Foreign Exchange (FOREX)

Foreign Exchange→buying and selling of currency
EX) In order to purchase souvenirs in France, it is first necessary for America to sell (supply) their dollars and buy (demand) Euros.

*The exchange rate (e) is determined in foreign currency markets
EX) The current exchange rate is approximately 77 Japanese yen to 1 U.S. dollar.

*Simply put: exchange rate is price of a currency
*do not try to calculate the exact exchange rate
*increase in demand of Euros relative to U.S. dollar

Extra: Credits vs. Debits

Credits→addition to a nation's account
Debits→subtractions to a nation's account

How to Calculate the following:
1. Balance of Trade: merchandise ↓ service exports-merchandise ↓service imports (typically)
2. Trade deficit occurs when the balance on trade is negative (imports>exports)/ Trade surplus occurs when the balance on trade is positive (exports>imports)
3. Balance on current account=Balance on trade (exports & imports)+Net investment income+Transfer payments
4. Official Reserves
*nationally

Δ in CA+Δ in FA+Δ in official reserves=not zero

Unit VII: Balance of Payments

Balance of Payments→measure of $ inflows and outflows b/t U.S. and rest of world (ROW)

• inflows referred to as "CREDITS"
• outflows referred to as "DEBITS"

They are divided into 3 accounts:

1. current account
2. capital/financial account
3. official reserves account

Double Entry Bookkeeping:

*every transaction in balance of payments is recorded twice in accordance w/ standard accounting practice

EX) U.S. manufacturer, John Deere, exports $50 million worth of farm equipment to Ireland.

-a credit of $50 mill. to current account 

(-$50 mill. worth of farm equipment or physical assets)

-a debit of $50 mill. to capital/financial account

(+$50 mill. worth of Euros or financial assets)

-notice that the 2 transactions offset (balance) each other. Theoretically, the balance payments should always =0.

Current Account:

1. Balance of Trade of Net Exports

• exports of goods & services --imports of goods & services
• exports create a CREDIT to balance of payments
• imports create a DEBIT to balance of payments

2. Net Foreign Income

• income earned by U.S. owned foreign assets--income paid to foreign held U.S. assets
• EX) Interest payments on U.S. owned Brazilian bonds--interest payments on German owned U.S. treasury bonds

3. Net Transfers (tend to be unilateral→one-sided)

• foreign aid→debit to current account
• EX) Mexican migrant workers send $ to family in Mexico

Capital/Financial Account

*the balance of capital ownership

*includes purchase of both real and financial assets

*direct investment in U.S. is a credit to capital account

EX) Toyota Factory in San Antonio

*direct investment by U.S. firms/individuals in a foreign country are debits to capital account

EX) the Intel Factory in San Jose, Costa Rica

*purchase of foreign financial assets represents a debit to capital account

EX) Warren Buffet (a wealthy man) buys stock in Petrochina

*purchase of domestic financial assets by foreigners represents a credit to capital account

EX) United Arab Emirates sovereign wealth fund purchases a large stake in NASDAQ

What Causes Capital/Financial Flows?

*differences in rates of return on investment

*Ceteris Paribus ("with other things the same" or "all other things being equal"), savings will flow toward higher returns

     

Relationship b/t Current & Capital Account

*current account and capital account should zero each other out (+/-; surplus/deficit)

EX) The constant net inflow of foreign financial capital to U.S. (capital account surplus) is what enables us to import more than we export (current account deficit)

Official Reserves

*foreign currency holdings of U.S. Federal Reserve System

*when there is a balance of payments surplus, the Fed accumulates foreign currency and debits the balance of payments

*when there is a balance of payments deficit, the Fed depletes its reserves of foreign currency and credits balances of payments 

*official reserves zero out the balance (everything)

*active vs. passive

Helpful Guide:

Reaganomics

Supply-side economics or Reaganomics:

1. support policies that promote GDP growth by arguing that high marginal tax rates along w/ current system of transfer payments (i.e. unemployment compensation and social security) provide disincentives to work, invest, innovate, and take entrepreneurial adventures
2. believe AS curve will determine levels of inflation, unemployment, and economics growth

Trickle-down Effect: 

*Rich→poor (direction of $ flow)

Marginal Tax Rate→amount paid on last $ earned or on each additional $ earned

• Reaganomics believe if you reduce the marginal tax rate, more people will be inclined to work longer, thus forgoing leisure time for extra income. 

Laffer Curve

**higher the tax rate you set, less $ you will collect
**Laffer Curve is controversial and debatable


*trade-off b/t tax rates and govt revenue
*as tax rates ↑ from 0, tax revenues ↑ from 0 to some max level, and then decline
*higher tax rates, less $ you collect
*Criticisms:

1. where economy is located on curve, it is difficult to determine
2. tax cuts also ↑ demand which can fuel inflation
3. empirical evidence suggests that impact on tax rates on incentives to work, save, and invest are small

Phillips Curve Cont.

