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QUICK STUDY NOTES - Ch 12 - 15 - Econ 1BB3

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Bridget O' Shaughnessy

Chapter 12 The Flow of Goods – Net Exports  Net Exports (Trade Balance) = Value of Countries Exports – Value of Countries Imports o Trade Surplus  +ve Trade Balance  Exports>Imports o Trade Deficit  -ve Trade Balance  ExportsForeigners Buy Domestic Assets o Capital Inflow  -ve NCO  Purchase of Foreign Assets by Domestic Residents 0 o Uses foreign currency to buy foreign assets  Capital Outflow  NCO > 0  Trade Deficit – Buying (foreign to domestic) more than Selling (domestic to foreign)  NX < 0 o Sells assets abroad to finance purchases  Capital Inflow  NCO < 0 Saving = Domestic Investment + Net Capital Outflow  S = I + NCO (In Closed Economy S = I because NCO = 0) o S > I  + NCO The nation is using some of it’s saving to buy assets abroad o S < I  - NCO Foreigners purchase domestic assets which finance some of the nations investments Nominal Exchange Rate – the rate at which a person can trade the currency of one country for the currency of another  Appreciation – an increase in value of a currency as measured by the amount of foreign currency it can buy o Discourages purchase of domestic G&S  NX decrease (domestic goods become more expensive relative to foreign goods)  Depreciation – a decrease in value of a currency as measured by the amount of foreign currency it can buy o Encourages purchase of domestic G&S  NX increase (domestic goods become cheaper relative to foreign goods) Real Exchange Rates – the rate at which a person can trade the goods and services of one country for the G&S of another  Real Exchange Rate = Nominal Exchange Rate x Domestic Price Foreign Price e = nominal exchange rate = (e x P) / P* P =price index for Canadian basket P* = price index for foreign basket Purchasing-Power Parity – a theory of exchange rates whereby a unit of any given currency should be able to buy the same quantity of goods in all countries; a unit of all currencies must have the same real value in every country  Law of One Price - a good must sell for the same price in all locations  Arbitrage – the process of taking advantage of differences in prices in different Markets  Nominal exchange rate between the currencies of two countries depends on the price levels in those countries  e = P* / P  Limitations –exchange rates do not always move to ensure that a dollar has the same real value in all countries all the time; real exchange rates fluctuate and people have incentive to move goods across national borders 1. Many goods are not easily traded 2. Even tradeable goods are not always perfect substitutes when they are produced in different countries Interest-Rate Parity – a theory of interest rate determination whereby the real interest rate on comparable financial assets should be the same in all economies with full access to world financial markets  Limitations 1. Financial assets carry with them the possibility of default 2. Financial assets offered for sale in different countries are not necessarily perfect substitutes for one another Model of Canada – Small open economy (trading abroad, negligible effect on world prices anwith perfect capital mobilit(full access to world financial markets, r = r ) Chapter 13 Market For Loanable Funds – one market in financial system, all savers deposit savings, all borrowers get loans, one interest rate  S = I + NCO  Demand for LF  comes from domestic investment (I)  Supply for LF  comes from national saving (S)  In open economy – amount nation saves ≠ amount nation spends  Supply > Demand (amount nation saves > amount nation spends on domestic capital) o Amount leftover used to finance purchase of foreign assets  NCO > 0  Supply < Demand (amount nation saves < amount nation spends on domestic capital) o Savings of foreigners finance extra purchases  NCO < 0  Qs of LF and Qd of LF  depend on real interest rate o Eg/ Higher interest encourages saving (raises Qs) and makes borrowing more costly (decreases Qd)  Difference between supply and demand = NCO (at world interest rate) Market For Foreign-Currency Exchange – countries exchange currency in order to purchase G&S or financial assets from each other  S – I = NX  Real Exchange Rate – relative price of domestic and foreign good; key determinant of NX  Supply for FCEM  comes from NCO (obtained from supply for LF) o Eg/ Change in NCO (in market for LF) means person is buying/selling foreign assets  must supply dollars in order to exchange them for foreign currency to buy foreign asset  Demand for FCEM  comes from NX World Interest Rates 1. An increase in the world interest rate would 2. Cause the NCO to increase 3. The increase in NCO increases the Supply for FCEM 4. Which causes the real exchange rate to depreciate Government Budget Deficits and Surpluses 1. An increase in the governmentbudget deficit reduces national saving 2. Which reduces NCO 3. Decrease in NCO reduces the supply for FCEM 4. Causes the real exchange rate to appreciate Trade Polity – government policy that directly Trade Policy influences the quantity of G&S imported and exported Tariff – a tax on G produced abroad sold domestically Import Quota – limit on the quantity of a good produced abroad sold domestically 1. An import quota increases the demand for dollars 2. Causes the real exchange rate to appreciate 3. NCO and NX remain the same Appreciated dollar causes price of domestic G&S to increase, decreases NX offsets increase in NX due to import quota Does not affect country trade balance  affects firms Political Instability and Capital Flight Capital Flight – a large and sudden reduction in the demand for assets located in a country 1. Increase in perceived risk of holding Mexican assets increased the paid interest rate on Mexican assets by γ (risk premium) 2. To save the same amount as before, Mexican savers must also perceive the risk premium (supply of LF shifts up by γ – same Qs, higher interest rate) 3. 3. NCO rises 4. Increase in NCO increases supply of pesos 5. Causes pesos to depreciate Chapter 14 Economic Fluctuations – (SR) modeled by aggregate demand and aggregate supply curve Classical Economic Assumptions 1. Economic Fluctuations Are Irregular and Unpredictable 1. Classical Dichotomy 2. Money does not matter 2. Most Macroeconomic Quantities Fluctuate Together 3. As Output Falls, Unemployment Rises 3. Money is a veil Aggregate Demand Curve Downward Slope 1. Wealth Effect (Price Level and Consumption) – lower price level raises real value of money – stimulates spending * 2. Interest-Rate Effect (Price Level and Investment) – interest rate falls, stimulates demand for investment goods 3. Real-Exchange Effect (Price Level and Net Exports) – exchange rate depreciates, stimulates demand for NX Curve Shift 1. Changes in Consumption o Level of Taxation – less tax, more spending; more tax, more spending 2. Changes in Investment o Investment Tax Credit - a tax rebate tied to a firms investment spending ; increases quantity of investment goods that firms demand at a given interest rate (shifts demand curve right) 3. Change in Government Purchases 4. Change in NX o Sometimes changes due to movements in the exchange rate Aggregate Supply Curve – LR Vertical  Economy’s labour, capital, natural resources and technology determine the total Qs – Qs is the same, regardless of price level Curve Shift – any change in the economy that changes the Natural Rate of Output  Natural Rate of Output – the production of G&S that an economy achieves in the LR when unemployment is at its normal rate 1. Change in Labour 2. Change in Capital o Human or Physical Capital
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