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Econ.202 University of Hail Semester 062 1 Dr. Abdul-karim Amer Course Handouts Ch. 21 What Macroeconomics Is All About Major Macroeconomic Issues: Macroeconomics is the study of economic activities and variables at the aggregate level, therefore it examines the behavior of economic variables in a macro view so that aggregates and averages are of interest such as price level , national income, gross domestic product, employment, unemployment, the exchange rate, and the balance of payment. The most important macroeconomic issues are those related to economic growth and economic stability. The issue of economic growth would include causes of long term growth and the size and sources of short term business cycles, while the issue of economic stability would investigate broad government policies such as monetary policy and fiscal policy. Key Macroeconomic Phenomena: Many macroeconomics variables are of great importance in economic analyses and economic policies such as gross national product, gross domestic product, national income, consumption, investment, government spending, taxes, interest rate, savings, exports, and imports. A key function in macroeconomics is that production generates income, thereby the value of goods and services produced in an economy in a given period of time is called national product. The national income is derived from the national product, and the most common measure of it is gross domestic product. The circular flow of macroeconomic activities is best illustrated in the following sketch: Domestic Households Financial System Abroad Government Domestic Producers Econ.202 University of Hail Semester 062 2 Dr. Abdul-karim Amer Nominal Values and Real Values: The nominal value of national income evaluates output in current prices, while real value of national income evaluates output inconstant based-period prices. Changes in real income reflect changes in quantities of output produced, while nominal changes reflect changes in prices only with no change in quantities. The real increase in output represents a growth in national income, whereas, nominal change in output reflects only inflation. Potential National Income: Potential real national income refers to the capacity of the economy to produce goods and services when production factors are fully utilized. The gross domestic product gap measures the difference between the potential real income and the actual income. Fluctuations around potential income are associated with business cycle, as recoveries pass through peaks then turn into recessions to be followed by troughs to become recoveries and so forth. In spite of the fact that those movements are systematic, they are by no means predictably regular. Unemployment: The unemployment rate is defined as the percentage of the labor force not employed at the market wage, but actively searching for job opportunities. Even though labor force and employment have been rapidly growing in the past half a century, unemployment rate has shown a dramatic increase worldwide in general, and in the developing countries in particular. The rising rate of unemployment creates serious problems to the economy in the form of economic wastes and human sufferings. Inflation: The price index measures the average price level, reflecting the cost of a set of goods in one year relative to the same cost in a base year. That index has shown a persistent up word trend since the end of the great depression in 1930. The inflation rate measures change in the price index, which fluctuated up and down for the last 70 years, worldwide, yet remained positive. Interest Rate: The interest rate is a very important macroeconomic variable as it shows the price must be paid to borrow money in terms of a percentage amount of money to be paid at the end of a specific period of time of a loan. This price derives its importance from being the rewards to savors and the cost of financing investments. A distinction is made between nominal and real interest rates. The nominal interest rate is expressed in money terms, while the real is expressed in terms of purchasing power. Econ.202 University of Hail Semester 062 3 Dr. Abdul-karim Amer Exchange Rate: The exchange rate is the number of units of a country currency, such as Saudi rials needed to purchase one unit of a foreign currency, such as US dollar. An increase in the exchange rate means a deterioration of the local currency and vice versa. Fluctuations in the exchange rate is mostly influenced by the condition of the balance of payments, which reflects the records of all international transactions made by the domestic firms, households, and governments. Trends Versus Cycles: Trends represent the long run path of the movements of various economic variables, while cycles are fluctuations around those trends. Thus, growth of the price level, real output, and employment is the long term trends, while fluctuations ups and down around those trends are considered short term cycles. Econ.202 University of Hail Semester 062 4 Dr. Abdul-karim Amer Ch. 22 The Measurement of National Income National income is the value of all goods and services produced in an economy in a given period of time generally one year. This value is the sum of all firms contributions to national product calculated as the value added of each firm which in turn is the value of total output minus the value of intermediate goods and services. The result is called the gross domestic product ( GDP ). National Income Accounting: Basics : Gross domestic product can be calculated in three different methods, but identical. The expenditure side, the income side, and the value added side are all equivalent methods to calculate GDP. The expenditure side gives the total value of expenditure required to purchase the total output, while the income side gives the total value of income claims generated by the production of that output. Aggregate Expenditure: The aggregate expenditure components of the GDP are grouped in four categories as follows: GDP = Ca + Ia + Ga + ( Xa- IMa ) Where: Ca: is consumption expenditure of the households. Ia : is the investment expenditure in plant, equipment, residential construction And inventory accumulation. Ga : is government purchases of goods and services. X-IM: is net exports. Income Side of GDP: The income side of the GDP is the sum of all production factors’ claims against production produced by those factors including wages, rents, interests, profits, depreciation, and indirect taxes net of subsidies. Econ.202 University of Hail Semester 062 5 Dr. Abdul-karim Amer National Income Accounts : Important Issues: The GDP, being the value of goods and services produced in an economy during a given period of time is the measure of economic activities performed within the border of the country, such as Saudi Arabia. While GNP measures income accruing to national residents of the country whether it is generated domestically or abroad. The difference is due to the balance between foreigners claims to income generated domestically and residents claims to income generated abroad. A distinction is critical between nominal and real income as the first measures changes in price and quantities while the later measures changes in quantities. Appropriate comparison of real and nominal measures yield implicit deflators that are used to split changes in prices and changes in quantities. It is widely preferred to measure GDP in per capita values such as GDP per capita, GDP per employed worker, and GDP per hour worked. A change in living standard is better reflected by changes in productivity than by GDP per capita. None withstanding, there are some limitations to the GDP as a measure of factors contributing to human well being since it does not include some of the activities that are either illegal or do not go through market channels. Nevertheless, GDP remains a good measure of economic activities that determines economic well being. Econ.202 University of Hail Semester 062 6 Dr. Abdul-karim Amer Ch. 23 National Income Determination Desired Versus Actual Expenditure: Desired or planned aggregate expenditures on consumption, investment, government purchases, and net exports are important in determining equilibrium national income with actual output. Desired expenditures are the amount that people are willing and planning to spend on national product. For the time being, our analysis, would consider only consumption and investment in equilibrium income determination. Later on, government spending and net exports will be added into play Consumption Function: The consumption function reflects the relationship between consumption as a dependent variable and disposable income as an independent variable. The consumption function consists of two parts, one is constant or autonomous that shows the minimum level of consumption that people must have in order to remain a live even if income