International Finance LO20-1 How the value of a currency is me.docx

International Finance
LO20-1 How the value of a currency is measured.
LO20-2 The sources of foreign exchange demand and supply.
LO20-3 How exchange rates are established.
LO20-4 How changes in exchange rates affect prices, output,
and trade
flows.
20
LEARNING OBJECTIVES
After learning about this chapter, you should know
CHAPTER
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No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
1
International Finance
Each country has its own currency (except in Europe, where
many countries have adopted the euro).
International trade therefore involves two currencies – that of
the exporter (which needs to pay bills in its currency) and that
of the buyer (which pays for items using its currency).
20-02

It might be worthy to set up a situation where students in your
state must exchange currencies to buy in an adjacent state.
Ask what differences there would be for, say, a Texan to have
to exchange his Texdollars for Okiemoney when he visits Tulsa.
2
International Finance II
The relative values of the two currencies affect trade patterns
and the answers to the questions of WHAT, HOW, and FOR
WHOM to produce.
We will focus specifically on,
What determines the value of one country’s money compared to
the value of another’s?
What causes the international value of currencies to change?
How and why governments intervene to alter currency values?
20-03

Since the answers to these questions are altered when prices
change, it follows that a change in the exchange rate will alter
prices and the answers to these questions.
3
Exchange Rates
Exchange rate: the price of one country's currency in terms of
another’s; the domestic price of a foreign currency.
If US $1.50 = 1 euro, then US $1 = 0.67 euro.
If US $1.25 = 1 euro, then US $1 = 0.80 euro.
Exchange rates in terms of each other must be reciprocals of
each other.
20-04
The reciprocity is vital. If it doesn’t exist, arbitrageurs will
enter the exchange market and make it exist. They will buy the
cheaper currency and simultaneously sell the expensive one.
That increases the demand for the cheap one, driving its price
up and increasing the supply of the expensive one, driving its
price down.

4
Foreign Exchange Markets
U.S. travelers to Europe have a demand for euros and a supply
of dollars.
European visitors to Disney World have a demand for dollars
and a supply of euros.
20-05
It might be a good idea to sort out those who have a demand for
dollars and those who have a supply of dollars.
Then do the same for those who have a demand for euros and
those who have a supply of euros.
5
Foreign Exchange Markets II
U.S. exporters of goods to Europe get paid in euros. They have
a supply of euros and a demand for dollars, which they need to
pay their bills.
European exporters of goods to the U.S. get paid in dollars.
They have a supply of dollars and a demand for euros.
20-06

It might be a good idea to sort out those who have a demand for
dollars and those who have a supply of dollars.
Then do the same for those who have a demand for euros and
those who have a supply of euros.
6
Foreign Exchange Markets III
The market demand for U.S. dollars originates in:
foreign demand for American exports.
foreign tourists in America.
foreign demand for American investments.
currency speculators.
possible government intervention.
The market demand for U.S. dollars represents a market supply
of foreign currency.
20-07

You could use this list to summarize the discussion you made
for the previous slide.
7
Foreign Exchange Markets IV
The market supply of U.S. dollars originates in
American demand for imports.
American tourists abroad.
American investments in foreign countries.
Currency speculators.
Possible government intervention.
The market supply of U.S. dollars represents a market demand
for foreign currency.
20-08
And also this list.

8
The Value of the Dollar
The value of the dollar is indicated by its purchasing power.
A BMW costing 30,000 euros must be priced in dollars if it is
to be sold in the United States.
If 1 euro = $1.50, then it will be priced at $45,000.
If the exchange rate changed to 1 euro = $1.60, then the BMW’s
price in the United States would rise to $48,000.
At this higher price, the quantity of BMWs sold will decrease.
20-09
Obviously this is a ceteris paribus situation. Excluded are
transportation costs, advertising, interactions with competitors,
etc.
9
The Value of the Dollar II
At a high euro price of the dollar, fewer will want to buy dollars
and more will want to sell dollars.
There will be a surplus of dollars, and the dollar’s euro price
will fall.

surplus
20-10
Here we are simply showing that a foreign exchange market is
simply a market, and it follows the rules of any market.
10
The Value of the Dollar III
At a low euro price of the dollar, more will want to buy dollars
and fewer will want to sell dollars.
There will be a shortage of dollars, and the dollar’s euro price
will rise.
The foreign exchange market will adjust to its equilibrium
price.
shortage
20-11

More analogy to any market.
11
The Value of the Dollar IV
Any increase in demand for the dollar or decrease in supply of
the dollar will push the dollar price in euros up.
The dollar appreciates in value.
20-12
Here we introduce the terms appreciation and depreciation.
12
The Value of the Dollar V
Any decrease in demand for the dollar or increase in supply of
the dollar will push the dollar price in euros down.
The dollar depreciates in value.
20-13

Here we introduce the terms appreciation and depreciation.
13
The Value of the Dollar VI
When the dollar appreciates against the euro, the euro
depreciates in value relative to the dollar.
When the dollar depreciates against the euro, the euro
appreciates in value relative to the dollar.
20-14
Again the reciprocal nature of the two currency values.
14

The Balance of Payments
The summary of all international money flows is contained in
the balance of payments.
Balance of payments: a summary record of a country’s
international economic transactions in a given period of time.
20-15
BOP accounting aims at a zero balance. In order to get there,
the accountants need all pertinent information. It is unlikely
that this will happen. So there is the statistical discrepancy.
Students don’t like such “fudge factor” things.
15
The Balance of Payments II
The balance of payments is divided into three parts:
current account balance (which includes the trade balance)
capital account balance
statistical discrepancy
20-16

BOP accounting aims at a zero balance. In order to get there,
the accountants need all pertinent information. It is unlikely
that this will happen. So there is the statistical discrepancy.
Students don’t like such “fudge factor” things.
16
The Balance of Payments III
The current account balance includes
Money flows in the trade balance.
Merchandise exports and imports
Service exports and imports
Money flows in investment income, government grants, and
private funds transfers.
There is a net dollar outflow in the current account.
20-17

Let’s keep it simple and use only dollars.
Essentially, we buy our imports from foreigners; we get the
goods, they get dollars.
They use some of those dollars to buy our exports; they get the
goods, we get dollars.
They have dollars left over. This is the net dollar outflow in the
current account.
17
The Balance of Payments IV
The capital account balance includes
Inflow due to foreign purchases of U.S. assets.
Outflow due to U.S. purchases of foreign assets.
Increase in U.S. official reserves.
Increase in foreign official assets in U.S.
There is a net dollar inflow in the capital account.
20-18

Those dollars left over are put into a bank as savings.
The bank lends them to clients who wish to buy dollar-
denominated assets (not merchandise or services).
A good place to buy dollar-denominated assets is the United
States.
The dollars flow back to the United States as payment for the
assets purchased by foreigners.
This is the net dollar inflow in the capital account.
18
The Balance of Payments V
If we had perfect accounting, the outflow in the current account
would balance the inflow in the capital account.
Because of several time lags in collecting data, the third part of
the balance of payments is the statistical discrepancy, which
indeed balances the two accounts.
Therefore, the balance of payments always must equal zero.
20-19
$out must equal $in. So, $out - $in = 0.

