12b Business Cycles

Exam Tuesday, Feb.13, 2007, 15:15 – 16:45, HG E 7 Closed book test Dictionary and non-programmable calculator allowed Answers can be in either English or German Example Exam on the homepage: http://www.vwl.ethz.ch Re-exam (for those who failed): Date: Monday, Mar.19, 2007, 15:15 – 16:45 (tentative)

Seminar: the economics of Globalization Aim of the seminar: discuss economic principles and political-economy approaches to the causes and consequences of globalization explore the main debates about globalization evaluate arguments on the achievements and failures of globalization Important dates: March 20 (Introduction) June 4/5 (Seminar) Credit points: 2

General Information 24.10. Introduction; Transformation Curve, Opportunity Cost Mankiw ch.1,2 31.10. Markets: Demand and Supply Ch. 4 7.11. Elasticities Ch. 5 14.11. Costs, Production Function Ch. 13 21.11. Markets with perfect competiton Ch. 7, 14 28.11. Taxation Ch. 8 5.12. International Trade Ch. 9 12.12. Imperfect competition: Monopoly, and Oligoploy Ch. 15, 16 19.12. Public Goods, Externalities Ch. 10,11 9.1. National Accounting, Gross Domestic Product, Growth Ch. 23, 25 16.1. Money and Inflation Ch. 24, 29, 30 23.1. Business Cycles Ch. 33, 34 30.1. Open Economy Macro Ch. 31

Figure 8 A Contraction in Aggregate Demand 2. . . . causes output to fall in the short run . . . Price Level Short-run aggregate supply, AS Long-run aggregate supply Aggregate demand, AD AS2 AD2 3. . . . but over time, the short-run aggregate-supply curve shifts . . . A P Y B P2 Y2 1. A decrease in aggregate demand . . . C P3 4. . . . and output returns to its natural rate. Quantity of Output

TWO CAUSES OF ECONOMIC FLUCTUATIONS Shifts in Aggregate Demand In the short run, shifts in aggregate demand cause fluctuations in the economy’s output of goods and services. In the long run, shifts in aggregate demand affect the overall price level but do not affect output.

TWO CAUSES OF ECONOMIC FLUCTUATIONS An Adverse Shift in Aggregate Supply A decrease in one of the determinants of aggregate supply shifts the curve to the left: Output falls below the natural rate of employment. Unemployment rises. The price level rises.

Figure 10 An Adverse Shift in Aggregate Supply 1. An adverse shift in the short- run aggregate-supply curve . . . Price Level Long-run Short-run aggregate supply, AS AS2 aggregate supply Aggregate demand B Y2 P2 Y A P 3. . . . and the price level to rise. Quantity of 2. . . . causes output to fall . . . Output

The Effects of a Shift in Aggregate Supply Stagflation Adverse shifts in aggregate supply cause stagflation—a period of recession and inflation. Output falls and prices rise. Policymakers who can influence aggregate demand cannot offset both of these adverse effects simultaneously.

The Effects of a Shift in Aggregate Supply Policy Responses to Recession Policymakers may respond to a recession in one of the following ways: Do nothing and wait for prices and wages to adjust. Take action to increase aggregate demand by using monetary and fiscal policy.

Figure 11 Accommodating an Adverse Shift in Aggregate Supply 1. When short-run aggregate supply falls . . . Price Level Long-run Short-run aggregate supply, AS AS2 aggregate AD2 supply C P3 2. . . . policymakers can accommodate the shift by expanding aggregate demand . . . 3. . . . which causes the price level to rise further . . . P2 A P 4. . . . but keeps output at its natural rate. Aggregate demand, AD Natural rate Quantity of of output Output

Open-Economy Macroeconomics 13 Open-Economy Macroeconomics

Open-Economy Macroeconomics: Basic Concepts An Open Economy An open economy interacts with other countries in two ways. It buys and sells goods and services in world product markets. It buys and sells capital assets in world financial markets.

