Unit 4: Foreign Trade and the Exchange Rate and The Monetary Policy Rule Flashcards
(112 cards)
1
Q
The Terms of Trade
A
the ratio of the price of exports to the price of imports (TT=P<sub>X</sub>/P<sub>IM</sub>).
2
Q
When the price of exports rises or the price of imports falls,
A
the terms of trade for U.S. residents improves but the amount
of net exports fall.
3
Q
When the price of exports falls or the price of imports rises,
A
the terms of trade for U.S. residents worsens but the amount
of net exports rise.
4
Q
When the value of imports (price multiplied by quantity)
exceeds the value of exports,
A
Americans must finance the
difference abroad. This amount of foreign borrowing is called
direct foreign investment.
5
Q
The foreign exchange (FX) market
A
(FX) The foreign exchange market is where dollars and other
currencies are traded freely.
6
Q
The Exchange Rate
A
The exchange rate (E) is the amount of foreign currency
exchanged for one U.S. Dollar.
7
Q
Suppose the exchange rate between the Japanese Yen
and the U.S. Dollar is 95 Yen per Dollar, and you wanted to exchange $100 in the FX market, ___
A
you would receive 9,500 Yen.
8
Q
The U.S. Dollar appreciates (i.e., its value increases) when
E ____.
A
rises
9
Q
The U.S. Dollar depreciates (i.e., its value decreases)
when E ____.
A
falls
10
Q
The rest of the world is specified as a weighted average of
foreign countries so there is one ____ and ____
A
foreign output, (YW); foreign price level (PW)
11
Q
The real exchange rate
A
(ER) is an exchange rate measure that
adjusts for the difference in the price level between the U.S.
and the rest of the world
ER = (E×P)/PW
- (E×P) is the average price of U.S. goods in the foreign
currency. (Ex., The average price of U.S. goods in the
Japanese Yen.) - PW is the average price of foreign goods in the foreign
currency. (Ex., The average price of Japanese goods in
Japanese Yen.)
12
Q
When ER is high (ER > 1), ____
A
U.S. goods are expensive for
foreigners while foreign goods are inexpensive in the U.S.
13
Q
When ER is low (ER < 1), ____
A
U.S. goods are inexpensive for
foreigners while foreign goods are expensive in the U.S.
14
Q
Purchasing power parity (PPP)
A
says that prices of goods
across countries should be equal. That is, ER = 1.
15
Q
Three things to note about PPP
A
a. Since goods across countries are not perfect substitutes,
prices do not have to be equal across countries.
b. PPP does not need to hold, especially in the short run.
c. PPP has an influence on ER and works well in the long run.
16
Q
Assumptions about the real exchange rate.
A
a. P and PW are fixed in the short run but flexible in the long run.
b. E is completely flexible in both the short and long run.
17
Q
Model of the Real Exchange Rate
A
Says that a higher R boosts foreign demand for U.S. assets, which increases demand for U.S. Dollars and drives up E and ER.
18
Q
Real Exchange Rate (Alg.)
A
ER = (E×P)/PW = q + qR×R,
where q and qR are constants.
19
Q
Higher ER’s effect on NX
A
- This makes U.S. products more expensive overseas so exports (X) decline. [ER↑→ X↓]
- This makes foreign products cheaper in the U.S. so
imports (IM) rise. [ER↑ → IM↑]
20
Q
A higher disposable income (YD)’s effect on NX
A
encourages consumers to spend more on imports (IM). [YD↑ → IM↑]
21
Q
Exports (Alg.)
A
22
Q
Imports (Alg.)
A
23
Q
Net Exports and ER (Alg. and Graph)
A
24
Q
The NX function with R and ER use the variables, respectively
A
gex, gEIM, vx, vIM; and gx, gIM, <span>n</span>x, nIM
25
If we take the net exports function with ER and set gX=(gEX–q×vX), gIM=(gEIM+vIM×q), nX=(vX×qR), and nIM=(vIM×qR), we get\_\_\_\_
the net export function from the shortrun
model
26
Suppose output starts at its potential (Y\*) and government
spending (G) increases.
In the short run, a rise in G pushes up Y to YB, which causes
the IS curve to shift rightward and R to increase. The higher
R increases demand for U.S. assets, which leads to an
increase in ER. Since P and PW remains at PA and PW′,
respectively, E must increase and the AD curve shifts
rightward from ADA to ADB.
In the long run, P rises from PA to PB, which causes MD and R
to rise. The higher R further increases demand for U.S. assets,
which leads to a further increase in ER. A higher R and ER
force down I and (X – IM), which causes Y to return to Y\*.
