Sat Review 05-13-07
From Scratchpad
05-13-07
Yesterday taped, except for first 30 minutes.
Will go over closed model (which was first 30 minutes of yesterday).
Closed Small Economy
IS-LM graph: Relationship between investment savings curve (IS) and the liquitiy of money curve (LM).
IS: Y = C + I + G
Y = C(Y-T, W/P, Expecctations) + I(r, expectations) + G
C is function of
- Y-T
- W/P = real wealth
- Expectations
I is function of
- r
- expectations
G is whatever Gov't decides it to be
LM Curve: (M/P) = L(r, Y) = demand for money (ie, liquidity) = function of interest rate & output.
The more output you have, the more money is demanded. The lower the interest rate, the more money is demanded.
AD-AS graph: relationship of P & Y
Changes in IS move the AD curve.
In the absence of anything changing, and you start in equib, Y = LRAS.
!!
Exam Tips:
- LRAS doesn't move. DO NOT EVER MOVE LRAS.
- UNLESS TEST SAYS OTHERWISE, START IN EQUILIBRIUM
- In Closed Econ model, a shift in one of these curves always shifts Y. Not always true in Open Econ model.
- If question asks: what will gov't do? Can include either Fiscal or Monetary Policy. But if specifically asks:
-- CB = Monetary Policy. -- G = Fiscal Policy
!!
What can shift IS curve?
- Taxes
- Gov't spending
- Expectations
-- business expectations impact investment -- consumer expectations impact consumption
- Real wealth (fall '05 has example of this).
-- ex: assuming prices constant, big change in stock market/housing prices => effects real wealth
What can shift LM curve?
- Change to money supply.
-- Fed/CB increases money supply -- Fed/CB decreases money supply
- Supply shock, like oil
Closed Econ Example: Taxes go up.
In the short-run:
T up => G down => IS shift in
- r down
- output down, so recession
- AD in
- P down, so reduction in inflation
- unemployment up
In the long-run, P drops ever further, SRAS drops down to intesection with new AD curve, until end up with
-- LR Y
-- natural level of unemployment
-- lower long-run price level
what is the mechanism that makes this happen? Wages and other input prices drop.
On the left of LRAS, unemployment goes up. On the right of LRAS of unemployment goes down.
Are you better off? It depends on who you are. Not everyone's price wages go down the same way. Some people will end up
better off, some people end up worse off.
In the long-run, prices don't matter.
!!!
TIP: Talk about
1.) Output/Recession 2.) Inflation 3.) Unemployment
DO NOT FORGET UNEMPLOYMENT
!!!
Closed Econ Example: Oil Prices Go Down
Start with AD-AS: SRAS goes down.
Oil down => SRAS out & down => output goes up, unemployment goes down, price level down
What is impact on IS-LM curve? P down => real money balances increase => LM shifts out
However, can be a second shift also. If you consider real wealth a factor in consumption, increase in real wealth => IS
shifts out. In this case, what happens to r? Depends on relative shifts between LM & IS. Could go up, could go down.
But primarily, shifts LM. That's good enough.
Long-run?
I'm above my natural level of employment, so wages will increase, driving SRAS back up to previous level. If you do nothing,
return back to SRAS0.
!!
tip: if he doesn't say otherwise, or other factors to indicate it, use "closed model". U.S. approximates
!!
EXAM REVIEW: Fall 2005
1.) House prices collapse. What happens first?
First step, draw IS-LM & AD-AS curves, start in equil. Assume this is reflective of where we are right now (ie, post interest
rate effects, and before impact of house price collapsing.)
My answer: Real wealth down, so consumption down.
Other answers? SRAS, pries, etc..
SRAS doesn't go down, b/c houses are not an input. (at least that's not start). Prices don't automatically go down. He would
say either: expectations go down, or real wealth down. Same effect either way.
- IS-LM: C down => IS shift in => Y down, r down
- AD-AS: Y down => AD down => P down, unemployment up
Question from class: Are wages the only mechanism by which SRAS changes? No. Other input prices can impact this.
2.) Is fixed EXR a good way to prevent domestic inflation?
False. Why?
In general, how to think about this question: ask if they "fix too low", "fix too high" or "fix just right"?
If they fix too low, they have to keep printing money to maintain the fix. Use foreign exchange graph to show how this works. If they fix too high, how long can you maintain the fix? Until you run out of foreign currency. Even if you fix it right -- constrained in the case that IS shifts. For example, if gov't spends more money, you will be
forced to print money to keep the fix, which will pressure prices upwards.
In particular for Latin America, they were printing money to monetize the debt.
(See class notes for FX graph, right after mid-term. There was talk about speculators crashing the bank..)
3.) In SOE.. which policy will reduce deficit?
!! Tip:
When you see a question that doesn't tell you which case to do, do all cases.
So there are both flex & fix, and there are two policies..
One way to do it is show all 4 cases
!!
Case 1: Flex rate, expansionary monetary
- Shift out LM* => lower exchange rate, higher output => economic growth, increased tax revenue
- All else being equal, increased tax revenue will reduce tax revenue
Case 2: Flex rate, contractionary fiscal (increase taxes or reduce G)
- Less G/more tax revenue => Shift in IS* => lower exchange rate, same output
- Obviously, this helps reduce deficit too
Case 3: Fixed rate, expansionary monetary
- Shift out LM* => have to just shift it back again.
- So, exp. monetary policy has no effect in fixed system
Case 4: Fixed rate, contradictionary fiscal
- Shift IS* in => have to shift LM* back to keep fix => output down
- decreased gov't spending creates recession. Depends on magnitude of the relative shifts, but no guaranty
Overall answer: it depends on the type of exchange system you have. If have a flex system, "yes it can", but in a fixed
system it might not. So answer: uncertain
4.) Didn't do
5.) Very similar to something he did on Sat. Also, look at pg 343 -- section on protectionist policies and impact on the IS
curve.
EXAM REVIEW: Spring 2006
1.) Croatia fixed too high. What are two policies?
- One Option: Let it float. Stop buying Foreign Reserves.
-- exporters more competitive -- local currency to pay foreign debts less valuable, may have to bail out the banks with your foreign reserves -- if you don't have enough foreign reserves, might not be able to do this.
- Second Option: Print more money to weakening the currency. Buy Euros, sell LC.
(What have we seen with China? 1.2T Foreign Reserves) -- If print more money, inflation goes up. Local consumers, savers lose. -- Importers lose.
2.) Note: its a fixed, so there is "no such thing as monetary policy", monetary policy = exchange policy.
(So one option would be to, using monetary policy, just choose to fix somewhere else. But normal answer is..)
Change fiscal policy to shift IS* in (dec. G or inc. T), LM* shifts in to maintain the fix. Go to AD-AS curve, and can show result is:
- lower prices
- higher unemployment
- lower output
3.) Result is stagflation (SRAS goes up.) If CB wants to help firms, stave off recession, can print money. But will exacerbate inflation. Else, CB can decide to fight inflation by pulling reducing money supply, but will likely make recession even worse.
