Unit 7

Balance of Payments

• Balance of Payments Defined
• The sum of all the transactions that have taken place between a nation's residents and the residents of all foreign nations.
• Transactions Include:
• Exports and imports of goods
• Exports and imports of services
• Tourist expenditures
• Interest and dividends received or paid abroad
• Purchases and sales of financial or real assets abroad

3 Components

• Current Account
• U.S. trade in currently produced goods and services
• Balance of Current Account is found when all transactions in current account are added.
• Capital Account
• Summarizes the purchase or sale of real or financial assets and the corresponding flows of monetary payments accompanying them.
• Official Reserves Account
• Quantities that central banks of nations hold of foreign currencies
• All three components must equal zero.

Balance of Payments Deficits and Surpluses

• Imbalances between current and capital accounts that cause a drawing down or up a building up of foreign currencies.

Foreign Exchange Market

• Foreign Exchange Market Defined
• A market in which various national currencies are exchanged for one another.
• Exchange Rates
• Equilibrium prices in the markets
• Two Points of Foreign Exchange Markets
• Competitive Market:
• Characterized by large numbers of buyers and sellers dealing in standardized products such as the euro, yen, and the dollar.
• Linkage to All Domestic and Foreign Prices:
• The market price or exchange rate of a nation's currency is an unusual price that links all the domestic prices with all the foreign prices.
• Changes in Foreign Exchange Rates
• Increase in the supply of currency will decrease the exchange rate of a currency.
• Decrease in supply will increase exchange rate.
• Increase in demand, increase in exchange rate.
• Decrease in demand, increase in exchange rate.
• Exchange Rate Determinants / Appreciate & Depreciation
• Buyer's Taste
• Relative Income
• Relative Price Level
• Appreciation: currency increases in value
• Depreciation: exchange rate decreases

Comparative and Absolute Advantage

• Principle of Absolute Advantage
• One country would have an absolute advantage over the other if it is able to produce the same amount of goods with fewer resources.
• Principle of Comparative Advantage
• A nation has the comparative advantage in the production of a product when it can produce the product a lower domestic opportunity cost than it can with a trading partner.
• Terms of Trade
• The rate of exchange of two products that can be determined through negotiation, thus the outcome is the terms of trade.
• Gains from trade are based on comparative advantage.
• Video

Specialization and Trade

• Specialization based on comparative advantage improves global resource allocation.
• Specialization and trade also increase the productivity and the standard of living within a nation.
• There will be a larger global output of goods and services due to specialization and trade.

Unit 5 & 6

Long Run and Short Run Curves

• AS curves doesn’t shift in response to changes in the AD curve in the short run.
• Nominal wages do not respond to price-level changes
• Workers may not realize impact of the changes or may be under contract.
• Long Run – period in which nominal wages are fully responsive to previous changes  in price level
• When changes occur in the short run they result in either increased or decreased
• producer profits – not changes in wages paid.
• Nominal wages – money getting paid, Real wages – actual value of money, actual gross pay
• In the long run, increases in AD result in a higher price level, as in the short run, but as workers demand more money the AS curve shifts left to equate production  at the original output level, but now at a higher price.
• In the long run, the AS curve is vertical at the natural rate of unemployment (NRU), or full employment (FE) level of output. Everyone who wants a job has one & no one is enticed (tempt) into or out of the market.
• Demand-pull inflation will result when an increase in demand shifts the AD  curve to the right, temporarily increasing output while raising prices.
• Cost-push inflation results when an increase in input costs that shifts the AS curve to the left. In this case, the price level increase is not in response to the 
• increase in AD, but instead the cause of price level increasing.

The Philips Curve

• represents the relationship between unemployment and inflation
• The trade-off between the inflation and the unemployment occurs in the short run
• Each point on the Philips curve corresponds to a different level of output

Long Run Philips Curve

• It occurs at the Natural Rate of Unemployment (NRU)
• It is represented by a vertical line
• There is no trade-off between unemployment and inflation in the long run
• The economy produces at the full-employment output level
• The nominal wages of workers fully incorporate any changes in price level as wages
• adjust to inflation over the long run.

Determinants of the Philips Curve

• Increase in AD = Up/left movement along SRPC
• Determinants (increase): AD to the right, GDPR up & PL down: u% down & π% up: up/left along the curve
• Decrease in AD = Down/right movement along SRPC
• Determinants (decrease): AD to the left, GDPR up & PL down: u% up & π% down: down/right along the curve
• SRAS down = SRPC to the left
• Determinants (Inflationary Expectations, Input Prices, Productivity, Business Taxes, and/or
• Deregulation) (decrease): SRAS to the right, GDPR up & PL up: u% down & π% down: SRPC to the left
• Supply shock - a rapid and significant increase in resource cost which causes the SRAS curve to shift
• Natural Rate of Unemployment (NRU) = frictional + structural + seasonal
• The natural rate at fewer worker benefits creates a lower NRU
• Misery Index – the combination of inflation and unemployment in any given year
• Single digit misery is good
• If the inflation rate persists and the expected rate of inflation rises, then the entire SRPC moves
• upward. If inflation expectations drop (new technology, efficiencies), then the SRPC moves downward. 
• Stagflation occurs when you have high unemployment and high inflation at the same time.
• Disinflation – when inflation decreases over time:

Nominal

• Business profits fall
• Firms reduce employment, thus unemployment increases
• Laffer Curve – trade-off between tax rates and government revenue; As tax rates increase from 0,tax revenues increase from 0 to some maximum level and then decline.
• The higher the tax rate you set, the less money you will collect. Laffer Curve is controversial anddebatable.

Criticisms on the Laffer Curve

1. Where the economy is located on the curve is difficult to determine.
2. Tax cuts also increase demand which can fuel inflation
3. Empirical evidence suggests that the impact of tax rates on incentives to work, save,
and invest are small
Supply-side economics or Reaganomics

• They support policies that support GDP growth by arguing that high marginal tax rates along with the current system of transfer payments (unemployment compensation and social security) provide disincentives to work, invest, innovative, and undertake entrepreneurial ventures. They believe that the AS curve will determine levels of inflation, unemployment, and economic growth.
• Marginal Tax-Rate: The amount paid on the last dollar earned or on each additional dollar earned.
• Supply-side economists believe that if you reduce the marginal tax rate then more people will be able to work longer thus forgoing leisure time.