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quantity theory of money:
the more money there is out there, the less value it has
what is P and what is 1/P?
- P= the price level of a basket of goods, measured in money
- 1/P= the value of $1, measured in goods
who developed the quantity theory of money and when?
David Hume in the 18th century
who determines the money supply?
the Federal Reserve
Money Demand (MD)
how much wealth people want to hold in liquid form
An increase in P ______ the value of money.
Quantity of money demanded is _______ related to the value of money and _______ related to P.
As the value of money rises, what happens to the pricel level?
what does an increase in money supply cause? why would prices rise?
increase in spending, increase demand for goods; supply for goods doesn't increase, so the prices rise
what are nominal variables measured in?
monetary units (i.e. nominal GDP)
what are real variables measured in?
physical units (i.e. Real GDP)
what are they measured in?
- the price of one good divided by another
- measured in physical units
Real wage formula:
- W= nominal wage
- P= price level
the theoretical separation of nominal and real variables
According to Hume and classical thinkers, if the bank doubles the money supply, what happens to the nominal and real variables?
- nominal - will double
- real - unchanged
the proposition that changes in the money supply do not affect real variables
Under Monetary neutrality, what elses isn't affected besides real variables?
- employment of resources
- real wage W/P
- total output
Velocity of money:
- how fast money changes hands
- V= (P*Y)/M
- Y= GDP
- M= money supply
- P= price level
Quantity equation formula:
M*V = P*Y
inflation exceeding 50% per month
printing money causes inflation, which is like a tax on everyone who holds money
Nominal interest rate formula:
Nominal interest rate = inflation rate + real interest rate
change in money growth affects inflation rate, but not the real interest rate
the resources wasted when inflation encourages people to reduce their money holdings
the costs of changing prices (printing new menues, changing catalogs, etc.)
Misallocation of resources from relative-price variability:
Firms don’t all raise prices at the same time, so relative prices can vary… which distorts the allocation of resources
Confusion and inconvenience:
Inflation changes the yardstick we use to measure transactions
Inflation makes nominal income grow faster than real income; people end up paying more for taxes without their income increasing
arbitrary redistribution of wealth:
Higher-than-expected inflation transfers purchasing power from creditors to debtors
difference between a closed and open economy:
closed economy doesn't interact with international economies and an open one does
domestically produced things sold abroad
foreign produced things sold domestically
Net exports AKA Trade balance (what – what?):
exports - imports
Variables influencing net exports –
- consumer preference for domestic and foreign goods
- prices AND income of consumers home and abroad
- exchange rates
- transportation costs
- government policies
excess of imports over exports
excess of exports over imports
exports = imports
net capital outflow (NCO):
domestic residents’ purchases of foreign assets minus foreigners’ purchases of domestic assets
Foreign direct investment:
Domestic residents actively manage the foreign investment, e.g., McDonalds opens a fast-food outlet in Moscow.
Foreign portfolio investment:
Domestic residents purchase foreign stocks or bonds, supplying “loanable funds” to a foreign firm.
when NCO > 0 "capital outflow"
Domestic purchases of foreign assets exceed foreign purchases of domestic assets
when NCO < 0 "capital inflow"
Foreign purchases of domestic assets exceed domestic purchases of foreign assets
variables that influence NCO:
- real interest rates paid on foreign and domestic assets
- percieved risks of holding foreign assets
- government policies affecting ownership of domestic assets
When a transaction affects NX, how much does it affect NCO?
When S > I, the excess loanable funds flow where?
abroad in the form of positive net capital outflow
When S < I, who is funding some of the counrty's investments?
foreigners are financing some of the country’s investment, and NCO < 0 BECAUSE WE'RE BORROWING!
Nominal exchange rate:
the rate at which one country’s currency trades for another
an increase in the value of a currency as measured by the amount of foreign currency it can buy
a decrease in the value of a currency as measured by the amount of foreign currency it can buy
Real exchange rate:
- the rate at which the g&s of one country trade for the g&s of another
- (e x P)/P*
- e= nominal exchange rate
- P= domestic price
- P*= foreign price
Law of One Price:
all goods should be sold at the same price in all markets
a theory of exchange rates whereby a unit of any currency should be able to buy the same quantity of goods in all countries
What does PPP imply?
the nominal exchange rate between two countries should equal the ratio of price levels
Two reasons why exchange rates do not always adjust to equalize prices across countries:
- Many goods cannot easily be traded (like a haircut)
- Foreign and domestic goods are not perfect substitutes
periods of falling real incomes and rising unemployment
severe recessions (very rare)
What does an Aggregate Demand curve show?
the quantity of all g&s demanded in the economy at any given price level.
Why the Aggregate Demand curve slopes down - The Wealth Effect: (C falls)
the dollar value goes down and people feel poorer
Why the Aggreagte Demand cure slopes downward - The Exchange-Rate Effect: (NX falls)
US exchange rate appreciates; exports become more expenseive and imports become cheaper
Why the Aggreagte Demand cure slopes downward - The Interest Rate Effect: (I falls)
Buying things requires more dollars, so people sell bonds and assets, driving up interest rates
What has to be affected to shift the Aggregate Demand curve?
C, I, G, or NX
What does the Aggregate Supply curve show?
the total quantity of g&s firms produce and sell at any given price level.
Natural Rate of Output: (YN)
the amount of output the economy produces when unemployment is at its natural rate.
An Aggregate Supply curve is _____ in the short run and _____ in the long run.
What is YN determined by?
the economy’s stocks of labor, capital, and natural resources, and on the level of technology.
Why is the Long Run Aggregate Supply curve vertical?
an increase in P doesn't affect labor, capital, and economy
Why does the Short Run Aggregate Supply cure slope upwards?
an increase in P causes an increase in the quantity of goods and services
Factors that shift the Long Run and Short Run Aggregate Supply curves:
- Changes in L (natural rate of unemployment)
- Changes in K or H (people getting college degrees, investment in factories, destroyed factories, etc.)
a period of falling output and rising prices
What did John Maynard Keynes argue about recessions and depressions, and what should policy makers do?
recessions and depressions can result from inadequate demand, so policy makers should shift the AD curve
John Maynard Keynes' criticism on the long run:
in the long run we'll all be dead, so it's misleading
in the 2008-2009 recession, what cause rising house prices?
- low interest rates
- easier credit for "sub-prime" borrowers
- government policies to increase homeownership
- securitization of mortgages
Consequences of the 2008-2009 house market crash:
- People owed more money that the worth of the house and many houses were forclosed
- Banks tried to sell the forclosed houses and ended up with bad investments
- Unemployment rose quickly (especially the construction industry)
What the government did to solve the 2008-2009 house market crash:
- Fed Reserve bought mortgage-backed securities and other loands
- US Treasury put more money into banks hoping to keep away a "credit crunch"
- Fiscal policy makers increase gov spending and reduced taxes by $800 billion