go up, so us bond is more attractive to hold than Japanese bonds. So demand for dollar goes up.
So, the dollar becomes stronger, it appreciates. Exchange rate appreciates up to a higher value than 120.

R goes up, causes demand for dollar to go up, so supply of dollar goes down. So e goes up.
X goes down, M goes up, NX goes down. Y goes down.

Question 37

Exchange rate affect on M and X

Answer 37

When dollar appreciates, price of foreign imports in dollars falls.
Foreign currency price of us exports rises.
Suppose exchange rate is 1:1. So an iPhone that costs $200will cost 200euros. But if the US dollar appreciates so exchange rate is now $1=1.2 euros, then same iPhone will cost French person 240euros. So, French person buys fewer iPhones. At same time, French wine is cheaper so we buy more of it. So, appreciation results in M going up and X going down. So NX down, and gdp down
E up causes M up and X down causing Y down.

Question 38

Export country targeting e

Answer 38

Export country wants e down so X is high and we can export.

Question 39

What does it mean for a currency to strengthen and is it good?

Answer 39

Strengthens when it’s value rises relative to other countries currencies.
Unclear if good. Makes exports more expensive and imports cheaper. Reverse is true overseas.

Question 40

Real exchange rate

Answer 40

Price of domestic good in terms of foreign goods
Real exchange rate = nominal rate * (domestic price level / foreign price level)
Suppose US dollar appreciates so new exchange rate is 1dollar =1.1 euros, not 1=1. Price level in us up to 105. Price level still 100 in uk
Real ex rate = (1.1 pounds / dollar) * (105/100)=1.15 pounds / dollar
Prices of us goods are now 15% higher than they were relative to prices of British goods. Reported as index

Question 41

Monetary policy in an open economy (say we increase money supply)

Answer 41

Expansionary monetary policy —> decrease interest rates. Causes investment to go up. Causes AE to go up causing Y to go up
In an open economy, this also causes demand for dollar to go down, causing e to go down, causing X to go up and M to go down, so NX up and AE up and Y up.
Expansionary MP results in AD going up by more in open economy than closed economy

Same with contractionary
Monetary policy more effective in open economy as it changes Y thru two different channels (NX and I up)

Question 42

Fiscal policy in an open Econ

Answer 42

Expansionary fiscal policy. G up or T down and C up. Causes AE up and Y up. Domestically G could crowd out I.
Y goes up in the money market. Money demand increases. So r goes up and I goes down. This is domestic crowding out.
But the higher interest rates also cause crowding out of net exports. R goes up, so e goes up as dollar appreciates. So NX goes down.
Also multiplier lower since some spending takes place on imported goods, don’t feed back into real gdp.
Fiscal policy is less effective in open economy than closed economy.

Question 43

Twin deficits

Answer 43

Budget deficit and interest rates going up causes e to go up causing NX to go down.
Trade deficit
When a government budget deficit leads to declines in NX. large federal budget deficits cause r to go up. E going up and large current account deficits followed.

Question 44

Trade surplus vs deficit

Answer 44

When X is bigger than M, surplus. When X smaller deficit.

Question 45

How to make dollar stronger?

Answer 45

OM sales. Money supply down. R up. E up.

Question 46

Speculation?
Suppose $100 buys you 1 TV in the US
IN FOREX, $1 buys you 100 yen. So yen / $ = 100
1 tv in japan costs 15,000 yen. Explain
(Purchasing power parity)

Answer 46

Purchasing power parity
In japan, a tv should only cost 10000 yen but it costs more.
Why?
1. Dollar should have bought 150 yen. Dollar bought too few yen. Value of the dollar should go up against the yen.
Or 2. Price of tv in japan is higher off a legit reason.

Use the Big Mac index to measure the PPP

Question 47

Big Mac index

Answer 47

Measures PPP by collecting the price of Big Macs in different countries.
For example, in Mexico, 1big Mac costs 32pesos. In the us it costs $4. So the implied exchange rate is $1 buys 8pesos or peso / $ = 8
If in the forex the peso/$ =10, then the $is overvalued.

Question 48

Floating currency

Answer 48

The outcome of a country allowing its currency’s exchange rate to be determined by demand and supply.
Moves toward this in long run in the PPP

Question 49

Exchange rate system

Answer 49

Allowing the relative values of currencies to be determined by demand and supply is one type of exchange rate system, or agreement among countries about how exchanges rates should be determined.
Others are managed float and fixed

Question 50

Managed float exchange rate system

Answer 50

Current exchange rate is this. The value of most currencies is determined by demand and supply with occasional govt intervention

Question 51

Fixed exchange rate system

Answer 51

One under which currencies agreed to keep exchange rates among their currencies fixed for long periods.
Suppose 1 peso buys 1dollar and tomorrow it changes so 1peso buys $.59.
Fluctuation bad because detracts foreign investment. So, to attract foreign direct investment, fix (peg) the currency so 1euro =1dollar.