19
Market Dynamics
Depreciation: a fall in the price of one currency relative to
another.
Caused by a decrease in demand or an increase in supply of the
first currency.
Appreciation: a rise in the price of one currency relative to
another.
Caused by an increase in demand or a decrease in supply of the
first currency.
20-20
This is a recap of depreciation and appreciation.
20
Market Dynamics II
The following could cause an increase in demand for the dollar
Foreign incomes rise faster than U.S. incomes.
Foreign prices rise faster than U.S. prices.
Foreigners have an increased need for U.S. goods.
U.S. interest rates become higher than in foreign countries.
20-21

Here we look at why the demand or supply of a currency would
change.
There are millions of participants in exchange markets every
day. Each is acting in her own self-interest, trying to better
herself.
Therefore, the demand for and supply of any currency will
change frequently each day.
This activity is reflected by instantaneous changes in the
exchange rates.
21
Market Dynamics III
The following could cause a decrease in demand for the dollar
U.S. incomes rise faster than foreign incomes.
U.S. prices rise faster than foreign prices.
Foreigners have an decreased need for U.S. goods.
U.S. interest rates become lower than in foreign countries.
Small changes like these occur all the time, and the $4 trillion
foreign exchange market adjusts to those changes.
20-22

Here we look at why the demand or supply of a currency would
change.
There are millions of participants in exchange markets every
day. Each is acting in her own self-interest, trying to better
herself.
Therefore, the demand for and supply of any currency will
change frequently each day.
This activity is reflected by instantaneous changes in the
exchange rates.
22
Do Exchange Rates Matter?
Daily participants in international trade prefer stable exchange
rates to reduce the uncertainty in planning.
Any exchange rate change automatically alters the prices of
exports and imports of that country, affecting many business
decisions.
20-23

It is easier to plan international activities (trade, asset purchase,
business deals, travel) if the exchange rates are stable
(unchanging).
Uncertainty will reduce this activity a bit because people want
to avoid risk.
23
Should the Government Control Exchange Rates?
The goal would be to achieve exchange rate stability, but that
could lead to other economic effects.
The standard way to eliminate instability in exchange rates is to
adopt fixed exchange rates, where all major trading countries
agree to keep the exchange rates between each currency fixed.
20-24
This is government intervention into the free market, pure and

simple. It is a price control on the exchange rates. It doesn’t
matter that several countries collude to do it. From a buyer and
seller point of view, it is a price control.
24
Should the Government Control Exchange Rates? II
The easiest way to fix exchange rates is to define each
currency’s value against a common standard, such as a gold
standard: an agreement by countries to fix the price of their
currencies in terms of gold.
The problem with fixed exchange rates is that the demand for
and the supply of each currency will continue to fluctuate, and a
fixed exchange rate does not account for this.
20-25
The main advantage of the gold standard is the inability of the
government and the central bank in each country to debase the
value of its money.
Since the United States abandoned the gold standard in 1973,
the value of the dollar has dwindled enormously as the Fed has
greatly increased the dollar supply.
25
Fixed Exchange Rates

With fixed exchange rates (at e1), the increase in demand for
pounds generates a shortage of pounds.
More dollars flow out than flow in, so it creates a balance of
payments (BOP) deficit for the United States and a BOP
surplus for Britain.
20-26
Market forces will not stop because of a fixed exchange rate.
26
Fixed Exchange Rates II
What to do?
Let the exchange rate rise (not acceptable), or the U.S.
government intervenes by selling pounds and buying dollars.
Also, the U.S. could transfer gold to Britain for dollars.
This can be done once or twice, but cannot be kept up forever.
20-27

There is an upper limit to the amount of pounds the government
can sell or the amount of gold it can transfer.
Ultimately there will be a devaluation. This occurs when the
devaluating country formally declares that its central bank will
no longer support the currency. Henceforth the new fixed
exchange rate is lower than before.
27
Fixed Exchange Rates III
Alternatively, erect protective barriers to eliminate the
increased demand for British goods.
Or increase taxes to reduce disposable income and thereby, the
demand for imports.
Or raise interest rates to slow spending and to draw foreign
currency to the United States.
20-28

The more a country defends its currency against changing
demand and supply, the more it surrenders internal tools to
combat problems such as high unemployment or high inflation
at home. Devaluation will boost domestic inflation but lower
unemployment as the country’s exports will look cheaper to
customers.
Revaluation (happens in the other country) would lower
inflation pressures but could cause increased unemployment as
that country’s exports suddenly become more expensive.
28
Application: The Economy Tomorrow
Currency bailouts
Sometimes a country gets into deep trouble with its balance of
payments and cries to the rest of the world for help.
A currency “bailout” is arranged, where the country in trouble
is lent reserves to prop up its currency. The International
Monetary Fund (IMF) usually leads the rescue.
20-29
There have been bailouts of this type in Asia and in Latin
America.

If it were not a euro country, there probably would not need to
be a bailout for Greece (and possibly Spain and Italy).
29
Application: The Economy Tomorrow II
Currency bailouts
Some say that bailouts are ultimately self-defeating. If a
country knows it will be bailed out, it might not practice sound
economic policy.
The IMF requires the nation to adhere to more prudent
monetary, fiscal, and trade policies.
Will other countries need a bailout? There are many reasons a
country could get into trouble in the economy tomorrow.
20-30
This is a moral hazard situation. Why bother to enact unpopular
measures that could cost us the next election if we can rely on
other countries to bail us out of our situation?
30
Revisiting the Learning Objectives
LO20-1 Know how the value of a currency is measured.
Exchange rates are the mechanism for translating the value of
one national currency into the equivalent value of another.

