2. Mr. Leader: AP Macroeconomics

3. Topics and percentages 8-12% Basic Economic Concepts 12-16% Measurement of Economic Performance 10-15% National Income and Price Determination 15-20% Financial Sector 20-30% Inflation, Unemployment, and Stabilization Policies 5-10% Economic Growth and Productivity 10-15% Open Economy: International Trade and Finance

4. 8-12% Basic Economic Concepts A. Scarcity, choice, and opportunity costs B. Production possibilities curve C. Comparative advantage, absolute advantage, specialization, and exchange D. Demand, supply, and market equilibrium E. Macroeconomic issues: business cycle, unemployment, inflation, growth

5. Production Possibilities Assumptions: Full Employment Fixed Resources and Technology Movements Along curve shows opportunity cost Outward shift illustrates economic growth Inward shift indicates destruction of resources Producing Capital Goods will lead to greater economic growth than producing consumer goods.

6. Production Possibilities Graph Capital Goods Consumer Goods A B C D E Points A,B,C, are efficient pts. Point D is underutilization Point E is economic growth May Lead to most Future growth May Lead to most Future economic growth F.E.F.E.1

7. Supply and Demand Factors Demand Changes when: Income changes Related Products, complements and substitutes, (price or quality change) Expectations (future price change) Consumers (more or less added) Tastes, Fads, Preferences change

8. Demand Increase: As Demand Increases, Price and Quantity Increase as well. P1 P2 Q1Q2 S1 D1 D2 Price Quantity

9. Demand Decrease: As Demand Decreases, Price and Quantity decrease as well D1 D2 S1 P1 P2 Q1Q2 Price Quantity

10. Supply Factors Supply Changes When: Input prices change (resources and wages) Government (tariffs, quotas, and subsidies) Number of sellers change Expectations (about price and product profitability change) Disasters (weather, strikes, etc..)

11. Supply Increase: As Supply Increases, Quantity Increases, but Price Falls. Price Quantity Q1 Q2 P1 P2 S1 S2 D1

12. Supply Decrease: As Supply Decreases, Quantity Decreases, but Price Increases. Price Quantity S1 S2 D1 P1 P2 Q1Q2

13. Comparative Advantage A nation should specialize in producing goods in which it has a comparative advantage: ability to produce the good at a lower opportunity cost. Example: CheeseWine Spain:2 pounds2 Cases France2 pounds6 Cases Spain should produce cheese (1C = 1W) France should produce wine (1W = 1/3C) :

14. Currency Terms AppreciationAppreciation: Currency is increasing in demand (stronger dollar) U.S. Currency will appreciate when more foreigners: travel to the U.S., buy more U.S. goods or services, or buy the U.S. dollar to invest in bonds

15. Currency Terms DepreciationDepreciation: Currency is decreasing in demand (weaker dollar) Being SUPPLIED in exchange for other currency. U.S. Currency will depreciate when fewer foreigners: travel to the U.S., buy fewer U.S. goods or services, or sell the U.S. dollar to invest in their own bonds

16. 15 Business Cycles The increases and decreases in Real GDP consisting of four phases: Peak: highest point of Real GDP Recession: Real GDP declining for 6 months Trough: lowest point of Real GDP Recovery: Real GDP increasing (trough to peak)

17. 16 Business Cycle Peak -- Greatest spending and lowest unemployment. Inflation becomes a problem. Contraction/Recession -- Reduction of spending levels and increasing unemployment. Some cyclical unemployment begins. Trough -- Least spending and highest unemployment Expansion -- Spending increases and unemployment decreases We want to avoid extreme inflation and extreme unemployment. We want stability! Full Employment

18. 17 The two big problems… The two big problems that plague the economy are:INFLATIONUNEMPLOYMENT People generally prefer steady, stable growth to large “ups” and “downs.” Therefore, government policies, both fiscal and monetary (see later sections), are aimed at flattening the business cycle. The government wants not only to stimulate the economy when it’s slow, but also to slow it down when it’s growing too quickly.

