1. A GGREGATE SUPPLY AND AGGREGATE DEMAND C HAPTERS 31, 32, AND 33 By Thuy Le

2. C HAPTER 31 Open-Economy Macroeconomics: Basic Concepts

3. C HAPTER 31 Prior to this you’ve only studied closed economies economies that do not interact with other economies in the world In macroeconomics, many new situations arise when studying open economies economies that interact freely with other economies around the world

4. C HAPTER 31 An open economy allows for a greater flow of goods and services. Some terms to know are: Exports: goods and services that are produced domestically and sold abroad Imports: goods and services that are produced abroad and sold domestically Net exports/Trade balance: the value of a nation’s exports minus the value of its imports

5. C HAPTER 31 More terms to know: balanced trade: a situation in which exports equal imports trade deficit: an excess of imports over exports trade surplus: an excess of exports over imports

6. C HAPTER 31 There are many variables which can affect international trade. Some of them are: Consumers’ preferences for foreign and domestic goods Prices of goods at home and abroad Incomes of consumers at home and abroad The exchange rates at which foreign currency trades for domestic currency Transportation costs Government policies

7. C HAPTER 31 Residents of an open economy participate in the market for goods and services, but they can also participate in the world financial market. When talking about the flow of financial resources economists use the term net capital outflow, formerly known as net foreign investment. the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners

8. C HAPTER 31 There are many terms related to a country’s NCO. Some are: Foreign direct investment: Domestic residents actively manage the foreign investment Ex: Thuy, a U.S. resident, is the owner of the H.B. Reese Company and builds a plant in China so she can produce Reese’s cups on the cheap Foreign portfolio investment: Domestic residents purchase foreign stocks or bonds, supplying loanable funds to a foreign firm. Ex: Nick, a U.S. resident, purchases stocks of Adidas, his favorite German shoe company

9. C HAPTER 31 NCO measures the imbalance in a country’s trade in assets: When NCO > 0, there is capital outflow When NCO < 0, there is capital inflow It is important to remember that NCO will always equal NX. Every transaction that affects NX also affects NCO by the same amount

10. C HAPTER 31 Earlier, you learned about GDP equaling C + I + G + NX. This identity can now be used with NCO so we can relate the flow of trade to savings and investment. Y = C + I + G + NX is also true when written as Y – C – G = I + NX, and this can be rearranged to be S = I + NX since S = Y – C – G, which means S = I + NCO since NX = NCO

11. C HAPTER 33 When S > I, the excess loanable funds flow abroad in the form of positive net capital outflow. When S < I, foreigners are financing some of the country’s investment, and NCO < 0.

12. C HAPTER 31 In addition to NX and NCO, economists also look at two other variables when studying international transactions. They are: nominal exchange rate: the rate at which a person can trade the currency of one country for the currency of another and real exchange rate: the rate at which a person can trade the goods and services of one country for the goods and services of another e x P P* P = domestic price P*=foreign price (in foreign currency) e = nominal exchange rate

13. C HAPTER 31 Exchange rates change from time to time. When they do, a nation’s currency is said to be appreciating or depreciating. Appreciation: an increase in the value of a currency as measured by the amount of foreign currency it can buy Depreciation: a decrease in the value of a currency as measured by the amount of foreign currency it can buy

14. C HAPTER 31 The simplest theory of exchange rates is the purchasing power parity, which is based on the law of one price. The purchasing power parity: a theory of exchange rates whereby a unit of any currency should be able to buy the same quantity of goods in all countries

15. C HAPTER 32 A Macroeconomic Theory of the Open Market

16. C HAPTER 32 The previous chapter explained the basic concepts and vocabulary of the open economy. This chapter ties these concepts together into a theory of the open economy. To understand open economies you have to focus on two main markets. The loanable funds market The foreign-currency exchange market

17. C HAPTER 32 The Market for Loanable Funds D = I + NCO r LF S = saving r1r1

18. C HAPTER 32 The Foreign Currency Exchange Market S = NCO E Dollars D = NX E1E1

19. C HAPTER 32 The link between the two markets is NCO, which is included in two important identities S = I + NCO NCO = NX NCO is part of the demand in loanable funds market and is the source of supply in the foreign currency exchange market. All three graphs are commonly drawn together to show this relationship.