Therefore, in the long run an increase in G leads to a rise in R
and ER and a decline in I and (X – IM).
27
Suppose output starts at its potential (Y\*) and the money supply
(MS) increases.
In the short run, the rise in MS pushes down R. This leads a
decreased demand for U.S. assets, which causes ER to fall.
Since P and PW remain unchanged, the decline in ER forces
down E. The combination of a lower R and ER leads to an
increase in I and (X – IM), which forces up Y to YB. As a
result, the AD curve shifts rightward from ADA to ADB.
In the long run, P rises from PA to PC, which causes MD and R
to rise. R increases to its original level and in the process
raises the demand for U.S. assets. This leads to a complete
reversal of the decline in ER so that ER returns to its pre-shock
level. A higher R and ER lead to declines in I and (X – IM),
which causes Y to return to Y\*. Since P has increased and ER
is unchanged, E must fall. Therefore, in the long run an
increase in MS causes P to increase and E to decrease, while
ER remains unchanged.
28
Suppose the Federal Reserve decides to make targeting the
exchange rate the objective of monetary policy.
* Since ER, responds to changes in R, the Federal Reserve must
supply sufficient MS to keep R constant.
* The Ms and LM curve will be perfectly horizontal.
29
If the spending line shifts up then
the shift in Md is accommodated by increasing money supply to keep R constant.
30
In the event RW rises, (ER as a target)
the Federal Reserve must increase its
target R from RA to RB in order to keep ER constant by decreasing the money supply.
31
Types of protection measures
a. Tariffs, which are a tax on imports.
b. Quotas, which limit the quantity of imports.
c. Outright bans of certain products.
32
Protection policies help domestic companies because they
\_\_\_\_but these policies hurt consumers because \_\_\_\_\_
face less competition;
they pay higher prices.
33
Suppose the government imposes protection policies [gIM↓]
1. In the short run, a decline in gIM (i.e., X – IM rises) forces
consumers to buy more domestic goods, which causes Y to
rise to YB. This causes the IS curve to shift rightward and R
to increase. The higher R increases demand for U.S. assets,
which leads to an increase in ER. Since P and PW remains at
PA and PW′, respectively, E increases and the AD curve shifts
rightward from ADA to ADB.
[gIM↓ → Y↑ → MD↑ → R↑ → ER↑ → E↑]
2. In the long run, P rises from PA to PC, which causes MD and R
to rise. The higher R further increases demand for U.S. assets,
which leads to a further increase in ER. A higher R and ER
combined force down I and moderate the increase in (X –
IM), which causes Y to return to Y\*. Therefore, in the long
run protectionist policies lead to increases in R, ER, and (X –
IM) and a decline in I. [Y \> Y\* → P↑ → MD↑ → R↑ → I↓ &
(X–IM) ↓ → Y↓] & [R↑ → ER↑ → E↑]
34
By enacting protectionist policies, the U.S. runs the risk of
our trading partners retaliating with protection policies of
their own, which would \_\_\_\_
prevent the exportation of our goods
[gX↓]. This action would reverse any benefits from
protectionism.
35
Functions of Money
1. Medium of Exchange
2. Unit of Account
3. Store of Value
36
Medium of Exchange
Money is any item that is universally accepted as a means
of payment.
37
Unit of Account
a. Money serves as a common unit to measure the value of
goods and services.
b. Ex. the U.S. dollar is the unit of account in the U.S. and
the Euro is the unit of account in the European Union.
38
Store of Value
a. Money is an asset that people use to store their wealth.
b. People prefer to hold their wealth in currencies that they
believe will not fall in value.
39
Currency
(CU) = paper money + coins
40
Total reserves
(TR) = bank deposits held at the Fed + vault
cash (The Fed requires banks to hold a certain fraction of
their checking deposits as reserves; Required Reserves)
41
Monetary base
(MB) = CU + TR
42
M1
= CU + checking deposits (ChD) [For this class, M1 is
our definition of the money supply (MS)]
43
M2
= M1 + savings accounts + small time deposits (CDs)
+ money market mutual funds
44
Total reserves (TR) are ___ plus \_\_\_\_
Required Reserves; Excess Reserves
TR = RR + ER
45
Required reserves equal the \_\_\_\_
multiplied by \_\_\_\_\_
required reserves ratio (rr); checking deposits (ChD)
RR = rr×ChD
46
Excess reserves equal the ____ multiplied by \_\_\_\_
excess reserves-to-deposit ratio
(e = ER/ChD)
checking deposits
ER = e×ChD.
47
```
Total reserves as a
function of checking deposits:
```
TR = (rr + e)×ChD.