19. 18 12-16% Measurement of Economic Performance A. National income accounts 1. Circular flow 2. Gross domestic product 3. Components of gross domestic product 4. Real versus nominal gross domestic product B. Inflation measurement and adjustment 1. Price indices 2. Nominal and real values 3. Costs of inflation C. Unemployment 1. Definition and measurement 2. Types of unemployment 3. Natural rate of unemployment

20. Circular Flow of Economic Activity Households supply resources (land, labor, capital, entrepreneurial ability) to the resource market. Households demand goods and services from businesses. Businesses demand household resources and supply goods and services to the product (factor) market.

21. 20

22. GDP (Gross Domestic Product): The total dollar (market) value of all final goods and services produced in a given year. Expenditure Formula: Consumption (C) + Business Investment (I) + Government Spending (G) + Net Exports (Xn) Gross Domestic Product

23. GDP: What Counts: Goods Produced but not Sold (I) Goods produced by a foreign country (Japan) in the U.S. (Honda, Toyota) Government spending on the military Increase in business inventories

24. GDP: What DOES NOT count: Intermediate Goods (Tires sold by Firestone to Ford) Used Goods Non-Market Activities (Illegal, Underground) Transfer Payments (Social Security) Stock Transactions

25. Shortcomings of GDP: Leading to GDP being understated. Nonmarket activities: (services of homemakers) does not count. Leisure: Does not include the value of leisure. Does not include improvements in product quality. Underground economy

26. Real GDP Real GDP= Nominal GDP adjusted for inflation. Calculation: Real GDP = Nominal GDP Price Index in Hundredths( deflator) Example: U.S. 2005 Real GDP= $12,4558 (billions) 1.1274 (based on 2000) $11.048 Trillion

27. Real GDP Per Capita Most commonly used to compare and measure each country’s standard of living and overall economic growth. Real GDP/Nation’s Population

28. 27 Inflation Rise in the general level of prices Reduces the purchasing power of money Measured with the Consumer Price Index (CPI) Reports the price of a market basket, more than 300 goods that are typically purchased by an urban household

29. Calculating Inflation CPI in Recent Year – CPI in Past Year Divided by CPI in Past Year (Number then Multiplied by 100) Example: 2002 CPI = 179.9 2001 CPI = 177.1 Rate of Inflation: 179.9-177.1 = 1.58% 177.1

30. Types of Inflation Demand Pull InflationDemand Pull Inflation: ‘too much money chasing too few goods.” AD Curve will shift to the right, resulting in a higher Price Level and greater Output (until reaching Y* Cost-Push InflationCost-Push Inflation: Major cause is a supply shock- OPEC cutting back on oil production AS Curve will shift to the left resulting in a higher Price Level and a decrease in Real GDP.

31. Inflation Winners Losers Inflation: Winners & Losers WinnersWinners: Debtors who borrow money that will be repaid with “cheap” dollars. Those who have anticipated inflation LosersLosers: Savers (especially savings accounts) Creditors (Banks will be repaid with those “cheap” dollars Fixed-Income Recipients (retirees receiving the same monthly pension)

32. 31 Unemployment Calculation: Number of Unemployed Labor Force (Multiplied by 100 to put as a %) The Labor Force is the total of employed and unemployed workers. U.S. unemployment should be about 5%

33. Employed You are considered to be employed if: You work for 1 hour as a paid employee (so part- time workers count) You are temporarily absent from work (illness, strike, vacation) You work 15 hours or more as an unpaid worker (family farms are common)

34. Unemployed Must be looking for work (at least 1 attempt in the past 4 weeks) Are reporting to a job within 30 days Are temporarily laid off from their job

35. Not In Labor Force A person who is not looking for work: Full-time students Stay at home parents Discouraged workersDiscouraged workers: those who have given up hope of finding a job. Retirees

36. 35 Unemployment 100% of the people will never be employed, so the government considers 4-6% unemployment to be “full employment.” Types of Unemployment Frictional - temporary and unavoidable Structural - results from changes in technology or a business restructure (ex. Merger) Seasonal- occurs when industries slow or shut down for a season Cyclical - results from a decline in the business cycle. We can never be at Full Employment if there is any percentage cyclically unemployed.

