1. FP  (%) r (%) AD  (%) G&S AD Question: How many final goods and services would be purchased, if the inflation rate (  ) were _______ percent, given that all other factors relevant to demand remained the same? Review: Government Purchases FP Question: What would the real interest rate (r) equal, if the inflation rate (  ) were _______ percent, given that the Fed does not change its inflation policy? At a given inflation rate (  ) Government purchases more More goods and services purchased Aggregate demand (AD) curve shifts right  AD 3.02,000 2.0 Inflation Targeting and International Finance

2.  (%) GDP 2,000 2.0 AD 0 2,100 AD 1, 2,… AS 0,1 AS 2 AS 7… 3.0 2.6 Inflation rate (  ) up  AD curve shifts right Govt ConInvestInt RateInfl Rate PeriodGDPPurchDeficitPurch r (%)  (%) 02,000 50001,3002003.02.0 12,100 6001001,3121884.22.6 22,040 6001001,2571834.72.8... 72,000 6001001,2201805.03.0 82,000 6001001,2201805.03.0 Increases in Government Purchasing – No Inflation Targeting  Lab 13.1  Real interest rate (r) up  C and I down Borrowing is more costly G increases FP  (%) r (%) 2.0 Taylor principle 3.0 5.0 AS dynamics kick in.

3. Budget deficits resulting from increased government purchases Possibility: The government could be financing infrastructure projects. This public investment would increase the productivity of American workers. Govt ConInvestInt RateInfl Rate PeriodGDPPurchDeficitPurch r (%)  (%) 02,000 50001,3002003.02.0 12,100 6001001,3121884.22.6 22,040 6001001,2571834.72.8... 72,000 6001001,2201805.03.0 82,000 6001001,2201805.03.0 Increase in Government Spending  In the future, U.S. workers will have fewer tools, less modern factories, etc. and will be less productive Bottom Line  (Private ) Investment falls: Crowding Out  Real interest rate (r) increases In the long run:GDP = GDP P = 2,000

4. Inflation Targeting In 2012, the Fed adopted inflation targeting: In historic shift, Fed sets inflation target By Jonathan Spicer Wed Jan 25, 2012 6:35 EST (Reuters) - The Federal Reserve took the historic step on Wednesday of setting an inflation target, a victory for Chairman Ben Bernanke that brings the Fed in line with many of the world's other major central banks. The U.S. central bank, in its first ever "longer-run goals and policy strategy" statement, said an inflation rate of 2 percent best aligned with its congressionally mandated goals of price stability and full employment. Inflation targeting uses autonomous monetary policies to achieve a predetermined inflation rate target: First, the Fed chooses a target inflation rate. Second, the Fed pursues autonomous monetary policies to meet the target. That is, the Fed shifts the Fed policy (FP) curve and therefore the aggregate demand (AD) curve to achieve its target inflation rate.

5. FP  (%) r (%) AD  (%) G&S AD Question: How many final goods and services would be purchased, if the inflation rate (  ) were _______ percent, given that all other factors relevant to demand remained the same? Review: Autonomous Monetary Policy: Shift of the Fed Policy (FP) curve FP Question: What would the real interest rate (r) equal, if the inflation rate (  ) were _______ percent, given that the Fed does not change its inflation policy? At a given inflation rate (  ) Households and firms purchase less Fewer goods and services purchased Aggregate demand (AD) curve shifts left  AD FP Fed increases the real interest rate (r) Loans become more costly  Autonomous Contractionary Monetary Policy Autonomous Expansionary Monetary Policy  Fed becomes tougher on inflation  Fed becomes easier on inflation FP curve shifts right  AD curve shifts left  Contractionary  Lab 10.1  Fed shifts the FP curve right  Fed shifts the FP curve left  At a given inflation rate (  ), the Fed increases the real interest rate (r).  At a given inflation rate (  ), the Fed decreases the real interest rate (r).

6.  Fed shifts the FP curve right  Borrowing costs up Households and firms purchases fewer goods  AD curve shifts right  GDP = C + I + G At a given r, GDP increases Govt ConInvestInt RateInfl Rate PeriodGDPPurchDeficitPurch r (%)  (%) 02,000 50001,3002003.02.0 12,000 6001001,2201805.02.0 22,000 6001001,2201805.02.0... 72,000 6001001,2201805.02.0 82,000 6001001,2201805.02.0 AD 0, AD 1 Increases in Government Purchases – Inflation Targeting  (%) GDP 2,000 2.0 AD 0  Lab 19.1 SRAS 0,1 Contractionary autonomous monetary policy  Fed becomes tougher on inflation  C and I decrease  GDP = C + I + G At a given r, GDP decreases  AD curve shifts left Expansionary fiscal policy  G increases AD 1 2,100

