Unit 10.4 Exchange rates and the public policies

No government or central bank intervention

In a free foreign exchange market, the balance of payments will automatically balance.

The credit side of the balance constitutes the demand for the currency: e.g. if foreigners buy another country’s exports, they demand that country’s currency in order to pay for them.

The debit side of the balance constitutes the supply of the currency: e.g. when the country’s residents buy foreign goods, the importers of them require foreign currency to pay for them. So they supply the country’s money in the FX markets. Thus credits on the balance of payments are equal to the debits.

With government or central bank intervention

The government or central bank may intervene in the foreign exchange market as they may be unwilling to let the country’s currency float freely.

The main reason for this is that frequent changes in the exchange rate cause uncertainty for businesses, which might reduce their trade and investment.

Reducing short-term fluctuations

Using reserves: Central Bank sells gold and foreign currencies from the reserves and buys national currency, which influences supply and demand.

Borrowing from abroad: The government gets a foreign currency loan and the Central Bank uses it to buy national currency, which again influences supply and demand.

Raising interest rates: Central Bank raises interest rates and people deposit money in the country, which influences supply and demand.

Maintaining a fixed rate of exchange over the long term.

Possible methods:

• Contractionary policies (fiscal and/or monetary policies);

• Supply-side policies;

• Controls on imports and/or foreign exchange dealing.

Contractionary policies

The government deliberately reduces aggregate demand by either fiscal policy or monetary policyor both.

Contractionary fiscal policy: to increase taxes and/or to decrease government spending

Contractionary monetary policy: to decrease the supply of money and to increase interest rates

A reduction in aggregate demand works in two ways:

• Level of consumer spending decreases → imports decrease → the supply of the national currency in FX market decrease.

• As a result, the rate of inflation decreases → domestic goods become more competitive abroad → the demand for national currency increases. Also imports decrease as consumers switch to the now more competitive home-produced goods → the supply of national currency in FX market decreases.

Supply-side policies

The government attempts to increase the long-term competitiveness of domestically produced goods by encouraging reductions in the costs of production and/or improvements in the quality of home-made goods.

Controls on imports and/or foreign exchange dealing

The government restricts the outflow of money, either by restricting people’s access to foreign exchange, or by the use of tariffs (customs duties) and quotas.

 

Key concepts

· The balance of payments shows spending flowing into and out of a country.

· The current account is an accounting statement that includes all spending flows across a nation’s border except those that represent purchases of assets. In our simplified analysis, the balance on current account equals net exports.

· A nation’s balance on capital account equals rest-of-world purchases of its assets during a period less its purchases of rest-of-world assets.

· Provided that the market for a nation’s currency is in equilibrium, the balance on current account equals the negative of the balance on capital account.

TESTS

Select the one that is best in each case

 

1. A country’s government runs a budget deficit when which of the following occurs in

a given year?

 

(A) The amount of new loans to developing nations exceeds the amount of loans paid off by developing nations.

(B) Government spending exceeds tax revenues.

(C) The debt owed to foreigners exceeds the debt owed to the country’s citizens.

(D) The amount borrowed exceeds the interest payment on the national debt.

(E) Interest payments on the national debt exceed spending on goods and services.

 

3. The transaction demand for money is very closely associated with money’s use as a

 

(A) store of value

(B) standard unit of account

(C) measure of value

(D) medium of exchange

(E) standard of deferred payment

 

4. Unlike a market economy, a command economy uses

 

(A) more centralized planning in economic decision making

(B) consumer sovereignty to make production decisions

(C) its resources more efficiently

(D) price signals in economic decision making

(E) the popular vote in making resource allocation decisions

 

5. The value of a country’s currency will tend to appreciate if

 

(A) demand for the country’s exports increases

(B) the country’s money supply increases

(C) the country’s citizens increase their travel abroad

(D) domestic interest rates decrease

(E) tariffs on the country’s imports decrease

 

6. Which of the following best illustrates an improvement in a country’s standard of living?

 

