open economy aggregate demand and supply and the phillips curve

Question 1

what do short run curves allow to consider

Answer 1

AD-AS the exogenous variables

Question 2

what do long run curves allow to consider

Answer 2

LAS AND LAD monetary neutrality holds, nominal monetary factors have no long run impact on real economic variables

Question 3

what does medium run allow to consider

Answer 3

takes us from short to long run

Question 4

two types of Aggregate demand

Answer 4

Fixed exchange rate AD

Flexible exchange rate AD

Question 5

Aggregate Demand- Fixed Exchange Rates

Answer 5

theory of PPP suggests the real exchange rate is constant in the long run

ppp = 𝜎 = SxP/P*

P and P* are at home and abroad price levels

under fixed, nominal exchange rate (S) is fixed

PPP condition therefore implies that the long run P/P* is constant

Inflation is imported from abroad under a fixed exchange rate

short run PPP does not hold since prices are sticky (prices don’t change all the time)

since S is fixed deviations from domestic inflation from foreign inflation must lead to short run deviations in the real exchange rate

By considering changes in Inflation, we arrive at out short run AD curve under fixed exchange rates

Question 6

shifts in AD (FIXED)

Answer 6

shifts when exogenous variables that shift the IS curve change e.g government spending, taxation, household wealth, Tobin’s q foreign income

Question 7

AD flexible exchange rates

Answer 7

monetary policy is exogenous and the nominal exchange rate becomes endogenous (determined by market forces)

AD is downward sloping due to the CB taylor rule and the fact that the CB will set a higher nominal interest when inflation is higher

Question 8

Taylor rule

Answer 8

i = i bar + a(𝜋 - 𝜋 bar) + B(Y-Y bar/Y bar)

CB will increase nominal interest rates (tighten policy) if inflation and/or output are above target

how aggressively this is done is captured by a and b

long run real interest rate (r bar) is determined by real economy

CB controls inflation, follows the target given by the fisher equation

i bar = r bar + 𝜋bar

r bar- determined by the marginal productivity of physical capital (tech and availability of labour)

𝜋bar chosen by the CB (taylor rule)

Question 9

AD flexible exchange rate with taylor rule

Answer 9

taylor rule interest rate responds to changes in both output and inflation rate

inflation is exogenous in IS-TR-IFM

suppose inflation rises to 𝜋’ > 𝜋 (bar)

requires CB to increase interest rate by a(𝜋’-𝜋(bar))

leads the TR curve to shift leftwards tr-tr’

real exchange rate appreciates reducing demand

is also shifts

monetary tightening triggers capital inflows and an exchange rate appreciation

NX deteriorates and IS shifts left

Question 10

phillips curve

Answer 10

policy makers make decisions as if there is a short run trade off between inflation and unemployment

not simple and stable relationship like phillips curve, dont pick point on the line

tighten monetary less inflation more unemployment

loosen monetary lower unemployment stimulate economy more inflation

Question 11

AS

Answer 11

high inflation, low unemployment high output and visa versa

Question 12

why we have inflation and why we have link between inflation and output

Answer 12

producers prefer higher prices

• charge high prices to some amount of market power, held in check by amount of buyer

-mark up pricing, depends on elasticity of demand for the good

producers set prices as a mark up over wages (costs)

Question 13

wages as part of mark up prices

Answer 13

prices depend on wages

wages depend on expected prices

employees bargain for a nominal wage that allows for expected inflation

battle of the mark up, each try to maximise its benefit from economic activity

Question 14

Battle of the mark ups/economic cycle

Answer 14

why is higher inflation associated with higher output and lower unemployment

during boom, opportunity for increased profits increases

leading to increase in competition

uncertain outcome, lots of customers, too carried away sector looks too attractive firms enter

boom, bargaining position of workers/unions tend to be stronger

due to higher demand for labour

firms offer higher wages to encourage new entrants to labour force

wage mark up procyclical

prices are a mark up over wages, overall mark up may be expected to move pro cyclically with the business cycle

implying a procyclical relationship between prices and the economic cycle (phillips curve)

Question 15

what is inflation driven by

Answer 15

the mark ups

expected inflation

𝜋= ∆(mark-ups)+𝜋^e

Question 16

sticky prices and sticky wages

Answer 16

wages and prices don’t change all the time- even when they do not all at once

rational decisions may be based on older information

no single 𝜋^e some mix with some part from past, present and future

inertial inflation captured as 𝜋~

Question 17

AS or phillips curve equation

Answer 17

𝜋 = 𝜋~ + aY_gap = 𝜋~ -bU_gap

inflation is equal to inertial inflation (what people expected inflation to be) and output gap (capturing economic cycle- wages and prices tend to be higher in times of more rapid growth)

a and b captures how the mark ups respond to cyclical fluctuations

higher economic activity leads to higher prices via higher mark ups

upwards SRAS curve

Question 17

underlying inflation

Answer 17

𝜋~, some combination of rates, some anchored in the past ot the present and some forward looking expectations

workers may

-look at past, have past inflation built into contracts etc.

higher underlying inflation, higher phillips curve, higher short run aggregate supply

Question 18

fiscal expansion under Fixed Exchange rates

Answer 18

Short run- AD shift rightward due to fiscal expansion (potential effect offset by appreciation of real exchange rate reducing competitiveness

Medium Run- underlying inflation catches up with actual inflation shifting AS up and left and is further left alongside AD

as inflation rises real competitiveness erodes output deteriorates

Long run- government budget constraint fiscal expansion eventually stops

under fixed exchange rate inflation rate can’t deviate for long from foreign inflation, economy back to long run equilibrium

Question 19

fiscal expansion under flexible exchange rate

Answer 19

fiscal expansion completely crowded out by reduced competitiveness and deterioration in NX

fiscal expansion does not shift AD economy remains at long run equilibrium

standard AD-AS curve

Question 20

supply shock

Answer 20

affect short run inflation significantly, oil and gas shocks

or significant depreciation making imported goods more expensive

exogenous parameter s models this

𝜋 = 𝜋~ + aY_gap + s (aggregate supply)

𝜋 = 𝜋~ + bU_gap + s (Phillips Curve)

actual inflation = underlying inflation - cyclical effects + supply shock

Question 20

devaluation (monetary policy under fixed rates)

Answer 20

starting at long run equilibrium

monetary policy leads to a nominal devaluation

improved net exports shift the IS curve to IS’

demand expansion shifts AD to AD’

some of potential gain in real competitiveness is lost due to higher inflation

inflation above the world level and real competitiveness is reduced shifting IS back.

CB could repeat process bit leads to higher inflation and series of devaluations