An exchange rate of $1 = 2 euros means that one dollar is worth
two euros in foreign exchange markets.
20-31
Here begins the review for the chapter.
31
Revisiting the Learning Objectives II
LO20-2 Know the sources of foreign exchange demand and
supply.
The supply and demand for foreign currency reflect the
demands for imports and exports, international investment,
currency speculation, and overseas activities of government
(and tourists).
20-32

Here begins the review for the chapter.
32
Revisiting the Learning Objectives III
LO20-3 Know how exchange rates are established.
There is a huge market in foreign currency that is worldwide.
Daily changes in demand for and supply of each currency are
immediately incorporated into the foreign exchange market.
This market will determine the current equilibrium price
between two currencies.
20-33
Revisiting the Learning Objectives IV
LO20-4 Know how changes in exchange rates affect prices,
output, and trade flows.
Currency appreciations make foreign goods more costly to
buyers of imports. Trade flows will decrease. Vice versa
applies.
Currency appreciations make domestically produced goods more
costly to export. Again trade flows will decrease. Vice versa

applies.
20-34
Looking Ahead: Chapter 21
Global Poverty
How U.S. and global poverty are defined.
How many people in the world are poor.
What factors impede or promote poverty reduction.
20-35

Theory versus Reality
LO18-1 The tools of macro policy.
LO18-2 How macro tools should work.
LO18-3 The constraints on policy effectiveness.
18
LEARNING OBJECTIVES
CHAPTER
consent of McGraw-Hill Education
1
Theory versus Reality
Theory is supposed to explain the business cycle and how to
control it.
Many realities keep us from reaching our economic goals.
Conflicting advice comes from Keynesians, monetarists, and
supply-siders.
Politics takes preference over economics in Congress and the
presidency.

A massive, unresponsive bureaucracy exists.
18-02
This chapter summarizes macro policies and attempts to bring
them into the real world.
2
Theory and Reality
In this chapter we look at the sources of these frustrations.
Specifically,
What is the ideal “package” of macro policies?
How well does our macro performance live up to the promises
of that package?
What kinds of obstacles prevent us from doing better?
18-03

3
Available Policy Tools
Fiscal policy
Tax cuts and increases
Changes in government spending
Monetary policy
Open market operations
Changes in reserve requirements
Changes in discount rates
Supply-side policy
Tax incentives for saving and investment
Deregulation
Human capital investment
Infrastructure development
Free trade
Immigration
18-04

This is a summary slide collecting the various levers in each of
the three policy tools.
4
Fiscal Policy
Automatic stabilizers: a basic countercyclical feature of the
federal budget.
Discretionary fiscal policy: deliberate policy decisions made to
expand (or shrink) the structural deficit and give the economy a
shot of fiscal stimulus (or restraint).
18-05
Summarizes fiscal policy.
5
Monetary Policy
The Fed’s Board of Governors makes monetary policy.
The Federal Open Market Committee pulls the levers.
Keynesians believe that changing interest rates are the critical
policy lever to shift aggregate demand.
Monetarists believe that expanding the money supply at a
steady, predictable rate is the critical policy tool.
18-06

Summarizes monetary policy.
6
Supply-Side Policy
A long-run policy to provide incentives to work, save, and
invest.
Marginal tax rates and government regulations must be reduced
to get more output without inflation.
The supply-side policy levers require changes in laws and
regulations, so Congress and the president must enact supply-
side policy.
Fiscal and supply-side policies often get entwined.
18-07

Summarizes supply-side policy.
7
Idealized Uses: Recession
Goal: to close the recessionary GDP gap.
Keynesians: increase AD by tax cuts or spending increases.
Also, decrease interest rates to spur investment.
Monetarists: fiscal policy doesn’t matter. The appropriate
response is patience.
Supply-siders: cut tax rates and reduce regulation to improve
production incentives and long-run development.
18-08
This looks at the policies from a problem point of view – here, a
recession.
8
Idealized Uses: Inflation
Goal: to close the inflationary GDP gap.
Keynesians: decrease AD by raising taxes and cutting
government spending.

Monetarists: reduce the money supply.
Supply-siders: expand productive capacity.
18-09
Here, for inflation.
9
Idealized Uses: Stagflation
Both inflation and unemployment are high, and economic
growth is stagnant.
Fiscal restraint and tight money will reduce inflation but
increase unemployment.
Fiscal stimulus and easy money will reduce unemployment but
increase inflation.
If caused by adverse policy (high taxes, excessive regulation),
supply-siders propose reversing those policies.
If caused by external forces (oil price spike, natural disaster),
no policy can help much.
18-10

Here, for stagflation.
10
Fine-Tuning
Fine-tuning: policy adjustments designed to counteract small
changes in economic outcomes.
In 1978 Congress set goals of 4% unemployment, 3% inflation,
and 4% economic growth.
The reality is that government has difficulty making fine-tuning
adjustments to meet these conflicting goals.
18-11
The term “fine-tuning” is a residual from early TV sets that had
a channel selector surrounded by a dial that made the picture
clearer. It fine-tuned the picture.
Keynesians championed fine-tuning to have policy makers

continuously monitor the economy and “tweak” it when it
seemed to move away from some ideal state.
Congress actually set these conflicting goals as the “ideal.”
11
The Economic Record
18-12
Here you can show recessions, recoveries, stagflation, and the
changes in the variables . Also, you can contrast the goal with
reality.
12
Why Things Don’t Always Work
There are four obstacles to policy success:
goal conflicts
measurement problems
design problems
implementation problems
18-13

Described on the next slides.
13
Goal Conflicts
Fiscal policy has a trade-off between unemployment and
inflation.
The Fed wants fiscal stability, but the president and Congress
may be unwilling to raise taxes or cut spending.
Some cutbacks may become politically impossible to enact.
Opportunity cost: conflict between the benefit and the cost of a
policy option.
18-14
You might remind your students that politics always trumps

economics in any discussion.
14
Measurement Problems
Measuring the macro variables takes time, so the results are not
available for a month or more.
Policymakers rely on economic forecasts made by “experts”
using models that are tied to one theory or another.
Some data (e.g., Leading Economic Index) try to predict turns
in the business cycle.
External shocks are not predictable.
18-15
The final report of GDP for the second quarter of each year
does not become public until three months later. The second
quarter ends in June, and that final report comes out in
September. Preliminary reports in July and August will be
revised by the later report.
This is the reason why expert forecasts are relied upon.
15
Design Problems
Once we think we know what the problem is, we must design a
“fix” for the problem.

