Econ Test 2 Book Notes

8/2/2019 Econ Test 2 Book Notes

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Econ test 2 ch. 7,17,22,24 March 28

Chapter 7 Stock Market, Theory Of Rational Expectations. Computing the Price of Common Stock Common Stock is principal way corporations raise equity capital

o Holders own interest in corporation consistent w/ percentage of outstanding sharesowned

Stockholders: those who hold interest in a corporation-have bundle of rightso Most important are right to vote and to be the residual claimant of all funds flowing into

the firm (known as cash flows)

Residual claimant: stockholder receives whatever remains after all other claimsagainst the firms assets have been satisfied

o Paid dividends(payments made periodically, usually every quarter, from net earningso Has right to sell stock

Board of directors of firm sets level of the dividend, usually based on recommendation of mgt 1 basic principal of Finance-value of any investment is found by computing PV of all cash flows

investment will generate over its life

o Ex. commercial building will sell for price that reflects net cash flows (rents-expenses)its projected to have over its useful life

o Similarilywe value common stock as value in todays dollars of all future cash flows The cash flows a stockholder might earn from stock dividends, sale price, or

both

To develop theory of stock valuation: Buy stock, hold it for one period to get dividend, then sellstock---called one-period valuation model

One Period Valuation Modelo Should you buy stock or not?---need to determine whether current price accurately

reflects analysts forecast

To value stock today: find present discounted value of expected cashflows(future payments) using equation

Equation: P0=(Div1)/(1+ke)+(P1)/(1+ke) P0= current price of stock. Zero subscript refers to time period zero or

present

Div1=dividend paid at end of year 1 Ke=required return on investments in equity P1= price at end of period; assumed sales price of the stock

Ex. satisfied to earn 12% return on investment(ke=.12), Intel pays %0.16 individends (Div1=.16), and forecast share price of $60 for next year(p1=$60)

P0=(.16)/(1+.12)+(60)/(1+.12)=.14+53.57=$53.71

Find PV of all cash flows is $53.71b/c current price of stock is $50 youwould buyhowever be aware stock may be selling for less than $53.71b/c other investors place different risk on cash flows or estimate cash

flows to be less than you do

Generalized Dividend Valuation Modelo Using PV concept, the one period div. valuation model can be extended to any number

of periods: Value of stock today is the PV of all future cash flows

o Only cash flows investor will receive are dividends and final sales price when stock isultimately sold in period n


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Gen. multi-period formula for stock valuation: P0=(D1)/(1ke)^1(D2)/(1ke)^2(Dn)/(1ke)^n(Pn)/(1ke)^n If to use to find value of share of stockmust first estimate value at

some point in future before estimate its value today(find Pn before P0)

o Ex. stock sells for 50$ 75 years from now, using 12% discountrate is*$50/1.12^75=$0.01+this implies that CV of stock can be

calc. as simply PV of future dividend stream

o Generalized dividend model: rewritten w/o final sales price Pg. 149 (3) Says that price of stock is determined only by PV of the dividends and that

nothing else matters

Many stocks do not pay dividendsso how do they have value? Buyers of the stock expect that the firm will pay dividends someday Most of time firm institutes dividends as soon as it has completed rapid

growth phase of its life cycle

Requires we compute PV of an infinite stream of dividendscan be difficult Thus developed simplified modelsGordon growth model: assumes

constant dividend growth

Gordon Growth Modelo P0=(D0 x (1+g)/(ke-g)=D1/(ke-g)

D0=most recent div. paid G= expected constant growth rate in dividends Ke=required return on investment in equity

o Useful for finding value of stock, given few assumptions 1. Dividends are assumed to continue growing at a constant rate forever.

As long as they are expected to grow at constant rate for extendedperiod of time, model should yield reasonable results.

o Errors about distant cash flows become small when discountedto present

2. Growth rate is assumed to be less than the required return on equity, ke. If growth rate were faster than rate demanded by holders of firms

equity, in long run firm would grow impossibly large

How the Market Sets Stock Prices Ex. 2 bidders at auction going for same carboth test drive and hear noise but one knows

problem and other doesntso one sets bid at $5,000 and other at $7,000bids $4,500 to

beginthen $5,000and finally $5,100 sold to more informed buyer

o 1. Price is set by buyer willing to pay highest price. Price not necessarily highest priceasset could fetch, but incrementally greater than what any other buyer willing to pay

o 2. Market price will be set by buyer who can take best advantage of assetbuyer knewhe could fix noise easily and cheaply so willing to pay more(same as buildings to whomcan put more to productive use)

o 3. Shows role played by information in asset pricing. Superior information about anasset can increase its value by reducing its risk.

When buying stockmany unknowns about future cash flowsbuyer who hasbest info. About future cash flows will discount them at lower interest rate than

will buyer who is uncertain


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Ex. Stock valuationconsidering purchase stock to pay $2 dividend next yearmarket analystsexpect firm growth at 3% indefinitely. You are uncertain about both constancy of dividend

stream and accuracy of estimated growth rate. Compensate yourself for uncertainty(risk) by

requiring return of 15%...Another investor spoken with industry insiders and feels more

confident about projected cash flows. She requires only 12% return b/c her perceived risk is

lowerAnother investor is dating CEO of company. He knows with more certainty what future

actually is, and thus requires 10% return. Applying Gordon Growth model yieldFirst investor

stock price willing to pay $16.67, second $22.22, third $28.57

o Investor with lowest perceived risk is willing to pay moreo No other traders for stock but these three, market price between $22.22 and $28.57o Already held stockyou would sell it to third investoro Thus players in mark, bidding against another, establish market priceo Stock prices are constantly changing b/c new information is always released/revising

expectation

Monetary Policy and Stock Priceso Stock market analysts tend to hang one every word chairman of Federal reserve utters

b/c know important determinant of stock prices is monetary policy

o Monetary Policy affects prices in two ways 1. When Fed lowers interest rates, return on bonds(alternative asset to stocks)

declines, and investors are likely to accept a lower required rate of return on an

investment in equity (ke)

Resulting decline in required return on an investment in equity(ke),would lower denominator in GGM, leads to higher current price of

stock, and raise stock prices

2. Lowering of interest rates is likely to stimulate economy so growth rate individends(g) is likely to be higher.

Also would lower denominator(ke-g) in Gordon growth model, highercurrent price of stock(P0) and rise in stock prices

Suprime Financial Crisis and Stock Marketo Led to downward revision of growth prospects for US companies, thus lowering

dividend growth rate(g)

o Resulting increase in denominatorlead to decline in current stock price(P0) and declinein stock prices

o Uncertaity for US economy and widening credit spreadswould also raise requiredreturn on investment in equity. Higher return on equity(ke) also leads to increase in the

denominator, decline in P0, and general fall in stock prices

Theory of Rational Expectations Examines how expectations are formedexpectations are crucial Most widely used theory to describe formation of business and consumer expectations Adaptive expectations: View of expectation formation; suggests that changes in expectation willoccur slowly over time as past date change

o 1950s typically viewed as being avg of past inflation rateso Ex. formely been steady at 5% rate, expectations of future inflation would be