level is zero, while the other is induced by income level. The relationship between income and consumption is positive. A change in income leads to a change in consumption in the same direction though not in the same magnitude. The responsiveness of that change is measured by the marginal propensity to consume ( MPC ) and marginal propensity to save ( MPS ), both of them sum up to 1, indicating that each one of them falls between zero and one, as income is allocated between consumption and saving. A change in wealth is positively related to consumption and negatively related to saving. An increase in wealth leads to an increase in consumption and a decrease in saving, and vice versa. Econ.202 University of Hail Semester 062 7 Dr. Abdul-karim Amer Investment: Investment spending depends on many factors among them are real interest rate, changes in sales, and business confidence. At this level investment is treated as an autonomous expenditure. Equilibrium National Income: The equilibrium national income is defined as that level of income where aggregate expenditure is equal to actual national income. Any level of income above equilibrium, desired expenditure falls short national income leading to undesirable accumulation of inventories; therefore, production will sooner or later have to cut back to the equilibrium level. Similarly, any income level below the equilibrium results in excess expenditure that leads to unplanned reduction in inventories; therefore, a pressure is emerging to increase production to the equilibrium level. Thus the economy has a built in forces that guide the economy back to equilibrium if any deviation occurs. In a closed economy, the equilibrium level of income ensures not only that aggregate expenditure equals national income, but also that saving equals investment. Econ.202 University of Hail Semester 062 8 Dr. Abdul-karim Amer Changes in Equilibrium National Income: An increase in autonomous desired consumption or investment or both of them would increase aggregate expenditure that leads to an increase in output and equilibrium income, and vice versa. This is shown graphically by an upward shift in the aggregate expenditure ( AE ) curve, causing an increase in equilibrium income level, or a downward shift of AE curve that leads to a fall in the equilibrium level of income. The magnitude of the shifts in equilibrium national income resulting from changes in autonomous spending depends on the value of the simple multiplier defined as follows: K=∆y/∆A Where: Y is national income. A is autonomous spending. The multiplier k is calculated as follows K=1/(1-z) Where z is the marginal propensity to spend out of national income. The value of the multiplier k is positively related to z, the larger is z, the larger is the multiplier, and vice versa. However, the value of the simple multiplier is always greater than one. Econ.202 University of Hail Semester 062 9 Dr. Abdul-karim Amer Ch. 24 National Income Determination Introducing Government: Previously, aggregate expenditure was assumed to consist of consumption spending and investment expenditure only, now government sector is introduced into the macro model. Government spending adds to the autonomous aggregate spending, while taxes reduce disposable income. Taxes minus transfer gives net taxes which indirectly affect aggregate expenditure The budget balance is defined as the net tax revenues minus government spending, T – G. If T –G is positive it indicates a surplus in the government budget, and a deficit if T – G is negative. Introducing Net Export: Exports are goods and services sold to foreign economies, while imports are purchases of goods and services from the external sector or foreign economies. Exports depend on demand of other countries for our goods and services; therefore, they are considered as autonomous spending, whereas imports depend on national income. Net exports are defined as exports minus imports. Net exports increase as exports increases and decrease as income grows and imports increase. A rise in domestic price level, holding foreign price level constant, leads to a fall in exports and a rise in imports, and vice versa. The same result holds, if exchange rate rises, thereby domestic goods and services become cheaper to foreigners and imports become expensive leading to a rise in exports and a fall in imports, and vice versa. Equilibrium National Income: The equilibrium national income is redefined after introduction of government and net exports to become as follows: Y = AE Where AE = C + I + G + ( X – IM ) The sum of investment and net exports is called ‘national asset formation’; therefore, at the equilibrium income level desired saving is equal to national asset formation. S + ( T – G ) = I + ( X – IM ) Econ.202 University of Hail Semester 062 10 Dr. Abdul-karim Amer Changes in Aggregate Expenditure and National Income: The addition of government and net exports to the macro model would reduce the value of the simple multiplier as the increase in income resulting from the increase in autonomous aggregate expenditure generates an increase in taxes and imports. That result means an increase in leakages from expenditure flow. An increase in government spending shifts the AE curve upward and raising equilibrium income, and vice versa. On the contrary, an increase in income tax rate rotates the AE curve and reduces equilibrium income level, and vice versa. An increase in government spending An increase in income tax rate A change in exports for any reason exercises the same effect on equilibrium national income as that of a change in government spending . Econ.202 University of Hail Semester 062 11 Dr. Abdul-karim Amer Equilibrium Income Determination: An Exercise. You are given the following information: C = 80 + 0.8 Yd I = 800 G = 500 X – IM = 600 – 0.1 Y T = 0.1 Y Use the above information to determine the following values? a) Equilibrium nation income? b) Consumption value? c) Imports value ? d) Net exports value ? e) Tax value ? Since the equilibrium condition is determined when AE = Yd, and AE = C+I+G+X-IM, and C= 80 + 0.8( 1-t ) Yd which equals C = 80 + 0.8( 1- 0.1 ) Yd = 80 + 0.8( 0.9 ) Yd, then: AE = 80 + 0.72 Yd + 800 + 500 + 600 – 0.1 Yd = Yd AE = 1980 + 0.62 Yd = Yd Then: Yd = 1980 + 0.62 Yd Yd – 0.62 Yd = 1980 Yd ( 1-0.62 ) = 1980 Yd = 1980 / 0.38 a) b) c) d) e) Yd = 5210.53 C = 80 + 0.62 ( 5210.53 ) = 80 +3230.53 = 3310.53 IM= 0.1 ( 5210.53 ) = 521.1 Net export = 600 – 521.1 = 78.9 Tax = 521.1 To make sure that the solution is correct, let us calculate AE as follows: AE = 1980 + 0.62 ( 5210.53 ) = 1980 + 3230.53 = 5210.53 Thus: AE = Yd =5210.5 3 Econ.202 University of Hail Semester 062 12 Dr. Abdul-karim Amer Ch.25 Output and Prices in the Short Run In previous analyses, macroeconomic adjustments for any change in any exogenous variable were made based on the assumption that price level is held constant and all changes will be in quantity only. In reality, any change in exogenous macroeconomic variable is likely to produce a change in both quantity and price; therefore, the analysis should incorporate those changes into the macroeconomic model, whereby a demand shock affects both national income and price level. The introduction of the price level into the analysis requires a link between the aggregate demand and the price level so that changes in the price level could be traced out through relevant changes in the aggregate expenditure then into the equilibrium national income. Generally, a price rise is expected to have a negative impact on the desired consumption expenditure and desired net exports and vice versa. The link emerges from the negative relationship between price level and wealth. A rise in the price level lowers the wealth of all people who hold money. A fall in the price level raises the wealth of all people who hold money. A rise in the domestic price level lowers the wealth of people which leads to a fall in the desired consumption spending and thus a downward shift in the AE curve from AE0 to AE1, thereby reducing equilibrium national income from Y0 to Y1 as seen in figure1(a). The reverse sequences hold if the domestic price level falls as can be seen in figure1(b). A similar analysis applies with respect to the effect of a change in domestic price level on net exports as price rise leads to a fall in net exports, AE , and equilibrium income as depicted in figure1(a). The opposite case is shown graphically in figure1(b). Econ.202 University of Hail Semester 062 13 Dr. Abdul-karim Amer The aggregate demand curve. The aggregate demand curve reflects the negative relationship between price level and equilibrium GDP which can be derived from the income-expenditure equilibrium figure. Each equilibrium point represents certain income-expenditure values associated with a given price level; therefore, it sets a point on the aggregate demand curve. A rise in the price level will lower wealth of people inducing them