48
Currency held outside of banks equals the ____ multiplied by \_\_\_\_\_:
currency-to-deposit
ratio (c = CU/ChD) ;
checking deposits:
**CU = c×ChD**
49
```
The monetary base as a
function of checking deposits:
```
MB = (c + rr + e)×ChD.
50
Balance Sheet Items (6)
1. Gold
2. Currency (CU)
3. Checking deposits (ChD)
4. Government bonds (B)
5. Reserves (TR)
6. Loans (L)
51
The Fed’s balance sheet
**Assets Liabilities**
Bonds Currency
Gold Reserves
52
Banks’ balance sheet
**Assets Liabilities**
Bonds Checking deposits
Reserves
Loans
53
Individuals’ and firms’ balance sheets
**Assets Liabilities**
Bonds Loans
Currency
Checking deposits
54
The balance sheet impact of an increase in the money supply. (Ex. MB increases by $100)
[The Fed and Bank Balance Sheets]
55
Bank makes a loan to Consumer with additional reserves
[The bank]
56
Consumer makes a purchase and the firm deposits c =.25 to Bank B
[Bank Balance Sheet]
57
Bank lends fraction of $80 deposit when rr=.10 and e=.5
What happens next?
58
Money Multiplier Effect (Alg.)
Why does it change the way it does?
The bottom portion acts exponentially, the top is linear
59
The Fed's tools to conduct monetary policy
* Open-market operations (Fed's main tool)
* Discount Rate
* Interest Rate on Reserves
* Required reserve ratio
60
Open-market operations (2)
The Fed’s main policy tool
**Open-market sale**
a. The Fed sells bonds for reserves.
b. This action reduces the money supply.
**Open-market purchase**
a. The Fed buys bonds for reserves.
b. This action increases the money supply.
61
Discount Rate
1. The Fed charges this interest rate on loans made to banks.
2. Higher rates discourage borrowing and lower the money
supply.
3. This is an imperfect tool for monetary policy.
62
Interest rate on reserves
1. In 2008, federal legislation gave the Fed the authority to pay
interest on reserves.
2. The Fed usually sets the interest rate on reserves at or above
the overnight interest rate (federal funds rate), so banks have
an incentive to hold excess reserves.
3. Since 2008, the Fed has used excess reserves to fund its
purchases of long-term bonds/mortgage-backed securities.
63
Required reserve ratio
1. This is the percentage of reserves a bank must hold against
deposits.
2. A higher required reserves ratio contracts the money supply.
3. This tool is very disruptive to the banking system.
4. This tool is rarely changed.
64
The total amount of reserves in the banking system is called
\_\_\_\_
total reserves.
65
The total amount of reserves in the banking system that are
required by the Fed is called \_\_\_\_
required reserves.
66
\_\_\_\_ are the difference between total reserves and
required reserves.
Excess reserves
67
Banks that do not have a sufficient amount of reserves to meet
their requirements can acquire additional reserves in two ways.
* Banks can borrow reserves from other banks that have excess
reserves in the **federal funds market.**
* Banks can also borrow reserves directly from the Fed at the
**discount window.**
68
Federal Funds Rate
the interest rate that one bank
charges another for borrowing reserves.
Primary place banks go to acquire reserves
69
Discount Rate
* the interest rate that the Fed charges banks for borrowing reserves.
* The discount rate is almost always equal to or greater than
the federal funds rate
* Restrictive regulations on the use of borrowed reserves
strongly discourage banks from going to the discount
window.
70
Borrowed Reserves
Reserves borrowed directly from the Fed at the discount
window
borrowed reserves + nonborrowed
reserves = total reserves.
71
Nonborrowewd Reserves
All reserves that weren't borrowed.
borrowed reserves + nonborrowed
reserves = total reserves.
72
Opportunity Cost of holding money
OCM,
OCM = R – RM
R is the return on bonds that people forgo
when they hold their assets as money instead of bonds.
The own rate on money, RM, is the interest rate earned from
holding assets as money. (Above zero for ChD but 0 for CU)
73
As the opportunity cost of money rises, \_\_\_\_\_.
the demand for
money falls
74
Number of time transfers are made
z = YM/(2×M))
75
Average Monthly Balance (Alg.)
M = YM/(2×z)
76
Optimal level of money balances (Alg. and implications)
M = ((k×YM)/(2×OCM))1/2
As M rises so does Y, k, and a dec. in OC
77
Demand for money as a store of wealth
1. People save some wealth in the form of money in case of an
emergency need for liquid assets.
2. Some people save their wealth in the form of money because
of the anonymity it provides the holder. (This case is
especially true in criminal activities where individuals are
seeking to avoid detection.)