37. 36 10-15% National Income and Price Determination A. Aggregate demand 1. Determinants of aggregate demand 2. Multiplier and crowding-out effects B. Aggregate supply 1. Short-run and long-run analyses 2. Sticky versus flexible wages and prices 3. Determinants of aggregate supply C. Macroeconomic equilibrium 1. Real output and price level 2. Short and long run 3. Actual versus full-employment output 4. Economic fluctuations

38. Aggregate Demand AD (C + I + G + X) Price Level Real GDP Downward sloping: 1.Real-Balances Effect: change in purchasing power 2. Interest-Rate Effect: Higher interest rates curtail spending 3.Foreign Purchase Effect: Substitute foreign products for U.S. products

39. Aggregate Demand Determinants of AD: C + I + G + Xn (Yes, its GDP) An increase in any of these, due to lower interest rates or optimism will increase AD and shift the curve to the right. A decrease in any of these: more debt, less spending, tax increase, will cause a decrease in AD and shift the curve to the left

40. Aggregate Demand Determinants Consumption Wealth Expectations Debt Taxes Investment Interest Rates Expected Returns Technology Inventories Taxes Government Change in Gov. spending Net Exports National Income Abroad Exchange Rates

41. Aggregate Supply Factors: R: resource prices (The CELL/ wages and materials, as well as OIL) E: environment [legal-institutional] (Taxes, Subsidies, more regulation) P: productivity (better technology)

42. Aggregate Supply Short Run: Is Upward sloping as businesses will increase output to maximize profits Generally considered to be a year or less. Long Run: Curve is vertical because the economy is at its full- employment output. As prices go up, wages have adjusted so there is no incentive to increase production. Generally considered to be longer than a year.

43. Another look as AS PL RGDP PL Y* LRAS SRAS AD Changes that lead to a new equilibrium on the left of LRAS = Recession Changes that lead to a new equilibrium on the right of LRAS = Inflation (AKA “an overheated economy”)

44. NOTE!! For the AP exam, assume that there are only two determinants that simultaneously affect BOTH short term aggregate supply and aggregate demand business tax changes and foreign currency changes. A change in business taxes shifts AD and AS in the same direction A change in FX sends both curves in the opposite directions.

45. 44 Demand-Pull Inflation Cost-Push Inflation Demand-Pull Inflation vs. Cost-Push Inflation

46. 45 DEMAND-PULL INFLATION o P1P1 AS 1 AS LR AD 1 a Q1Q1 Price Level Real domestic output b P2P2 P3P3 AD 2 AS 2 c

47. 46 Q2Q2 COST-PUSH INFLATION o P1P1 AS 1 AS LR AD 1 a Q1Q1 Price Level Real domestic output b P2P2 AS 2 Occurs when short-run AS shifts left

48. 47 Q2Q2 COST-PUSH INFLATION o P1P1 AS 1 AS LR AD 1 a Q1Q1 Price Level Real domestic output b P2P2 P3P3 AD 2 AS 2 Government response with increased AD c Even higher price levels

49. 48 COST-PUSH INFLATION o P1P1 AS 1 AS LR AD 1 a Q1Q1 Price Level Real domestic output b P2P2 AS 2 If government allows a recession to occur Q2Q2

50. 49 Q2Q2 COST-PUSH INFLATION o P1P1 AS 1 AS LR AD 1 a Q1Q1 Price Level Real domestic output b P2P2 AS 2 If government allows a recession to occur Nominal wages fall & AS returns to its original location

51. 50 15-20% Financial Sector (Money and Banking) A. Money, banking, and financial markets 1. Definition of financial assets: money, stocks, bonds 2. Time value of money (present and future value) 3. Measures of money supply 4. Banks and creation of money 5. Money demand 6. Money market 7. Loanable funds market B. Central bank and control of the money supply 1. Tools of central bank policy 2. Quantity theory of money 3. Real versus nominal interest rates

52. 51 Money Supply Terms M1= Checkable Deposits and Currency M2= M1 + Savings deposits, money market accounts, small time deposits (less than $100,000) Velocity of Money Equation: MV = PQ ( GDP) (M= Money Supply and V = Velocity (number of times per year the average dollar is spent on goods and services.

