AP MACROECONOMICS REVIEW • Vocabulary • Graphs
THREE BASIC ECONOMIC QUESTIONS • What to produce • How to produce • For whom to produce • Can apply to anything
PRODUCTION POSSIBILITIES • Assumptions: • Full Employment • Fixed Resources and Technology • Movements • Along curve shows opportunity cost • Outward shift illustrates economic growth • Inward shift indicates destruction of resources • Producing Capital Goods will lead to greater economic growth than producing consumer goods. (Butter will lead to more growth than guns)
PRODUCTION POSSIBILITIES GRAPH Capital Goods Points B, C, D are efficient pts. Point G is underutilization Point F is economic growth A B May Lead to most Future economic growth F C G D E Consumer Goods
ECONOMIC SYSTEMS • Capitalism=Free Market • Most decisions made by Private businesses • Communism=Command Economy • Most decisions made by the government • Mixed Economy=Features of both Capitalism and Communism • Decisions made by both the market and governments
SUPPLY AND DEMAND FACT FOR ANYTHING Demand is Down Supply is UP
SUPPLY AND DEMAND FACTORS • Demand Shift when: • Taste and preferences of consumers • Related Products, complements and substitutes, (price or quality change) • Income of buyers (more or less added) • Buyers (population more or less) • Expectations (future price change) • DEMAND SHIFT HAPPENS
DEMAND INCREASE: AS DEMAND INCREASES, PRICE AND QUANTITY INCREASE AS WELL. Price S 1 P 2 P 1 D 2 D 1 Q 2 Quantity
DEMAND DECREASE: AS DEMAND DECREAES, PRICE AND QUANTITY DECREASE AS WELL Price S 1 P 2 D 1 D 2 Q 1 Quantity
SUPPLY AND DEMAND FACTORS • Supply shifts when: • Resource cost (Input prices change: resources and wages) • Other goods’ prices (substitutes in production and joint products) • Taxes and subsidies (Government: tariffs, quotas, regulations) • Technology changes • Expectations (about price and product profitability change: weather, strikes) • Number of sellers change • SUPPLY SHIFT HAPPENS
SUPPLY INCREASE: AS SUPPLY INCREASES, QUANTITY INCREASES, BUT PRICE FALLS. S 1 Price S 2 P 1 P 2 D 1 Q 2 Quantity
SUPPLY DECREASE: AS SUPPLY DECREASES, QUANTITY DECREASES, BUT PRICE INCREASES. S 2 Price S 1 P 2 P 1 D 1 Quantity Q 2 Q 1
COMPARATIVE ADVANTAGE • A nation should specialize in producing goods in which it has a comparative advantage: ability to produce the good at a lower opportunity cost. (who gives up the least in that product) Example: Cheese Wine Spain: 2 pounds 2 Cases France 2 pounds 6 Cases Spain should produce cheese (1 C = 1 W) France should produce wine (1 W = 1/3 C) :
ADVANTAGE DEFINITIONS • Trade does not rely on absolute advantages, but on comparative advantages. • If you have a comparative advantage in production of a good, specialize in production of that good and trade for the other. • Absolute Advantage is when a country has the ability to produce a good using fewer resources per unit of output than another country • Comparative Advantage is when a country can produce a good at a lower opportunity cost (smaller loss in terms of production of another good)
CURRENCY TERMS • Appreciation: Currency is increasing in demand (stronger dollar) • U. S. Currency will appreciate when more foreigners: travel to the U. S. , buy more U. S. goods or services, or buy the U. S. dollar to invest in bonds
CURRENCY TERMS • Depreciation: Currency is decreasing in demand (weaker dollar) Being SUPPLIED in exchange for other currency. • U. S. Currency will depreciate when fewer foreigners: travel to the U. S. , buy fewer U. S. goods or services, or sell the U. S. dollar to invest in their own bonds
CIRCULAR FLOW OF ECONOMIC ACTIVITY • Households supply resources (land, labor, capital, entrepreneurial ability) to the resource market. Households demand goods and services from businesses. • Businesses demand household resources and supply goods and services to the product (factor) market.
