Balance of Payments 2 (Chap. 7)

assume that home/foreign price levels are fixed due to stickiness

gov. spending are fixed, subject to policy change

foreign output and interest rates are fixed

income is equal to output, Y = GDP = GNDI

consumption: simplest model of aggregate private consumption rates

consumption = C(Y-T)

marginal propensity to consume is the slope of the consumption function

MPC states how much of every $1 of household disposable income is spent on consumption

three expectations

as a home country's real exchange rate rises (depreciates), it will export more and import less, and the trade balance will rise

expect an increase in home income to be associated with an increase in home imports, and a fall in the home country's trade balance

increase in ROW income to be associate with an increase in home exports and a rise in the home country's trade balance

exogenous shocks to consumption, investment, and the trade balance Link Title

keynesian cross Link Title

the LM curve Link Title

stabilization policy: expansionary monetary and fiscal policies used to prevent a deep recession if the economy is hit by a temp adverse shock

key points

Keynesian consumption function states that private consumption spending (C) is an increasing function of household disposable income (Y-T)

Investment function: total investment I is a decreasing function of the real or nominal interest rate (I)

Gov spending (G) is exogenously given at a level

trade balance is an increasing function of the real exchange rate EP*/P

P* = foreign price level

key points con't

if an interest rate falls in a foreign country, demand is stimulated

lower interest rate directly stimulates investment

lower interest leads to an exchange rate depreciation, which increases the trade balance

real money demand arises from transactions requirements

increases when volume of transactions increases

decreases when opportunity cost of holding money increases

money market equilibrium states that demand for real money balances must equal the real money supply

under a floating exchange rate, the interest rate and exchange rate are free to adjust to maintain equilibrium

gov policy can move IS or LM curves

leads to money expansion: LM shifts to the right, output rises, interest falls, exchange rate rises/depreciates

fiscal expansion: IS shifts to the right, output rises, interest rate rises, exchange rate falls/appreciates