53. 52 Banks and Balance Sheets AssetsLiabilities Reserves$15,000Checkable Deposits$100,000 Securities$15,000 Loans$70,000 If the current reserve requirement is 10%: 1. What is the amount of new loans this bank can generate? Answer: $100,000 Checkable deposits X a 10% reserve requirement = $10,000 required reserves. If the bank has $15,000 in reserves, $5,000 of those are excess reserves and can be loaned out. 2. How much in new loans can be generated by the entire banking system? Answer: Money Multiplier = 1/Required Reserve Ratio=1/.10 10 X $5,000 = $50,000

54. 53 FED and the Money Market MS1 MS2 MD Nominal Interest Rate Quantity of Money nir1 nir2 Q1 Q2 Vertical curve-Supply controlled By the FED. An increase in MS leads to a rightward shift and lower nominal interest rates.

55. Loanable Funds Market and Expansionary Fiscal Policy Used for FISCAL POLICY (Government spending- Deficit Spending) Quantity of Funds Real Interest Rate DLF1 DLF2 An increase in Gov. spending increases the demand for loanable funds and raises real interest rates R1 R2 Q1 Q2 SLF

56. Loanable Funds Market and Contractionary Fiscal Policy Used for FISCAL POLICY (Government spending-Deficit Spending) Quantity of Funds Real Interest Rate DLF2 DLF1 A decrease in Gov. spending decreases the demand for loanable funds and lowers real interest rates R2 R1 Q2 Q1 SLF

57. 56 Nominal: with Inflation Real: without Inflation

58. 57 GDP Nominal GDP: GDP measured in terms of current Price Level at the time of measurement. (Unadjusted for inflation) Real GDP: GDP adjusted for inflation; GDP in a year divided by a GDP deflator (Price Index) for that year

59. 58 INCOME NOMINAL INCOME: number of dollars received by an individual or group for its resources during some period of time REAL INCOME: amount of goods and services which can be purchased with nominal income during some period of time; nominal income adjusted for inflation

60. 59 INTEREST RATE ( I %) NOMINAL I %: interest rate expressed in terms of annual amounts currently charged for interest; not adjusted for inflation REAL I %: interest rate expressed in dollars of constant value (adjusted for Inflation) and equal to the NOMINAL I % minus the EXPECTED RATE OF INFLATION

61. 60 WAGES NOMINAL WAGES: amount of money received by a worker per unit of time (hour, day, etc.); Money Wage REAL WAGES: amount of goods and sevices a worker can purchase with their NOMINAL WAGE; purchasing power of the nominal wage. (Real = Nominal – Inflation rate)

62. 61 NOMINAL NOMINAL/REAL TIPs If nominal rates INCREASE and Price Level INCREASE, the CHANGE in Real is “indeterminable.” If nominal Wage rates do NOT change and Price Level fall. REAL WAGES increase. NOMINAL RATES “PIGGY-BACK” REAL RATES & NOT VICE VERSA.

63. 62 20-30% Inflation, Unemployment, and Stabilization Policies A. Fiscal and monetary policies 1. Demand-side effects 2. Supply-side effects 3. Policy mix 4. Government deficits and debt B. Inflation and unemployment 1. Types of inflation a. Demand-pull inflation b. Cost-push inflation 2. The Phillips curve: short run versus long run 3. Role of expectations

64. Fiscal Policy Using Taxes and Government spending to stabilize the economy. Controlled by the President and Congress Discretionary Fiscal Policy: Congress must take action (change the tax rates) in order for the action to be implemented. Automatic Stabilizers: Unemployment benefits, Progressive Tax System, these changes are implemented automatically to help the economy. FISCAL POLICY CHANGES AD …. EXCEPT when the question specifically states there is a change in business taxes.