CIRCULAR FLOW
GDP (GROSS DOMESTIC PRODUCT): THE TOTAL DOLLAR (MARKET) VALUE OF ALL FINAL GOODS AND SERVICES PRODUCED IN A GIVEN YEAR. • Expenditure Formula: • Consumption (C) + Business Investment (I) + Government Spending (G) + Net Exports (X-M)
WHAT ARE THE COMPONENTS OF GDP? GDP Personal Consumption Expenditures Investment Government (I) (G) (C) Net Exports (NX) Fixed Investment Nonresidential Inventories Residentia l GDP = C + I + G + NX Exports Imports
GDP: WHAT COUNTS: • Goods Produced but not Sold (I) • Goods produced by a foreign country (Japan) in the U. S. (Honda, Toyota) • Government spending (F, SL) • Increase in business inventories
GDP: WHAT DOES NOT COUNT: • Intermediate Goods (Tires sold by Firestone to Ford for a car off the production line) • Used Goods • Non-Market Activities (Illegal, Underground) • Transfer Payments (Social Security) • Stock Transactions
SHORTCOMINGS OF GDP: LEADING TO GDP BEING UNDERSTATED. • Nonmarket activities: (services of homemakers) does not count. • Leisure: Does not include the value of leisure. • Does not include improvements in product quality. • Underground economy
REAL GDP • Real GDP= Nominal GDP adjusted for inflation. • Calculation: • Real GDP = Nominal GDP Price Index in Hundredths( deflator) Example: U. S. 2005 Real GDP= $12, 4558 (billions) 1. 1274 (based on 2000) $11. 048 Trillion
REAL GDP PER CAPITA • Most commonly used to compare and measure each country’s standard of living and overall economic growth. • Real GDP/Nation’s Population
GDP EXTRA • Value added price: how much value the product has through the stages of production • GNP: GDP + the rest of the world • NI: income adjusted for depreciation and indirect business taxes • PI: households only • DPI: income after taxes (spent + save)
BUSINESS CYCLES • The increases and decreases in Real GDP consisting of four phases: • Peak: highest point of Real GDP • Recession: Real GDP declining for 6 months • Trough: lowest point of Real GDP • Recovery: Real GDP increasing (trough to peak)
UNEMPLOYMENT • Calculation: Number of Unemployed Labor Force (Multiplied by 100 to put as a %) The Labor Force is the total of employed and unemployed workers. U. S. unemployment should be about 5%
EMPLOYED • You are considered to be employed if: • You work for 1 hour as a paid employee (so part-time workers count) • You are temporarily absent from work (illness, strike, vacation) • You work 15 hours or more as an unpaid worker (family farms are common)
UNEMPLOYED • Must be looking for work (at least 1 attempt in the past 4 weeks) • Are reporting to a job within 30 days • They are temporarily laid off from their job
TYPES OF UNEMPLOYMENT • Frictional: Have skills that are in demand; just need time to find a job (College Graduate) • Structural: Current skills do not match job openings (Factor jobs being outsourced; Flight attendant after 9/11/2001). • Frictional + Structural = Natural Rate of Unemployment (Full –Employment rate) • Cyclical: Due to a recession (Requires Government action).