to lower desired consumption spending, hence shifting AE curve downward, resulting in a lower equilibrium income associated with that price level , thus establishing another point on the aggregate demand curve. The opposite holds with respect to a price fall as it leads to a rise in the wealth of people, increases desired consumption spending, an upward shift in AE curve, a higher equilibrium level of income associated with that price level, thus establishing a third point on the aggregate demand curve. Connecting those points will give the aggregate demand curve as seen in figure2. Figure 2 Every point on the aggregate demand curve reflects an equilibrium level of GDP associated with that given level of price. Any point above the demand curve represents excess output compared to desired expenditure, and any point below the curve reflects excess expenditure compared to output, whereas all points on the curve represents equality of desired expenditure and output. The demand curve will shift upward to the right in response to any increase in autonomous consumption, investment level, government spending, and exports that leads to an increase and a shift in the aggregate expenditure curve, then a shift in the aggregate demand curve, and vice versa. Econ.202 University of Hail Semester 062 14 Dr. Abdul-karim Amer The simple multiplier and the demand curve : The simple multiplier shows the change in equilibrium national income in response to a change in autonomous spending at any given price level. Now that price level is changing the simple multiplier can be estimated as the horizontal shift in the demand curve in response to the initial change in the autonomous spending, as seen in figure 3. Figure 3 The supply side of the economy: Having introduced the price level into action and explored the impact of a price change on the aggregate spending and output level, whereby, establishing a relationship between the price level and output level that enabled us to construct the demand curve, it is now possible to complete the model by adding the supply side of the economy. The aggregate supply curve: The aggregate supply curve relates aggregate supply to the price level. It is important to distinguish between short run supply curve and long run supply curve, the first operates under the assumption of given factor prices and technology, while the later relaxes such an assumption. The slope of the short run aggregate supply curve: The short run aggregate supply curve(SRAS) has the typical positive slope due to the fact that price taking firms will experience an increase in production cost as they increase output, an increase in price is required to induce them to produce more, and vice versa. Meanwhile, price setting firms will increase their prices when they expand output into the Econ.202 University of Hail Semester 062 15 Dr. Abdul-karim Amer range in which unit costs are rising. Thus, the price level and the short run aggregate supply are positively related, as seen in the following figure. Figure 4 Shifts in the supply curve: The sort run aggregate supply curve shifts right or left in response to a change in either factor prices or productivity because any given output will be supplied at a different price level. An increase in factor prices or deterioration in productivity will shift SRAS leftward and vice versa. Macroeconomic Equilibrium: We have reached a stage where macroeconomic equilibrium has become possible to establish as all forces in the economy are put in action. The equilibrium values of real GDP and the price level are determined at the intersection of AD and SRAS curves as seen in figure 5. Figure 5 At the equilibrium point Eo, AD is equal to SRAS with Po and Yo are the equilibrium price level and real GDP. At any other point AD and SRAS behavior will not be consistent and the economy will converge to the equilibrium point Eo. Changes in the macroeconomic equilibrium: Econ.202 University of Hail Semester 062 16 Dr. Abdul-karim Amer A shift in the AD or SRAS curves leads to changes in the equilibrium values of the price level and real GDP. A rightward shift in the AD curve indicates an expansionary shock as expenditure decisions are now consistent with a higher level of real GDP at all price levels. Whereas a leftward shift in the AD curve reflects a contrationary shock as aggregate demand decreases so that at all price levels expenditure decisions are now consistent with a lower level of real GDP. Thus, aggregate demand shocks cause the price level and the real GDP to change in the same direction as they both rise with an increase in the AD and both falls with a decrease in AD, as seen in the figure 6. Figure 6 It is worth mention that incorporating price changes into the macro adjustment process would lead to a reduction in the value and impact of the multiplier on the equilibrium real GDP, as a result of an upward sloping SRAS. The importance of the shape of the SRAS curve: Three ranges can be distinguished in the SRAS, the flat, the intermediate, and the steep ranges. In the flat range, an increase in the AD will lead to an increase in the real GDP, only. Whereas, in the intermediate range, an increase in the AD will lead to an increase in both real GDP and the price level. The third case is where an increase in AD leads only to an increase in the price level with no change at all in the real GDP. All those cases are shown in figure 7. Aggregate supply shocks: Figure 7 Econ.202 University of Hail Semester 062 17 Dr. Abdul-karim Amer Generally, an aggregate supply shock would create a disequilibrium in the economy characterized by either an excess demand or excess supply that causes the price level and the real GDP to change in the opposite directions. A decrease in the supply would shift the SRAS curve leftward resulting in a shortage of supply or excess demand that raises the price level and set the new equilibrium at a higher price level and a lower real GDP. Conversely, an increase in the supply would shift the SRAS curve resulting in an increase in output, hence, creating an excess supply that bid price level down setting the economy in an equilibrium with a higher level of real GDP and a lower level of price level, as seen in figure 8. Figure 8 Econ.202 University of Hail Semester 062 18 Dr. Abdul-karim Amer Ch.26. Output and Prices in the Long Run: In chapter 25, output, prices, and macroeconomic equilibrium were analyzed based on the assumption of constant factor prices and given technology. If factor prices are allowed to adjust to the economic condition, then output, prices, and macroeconomic equilibrium will have to incorporate that into the analysis, especially in the long run. Factor prices and the output gap: The output gap provides a convenient measure of the pressure of demand on factor prices. When there is an inflationary gap, actual GDP exceeds potential GDP and the demand for labor will be relatively high. Conversely, when there is a recessionary gap, actual GDP is below potential GDP and the demand for labor will be relatively low. Consequently, wages are likely to rise as a result of an inflationary gap and fall as a result of a recessionary gap. Those two gaps are illustrated in figure 1. Figure 1 A Recessionary gap An Inflationary gap The boom associated with inflationary gap generates high profits for firms and large demand for labor that causes wages and unit labor costs to rise. Consequently, firms will reduce the quantity of output produces for any given price level, thereby shifting SRAS curve up to the left reducing actual GDP to the potential level and closing the inflationary gap, but at a higher price level. Similarly, a slump associated with a recessionary gap generates low profits for firms and low demand for labor that causes wages and unit labor costs to fall. As a result, firms will increase the quantity of output supplied for any given price level leading to a rightward shift of SRAS curve and expanding actual GDP to potential GDP, hence, closing the output gap. Those two cases are graphically illustrated in figure 2. Econ.202 University of Hail Semester 062 Figure 2 The effects of aggregate demand shocks: 19 Dr. Abdul-karim Amer Econ.202 University of Hail Semester 062 20 Dr. Abdul-karim Amer If an expansionary AD shock occurs, perhaps, due to an increase in autonomous consumption or investment or government spending or exports, then AE will increase leading to an increase in GDP above the potential level. Therefore, the AD curve will shift upward to the right from Ado to AD1 as seen in figure 1 part (i). Consequently, an inflationary gap emerges inducing price level to rise from Po to P1 followed by an increase in the wage rate that raise cost per unit of output, thereby causing a leftward shift in the SRAS curve from SRASo to SRAS1. The final equilibrium will convert to the potential GDP associated with a higher price level. As can be seen in part (ii) of figure 2. The opposite