5%...Inflation rose to steady rate of 10% then expectations of future inflation would rise

towards 10%, But slowly: in first year expected inflation might rise only to 6%, in second

7% and so on


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o Has been faulted b/c people use more info than just past data to form expectations ofthat variablealso effected by

Expectations of inflation affected by future monetary policy as well as bycurrent and past monetary policy

People often change their expectations quickly in light of new information Rational expectations: to meet these objections to adaptive expectations; thus

an alternative theory of expectations

Expectations will be identical to optimal forecasts (the best guess of thefuture) using all available information

Ex. Takes avg of 30 min to work when not rush hoursometimes takes25, other times 35leaves for work during rush hour, takes him on avg

an additional 10 minutes to get to workGiven that leaves for work

during rush, best guess of driving timethe optimal forecast---is 40

minutes

o Best guess of driving time using all info is 40 min, expectationshould be the same

o Expectation of 35 min not rational b/c not equal to optimalforecast(best guess of driving time)

o Somedays may take 45 or 45 but forecast does not have to beperfectly accurate to be rational--- need be the best possible

given the available information; has to be correct on average

o Bound to be some randomness, so optimal forecast will neverbe accurate

o Accident happens along the way that causes traffic..still rationalo However if there is a radio report of accident and does not put

that into account then it is no longer rational for 40 min

Even though a rational expectation equals the optimal forecast using allavailable information, a prediction based on it may not always be

perfectly accurate Two reasons expectations may fail to be rational:

o People might be aware of all available information but find ittakes too much effort to make their expectation the best guess

possible

o People might be unaware of some available relevantinformation, so their best guess of the future will not be

accurate

If an additional factor is important but information about it is notavailable, an expectation that does not take account of it can still be

rational

Formal Statement of the Theory

o Theory of expectation more formally: X^e=X^(of) Expectation of X=optimal forecast using all available information X=variable being forecast(Driving time) X^e=expectation of variable(Expectation of driving time) X^(of)=optimal forecast of X using all available info(best guess possible)

Rationale behind the Theory


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o Ex. GE makes poor forecasts of interest rates, earn less profit, b/c may make too mayappliances or to few

o Incentives for equating expectations with optimal forecasts are strong in financial mark. People w/ better forecasts get rich

o Application of the theory of rational expectations to financial markets(where it is calledefficient market hypothesis or theory of efficient capital markets) is useful

Implications of the Theoryo 1. If there is a change in the way a variable moves, the way in which expectations of this

variable are formed will change as well.

Ex. interest rates move in a way that return back to normal. Todays interestrate is high relative to normal, optimal forecast for future says will decline to

normal level. Rational expectations theory would imply that when todays

interest rate is high, the expectation is that it will fall in the future

Ex. now says rates will stay high and optimal forecast says and hence rationalexpectation, will stay highChange in way interest rate variable moves has lead

to change in way that expectations of future interest rates are formed

When there is a change in the way any variable moves, the way in whichexpectations of this variable are formed to change, too.

o 2. The forecast errors of expectations will, on average, be zero and cannot be predictedahead of time.

Forecast error of expec: X-X^e(difference between realization of a variable Xand expectation of the variable

Ex. some days takes 45 min rather then 40 so forecast error is 5minutesrealizes avg not equal to zero and actually equals 5 so adjusts driving

time to 45 minutesRat. Exp. Theory implies he will do this b/c wants best guess

possible. When revised his forecast error will equal zero so cannot be predicted

ahead of time.

Rat. Expect. Theory implies that forecast errors of expectations cannotbe predicted

The Efficient Market Hypotheses: Rational Expectations in Financial Markets Efficient market hypothesis: Expectations in financial markets are equal to optimal forecasts

using all available info.

o Application of rational expectations to the pricing of stocks and other securitieso Based on assumptions that prices of securities in financial markets fully reflect all

available information

o Pg. 156 equationo Views expectations of future prices as equal to optimal forecasts using all currently

available informationso markets expect. Of future securities prices are rational

o Expected return on security will equal optimal forecast of the returno Does not tell about how financial markets behaveo Expected return on a security will have tendency to head toward equilibrium return that

equates qty demanded to qty supplied

o Equation tells us that current prices in a financial market will be set so that the optimalforecast of a securitys return using all available information equals the securitys

equilibrium return

in an efficient market, a securiys prices fully reflects all available information Rationale Behind the Hypothesis


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o Arbitrage: market participants(arbitrageurs) eliminate unexploited profitoppurtunities(returns on a security that are larger than what is justified by the

characteristic of that security)

2 typesone takes on risk and pure doesnt Pure arbitrage: the elimination of unexploited profit oppurtunities involves no

risk

Ex. annual/ equil rate is 10%...optimal forecast of return is 50%...can predictreturn would be abnormally high and thus unexploited profit opportunity.you

would buy more b/c abnormally high rate of returnthus drive up current price

and lowering rate of returnwhen current price risen sufficiently and efficient

market condition satisfiedunexploited profit opportunity would disappear

o In an efficient market, all unexploited profit oppurtunities are eliminatedo Not everyone in a financial market must be well informed by a security or have

rational expectations for its price to be driven to the point at which the efficient

market condition holds Structured so many participants can play As long as few keep eyes open for unexp profit opp (often reffered as smart

money) they will eliminate profit oppurtunities that appear, b/c they make aprofit

Efficient market hyp makes sence b/c doesnt require everyone in a market tobe cognizant of what is happening to every security

Stronger Version of the Efficient Market Hypothesiso Efficient markets

Expectations are rational(equal to optimal forecasts using all available info.) Prices reflect the true fundamental(intrinsic) value of the securities All prices are always correct and reflect market fundamentals (items that have a

direct impact on future income streams of the securities)o 1. Implies that in an efficient capital market, one investment is as good as any other b/c

the securities prices are correcto 2. Implies that a securitys price reflects all available info. About intrinsic value of the

securityo 3. Implies that security prices can be used by managers of both financial and

nonfinancial firms to assess their cost of capital(cost of financing their investments)

accurately and hence that security prices can be used to help them make the correct

decisions about whether a specific investment is worth making Behavioral Finance Doubts about efficient market hypothesis led to this Applies concepts from other social sciences such as anthropology, sociology, and particularly,

psychology to understand the behavior of securities prices Efficient market hyp suggests that smart money participants will sell when a stock price goes up

irrationally, with the result that the stock price falls back down to a level that is justified by

fundamentalso For this to occur, smart money investors must be able to engage in short sales(must

borrow stock from brokers and then sell it in the market, with the aim that they earn a

profit by buying the stock back again (covering the short) after it has fallen in price People are subject to loss aversion: they are more unhappy when they suffer losses than they

are happy when they achieve gains


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Short sales can result in losses far in excess of an investors initial investment if the stock priceclimbs sharply higher than the price at which the short sale is made

o Very little short selling actually takes place Thus reason why stock prices are sometimes overvalued

o Also can be constrained by rules restricting it b/c seems unsavory for someone to makemoney from another persons misfortune

o People tend to be overconfident on beliefs then facts Why securities markets have such large trade volumes-hyp. Doesnt predict Over confidence and fads provide explanation for stock market bubbles