78
Recent trends in currency and checking deposits.
1. Currency holdings fell from the 1960s to the 1980s as new
transactions technology reduced the need for currency.
2. Currency holdings since the mid-1980s have risen due to
increased foreign demand for the U.S. dollar. (Foreigners in
some politically unstable countries like to store their wealth in
the U.S. dollar.)
3. The amount of money held in checking accounts declined
from 1960-1980 as higher interest rates encouraged
household to learn to economize on their checking balances.
4. The amount of money held in checking deposits has
fluctuated with its opportunity cost since interest rates peaked
in 1980.
79
The demand for currency (DCU) and checking deposits (DChD)
* 1. The DCU and DChD decline as the opportunity cost of money, OCM, rises.
a. As R rises, OCM increases, which causes DCU and DChD to fall.
b. As RM rises, OCM falls, which causes DChD to increase.
(note: the own rate of currency is always zero)
* 2. DCU and DChD increases as output rises.
* 3. DCU and DChD increases as the price level rises.
80
Monetary policy by money supply growth targets.
Approach and Problems.
* The Fed sets a MS growth rate target and then estimates
the money multiplier to determine how much the MB
needs to increase to reach its MS growth rate target.
* One problem with this approach is that a bad estimate of
MD or a shock to MD will cause fluctuations in R, which
leads to undesirable movements in I and Y.
* Another problem is what measure of money growth
should the Fed target? M1? M2?
81
Money growth targets were used primarily by the Fed in
\_\_\_ when the money demand function was
\_\_\_\_ and when inflation expectations were \_\_\_\_.
the early 1980s; predictable; volatile
82
Monetary policy by interest rate targets
* The Fed sets a nominal interest rate target and then
estimates the money multiplier to determine how much
the MB needs to increase to reach its nominal interest rate
target.
* One problem with this approach is that a bad estimate of
inflation expectations causes an unintentional change in
the real interest rate. Unplanned changes in the real
interest rate leads to undesirable movements in I and Y.
* c. Interest rate targets have been used primarily by the Fed
since the mid-1980s because inflation expectations have
been low and predictable while the money demand
function has been volatile.
83
Interest rate targets have been used primarily by the Fed
since ___ because inflation expectations have
been \_\_\_\_while the money demand
function has been \_\_\_\_.
the mid-1980s; low and predictable; volatile
84
Objectives of the Fed
a. Keep inflation low and stable
b. Keep deviations of real GDP from its potential, [(Y–
Y\*)/Y\*], small
85
Monetary Policy Rule
describes how the Fed sets the money
growth rate or the interest rate in response to variables in the
economy.
86
The Taylor Rule
A monetary policy rule describing an interest rate target
R = π + βπ×(π – π\*) + βY×[(Y – Y\*)/Y\*] + re*
where
π is the actual inflation rate.
π* is the target inflation rate.
(Y–Y*)/Y* is the percent deviation of Y from Y*.
re* is the Fed’s belief of the value of the real interest rate
when Y is at Y*.
βπ and βY are constant coefficients that are greater than zero. The sensitivity of R to those factors.
π is the actual inflation rate.
π* is the target inflation rate.
(Y–Y*)/Y* is the percent deviation of Y from Y*.
re* is the Fed’s belief of the value of the real interest rate
when Y is at Y*.
βπ and βY are constant coefficients that are greater than zero. The sensitivity of R to those factors.
87
The Taylor rule does a good job of explaining Fed behavior since \_\_\_\_\_
the mid to late 1980s.
88
the inflation rate rises if ___ increases and the Fed
does not increase \_\_\_.
r; re*
89
Theories as to why P does not adjust as fast as MS in the short run
A. Imperfect Information
B. Sticky Prices
C. Sticky Wages
90
The Imperfect Information Theory
* Prices are completely flexible.
* Firms, however, have imperfect information on whether a
shift in its demand curve is due to
* a. a change in MS or
b. a shift that is product specific (ex. increased consumer
demand for that firm’s product)
* Specifically, this model assumes firms have a difficult time
observing P so they must form expectations of P in order to
interpret the source of a change in Pi.
* The effect of this informational problem is that P will slowly
adjust after a change in MS if firms believe the source of the
shift in its demand curve maybe product specific.
91
A firm's change of Pi in reponse to a demand curve shift depends not he source of the shift.
* If a MS change is the source, a firm does not adjust its output, Yi, because the change in Pi is economy wide. (i.e., the price level, P, changes)
* If the shift is product specific, the firm adjusts Yi because
the change in Pi is product specific. (i.e., P does not
change)
92
Theory of Supply
a firm will increase Yi if its relative price, (Pi – P),
rises.
