Econ 520 - Fall 2009

Last Day of Class

Midterm 2 Answers

Midterm 2

Thanksgiving

Discussion of Homework, Etc.

Class Cancelled

Fixed Exchange Rates

Fiscal policy. The graph on the right shows how both curve move together so we do not actually ever get to point B.

Monetary policy.

A foreign recession.

Devaluation from below or above y-bar.

Floating Exchange Rates

An increase in y-bar:

Changes in p shift both curves (to point B). Changes in s move just the IS curve, getting both to end up at point C.

Short-run:

A drop in the world interest rate:

Getting Started

We took up a variety of topics to get started with floating and fixed exchange rates.

Shift the IS curve in a closed economy model.

Shift the LM curve in a closed economy model. (This is "lower P," but "higher M" looks the same.)

An effort to explain how "shift the curve" works for the first equation on page 111. (You had to be there.)

Think of changes in x2 as changes in a composite intercept. (Picture from lecture on 11/12.)

An increase in y-bar:

Balance of Payments and NIPA Accounting

You can study data on these variables at the BEA (Bureau of Economic Analysis) web site. In class, we studied a balance of payments table.

The Basic Model

The model on the left has five equations based economic theory, accounting identities, and definitions. Thinking about the equilibrium and how it changes would be difficult given the algebraic complexities of these equations.

Therefore, we will work with linearized versions, where lower-case letter denote logarithms of upper-case variables. The linearized model is on the right.

The definition of the real exchange rate (1) has an exact equivalent in logs. Uncovered interest parity (2) in logs requires just the one approximation that log(1+x) is approximately x for small x. The definition of the real interest rate (3) uses the same approximation in the form that the rate of inflation is approximately the difference over time of the log of the price level. The LM equation (4) and the IS equation (5) both replace the unspecified functions on the right with linearized versions in logs. The net exports function, for example, does not appear in the linearized IS equation, but the logs of the real exchange rate and foreign income do. Changes in the latter variables affect y via an implicit path involving net exports.

The model on the right has the advantage that we will be able to figure out what happens when a variable changes.

We have six endogenous variables (not counting expectations!), but only five equations. We need an extra equations (and a theory of expectation formation). The extra equation could be we are already at full employment or that the price level is fixed. The former is a long run view while the latter is more short run.

The Basic Model - Another View

The 9:30 lecture provides another view.

]]>

Logarithms

The Basic Model uses the property that log(1+x) is approximately equal to x if x is near zero. Changes in logs of a varible are very nearly equal to the percentage changes.

The Basic Model

Exchange Rates

When bond prices go up, bond yields go down. This happens because the future payments are fixed.