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# Econ test 2 ch. 7,17,22,24 March 28 Chapter 7 Stock Market, Theory Of Rational Expectations.

ons. Computing the Price of Common Stock Common Stock is principal way corporations raise equity capital o Holders own interest in corporation consistent w/ percentage of outstanding shares owned Stockholders: those who hold interest in a corporation-have bundle of rights o Most important are right to vote and to be the residual claimant of all funds flowing into the firm (known as cash flows) Residual claimant: stockholder receives whatever remains after all other claims against the firms assets have been satisfied o Paid dividends(payments made periodically, usually every quarter, from net earnings o Has right to sell stock Board of directors of firm sets level of the dividend, usually based on recommendation of mgt 1 basic principal of Finance-value of any investment is found by computing PV of all cash flows investment will generate over its life o Ex. commercial building will sell for price that reflects net cash flows (rents-expenses) its projected to have over its useful life o Similarilywe value common stock as value in todays dollars of all future cash flows The cash flows a stockholder might earn from stock dividends, sale price, or both To develop theory of stock valuation: Buy stock, hold it for one period to get dividend, then sell stock---called one-period valuation model One Period Valuation Model o Should you buy stock or not?---need to determine whether current price accurately reflects analysts forecast To value stock today: find present discounted value of expected cash flows(future payments) using equation Equation: P0=(Div1)/(1+ke)+(P1)/(1+ke) P0= current price of stock. Zero subscript refers to time period zero or present Div1=dividend paid at end of year 1 Ke=required return on investments in equity P1= price at end of period; assumed sales price of the stock Ex. satisfied to earn 12% return on investment(ke=.12), Intel pays %0.16 in dividends (Div1=.16), and forecast share price of \$60 for next year(p1=\$60) P0=(.16)/(1+.12)+(60)/(1+.12)=.14+53.57=\$53.71 Find PV of all cash flows is \$53.71b/c current price of stock is \$50 you would buyhowever be aware stock may be selling for less than \$53.71 b/c other investors place different risk on cash flows or estimate cash flows to be less than you do Generalized Dividend Valuation Model o Using PV concept, the one period div. valuation model can be extended to any number of periods: Value of stock today is the PV of all future cash flows o Only cash flows investor will receive are dividends and final sales price when stock is ultimately sold in period n

Has been faulted b/c people use more info than just past data to form expectations of that variablealso effected by Expectations of inflation affected by future monetary policy as well as by current and past monetary policy People often change their expectations quickly in light of new information Rational expectations: to meet these objections to adaptive expectations; thus an alternative theory of expectations Expectations will be identical to optimal forecasts (the best guess of the future) using all available information Ex. Takes avg of 30 min to work when not rush hoursometimes takes 25, other times 35leaves for work during rush hour, takes him on avg an additional 10 minutes to get to workGiven that leaves for work during rush, best guess of driving timethe optimal forecast---is 40 minutes o Best guess of driving time using all info is 40 min, expectation should be the same o Expectation of 35 min not rational b/c not equal to optimal forecast(best guess of driving time) o Somedays may take 45 or 45 but forecast does not have to be perfectly accurate to be rational--- need be the best possible given the available information; has to be correct on average o Bound to be some randomness, so optimal forecast will never be accurate o Accident happens along the way that causes traffic..still rational o However if there is a radio report of accident and does not put that into account then it is no longer rational for 40 min Even though a rational expectation equals the optimal forecast using all available information, a prediction based on it may not always be perfectly accurate Two reasons expectations may fail to be rational: o People might be aware of all available information but find it takes too much effort to make their expectation the best guess possible o People might be unaware of some available relevant information, so their best guess of the future will not be accurate If an additional factor is important but information about it is not available, an expectation that does not take account of it can still be rational Formal Statement of the Theory o Theory of expectation more formally: X^e=X^(of) Expectation of X=optimal forecast using all available information X=variable being forecast(Driving time) X^e=expectation of variable(Expectation of driving time) X^(of)=optimal forecast of X using all available info(best guess possible) Rationale behind the Theory

Ex. GE makes poor forecasts of interest rates, earn less profit, b/c may make too may appliances or to few o Incentives for equating expectations with optimal forecasts are strong in financial mark. People w/ better forecasts get rich o Application of the theory of rational expectations to financial markets(where it is called efficient market hypothesis or theory of efficient capital markets) is useful Implications of the Theory o 1. If there is a change in the way a variable moves, the way in which expectations of this variable are formed will change as well. Ex. interest rates move in a way that return back to normal. Todays interest rate is high relative to normal, optimal forecast for future says will decline to normal level. Rational expectations theory would imply that when todays interest rate is high, the expectation is that it will fall in the future Ex. now says rates will stay high and optimal forecast says and hence rational expectation, will stay highChange in way interest rate variable moves has lead to change in way that expectations of future interest rates are formed When there is a change in the way any variable moves, the way in which expectations of this variable are formed to change, too. o 2. The forecast errors of expectations will, on average, be zero and cannot be predicted ahead of time. Forecast error of expec: X-X^e(difference between realization of a variable X and expectation of the variable Ex. some days takes 45 min rather then 40 so forecast error is 5 minutesrealizes avg not equal to zero and actually equals 5 so adjusts driving time to 45 minutesRat. Exp. Theory implies he will do this b/c wants best guess possible. When revised his forecast error will equal zero so cannot be predicted ahead of time. Rat. Expect. Theory implies that forecast errors of expectations cannot be predicted The Efficient Market Hypotheses: Rational Expectations in Financial Markets Efficient market hypothesis: Expectations in financial markets are equal to optimal forecasts using all available info. o Application of rational expectations to the pricing of stocks and other securities o Based on assumptions that prices of securities in financial markets fully reflect all available information o Pg. 156 equation o Views expectations of future prices as equal to optimal forecasts using all currently available informationso markets expect. Of future securities prices are rational o Expected return on security will equal optimal forecast of the return o Does not tell about how financial markets behave o Expected return on a security will have tendency to head toward equilibrium return that equates qty demanded to qty supplied o Equation tells us that current prices in a financial market will be set so that the optimal forecast of a securitys return using all available information equals the securitys equilibrium return in an efficient market, a securiys prices fully reflects all available information Rationale Behind the Hypothesis