65. Types of Fiscal Policy ExpansionaryExpansionary Used to Fight a Recession LOWER TAXES INCREASE GOVERNMENT SPENDING Contractionary Contractionary Used to fight Inflation RAISE TAXES DECREASE GOVERNMENT SPENDING

66. Tax Mult. / Spending Mult. Remember, if the government decreases or increases taxes, or decreases or increases spending the money gets multiplied. The Tax Multiplier is –MPC/(1-MPC) Gov. Spending Multiplier is 1/1-MPC

67. Crowding-Out Effect An Expansionary Fiscal Policy as previously diagrammed will lead to higher interest rates. At higher interest rates, businesses will take out fewer loans and there will be a decrease in INVESTMENT ( I ) At the same time there will be a decrease in CONSUMER SPENDING (C) as they will take out fewer loans as well. This CROWDING OUT EFFECT will reduce the gain made by the expansionary fiscal policy.

68. Net Export Effect & Expansionary Fiscal Policy Government spending has led to an increase in interest rates. At higher interest rates, foreigners demand more U.S. dollars to invest in bonds. This leads to an appreciation of the U.S. dollar. This leads to a decrease in Net Exports, as foreigners now have to exchange more of their currency for the U.S. dollar to buy exports. This decrease in Net Exports will reduce AD and counter to some extent the expansionary fiscal policy.

69. Net Export Effect & Contractionary Fiscal Policy A decrease in government spending has led to a decrease in real interest rates. At lower interest rates, foreigners demand less U.S. dollars to invest in bonds. This leads to a depreciation of the U.S. dollar. This leads to an increase in Net Exports, as foreigners now have to exchange less of their currency for the U.S. dollar to buy exports. This increase in Net Exports will increase AD and further strengthen the contractionary fiscal policy.

70. Criticisms of Fiscal Policy Timing Problems Recognition Lag: identifying recession or inflation Administrative Lag: getting Congress/President to agree to take action Operational Lag: Time needed to see the results of the fiscal policy Political Business Cycles: Politicians may take inappropriate action to get reelected (lower taxes during an inflationary period). Plus it is difficult to raise taxes

71. The Federal Reserve System (FED) Control Monetary Policy Headquartered in Washington D.C. 12 Federal Reserve Districts Board of Governors (7 members) is the central authority Members are appointed by the President and confirmed by the Senate

72. Federal Open Market Committee (FOMC) Made up of 12 people: Board of Governors + New York FED President + 4 other regional presidents (who rotate) Meets regularly to direct OPEN MARKET OPERATIONS (buying or selling of bonds) to maintain or change interest rates

73. FED and the Money Market MS1 MS2 MD Nominal Interest Rate Quantity of Money nir1 nir2 Q1 Q2 Vertical curve-Supply controlled By the FED. An increase in MS leads to a rightward shift and lower interest rates.

74. Easy Money Policy on AD/AS Buying Government Bonds, lowering the discount rate, or lowering reserve requirements, to fight a recession, by decreasing interest rates, increasing investment spending and/or consumption and increasing AD.

75. Effects of an Easy Money Policy LOWER INTEREST rates which will lead to an INCREASE in INVESTMENT and CONSUMPTION. The U.S. dollar will DEPRECIATE, leading to an increase in NET EXPORTS as well. These effects STRENGTHEN the overall monetary policy (opposite of fiscal policy’s crowding-out and net export effect

76. FED and a TIGHT Money Policy MS2 MS1 MD Nominal Interest Rate Quantity of Money nir2 nir1 Q2 12 Vertical curve-Supply controlled By the FED. A decrease in the Money supply, shifts the MS curve to the left and raises interest rates.

77. Tight Money Policy and AD/AS Selling bonds, raising the discount rate, or raising reserve requirements to fight inflation which will raise interest rates, decrease investment and/or consumption and decrease Aggregate Demand (AD).

78. Effects of a Tight Money Policy At the higher interest rates, INVESTMENT SPENDING, and CONSUMPTION will decrease. At higher interest rates, the U.S. dollar will APPRECIATE (foreigners demand more U.S. securities). This will lead to a DECREASE in NET EXPORTS. Again, the Monetary Policy is STRENGTHENED as a result, unlike the effects of a contractionary fiscal policy.