The Flow of Goods: Exports, Imports, Net Exports Exports are goods and services that are produced domestically and sold abroad. Imports are goods and services that are produced abroad and sold domestically.

The Flow of Goods: Exports, Imports, Net Exports Net exports (NX) are the value of a nation’s exports minus the value of its imports. Net exports are also called the trade balance.

The Flow of Goods: Exports, Imports, Net Exports A trade deficit is a situation in which net exports (NX) are negative. Imports > Exports A trade surplus is a situation in which net exports (NX) are positive. Exports > Imports Balanced trade refers to when net exports are zero—exports and imports are exactly equal.

The Flow of Goods: Exports, Imports, Net Exports Factors That Affect Net Exports The tastes of consumers for domestic and foreign goods. The prices of goods at home and abroad. The exchange rates at which people can use domestic currency to buy foreign currencies. The incomes of consumers at home and abroad. The costs of transporting goods from country to country. The policies of the government toward international trade.

Figure 1 The Internationalization of the U.S. Economy Percent of GDP 15 Imports 10 Exports 5 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 Copyright © 2004 South-Western

The Flow of Financial Resources: Net Capital Outflow Net capital outflow refers to the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners. A Swiss resident buys stock in the Pfizer corporation and an American buys stock in the Novartis corporation.

The Flow of Financial Resources: Net Capital Outflow When a Swiss resident buys stock in Pfizer, the purchase raises Swiss net capital outflow. When a Japanese residents buys a bond issued by the Swiss government, the purchase reduces the Swiss net capital outflow.

The Flow of Financial Resources: Net Capital Outflow Variables that Influence Net Capital Outflow The real interest rates being paid on foreign assets. The real interest rates being paid on domestic assets. The perceived economic and political risks of holding assets abroad. The government policies that affect foreign ownership of domestic assets.

The Equality of Net Exports and Net Capital Outflow Net exports (NX) and net capital outflow (NCO) are closely linked. For an economy as a whole, NX and NCO must balance each other so that: NCO = NX This holds true because every transaction that affects one side must also affect the other side by the same amount.

Saving, Investment, and Their Relationship to the International Flows Net exports is a component of GDP: Y = C + I + G + NX National saving is the income of the nation that is left after paying for current consumption and government purchases: Y - C - G = I + NX

Saving, Investment, and Their Relationship to the International Flows National saving (S) equals Y - C - G so: S = I + NX or Saving Domestic Investment Net Capital Outflow = + S I NCO = +

Figure 2 National Saving, Domestic Investment, and Net Foreign Investment (a) US National Saving and Domestic Investment (as a percentage of GDP) Percent of GDP 20 Domestic investment 18 16 14 National saving 12 10 1960 1965 1970 1975 1980 1985 1990 1995 2000

Figure 2 National Saving, Domestic Investment, and Net Foreign Investment (b) Net Capital Outflow (as a percentage of GDP) Percent of GDP 4 3 2 Net capital outflow 1 –1 –2 –3 –4 1960 1965 1970 1975 1980 1985 1990 1995 2000

THE PRICES FOR INTERNATIONAL TRANSACTIONS: REAL AND NOMINAL EXCHANGE RATES International transactions are influenced by international prices. The two most important international prices are the nominal exchange rate and the real exchange rate.

Nominal Exchange Rates The nominal exchange rate is the rate at which a person can trade the currency of one country for the currency of another. The nominal exchange rate is expressed in two ways: In units of foreign currency per one unit of home currency. And in units of home currency per one unit of the foreign currency.

Nominal Exchange Rates Assume the exchange rate between the Japanese yen and U.S. dollar is 80 yen to one dollar. One U.S. dollar trades for 80 yen. One yen trades for 1/80 (= 0.0125) of a dollar.

Nominal Exchange Rates Appreciation refers to an increase in the value of a currency as measured by the amount of foreign currency it can buy. Depreciation refers to a decrease in the value of a currency as measured by the amount of foreign currency it can buy.