7. Govt ConInvestInt RateInfl Rate PeriodGDPPurchDeficitPurch r (%)  (%) No Inflation Targeting (No auto. monetary policy) 02,00050001,3002003.02.0 12,1006001001,3121884.22.6 22,0406001001,2571834.72.8... 72,0006001001,2201005.03.0 82,0006001001,2201005.03.0 Inflation Targeting: 2.0% (Auto. monetary policy) 02,00050001,3002003.02.0 12,0006001001,2201805.02.0 22,0006001001,2201805.02.0... 72,0006001001,2201805.02.0 82,0006001001,2201805.02.0 In the long run, the Fed’s autonomous monetary policy: Has no effect on the “real” economy. Has no effect on real GDPConsumption purchases Interest rateInvestment purchases Government purchases Has an effect only on the inflation rate. This phenomenon has a fancy name: Classical dichotomy. Classical Dichotomy

8. Foreign Exchange Rates – Wednesday, December 10 9:00 am €1.00 “buys” $1.10 Exchange Rate for Euros can also be expressed as Euros per Dollar =.91$1.00 “buys” €.91 Exchange Rates and Prices Price of a Chevy Volt = $30,000 Exchange Rate ( Euros per Dollar) €.50 per $1.00 €15,000 €1.00 per $1.00€2.00 per $1.00 Price of a BMW = €60,000 Weak Dollar (Strong Euro) Strong Dollar (Weak Euro) Who does a weak dollar European consumers International Finance Price of a Volt Price of a BMW $30,000 €30,000 $30,000 €60,000 $30,000 €60,000 $120,000 €60,000 $60,000 €60,000 $30,000 Euro Japanese Yen British Pound 1.10 121 1.52 Dollars per Euro Yens per Dollar Dollars per Pound Exchange Rate for Euros is expressed as Dollar per Euro = 1.10 benefit? hurt? American consumers Who does a strong dollar American consumers benefit? hurt? European consumers Question: How is the exchange rate determined?

9. € per $ Dollars D S Claim: The demand curve for dollars in the foreign exchange market is downward sloping. Claim: The supply curve for dollars in the foreign exchange market is upward sloping. Foreign Exchange Market for Dollars Equilibrium: Quantity of Dollars Demanded by Europeans Quantity of Dollars Supplied by Americans = Foreign Exchange Market for Dollars

10. €.50 per $1.00 €15,000 €1.00 per $1.00€2.00 per $1.00 Price of a Volt Price of a BMW $30,000 €30,000 $30,000 €60,000 $30,000 €60,000 $120,000 €60,000 $60,000 €60,000 $30,000 Exchange Rate ( Euros per Dollar) Foreign Exchange Market for Dollars Do U.S. produced goods and services become more or less expensive for Europeans? More Do European demand more or fewer U.S. produced goods and services? Fewer Do European demand more or fewer U.S. Dollars? Fewer Is the demand curve for U.S. Dollars in the foreign exchange market is downward or upward sloping? Downward Do European produced goods and services become more or less expensive for Americans? Less Do Americans demand more or fewer European produced goods and services? More Do Americans supply more or fewer Dollars? More Is the supply curve for U.S. Dollars in the foreign exchange market is downward or upward sloping? Upward As the exchange rate (Euros per Dollar) increases

11. € per $ Dollars D G&S S G&S Demand Curve: European Demand Supply Curve: American Demand Foreign Exchange Market for Dollars U.S. Net Exports = 0 U.S. Exports of G&S U.S. Imports of G&S European Purchases of American Goods and Services American Purchases of European Goods and Services

12. Question: What are we missing? U.S. Net Exports = U.S. Exports  U.S. Imports U.S. Net Exports < 0  U.S. Exports < U.S. Imports  Net inflow of Goods into the U.S. Question: How does the U.S. pay for the goods?  Net outflow of Assets into the U.S. U.S. Net Exports equals U.S. Exports  U.S. Imports

13. Assets U.S. € per $ Dollars D G&S D G&S+A S G&S S G&S+A Demand Curve: European Demand Supply Curve: American Demand Foreign Exchange Market for Dollars U.S. Net Exports = 0 U.S. Exports of G&S U.S. Imports of G&S Assets Eur D G&S S G&S Benchmark Case: European Purchases of American Assets American Purchases of European Assets equals

14. € per $ Dollars D G&S D G&S+A S G&S+A Demand Curve: European Demand Supply Curve: American Demand Foreign Exchange Market for Dollars U.S. Net Exports = 0 U.S. Exports of G&S U.S. Imports of G&S Net Exports and Real Interest Rates U.S. Net Exports < 0 S G&S U.S. real interest rates increase: Europeans find American assets more attractive Americans find European assets less attractive  Demand curve for Dollars shifts right  Supply curve for Dollars shifts left

15. January 2011 – September 2011: Specter of Greek Default Emerges Became apparent that tax payments could not meet the government’s payments. Greek Debt Crisis Question: How might the problem be resolved? The bond rating agencies (Moodys, etc.) cut Greece’s credit ratings fearing that the Greek Treasury would not be able to meet its bond commitments. Answer: Austerity.. The basic problem was straightforward: More Euros were flowing out of the Greek Treasury than were flowing into it.