Should we take
The Keynesian approach?
The monetarist approach?
The supply-sider approach?
How will the marketplace respond to our plan?
18-16
We have looked at the various approaches. Each has its
advocates. Which will be used depends on the number of people
in power who advocate each approach as well as their ability to
persuade the others.
16
Implementation Problems
Any “fix” must work through congressional deliberations and be
approved by the president.
Once approved, will it be put into effect in a timely manner?
The time lag may be so great that a stimulus package may go
into effect after a recession has ended.
Political pressure may preclude a correct “fix” from ever being
passed.
18-17

Time is lost just getting the data. Time goes by as Congress
deliberates. Time will pass as the bureaucracy implements the
policy. More time goes by as the implemented policy hits the
street. More time passes to get the multiplier effect to work.
17
Time Lags
It is highly possible that the impact of the policy may not occur
until after the problem has begun to “fix” itself.
18-18

Hands on? Or Hands off?
Hands on: policy activists emphasize that there are greater risks
in doing nothing when the economy is faltering.
They advocate active government intervention and assure the
country that the proposed “fix” implies progress.
They believe there is enough knowledge to manipulate the
economy through its troubles.
18-19
Elected officials know they were sent to Washington to do
something; doing nothing might not be an option.
19
Hands on? Or Hands off?
Hands off: proponents argue that discretional fiscal policy or
monetary policy can help, but the implementation problems are
too great.
New classical economics: government should provide a stable
environment and then get out of the way.
Rational expectations: people anticipate what the government
will do and take actions to protect themselves, countering the
government’s action.
18-20

There is no prospect for this argument to be resolved in the near
future.
20
Application: The Economy Tomorrow III
18-21
21

LO18-1 Know the tools of macro policy.
To end a recession, cut taxes, increase government spending, or
expand the money supply.
To curb inflation, reverse each of those policy tools.
To overcome stagflation, combine fiscal and monetary levers
with supply-side incentives.
18-22
Here we begin the review of the chapter.
22
LO18-2 Know how macro tools should work.
AD increases if we cut taxes, increase government spending, or
expand the money supply.
AD decreases if we raise taxes, decrease government spending,
or shrink the money supply.
AS increases if we reduce tax rates and decrease government
regulation.
18-23

LO18-3 Know the constraints on policy effectiveness.
Implementing macro policy is difficult due to several obstacles:
goal conflicts
measurement problems
design problems
implementation problems
This leads to the hands-on versus hands-off argument.
18-24
Consumer Choice

Why demand curves are downward sloping.
The nature and sources of consumer surplus.
The meaning and use of price discrimination.
How consumers maximize utility.
18-25
Supply-Side Policy:
Short-Run Options
Why the short-run AS curve slopes upward.
How an unemployment–inflation trade-off arises.
How shifts of the aggregate supply curve affect macro
outcomes.
The tools of supply-side policy.
LO16-1
LO16-2
LO16-3
LO16-4
16

LEARNING OBJECTIVES
CHAPTER
1
Supply-Side Policy
Fiscal and monetary policies focus on the demand side of the
macro economy. These policies shift the aggregate demand
curve.
Policies that alter the willingness or ability to supply goods at
various price levels will shift the aggregate supply curve. They
are supply-side policies.
16-02
Fiscal and monetary policy are relatively short-run policies that
work on AD.
Supply-side policies are much more long-run policies that work

on AS.
They must be longer-run because they rely on changing the
capability and the intention to produce, which takes time.
2
Supply-Side Policy II
In this chapter we focus on two issues:
how does the aggregate supply curve affect macro outcomes?
how can the aggregate supply curve be shifted?
16-03
Again, the macro outcomes of significance here are
unemployment, inflation, and GDP growth.
Draw an AD-AS graph on the board. Shift AS left:
unemployment rises, inflation rises, and GDP falls – a triple
bad.
Shift AS right: unemployment falls, inflation falls, and GDP
rises – a triple good.
3
Aggregate Supply
In the 1970s, the U.S. experienced stagflation: the simultaneous
occurrence of substantial unemployment and inflation.
Shifting AD to “fix” stagflation is not possible.

Increase AD: unemployment falls and inflation rises.
Decrease AD: unemployment rises and inflation falls.
Supply-side policy arose to provide an answer to stagflation.
16-04
The term “stagflation” became a favorite new headline in the
1970s. It was coined by a British politician, Iain Macleod, in a
speech to Parliament in 1965.
Keynesians were in total command of the economics world at
the time.
Their favorite technique, shifting AD, couldn’t fix the problem.
So they were out of arrows in their quiver.
In New York a small group of economists, newspaper people,
and politicians met several times and came up with what came
to be called supply-side policy as an antidote to stagflation.
4
Shape of the AS Curve
The Keynesian version:
AS is horizontal until Q*, is reached.
An AD shift to the right in recession increases Q but does not
increase P.
Inflation becomes a problem only after AD shifts past Q*, the

production capacity and AS becomes vertical.
16-05
Remember, Keynesians never considered that moving AS was of
any relevance or consequence.
They focused solely on AD. So their opinion of AS was molded
by how it affected the AD shift.
5
Shape of the AS Curve II
The Monetarist version:
Changes in the money supply affect prices but not output.
An AD shift to the right increases inflation.
AS is a long-run concept and is vertical.
16-06

Similarly, monetarists are focused on the shift of AD. Their
concept of AS is long-run at the “full-employment” level of
GDP.
6
Shape of the AS Curve III
The Hybrid version:
Most economists now see an AS curve with an upward slope
that increases near full employment.
Inflation accelerates in that region of the curve as AD shifts
right.
16-07
This version of the AS curve includes the horizontal version of
the Keynesians at levels of high unemployment and the vertical
version of the monetarists at times of stressing the capacity of
the country to produce (boom times). A transition zone lies in

between as the AS crosses the full-employment GDP level.
7
Impact of the Hybrid AS Curve
Shifts of AD affect both prices and output.
Outcomes of fiscal and monetary policy depend on how close
the economy is to full employment.
The closer to full employment we are, the greater the risk that
fiscal or monetary stimulus will spill over into inflation.
16-08
Most activity occurs in the transition zone.
8
Inflation-Unemployment
Trade-Off
The message of the upward-sloping AS curve is that demand-
side policies alone can never succeed completely; they will
always cause some unwanted inflation or unemployment.
This is the inflation-unemployment trade-off, which is
expressed in the Phillips curve.
16-09