Nominal Exchange Rates If a Swiss Frank buys more foreign currency, there is an appreciation of the Swiss Frank. If it buys less there is a depreciation of the Swiss Frank.

Real Exchange Rates The real exchange rate is the rate at which a person can trade the goods and services of one country for the goods and services of another. The real exchange rate compares the prices of domestic goods and foreign goods in the domestic economy. If a case of German beer is twice as expensive as American beer, the real exchange rate is 1/2 case of German beer per case of American beer.

Real Exchange Rates The real exchange rate depends on the nominal exchange rate and the prices of goods in the two countries measured in local currencies.

Real Exchange Rates The real exchange rate is a key determinant of how much a country exports and imports.

Real Exchange Rates A depreciation (fall) in the Swiss real exchange rate means that Swiss goods have become cheaper relative to foreign goods. This encourages consumers both at home and abroad to buy more Swiss goods and fewer goods from other countries.

Real Exchange Rates As a result, Swiss exports rise, and Swiss imports fall, and both of these changes raise Swiss net exports. Conversely, an appreciation in the Swiss real exchange rate means that Swiss goods have become more expensive compared to foreign goods, so Swiss net exports fall.

A FIRST THEORY OF EXCHANGE-RATE DETERMINATION: PURCHASING-POWER PARITY The purchasing-power parity theory is the simplest and most widely accepted theory explaining the variation of currency exchange rates.

The Basic Logic of Purchasing-Power Parity According to the purchasing-power parity theory, a unit of any given currency should be able to buy the same quantity of goods in all countries.

Basic Logic of Purchasing-Power Parity The theory of purchasing-power parity is based on a principle called the law of one price. According to the law of one price, a good must sell for the same price in all locations.

Basic Logic of Purchasing-Power Parity If the law of one price were not true, unexploited profit opportunities would exist. The process of taking advantage of differences in prices in different markets is called arbitrage.

Basic Logic of Purchasing-Power Parity If arbitrage occurs, eventually prices that differed in two markets would necessarily converge. According to the theory of purchasing-power parity, a currency must have the same purchasing power in all countries and exchange rates move to ensure that.

Implications of Purchasing-Power Parity If the purchasing power of the dollar is always the same at home and abroad, then the exchange rate cannot change. The nominal exchange rate between the currencies of two countries must reflect the different price levels in those countries.

Implications of Purchasing-Power Parity When the central bank prints large quantities of money, the money loses value both in terms of the goods and services it can buy and in terms of the amount of other currencies it can buy.

Exchange rates of the euro and PPPs

Figure 3 Money, Prices, and the Nominal Exchange Rate During the German Hyperinflation Indexes (Jan. 1921 5 100) 1,000,000,000,000,000 Money supply 10,000,000,000 Price level 100,000 1 Exchange rate .00001 .0000000001 1921 1922 1923 1924 1925 Copyright © 2004 South-Western

Limitations of Purchasing-Power Parity Many goods are not easily traded or shipped from one country to another. Tradable goods are not always perfect substitutes when they are produced in different countries.

Summary Net exports are the value of domestic goods and services sold abroad minus the value of foreign goods and services sold domestically. Net capital outflow is the acquisition of foreign assets by domestic residents minus the acquisition of domestic assets by foreigners.

Summary An economy’s net capital outflow always equals its net exports. An economy’s saving can be used to either finance investment at home or to buy assets abroad.

Summary The nominal exchange rate is the relative price of the currency of two countries. The real exchange rate is the relative price of the goods and services of two countries.

Summary When the nominal exchange rate changes so that each dollar buys more foreign currency, the dollar is said to appreciate or strengthen. When the nominal exchange rate changes so that each dollar buys less foreign currency, the dollar is said to depreciate or weaken.

Summary According to the theory of purchasing-power parity, a unit of currency should buy the same quantity of goods in all countries. The nominal exchange rate between the currencies of two countries should reflect the countries’ price levels in those countries.