is illustrated graphically in figure 3. Figure 3 The long run aggregate supply curve: Econ.202 University of Hail Semester 062 21 Dr. Abdul-karim Amer The long run aggregate supply reflects the output level that can be produced after all prices and factor costs have fully adjusted to eliminate any unemployment or shortages in labor; therefore, output level will convert to the full employment level at Y*. The long run aggregate supply curve (LRAS) takes a vertical line form reflecting the full employment level of output that can not be exceeded at the given state of technology and available resources, as seen in the figure 4. Figure 4 Econ.202 University of Hail Semester 062 22 Dr. Abdul-karim Amer Long Run Equilibrium: The long run equilibrium is established at the intersection point of AD and LRAS curves, where real GDP and price level are determined, as seen at point Eo of figure 4 (i). However, the long run equilibrium output is solely determined by the aggregate supply condition leaving the price level to be determined by the AD. The vertical LRAS curve shows that given full adjustment of input prices, potential output, Y*, is compatible with any price level, although its composition among consumption, investment, government, and net exports may vary at different price levels. An increase in the aggregate demand or a temporary increase in aggregate supply can increase real GDP in the short run, but not in the long run. Only permanent increases in long-run aggregate supply can lead to permanent increases in real GDP, as shown in figure 5. Econ.202 University of Hail Semester 062 23 Dr. Abdul-karim Amer Economic Growth: Long run supply curve is vertical indicating a full employment of resources whereby excess demand will only result in an increase in price level, and any expansionary gap will only be temporary. Consequently, a permanent increase in LRAS that shifts potential output Y* to the right, instantly, requires economic growth induced by an increase in economic resources and/or technological progress as depicted in part (iii) of figure 5. Fiscal Policy and the Business Cycle: Fiscal policy is a discretionary tool to counteract business cycle through corrective measures that apply government spending or tax policy to eliminate inflationary gap or recessionary gap. A recessionary gap: A recessionary gap in which actual GDP is less than potential GDP (Y*) can be corrected through wage and other factor prices fall caused by the recession that eventually shifts SRAS curve to the right, hence, reinstate potential output Y* at a lower price level. Yet, such a policy takes a long time to eliminate the gap, therefore, fiscal policy is called upon to correct the case by expanding government spending and/or reducing tax rate in order to increase AE and shifts AD to the right restoring potential output Y* at a higher price level, as seen in figure 7. Econ.202 University of Hail Semester 062 24 Dr. Abdul-karim Amer An inflationary gap: An inflationary gap occurs whenever actual GDP is greater than potential output Y*, therefore, wages and other factor prices will start to rise causing a leftward shift in the SRAS curve that restores potential output Y* at a higher price level. However, such a process requires a long time to be completed and for the gap to be eliminated. Instead, a fiscal policy might come into action through a reduction in government spending and/or a tax hike to curb AE and shift AD curve to the left downward, thus restoring potential output Y* at a lower price level, as seen in figure 8. Econ.202 University of Hail Semester 062 25 Dr. Abdul-karim Amer Ch. 27 Money, Banking, and Monetary Policy Historically, there have been some thought considering the economy as divided into a real sector and a monetary sector. The real sector involves production, allocation of resources, and distribution of income, determined by relative prices. The level of prices are determined in the monetary sector by the money demand and supply. Since the demand for money is assumed constant, any increase in money supply would induce all the equilibrium money prices to rise leaving relative prices and everything in the real sector unaffected. Therefore, money was thought to be nothing but a veil . Now a days, such thought is no more accepted as most economists think that money does matter, and it has an effect on the real sector in the short run as well as in the long run. The Nature of Money: The general perception about money is anything accepted as a medium of exchange. However, there are a number of functions performed by money including a medium of exchange, a store of value, and a unit of account. The need for money emerged from the inconveniences of barter. Money went through a gradual development from precious metals to token coinage and paper money partly backed by precious metals to fiat money and to deposit money. The Banking System: The banking system consists of the central bank and the commercial banks. The central bank is the official institution responsible for designing and implementing the nation’ s monetary policy. On the other hand the commercial banks are profit seeking institutions that facilitate transfer demand deposits of their customers from one bank to another through checks. They also create money by means through lending and investment. It is the fractional- reserve aspect of the commercial banking that allow them to create deposit money.. The maximum deposit money a commercial bank can create is determined by the initial deposit multiplied by the reciprocal of the reserve ratio. The Money Supply: The money supply as being the stock of money in an economy at a specific point of time, can be defined in different ways as follows: M1 : The narrowest definition, includes currency, traveler’s checks, and demand deposits. M2 : Includes M1 plus savings deposits and small time deposits. M3 : Includes M1 and M2 plus money market funds, and overnight loans. Near money includes interest earning assets that are convertible into money not included in the definition of money. There are a number of money substitutes such as credit cards that serve as a medium of exchange but are not considered as money. Econ.202 University of Hail Semester 062 26 Dr. Abdul-karim Amer Ch.28. Money, Output, and Prices Understanding financial assets: Financial assets constitute the wealth that people own. Those forms of wealth are simply grouped into “money”, which is a medium of exchange and earns no interest, and “bonds”, that earn interest and can be liquidated by selling them in the open stock market at the market price. Since the bonds entail future payments, the present value has to be calculated in order to effect the transactions. The present value is calculated for a single future payment as follows: PV = R / ( 1+ i ) For a sequence of payments, the present value is calculated as follows: PV = R1/ (1+i ) + R2/ (1+i )2+ R3/ (1+i )3+……………….+ RT/ (1+i )T For a perpetual stream of payments, the present value is calculated as follows: PV = R / i In general, the present value of any asset that yields a given stream of payments over time is negatively related to the interest rate. The equilibrium market price of any asset will be the present value of the income stream that it produces. The demand for money. Due to the fact that money earns no interest, holding money bears an opportunity cost in the form of interest payments forgone by holding cash money rather than buying bonds. Nevertheless, households and firms demand money for three main reasons: 1) The transactions motive: The transactions motive arises because payments and receipts are not synchronized. The larger the value of national income, the more transactions are made and thus the larger will be the value of transactions balances. 2) The precautionary motive: The precautionary motive arises because households and firms are uncertain about the timing of payments and receipts. Precautionary balances rise when national income rises. 