Chapter 17 The Foreign Exchange Market Exchange rate: price of one currency in terms of another

o Highly volatileo US dollar becomes more valuable relative to foreign currencies, foreign goods become

cheaper for Americans and American goods become more expensive for foreigners

o When US dollar falls in value, higher prices of imported goods feed directly into a higherprice level and high inflation

Same time increases demand for US goods and leads to higher production andoutput b/c foreigners want to buy cheap American goods

Foreign exchange Market Financial market where exchange rates are determined Where trading of currencies and bank deposits in particular currencies takes place Transactions conducted here, determine rates at which currencies are exchanged, which in turn

determine the cost of purchasing foreign goods and financial assets

What Are Foreign Exchange Rates?o Two types of transactions

Spot transactions:predominant ones; involve the immediate(two day) exchangeof bank deposits

Forward Transactions: exchange of bank deposits at some specified future dateo Spot exchange rate: exchange rate for the spot transactiono Forward exchange rate: exchange rate for the forward transactiono Appreciation: currency increase in valueo Depreciation: currency falls in value and worth fewer US dollars

Ex. .85 euro per dollar went to .78depreciated by 8%(.78-.85)/.85=-.08 Why are exchange rates important?

o Important b/c affect relative price of domestic and foreign goodso When a countrys currency appreciates(rises in value relative to other currencies), the

countrys goods abroad become more expensive and foreign goods in that country

become cheaper(holding domestic prices constant in two countries). Conversely,

when a countrys currency depreciates, its goods abroad become cheaper and foreign

goods in that country become more expensive. Depreciation makes it easier for domestic manufacturers to sell their goods

abroad and makes foreign goods less competitive in domestic markets

Ex. euro drops in value to $1.00costs her $1,000 rather then$1280Depreciation of euro lowers cost of French goods in America but raises

cost of American goods in France

How Is Foreign Exchange Traded?o Over the counter market


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o Several hundred dealers(mostly banks) stand ready to buy and sell depositsdenominated in foreign currencies

o Very competitiveo Most trades involve buying and selling of bank deposits denominated in different

currencies

When we say bank is buying dollarsmeans buying deposits denominated indollarsvolume exceeds $1 trillion per day

o Buy foreign currency from dealers such as banks and American Expressb/c consist oftransactions in excess of $1 million

Retail prices higher then wholesalewhen buy, obtain fewer units of foreigncurrency per dollar (pay higher price for foreign currency, than exchange rates

indicate)

Exchange Rates in the Long Run Determined by interaction of supply and demand Law of One Price

o Starting point for understanding how exchange rates are determinedo If two countries produce an identical good, and transportation costs and trade barriers

are very low, the price of the good should be the same throughout the world no matterwhich country produces it

o Ex. American steel costs $100 per ton and identical Japanese steel costs 10,000 yen perton.exchangerate b/w yen and dollar must be 100 yen per dollarif rate was 200 then

Japanese steel price would be half of American...Demand for American steel would go

to zero and excess supplyexcess can be eliminated if rate falls back to 100

Theory of Purchasing Power Parityo States that exchange rates b/w any two currencies will adjust to reflect changes in the

price levels of the two countries

o Simply an application of law of one price to national price levels rather than to individualprices

o Ex. yen price rises by 10% to 11,000 yen for Japan SteelAmerican remains unchangedat 100for law of one price to hold rate must rise to 110 yen per dollar10%appreciation of dollarapplying law of one price to price levels in two countries

produces PPP theory, which maintains that if Jap price level rises 10% relative to US

price level, dollar will appreciate by 10%

o Real exchange rate: rate at which domestic goods can be exchanged for foreign goods Price of domestic goods relative to price of foreign goods denominated in the

domestic currency

Ex. basket of apples cost $50 in New York and $75 in Tokyocosts 7500 yen perdollar for basket while rate is at 100 yen per dollar then real exchange rate is

.66=(50/75)real exchange rate below 1 indicating cheaper to buy in US

Determines whether currency is relatively cheap or noto Predicts the real exchange rate is always equal to 1, so that the purchasing power of the

dollar is the same as the purchasing power of other currencies such as yen or euro

o PPP suggests that if one countrys price level rises relative to anothers, its currencyshould depreciate(the other countrys currency should appreciate)

Why the theory of PPP Cannot fully Explain Exchange Rateso PPP conclusion that exchange rates are determined solely by changes in price levels

rests on assumption that all goods are identical in both countries and transportation

costs and trade barriers are very low


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If truewill determine exchange rateo PPP does not take into account that many goods and services(whose prices are included

in a measure of a countrys price level) are not traded across borders

Housing, land, services, restaurant meals, haircuts, Chevy and Toyotaexampleprices may rise and lead to higher price level but little direct effect on

exchange rate

Factors that Affect Exchange Rate in the Long Run (pg 441)o Relative Price Levels

Ex. if prices of Japan goods rise so that relative price of American goods fall, thedemand for American increases and the dollar tends to appreciate, b/c

American goods will still sell well even with a higher value of domestic currency

In the long run, a rise in a countrys price level (relative to foreign price level)causes its currency to depreciate, and a fall in the countrys relative price level

causes its currency to appreciate

o Trade Barriers Tariffs: taxes on imported goods Quotas: restrictions on qty of foreign goods that can be imported Ex. US increases tariff or puts lower quota on Jap steel, dollar tends to

appreciate b/c American steel will still sell even w/ higher value of the dollar

Increasing trade barriers causes a countrys currency to appreciate in the longrun

o Preferences for domestic versus foreign goods Increased demand for a countrys exports causes its currency to appreciate in

the long run; conversely, increased demand for imports causes the domestic

currency to depreciate

ex. Jap develop hunger for American goods-oranges/movies-increased demandfor these (exports) tends to appreciate dollar, b/c will continue to sell even at

higher value of a dollar

o Productivity In the long run, as a country becomes more productive relative to othercountries, its currency appreciates

Higher productivity is associated with a decline in price of domesticallyproduced traded goods relative to foreign traded goodsas a result, the

demand for domestic traded goods rises, and domestic currency tends to

appreciate

Productivity risestends to rise in domestic sectors that produce traded goodsrather than nontraded goods