Arbitrage: market participants(arbitrageurs) eliminate unexploited profit oppurtunities(returns on a security that are larger than what is justified by the characteristic of that security) 2 typesone takes on risk and pure doesnt Pure arbitrage: the elimination of unexploited profit oppurtunities involves no risk Ex. annual/ equil rate is 10%...optimal forecast of return is 50%...can predict return would be abnormally high and thus unexploited profit opportunity.you would buy more b/c abnormally high rate of returnthus drive up current price and lowering rate of returnwhen current price risen sufficiently and efficient market condition satisfiedunexploited profit opportunity would disappear o In an efficient market, all unexploited profit oppurtunities are eliminated o Not everyone in a financial market must be well informed by a security or have rational expectations for its price to be driven to the point at which the efficient market condition holds Structured so many participants can play As long as few keep eyes open for unexp profit opp (often reffered as smart money) they will eliminate profit oppurtunities that appear, b/c they make a profit Efficient market hyp makes sence b/c doesnt require everyone in a market to be cognizant of what is happening to every security Stronger Version of the Efficient Market Hypothesis o Efficient markets Expectations are rational(equal to optimal forecasts using all available info.) Prices reflect the true fundamental(intrinsic) value of the securities All prices are always correct and reflect market fundamentals (items that have a direct impact on future income streams of the securities) o 1. Implies that in an efficient capital market, one investment is as good as any other b/c the securities prices are correct o 2. Implies that a securitys price reflects all available info. About intrinsic value of the security o 3. Implies that security prices can be used by managers of both financial and nonfinancial firms to assess their cost of capital(cost of financing their investments) accurately and hence that security prices can be used to help them make the correct decisions about whether a specific investment is worth making Behavioral Finance Doubts about efficient market hypothesis led to this Applies concepts from other social sciences such as anthropology, sociology, and particularly, psychology to understand the behavior of securities prices Efficient market hyp suggests that smart money participants will sell when a stock price goes up irrationally, with the result that the stock price falls back down to a level that is justified by fundamentals o For this to occur, smart money investors must be able to engage in short sales(must borrow stock from brokers and then sell it in the market, with the aim that they earn a profit by buying the stock back again (covering the short) after it has fallen in price People are subject to loss aversion: they are more unhappy when they suffer losses than they are happy when they achieve gains

Exchange rates in the Short Run: A Supply and Demand Analysis Recognize that an exchange rate is the price of domestic assets (banks deposits, bonds, equities,etc., denominated in foreign currency) Over short period, decisions to hold domestic or foreign assets play much greater role in exchange rate determination than demand for exports and imports does Supply curve for domestic Assets o Qty of dollar assets supplied is primarily the qty of bank deposits, bonds, and equities in the US, and for all practical purposes we can take this amount as fixed with respect to exchange rate o Qty supplied at any exchange rate does not change, so supply curve is vertical Demand curve for domestic assets o Most important determinant of qty of domestic(dollar) assets demanded is the relative expected return of domestic assets o Lower value of exchange rate implies that the dollar is more likely to rise in value(appreciate) o Greater expected rise (appreciation) of dollar, the higher is the relative expected return on dollar (domestic) assets o b/c dollar assets more desirable to hold, qty of dollar assets demanded will rise o if exchange rate falls even further, even higher expected apprectiation, higher expected return, and therefore even greater qty of dollar assets demanded o at lower current values of the dollar, qty demanded of dollar assets is higher Equilibrium in Foreign Exchange Market o Market in equil. When qty of dollar assets demanded=qty supplied o Ex. exchange rate higher then equilqty of dollar assets supplies is then greater than qty demanded(excess suplly)people want to sell dollar assets than want to buy themvalue of dollar will fallas long as rate remains above equil, there will continue to be excess supply of dollar assets, and dollar will fall in value until reaches equil. Vice versais excess demand Explaining Changes in Exchange rates Assuming the amount of dollar assets is fixed: supply curve is vertical at a given qty and does not shift Shifts in the Demand for Domestic Assets o If relative expected return of dollar assets rises holding the current exchange rate constant, the demand curve shifts to the right o If expected returns falls, demand curve shifts to the left o Domestic Interest Rate, i^D A n increase in the domestic interest rate i^D shifts the demand curve for domestic assets, D, to the right and causes the domestic currency to appreciate (E up) A decrease in the domestic interest rate shifts demand curve for domestic assets to the left and causes the domestic currency to depreciate Domestic interest rate falls, relative expected return on dollar asset falls, demand curve shifts to the left, and exchange rate falls o Foreign interest rate, i^F An increase in the foreign interest rate, i^F, shifts the demand curve D to the left and causes the domestic currency to depreciate; a fall in the foreign