3) The speculative motive: The speculative motive emerges from the fact that firms and households hold some money to provide a hedge against the uncertainty inherent in fluctuating prices of other financial assets. The speculative motive implies that the demand for money varies negatively with the rate of interest. Econ.202 University of Hail Semester 062 27 Dr. Abdul-karim Amer Real and nominal money balances: The real demand for money is the nominal quantity demanded divided by the price level. Thus, other things being equal, the nominal demand for money balances varies in proportion to the price level. Total demand for money: The total demand for money is composed of transactions motive, precautionary motive, and speculative motive. Consequently, a positive relationship is established between real national income, price level, and quantity of money. Similarly, a negative relationship is established between interest rate and quantity of money. The following figure (1). Econ.202 University of Hail Semester 062 28 Dr. Abdul-karim Amer Monetary forces and national income: Monetary forces and national income examines the relationship between money, on the one hand, and the equilibrium values of real GDP and the price level, on the other. The analysis is a two step process. First, establishing the link between monetary equilibrium and aggregate demand, second, tracing out the effect of a shift in aggregate demand on equilibrium values of real GDP and the price level. As known before, both money supply and money demand are a stock as they represent so many billions of rials at a point of time. Monetary equilibrium and aggregate demand: Monetary equilibrium occurs when the rate of interest is such that the quantity of money demanded ( liquidity preference ) equals the quantity of money supplied, as shown in figure 2. Econ.202 University of Hail Semester 062 29 Dr. Abdul-karim Amer An excess demand for money balances leads people to sell bonds, which pushes the price of bonds down and the interest rate up. Conversely, an excess supply of money balances leads people to buy bonds, which pushes the price of bonds up and the interest rate down. Monetary equilibrium is established when people are willing to hold the fixed stock of money, hence bonds, at the current rate of interest. The Transmission Mechanism: The transmission mechanism is the link between changes in the demand for and supply of money and aggregate demand. The transmission mechanism operates in three stages: The first is the link between monetary equilibrium and the interest rate, the second is the link between interest rate and investment expenditure, and the third is the link between investment expenditure and aggregate demand. Thus, Monetary disturbances that might arise from changes in either the demand for or the supply of money, cause changes in the interest rate, as shown in figure 3. Econ.202 University of Hail Semester 062 30 Dr. Abdul-karim Amer An increase in the money supply leads to a fall in the interest rate and an increase in investment expenditure, and vice versa, as shown in figure 4 attached. The increase in investment expenditure will result in a shift in aggregate expenditure, then a shift in aggregate demand curve, as seen in figure 5. Figure 5 Econ.202 University of Hail Semester 062 31 Dr. Abdul-karim Amer The process of the transmission mechanism operation for an expansionary monetary shock is shown in the following chart. Figure 6. Econ.202 University of Hail Semester 062 32 Dr. Abdul-karim Amer The negatively sloped aggregate demand curve indicates that the higher the price level, the lower the equilibrium national income. That is mainly due to the fact that ,other things being equal, the higher the price level, the higher the demand for money and the higher the rate of interest, which leads to a lower aggregate expenditure, hence a lower equilibrium income, as shown in the following figure. Figure 7. The adjusting mechanism of prices and wages to an output gap implies that inflationary gaps are eventually eliminated. However, this mechanism can be frustrated if Econ.202 University of Hail Semester 062 33 Dr. Abdul-karim Amer the central bank validates the price rise by increasing the money supply, as shown in figure 8. Figure 8. Changes in the money supply affect real GDP through shifts in the AD curve. But such changes do not affect potential output. Hence changes in the money supply can affect output in the short run but not in the log run. Econ.202 University of Hail Semester 062 34 Dr. Abdul-karim Amer Ch.29. Monetary Policy. The Federal Reserve and the Money Supply: The Federal Reserve (Central Bank) depends very much on the open market operations to influence money supply. When the central bank buys securities in the open market, the reserves of commercial banks are increased. These banks can then expand deposits, thereby increasing the money supply. Conversely, when central bank sells securities in the open market, the reserves of the commercial banks are decreased. These banks must in turn contract deposits, thereby decreasing the money supply. Even though open market operations are the main monetary policy tool in the hand of the central bank to influence money supply, there are other tools to serve the purpose. Among those tools are reserve requirements, the discount rate, and selective credit controls. An increase in required reserve ratios force banks with no excess reserves to decrease deposits and thus reduce money supply. On the contrary, a decrease in reserve ratios permits banks to expand deposits and thus increase the money supply. The discount rate is the interest rate at which the central bank will lend funds to commercial banks whose reserves are temporarily below the required level. A higher discount rate would induce commercial banks to increase their reserves to avoid borrowing at that rate, thereby limiting deposits and vice versa. Selective credit controls are commonly exercised through margin requirements, installment credit controls, mortgage controls, and maximum interest rates. Monetary Transmission Mechanism: Monetary policy influences aggregate demand through the transmission mechanism; macroeconomic equilibrium then determines the price level and the level of real output. Monetary equilibrium requires that interest rate be such that money supply equals the quantity of money demanded. Changes in the money market give rise to changes in the interest rate and hence, via the transmission mechanism, to the price level, P, and the level of real GDP, Y. Figure 1 shows that links among macroeconomic variables and the transmission mechanism. Figure 1 Econ.202 University of Hail Semester 062 35 Dr. Abdul-karim Amer Policy Variables and Policy Instruments. The ultimate objectives of the central bank are to influence the real GDP and the price level which are called policy variables. Real GDP represents monetary short run variable where as price level represents long run monetary variable. The central bank relies on the primary instruments represented by open market operations to conduct monetary policy to influence policy variables. Due to information lag and medium to long run nature of the policy variables intermediate targets are considered to guide monetary policy on most frequently basis given by money supply and interest rate, with due attention to consistency requirements. The two intermediate targets can not be controlled simultaneously or independently by the central bank. The central bank can either control the money supply or accept the resulting interest rate or vice versa, as can be seen in the following figures: Econ.202 University of Hail Semester 062 36 Dr. Abdul-karim Amer When conducting monetary policy, exchange rate is relevant as movement in exchange rate can provide valuable information, thereby care must be taken when determining the cause of any change in it. Monetary policy is conducted with a time lag when exerting expansionary and contractionary forces on the economy, which may be long and variable. As a result, monetary fine tuning becomes difficult and may be destabilizing. Econ.202 University of Hail Semester 062 37 Dr. Abdul-karim Amer Ch.30 Inflation. Causes and consequences of inflation: Inflation is generally defined as a continuous increase in the price level; therefore, an inflationary shock is anything that tends to increase the price level; where as a deflationary shock is any thing that tends to decrease it. Three important shocks are distinguished in this respect as follows: 1) Inflation or deflation that are caused by shifts in aggregate demand ( demand shocks ) as compared to those shocks caused by shifts in aggregate supply (supply shocks ). 2) Isolated, once and for all shocks, as compared to repeated shocks. The former Cause temporary bouts of inflation as the price level moves from one equilibrium level to another. The latter cause continuous or sustained inflation. 