If lagging behind other countries, traded goods become more expensive, andcurrency tends to depreciate

o Anything that increases the demand for foreign goods relative to domestic goods tendsto depreciate the domestic currency b/c domestic goods will continue to sell well only if

the value of the domestic currency is lower

o Anything that increases the demand for domestically produced goods that are tradedrelative to foreign traded goods tends to appreciate the domestic currency b/c domestic

goods will continue to sell well even when the value of domestic currency is higher

o If a factor increases the demand for domestic goods relative to foreign goods, thedomestic currency will appreciate; if a factor decreases the relative demand for

domestic goods, the domestic currency will depreciate


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Exchange rates in the Short Run: A Supply and Demand Analysis Recognize that an exchange rate is the price of domestic assets (banks deposits, bonds,

equities,etc., denominated in foreign currency)

Over short period, decisions to hold domestic or foreign assets play much greater role inexchange rate determination than demand for exports and imports does

Supply curve for domestic Assets

o Qty of dollar assets supplied is primarily the qty of bank deposits, bonds, and equities inthe US, and for all practical purposes we can take this amount as fixed with respect to

exchange rate

o Qty supplied at any exchange rate does not change, so supply curve is vertical Demand curve for domestic assets

o Most important determinant of qty of domestic(dollar) assets demanded is the relativeexpected return of domestic assets

o Lower value of exchange rate implies that the dollar is more likely to rise invalue(appreciate)

o Greater expected rise (appreciation) of dollar, the higher is the relative expected returnon dollar (domestic) assets

o b/c dollar assets more desirable to hold, qty of dollar assets demanded will riseo if exchange rate falls even further, even higher expected apprectiation, higher expected

return, and therefore even greater qty of dollar assets demanded

o at lower current values of the dollar, qty demanded of dollar assets is higher Equilibrium in Foreign Exchange Market

o Market in equil. When qty of dollar assets demanded=qty suppliedo Ex. exchange rate higher then equilqty of dollar assets supplies is then greater than qty

demanded(excess suplly)people want to sell dollar assets than want to buy

themvalue of dollar will fallas long as rate remains above equil, there will continue to

be excess supply of dollar assets, and dollar will fall in value until reaches equil.

Vice versais excess demand Explaining Changes in Exchange rates Assuming the amount of dollar assets is fixed: supply curve is vertical at a given qty and does not

shift

Shifts in the Demand for Domestic Assetso If relative expected return of dollar assets rises holding the current exchange rate

constant, the demand curve shifts to the right

o If expected returns falls, demand curve shifts to the lefto Domestic Interest Rate, i^D

A n increase in the domestic interest rate i^D shifts the demand curve fordomestic assets, D, to the right and causes the domestic currency to

appreciate (E up)

A decrease in the domestic interest rate shifts demand curve for domesticassets to the left and causes the domestic currency to depreciate Domestic interest rate falls, relative expected return on dollar asset

falls, demand curve shifts to the left, and exchange rate falls

o Foreign interest rate, i^F An increase in the foreign interest rate, i^F, shifts the demand curve D to the

left and causes the domestic currency to depreciate; a fall in the foreign


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interest rate i^F shifts the demand curve D to the right and causes the

domestic currency to appreciate

Foreign interest rises, the return on foreign assets rises relative to dollar assets,thus expected return on dollar asset falls, now people want to hold fewer dollar

assets, and qty demanded decreases at every value of exchange rate

o Changes in Expected Future Exchange Rate A rise in the expected future exchange rate shifts the demand curve to the

right and causes an appreciation of the domestic currency

A fall in the expected future exchange rate, shifts the demand curve to the leftand causes a depreciation of currency

Any factor that causes expected future exchange rate to rise increases theexpected appreciation of the dollarresult is a higher relative expected return

on dollar assets, which increases the demand for dollar assets at every exchange

rate, shifting demand curve to the right

By increasing changes in future exchange rate, all of these increase expectedreturn on dollar assets, shift demand curve to the right, and cause appreciation

to domestic currency

1. Expectations of a fall in American Price level relative to foreign pricelevel

2. Expectations of higher American trade barriers relative to foreigntrade barriers

3. Expectations of lower American import demand 4. Expectations of higher foreign demand for American exports 5. Expectation of higher American productivity relative to foreign prod.

o Recap: Factors that change Exchange Rate pg. 447/448 look!!o Changes in Interest Rates

When domestic real interest rates rise, domestic currency appreciates Domestic real interest rate increases so Increase in nominal interest

rate increases the relative expected return on dollar assets, increasesthe qty of dollar assets demanded at each level of the exchange rate,

and shifts demand curve rightexpected inflation unchanged

When domestic interest rate rise due to an expected increase in inflation, thedomestic currency depreciates

Nominal interest rate rises b/c of increase in expected inflationleadsto decline in expected appreciation of the dollar, which is thought to be

larger then increase in domestic interest rateresults in at any

exchange rate, expected return on domestic assets falls, demand curve

shifts left, and exchange rate falls

Must always distinguish b/w real and nominal measures on effects of interestrates on exchange rates

o Changes in the Money Supply Higher money supply, leads to higher price level in long run and hence to a

lower expected future exchange ratelowers qty of dollar assets demanded at

each level of exchange rate and shifts demand curve to the left

Higher money supply will lead to higher real money supply b/c price level doesnot immediately increase in short runresulting real money rise causes


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domestic interest rate to fall, lowers expected return and thus demand curve

shifts left

A higher domestic money supply causes the domestic currency to depreciateo Exchange rate overshooting

Monetary neutrality: states that in the long run, a one time percentage rise inthe money supply is matched by the same one time percentage rise in the price

level, leaving unchanged the real money supply and all other economic variables

such as interest rates

Tells that in long run, rise in money supply would not lead to change indomestic interest rate so it would rise back to its old leve

Demand curve would shift right but not all the way back b/c price levelwill still be higher in long runmeans exchange rates will rise

Exchange rate overshooting: exchange rate falls by more in the short run than itdoes in the long run when money supply increases

When domestic interest rate falls in short run, equilibrium in foreignexchange market means that expected return on foreign deposits must

be lowerforeign interest give, this lower expected return on foreign

deposits means there must be expected appreciation of dollar anddepreciation of the euro for the expected expected return on foreign

deposits to decline when domestic interest rates fall

o Can only occur only if current exchange rate falls below its longrun value

Chapter 17 appendixThe Interest Parity Condition Expected return on dollar assets in terms of euros does not equal i^D, instead expected return

must be adjusted for any expected appreciation or depreciation

o Dollar expected to appreciate by 3% , the expected return on dollar assets in terms ofeuros would be 3% higher than i^D b/c the dollar is expected to become worth 3% more

in terms of euros

o Interest rate on dollar assets is 4%, with expected 3% appreciation of the dollar,expected return on dollar assets in terms of euros is 7% Expected return on dollar assets in terms foreign currency=interest rate on dollar assets +

expected appreciation of the dollar

Relative expected return on dollar assets: difference between the expected return on dollarassets and euro assets