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interest rate i^F shifts the demand curve D to the right and causes the domestic currency to appreciate Foreign interest rises, the return on foreign assets rises relative to dollar assets, thus expected return on dollar asset falls, now people want to hold fewer dollar assets, and qty demanded decreases at every value of exchange rate Changes in Expected Future Exchange Rate A rise in the expected future exchange rate shifts the demand curve to the right and causes an appreciation of the domestic currency A fall in the expected future exchange rate, shifts the demand curve to the left and causes a depreciation of currency Any factor that causes expected future exchange rate to rise increases the expected appreciation of the dollarresult is a higher relative expected return on dollar assets, which increases the demand for dollar assets at every exchange rate, shifting demand curve to the right By increasing changes in future exchange rate, all of these increase expected return on dollar assets, shift demand curve to the right, and cause appreciation to domestic currency 1. Expectations of a fall in American Price level relative to foreign price level 2. Expectations of higher American trade barriers relative to foreign trade barriers 3. Expectations of lower American import demand 4. Expectations of higher foreign demand for American exports 5. Expectation of higher American productivity relative to foreign prod. Recap: Factors that change Exchange Rate pg. 447/448 look!! Changes in Interest Rates When domestic real interest rates rise, domestic currency appreciates Domestic real interest rate increases so Increase in nominal interest rate increases the relative expected return on dollar assets, increases the qty of dollar assets demanded at each level of the exchange rate, and shifts demand curve rightexpected inflation unchanged When domestic interest rate rise due to an expected increase in inflation, the domestic currency depreciates Nominal interest rate rises b/c of increase in expected inflationleads to decline in expected appreciation of the dollar, which is thought to be larger then increase in domestic interest rateresults in at any exchange rate, expected return on domestic assets falls, demand curve shifts left, and exchange rate falls Must always distinguish b/w real and nominal measures on effects of interest rates on exchange rates Changes in the Money Supply Higher money supply, leads to higher price level in long run and hence to a lower expected future exchange ratelowers qty of dollar assets demanded at each level of exchange rate and shifts demand curve to the left Higher money supply will lead to higher real money supply b/c price level does not immediately increase in short runresulting real money rise causes

domestic interest rate to fall, lowers expected return and thus demand curve shifts left A higher domestic money supply causes the domestic currency to depreciate o Exchange rate overshooting Monetary neutrality: states that in the long run, a one time percentage rise in the money supply is matched by the same one time percentage rise in the price level, leaving unchanged the real money supply and all other economic variables such as interest rates Tells that in long run, rise in money supply would not lead to change in domestic interest rate so it would rise back to its old leve Demand curve would shift right but not all the way back b/c price level will still be higher in long runmeans exchange rates will rise Exchange rate overshooting: exchange rate falls by more in the short run than it does in the long run when money supply increases When domestic interest rate falls in short run, equilibrium in foreign exchange market means that expected return on foreign deposits must be lowerforeign interest give, this lower expected return on foreign deposits means there must be expected appreciation of dollar and depreciation of the euro for the expected expected return on foreign deposits to decline when domestic interest rates fall o Can only occur only if current exchange rate falls below its long run value Chapter 17 appendixThe Interest Parity Condition Expected return on dollar assets in terms of euros does not equal i^D, instead expected return must be adjusted for any expected appreciation or depreciation o Dollar expected to appreciate by 3% , the expected return on dollar assets in terms of euros would be 3% higher than i^D b/c the dollar is expected to become worth 3% more in terms of euros o Interest rate on dollar assets is 4%, with expected 3% appreciation of the dollar, expected return on dollar assets in terms of euros is 7% Expected return on dollar assets in terms foreign currency=interest rate on dollar assets + expected appreciation of the dollar Relative expected return on dollar assets: difference between the expected return on dollar assets and euro assets Expected return on foreign assets in terms of dollars= interest rate on foreign assets + expected appreciation of the foreign currency, equal to minues the expected appreciation of the dollar o Interest rate on euro assets is 5%, dollar expected to appreciate 3%, then the expected return on euro assets in terms of dollars is 2%...earns 5% interest rate but expects to lose 3% b/c expects euro to be worth 3% less in terms of dollars due to appreciation of dollar As relative expected return on dollar assets increases, both foreigners and domestic residents respond same wayboth want to hold more dollar assets and fewer foreign Interest Parity Condition Capital mobility: foreigners can easily purchase American assets, and Americans can easily purchase foreign assets o Currently live in this world o Assume domestic and foreign assets are perfect substitutes(equally desirable)