SRAS→=SRPC←

(imagine the direction of the arrows on the corresponding graphs below)

• inflationary expectations ↓, input prices ↓, productivity ↑, business taxes ↓, +/or deregulation
• SRAS→: GDPR↑ and PL ↓; u%↓ and π%↓
• SRPC← (disinflation)

 *supply shock→rapid and significant increase in resource cost which causes the SRAS to shift

*NRU→is = to frictional, structural, and seasonal (cyclical based on economy)

• natural rates and fewer worker benefits create a lower NRU (free med. care for all workers, lay-off some b/c profits being eaten)

*misery index→combo. of inflation (2-3%) and unemployment (double digits=depression, forget a recession) in any given year. Single digit misery is good. 

*if inflation rate persists and expected rate of unemployment rises, then entire SRPC moves upward. When that happens, stagflation exists. 

*if inflation expectations drop (due to new tech., efficiency, etc.), the SRPC moves downward

*stagflation→↑ unemployment and ↑inflation occurring at same time

*disinflation→when inflation decreases over time 

• nominal wages ↓ (good)
• business profits fall as prices ↑ (bad)
• firms reduce employment, thus, unemployment ↑

Unit VI: The Phillips Curve

u%=unemployment rate
π%=rate of inflation

*The Phillips Curve represents the relationship b/t unemployment and inflation
*trade-off b/t unemployment and inflation occurs over SR
*each point on the Phillips Curve corresponds to a different level of output
*LRPC=long run Phillips Curve

• occurs at NRU

• represented by ↨ line

• no trade-off b/t unemployment and inflation in LR

1. economy produces @ FE output level
2. nominal wages of workers fully incorporates any changes in PL as wages adjust to inflation over the LR

*LRPC only shifts when LRAS shifts (both have the same determinants)
*↑ in unemployment, LRPC →
*↓ in unemployment, LRPC ←
*Increase in AD=up/left movement along SRPC 

• C↑, Ig↑, G↑, and/or Xn↑
• AD→: GDPR↑ and PL ↑; u%↓ and π%↑; up/left along SRPC
• this would be depicted in the graph below 

*Decrease in AD=down/right along SRPC

• C↓, Ig↓, G↓, and/or Xn↓
• AD←: GDPR↓ and PL↓; u%↑ and π%↓; down/right along SRPC
• in this case, point B would move to point A in the graph below

**Check out this blog for more info. on the Phillips Curve and other economic topics: http://macroeconomic1.wordpress.com/ 

Unit V: AD/AS: From SR to LR

*AS curve doesn't shift in response to changes in the AD curve in the short run

• i.e.-nominal wages do not respond to PL changes
• workers may not realize impact of the changes or may be under contract (i.e. teachers don't get paid more for tutorials)

*Long run (vertical)-prd in which nominal wages are fully responsive to previous changes in PL

*when changes occur in the SR, they result in either increased/decreased producer profits-not changes in wages paid

*in the LR, increases in AD result in a higher PL. As in SR, but as workers demand more $, the AS curve shifts left to equate production @ the original output level, but now @ a higher price. 

*in the LR, the AS curve is vertical (LRAS) @ the natural rate of unemployment (NRU), or FE level of output. Everyone who wants a job has one and no one is enticed (lured or tempted) into or out of market.

*Demand-pull inflation will result when an increase in demand shifts the AD curve to →, temporarily increasing output while raising prices. 

*Cost-push inflation results when an increase in input costs that shifts the AS curve to ←. In this case, the PL increase is not in response to ↑ in AD, but instead the cause of PL increasing. (in a recession, AD ↓ and shifts ←)

Graph: Crowding Out

Monetary & Fiscal Policy (during a recession)

Monetary Policy (Recession)	International Trade
Fed will:       1.       Buy bonds                       2.       Lower RR                       3.       Lower DR       4.       Lower FF  all contribute to: MS ↑, i ↓, Ig ↑, AD ↑, GDP ↑ **opposite occurs during inflationary prd	D $ (demand for $) ↓ ↓ $ depreciated (value of $ goes ↓) ↓ Exports ↑ (cheaper) ↓ Xn ↑ ↓ AD ↑ ↓ GDP ↑

Fiscal Policy (Recession)	International Trade
-congress will cut taxes or ↑ govt spending -consumption and govt spending will ↑ -AD will ↑ -GDP ↑ -Deficit→supply of LF ↓ (none to loan out) ↓ I (interest) ↑ Ig ↓	D $ ↑ ↓ $ appreciate (increase in value) ↓ Exports ↓ ↓ Net exports ↓ ↓ AD ↓ ↓ GDP ↓

Loanable Funds Market

Loanable Funds Market (LF)→market where savers and borrowers exchange funds (QLF) @ real rate of interest (r%)

• D for LF, or borrowing comes form households, firms, govt, and foreign sector. DLF is supply of bonds

• SLF, or savings comes from households, firms, govt, and foreign sector. SLF also demand for bonds. 