(A) An increase in real per capita gross domestic product

(B) An increase in nominal per capita gross domestic product

(C) Price stability

(D) A balanced budget

(E) An increase in the consumer price index

 

7. Hyperinflation is typically caused by

(A) high tax rates that discourage work effort

(B) continuous expansion of the money supply to finance government budget deficits

(C) trade surpluses that are caused by strong protectionist policies

(D) bad harvests that lead to widespread shortages

(E) a large decline in corporate profits that leads to a decrease in production

 

8. All of the following changes will shift the investment demand curve to the right EXCEPT

 

(A) a decrease in the corporate income tax rate

(B) an increase in the productivity of new capital goods

(C) an increase in the real interest rate

(D) an increase in corporate profits

(E) an increase in real gross domestic product

 

9. The official unemployment rate understates the unemployment level in the economy because the official unemployment rate

 

(A) ignores the duration of unemployment

(B) ignores underemployed and discouraged workers

(C) includes jobs created by the underground economy

(D) excludes all unemployed teenagers

(E) excludes frictionally unemployed workers

 

10. If a reduction in aggregate supply is followed by an increase in aggregate demand, which of the following will definitely occur?

(A) Output will increase.

(B) Output will decrease.

(C) Output will not change.

(D) The price level will increase.

(E) The price level will decrease.

 

11. Which of the following combinations of changes in government spending and taxes is necessarily expansionary?

 

Government SpendingTaxes

 

(A) Increase                 Increase

(B) Increase                 Decrease

(C) Decrease                Not change

(D) Decrease                Increase

(E) Decrease                Decrease

 

12. The amount of money that the public wants to hold in the form of cash will

 

(A) be unaffected by any change in interest rates or the price level

(B) increase if interest rates increase

(C) decrease if interest rates increase

(D) increase if the price level decreases

(E) decrease if the price level remains constant

 

13. For an economy consisting of households and businesses only, which of the following is consistent with the circular flow of income and production?

 

(A) Households are producers of goods and services and consumers of resources.

(B) Households are users of resources, and businesses are sources of saving.

(C) Households are suppliers of resources and consumers of goods and services.

(D) Businesses are users of taxes, and households are sources of taxes.

(E) Businesses are suppliers of resources and consumers of goods and services.

 

14. With an increase in the real interest rate, consumption and real gross domestic product will most likely change in which of the following ways?

 

Consumption               Real Gross Domestic Product

(A) Increase                Increase

(B) Increase                Decrease

(C) Decrease              Increase

(D) Decrease              Decrease

(E) No change            Increase

 

15. According to the short-run Phillips curve, lower inflation rates are associated with

 

(A) higher unemployment rates

(B) higher government spending

(C) larger budget deficits

(D) greater labor-force participation rates

(E) smaller labor-force participation rates

 

  16. Which of the following will lead to a decrease in a nation’s money supply?

 

(A) A decrease in income tax rates

(B) A decrease in the discount rate

(C) An open market purchase of government securities by the central bank

(D) An increase in reserve requirements

(E) An increase in government expenditures on goods and services

 

17. An increase in which of the following would cause the aggregate demand curve to shift to the left?

 

(A) Consumer optimism

(B) Population

(C) Cost of resources

(D) Income taxes

(E) Net exports

18. If all prices doubled, which of the following would be true?

(A) real income have halved

(B) the price index will double

(C) the proportion of income is unchanged

(D) nominal income have doubled

 

21. With an upward-sloping short-run aggregate supply curve, an increase in government expenditure will most likely

 

(A) reduce the price level

(B) reduce the level of nominal gross domestic product

(C) increase real gross domestic product

(D) shift the short-run aggregate supply curve to the right

(E) shift both the aggregate demand curve and the long-run aggregate supply curve to the left

 

23. In the short run, an expansionary monetary policy would most likely result in which of the following changes in the price level and real gross domestic product (GDP)?