Interest Parity condition: states that the domestic interest rate equals the foreign interest rate minus the expected appreciation of the domestic currency o The domestic interest rate = foreign interest rate + expected appreciation of foreign currency o If domestic interest rate is higher than foreignthere is a positive expected appreciation of foreign currencywhich compensates for lower foreign interest rate o Ex. domestic interest rate of 5% versus a foreign of 3% means that the expected appreciation of foreign currency must be 2% (or expected depreciation of dollar must be 2%) o Simply means expected returns are same on both dollar and foreign assets o Equilibrium condition for foreign exchange market o Only when exchange rate is such that expected returns on domestic and foreign assets are equal---that is; when interest parity holds---investors will be willing to hold both domestic and foreign assets Ch. 22 Aggregate Demand and Supply Analysis Aggregate demand: the total qty of an economys final goods and services demanded at different price levels Aggregate supply: total qty of final goods and services that firms in the economy want to sell at different price levels Analysis of both will enable us how aggregate output and price level are determined Aggregate Demand Aggregate demand curve: describes the relationship between qty of aggregate output demanded and price level when all other variables are held constant Four components o Consumer expenditure (C): total demand for consumer goods and services o Planned investment spending (I) : total planned spending by business firms on new machines, factories, and other capital goods, plus planned spending on new homes o Government spending (G) : spending by all levels of government (federal, state, and local) on goods and services (paper clips, computers, computer programming, missiles, government workers, and so on) o Net exports (NX): net foreign spending on domestic goods and services, equal to export minus imports o Expression for Aggregate demand (Y^ad)= C+I+G+NX Deriving the Aggregate Demand Curve o Curve is downward sloping b/c a lower price level (P down arrow), holding the nominal qty of goods money (M) constant, leads to a larger qty of money in real terms (in terms of the goods and services that it can buy, M/P up arrow) larger qty of money in real terms that results from lower price level causes interest rates to fall resulting lower cost of financing purchases of new physical capital makes investment more profitable and stimulates planning investment spending(I arrow up) increase in investment spending adds directly to aggregate demand, the lower price level leads to higher level of qty of aggregate output demanded and so aggregate demand curve slopes down P down arrow M/P upi downI upY^ad up

Because lower price level leads to larger qty of money in real terms(M/P up) and lower interest rates(i down)US dollar assets become less attractive relative to assets denominated in foreign currenciescausing a decline in the demand for dollar assets and a decline in exchange rate for the dollar, denoted by E down arrow Lower value of dollarmakes domestic goods cheaper relative to foreigncausing NX to risein turn increases aggregate demand P downM/P upi downE downNX upY^ad o Equation of exchange: indicates that if velocity stays constant, a constant money supply (M) implies that nominal aggregate spending (PY) Is also constant MV=PY When price level falls (P down), aggregate demand must necessarily rise (Y^ad up) to keep aggregate spending at the same level Factors that Shift the Aggregate Demand Curve o An increase in the money supply (M up) shifts the aggregate demand curve to the right with velocity constant, the higher money supply raises nominal aggregate spending (PY up) at a given price level, qty of aggregate demand increases (Y^ad up) increase in the qty of money increases the qty of aggregate demand at each price level and shifts the aggregate demand curve to the right o for a given price levelRise in money supply causes real money supply to increase (M/P up)leads to decline in interest rates (i down)increase in investment and net exports( I, NX up)and increase in qty of aggregate demand (Y^ad) o if gov spend more (G up) or next exports increase (NX up)qty of aggregate output demanded at each price level rises, and curve shifts right o decrease in gov taxes (T down) leaves consumers with more income to spendconsumer expenditure rises (C up)qty of aggregate output demanded rises and shifts right o consumer and business optimism increasesconsumer expenditure and planned investment spending rise(C up, I up)shifting curve right o John Keynes described waves of optimism and pessimism as animal spirits and considered them a major factor affecting aggregate demand curve and an important source of business cycle fluctuations Summary o Both the quantity theory and components approach to aggregate dem. agree aggregate demand curve slopes downward and shifts in response to changes in money supply o In qty theory approachonly one important source of movements in aggregate demand curve: changes in the money supply o In components approach: suggest other factorsfiscal policy, net exports, and animal spiritsare equally important sources of shifts in aggregate demand curve o Six factors shift aggregate demand curve Money supply, gov. spending, taxes, net exports, consumer optimism, and business optimism Last two animal spiritsaffect willingness to spend Often reffered as demand shocks (pg 569 table) Aggregate Supply Aggregate supply curve: relationship between qty of output supplied and price level Prices and wages take time to adjust to their long run level o Supply curve differs in short and long run

Long-Run Aggregate Supply Curve o Amount of output that can be produced in the economy in the long run is determined by the amount of capital in the economy, the amount of labor supplied at full employment, and available technology o Some unemployment cannot be helped b/c frictional or structural o At full employment, unemployment is not zerorather at a level above zero at which demand for labor equal supply of labor Natural rate of unemployment Currently around 5% o Natural rate of output: level of aggregate output produced at natural rate of unemployment Where economy settles in long run for any price leve Long run Aggregate Supply curve (LRAS) is vertical at natural rate of output Short-Run Aggregate Supply Curve o Wages and prices are sticky: wages and prices take time to adjust to economic conditions o Upward sloping in short run o b/c goal of business firms is to maximize profit; qty of output supplied is determined by profit made on each output profit rises, more aggregate output will be producedqty of output supplied will increase; if it falls, less output produced and qty of aggregate output supplied will fall profit on a unit of output=price for unit-cost of producing it o in short run, costs of many factors that go into producing goods and services are fixed ex. wages, often fixed for periods of time by labor contracts, and raw materials are often bought by firms under long term contracts that fix the price b/c costs of production are fixed in short runwhen overall price level rise, price for a unite of output will rise relative to costs of producing it, and profit per unit will rise b/c higher price level results in higher profitsfirms increase production, and qty of aggregate output supplied rises, resulting in upward sloping short-run aggregate supply curve short run: relationship b/w price level and aggregate output embodied in upward sloping short run curvemay not remain fixed as time passes shifts in the short run Aggregate Supply Curve o cost of producing a unit of output rises, profit on each falls, and qty of output supplied at each price level falls o ex. firms are earning lower profit per unit of output..they reduce production at that price leveand qty of aggregate output supplied falls..shifts left o short run aggregate supply curve shifts to left when costs of production increase and to right when costs decrease Factors that Shift the short run aggregate Supply curve o Ones that affect costs of production o 1. Tightness of labor market Economy is booming and labor market tight(Y>Yn)employers have difficulty hiring qualified workers and may have hard time keeping present employees Demand for labor now exceeds supplyemployers will raise wages to attract needed workers, and costs of production will rise