79. Extended AD-AS Model This is the other way to graph the AD-AS Model AD Price Level Real GDP Y* P1 SRAS LRAS The intersection of the 3 curves Is the Full-Employment Equilibrium

80. Extended AD-AS Model and Demand-Pull Inflation In Demand-Pull Inflation, the AD curve has shifted to the right of the LRAS and SRAS intersection. AD2 Price Level Real GDP Y* P2 SRAS LRAS Y2 The Price Level and Real GDP has increased. AD1 PF

81. Extended AD-AS and Demand-Pull Inflation Mainstream economists will fight inflation as previously discussed: with either a tight monetary policy or a contractionary fiscal policy. The goal would be to move the aggregate demand curve to the left. Classical economists would argue to DO NOTHING. As nominal wages rise, the SHORT-RUN AS curve will shift to the left (resources and wages are becoming more expensive), restoring the economy to its full-employment output level, but with a higher Price Level.

82. Extended AD-AS Model and Cost-Push Inflation AD1 Price Level Real GDP Y* SRAS2 LRAS Cost-Push inflation occurs when the SRAS has shifted to the left Of the LRAS and AD intersection. P1 Y1 Here the Price level has Increased and REAL GDP has decreased. SRAS1 PF

83. Extended AD-AS and Cost-Push Inflation Mainstream economists must decide whether to target the Price Level or Unemployment, before taking any action. Classical economists would argue to DO NOTHING. Eventually, wages and resource prices must decrease and when they do the SRAS curve will shift back to the right, restoring the economy to its full-employment output level and the original Price Level.

84. Extended AD-AS Model and Recession In a recession due to a decrease in AD, the AD curve is to the left of the LRAS and SRAS intersection; showing a decrease in both the Price Level and Real GDP. AD Price Level Real GDP Y* SRAS LRAS P1 Y1 PF

85. Extended AD-AS and Recession Mainstream economists will fight a recession as previously discussed: with either an easy money policy or an expansionary fiscal policy. The goal would be to move the aggregate demand curve to the right. Classical economists would argue to DO NOTHING. The decrease in wages and resource prices will shift the SRAS curve to the right, restoring the economy to its full-employment output level, but with a LOWER price. (SELF-CORRECTION)

86. Short-Run Phillips Curve Suggests an inverse relationship between the inflation rate and the unemployment rate. Inflation Rate (percent) Unemployment Rate (percent) 2 8 2 8 When the unemployment rate is Low (2%), the inflation rate will Most likely be high (8%). When the Unemployment rate Is high, inflation will likely be low. SRPC1

87. Short-Run Phillips Curve When the Government fights unemployment, typically higher inflation will result. When the Government fights inflation, typically, more unemployment will result. Thereby, we move along the Short-Run Phillips Curve. (Changes in AD = movements on the SRPC. Inflation Rate (percent) Unemployment Rate (percent) A B 7 2 36 SRPC1

88. Shifting the Short-Run Phillips Curve The Short-Run Phillips curve can also shift, this would mean that both the unemployment rate and inflation rate are changing at the same time. (A change in AS) SRPC1 SRPC2 4 5 67 Stagflation, unemployment and Inflation occurring together (OPEC decreasing Oil supply, causes this type of shift) Inflation Rate % Unemployment Rate %

89. Shifting the Short-Run Phillips Curve The Short-Run Phillips curve can also shift, this would mean that both the unemployment rate and inflation rate are changing at the same time. SRP2 SRPC1 5 7 When Supply increases (productivity surge in 90s) more than demand, prices will fall, while GDP and employment Increase; shifting the curve to the left. Inflation Rate % Unemployment Rate % 3 5 The SRPC is a mirror image of AS – If AS moves right, SRPC moves left.