Price Level             Real GDP

(A) Decrease         Increase

(B) No change                  Decrease

(C) Increase          No change

(D) Increase          Decrease

(E) Increase           Increase

 

25. Which of the following is likely to occur following the depreciation of the United States dollar?

 

(A) United States imports will increase.

(B) United States exports will increase.

(C) Demand for the United States dollar will decrease.

(D) United States demand for foreign currencies will increase.

(E) United States goods will become more expensive in foreign markets

 

27. Which of the following individuals is considered officially unemployed?

 

(A) Chris, who has not worked for more than three years and has given up looking for work

(B) Kim, who is going to school full-time and is waiting until graduation before looking for a job

(C) Pat, who recently left a job to look for a different job in another town

(D) Leslie, who retired after turning 65 only five months ago

(E) Lee, who is working 20 hours per week and is seeking full-time employment

28. An increase in net investment leads to faster economic growth because capital per worker and output per worker will change in which of the following ways?

 

Capital per WorkerOutput per Worker

(A) Increase          Increase

(B) Increase          Decrease

(C) No change                  Increase

(D) Decrease         Increase

(E) Decrease         Decrease

 

29. A commercial bank’s ability to create money depends on which of the following?

 

(A) The existence of a central bank

(B) A fractional reserve banking system

(C) Gold or silver reserves backing up the currency

(D) A large national debt

(E) The existence of both checking accounts and savings accounts

 

30. The consumer price index (CPI) is designed to measure changes in the

 

(A) spending patterns of urban consumers only

(B) spending patterns of all consumers

(C) wholesale price of manufactured goods

(D) prices of all goods and services produced in an economy

(E) cost of a select market basket of goods and services

31. In the short run, which of the following would occur to bond prices and interest rates if a central bank bought bonds through open-market operations?

 

Bond Prices          Interest Rates

(A) No change             Increase

(B) Increase                 Increase

(C) Increase                 Decrease

(D) Decrease                Increase

(E) Decrease                Decrease

32. The diagram above shows the production possibilities curve for an economy that produces only consumption and capital goods. All of the following statements about this economy are true EXCEPT:

 

(A) Producing at point Z results in the underutilization of resources.

(B) The combination represented by point Y is unattainable, given the scarcity of resources.

(C) Resources are fully utilized at points W and X.

(D) Producing at point X will result in greater economic growth than will producing at point W.

(E) Point X represents the most efficient combination of the two goods that can be produced by this economy.

33. The shifting of a country’s production possibilities curve to the right will most likely cause

 

(A) net exports to decline

(B) inflation to increase

(C) the aggregate demand curve to shift to the left

(D) the long-run aggregate supply curve to shift to the left

(E) the long-run aggregate supply curve to shift to the right

 

34. An increase in which of the following would LEAST likely increase labor productivity?

 

(A) Physical capital

(B) Human capital

(C) Technological improvements

(D) Educational achievement

(E) The labor force

 

35. In the narrowest definition of money, M1, savings accounts are excluded because they are

 

(A) not a medium of exchange

(B) not insured by federal deposit insurance

(C) available from financial institutions other than banks

(D) a store of purchasing power

(E) interest-paying accounts

Key concepts

A healthy economy: This is when annual output of goods and services grows at a rate that it can sustain which includes having stable price level and low unemployment rate.

GDP is the total value of all final goods and services produced in the country during a particular year or period.

Double counting: A faulty practice in economics of counting the value of a nation’s goods more than once.

Nominal GDP is the value of goods and services for a particular period, valued in terms of prices for that period.

Business cycle is a fluctuation in economic activity that an economy experiences over a period of time. It has four phases.

1) Expansion - the period when the economy is growing. It is between the trough and the peak.

2) Peak - Is the 2^nd phase. The period when the expansion transitions into the contraction phase.

3) Contraction - It starts at the peak and ends at the trough.

4) Trough - the 4^th phase where the economy transitions from the contraction phase to the expansion phase. It is when the economy hits bottom.