Higher costs of production..lower profit per unitcurve shifts left Economy in recession and labor market is slack(Y<Yn)demand for labor less than supply, workers who cannot find jobs will be willing to work for lower waigesaddition current employees may be willing to make wage concessions to keep jobs Wages and costs of production will fall..profit per unit of output will rise..and shifts right When aggregate output is above natural rate, short run aggregate supply curve shifts to the left; when aggregate output is below natural rate, short run aggregate supply curve shifts to right o 2.expectations of inflation (expected Price Level) Increase in expected price level leads to higher wages, which in turn raise costs of production, lower profit per unit of output at each price level, and shift curve to left Ex. construction worker expects 5% increase in prices, will want wage increase of at least 5%(more if thinks he deserves increase in real wages)If boss knows houses he is building will rise in value at same rate as inflation 5%, will be willing to pay 5% more Rise in the expected price level causes the aggregate supply curve to shift to the left; greater the expected increase in price level (higher the expected inflation), the larger the shift o 3. Workers attempts to push up their real wages(wage push) Ex. Workers go on strike and succeed in obtaining higher real wageswage push will raise costs of production, and aggregate supply curve will shift left A successful wage push by workers will cause aggregate supply curve to shift to the left o 4. Changes in the production costs that are unrelated to wages(energy costs) Affects costs of production Changes in technology and in supply of raw materials(called supply shocks) can shift supply curve Negative supply shock, such as reduction in availability of raw materials (like oil), raises their price, increases production costs and shifts the aggregate supply curve leftward Positive supply shock, such as unusually good weather that leads to bountiful harvest and lowers the cost of food, will reduce production costs and shift curve right Development of a new technology that lowers production costs, perhaps by raising worker productivity, can be considered positive supply shock that shifts aggregate supply curve right A negative supply shock that raises production costs shifts aggregate supply curve to the left; a positive supply shock that lowers production costs shifts aggregate supply curve to the right o First 3 affecting wage costs o Pg 573 table Equilibrium in aggregate Supply and Demand Analysis Two types of equilibrium Equilibrium in the Short Run

Price level above equilibriumqty of aggregate output supplied is greater than qty of aggregate output demanded People want to sell more goods and services than others want to buy(excess supply)prices of goods and services will fall, and aggregate price level will dropdecline will continue until reach equilibrium o price level below equilibriumqty of output demanded is greater than qty of output supplied price level will rise b/c people want to buy more goods than others want to sell(excess demand)rise in price level will continue until reach equil. Level equilibrium in the Long Run o even when qty of aggregate output demanded equals qty supplied, forces operate that can cause equil to mover over time if Y* not equal to Yn understand that if costs of production change, supply curve will shift o how short run equilibrium changes over time in response to: short run equilibrium is initially above natural rate level and when it is initially below natural rate level o economy will not remain at a level of output higher than natural rate level b/c short run aggregate supply curve will shift to the left, raise the price level, and cause economy(equilibrium) to slide upward along aggregate demand curve until comes to rest at a point on the long run aggregate supply curve at natural rate level of output Yn level of equilibrium output is greater than natural rate levelunemployment is less than its natural rateexcessive tightness exists in the labor markettightness drives wages up, raises production costs, and shifts aggregate supply curve to the leftaggregate output still above natural rate level, wages continue to be driven up, eventually shifting supply curve to left againequilibrium reached at this point is on vertical long run aggregate supply curve (LRAS) and is a long run equilibriumnow at output natural rate levelno further pressure on wages to rise and thus no further tendency for supply curve to shift pg. 576 figure o regardless of where output is initially, it returns eventually to natural rate level described by saying economy has a self correcting mechanism takes a long time, so approach to long run equilibrium is slow in the long run we are all dead-Keyness Slow b/c wages are inflexible, particularly in downward direction when unemployment is high Resulting slow wage and price adjustments mean aggregate supply curve does not move quickly to restore economy to natural rate of unemployment When unemployment is higheconomists known as Keynesians More likely to see the need for active government policy to restore the economy to full employment Other economists believe wages are sufficiently flexible that the wage and price adjustment process is reasonably rapid Result of this flexibilityadjustment of supply curve to its long run position and economys return to natural rate levels of output and unemployment will occur quickly See much less need for active government policy to restore economy to natural rate levels of output and unemployment when unemployment is high