90. Long-Run Phillips Curve The Long-Run Phillips Curve is vertical, like the Long Run Aggregate Supply Curve. So, in the long run there is no tradeoff between inflation and unemployment. Only the Price Level will change. Inflation Rate% Unemployment Rate % 5 3 SRPC LRPC

91. Laffer Curve What is the optimal tax rate? A tax of 0% will provide no tax revenue. A tax rate of 100% will also lead to no tax revenue (no incentive to work). Answer must be somewhere in between. Tax Rate Tax Revenue 0 100

92. Economic Philosophies Classical: Believes that the government SHOULD NOT interfere in the economy. And believes in self- correction of economic problems. Keynesian: Believes that GOVERNMENT SHOULD interfere in the economy (taxes, government spending). Most “mainstream” economists are Keynesians Rational Expectations: Believes that monetary and fiscal policy have certain effects on the economy and take action to make these policies ineffective.

93. 92 5-10% Economic Growth and Productivity A. Investment in Human Capital B. Investment in Physical Capital C. Research and development, and technological progress D. Growth Policy

94. Economic Growth Five Factors connected to long run economic growth. Supply Factors: Increase in natural resources (quantity and quality) Increase in human resources (quantity and quality) Increase in capital goods Improvements in technology Demand Factors: Increase in consumption by households, businesses, and government

95. Illustrating Economic Growth Production Possibilities Curve Capital Goods Consumer Goods A B PPC1 PPC2

96. Illustrating Long Run Growth Can also be illustrated with the extended AD-AS Model. Real GDP Price Level AD1 AD2 SRAS1 SRAS2 LRAS1 LRAS2 Y1 Y2 P1 P2

97. 96 10-15% Open Economy: International Trade and Finance A. Balance of payments accounts 1. Balance of trade 2. Current account 3. Capital account B. Foreign exchange market 1. Demand for and supply of foreign exchange 2. Exchange rate determination 3. Currency appreciation and depreciation C. Net exports and capital flows D. Links to financial and goods markets

98. International Trade International Trade Comparative Advantage and Specialization allows for economic growth and efficiency. (More of each good can be obtained by trading-Trading line illustrates this) Trade barriers create more economic loss than benefits. Today there is a trend towards free trade and a reduction in trade barriers. Strongest arguments for protection are the infant industry and military self-sufficiency arguments. WTO oversees trade agreements and disputes, but has become a target of protesters lately.

99. 98 exchange rate The value of a foreign nation’s currency in relation to your own currency is called the exchange rate. Exchange Rates and International Markets appreciationAn increase in the value of a currency is called appreciation. depreciationA decrease in the value of a currency is called depreciation. Multinational firms convert currencies on the foreign exchange market, a network of about 2,000 banks and other financial institutions.

100. 99 Types of Exchange Rate Systems Fixed Exchange-Rate Systems A currency system in which governments try to keep the values of their currencies constant against one another is called a fixed exchange-rate system. Flexible Exchange-Rate Systems Flexible exchange-rate systems allow the exchange rate to be determined by supply and demand.

101. Foreign Exchange Market Let’s say a U.S. citizen travels to Japan. This transaction will provide a supply of the U.S. dollar and result in a demand for yen. It will become cheaper for the Japanese to buy the dollar and more expensive for Americans to buy the Yen. The Yen is Appreciating and the dollar is Depreciating. Quantity of U.S. Dollars Quantity of Yen Yen Price of dollar (Y/$) Dollar Price of Yen ($/Y) P1 Q1 D$1 S$1 S$2 P2 Q2 P1 Q1 DY1 SY1 DY2 Q2 P2

102. Balance of Payments Balance of Payments: The sum of all transactions between U.S. residents and residents of all foreign nations Current Account: Shows U.S. exports and U.S. imports of goods and services. Capital Account: Shows the U.S. investment (financial as well as capital- plants and factories) abroad and Foreign investment in the U.S. Credits: A credit are those transactions for which the U.S. receives income (exports, foreign purchase of assets) Debits: Those transactions that the U.S. must pay for: imports and purchasing of assets abroad.

103. Balance of Payments [continued] The Current Account and Capital Account must be equal. Official Reserves Account: The Central Banks of all nations hold foreign currency to make up any deficit in the combined capital and current accounts. If the U.S. has more credits than debits it finances this difference by dipping into its reserve account.

104. 103 So………… That’s it! Good Luck!!!