NOT IN LABOR FORCE • A person who is not looking for work: • Full-time students • Stay at home parents • Discouraged workers: those who have given up hope of finding a job. • Retirees
INFLATION • Rise in the general level of prices • Reduces the purchasing power of money • Measured with the Consumer Price Index (CPI) • Reports the price of a market basket , more than 300 goods that are typically purchased by an urban household
CONSUMER PRICE INDEX (CPI) • CPI = Recent Price of Market Basket Price of same basket in base year (This number is then multiplied by 100) Example: Assuming only 2 Goods Recent Year Base Year Jeans P $25 Q 5 P $20 Q 5 Pizza $20 10 $15 10 $325 = 1. 3 * 100=130 $250
CALCULATING INFLATION • CPI in Recent Year – CPI in Past Year Divided by CPI in Past Year (Number then Multiplied by 100) Example: 2002 CPI = 179. 9 2001 CPI = 177. 1 Rate of Inflation: 179. 9 -177. 1 = 1. 58% 177. 1
TYPES OF INFLATION • Demand Pull Inflation: ‘too much money chasing too few goods. ” • AD Curve will shift to the right, resulting in a higher Price Level and greater Output (up til FE) • Cost-Push Inflation: Major cause is a supply shock-OPEC cutting back on oil production • AS Curve will shift to the left resulting in a higher Price Level and a decrease in Real GDP.
REAL AND NOMINAL TERMS • Real Income = Nominal Income Price Index (Hundredths) • Real Interest Rate = Nominal Interest Rate – Inflation Rate • Nominal Interest Rate = Real Interest Rate + Inflation Premium (anticipated inflation)
INFLATION: WINNERS & LOSERS • Winners: • Debtors who borrow money that will be repaid with “cheap” dollars. • Those who have anticipate inflation • Losers: • Savers (especially savings accounts) • Creditors (Banks will be repaid with those “cheap” dollars • Fixed-Income Recipients (retirees receiving the same monthly pension)
CONSUMPTION AND SAVING • As income increases, both consumption and savings will increase. • The determinants of overall consumption and savings are: (More money or a positive outlook will increase consumption and reduce savings. Less money or a negative outlook will increase savings and reduce consumption. • • • Wealth (financial assets) Expectations about future prices and income Real Interest Rates Household Debt Taxes
MARGINAL PROPENSITIES • Marginal Propensity to Consume (MPC) and the Marginal Propensity to save (MPS) must equal 1. • The MPS is used to derive the spending multiplier, which equals: 1 MPS If the MPS is. 2, the spending multiplier is 5. Any increase in spending must be multiplied by 5 to determine the overall increase in Real GDP.
INTEREST RATE-INVESTMENT • Expected Rate of Return: Amount of Profit (expressed as a percentage) a business expects to gain on a project/investment. • This rate must be greater than the interest in order to be profitable. • The Real Rate of Return is most important. An expected profit of 10%, that costs 5% in interest = The real rate of return: 5%.
INVESTMENT DEMAND CURVE: Real Rate of Return At lower real interest rates businesses will Increase investment , leading to an increase In AD (aggregate demand). At higher rates of Interest, less money will be invested r 1 r 2 ID Q 1 Q 2 Quantity of Investment
SHIFTS OF THE INVESTMENT DEMAND CURVE A shift from ID 1 to ID 2 Represents an increase in Investment demand. A shift From ID 1 to ID 3 represents a decrease in investment Demand. PL ID 2 ID 1 ID 3 Real GDP
AGGREGATE DEMAND Price Level Downward sloping: 1. Real-Balances Effect: change in purchasing power 2. Interest-Rate Effect: Higher interest rates curtail spending 3. Foreign Purchase Effect: Substitute foreign products for U. S. products AD (C + I + G + X) Real GDP
AGGREGATE DEMAND • Determinants of AD: • C + I + G + X (Yes, its GDP) • An increase in any of these, due to lower interest rates or optimism will increase AD and shift the curve to the right. • A decrease in any of these: more debt, less spending, tax increase, will cause a decrease in AD and shift the curve to the left
AGGREGATE DEMAND DETERMINANTS • Consumption • • Wealth • Change in Gov. spending • Expectations • Debt • Taxes • Investment • Interest Rates • Expected Returns • Technology • Inventories • Taxes Government • Net Exports • National Income Abroad • Exchange Rates
AGGREGATE SUPPLY FACTORS: • R: resource prices (wages and materials, as well as OIL) • A: actions by government (Taxes, Subsidies, more regulation) • P: productivity (better technology)
AGGREGATE SUPPLY • Short Run: • Long Run: • Assumes that nominal wages are “sticky” and do not respond to price level changes. • Curve is vertical because the economy is at its full-employment output. • Is Upward sloping as businesses will increase output to maximize profits • As prices go up, wages have adjusted so there is no incentive to increase production.