Inflation: An increase in average level of prices (prices increase during inflation)

Deflation: A decrease in average level of prices (prices decrease during deflation)

Fixed income: An income (salary/wage) that is pre-determined through contractual agreements and does not change with economic conditions.

Indexed payments: Salaries/wages that have been adjusted to changes in the economy or price levels e.g. social security payments and pensions.

Hyperinflation: Hyperinflation is described as an inflation rate in excess of 200% per year

Price Index: It is a number whose movement reflects changes in the average level of prices e.g. if price index increases by 10% it means the average level of price has increased by 10%.

Price index = the ratio of current cost of the basket to the base-period cost.

Laspeyres Index

Paasche index (Deflator)

Consumer Price Index (CPI): Is a price index whose movements reflect changes in price of goods and services purchased by consumers. It is used to determine whether people are keeping up the costs of the things they buy. It measures changes in the cost of living.

Implicit Price Deflector: is a price index for all final goods and services produced. It is the ratio of nominal GDP to the Real GDP

Market Basket: It includes all final goods and services produced during that period.

Price consumption expenditure (PCE): An index that includes durable, non-durable goods and services.

Rate of inflation/deflation: it is the rate of change in the price index between two periods.

Rate of inflation = percentage change in index divided by initial value of index

Unemployment: unemployment can be defined as a person that us not working but is capable and looking for work.

Labour force: It is the total number of people working age who are willing and able to work.

Unemployment rate – a number of unemployed people divided by the total labour force.

· Frictional Unemployment: Frictional unemployment occurs because information about the labor market is costly; it takes time for firms seeking workers and workers seeking firms to find each other.

· Structural unemployment: Structural unemployment occurs when there is a mismatch between the skills offered by potential workers and the skills sought by firms.

· Both frictional and structural unemployment occur even if employment and the unemployment rate are at their natural levels.

· Cyclical unemployment: An economy can be operating below or above its natural level of employment. Cyclical unemployment is unemployment in excess of the unemployment that exists at the natural level of employment. The part of unemployment that is cyclical unemployment grows during recessions.

Components of GDP are personal consumption (C), gross private domestic investment (I), government purchases (G), and net exports (X n). GDP = C + I + G + Xn

GDP=consumption (C)+private investment (I)+government purchases (G)+net exports (Xn)

Personal consumption is a flow variable that measures the value of goods and services purchased by households during a time period. Purchases by households of groceries, health-care services, clothing, and automobiles—all are counted as consumption. Personal consumption represents a demand for goods and services placed on firms by households.

Gross private domestic investment is the value of all goods produced during a period for use in the production of other goods and services. It includes three flows that add to or maintain the nation’s capital stock: expenditures by business firms on new buildings, plants, tools, equipment, and software that will be used in the production of goods and services; expenditures on new residential housing; and changes in business inventories.

Private investment constitutes a demand placed on firms by other firms. It also generates factor incomes for households. To simplify the diagram, only the spending flows are shown—the corresponding flows of goods and services have been omitted.

Government purchases are the sum of purchases of goods and services from firms by government agencies plus the total value of output produced by government agencies themselves during a time period. Purchases of goods and services by government agencies create demands on firms. As firms produce these goods and services, they create factor incomes for households.

Net exports (Xn) = Exports (X) − imports (M)

The value of an economy’s output in any period can be estimated in either of 2 ways. The values of final goods and services produced can be added directly, or the values added at each stage in the production process can be added.

Gross national product (GNP) is the total value of final goods and services produced during a particular period with factors of production owned by the residents of a particular country.

GNP = GDP + net income received from abroad by residents of a nation

GDI (Gross domestic income) = the total income generated in an economy by the production of final goods and services during a particular period. Because an economy’s total output equals the total income generated in producing that output, GDP = GDI. We can estimate GDP either by measuring total output or by measuring total income.