16. Nov 2011 – Jan 2012: Austerity, Protests, Political Turmoil, and Negotiations for a Bailout The Socialist Greek Prime Minister, George Papandreou, calls for austerity moves: sharp increases in taxes and spending cuts. Violent protests erupt amid a 48-hour general strike. Greek Prime Minister George Papandreou loses his majority in Parliament and resigns. A unity government is formed by the opposing Conservative and Socialist parties naming Lucas Papademos as prime minister. Nationwide strike called to protest new cutbacks. The unity Greek Prime Minister Papademos heads to Brussels to negotiate a bailout from the European Central Bank.

17. € per $ Dollars D G&S D G&S+A S G&S+A Demand Curve: European Demand Supply Curve: American Demand Foreign Exchange Market for Dollars U.S. Net Exports = 0 U.S. Exports of G&S U.S. Imports of G&S European Bonds Perceived as Riskier U.S. Net Exports < 0 Nov 2011 – Jan 2012: Austerity, Protests, Political Turmoil, and Negotiations for a Bailout S G&S Europeans find American assets more attractive  Demand curve shifts right Americans find European assets less attractive  Supply curve shifts left

18. Nov 2011 – Jan 2012: Austerity, Protests, Political Turmoil, and Negotiations for a Bailout The Socialist Greek Prime Minister, George Papandreou, calls for austerity moves: sharp increases in taxes and spending cuts. Violent protests erupt amid a 48-hour general strike. Greek Prime Minister George Papandreou loses his majority in Parliament and resigns. A unity government is formed by the opposing Conservative and Socialist parties naming Lucas Papademos as prime minister. Nationwide strike called to protest new cutbacks. The unity Greek Prime Minister Papademos heads to Brussels to negotiate a bailout from the European Central Bank. Question: What’s a bailout? Postpone the date at which Greece must pay the bonds. Instead of paying the bonds in full, pay 75 percent of the bond or 50 percent of the bond. Without a bailout, the Greek government would be bankrupt.

19. Speculation Today: Exchange Euros for Dollars January: Exchange Dollars for Euros Exchange Rate: €.80 per $1.00 Exchange Rate: €1.00 per $1.00 €8,000  $10,000  €10,000 If others share your view  They will also convert their Euro assets into Dollar assets  Demand curve for Dollars shifts right  Supply curve for Dollars shifts left expect the dollar to strengthen with the exchange rate rising from €.80 per $1.00 today to €1.00 per $1.00 in January Suppose you have €8,000 deposited in a Paris bank that you plan to use in January when you will be vacationing in France. Question: What would occur if individuals expect the Dollar to become dramatically stronger and hence the Euro dramatically weaker in the near future? € per $ Dollars D G&S+A S G&S+A Foreign Exchange Market for Dollars   Exchange rate increases This cycle could then continue. Claim: You would convert your Euro assets into Dollar assets.

20. May 2012 – June 2012: Greek Elections and the Return of Political Turmoil January 2012 – February 2012: Austerity and a Tentative Bailout Agreement March 2012 – April 2012: Relative Calm July 2012 – December 2012: New Government Formed and Austerity A tentative agreement is reached between Greek leaders, bondholders and the ECB. Greek elections scheduled for early May to seal the agreement. Greek voters rejected the austerity program derailing the austerity program. Greek leaders could not form a new government. June elections allow the Conservatives to form a new government. The Conservative Prime Minister, Antonis Samaras, implements the austerity program. New elections were scheduled for June.

21. January 2013 – December 2013: Austerity Continued The Greek parliament abolishes 15,000 state jobs in April. In July, the parliament passes a plan for thousands of more layoff and wage cuts for public employees. In November, Greece’s credit rating is raised by Moody. January 2014 – May 2014: Progress of a Sort In January, Greece posts a budget surplus In May, Greece’s credit rating is raised by Fitch. June 2014 – December 2014: More Political Turmoil Unemployment rises to nearly 30 percent. In December, the Conservative government resigns and a vote is scheduled for January.

22. January 2015– December 2015: More Turmoil Syriza, the anti-austerity coalition party, wins the election in January. It ran on a platform that the austerity program endorsed was too severe and it would negotiate a better deal. In July, an austerity program is put before Greek voters in a referendum that was not substantially less austere. More than 60 percent of them vote against it. In July and August attempts were made to agree on a new agreement. Much turmoil took place: violent protests in the streets, Cabinet reshuffling, etc. Eletions are sheduled for September. Syriza wins again in November. In November, Syriza proposed an austerity program that did not differ substantially from the one it opposed in January. This program passed the Greek parliament in November. For several months, negotiations took place, but Syriza failed to gain many concessions.