Expected return on foreign assets in terms of dollars= interest rate on foreign assets + expectedappreciation of the foreign currency, equal to minues the expected appreciation of the dollar

o Interest rate on euro assets is 5%, dollar expected to appreciate 3%, then the expectedreturn on euro assets in terms of dollars is 2%...earns 5% interest rate but expects to

lose 3% b/c expects euro to be worth 3% less in terms of dollars due to appreciation of

dollar As relative expected return on dollar assets increases, both foreigners and domestic residents

respond same wayboth want to hold more dollar assets and fewer foreign

Interest Parity Condition Capital mobility: foreigners can easily purchase American assets, and Americans can easily

purchase foreign assets

o Currently live in this worldo Assume domestic and foreign assets are perfect substitutes(equally desirable)


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Interest Parity condition: states that the domestic interest rate equals the foreign interest rateminus the expected appreciation of the domestic currency

o The domestic interest rate = foreign interest rate + expected appreciation of foreigncurrency

o If domestic interest rate is higher than foreignthere is a positive expected appreciationof foreign currencywhich compensates for lower foreign interest rate

o Ex. domestic interest rate of 5% versus a foreign of 3% means that the expectedappreciation of foreign currency must be 2% (or expected depreciation of dollar must be

2%)

o Simply means expected returns are same on both dollar and foreign assetso Equilibrium condition for foreign exchange marketo Only when exchange rate is such that expected returns on domestic and foreign assets

are equal---that is; when interest parity holds---investors will be willing to hold both

domestic and foreign assets

Ch. 22 Aggregate Demand and Supply Analysis Aggregate demand: the total qty of an economys final goods and services demanded at

different price levels

Aggregate supply: total qty of final goods and services that firms in the economy want to sell atdifferent price levels

Analysis of both will enable us how aggregate output and price level are determined Aggregate Demand Aggregate demand curve: describes the relationship between qty of aggregate output

demanded and price level when all other variables are held constant

Four componentso Consumer expenditure (C): total demand for consumer goods and serviceso Planned investment spending (I) : total planned spending by business firms on new

machines, factories, and other capital goods, plus planned spending on new homes

o Government spending (G) : spending by all levels of government (federal, state, andlocal) on goods and services (paper clips, computers, computer programming, missiles,government workers, and so on)

o Net exports (NX): net foreign spending on domestic goods and services, equal to exportminus imports

o Expression for Aggregate demand (Y^ad)= C+I+G+NX Deriving the Aggregate Demand Curve

o Curve is downward sloping b/c a lower price level (P down arrow), holding the nominalqty of goods money (M) constant, leads to a larger qty of money in real terms (in terms

of the goods and services that it can buy, M/P up arrow)

larger qty of money in real terms that results from lower price level causesinterest rates to fall

resulting lower cost of financing purchases of new physical capital makesinvestment more profitable and stimulates planning investment spending(Iarrow up)

increase in investment spending adds directly to aggregate demand, the lowerprice level leads to higher level of qty of aggregate output demanded and so

aggregate demand curve slopes down

P down arrowM/P upi downI upY^ad up


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o Because lower price level leads to larger qty of money in real terms(M/P up) and lowerinterest rates(i down)US dollar assets become less attractive relative to assets

denominated in foreign currenciescausing a decline in the demand for dollar assets

and a decline in exchange rate for the dollar, denoted by E down arrow

Lower value of dollarmakes domestic goods cheaper relative toforeigncausing NX to risein turn increases aggregate demand

P downM/P upi downE downNX upYâdo Equation of exchange: indicates that if velocity stays constant, a constant money supply

(M) implies that nominal aggregate spending (PY) Is also constant

MV=PY When price level falls (P down), aggregate demand must necessarily rise (Yâd

up) to keep aggregate spending at the same level

Factors that Shift the Aggregate Demand Curveo An increase in the money supply (M up) shifts the aggregate demand curve to the right

with velocity constant, the higher money supply raises nominal aggregatespending (PY up)

at a given price level, qty of aggregate demand increases (Yâd up) increase in the qty of money increases the qty of aggregate demand at each

price level and shifts the aggregate demand curve to the right

o for a given price levelRise in money supply causes real money supply to increase (M/Pup)leads to decline in interest rates (i down)increase in investment and net exports(

I, NX up)and increase in qty of aggregate demand (Yâd)

o if gov spend more (G up) or next exports increase (NX up)qty of aggregate outputdemanded at each price level rises, and curve shifts right

o decrease in gov taxes (T down) leaves consumers with more income tospendconsumer expenditure rises (C up)qty of aggregate output demanded rises and

shifts right

o consumer and business optimism increasesconsumer expenditure and plannedinvestment spending rise(C up, I up)shifting curve right

o John Keynes described waves of optimism and pessimism as animal spirits andconsidered them a major factor affecting aggregate demand curve and an important

source of business cycle fluctuations

Summaryo Both the quantity theory and components approach to aggregate dem. agree aggregate

demand curve slopes downward and shifts in response to changes in money supply

o In qty theory approachonly one important source of movements in aggregate demandcurve: changes in the money supply

o In components approach: suggest other factorsfiscal policy, net exports, and animalspiritsare equally important sources of shifts in aggregate demand curve

o Six factors shift aggregate demand curve Money supply, gov. spending, taxes, net exports, consumer optimism, and

business optimism

Last twoanimal spiritsaffect willingness to spend Often reffered as demand shocks (pg 569 table)

Aggregate Supply Aggregate supply curve: relationship between qty of output supplied and price level Prices and wages take time to adjust to their long run level

o Supply curve differs in short and long run


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Long-Run Aggregate Supply Curveo Amount of output that can be produced in the economy in the long run is determined

by the amount of capital in the economy, the amount of labor supplied at full

employment, and available technology

o Some unemployment cannot be helped b/c frictional or structuralo At full employment, unemployment is not zerorather at a level above zero at which

demand for labor equal supply of labor

Natural rate of unemployment Currently around 5%

o Natural rate of output: level of aggregate output produced at natural rate ofunemployment

Where economy settles in long run for any price leve Long run Aggregate Supply curve (LRAS) is vertical at natural rate of output