Monetarists Advocate use of a rule whereby the money supply or monetary base grows at a constant rate so as to minimize fluctuations in aggregate demand that might lead to output fluctuations Changes in Equilibrium Caused by Aggregate Demand Shocks o Rightward shift in aggregate demand curve due to positive demand shocks Increase in the money supply(M up) Increase in government spending(G up) Increase in Net exports (NX) Decrease in taxes(T down) Increase in wiliness of consumers and businesses to spend b/c become more optimistic (C up, I up) Pg 577 figure o When demand curve shifts right to AD2, economy moves to point 1, and both output and price level riseeconomy will not remain at point 1 in long run, b/c output at Y1 is above natural rate levelwages will rise, increasing cost of production at all price levels, and short run supply curve will eventually shift leftward to AS2, where finally comes to rest The economy(equilibrium) thus slids up the aggregate demand curve from point 1 to 2, which is point of long run equilibrium at intersection of AD2 and long run aggregate supply curve (LRAS) at Yn Although the initial short run effect of the rightward shift in aggregate demand curve is a rise in both the price level and output, the ultimate long run effect is only a rise in the price level Changes in Equilibrium Caused by Aggregate Supply Shocks o Ex. economy initially at natural level of outputshort run supply curve shifts left b/c of negative supply shock(sharp rise in energy prices)economy will move from point 1 to point 2, where price level rises but aggregate output fallsthis situation of rising price level but falling level of aggregate output is staglflationat point 2 output is below natural rate level, wages fall and shift short run supply curve back to rightresult is economy (equilibrium) slides down aggregate demand curve and returns to long run equilibrium point 1 Although a leftward shift in short run aggregate supply curve initially raises price level and lowers output, the ultimate effect is that output and price level are unchanged(holding aggregate demand curve constant) Shifts in long run aggregate supply curve: Real business Cycle theory and Hypothesis o Over time, natural rate level of output increases as result of economic growth o Ex. productive capacity of economy growing at steady rate 3% per yearevery year Yn will grow by 3% and long run aggregate supply curve at Yn will shift to right by 3% Yn grows at steady rate, Yn and long run supply curve are drawn as fixed in aggregate demand and supply diagrams o Real business cycle theory: theory of aggregate economic fluctuations Aggregate supply (real) shocks do affect natural rate level of output Yn Views shocks to tastes(workers willingness to work) and technology(productivity) as major driving forces behind short run fluctuations in the buss. Cycle b/c these shocks lead to substantial short run fluctuations in Yn

Shifts in aggregate demand curve, perhaps as a result of changes in monetary policy are not viewed as being important to output fluctuations Views most business cycle fluctuations as resulting from fluctuations in natural rate level of output Not see much need for activist policy to eliminate high unemployment Highly controversial and under much research o Another group disagrees with assumption that natural rate level of output Yn is always at full employment level and is unaffected b y aggregate demand shocks Contend that natural rate level of unemployment and output are subject to hysteresis(departure from full employment levels as a result of past high unemployment) When unemployment rises because of reduction of demand that shifts AD curve inwardsnatural rate of unemployment viewed as rising above full employment level Could occur b/c unemployed become discouraged and fail to look hard for work or employer may not higher b/c been unemployed for long time Outcome is natural rate of unemployment shifts upward after unemployment has become high, and Yn falls below full employment level Self correcting mech. Will return economy only to natural rate levels of output and unemployment, not to full employment Only with expansionary policy to shift demand curve right and raise output can natural rate of unemployment be lowered (Yn raised) to full employment level Proponents of hysteresis more like to promote activist, expansionary policies to restore economy to full employment Conclusions o Aggregate Demand and Supply yields conclusions(under usual assumption that natural rate level of output is unaffected by aggregate demand and supply shocks) 1. A shift in aggregate demand curvecan be caused by changes in monetary policy (money supply), fiscal policy (gov spending or taxes), international trade(net exports, or animal spirits(business and consumer optimism) affects output only in short run and has no effect in long run, when aggregate supply curve has fully adjusted 2. A shift in the aggregate supply curvewhich can be caused by changes in expected inflation, workers attempts to push up real wages, or a supply shock affects output prices only in the short run and has no effect in the long run(holding aggregate demand curve constant) 3. The economy has a self correcting mechanism, which will return it to the natural rate levels of unemployment and aggregate output over time Ch. 24 Money and Inflation Source of all inflation episodes is a high growth rate of the money supply: simply by reducing the growth rate of the money supply to low levels, inflation can be prevented Money and Inflation: Evidence Whenever a countrys inflation rate is extremely high for a sustained period of time, its rate of money supply growth is also extremely high o Countries with highest inflation rates also had highest rates of money growth