93
Derivation of the supply curve in a model with imperfect
information
1. It is assumed there are n identical firms.
2. Firm i’s (where i E [1,n]) supply curve is given by
Yi = h×(Pi – P) + Yi\* (1)
where
Yi is firm i’s output.
Yi\* is firm i’s potential output.
Pi is firm i’s price.
P is the aggregate price level.
h is a constant coefficient such that h \> 0.
94
Firm i's expectation of P (alg.)
Pe = Pf + b×(Pi – Pf)
where Pf is firm i’s forecast of P at the start of the year
(before Pi changes), while b is a constant coefficient such that
0 ≤ b ≤ 1 {The Level of Certainty]
95
Aggregate Supply Curve (AS)
How does it look with perfect information?
How does it look with imperfect information?
Add up all supply curves for all *n* firms in the economy
Y = n×h×(1 – b)×(P – Pf) + Y\*
When b=1, it is perfectly vertical, and a Ms change has no effect on output.
When b\<1, it is upward sloping.
96
AD in terms of Ms and P
Y = k0 + k1×(MS – P)
where k0 and k1 are constant coefficients.
97
LRAS
Firms have perfect information so it is a vertical line at potential output.
98
Inc. in MS on the AD/AS Curve
99
An anticipated increase in the money supply in the Short-run
100
An unanticipated increase in the money supply
101
Sticky Prices
Studies have shown that prices tend to be “stuck” at a
particular U.S. dollar value for a long time.
102
In some economies, prices are set in terms other than its
domestic currency (ex. Chile sets prices in terms of the UF
and not it currency: the peso). In these economies, \_\_\_\_\_
price
stickiness, as observed in the U.S., is not present.
103
Menu costs
Firms incur a cost to print new catalogs, price sheets, and menus every time they adjust their prices.
It is a source of price stickiness.
104
Sticky Wages
Wages tend to be sticky because
a. the wage bargain is made in monetary terms.
b. it is complicated and costly to index wages based on some
measure of the average wage rate.
Spreads to price stickiness
105
If wages are sticky, then prices are sticky. Why?
A profit-maximizing firm sets its price in relation to its
marginal cost.
b. Since wages are a key component of marginal cost, wage
stickiness is transferred to prices through the marginal
cost. As a result, prices become sticky.
106
The length of a wage contract depends, in part, on whether
\_\_\_\_ [Details]
there is a union or not.
a. Union contracts tend to last for several years. (Three-year
contracts are especially popular.)
b. Non-union workers tend to receive salary and wage
adjustments once a year. While there usually is not a
formal contract, the wage rate is rarely changed before the
next adjustment period.
107
Wage contracts, whether formal or informal, tend to be
\_\_\_\_\_
staggered, which means that at any one time only a small
number of workers are signing contracts.
108
Factors influencing the outcome of wage negotiations.
a. One factor is the state of the labor market. That is, low
unemployment favors the employee, while high
unemployment favors the employer.
b. Another factor is the wage rate paid to comparable
workers at other companies and in other industries. This
includes both recently signed wage contracts and expected
wage contracts to be signed in the near future.
c. A final factor is the expected inflation rate pie.
109
Why are wage contracts set for long periods without indexing
them to P?
1. The time and resources for employees and employers to
acquire information on labor market conditions is substantial.
2. In unionized industries, there is always possibility of a costly
strike. In addition, it is expensive to prepare for that strike
regardless of whether or not it occurs.
3. Since firms choose labor where W/P=MPL, indexing the wage
(W) to P would prevent W/P from falling. In the event there is
a negative technology shock that shifts down the MPL, the
inability to adjust W/P forces the employer to push up the
MPL by decreasing their labor input.
4. Indexing contracts to P adds complexity to the contract,
which could make it harder to sell to some union members.
1. Some workers object to indexing because it adds uncertainty
to future wages, even though economists argue that the
workers are better off with it.
110
A Model with Staggered Wage-Setting (Assumptions)
1. All wage contracts last 2 years.
2. ½ of all contracts are signed at the start of even-numbered
years and the other ½ are signed at the start of odd-numbered
years.
3. There is no indexing in the contract.
111
Average Wage Rate
W = ½×(X + X-1)
X denotes the contract wage negotiated this year. (X-1 is the
contact wage negotiated last year)
112
Determining the Value of X
X = ½×(X-1+X+1)–d×[(U–U\*)+(U+1–U\*)]
1. X-1 reflects the influence of last year’s contract and is
what makes inflation persist from year to year.
2. X+1 reflects the influence of next year’s contract and is
what makes expectations about future monetary policy
important.