Components of GDI

GDI = Employee compensation + profit + rent + net interest + depreciation + indirect taxes

Employee compensation is the largest among the components of factor income. Factor income also includes profit, rent, and interest. In addition, GDI includes charges for depreciation and taxes associated with production. Depreciation and production-related taxes, such as sales taxes, make up part of the cost of producing goods and services and must be accounted for in estimating GDI.

Profits - the profit component of income earned by households Profit = TR – Costs as measured by conventional accounting. Profits are the reward the owners of firms receive for being in business.

Rental Income, such as the income earned by owners of rental housing or payments for the rent of natural resources, is the smallest of the income flows to households.

Net Interest Businesses both receive and pay interest. GDI includes net interest = interest paid – interest received by domestic businesses, + interest received from foreigners (–) interest paid to foreigners. Interest payments on mortgage and home improvement loans are counted as interest paid by business, because homeowners are treated as businesses in the income accounts.

Depreciation is a measure of the amount of capital that wears out or becomes obsolete during a period. Depreciation is referred to in official reports as the consumption of fixed capital.

Indirect Taxes are taxes imposed on the production or sale of goods and services or on other business activity.

Changes in aggregate demand are changes in response to a change in any of its components. An increase in the total quantity of consumer goods and services demanded at every price level, for example, would shift the aggregate demand curve to the right.

Consumption One determinant of consumption is consumer confidence. If consumers expect good economic conditions and are optimistic about their economic prospects, they are more likely to buy.

Investment. If firms expect their sales to go up, they are likely to increase their investment so that they can increase production and meet consumer demand. Such an increase in investment raises the aggregate quantity of goods and services demanded at each price level; it increases aggregate demand.

Government Purchases An increase in government purchases increases aggregate demand; a decrease in government purchases decreases aggregate demand.

A multiplier is the ratio of the change in the quantity of real GDP demanded at each price level to the initial change in one or more components of aggregate demand that produced it:

Multiplier = Δ (real GDP demanded at each price level) / initial Δ (component of AD)

The short run in macroeconomics is a period in which wages and some other prices are sticky.

The long run is a period in which full wage and price flexibility, and market adjustment, has been achieved, so that the economy is at the natural level of employment and potential output.

A long-run aggregate supply curve is a vertical line at the potential level of output. The intersection of the economy’s aggregate demand and long-run aggregate supply curves determines its equilibrium real GDP and price level in the long run.

A short-run aggregate supply curve is an upward-sloping curve that shows the quantity of total output that will be produced at each price level in the short run. Wage and price stickiness account for the short run aggregate supply curve’s upward slope.

A recessionary gap is a term routed in macroeconomic theory that summarizes the situation where an economy is operating at below its full-employment equilibrium. Under this condition, the level of real GDP is currently lower than it is at full employment, which puts downward pressure on prices in the long run.

An inflationary gap is a macroeconomic concept that describes the difference between the current level of real gross domestic product (GDP) and the anticipated GDP that would be experienced when an economy is at full employment, also referred to as the potential GDP. For the gap to be considered inflationary, the current real GDP must be the higher of the two metrics.

A nonintervention policy is a policy choice to take no action to try to close a recessionary or an inflationary gap, but to allow the economy to adjust to its potential output on its own.

Stabilization policy is a policy in which the government or central bank take measures to move the economy to its potential output.

Economic Growth A long-run process that occurs as an economy’s potential output increases. The process through which an economy achieves an outward shift in its production possibilities curve.

Potential Output can be described as what an economy can produce when all its resources such as workforce, equipment, technology, natural resources and others are fully utilized

Nominal GDP is GDP evaluated at current market prices. Therefore, nominal GDP will include all of the changes in market prices that have occurred during the current year due to inflation or deflation.

Aggregate Supply is the total national output of goods and services. When aggregate supply increases, spending in the economy will also increase.

Aggregate demand is the relationship between the total quantity of goods and services demanded (from all the four sources of demand) and the price level, all other determinants of spending unchanged. The aggregate quantity of goods and services demanded is measured as real GDP. It is also the total amount of spending in the economy (by consumers, by government, or by firms). If aggregate demand is high, aggregate supply will increase.