You are looking at reduced form evidencefocuses on correlation of two variables o Money growth and inflation rate variables o Reverse causation(inflation causing money supply growth) or an outside factor that drives both money growth and inflation could be involved o Rule out these by looking at historical episodes in which an increase in money growth appears to be an exogenous event(high inflation rate for a sustained period following the increase in money growth Strong evidence that high money growth is driving force behind inflation o Clear evidence have occurredhyperinflations(extremely rapid inflations with inflation rates exceeding 50% per month)-most notorious German hyper. 1921/23 German Hyperinflation, 1921-1923 o Need to make reparations and reconstruct economy after WW1 o Gov. expendendetures greatly exceeded revenues o Could have obtained by raising taxes but politically unpopular/time to enact o Government could have financed expenditure by borrowing from the public, but the amount needed was far in excess of its capacity to borrow o Only one route to work: the printing press---could pay simply by printing more currency(increasing the money supply)made payments to individuals and companies that were providing it with goods and services o Result of explosion in money supply was price level blasted off Inflation rate for 1923 exceeded 1 milion percent o Qualified as a control experiment;supports inflation is a monetary phenomenom Recent Episodes of Rapid Inflation o 2008 Zimbabwes inflation rate over 2 million percent officially(unofficially over 10) o Only country to top Germany o Issued 100 billion dollar note o Same reasons of Germnay: high money growth Meaning of inflation Says 1% may have only risen temporarily by one month an 12% annually Only if remains high persistently will economists say inflation has been high Friedman says upward movements in price level are monetary phenomenum only if this is a sustained process When inflation is defined as persistent and rapid rise in price level, almost all agree with friedman and money alone is to blame Views of Inflation Large and persistent upward movements in price level(high inflation) can occur only if there is continually growing money supply How money growth Produces Inflation o If money supply keeps growing then price level keeps getting higher year after year o High money growth produces inflation o Pg 620 figure 2 Can other Factors Besides Money Growth produce Inflation? o NoHigh Inflation is always a Monetary Phenomenon o Other factors can affect Aggregate Demand and supply curves(Fiscal policy and supply shocks) Can Fiscal Policy By itself Produce Inflation? o Pg 622 figure

One shot increase in government expedenture leads to only a temporary increase in the inflation rate, not to persistent inflation in which price level is contrinually rising o Continually increasing level of gov. expedentures is not a feasible policy o Limit on amount of possible gov. exp.; cannot spend more than 100% GDPonce limit reached political process will stop it from continuing o Could continual tax cuts generate inflation?...again no Increase in inflation rate only temporary again Once tax cuts reach zerocant be cut anymore o ConcludePersistent high inflation cannot be driven by fiscal policy alone Can supply side phenomena by themselves produce Inflation? o net result of a supply shock is that we return to full employment at the initial price level, and there is no continuing inflationadditional neg supply shocks that shift short run aggregate supply curve leftward will lead to only temporarily based, but persistent inflation will not result o Supply side phenomena cannot be the source of persistent high inflation Summary o Aggregate demand and supply analysis shows that persistent high inflation can occur only with a high rate of money growth o Inflation refers to a continuing increase in the price level at a rapid rate.now see why Friedman was correct when he saidInflation is always and everywhere a monetary phenomenom Origins of Inflationary Monetary Policy Gov. policies that are the most common sources of inflation High Employment Targets and Inflation o First goal of most governments is high employmentleads to high inflation o Laws require a commitment to high level of employment consistent with a stable price leve, in practive our gov has often pursued a high employment target with little concern about the inflationary consequences of its policies o Two types of inflation that can result from policy to promote high empl. Cost push inflation: occurs b/c of neg supply shocks or a push by workers to get higher wages Pg 625 figure b/c gov has given in to the demands of workers for higher wages, an activist policy with a high employment target is often referred to as an accommodating policy wages have now fallen compared to other workers, and now they will seek higher wagesthus continuing the processcontinuing price level increase---a persistent cost push inflation can only occur only if aggregate demand curve is shifted continually to the right first shift can be achieved by a one shot gov expenditure or a one shot decrease in taxes o can not continue shifting aggregate demand curve can be shifted to the right by continually increasing the money supply

Persistent cost push inflation is a monetary policy phenomenom because it can not occur without the monetary authorities pursuing an accommodating policy of a higher rate of money growth Demand Pull inflation: results when policy makers pursue policies that shift the aggregate demand curve to the right Pg 626 figure Pursuing to low an unemployment rate target or too high an output target is the source of inflationary monetary policy b/c inflation results from policymakers pursuing policies that shift aggregate demand curve to the rightit is called this associated with periods when unemployment is below the natural rate level, whereas cost push is associated with period when unemployment is above the natural rate level when a demand pull inflation produces higher inflation rates, expected inflation will eventually rise and cause workers to demand higher wages so that their real wages will eventually rise and cause workers to demand higher wages so that real wages do not fall o demand pull inflation can eventually trigger cost push inflation Budget Deficits and Inflation o Government Budget Constraint Government has to pay bills.. so has this Two ways to pay: raise revenue (by working) or borrow Gov has third option: can create money Methods of financing gov spending States that the gov budget deficit DEF, equals the excess of gov spending G over Tax revenue Y, must equal the sum of the change in the monetary base delta MB and the change in gov bonds held by the public delta B DEF=G-T=delta MB + delta B Gov buys \$100 mill supercomputercan convince that worth paying then budget deficit equal zerotaxpayers refuse to pay taxes for it then budget constraint indicates gov must pay for it by selling \$100 mill of new bonds to either public or by printing \$100 mill of currencyeither case, budget constraint is satisfiedbalanced by changed in stock of gov bonds held by the publice (delta B=\$100 mill) or by change in monetary base (delta MB=\$100 mill) Reveals two imp facts: Gov deficit is financed by an increase in bond holdings by the public, there is no effect on the monetary base and hence on the money supply. But if the deficit is not financed by increased bond holdings by the public, the monetary base and the money supply increase Monetizing the debt: method of financing gov spending Two step processgov debt issued to finance gov spending has been removed from the hands of the public and has been replaced by high powered money Method of financing or when a gov just issues the currency directly:reffered to sometimes as printing money b/c high powered money(the monetary base) is created in the process