AGGREGATE SUPPLY GRAPH Price Level Short Run Recession AS Inflation Long Run Growth Extended vertical line Illustrates the LRAS and QF (Full-Employment) QF Real GDP
DEMAND-PULL INFLATION AS Price Level P 2 P 1 AD 2 AD 1 (C + I + G + X) QF Real GDP
COST-PUSH INFLATION Price Level AS 2 AS 1 P 2 P 1 AD 1 ( C + I + G + X) Q 2 QF Real GDP
FISCAL POLICY • Using Taxes and Government spending to stabilize the economy. • Controlled by the President and Congress • Discretionary Fiscal Policy: Congress must take action (change the tax rates) in order for the action to be implemented. • Automatic Stabilizers: Unemployment benefits, Progressive Tax System, these changes are implemented automatically to help the economy.
TYPES OF FISCAL POLICY • Expansionary • Contractionary • Used to Fight a Recesssion • Used to fight Inflation • LOWER TAXES • RAISE TAXES • INCREASE GOVERNMENT SPENDING • DECREASE GOVERNMENT SPENDING
EXPANSIONARY FISCAL POLICY • Increasing Government Spending and or cutting taxes will shift AD to the right and increase output and the price level. As 1 Price Level P 2 P 1 AD 2 Q 1 AD 1 ( C + I + G + X ) Real GDP QFE
TAX MULTIPLIER • Remember, if the government decreases taxes, the result is not as great as a spending increase, since households will save a portion (MPS) of the tax cut. • The Tax Multiplier = MPC X Spending Multiplier. • Example: If the MPC is. 8 and the MPS is. 2 • Spending Multiplier = 1/. 2 or 5 • Tax Multiplier =. 8 X 5 or 4
LOANABLE FUNDS MARKET & EXPANSIONARY FISCAL POLICY • Used for FISCAL POLICY (Government spending-Deficit Spending) An increase in Gov. spending increases the demand for loanable funds and raises real interest rates Real Interest Rate R 2 R 1 D 2 D 1 Q 2 Quantity of Funds
CROWDING-OUT EFFECT • An Expansionary Fiscal Policy as previously diagrammed will lead to higher interest rates. • At higher interest rates, businesses will take out fewer loans and there will be a decrease in INVESTMENT (I) • At the same time there will be a decrease in CONSUMER SPENDING (C) as they will take out fewer loans as well. • This CROWDING OUT EFFECT will reduce the gain made by the expansionary fiscal policy.
NET EXPORT EFFECT & EXPANSIONARY FISCAL POLICY • Government spending has led to an increase in interest rates. • At higher interest rates, foreigners demand more U. S. dollars to invest in bonds. • This leads to an appreciation of the U. S. dollar. • This leads to a decrease in Net Exports, as foreigners now have to exchange more of their currency for the U. S. dollar to buy exports. • This decrease in Net Exports will reduce AD and counter to some extent the expansionary fiscal policy.
CONTRACTIONARY FISCAL POLICY • Raising taxes or reducing government spending to fight inflation and stabilize the economy. Price Level AS P 1 P 2 AD 1 AD 2 QF Real GDP
LOANABLE FUNDS MARKET & CONTRACTIONARY FISCAL POLICY • Used for FISCAL POLICY (Government spending-Deficit Spending) A decrease in Gov. spending decreases the demand for loanable funds and lowers real interest rates Real Interest Rate R 1 R 2 D 1 D 2 Q 1 Quantity of Funds
NET EXPORT EFFECT & CONTRACTIONARY FISCAL POLICY • A decrease in government spending has led to a decrease in real interest rates. • At lower interest rates, foreigners demand less U. S. dollars to invest in bonds. • This leads to a depreciation of the U. S. dollar. • This leads to an increase in Net Exports, as foreigners now have to exchange less of their currency for the U. S. dollar to buy exports. • This increase in Net Exports will increase AD and further strengthen the contractionary fiscal policy.