20. C HAPTER 32 Many policies and events can affect the open market and in turn affect all three graphs. Some possible things are: Government budget deficits Trade policies Political instability/Capital flight

21. C HAPTER 32 Budget deficits Decreases the supply of loanable funds Increases the RIR Reduces NCO Decreases the supply of dollars Causes the dollar to appreciate

22. C HAPTER 32 Trade policies: a government policy that directly influences the quantity of goods and services that a country imports or exports. Some examples are: Tariff : a tax on imports Import quota : a limit on the quantity of imports “Voluntary export restrictions”: the government pressures another country to restrict its exports which is essentially the same as an import quota

23. C HAPTER 32 Capital flight: a large and sudden reduction in the demand for assets located in a country. Capital flight Increases NCO Increases the demand for loanable funds Increases the RIR Increases the supply of dollars Causes the dollar to depreciate

24. C HAPTER 33 Aggregate Demand and Aggregate Supply

25. C HAPTER 33 Over the long run, real GDP grows about 3% per year on average. In the short run, GDP fluctuates around its trend. Recessions: periods of falling real incomes and rising unemployment Depressions: severe recessions Short-run economic fluctuations are often called business cycles.

26. C HAPTER 33 There are three facts about economic fluctuations Economic fluctuations are irregular and unpredictable. Most macroeconomic quantities fluctuate together. As output falls, unemployment rises.

27. C HAPTER 33 Explaining these fluctuations is difficult, and the theory of economic fluctuations is controversial. Most economists use the model of aggregate demand and aggregate supply to study fluctuations. This model differs from the classical economic theories economists use to explain the long run.

28. C HAPTER 33 The previous chapters are based on the ideas of classical economics The Classical Dichotomy is the separation of variables into two groups: Real: quantities, relative prices Nominal: measured in terms of money The neutrality of money: Changes in the money supply affect nominal but not real variables.

29. C HAPTER 33 Most economists believe classical theory describes the world in the long run, but not the short run. In the short run, changes in nominal variables (like the money supply or PL) can affect real variables (like Y or unemployment). To study the short run, we use a new model.

30. C HAPTER 33 The model of aggregate demand and aggregate supply P Y AD SRAS P1P1 Y1Y1

31. C HAPTER 33 Terms to know: aggregate-demand curve: a curve that shows the quantity of goods and services that households, firms, the government, and customers abroad want to buy at each price level aggregate-supply curve: a curve that shows the quantity of goods and services that firms choose to produce and sell at each price level

32. C HAPTER 33 The aggregate demand curve is downward sloping because of The wealth effect The exchange-rate effect The interest-rate effect AD will shift if there is a change in GDP Money supply

33. C HAPTER 33 The aggregate supply curve is Upward-sloping in the short run Vertical in the long run P Y SRAS LRAS

34. C HAPTER 33 LRAS is vertical because Y N determined by the economy’s stocks of labor, capital, and natural resources, and on the level of technology. An increase in P does not affect any of these, so it does not affect Y N. P Y LRAS YNYN

35. C HAPTER 33 LRAS will shift if there is a change in Any factors of production Natural resources Technology SRAS will shift if LRAS shifts There is a change in price level/expectations There is a supply shock

36. C HAPTER 33 There are 3 theories of SRAS The sticky wage theory The sticky price theory The misperceptions theory The imperfections in these theories are temporary. Over time, sticky wages and prices become flexible misperceptions are corrected In the LR, P E = P AS curve is vertical

37. Congratulations! You’ve learned everything there is to know in Chapters 31-33!