The modern-day Phillips curve grew out of the work of A. W.
Phillips, who studied the relationship of wages and prices in the
U.K.
A very instructive documentation of the economic history of the
last 50 years can be seen by following the Phillips curve.
The most significant revelation is just how few times in that
half-century AD was the only curve that shifted. In other words,
AS shifts have had a greater impact over the last half-century
than AD shifts.
Phillips curve for the U.S.: http://www.j-bradford-
delong.net/multimedia/USPCurve.html.
9
Inflation-Unemployment
Trade-Off II
As the economy moves from point A to B to C (left picture), the
inflation-unemployment trade-off shifts from point a to b to c
(right picture) on the Phillips curve.
16-10

The AS curve is the mirror image of the Phillips curve.
10
The Inflationary Flashpoint
The upward-sloped AS curve has a point at which inflation
rockets upward as the decrease in unemployment slows.
It is called the inflationary flashpoint: the output at which
inflationary pressures intensify; the point on the AS curve
where slope increases sharply.
16-11
As the AS transitions from flat to vertical, there is a point
where inflation accelerates.
11

Shifts of the AS Curve
Rightward shift of AS:
Good news! Reduces unemployment and inflation at the same
time.
Also increases output.
Shifting AD cannot do this.
Leftward shift of AS:
Bad news! Both unemployment and inflation increase, and
output decreases.
16-12
This demonstrates what happens when AS shifts. Right? Good!
Left? Bad!
12
Relation between AS and Phillips Curve
When AS shifts right, the Phillips curve shifts left.
This eases the inflation-unemployment trade-off.
Both inflation and unemployment fall.
When AS shifts left, the Phillips curve shifts right.
This makes the inflation-unemployment trade-off much more
severe.

Both inflation and unemployment rise.
16-13
This simply verbalizes the mirror image quality.
13
The Misery Index
Misery index: a simple sum of the inflation and unemployment
rates.
If AS shifts right, both elements decrease and the misery index
falls sharply.
If AS shifts left, both elements increase and the misery index
rises sharply.
16-14

Another big headline in the 1970s. This term was coined by
Arthur Okun.
AS shifts left? Misery index rises.
AS shifts right? Misery index falls.
14
What Shifts the AS Curve?
Shifting AS right:
Policies that provide incentives for suppliers to increase
production.
Tax incentives for saving, investment, and work.
Human capital investment.
Deregulation.
Trade liberalization.
Infrastructure development.
Generates desirable macro outcomes.
16-15
Anything that increases the reward for working, investing, and
saving.
Anything that improves productivity.

Anything that lowers costs of operation, including taxes and
compliance with regulation.
15
What Shifts the AS Curve? II
Shifting AS left:
Policies that provide disincentives for suppliers to increase
production.
Tax increases for saving, investment, and work.
Deteriorating human capital investment.
Excessive, costly regulation.
Trade restrictions.
Decaying infrastructure.
Negative external shocks, such as natural disasters and war.
Generates undesirable macro outcomes.
16-16
Anything that decreases the reward for working, investing, and
saving.
Anything that degrades productivity.
Anything that raises costs of operation, including taxes and
compliance with regulation.
Plus external effects.

16
Tax Incentives
Keynesians will cut taxes to increase AD.
Supply-siders note that high tax rates destroy the incentive to
work and produce, which ends up reducing output.
Lowering tax rates encourage people to earn more because more
ends up in disposable income and less goes to the government.
16-17
This contrasts the different ways of looking at tax law changes.
17
Tax Incentives II
Supply-siders emphasize a reduction in marginal tax rates for
both workers and firms.
Marginal tax rate: the tax rate imposed on the latest earned
(marginal) dollar of income.
High marginal tax rates provide a disincentive to:
increase their earnings.
start or expand a business.
increase investment spending.

16-18
In the Reagan era, when the top tax rate was reduced from 70%
to 35%, an entrepreneur who could do some extra work and earn
an extra $100,000 would see his or her added take-home pay
more than double from $30,000 to $65,000.
18
Marginal Tax Rates
16-19
Top marginal income tax rates in the US since 1914.

Tax Incentives III
High marginal tax rates will shift AS to the left.
A reduction in marginal tax rates will shift AS to the right.
On the other hand, a tax rebate (one-time tax refund) adds to
disposable income but does not affect the marginal tax rate, so
AS does not shift.
16-20
Keynesians, of course, would prefer the tax rebate. Its only
effect would be to shift AD.
20
Savings Incentives
Keynesians treat saving as a deterrent to spending, a leakage.
Supply-siders emphasize the importance of saving for financing
more investment and economic growth.
They favor tax incentives that encourage saving and greater tax
incentives for investment.
16-21

Savings provide the input for the credit market.
Encouraging saving would expand the availability of credit and
lower interest rates with no Fed involvement.
Tax incentives for investment encourage more of it to occur.
Both will increase investment and shift AS, both short-run and
long-run, to the right.
21
Investment Incentives
Supply-siders advocate tax incentives for investment.
Reduced taxes on capital gains and dividends.
Larger capital expensing of new investment.
The goal is to expand investment spending, which increases the
capacity to produce. This will shift AS to the right.
16-22

Summarizes the supply-siders point on investment incentives.
22
Human Capital Investment
Supply-siders encourage investments in human capital – the
knowledge and skills possessed by the workforce – to provide
the knowledge and skills needed to reduce structural
unemployment.
This can be done by providing tax credits to employers who
offer more worker training.
16-23
The goal here is to improve productivity.
Productivity leads to lower per-unit costs.
Lower per-unit costs lead to expansion of production.
23
Other Human Capital Incentives
Expand and improve the educational system.
Reduce discriminatory barriers by using affirmative action
programs.
Keep transfer payments from becoming excessive and providing

a disincentive for recipients to take a job.
16-24
All of these will aid in shifting AS to the right.
24
Deregulation
When government imposes regulations that directly affect
employment and production decisions, it affects the AS curve.
Excessive regulation is costly to producers and will shift AS to
the left.
Decreased regulation (or deregulation) reduces costs for
producers and will shift AS to the right.
16-25

