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Balance of Payments 2 (Chap. 7) (three expectations (as a home country'…
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
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keynesian cross
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the LM curve
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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