Recessionary Gaps occur when the economy is operating at below its full-employment equilibrium. Under this condition, the level of GDP is currently lower than it is at full employment, which puts downward pressure on prices in the long run.

Inflation is the rate at which the general level of prices for goods and services is rising and, consequently, the purchasing power of currency is falling.

Inflationary Gap occurs when the demand for goods and services exceeds production due to factors such as higher levels of overall employment, increased trade activities or increased government expenditure. This can lead to the real GDP exceeding the potential GDP.

Per capita GDP is a measure of the total output of a country that takes gross domestic product (GDP) and divides it by the number of people in the country. The per capita GDP is especially useful when comparing one country to another, because it shows the relative performance of the countries.

Per Capita Output equals real GDP per person. If we let N equal population, then Output per capita = real GDP/N

Long Run Aggregate Supply Economic growth means the economy’s potential output is rising. Because the long-run aggregate supply curve is a vertical line at the economy’s potential, we can depict the process of economic growth as one in which the long-run aggregate supply curve shifts to the right.

Money: Money is anything that serves as a medium of exchange. By definition, it is a medium of exchange. It also serves as a unit of account and as a store of value.

A Medium of Exchange: A medium of exchange is anything that is widely accepted as a means of payment. is an intermediary instrument used to facilitate the sale, purchase or trade of goods between parties, for an instrument to function as a medium of exchange, it must represent a standard of value accepted by all parties. In modern economies, the medium of exchange is currency.

A Unit of Account: Money serves as a unit of account, which is a consistent means of measuring the value of things. We use money in this fashion because it is also a medium of exchange. in economics is a nominal monetary unit of measure or currency used to represent the real value (or cost) of any economic item; i.e. goods, services, assets, liabilities, income, expenses.

A Store of Value: The third function of money is to serve as a store of value, that is, an item that holds value over time. So, it is the function of an asset that can be saved, retrieved and exchanged at a later time, and be predictably useful when retrieved. The most common store of value in modern times has been money, currency, or a commodity like a precious metal or financial capital.

Commodity money: is money that has value apart from its use as money. Gold and silver are the most widely used forms of commodity money.

Fiat money: is money that some authority, generally a government, has ordered to be accepted as a medium of exchange. The currency — paper money and coins — used in the United States today is fiat money; it has no value other than its use as money. You will notice that statement printed on each bill: “This note is legal tender for all debts, public and private.”

Checkable deposits: which are balances in checking accounts, and traveler’s checks are other forms of money that have no intrinsic value. They can be converted to currency, but generally they are not; they simply serve as a medium of exchange. If you want to buy something, you can often pay with a check or a debit card. A check is a written order to a bank to transfer ownership of a checkable deposit. A debit card is the electronic equivalent of a check.

Money supply: The total quantity of money in the economy at any one time. Economists measure the money supply because it affects economic activity.

M1: M1 is the narrowest of the Fed’s money supply definitions. It includes currency in circulation, checkable deposits, and traveler’s check. The assets in M1 may be regarded as perfectly liquid; the assets in M2 are highly liquid, but somewhat less liquid than the assets in M1. So, it is currency in circulation + over high deposit.

M2: M2 is a broader measure of the money supply than M1. It includes M1 and other deposits such as small savings accounts (less than $100,000), as well as accounts such as money market mutual funds (MMMFs) that place limits on the number or the amounts of the checks that can be written in a certain period. So, it is M1 + deposit with agreed maturity up to 2 years + deposit.

M3: M1 +M2 +repurchase agreement + Money Market Fund (MMF)+ debts securities up to 2 years.         

A balance sheet: is a financial statement that summarizes a company's assets, liabilities and shareholders' equity at a specific point in time. These three balance sheet segments give investors an idea as to what the company owns and owes, as well as the amount invested by shareholders.