Changes in DLF:

• more borrowing=more demand for LF (→)
• less borrowing=less demand for LF (←)

EX) Govt deficit spending=more borrowing

• =more DLF (DLF→, r% ↑) 

 less investment demand=less borrowing

• less DLF (DLF ←, r% ↓)

Changes in SLF:

• more saving=more SLF (→)
• less saving=less SLF (←)

EX) Govt budget surplus=more saving

• more SLF (SLF →, r% ↓)

Decrease in consumer's MPS=less saving

• less SLF (SLF ←, r% ↑)

Multiple Deposit Expansion

How Banks Work:

Assets	Liabilities & Equity
-Reserves ·         Required reserves (RR)→% required by Fed. To keep on hand to meet demand. ·         Excess reserves (ER)→% reserves over and above the amount needed to satisfy minimum reserve ration set by Fed. -loans to firms, consumers, and other banks (earns interest) Loans to govt=treasury securities -bank property—if bank fails, you could liquidate the building/property	-Demand Deposits ($ put into bank) -timed deposits (CD’s) -loans from: Federal reserve and other banks -Shareholders’ Equity→to set up a bank, you must invest your own $ in it to have a stake in bank’s success/failure

Reserve Requirement:

• Fed requires banks always have some $ readily available to meet consumers' demands for cash
• amount (set by Fed) is Required Reserve Ratio
• required RR is % of demand deposits (checking account balances) must NOT be loaned out
• typically RR ratio=10%

EX 1) Reserve ratio is 5%. You deposit $1000 in bank. How much is bank required to add to its reserves?

0.05x$1000=$50 in reserve ratio

How much $ can bank loan out?

1000 (deposited) - 50 (reserve ratio) = $950 loaned out to next borrower

EX 2) Scenario: 100% Reserve Banking: Now suppose households deposit $1000 @ "Firstbank"

• falls under liabilities (claims of non-owners)
• reserves=$1000 under assets (each side must balance)

**100% reserve banking has no impact on size of $ supply
EX 3) Scenario: Fractional Reserve Banking: Suppose banks hold 20% of deposits in reserve, making loans w/ the rest

-Firstbank will make $800 in loans

Assets	Liabilities
Reserves $200 Loans $800	Deposits $1000

  

-$ supply now=$1800

-depositor still has $1000 in demand deposits (but borrower now holds $800 in currency)

**In a fractional reserve banking system, banks create $.

Required Reserve Ratio:

-% of demand deposits that must be stored as vault cash or kept on reserve as Federal funds in the bank's account w/ Federal Reserve

-Required Reserve Ratio determines the $ multiplier (1/reserve ratio)

• Decreasing the reserve ratio increases rate of $ creation in banking system and is expansionary
• Increasing the reserve ratio decreases rate of $ creation in banking system and is contractionary

-changing required reserve ratio is least used tool of monetary policy and usually held constant @ 10%

Money Multiplier:
-shows us impact of change in demand deposits on loans + eventually the $ supply
-indicates total # of dollars created in banking system by each $1 addition to monetary base (bank reserves + currency in circulation)
-to calculate $ multiplier, divide 1 by required reserve ratio

$ multiplier=1/reserve ratio

EX) if reserve ratio is 25%, multiplier=4

4 Types of Multiple Deposit Expansion Questions:

• Type 1: Calculate initial change in ER aka amount a single bank can loan from initial deposit
• Type 2: Calculate change in loans in banking system
• Type 3: Calculate change in $ supply **sometimes Types 2&3 will have same result if there is no Fed involvement
• Type 4: Calculate change in demand deposits

EX 1) Given a required reserve ratio of 20%, assume Federal Reserve purchases $100 million worth of U.S. Treasury Securities on open market from a primary security dealer. Determine amount that a single bank can lend from this Fed Reserve purchase of bonds.  

the amount of new demand deposits - required reserve=initial change in ER

$100 mill. - (20% x $100 mill.) 

$100 - 20 = $80 mill. in ER

EX 2) Maximum change in loans in banking system.

initial change in ER x $ multiplier=max change in loans

$80 mill. x (1/20%)

$80 mill. x 5 = $400 mill. max in new loans 

EX 3) Maximum change in $ supply.

maximum change in loans + $ amount of Federal Reserve action

$400 mill. + $100 mill.=$500 mill. max change in $ supply

EX 4) Maximum change in demand deposits.

maximum change in loans + $ amount of initial deposit

$400 mill. + $100 mill. = $500 mill. max change in demand deposits