CRITICISMS OF FISCAL POLICY • Timing Problems • Recognition Lag: identifying recession or inflation • Administrative Lag: getting Congress/President to agree to take action • Operational Lag: Time needed to see the results of the fiscal policy • Political Business Cycles: Politicians may take inappropriate action to get reelected (lower taxes during an inflationary period). Plus it is difficult to raise taxes
MONEY SUPPLY TERMS • M 1= Checkable Deposits and Currency • M 2= M 1 + Savings deposits, money market accounts, small time deposits (less than $100, 000) • Velocity of Money Equation: • MV = PQ ( GDP) (M= Money Supply and V = Velocity (number of times per year the average dollar is spent on goods and services.
THE FEDERAL RESERVE SYSTEM (FED) • Control Monetary Policy • Headquartered in Washington D. C. • 12 Federal Reserve Districts • Board of Governors (7 members) is the central authority • Members are appointed by the President and confirmed by the Senate
FEDERAL OPEN MARKET COMMITTEE (FOMC) • Made up of 12 people: Board of Governors + New York FED President + 4 other regional presidents (who rotate) • Meets regularly to direct OPEN MARKET OPERATIONS (buying or selling of bonds) to maintain or change interest rates
BANKS AND BALANCE SHEETS Assets Reserves Securities Loans Liabilities $15, 000 Checkable Deposits $15, 000 $70, 000 $100, 000 If the current reserve requirement is 10%: 1. What is the amount of new loans this bank can generate? Answer: $100, 000 Checkable deposits X a 10% reserve requirement = $10, 000 required reserves. If the bank has $15, 000 in reservers, $5, 000 of those are excess reserves and can be loaned out. 2. How much in new loans can be generated by the entire banking system? Answer: Money Multiplier = 1/Required Reserve Ratio=1/. 10 10 X $5, 000 = $50, 000
FED AND THE MONEY MARKET Nominal Interest Rate MS 1 MS 2 Vertical curve-Supply controlled By the FED. An increase in MS leads to a rightward shift and I 1 lower interest rates. I 2 MD Q 1 Q 2 Quantity of Money
EASY MONEY POLICY • Buying Government Bonds, lowering the discount rate, or lowering reserve requirements, to fight a recession, by decreasing interest rates, increasing investment spending and/or consumption and increasing AD. AS Price Level P 2 AD 2 P 1 AD 1 Q 1 (C + I + G + X) QF Real GDP
EFFECTS OF AN EASY MONEY POLICY • LOWER INTEREST rates which will lead to an INCREASE in INVESTMENT and CONSUMPTION. • The U. S. dollar will DEPRECIATE, leading to an increase in NET EXPORTS as well. • These effects STRENGTHEN the overall monetary policy (opposite of fiscal policy’s crowding-out and net export effect
FED AND A TIGHT MONEY POLICY Nominal Interest Rate MS 2 MS 1 Vertical curve-Supply controlled By the FED. A decrease in the Money supply, shifts the MS curve to the left and raises interest rates. I 2 I 1 MD Q 2 12 Quantity of Money
TIGHT MONEY POLICY • Selling bonds, raising the discount rate, or raising reserve requirements to fight inflation which will raise interest rates, decrease investment and/or consumption and decrease Aggregate Demand (AD). Price Level AS P 1 P 2 AD 1 AD 2 QF Real GDP
EFFECTS OF A TIGHT MONEY POLICY • At the higher interest rates, INVESTMENT SPENDING, and CONSUMPTION will decrease. • At higher interest rates, the U. S. dollar will APPRECIATE (foreigners demand more U. S. securities). This will lead to a DECREASE in NET EXPORTS. • Again, the Monetary Policy is STRENGTHENED as a result, unlike the effects of a contractionary fiscal policy.