Short-Run Aggregate Supply Curveo Wages and prices are sticky: wages and prices take time to adjust to economic

conditions

o Upward sloping in short runo b/c goal of business firms is to maximize profit; qty of output supplied is determined by

profit made on each output

profit rises, more aggregate output will be producedqty of output supplied willincrease; if it falls, less output produced and qty of aggregate output supplied

will fall

profit on a unit of output=price for unit-cost of producing ito in short run, costs of many factors that go into producing goods and services are fixed

ex. wages, often fixed for periods of time by labor contracts, and raw materialsare often bought by firms under long term contracts that fix the price

b/c costs of production are fixed in short runwhen overall price level rise, pricefor a unite of output will rise relative to costs of producing it, and profit per unit

will rise b/c higher price level results in higher profitsfirms increase production, and

qty of aggregate output supplied rises, resulting in upward sloping short-run

aggregate supply curve

short run: relationship b/w price level and aggregate output embodied inupward sloping short run curvemay not remain fixed as time passes

shifts in the short run Aggregate Supply Curveo cost of producing a unit of output rises, profit on each falls, and qty of output supplied

at each price level falls

o ex. firms are earning lower profit per unit of output..they reduce production at thatprice leveand qty of aggregate output supplied falls..shifts left

o short run aggregate supply curve shifts to left when costs of production increase andto right when costs decrease

Factors that Shift the short run aggregate Supply curveo Ones that affect costs of productiono 1. Tightness of labor market

Economy is booming and labor market tight(Y>Yn)employers have difficultyhiring qualified workers and may have hard time keeping present employees

Demand for labor now exceeds supplyemployers will raise wages to attractneeded workers, and costs of production will rise


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Higher costs of production..lower profit per unitcurve shifts left Economy in recession and labor market is slack(Y


17/25

o Price level above equilibriumqty of aggregate output supplied is greater than qty ofaggregate output demanded

People want to sell more goods and services than others want to buy(excesssupply)prices of goods and services will fall, and aggregate price level will

dropdecline will continue until reach equilibrium

o price level below equilibriumqty of output demanded is greater than qty of outputsupplied

price level will rise b/c people want to buy more goods than others want tosell(excess demand)rise in price level will continue until reach equil. Level

equilibrium in the Long Runo even when qty of aggregate output demanded equals qty supplied, forces operate that

can cause equil to mover over time if Y* not equal to Yn

understand that if costs of production change, supply curve will shifto how short run equilibrium changes over time in response to: short run equilibrium is

initially above natural rate level and when it is initially below natural rate level

o economy will not remain at a level of output higher than natural rate level b/c short runaggregate supply curve will shift to the left, raise the price level, and cause

economy(equilibrium) to slide upward along aggregate demand curve until comes torest at a point on the long run aggregate supply curve at natural rate level of output Yn

level of equilibrium output is greater than natural rate levelunemployment isless than its natural rateexcessive tightness exists in the labor

markettightness drives wages up, raises production costs, and shifts aggregate

supply curve to the leftaggregate output still above natural rate level, wages

continue to be driven up, eventually shifting supply curve to left

againequilibrium reached at this point is on vertical long run aggregate supply

curve (LRAS) and is a long run equilibriumnow at output natural rate levelno

further pressure on wages to rise and thus no further tendency for supply curve

to shift

pg. 576 figureo regardless of where output is initially, it returns eventually to natural rate level

described by saying economy has a self correcting mechanism takes a long time, so approach to long run equilibrium is slow in the long run we are all dead-Keyness Slow b/c wages are inflexible, particularly in downward direction when

unemployment is high

Resulting slow wage and price adjustments mean aggregate supply curve doesnot move quickly to restore economy to natural rate of unemployment

When unemployment is higheconomists known as Keynesians More likely to see the need for active government policy to restore the

economy to full employment

Other economists believe wages are sufficiently flexible that the wage and priceadjustment process is reasonably rapid

Result of this flexibilityadjustment of supply curve to its long runposition and economys return to natural rate levels of output and

unemployment will occur quickly

See much less need for active government policy to restore economy tonatural rate levels of output and unemployment when unemployment is

high


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o Monetarists Advocate use of a rule whereby the money supply or

monetary base grows at a constant rate so as to

minimize fluctuations in aggregate demand that might

lead to output fluctuations

Changes in Equilibrium Caused by Aggregate Demand Shockso Rightward shift in aggregate demand curve due to positive demand shocks

Increase in the money supply(M up) Increase in government spending(G up) Increase in Net exports (NX) Decrease in taxes(T down) Increase in wiliness of consumers and businesses to spend b/c become more

optimistic (C up, I up)

Pg 577 figureo When demand curve shifts right to AD2, economy moves to point 1, and both output

and price level riseeconomy will not remain at point 1 in long run, b/c output at Y1 is

above natural rate levelwages will rise, increasing cost of production at all price levels,

and short run supply curve will eventually shift leftward to AS2, where finally comes torest

The economy(equilibrium) thus slids up the aggregate demand curve from point1 to 2, which is point of long run equilibrium at intersection of AD2 and long run

aggregate supply curve (LRAS) at Yn

Although the initial short run effect of the rightward shift in aggregatedemand curve is a rise in both the price level and output, the ultimate long run

effect is only a rise in the price level

Changes in Equilibrium Caused by Aggregate Supply Shockso Ex. economy initially at natural level of outputshort run supply curve shifts left b/c of

negative supply shock(sharp rise in energy prices)economy will move from point 1 to

point 2, where price level rises but aggregate output fallsthis situation of rising pricelevel but falling level of aggregate output is staglflationat point 2 output is below

natural rate level, wages fall and shift short run supply curve back to rightresult is

economy (equilibrium) slides down aggregate demand curve and returns to long run

equilibrium point 1

Although a leftward shift in short run aggregate supply curve initially raisesprice level and lowers output, the ultimate effect is that output and price level

are unchanged(holding aggregate demand curve constant)

Shifts in long run aggregate supply curve: Real business Cycle theory and Hypothesiso Over time, natural rate level of output increases as result of economic growtho Ex. productive capacity of economy growing at steady rate 3% per yearevery year Yn

will grow by 3% and long run aggregate supply curve at Yn will shift to right by 3%

Yn grows at steady rate, Yn and long run supply curve are drawn as fixed inaggregate demand and supply diagrams

o Real business cycle theory: theory of aggregate economic fluctuations Aggregate supply (real) shocks do affect natural rate level of output Yn Views shocks to tastes(workers willingness to work) and

technology(productivity) as major driving forces behind short run fluctuations in

the buss. Cycle b/c these shocks lead to substantial short run fluctuations in Yn


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Shifts in aggregate demand curve, perhaps as a result of changes in monetarypolicy are not viewed as being important to output fluctuations

Views most business cycle fluctuations as resulting from fluctuations in naturalrate level of output

Not see much need for activist policy to eliminate high unemployment Highly controversial and under much research

o Another group disagrees with assumption that natural rate level of output Yn is alwaysat full employment level and is unaffected b y aggregate demand shocks

Contend that natural rate level of unemployment and output are subject tohysteresis(departure from full employment levels as a result of past high

unemployment)