3) Validated inflation as opposed to invalidated inflation. The former is accompanied by an increase in money supply, while the other is not accompanied by an increase in money supply. Inflation and wage change: There is a strong relationship between inflation and wage rate. When output exceeds potential, an inflationary gap occurs that is characterizes by excess demand for labor; wages and unit costs tend to rise. Conversely, when output is less than potential, a recessionary gap occurs that is characterized by excess supply of labor; wages and unit costs tend to fall. Those relations are summarized in the following table: Recessionary gaps Y < Y* U > U* W'<0 c' < 0 Potential gaps Y = Y* U = U* W '= 0 c' = 0 Inflationary gaps Y > Y* U < U* W'>0 c' > 0 Where: Y is actual output. Y* is potential output. U is actual unemployment rate. U* is natural rate of unemployment (NIARU). W ' is wage change. c' is unit costs change. Expected Inflation: Another form of inflation-wage relation is through expected inflation. The expectation of some specific inflation rate creates pressure for wages to rise by that rate and hence for unit costs to rise at that rate as well. The adjustment process could be based on past experience, that is backward looking, future economic conditions and policies, that is forward looking expectations. Econ.202 University of Hail Semester 062 38 Dr. Abdul-karim Amer The over all effect of change in money wages is the sum of demand effect plus expectational effect. The net effect of the two forces acting on unit costs (demand and inflation expectation) determines what happens to the SRAS curve. The following figure summarizes the effect of inflationary shocks. Figure 1 Econ.202 University of Hail Semester 062 39 Dr. Abdul-karim Amer Figure 2 Monetary validation of a positive demand shock causes the AD curve to shift further to the right, offsetting the leftward shift in the SRAS curve and thereby leaving an inflationary gap despite the ever rising price level. Econ.202 University of Hail Semester 062 40 Dr. Abdul-karim Amer Figure 3 Monetary validation of an isolated adverse supply shock causes the initial rise in the price level to be followed by a further rise , resulting in a higher price level than would occur if the recessionary gap were relied on to reduce factor prices. Econ.202 University of Hail Semester 062 41 Dr. Abdul-karim Amer Repeated and nonvalidated adverse supply shocks have natural correctives that are created by the increasing recessionary gap. But these correctives may take a long time to operate, and hence a wage-cost push can cause long and sustained stagflation, combining inflation with rising unemployment. If a repeated supply shock is validated, then a continuous inflation will occur and persist, as seen in the following figure. Figure 4 Inflation can also emerge from expectation as another source of inflation. Actual inflation = demand inflation + expected inflation. Econ.202 University of Hail Semester 062 42 Dr. Abdul-karim Amer Ch.31. Unemployment. Over the span of many years, increases in the labor force are more or less matched by increases in employment. But occasionally the unemployment rate fluctuates because changes in the labor force are not exactly matched by changes in employment. Generally, enough new jobs have been created both to replace old jobs that have been eliminated and to provide jobs for the increased numbers of people in the labor force. The result has been a net increase in employment in almost all years. However, unemployment rises from time to time especially in developing countries leading to a loss of output and a personal costs to unemployed people. Types of unemployment: There are three types of unemployment: cyclical, frictional, and structural unemployment. Cyclical unemployment is mostly associated with macroeconomic fluctuations, while frictional and structural unemployment exist even at potential level of output. When there is no cyclical unemployment, the number of unfilled jobs currently available is just equal to the number of persons unemployed. In other words, cyclical unemployment is involuntary, where as frictional and structural unemployment could be voluntary. New classical theories state that in a perfectly competitive labor market, real wages and employment fluctuate in the same direction when demand fluctuates and in opposite directions when supply fluctuates, in both cases there is no involuntary unemployment. As seen in the following figure. Figure 1 Econ.202 University of Hail Semester 062 43 Dr. Abdul-karim Amer New classical explanations assume that labor markets clear, and then look for reasons why employment fluctuates. They imply, therefore, that people who are not working have voluntarily withdrawn from the labor market for one reason or another, there is no involuntary unemployment. New Keynesians think that many people who are recorded as unemployed are involuntarily unemployed in the sense that they would accept an offer of work in jobs for which they are trained, at the going wage rate, if such an offer were made. The non-accelerating inflationary rate of unemployment (NAIRU): The natural rate of unemployment (NAIRU) consists of frictional unemployment and structural unemployment. The normal turnover of labor causes frictional unemployment to exists and perhaps persists even if the economy is at potential output. Meanwhile, structural unemployment will emerge and increase if there is either an increase in the pace at which the structure of the demand for labor is changing or a decrease in the pace at which labor is adapting to these changes. However, the major characteristic of both frictional and structural unemployment is that there are as many unfilled vacancies as there are unemployed persons. Reducing unemployment: Cyclical unemployment can be reduced by raising aggregate demand . Frictional and structural unemployment can be reduced by making it easier to move between jobs, by slowing down the rate of change in the economy , and by raising the cost of staying unemployed. Nevertheless, it is neither possible nor desirable to reduce unemployment to zero. Econ.202 Ch.32 University of Hail Semester 062 44 Dr. Abdul-karim Amer Government debt and deficit: The government’s budget deficit is equal to total government expenditure minus total government revenue. Since the government must borrow to finance any deficit, the annual deficit can be measured by the increase in the stock of a government debt during that year. Government expenditure = Tax revenue + borrowing G + TR + i * D = T + borrowing ( G + TR + i * D ) – T = borrowing Primary budget deficit = total budget deficit – debt-service payments = ( G + TR + i X D – T ) – i X D = ( G + TR ) – T The primary budget deficit is the difference between the overall budget deficit and the level of debt-service payments. Since taxes tend to rise when national income rises, the overall budget deficit tends to rise during recession and fall during booms. This tendency makes the budget deficit a poor measure of the stance of fiscal policy. The cyclically adjusted deficit is the budget deficit that would exist with the current set of fiscal policies if national income were equal to potential income. Changes in the cyclically adjusted deficit reflect changes in the stance of fiscal policy. The change in the debt-to-GDP ratio from one year to the next is given by : ∆d=x+(r–g)Xd Where: d : is the debt-to-GDP ratio x : is the primary deficit as a percentage of GDP. r : is the real interest rate. g : is the growth rate of real GDP Changes in the debt-to-GDP ratio depend on the real interest rate, the growth rate of real GDP, and the size of the primary budget deficit. Reduction in the debt-to-GDP ratio can be achieved even though the overall budget deficit is not eliminated. For a given real interest rate and rate of growth of real GDP, a larger primary budget surplus implies a smaller increase in the debt-to-GDP ratio. If r exceeds g, then a primary surplus is required to stabilize the debt-to-GDP ratio. Government deficit and national saving: National saving = private saving + government saving If government saving is negative, then: National saving = private saving – government budget deficit The government budget deficit is a reduction of national saving as the government needs to borrow in order to finance the deficit which is a postponed tax liability and the interest paid on that debt is the cost of postponing the liability. Econ.202 University of Hail Semester 062 45 Dr. Abdul-karim Amer The effect of government debt and deficit: 1) 2) 3) 4) 5) 6) If government borrowing to finance the deficit drives up the interest rate, some private investment will be crowded out. In an open economy, instead of driving up interest rate sufficiently to crowd out private investment, the government budget deficit tends to attract foreign financial capital, appreciate the currency , and crowd out net exports. In a closed economy, the government budget deficit leads to a lower private investment and less capital stock, thereby less goods and services produced, hence low level of standard of living. In an open economy, government budget deficit leads to an appreciation of currency, thereby reducing net exports and national asset formation leading to an increase in the capital stock of debt that the country as a whole owes to foreigners at the expense of domestic residents. In the long run, government borrowing generates a distribution of resources away from future generations toward the current generation. If government budget deficit is financed by creation of new money, it causes a sustained inflation. Reducing the government budget deficit through an annual budget balancing and/or through changing debt-to-GDP ratio might become necessary to stabilize the economy in the short run and ensure economic growth in the long run. Econ.202 University of Hail Semester 062 46 