EXTENDED AD-AS MODEL • This is the other way to graph the AD-AS Model Price Level LRAS SRAS P 1 AD QF The intersection of the 3 curves Is the Full-Employment Equilibrium Real GDP
EXTENDED AD-AS MODEL AND DEMAND-PULL INFLATION • In Demand-Pull Inflation, the AD curve has shifted to the right of the LRAS and SRAS intersection. LRAS Price Level SRAS P 2 PF AD 2 AD 1 QF Q 2 Real GDP The Price Level and Real GDP has increased.
EXTENDED AD-AS AND DEMAND-PULL INFLATION • Mainstream economists will fight inflation as previously discussed: with either a tight monetary policy or a contractionary fiscal policy. The goal would be to move the aggregate demand curve to the left. • Classical economists would argue to DO NOTHING. As nominal wages rise, the SHORT-RUN AS curve will shift to the left (resources and wages are becoming more expensive), restoring the economy to its full-employment output level, but with a higher Price Level.
EXTENDED AD-AS MODEL AND COST-PUSH INFLATION Cost-Push inflation occurs when the SRAS has shifted to the lef Of the LRAS and AD intersection. LRAS Price Level P 1 SRAS 1 Here the Price level has Increased and REAL GDP has decreased. SRAS 2 PF AD 1 QF Real GDP
EXTENDED AD-AS AND COST-PUSH INFLATION • Mainstream economists must decide whether to target the Price Level or Unemployment, before taking any action. • Classical economists would argue to DO NOTHING. Eventually, wages and resource prices must decrease and when they do the SRAS curve will shift back to the right, restoring the economy to its full-employment output level and the original Price Level.
EXTENDED AD-AS MODEL AND RECESSION • In a recession due to a decrease in AD, the AD curve is to the left of the LRAS and SRAS intersection; showing a decrease in both the Price Level and Real GDP. LRAS Price Level SRAS PF P 1 AD Q 1 QF Real GDP
EXTENDED AD-AS AND RECESSION • Mainstream economists will fight a recession as previously discussed: with either an easy money policy or an expansionary fiscal policy. The goal would be to move the aggregate demand curve to the right. • Classical economists would argue to DO NOTHING. The decrease in wages and resource prices will shift the SRAS curve to the right, restoring the economy to its full-employment output level, but with a LOWER price. (SELF-CORRECTION)
SHORT-RUN PHILLIPS CURVE • Suggests an inverse relationship between the inflation rate and the unemployment rate. Inflation Rate (percent) When the unemployment rate is Low (2%), the inflation rate will Most likely be high (8%). 8 When the Unemployment rate Is high, inflation will likely be low. 2 SRPC 1 2 8 Unemployment Rate (percent)
SHORT-RUN PHILLIPS CURVE • When the Government fights unemployment, typically higher inflation will result. When the Government fights inflation, typically, more unemployment will result. Thereby, we move along the Short-Run Phillips Curve. Inflation Rate (percent) 7 B 2 A SRPC 1 3 6 Unemployment Rate (percent)
SHIFTING THE SHORT-RUN PHILLIPS CURVE • The Short-Run Phillips curve can also shift, this would mean that both the unemployment rate and inflation rate are changing at the same time. Stagflation, unemployment and Inflation occurring together (OPEC decreasing Oil supply, causes this type of shift) Inflation Rate % 5 4 SRPC 2 SRPC 1 6 7 Unemployment Rate %
SHIFTING THE SHORT-RUN PHILLIPS CURVE • The Short-Run Phillips curve can also shift, this would mean that both the unemployment rate and inflation rate are changing at the same time. When Supply increases (productivity surge in 90 s) more than demand, prices will fall, while GDP and employment Increase; shifting the curve to the left. Inflation Rate % 5 3 SRPC 1 SRP 2 5 7 Unemployment Rate %
LONG-RUN PHILLIPS CURVE • The Long-Run Phillips Curve is vertical, like the Long Run Aggregate Supply Curve. So, in the long run there is no tradeoff between inflation and unemployment. Only the Price Level will change. LRPC Inflation Rate% 3 SRPC 5 Unemployment Rate %