When unemployment rises because of reduction of demand that shifts AD curveinwardsnatural rate of unemployment viewed as rising above full employment

level

Could occur b/c unemployed become discouraged and fail to look hardfor work or employer may not higher b/c been unemployed for long

time

Outcome is natural rate of unemployment shifts upward after unemploymenthas become high, and Yn falls below full employment level

Self correcting mech. Will return economy only to natural rate levels ofoutput and unemployment, not to full employment

Only with expansionary policy to shift demand curve right and raiseoutput can natural rate of unemployment be lowered (Yn raised) to full

employment level

Proponents of hysteresis more like to promote activist, expansionary policies torestore economy to full employment

Conclusionso Aggregate Demand and Supply yields conclusions(under usual assumption that natural

rate level of output is unaffected by aggregate demand and supply shocks) 1. A shift in aggregate demand curvecan be caused by changes in monetary

policy (money supply), fiscal policy (gov spending or taxes), international

trade(net exports, or animal spirits(business and consumer optimism)

affects output only in short run and has no effect in long run, when aggregate

supply curve has fully adjusted

2. A shift in the aggregate supply curvewhich can be caused by changes inexpected inflation, workers attempts to push up real wages, or a supply shock

affects output prices only in the short run and has no effect in the long

run(holding aggregate demand curve constant)

3. The economy has a self correcting mechanism, which will return it to thenatural rate levels of unemployment and aggregate output over time

Ch. 24 Money and Inflation Source of all inflation episodes is a high growth rate of the money supply: simply by reducing the

growth rate of the money supply to low levels, inflation can be prevented

Money and Inflation: Evidence Whenever a countrys inflation rate is extremely high for a sustained period of time, its rate of

money supply growth is also extremely high

o Countries with highest inflation rates also had highest rates of money growth


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You are looking at reduced form evidencefocuses on correlation of two variableso Money growth and inflation rate variableso Reverse causation(inflation causing money supply growth) or an outside factor that

drives both money growth and inflation could be involved

o Rule out these by looking at historical episodes in which an increase in money growthappears to be an exogenous event(high inflation rate for a sustained period following

the increase in money growth

Strong evidence that high money growth is driving force behind inflationo Clear evidence have occurredhyperinflations(extremely rapid inflations with inflation

rates exceeding 50% per month)-most notorious German hyper. 1921/23

German Hyperinflation, 1921-1923o Need to make reparations and reconstruct economy after WW1o Gov. expendendetures greatly exceeded revenueso Could have obtained by raising taxes but politically unpopular/time to enacto Government could have financed expenditure by borrowing from the public, but the

amount needed was far in excess of its capacity to borrow

o Only one route to work: the printing press---could pay simply by printing morecurrency(increasing the money supply)made payments to individuals and companiesthat were providing it with goods and services

o Result of explosion in money supply was price level blasted off Inflation rate for 1923 exceeded 1 milion percent

o Qualified as a control experiment;supports inflation is a monetary phenomenom Recent Episodes of Rapid Inflation

o 2008 Zimbabwes inflation rate over 2 million percent officially(unofficially over 10)o Only country to top Germanyo Issued 100 billion dollar noteo Same reasons of Germnay: high money growth

Meaning of inflation Says 1% may have only risen temporarily by one month an 12% annually Only if remains high persistently will economists say inflation has been high Friedman says upward movements in price level are monetary phenomenum only if this is a

sustained process

When inflation is defined as persistent and rapid rise in price level, almost all agree withfriedman and money alone is to blame

Views of Inflation Large and persistent upward movements in price level(high inflation) can occur only if there is

continually growing money supply

How money growth Produces Inflationo If money supply keeps growing then price level keeps getting higher year after yearo High money growth produces inflationo Pg 620 figure 2

Can other Factors Besides Money Growth produce Inflation?o NoHigh Inflation is always a Monetary Phenomenono Other factors can affect Aggregate Demand and supply curves(Fiscal policy and supply

shocks)

Can Fiscal Policy By itself Produce Inflation?o Pg 622 figure


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o One shot increase in government expedenture leads to only a temporary increase in theinflation rate, not to persistent inflation in which price level is contrinually rising

o Continually increasing level of gov. expedentures is not a feasible policyo Limit on amount of possible gov. exp.; cannot spend more than 100% GDPonce limit

reached political process will stop it from continuing

o Could continual tax cuts generate inflation?...again no Increase in inflation rate only temporary again Once tax cuts reach zerocant be cut anymore

o ConcludePersistent high inflation cannot be driven by fiscal policy alone Can supply side phenomena by themselves produce Inflation?

o net result of a supply shock is that we return to full employment at the initial price level,and there is no continuing inflationadditional neg supply shocks that shift short run

aggregate supply curve leftward will lead to only temporarily based, but persistent

inflation will not result

o Supply side phenomena cannot be the source of persistent high inflation Summary

o Aggregate demand and supply analysis shows that persistent high inflation can occuronly with a high rate of money growth

o Inflation refers to a continuing increase in the price level at a rapid rate.now see whyFriedman was correct when he saidInflation is always and everywhere a monetary

phenomenom

Origins of Inflationary Monetary Policy Gov. policies that are the most common sources of inflation High Employment Targets and Inflation

o First goal of most governments is high employmentleads to high inflationo Laws require a commitment to high level of employment consistent with a stable price

leve, in practive our gov has often pursued a high employment target with little concern

about the inflationary consequences of its policies

o Two types of inflation that can result from policy to promote high empl. Cost push inflation: occurs b/c of neg supply shocks or a push by workers to get

higher wages

Pg 625 figure b/c gov has given in to the demands of workers for higher wages, an

activist policy with a high employment target is often referred to as an

accommodating policy

wages have now fallen compared to other workers, and now they willseek higher wagesthus continuing the processcontinuing price level

increase---a persistent cost push inflation

can only occur only if aggregate demand curve is shifted continually tothe right

first shift can be achieved by a one shot gov expenditure or a one shotdecrease in taxes

o can not continue shifting aggregate demand curve can be shifted to the right by continually

increasing the money supply


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Persistent cost push inflation is a monetary policy phenomenombecause it can not occur without the monetary authorities pursuing an

accommodating policy of a higher rate of money growth

Demand Pull inflation: results when policy makers pursue policies that shift theaggregate demand curve to the right

Pg 626 figure Pursuing to low an unemployment rate target or too high an output

target is the source of inflationary monetary policy

b/c inflation results from policymakers pursuing policies that shiftaggregate demand curve to the rightit is called this

associated with periods when unemployment is below the natural ratelevel, whereas cost push is associated with period when unemployment

is above the natural rate level

when a demand pull inflation produces higher inflation rates, expectedinflation will eventually rise and cause workers to demand higher wages

so that their real wages will eventually rise and cause workers to

demand higher wages so that real wages do not fall

o demand pull inflation can eventually trigger cost push inflation Budget Deficits and Inflation

o Government Budget Constraint Government has to pay bills.. so has this Two ways to pay: raise revenue (by working) or borrow