Dr. Abdul-karim Amer Ch. 33 Economic Growth. The nature of economic growth : Economic growth refers to the increase in output, income, and standard of living. Generally, there are three ways of increasing national income: closing recessionary gap through removing deficient demand unemployment, reducing frictional or structural unemployment, and continual economic growth, as seen in figure 1. In those cases, there will be a once and for all increase in real GDP. Figure 1 Econ.202 University of Hail Semester 062 47 Dr. Abdul-karim Amer Growth is frequently measured by using rates of change of potential real per GDP per person that become very large over a long period of time through the cumulative effects. The most important benefit of growth lies in its contribution to raise living standards and escape poverty, in addition to facilitating income distribution among people. However, growth is never costless. The opportunity cost of growth is the diversion of resources from current consumption to capital stock Established theories of economic growth: The established theories of economic growth are based on four determinants of growth including growth in the labor force, human capital, physical capital, and technology. Investment, saving, and growth: The theory of economic growth is a long run theory focusing on the effects of investment in raising potential output and ignoring short run fluctuations of actual output around potential. Short run and long run effects of saving: The short run effect of an increase in saving is to reduce aggregate demand that leads to a lower equilibrium national income. However, in the long run higher national saving is necessary for higher investment. Therefore, in the long run, there is no paradox of thrift; societies with high rates of national saving have high investment rates and high growth rates of real GDP. Recent theories of economic growth: Old growth theories emphasized diminishing returns under conditions of given technology. By contrast, modern growth theories emphasize the unlimited potential of knowledge-driven technological change to economize on all resource inputs displaying increasing returns to investment, which makes growth boundless. Econ.202 University of Hail Semester 062 48 Dr. Abdul-karim Amer Ch.34 Growth in the Developing countries. The uneven pattern of development: The pattern of world development still reflect a substantial disparity as one quarter of world population lives at a level of bare subsistence, and about three-quarters are poor by World Bank standards. In spite of the fact that some poor countries have grown rapidly in the past two to three decades, the gap between the very richest and very poorest remains large and perhaps widening, as seen in figure 1. Figure 1 Econ.202 University of Hail Semester 062 49 Dr. Abdul-karim Amer Impediments to economic development: Economic development is not an automatic process and can not be randomly achieved. Rather it is a very complicated and comprehensive challenge ever facing nations all over the world. Consequently, there exists a lot of impediments and hindrances a long the way including excessive population growth, resource limitations, inefficient use of resources, inadequate infrastructure, excessive government intervention, and unfavorable institutional and cultural structures. Development policies: The older model for development policies was based on protectionism philosophy that relies on heavy tariff barriers and a hostile attitude towards foreign direct investments(FDI) to protect the home market for local firms. In addition, excessive government controls over, and subsidization of , local activities were widely exercised. Furthermore, exchange rates were pegged at excessively low values (overvalued currencies), along with subjecting imports to regulations by licenses. The new view of development policies takes the opposite stand to the old one, as it calls for avoiding heavy indiscriminate protection of home markets, and limiting protection, if necessary to sectors that have a real chance of creating a comparative advantage for a limited period of time, only. Moreover, competition is seen as an important spur to efficiency and innovation, with no use of quantitative controls over private sector and market forces to allocate resources among various economic uses. Today, virtually all developing countries encourage foreign TNCs to locate within their borders, hence reversing the attitude towards FDI from hostility to appreciation. The Washington Consensus: The Washington consensus is formulated in ten general principles stated as follows: 1) Adopting free market philosophy to run economic activities and allocate economic resources. 2) Adopting sound government policies to avoid persistent structural budget deficits. 3) Adopting sound monetary policies aiming at maintaining low and stable inflation rates. 4) Broadening tax base with a moderate marginal tax rates. 5) Eliminating government intervention in determining prices of goods and services, exchange rates, resource allocation, and trade flow, and allowing market forces to take charge of all those activities. 6) Restricting protection to specific industries that are viable and for a short period only. 7) Industrial development should rely on local firms and attracting FDI with little, if any, restrictions. 8) An export oriented strategy provides competitive incentives for building of skills and technologies geared to world markets, permits realization of scale Econ.202 9) 10) University of Hail Semester 062 50 Dr. Abdul-karim Amer economies, and provides access to valuable information flows from buyers and competitors in advanced countries. Emphasizing education, health improvement (especially for the disadvantaged), and infrastructures investments are desirable areas for public expenditures. Finally, emphasis should be placed on poverty reduction to avoid its negative impact on growth potentials and help create attractive labor force. The Washington consensus was adopted by the World Bank, the International Monetary Funds, and several United Nations organizations. An active debate is still running whether the conditions of the Washington consensus are sufficient, or just necessary to set a country on a sustained growth path. Those who consider it as sufficient think that once unleashed, natural forces will create sustained growth. On the other hand, those who consider it as necessary but not sufficient point to substantial externalities and pervasive market failures in the diffusion of technological knowledge from developed to developing countries. Therefore, active government policies are needed to assist in the transfer of technological know-how and practice to the local economy. Econ.202 University of Hail Semester 062 51 Dr. Abdul-karim Amer Ch.35 The Gains from International Trade. Sources of the gains from trade: Each individual, a region, and a country has an absolute advantage over another in the production of a specific product when, with the same input of resources it can produce more of the product than can the other. Comparative advantage is the relative advantage one country enjoys over another in the production of various products. That occurs whenever countries have different opportunity costs of producing particular goods. World production of all products can be increased if each country specializes in the production of goods it has a comparative advantage in producing them. The following table provides an illustration of that theory. Table 1 Gains from specialization with comparative advantage Wheat (bushels) Cloth (yards) United States 100 60 England 5 10 Changes resulting from the transfer of one-tenth of a unit of American resources into wheat production and a unit of English resources into cloth production. Wheat (bushels) Cloth (yards) United States +10 -6 England -5 +10 World +5 +4 Thus, specialization based on comparative advantage resulted in an increase in world production of all goods. The most important proposition of the theory of the gains from trade is that trade allows all countries to obtain the goods in which they have no comparative advantage at a lower opportunity cost than they would face if they were to produce all products for themselves. Therefore, specialization and trade allow all countries to have more of all goods than they could have if they try to be self-sufficient. In addition to realizing the gains from specialization and trade , a nation could also experience the benefits of economies of large scale production and of learning by doing. Sources of comparative advantages: Classical theory regarded comparative advantage as largely determined by natural resource endowments that are difficult to change (Heckscher-Ohlin theory), as well as differences in climates. Economists, now, believe that some comparative advantages can be acquired, thereby can be changed. A country may influence its role in world production and trade. Successful intervention leads to a country’s acquiring a comparative advantage; unsuccessful intervention fails to develop such an advantage. Econ.202 University of Hail Semester 062 52 Dr. Abdul-karim Amer The terms of trade: The terms of trade refer to the ratio of the prices of goods exported to the prices of those imported. That ratio determines the quantity of imports that can be obtained per unit of exports. The terms of trade also reflect how the gains from trade are shared. A favorable change in the terms of trade means that a country can acquire more imports per unit of exports, and vice versa. Econ.202 University of Hail Semester 062 53 Dr. Abdul-karim Amer Ch.36 Trade Policy. The theory of trade policy: The case for free trade: There is an abundant evidence that significant differences in opportunity costs do exist and that large gains are realized from international trade resulting from those differences. The case for protection: The case for protection rests on two arguments: The first concerns national objectives other than maximizing national income, the second concerns the desire to increase a country’s national income. Objectives other than maximizing national income: 1) Noneconomic advantages of diversification. 