One of the big uncertainties that slowed the economic recovery
in 2010-2012 was the huge uncertainty among business about
how much of an increase in regulatory costs they would face
when all the new banking, health, and environmental regulations
in the pipeline went into effect.
They envisioned rapidly rising regulatory costs, which would
shift AS left and cause the triple bad.
25
(De)regulation
Regulations have good reasons for existing but shift AS to the
left by increasing costs to producers. Examples:
minimum wage.
mandatory benefits.
occupational health and safety.
transportation costs.
food and drug standards.
environmental protection.
Supply-siders contend that regulatory costs are now too high.
16-26

If high regulatory costs shift AS left and cause higher
unemployment, higher inflation, and slow GDP growth, it might
be time to do a benefit-cost analysis on some of the offending
regulations.
26
Easing Trade Barriers
When production costs rise, AS shifts left.
Tariffs (taxes on imported goods) make input costs higher.
Immigration restrictions make it more difficult to overcome
skill shortages in the labor market.
Supply-siders say that tariff reduction on inputs and
improvement in the flow of immigrant workers cause production
costs fall and AS will shift right.
16-27
Protection occurs when tariffs and quotas are passed by
Congress with the rationale of “protecting” American jobs. We
will debunk that myth in the international chapters. What
protectionism really does is raise costs of all production and
destroy jobs in exporting industries.
27

Adverse Supply-Side Policies
The following policies shift AS to the left:
higher marginal tax rates for individuals and businesses.
increased taxes on saving and investment.
letting infrastructure deteriorate.
increased government regulation.
increased trade barriers.
When AS shifts left, output decreases, unemployment rises, and
inflation increases.
16-28
Supply-side policy is one-way: advocate practices that will shift
AS right. Never advocate practices that will shift AS left.
28
Rebuilding America.
We must maintain, improve, expand, and in some cases replace
our public infrastructure.
Delay in doing so imposes severe costs in the everyday activity
of America.
In the economy tomorrow:
deteriorating or inadequate infrastructure will shift the AS
curve to the left.

modernizing and updating infrastructure will shift the AS curve
to the right.
16-29
Some infrastructure improvements in the world have skipped a
generation or two in technology. In Africa and Asia,
communications jumped over the landline telephone directly to
cell phone technology, for example.
29
Infrastructure: The transportation, communications, education,
judicial, and other institutional systems that facilitate market
exchanges.
Improving these institutional structures makes commerce flow
easier and therefore reduces costs.
Reducing costs will cause the AS curve to shift right.
16-30

Nobody advocates the wanton and deliberate deterioration of
infrastructure.
However, when funds are allocated for infrastructure, they seem
to have to go through the “pork barrel” and go to projects that
are more political than necessary.
30
LO16-1 Explain why the short-run AS curve slopes upward.
There is a maximum capacity to produce at any time in an
economy. As output nears that capacity, output increases slow
down but price increases accelerate.
The AS curve traces this phenomenon.
16-31
Here begins the review of the chapter.
31

LO16-2 Discuss how an unemployment-inflation trade-off
arises.
Because the AS curve slopes upward, there is a trade-off
between unemployment and inflation as illustrated by the
Phillips curve.
The Phillips curve and the AS curve are mirror images.
The inflationary flashpoint is the rate of output where inflation
accelerates and the trade-off becomes acute.
16-32
LO16-3 How shifts of the aggregate supply curve affect macro
outcomes.
Supply-side policies attempt to shift AS to the right, yielding
less inflation and less unemployment.
Marginal tax rates are a major concern of supply-side
economists. They believe high tax rates discourage extra work,
investment, and saving shifting the AS curve to the left.
16-33

Revisiting the Learning Objectives IV
LO16- 4 Identify the tools of supply-side policy.
The goal of any supply-side policy should be to shift AS to the
right.
A reduction in marginal tax rates will do this.
Also, a rightward shift of AS is the result of investments in
human capital, reduction of regulatory costs, infrastructure
development, and reduction of trade barriers.
16-34
Growth and Productivity: Long-Run Possibilities

After learning about this chapter, you should know:
The principal sources of economic growth.
The policy tools for accelerating growth.
The pros and cons of continued growth.
16-35
Monetary Policy
LO15-1 How interest rates are set in the money market.
LO15-2 How monetary policy affects macro outcomes.
LO15-3 The constraints on monetary policy impact.
LO15-4 The differences between Keynesian and monetarist
monetary theories.
15
LEARNING OBJECTIVES
CHAPTER

1
Monetary Policy
Control over the money supply is a critical policy tool for
altering macroeconomic outcomes.
The quantity of money in circulation influences its value in the
marketplace.
Interest rates and access to credit are basic determinants of
spending behavior.
15-02
This chapter details how and when the policy tools of the Fed
are used and the various outcomes that can be expected.
2
Monetary Policy II
In this chapter we explore the effectiveness of monetary policy.
Specifically,

What’s the relationship between money supply, interest rates,
and aggregate demand?
How can the Fed use its control of the money supply or interest
rates to alter macro outcomes?
How effective is monetary policy, compared to fiscal policy?
15-03
3
The Money Market
Money is a commodity that is traded in a marketplace, the
money market.
The money supply is controlled by the Fed and society has
demand for money.
The market determines the “price” of money, the interest rate.
At high interest rates, money is expensive to acquire.
At low interest rates, money is cheap to acquire.
15-04

Here is a good place to use the product market analogy.
Remember to make the money supply a vertical line on the
market model.
While any participant in an economy can increase or decrease
the quantity of money that he or she holds individually, all
participants taken together cannot change the quantity of money
that they hold because the quantity of money is fixed. Currency
and bank account balances can move from one participant to
another, but only the Fed can change the total amount of money
that everyone holds in aggregate.
4
The Money Market II
Money supply (M1): currency held by the public, plus balances
in transactions accounts.
Money supply (M2): M1 plus balances in savings accounts and
money market mutual funds.
Money demand: quantities of money the public wants to hold at
alternative interest rates.
15-05

Review of definitions
5
The Money Market III
Money demand: If people hold cash as M1, they suffer an
opportunity cost: the forgone interest they could have earned.
At low interest rates, the opportunity cost of holding money is
low, so people will hold more of it, and vice versa.
15-06
The concept of opportunity cost is a real one.
6
The Demand for Money
Why would people want to hold money, that is, have a demand
for money?
Transactions demand: Money held for the purpose of making
everyday market purchases.