LAFFER CURVE • What is the optimal tax rate? A tax of 0% will provide no tax revenue. A tax rate of 100% will also lead to no tax revenue (no incentive to work). Answer must be somewhere in between. Tax Rate 100 0 Tax Revenue
ECONOMIC GROWTH • Five Factors connected to long run economic growth. • Supply Factors: • Increase in natural resources (quantity and quality) • Increase in human resources (quantity and quality) • Increase in capital goods • Improvements in technology • Demand Factors: • Increase in consumption by households, businesses, and government
ILLUSTRATING ECONOMIC GROWTH • Production Possibilities Curve Capital Goods B A PPC 2 PPC 1 Consumer Goods
ILLUSTRATING LONG RUN GROWTH • Can also be illustrated with the extended AD-AS Model. LRAS 1 SRAS 1 Price Level LRAS 2 SRAS 2 P 1 AD 2 AD 1 Q 2 Real GDP
BUDGET PHILOSOPHIES Annually Balanced Budget: Government will spend what it makes. • Problem: Does not have money during a recession, it will not be able to increase spending to help the economy. • If there is inflation, it will also be forced to spend the extra money Cyclically Balanced Budget: Government willoff • In both cases the economy will be worse finance a deficit during a recession and pay it off with tax revenue received during expansion. a Problem: A long recession may run up a large deficit that short expansion period can not pay off
NATIONAL DEBT ($8. 7 TRILLION AND GROWING) Functional Finance: A deficit is necessary to balance the economy. The national debt should not be worried about too much. Causes of the Debt: 1. Wars 2. Recessions 3. Lack of Fiscal Discipline Concerns: 1. Interest Payments 2. Income Gap (Debt and interest payments held by the wealthy) 2. Crowding Out
ECONOMIC PHILOSOPHIES • Classical: Believes that the government SHOULD NOT interfere in the economy. And believes in selfcorrection of economic problems. • Keynesian: Believes that GOVERNMENT SHOULD interfere in the economy (taxes, government spending)
INTERNATIONAL TRADE • Comparative Advantage and Specialization allows for economic growth and efficiency. (More of each good can be obtained by trading-Trading line illustrates this) • Trade barriers create more economic loss than benefits. • Today there is a trend towards free trade and a reduction in trade barriers. • Strongest arguments for protection are the infant industry and military self-sufficiency arguments. • WTO oversees trade agreements and disputes, but has become a target of protesters lately.
FOREIGN EXCHANGE MARKET • Let’s say a U. S. citizen travels to Japan. This transaction will provide a supply of the U. S. dollar and result in a demand for yen. It will become cheaper for the Japanese to buy the dollar and more expensive for Americans to buy the Yen. The Yen is Appreciating and the dollar is Depreciating. Yen Price of dollar Dollar Price of Yen S 1 S 2 P 1 S 1 P 2 P 1 D 2 P 2 D 1 Q 1 Q 2 Quantity of U. S. Dollars Q 1 Q 2 Quantity of Yen
BALANCE OF PAYMENTS: THE SUM OF ALL TRANSACTIONS BETWEEN U. S. RESIDENTS AND RESIDENTS OF ALL FOREIGN NATIONS • Current Account: Shows U. S. exports and U. S. imports of goods and services. • Capital Account: Shows the U. S. investment (financial as well as capital-plants and factories) abroad and Foreign investment in the U. S. • Credits: A credit are those transactions for which the U. S. receives income (exports, foreign purchase of assets) • Debits: Those transactions that the U. S. must pay for: imports and purchasing of assets abroad.
BALANCE OF PAYMENTS CONTINUED • The Current Account and Capital Account must be equal. • Official Reserves Account: The Central Banks of all nations hold foreign currency to make up any deficit in the combined capital and current accounts. • If the U. S. has more credits than debits it finances this difference by dipping into its reserve account.
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