2) Risks of specialization. 3) National defense. 4) Protection of specific groups. Maximizing one country’s national income: 1) To alter the terms of trade. 2) To protect against “unfair” actions by foreign firms and governments, such as “dumping”. 3) To protect infant industries. 4) To encourage learning by doing. 5) To create and exploit a strategic trade advantage. Fallacious arguments for protection: 1) Keep the money at home. 2) Protect against low-wage foreign labor 3) Exports are good; imports are bad. 4) Create domestic jobs. Methods of protection: 1) Policies that directly raise prices, such as tariffs or import duties. 2) Policies that directly lower Quantities, such as import quota. The impact of those methods of protection is illustrated in figures 1 and 2. Econ.202 University of Hail Semester 062 Figure 1 54 Dr. Abdul-karim Amer Econ.202 University of Hail Semester 062 Figure 2 55 Dr. Abdul-karim Amer Econ.202 University of Hail Semester 062 56 Dr. Abdul-karim Amer Ch.37 Exchange Rates and the Balance of Payments. International trade normally requires the exchange of the currency of one country for that of another. The exchange rate between the US dollar and some foreign currency is defined to be the number of US dollars required to purchase one unit of the foreign currency; in other words it is the price of that currency. A rise in the exchange rate is the same thing as a depreciation of the US dollar in terms of foreign currency; on the other hand a fall in the exchange rate is an appreciation of the US dollar in terms of foreign currency. The Balance of Payments. All transactions among countries are recorded in the balance of payments of each country. Exports of goods and services are recorded as credit to the country, where as imports of goods and services are recorded as debit. Major categories in the balance of payments accounts are the trade account, the capital-service account, the current account, the capital account and the official financing account. If there is a balance of payments deficit (or a surplus) it means that the sum of current and capital accounts is a deficit (or a surplus), excluding the transactions on the financial account. If official financing is zero, then the balance in the current account must equal a balance in the capital account of the same magnitude but the opposite sign. The foreign exchange market. The supply of foreign exchange comes from exports of goods and services, capital inflow, and the desire of foreign banks, firms, and countries to use the country’s currency as a medium of exchange or as part of their reserves. On the other hand, the demand for the foreign exchange arises from needs to pay for imports of goods and services, capital flow, and the desire of holders of the country’s currency to decrease the size of their holdings. The supply of foreign currency in relation to the exchange rate is positively sloped, while the demand for it is negatively sloped. The determination of exchange rate. There are several conditions for determining exchange rate. If the central bank does not intervene in the foreign exchange market(zero official financing), the exchange rate will be flexible. Where as under fixed exchange rate, the central bank intervenes in the foreign exchange market to maintain the exchange rate at or around the announced value. In order for the central bank to monitor the exchange rate at/or near the announced value, it has to hold sufficient stocks of foreign exchange reserves. Under a flexible or floating exchange rate, the exchange rate is determined by supply and demand of foreign exchange according to the interaction of market forces embodied Econ.202 University of Hail Semester 062 57 Dr. Abdul-karim Amer by supply and demand. Changes in exchange rate could result from various factors including prices of exports and imports, the rates of inflations in different countries, capital movements, structural conditions, and expectations about future exchange rates. The behavior of exchange rates: The theory of purchasing power parity(PPP), predicts that exchange rates should adjust so that the purchasing power of a given currency is the in different countries, in other words, the price of an identical basket of goods should be the same in different countries expressed in the same currency. However, the use of PPP approach should be done with due care and cautiousness. Econ.202 University of Hail Semester 062 58 Dr. Abdul-karim Amer Ch.38 Macroeconomic Policy in an Open Economy. The balance of trade and national income: Macroeconomic policy in an open economy is subject to different structure compare to that of a closed economy with r4espect to transmission mechanism and effectiveness. An open economy would, by necessity introduce new factors into play, such as interest rates fluctuations with respect to capital flow, changes in the value of domestic currencies, and exchange rate adjustments. Fixed exchange rate policy: Under fixed exchange rate, international trade, through reducing the multiplier effect, acts as an automatic stabilizer. An increase in national income leads to an increase in imports, a reduction in net exports, and a reduction in the multiplier effect. Thus with fixed exchange rate and zero capital mobility, the responsiveness of imports to national income reduces the size of the autonomous spending multiplier and acts as an automatic stabilizer. On the other hand, autonomous changes in exports leads to an increase in net exports and equilibrium national income. Flexible exchange rate policy: Under flexible exchange rate policy and zero capital mobility, the exchange rate adjusts until the balance of trade is zero. Consequently, net exports do not influence desired aggregate expenditure and the economy is behaving as if there were no international trade. Neither there is an automatic stabilizing role played by imports, and the export multiplier is zero. International capital mobility: International capital mobility means that capital flows, thereby the capital account balance must be included in the analysis of open-economy macroeconomics. Capital movements respond to changes in interest rates, especially interest rate differentials from one country to another, which makes it subject to the influence of both fiscal and monetary policy. Under flexible exchange rate the monetary policy is effective in influencing national income. When capital flows are highly interest elastic, a monetary expansion lowers domestic interest rates leading to capital outflow. That will result in a depreciation of the domestic currency, thereby stimulating net exports and enhancing the initial monetary expansion effect. On the other hand, fiscal policy is rendered less effective in raising national income under flexible exchange rate. An increase in government spending resulting in an increase in national income leads to an increase in money demand and pushes up interest rates. Consequently, attracting capital inflow and causing an appreciation of domestic currency that leads to a reduction in net exports and off setting effect to the initial expansion of fiscal policy. Econ.202 University of Hail Semester 062 59 Dr. Abdul-karim Amer Finally, a relationship is established between government budget deficit and the current account deficit as follows: ( S - I ) + ( T - G ) = ( X - IM ) + ( Rf - Rp ) Where: S : is saving. I : is Investment. T : is tax value. G : is government spending. X : is exports. IM : is imports. Rf : is receipts from foreigners. Rp : is payments to foreigners. The essence of the above equation is that a one dollar increase in government budget deficit will be matched by a one dollar increase in the current account deficit.