Question 52

Pegging advanatges and disadvantages

Answer 52

Fixes their exchange rate against the dollar.
Advantages:
Easier planning for firms. A more credible commitment to fighting inflation
Disadvantages:
Needing to support an under or overvalued currency. Potential for destabilizing speculation if speculators believe currency will eventually appreciate or depreciation. Difficult to pursue independent monetary policy.

Question 53

Pegging on the $/peso vs Q of peso in FOREX graph

Answer 53

Pegging is the official exchange rate. We want that to be at they market rate. But say that there is a change in the Mexican economy so $/peso = .5 (Mexican POV). So we increase ms in Mexico. R goes down, so S of peso up, demand for peso down. So e down. $/peso down.
Fundamental rate is where supply and demand intersect (market rate).
Currency crisis. Reserve assets are depleted. Abolished the peg. Devaluation.
For Mexico to organically maintain the peg, need to have e go up. So decrease MS, R UP, E UP. this tightening MS policy has domestic repercussions though, as r goes up, I goes down and Y goes down.
If primary thing is peg, then reduce MS. in the us, this isn’t a priority.

If the fundamental (market) rate falls below the peg, excess supply will push e down.

Question 54

The euro problem

Answer 54

European countries all adapt same currency. Fixed exchange rate system. Problem is that domestic economies could be on a different schedule. So say France is in a recession and remand isn’t. Domestic response is French central bank increasing MS, R down, I up, Y up. But r down causes e to go down so the German /French ratio down.
Germany needs to also reduce r to increase MS to maintain peg. But if not in recession, don’t want to do this.
This is a problem. Don’t want to do this. Doesn’t work.

Question 55

4 determinants of exchange rates in long run

Answer 55

1 relative price levels.
PPP explains some exchange rate movements.
Prices in japan have risen slower than prices in us, helping to explain why Japanese yen has appreciated in value relative to the dollar
2 relative rates of productivity growth
A country with relatively high productivity growth will have less expensive products, demand for these products from foreigners will cause domestic currency to appreciate.
3. Preferences for domestic or foreign goods
If consumers in Canada increase their demand for us goods, they increase demand for US dollars, and hence appreciate value of dollar
4. Tariffs and quotas. High tariffs or restrictive quotas reduce demand for foreign goods. Cause domestic currency to appreciate.

Question 56

Big Mac index interpretation

Overvalued vs undervalued

Answer 56

Say the peso / $ is implied at 8 but is acrually 10
This means the dollar is overvalued.
The peso is undervalued.
WHEN ACTUAL (unit / $) > IMPLIED, PESO IS UNDERVALUED. DOLLAR IS OVERVWLUED.
WHEN IMPLIED IS BIGGER, FRANCS IS OVERVALUED. DOLLAR UNDER
Actual - implied / actual tells you how much undervalued or overvalued by. If looking at non dollar and positive, then undervalued.
Shortage means undervalued. If e is below eq rate, undervalued. Sell the currency to get to peg value.

Question 57

Bretton woods system

Answer 57

Destabilizing speculation is actions by investors making it more difficult to maintain fixed exchange rate
DS played a role in demise of BWS because investors sold currencies they believed to be overvalued and purchased currencies they believed to be undervalued. Made it hard to maintain fixed rates.

Question 58

In the forex, the demand and supply of euro are s2 and d2. What would happen if Europeans demand for us exports increase?
From European point of view

Answer 58

Supply would shift right. Demand stays the same.

Euro want more us export, more Euros are supplied in the market.

Question 59

Say the demand and supply for the euro in the European point of view is s2 and d2. How could we increase e and the quantity of euros?

Answer 59

Need the demand to shift right while keeping supply the same.
This could happen by increasing income in the US. increased us income will result in more demand for euros while supply will stay the same.
Increasing interest rate would also increase demand but this would shift supply left.

Question 60

Demand and supply of euros from European point of view are S1 and D2. Describe an event that would increase e but keep quantity the sane

Answer 60

Shift demand right and shift supply left.
If the interest rate in European countries went up, then there’d be more demand for Euros. Less supply as Europeans invest in their own goods since lower prices. So e up.

Question 61

To offset an appreciation of the dollar against the yen, the Fed should ___

Answer 61

Sell dollars on the FOREX and lower domestic interest rates
Sell dollars, S shifts right
R going down shifts D right and S left. Allows for e to go down too

Question 62

Suppose the government decides to follow an expansionary fiscal policy while the fed does an expansionary monetary policy. In the SR, what happens to output, price level, interest rate

Answer 62

Output goes up because fiscal expansion causes G up and Y up and T down so Y up. Exp monetary causes MS up, so r down and investment up. Even with crowding out Y will go out

Price level and interest rate depend. On the r vs Qm graph MS shifts right, but so does MD. so it depends which is more to see how r changes.