Gov has third option: can create money Methods of financing gov spending States that the gov budget deficit DEF, equals the excess of gov spending G over

Tax revenue Y, must equal the sum of the change in the monetary base delta

MB and the change in gov bonds held by the public delta B

DEF=G-T=delta MB + delta B Gov buys $100 mill supercomputercan convince that worth paying then

budget deficit equal zerotaxpayers refuse to pay taxes for it then budget

constraint indicates gov must pay for it by selling $100 mill of new bonds to

either public or by printing $100 mill of currencyeither case, budget constraint

is satisfiedbalanced by changed in stock of gov bonds held by the publice

(delta B=$100 mill) or by change in monetary base (delta MB=$100 mill)

Reveals two imp facts: Gov deficit is financed by an increase in bond holdingsby the public, there is no effect on the monetary base and hence on the

money supply. But if the deficit is not financed by increased bond holdings by

the public, the monetary base and the money supply increase

Monetizing the debt: method of financing gov spending Two step processgov debt issued to finance gov spending has beenremoved from the hands of the public and has been replaced by high

powered money

Method of financing or when a gov just issues the currencydirectly:reffered to sometimes as printing money b/c high powered

money(the monetary base) is created in the process


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o Monetary base increase when central bank conducts openmarket purchases, just as it would if more currency were put in

circulation

Budget deficit can increase in the money supply if it is financed by the creationof high powered money

Financing a persistent deficit by money creation will lead to a sustainedinflation

A deficit can be the source of a sustained inflation only if it is persistent ratherthan temporary and if the gov finances it by creating money rather than by

issuing bonds to the public

Budget deficits and money creation in other countrieso Only way to finance deficits is to print more more;ultimate source of high inflation rates

was large budgets

Budget deficits and Money creation in the USo Best developed gov bond market of any country in the worldit can issue large wty of

bonds when it needs to finance its deficit

o Magnititude of deficits relative to GDP small compared to others6% in 1983 whereasArgentina was 15%

o Gov budget deficit can lead to Federal Reserve open market purchases, which raisemonetary base(create high powered money) and raise money supply

o Ricardian equivalence: contends that when gov runs deficits and issues bonds, thepublic recognizes that it will be subject to higher taxes in the future to pay off these

bonds

o Why inflationary monetary policy might come about Adherence of policymakers to a high employment target Presence of persistent gov budget deficits

The Discretionary/Nondiscretionary Policy Debate Advocates of discretionary policy, that is, policy to eliminate high unemployment whenever it

appears, regard the self correcting mechanism through wage and price adjustment as very slow Opponents of discretionary policybelieve that the performance of the economy would be

improved if the gov avoided discretionary policy reactions to eliminate unemployment

Responses to High Unemploymento Aggregate output is lower than natural rate level, and economy is suffering from high

unemployment.policymakers have two viable choices:

If they are proponents of nondiscretionary policy and do nothing, the short runaggregate supply curve will eventually shift right overtime, where full

employment is restored

The discretionary policy alternative is to try to eliminate high unemployment byattempting to shift aggregate demand curve rightward by pursuing

expansionary policy( increase in the money supply, increase in gov spending, orlowering of taxes)

o Lags prevent immediate moving to full employment 1. Data lag: time it takes for policymakers to obtain the date that tell them what

is happening in the economy

Ex. accurate GDP data not avail. Until months after a quarter is over 2. Recognition lag: time it takes for policymakers to be sure of what the date are

signaling about the future course of the economy


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Ex. to minimize errors, National Bureau of Economic Researd(officialydates buss cycles) will not declare the economy to be in recession until

at least six months after it has determined that one has began

3. Legislative lag:time it takes to pass legislation to implement a particular policy Doesnt exist as open market operations or most monetary policy

actions

Important for implementation of fiscal policy, when it can be sometimestaken six months to a year to get legislation passed to change taxes or

gov spending

4. Implementation lag: time it takes for policymakers to change policyinstruments once they have decided on the new policy

Unimportant for open market operations b/c Feds trading desk canpurchase or sell bonds almost immediately

Implementing fiscal policy may take timegetting gov agencies tochange their spending habits takes time, as does changing tax tables

5. Effectiveness lag: time it takes for policy to actually have an impact on theeconomy

Imp. Arg. Against discretionary policy is that effectiveness lag is long(often year or longer) and variable (uncertainty about how long this lag

is)

Discretionary and Nondiscretionary positions Case for Discretionary Policy

o Advocates view wage and price adjustment process as extremely slowo Costly b/c slow movement of the economy back to full employment results in a large

loss of output

o Even though five lags may result in year or more delay before aggregate demand curveshifts, short run aggregate supply curve likewise moves very slow during this time

o Pg 635 moving back to point 2 thus this is right path Case for Nondiscretionary Policy

o View wage and price adjustment as more rapid and consider less costly b/c ouput issoon back at natural rate level

o Suggest a discretionary policy of shifting aggregate demand curve is costly, b/c itproduces more volatility in both price level and output

Time to shift is substantial, whereas wage and price adjust is more rapido Discretionary Leads to a sequence of equilibrium points at which both output and price

level have been highly variable: output overshoots its target levelprice level falls and

then rises and eventually to P2b/c this variability is undesiarablebetter off with

nondiscretionary

o Pg 635 figureo Before aggregate demand curve shifts right, short run supply curve will have shiftedright, and economy returns to natural rate level of outputafter adjustment is

complete, the shift of demand curve final takes effect to right leading economy to point

2aggregate output is now greater then natural rate level, so short run supply curve will

now shift leftward backmoving economy to point, where output again at natural rate

level

Discretionary vs Non: Conclusions


25/25

o Advocates of discretionary policy believe in the use of policy to eliminate excessiveunemployment whenever it develops b/c they view the wage and price adjustment

process as sluggish and unresponsive to expectations about policy

o Proponents of nondiscretionary believe that a discretionary reacts to excessiveunemployment is counterproductive, b/c wage and price adjustment is rapid and b/c

expectations about policy can matter to wage setting process

o Proponents of non advocate use of a policy rule to keep aggregate demand curve fromfluctuating from trend rate of growth of natural level of output

o Monetarists; who oppose discretionary and who also see money as sole source offluctuations in demand curvein the past advocated a policy rule whereby the Fed

keeps the money supply growing at a constant rate

Constant money growth rate ruleo Important element of non to be successful is that it be credible: public must believe

policymakers will be tough and not accede to a cost push by shifting aggregate demand

curve to the right to eliminate unemployment

Otherwise, workers will be more likely to push for higher wages, shift supplycurve leftward and will lead to unemployment or inflation or both

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Econ Test 2 Book Notes

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