An asset: is a resource with economic value that an individual, corporation or country owns or controls with the expectation that it will provide future benefit. Assets are reported on a company's balance sheet, and they are bought or created to increase the value of a firm or benefit the firm's operations.

A Liability: is a company's financial debt or obligations that arise during its business operations. Liabilities are settled over time through the transfer of economic benefits including money, goods or services. Recorded on the right side of the balance sheet, liabilities include loans, accounts payable, mortgages, deferred revenues and accrued expenses.

A reserve requirement: is expressed as a required reserve ratio (rrr); it specifies the ratio of reserves to checkable deposits a bank must maintain.

The bank is loaned up: It is when a bank’s excess reserves equal zero.

A deposit multiplier: Also referred to as a deposit expansion multiplier, is a function used to describe the amount of money a bank creates in additional money supply through the process of lending the available capital it has in excess of the bank’s reserve requirement. It equals the ratio of the maximum possible change in checkable deposits (ΔD) to the change in reserves (ΔR). In our example, the deposit multiplier was 10:

Md = ΔD / ΔR = $10,000 / $1,000 = 10

Reserves: To see how the deposit multiplier md is related to the required reserve ratio, we use the fact that if banks in the economy are loaned up, then reserves, R, equal the required reserve ratio (rrr) times checkable deposits, D:                    R = rrr D

A change in reserves: It produces a change in loans and a change in checkable deposits. Once banks are fully loaned up, the change in reserves, ΔR, will equal the required reserve ratio times the change in deposits, ΔD:

ΔR=rrr ΔD. Solving for ΔD, we have: 1/rrr ΔR = ΔD

Dividing both sides by ΔR, we see that the deposit multiplier, md, is 1/rrr: 1/rrr=ΔD ΔR=md

A central bank performs five functions:

(1) it acts as a banker to the central government,

(2) it acts as a banker to banks,

(3) it acts as a regulator of banks,

(4) it conducts monetary policy,

(5) it supports the stability of the financial system.

A discount rate: Ii is the interest rate charged by the CB when it lends reserves to banks.

Open market operations (OMO): refers to the buying and selling of government securities in the open market in order to expand or contract the amount of money in the banking system, facilitated by the Federal Reserve (Fed).

A bond is a debt investment in which an investor loans money to an entity (typically corporate or governmental) which borrows the funds for a defined period at a variable or fixed interest rate.

Face value is the amount the issuer will have to pay on the maturity date of the bond.

The interest rate on any bond is determined by its price. As the price falls, the interest rate rises.

Foreign Exchange market is a market in which currencies of different countries are traded for one another.

A country’s exchange rate is the price of its currency in terms of another currency or currencies.

The demand for money People hold money in order to buy goods and services (transactions demand), to have it available for contingencies на случай непредвиденных обстоятельств (precautionary demand), and in order to avoid possible drops in the value of other assets such as bonds (speculative demand).

The Supply of Money. T he quantity of money supplied in the economy is determined as a fixed multiple of the quantity of bank reserves, which is determined by the CB. The supply curve of money is a vertical line at that quantity.

Equilibrium in the Market for Money. The market for money is in equilibrium if the quantity of money demanded is equal to the quantity of money supplied.

Monetary policy refers to the actions the CB takes in pursuit of price stability, maximum employment and moderate long-term interest rates.

Contractionary monetary policy is a macroeconomic tool used to slow down an economy.

1) reduce the monetary supply by selling bonds thus withdrawing money from circulation

2) this raises interest rates and reduces investment and increases exchange rate, which reduces exports and increases imports

3) AD shifts to the left

A time lag i s a delay between an economic action and a consequence. An impact of time lags is that the effect of policy may be more difficult to quantify because it takes a period of time to actually occur.

Velocity is the number of times the money supply is spent to obtain the goods and services that make up GDP during a particular time period.

Government Purchases includes all purchases by government agencies of goods and services produced by firms, as well as direct production by government agencies themselves.

