Suppose the economy was in recession at point1. If you’re a Keynesian, you’re going to say that
because prices are sticky we could stay there for a very long time. So, you can get us to point 3
However, if you believe in rational expectations you’re going to say that you can’t actually steer
the economy to a point like point 3. You would need a tremendous amount of information that is
simply no available to us. You would have to know things like:
1) Exactly where y* lies.
2) Even if you did know where y* is, you would need to know how to get to a point like
point 2. Remember that underlying this model is a IS/LM model. In order to be able to
shift any of these curves you need to know parameters like sensitivity to the interest rate,
money supply, etc.
3) If you manage to get all of the information from above, now you need to take a micro
approach to the problem. Remember that individuals are out there trying to maximize
their utility subject to some constraint.
Lucas Critique: you’re under some sort of policy regime. Now suppose the policy changes.
When the policy changes, you will maximize your utility subject to this new constraint. So this
leads us to conclude that the Keynesian model is nothing more than a snapshot. Once you change
policy, people alter their behaviors and your model doesn’t tell you very much. So it isn’t very
certain that you’ll be able to reach point 2.
As policy makers, we are way over our heads. We have no legitimate way of knowing what our
policies will do to the economy. Policies have long and variable lags and there is no way of
knowing if people will change their behavior. But remember that people behave differently in different situations.
Canadian price of one USD (1/0.97)=1.03
Us price of one Canadian dollar = $0.97
Relatively speaking, the USD is worth more than the Canadian dollar.
Suppose the current CAD/USD exchange rate was equal to 1.03. If the exchange rate in this case
were to go to 1.05, then we have seen a depreciation of the CAD (since it takes more Canadian
dollars to buy one USD) and an appreciation of the USD (since it now takes less USD to buy one
unit of CAD ($0.85)).
It is always useful to keep in mind that the exchange rate is nothing more than a price. As a price,
there is a nominal exchange rate and a real exchange rate. Suppose we have two goods, good X
at price Pxand good Y at price P .yIn this case the . This is called the real
exchange rate because it tells us how many units of x we can trade for y, and vice versa.
If we want to know how exactly Canadian goods trade as a whole with American goods, we have
to consider the real exchange rate. This is why the real exchange rate is also called the terms of
Where S=Canadian price of one USD, Pf=American price level and
p=Canadian price level.
If were to go up, then American goods would become more expensive and we could expect
our exports to go up and our imports to go down.
What determines level of all nominal variables in the long run? The answer is the quantity theory
How does quantity theory of money play a role? The QTOM plays a role because there is some
level of foreign money stock that determines that foreign price level just as there is some
domestic level of money stock that determines the domestic price level. So now we have to
worry about what the foreign country is doing.
In the long run, the nominal money stock determines the exchange rate. 18/03/13
Purchasing Power Parity
PPP serves as a way to determine if your currency is undervalued or overvalued using the Big
For greater discussion on the subject look at the excel spreadsheet Dr. Atkins provided on
In previous discussion we said that Keynesian models give us a snapshot of what the economy
was at one point.
Classical propositions give us a view of how the economy is trending. These models are great in
a classroom setting but when we look out the window they don’t always work. The way classical
models explain trends is as follows: you get some shock that throws the economy in a certain
direction. Once you reach equilibrium, suppose you get yet another shock. Continue this for very
long time and we can conclude that the long run equilibrium proposed by classical models is
simply the summation of all these shocks that lead us to equilibrium. 20/03/13
Review of assignment 2
Once you go through the trivial derivation of the AS curve from the naïve Phillips curve, you
must answer the following:
(iii) A question of some importance in macroeconomics concerns the existence