1. Chapter 9

2. Chapter 9 Essential macroeconomic tools

3. Output and prices
Economic activity is measured by the GDP (gross domestic product)
GDP = sum of all production = sum of all sales = sum of all incomes
Nominal GDP (measured) vs. Real GDP (computed taking into account inflation)
GDP trend is increasing
Actual GDP is above or below trend, according to business cycles

4. Output gap: the difference between trend and actual GDP

5. Choice of exchange rate
The business cycles are undesired and the most governments try to iron them out through fiscal and monetary policies
Does the exchange rate regime, i.e. selecting a system with fixed or floating exchange rates, influence the effect of macroeconomic policies?
Let us look at this Aggregate Demand (AD) and aggregate supply (AS) setting:
Aggregate supply (AS): upwards sloping. As output gap increases threat of unemployment moderates wages and firms cut price
Aggregate demand (AD): downward sloping. Higher prices erode purchasing power and external competitiveness and output gap decreases
Changes in aggregate demand, e.g. a boom abroad: shifts aggregate demand up (AD’)

6. The AD-AS diagram

7. Long Term: Neutrality of Money
Comparison between France and Switzerland
Growth rate in France less growth rate in Switzerland
Year to year:
Nothing really visible

8. Long Term: Neutrality of Money
Comparison between France and Switzerland
Growth rate in France less growth rate in Switzerland
Five-year
averages:
Something emerges

9. Long Term: Neutrality of Money
Comparison between France and Switzerland
Growth rate in France less growth rate in Switzerland

10. PPP: An Implication of Long Term Neutrality
The real exchange rate:
defined as  = EP/P*
PPP: E offsets changes in P/P*
so  is constant.
Equivalently:

11. The real exchange rate
Example: real exchange rate of euro in terms of dollar
Price of basket of European goods: P= €100
Nominal exchange rate ($/€): E = 1.3$/€
Price of basket of American goods: P*= $130
real exchange rate:
= E x P/P* = €100x 1.3$/€ : $130 = 1 basket of American goods for 1 basket of European goods
NOTE: when real exchange rate appreciates, competitiveness declines as more baskets of goods in the USA would need to be traded for 1 basket of European goods.

12. Real versus nominal exchange rate appreciation

13. The Balassa-Samuelson Effect
Increasing real exchange rates in new EU members
(Annual % change, )
Bulgaria
Czech R.
Estonia
Latvia
Lithuania
Inflation differential
29.0
1.6
3.2
3.7
1.4
Nominal appreciation
-19.7
2.6
-0.2
0.0
Real appreciation
9.3
4.2
3.0
4.6
Hungary
Poland
Romania
Slovenia
Slovakia
6.2
3.3
28.3
3.8
4.1
-2.4
-20.6
-2.8
1.5
3.1
7.7
1.0
5.6

14. Short Term Non-Neutrality of Money
From AD-AS: the short-run AS schedule.
So monetary policy matters in the short run.
Channels of monetary policy:
the interest rate channel
the credit channel
the stock market channel
the exchange rate channel.

15. Exchange Rate Regimes and Policy Effectiveness

16. Exchange Rate Regimes and Policy Effectiveness

17. When Does the Regime Matter?
In the short run, changes in E are mirrored in changes in  = EP/P*: P and P* are sticky.
In the long run,  is independent of E: P adjusts.
If P is fully flexible, the long run comes about immediately and the nominal exchange rate does not affect the real economy.
Put differently, the choice of an exchange rate regime has mostly short-run effects because prices are sticky.