Monetary base increase when central bank conducts open market purchases, just as it would if more currency were put in circulation Budget deficit can increase in the money supply if it is financed by the creation of high powered money Financing a persistent deficit by money creation will lead to a sustained inflation A deficit can be the source of a sustained inflation only if it is persistent rather than temporary and if the gov finances it by creating money rather than by issuing bonds to the public Budget deficits and money creation in other countries o Only way to finance deficits is to print more more;ultimate source of high inflation rates was large budgets Budget deficits and Money creation in the US o Best developed gov bond market of any country in the worldit can issue large wty of bonds when it needs to finance its deficit o Magnititude of deficits relative to GDP small compared to others6% in 1983 whereas Argentina was 15% o Gov budget deficit can lead to Federal Reserve open market purchases, which raise monetary base(create high powered money) and raise money supply o Ricardian equivalence: contends that when gov runs deficits and issues bonds, the public recognizes that it will be subject to higher taxes in the future to pay off these bonds o Why inflationary monetary policy might come about Adherence of policymakers to a high employment target Presence of persistent gov budget deficits The Discretionary/Nondiscretionary Policy Debate Advocates of discretionary policy, that is, policy to eliminate high unemployment whenever it appears, regard the self correcting mechanism through wage and price adjustment as very slow Opponents of discretionary policybelieve that the performance of the economy would be improved if the gov avoided discretionary policy reactions to eliminate unemployment Responses to High Unemployment o Aggregate output is lower than natural rate level, and economy is suffering from high unemployment.policymakers have two viable choices: If they are proponents of nondiscretionary policy and do nothing, the short run aggregate supply curve will eventually shift right overtime, where full employment is restored The discretionary policy alternative is to try to eliminate high unemployment by attempting to shift aggregate demand curve rightward by pursuing expansionary policy( increase in the money supply, increase in gov spending, or lowering of taxes) o Lags prevent immediate moving to full employment 1. Data lag: time it takes for policymakers to obtain the date that tell them what is happening in the economy Ex. accurate GDP data not avail. Until months after a quarter is over 2. Recognition lag: time it takes for policymakers to be sure of what the date are signaling about the future course of the economy

Ex. to minimize errors, National Bureau of Economic Researd(officialy dates buss cycles) will not declare the economy to be in recession until at least six months after it has determined that one has began 3. Legislative lag:time it takes to pass legislation to implement a particular policy Doesnt exist as open market operations or most monetary policy actions Important for implementation of fiscal policy, when it can be sometimes taken six months to a year to get legislation passed to change taxes or gov spending 4. Implementation lag: time it takes for policymakers to change policy instruments once they have decided on the new policy Unimportant for open market operations b/c Feds trading desk can purchase or sell bonds almost immediately Implementing fiscal policy may take timegetting gov agencies to change their spending habits takes time, as does changing tax tables 5. Effectiveness lag: time it takes for policy to actually have an impact on the economy Imp. Arg. Against discretionary policy is that effectiveness lag is long (often year or longer) and variable (uncertainty about how long this lag is) Discretionary and Nondiscretionary positions Case for Discretionary Policy o Advocates view wage and price adjustment process as extremely slow o Costly b/c slow movement of the economy back to full employment results in a large loss of output o Even though five lags may result in year or more delay before aggregate demand curve shifts, short run aggregate supply curve likewise moves very slow during this time o Pg 635 moving back to point 2 thus this is right path Case for Nondiscretionary Policy o View wage and price adjustment as more rapid and consider less costly b/c ouput is soon back at natural rate level o Suggest a discretionary policy of shifting aggregate demand curve is costly, b/c it produces more volatility in both price level and output Time to shift is substantial, whereas wage and price adjust is more rapid o Discretionary Leads to a sequence of equilibrium points at which both output and price level have been highly variable: output overshoots its target levelprice level falls and then rises and eventually to P2b/c this variability is undesiarablebetter off with nondiscretionary o Pg 635 figure o Before aggregate demand curve shifts right, short run supply curve will have shifted right, and economy returns to natural rate level of outputafter adjustment is complete, the shift of demand curve final takes effect to right leading economy to point 2aggregate output is now greater then natural rate level, so short run supply curve will now shift leftward backmoving economy to point, where output again at natural rate level Discretionary vs Non: Conclusions

o o

Advocates of discretionary policy believe in the use of policy to eliminate excessive unemployment whenever it develops b/c they view the wage and price adjustment process as sluggish and unresponsive to expectations about policy Proponents of nondiscretionary believe that a discretionary reacts to excessive unemployment is counterproductive, b/c wage and price adjustment is rapid and b/c expectations about policy can matter to wage setting process Proponents of non advocate use of a policy rule to keep aggregate demand curve from fluctuating from trend rate of growth of natural level of output Monetarists; who oppose discretionary and who also see money as sole source of fluctuations in demand curvein the past advocated a policy rule whereby the Fed keeps the money supply growing at a constant rate Constant money growth rate rule Important element of non to be successful is that it be credible: public must believe policymakers will be tough and not accede to a cost push by shifting aggregate demand curve to the right to eliminate unemployment Otherwise, workers will be more likely to push for higher wages, shift supply curve leftward and will lead to unemployment or inflation or both