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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
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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:
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University of Hail
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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
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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
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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
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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
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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
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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.
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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).
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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.
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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.
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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
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The process of the transmission mechanism operation for an expansionary monetary
shock is shown in the following chart.
Figure 6.
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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
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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.
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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
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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:
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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.
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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.
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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
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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.
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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.
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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.
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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
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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.
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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.
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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.
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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
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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.
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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
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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
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10)
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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.
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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.
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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.
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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.
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Figure 1
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Figure 2
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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
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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.