Transfer Payment is the provision of aid or money to an individual who is not required to provide anything in exchange. Social Security and welfare benefits are examples of transfer payments.

Taxes affect the relationship between real GDP and personal disposable income; they therefore affect consumption. They also influence investment decisions.

The government’s budget balance is the difference between the government’s revenues and its expenditures. A budget surplus occurs if government revenues exceed expenditures. A budget deficit occurs if government expenditures exceed revenues. The minus sign is often omitted when reporting a deficit. If the budget surplus equals zero, we say the government has a balanced budget.

Fiscal policy is the use of government expenditures and taxes to influence the level of economic activity—is the government counterpart to monetary policy. Like monetary policy, it can be used in an effort to close a recessionary or an inflationary gap.

Automatic Stabilizers is any government program that tends to reduce fluctuations in GDP automatically. Automatic stabilizers tend to increase GDP when it is falling and reduce GDP when it is rising. Changes in expenditures and taxes that occur through automatic stabilizers do not shift the aggregate demand curve. Because they are automatic, their operation is already incorporated in the curve itself.

An expansionary fiscal policy might consist of an increase in government purchases or transfer payments, a reduction in taxes, or a combination of these tools to shift the aggregate demand curve to the right.

A contractionary fiscal policy might involve a reduction in government purchases or transfer payments, an increase in taxes, or a mix of all three to shift the aggregate demand curve to the left.

Changes in government purchases One policy through which the government could seek to shift the aggregate demand curve is a change in government purchases.

A change in investment affects the aggregate demand curve in precisely the same manner as a change in government purchases. It shifts the aggregate demand curve by an amount equal to the initial change in investment times the multiplier.

Income taxes affect the consumption component of aggregate demand. An increase in income taxes reduces disposable personal income and thus reduces consumption.

Changes in transfer payments, like changes in income taxes, alter the disposable personal income of households and thus affect their consumption, which is a component of aggregate demand.

A recognition lag It takes some time for policy makers to realize that a recessionary or an inflationary gap exists.Recognition lags stem largely from the difficulty of collecting economic data in a timely and accurate fashion.

An implementation lag More time elapses before a fiscal policy, such as a change in government purchases or a change in taxes, is agreed to and put into effect. Changes in fiscal policy are likely to involve a particularly long implementation lag.

An impact lag Time goes by before the policy has its full effect on aggregate demand.

Crowding out is a tendency for an expansionary fiscal policy to reduce other components of aggregate demand. In the short run, this policy leads to an increase in real GDP to Y2 and a higher price level, P2. Crowding out reduces the effectiveness of any expansionary fiscal policy.

Crowding in occurs with a contractionary fiscal policy. A cut in government purchases or transfer payments, or an increase in taxes reduces the deficit (or increases the surplus) and thus reduces government borrowing, shifting the supply curve for bonds to the left. Both crowding out and crowding in clearly weaken the impact of fiscal policy.

Supply-side economics stresses the use of fiscal policy to stimulate economic growth. Advocates of supply-side economics generally favor tax cuts to stimulate companies’ economic activity.

A country’s balance of payments account is a record of all the flows of money between residents of that country and the rest of the world.

The current account records payments for imports and exports of goods and ser­vices, plus incomes flowing into and out of the country, plus net transfers of money into and out of the country. It is normally divided into four subdivisions: the trade in goods account; the trade in services account; income flows, and current transfers of money.

The capital account records the flows of funds, into the country (credits) and out of the country (debits), associated with the acquisition or disposal of fixed assets (for example, land), the transfer of funds by migrants, and the payment of grants by the govern­ment for overseas projects and the receipt from international sources for capital projects

References

Rittengerg, L. & Tregarthen, T. Principles of economics, Flat World Knowledge, L.L.C., 2009.

Begg D., Vernasca G., Fischer S., Dornbusch R. Economics, 11^th ed. – McGraw-Hill Education, 2014. – 1197 p.