Precautionary demand: Money held for unexpected market
transactions or for emergencies.
Speculative demand: Money held for speculative purposes, for
later financial opportunities.
15-07
Not all people have all of these elements of money demand.
Because of that, it might be necessary to more fully explain
those that the students have not encountered.
Most likely, those would be the precautionary demand (just-in-
case money) and the speculative demand (I have to be ready to
act when the opportunity presents itself). The transactions
demand should present no problem.
7
Money Market Equilibrium
Money demand: the quantity of money people are willing and
able to hold (demand) increases as interest rates fall, and vice
versa.
Money supply: since the Fed controls the money supply, it is
represented by a vertical line.
15-08

As an exercise, you could show what happens when interest
rates rise (surplus) and what happens when interest rates fall
(shortage).
Also, show what happens when MS shifts left (interest rates
rise) or shifts right (interest rates fall).
This sets up the next several slides.
8
Money Market Equilibrium II
The intersection of money demand and money supply (E1)
establishes the equilibrium rate of interest.
15-09

This slide establishes the connection between MS and interest
rates.
9
Money Market Equilibrium III
If interest rates are higher than equilibrium, there is a money
surplus.
People must hold more money as M1 than they want to.
They will move money out of M1 into M2 or other assets (such
as bonds).
The interest rate will then fall to E1.
15-10
Walk through the reactions of money holders when interest rates
are above equilibrium.
10
Money Market Equilibrium IV
If interest rates are lower than equilibrium, there is a money

shortage.
5
People must hold less money as M1 than they want to.
They will move money into M1 from M2 or other assets (such
as bonds).
The interest rate will then rise to E1.
15-11
Similarly for interest rates below equilibrium.
11
Changing Interest Rates
The Fed controls the money supply.
The Fed can use its policy tools to change the equilibrium rate
of interest.
By increasing the money supply (causing a surplus), the Fed
tends to lower the equilibrium rate of interest.
By decreasing the money supply (causing a shortage), the Fed
tends to raise the equilibrium rate of interest.
15-12

You might want to show this on a graph on the board.
12
Interest Rates and Spending
Lowering interest rates: a tactic of monetary stimulus, to
increase aggregate demand (AD).
Reduce the cost of investment spending.
Reduce the cost of holding inventory.
The investment spending increase will kick off a positive
multiplier effect. AD will shift right because of this.
15-13

Here we connect lower interest rates through increased money
available to increased spending and an AD shift to the right.
13
Interest Rates and Spending II
Raising interest rates: a tactic of monetary restraint, to decrease
aggregate demand (AD).
Increase the cost of investment spending.
Increase the cost of holding inventory.
The investment spending decrease will kick off a negative
multiplier effect. AD will shift left because of this.
15-14
Here we connect higher interest rates through decreased money
available to decreased investment spending and an AD shift to
the left.
14
Summary
Goal 1: to stimulate the economy.
An increase in the money supply leads to,
Lower interest rates, which lead to,

An increase in aggregate demand.
Goal 2: to restrain the economy.
A decrease in the money supply leads to,
Higher interest rates, which lead to.
An decrease in aggregate demand.
15-15
This summarizes the connections.
15
Policy Constraints:
On Monetary Stimulus
Short- vs. long-term rates.
The Fed has greater influence on short-term rates (that is, the
Fed funds rate) than long-term rates (mortgages and installment
loans).
Monetary stimulus will be most effective if long-term interest
rate changes mirror short-term rate changes.
If not, the AD increase will be less than hoped for.
15-16

How could this happen?
Easing up in the Fed sends strong signals to the private sector,
especially the investment community.
If this community concludes that, due to the Fed’s easing,
future expectations are rosier, then more long-term investment
will occur.
And vice versa.
16
Policy Constraints:
On Monetary Stimulus II
Reluctant lenders.
Banks must be willing to increase lending activity.
Banks may pile up excess reserves instead of making loans (this
happened 2008-2014).
They worry about their financial well-being.
They worry about not being paid back by weak borrowers.
They worry about how new bank regulations may affect
profitability.
15-17

In a previous chapter, the current atmosphere in banking was
described as being reluctant to lend.
If this is the case, the Fed increasing the money supply with the
intent of increasing reserves will not accomplish the added
spending and the shift of AD right.
Say the Fed did this by buying bonds in the open market.
Amazingly, the banks, instead of increasing loans, put their
excess reserves in bonds.
17
Policy Constraints:
On Monetary Stimulus III
Lowering interest rates too far eliminates the opportunity cost
of holding M1. The public simply hold the money instead of
investing.
This is the liquidity trap: The portion of the money demand
curve that is horizontal; people are willing to hold unlimited
amounts of money at some low interest rate.
15-18

How low can interest rates go? Zero? Negative?
Once interest rates get down to numbers like these, the
opportunity cost of holding cash is also zero.
18
Policy Constraints:
On Monetary Stimulus IV
Low expectations:
In a recession, firms have little incentive to expand production
capability (evident in 2008-2014).
There would be little expectation of future profit, or return on
investment (ROI), from new investment.
Consumers may be reluctant to take on added debt when future
income prospects are uncertain.
15-19
For decades up to the onset of the Great Recession, Americans
operated on credit. A major change began when the Great
Recession occurred.
Instead of using stimulus funds to buy more, Americans used
them to pay down existing debt, and their propensity to save
increased.

This upset a lot of calculations made by policy makers, which
were based on what they expected people to do, which they did
not do.
19
Policy Constraints:
On Monetary Stimulus V
Time lags:
It takes time to develop and implement new investments in
response to lower interest rates.
Consumers also may take time to decide to increase their
borrowing.
It may take 6 to 12 months before market behavior responds to
monetary policy.
15-20
In both the government sector and the private sector, plans must
be drawn up, analyzed, approved, and then implemented.
20
Policy Constraints:
On Monetary Restraint
High expectations:

In a growing economy consumers and businesses may believe
that future income and revenue will be sufficient to cover
higher interest rates.
Global Money:
Market participants can look outside of US money market for
loanable funds in foreign subsidiaries, banks and bond markets.
15-21
After a prolonged period of recession market participants may
be slow to respond to “tight” money policy.
Instead of slowing down due to higher interest rates, growing
expectations of future revenue and income could cause
continued borrowing.
In a global economy market participants may find low interest
alternatives for funding outside the US banking system.
21
The Monetarist Perspective
Keynesians say that changes in the money supply changes in
interest rates, which shift AD.
Monetarists say that real output levels are not affected by
monetary policy. Only the price level is affected by Fed policy
… and then only by changes in the money supply.
So they say monetary policy is not effective for fighting

recession, but is a powerful tool for managing inflation.
15-22
Remember Keynesians are all about spending and moving AD.
Monetarists have seen over the last 50 years or so that
increasing MS to improve the unemployment numbers has not
been very effective, but decreasing MS to strangle inflation has
been highly effective (witness the events of 1982-1984).
22
The Equation of Exchange
The equation of exchange is:
In this equation, total spending is price level (P) times quantity
of output (Q). This spending is financed by the money supply
(M) times the velocity of its circulation (V).
Velocity (V): the number of times per year, on average, that a
dollar is used to purchase final goods and services.
MV = PQ
15-23

This is not really an equation. A math purist will tell you it is
an identity.
On the left is how much money is spent to buy the nominal
GDP. On the right is the amount of money needed to buy the
nominal GDP.
23
The Equation of Exchange II
PQ is the same as nominal GDP.
The quantity of money (M) in circulation and the velocity (V)
with which it exchanges hands will always be equal to the value
of nominal GDP.
Monetarist view: If M increases, P and/or Q must rise, or V
must fall.
MV = PQ
15-24

Velocity is an odd duck.
It might be useful to consider it as an indicator of how the
public handles money. How the public handles money over a
period of time can change (look at how the ubiquity of ATMs
has altered the way we handle money). If we do not change the
ways we handle money, then V should not vary much. When we
do change the ways we handle money, then V will change.
http://research.stlouisfed.org/fred2/series/M1V?cid=32242.
24
The Equation of Exchange III
Monetarists assume V is stable – that is, does not change.
V is a function of how people handle their money and the
institutions they use to do so. Neither should change much in
the short run.
Thus, total spending (PQ) must rise if money supply (M) grows
and velocity (V) is stable, regardless of interest rates.
MV = PQ
15-25

An alternative version of the formula is %change in M +
%change in V = %change in P + %change in Q.
Someone in the math department will show you, via calculus,
why this is so.
If V is stable, then the %change in V = 0.
So a 6% increase in M must show up as a collective 6% change
in those two variables.
Possibilities: 6% increase in P and 0% change in Q; 0% change
in P and a 6% increase in Q, or some combination adding up to
6.
25
Money Supply Focus
If spending increases when the money supply grows, then the
Fed should focus on the money supply, not interest rates.
Fed policy should not be to manipulate interest rates.
Fed policy should focus on the size and growth of the money
supply.
15-26
Here is one position in the what to do with monetary policy
debate.

26
“Natural” Unemployment
Monetarists also say that, in the short run:
Q is stable; a function of productive capacity, labor efficiency,
and other “structural” forces.
This leads to a “natural” rate of unemployment that is fairly
immune to short-run policy intervention.
Natural rate of unemployment: The long-term rate of
unemployment determined by structural forces in labor and
product markets.
MV = PQ
15-27
In the short run, over three to six months, real GDP does not
increase very much, so we could say that Q is stable.
A MS increase, however, would become effective more
immediately. So an increase in M, with both V and Q constant,
would cause an increase in P.
The consequence of this reasoning is that, at some level of real
GDP, we reach a point where real GDP will not increase.
Further injections of money will simply increase prices. The
real GDP at which this happens is at the “natural” rate of
unemployment, or more simply, full-employment GDP.

27
“Natural” Unemployment II
If both V and Q are stable, any increase in M in the long-run
only increases P.
If prices rise, costs of production will rise also, so there is no
profit incentive to increase Q.
Any increase in AD directly increases the price level.
MV = PQ
15-28
Summary slide.
28
Monetarist Policy: Fighting Inflation
With an inflationary gap, interest rates are likely to be high. A
decrease in the money supply will lower nominal interest rates,
not raise them.
Nominal interest rate: the interest rate we actually see and pay.
Real interest rate: the nominal rate minus the anticipated
inflation rate.
As the money supply shrinks, the price level falls and
anticipated inflation decreases, so nominal interest rates fall,
not rise.

15-29
When we talked about liquidity earlier, we asked how low
interest rates can go. Zero?
The interest rate people pay is the nominal rate. Lenders build
the effects of inflation into that rate. Subtract the expected
inflation and we get the real rate.
If the nominal rate is 1.5% and expected inflation is 3%, then
the real rate is -1.5%, a negative rate.
In the example on the slide inflation is high, say 10%.
Decreasing the money supply will be viewed as an inflation
fighter, and expected inflation ultimately will decrease, which
will lower the nominal rate.
29
Monetarist Policy: Fighting Inflation II
To close an inflationary GDP gap using monetary policy, reduce
the money supply and shift AD left.
Monetarists advise steady and predictable changes in the money
supply, to reduce uncertainty and thus stabilize both long-term
interest rates and GDP growth.
15-30

Both Keynesians and monetarists advocate a decrease in the
money supply to fight inflation, but they expect it to work for
different reasons.
The other big factor in the activities of the players in the
economy is uncertainty. What is the Fed going to do next? What
is the Congress going to do next?
In times of great uncertainty, the private sector holds off on
making decisions, including investment decisions. This is why
the monetarists advise a steady and predictable policy … to
remove a huge element of uncertainty.
30
Monetarist Policy: Fighting Unemployment
The policy goal would be to increase aggregate demand.
Increased money supply leads to higher prices, immediately
raising people’s inflationary expectations. Long-term interest
rates might actually rise, defeating the purpose of monetary
stimulus.
Monetarists conclude that expansionary monetary policy can’t
lead us out of recession.
15-31

Here are the contrasting views on how to fight high
unemployment.
Monetarists believe in fixed money supply targets, or a “rule”
for how much to change the money supply.
31
In the equation of exchange (MV = PQ), Keynesians’ fiscal
policy relies on changes in V while monetarists assume V is
stable and rely on changes in M.
The two tables following summarize their views on how fiscal
and monetary policies work.
15-32

This Economy Tomorrow segment summarizes the contrasting
views of Keynesians and monetarists.
32
Application: The Economy Tomorrow: Fiscal Policy
15-33
Application: The Economy Tomorrow: Monetary Policy
15-34

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