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Chapter 9

Chapter 9. Chapter 9 Essential macroeconomic tools. Output and prices. Economic activity is measured by the GDP (gross domestic product) GDP = sum of all production = sum of all sales = sum of all incomes Nominal GDP (measured) vs. Real GDP (computed taking into account inflation)

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Chapter 9

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  1. Chapter 9

  2. Chapter 9 Essential macroeconomic tools

  3. Output and prices • Economic activity is measured by the GDP (gross domestic product) • GDP = sum of all production = sum of all sales = sum of all incomes • Nominal GDP (measured) vs. Real GDP (computed taking into account inflation) • GDP trend is increasing • Actual GDP is above or below trend, according to business cycles

  4. Output gap: the difference between trend and actual GDP

  5. Choice of exchange rate • The business cycles are undesired and the most governments try to iron them out through fiscal and monetary policies • Does the exchange rate regime, i.e. selecting a system with fixed or floating exchange rates, influence the effect of macroeconomic policies? • Let us look at this Aggregate Demand (AD) and aggregate supply (AS) setting: • Aggregate supply (AS): upwards sloping. As output gap increases threat of unemployment moderates wages and firms cut price • Aggregate demand (AD): downward sloping. Higher prices erode purchasing power and external competitiveness and output gap decreases • Changes in aggregate demand, e.g. a boom abroad: shifts aggregate demand up (AD’)

  6. The AD-AS diagram

  7. Long Term: Neutrality of Money Comparison between France and Switzerland Growth rate in France less growth rate in Switzerland Year to year: Nothing really visible

  8. Long Term: Neutrality of Money Comparison between France and Switzerland Growth rate in France less growth rate in Switzerland Five-year averages: Something emerges

  9. Long Term: Neutrality of Money Comparison between France and Switzerland Growth rate in France less growth rate in Switzerland

  10. PPP: An Implication of Long Term Neutrality • The real exchange rate: • defined as  = EP/P* • PPP: E offsets changes in P/P* • so  is constant. • Equivalently:

  11. The real exchange rate Example: real exchange rate of euro in terms of dollar • Price of basket of European goods: P= €100 • Nominal exchange rate ($/€): E = 1.3$/€ • Price of basket of American goods: P*= $130 • real exchange rate: = E x P/P* = €100x 1.3$/€ : $130 = 1 basket of American goods for 1 basket of European goods NOTE: when real exchange rate appreciates, competitiveness declines as more baskets of goods in the USA would need to be traded for 1 basket of European goods.

  12. Real versus nominal exchange rate appreciation

  13. The Balassa-Samuelson Effect Increasing real exchange rates in new EU members (Annual % change, 1996-2008)

  14. Short Term Non-Neutrality of Money • From AD-AS: the short-run AS schedule. • So monetary policy matters in the short run. • Channels of monetary policy: • the interest rate channel • the credit channel • the stock market channel • the exchange rate channel.

  15. Exchange Rate Regimes and Policy Effectiveness

  16. Exchange Rate Regimes and Policy Effectiveness

  17. When Does the Regime Matter? • In the short run, changes in E are mirrored in changes in  = EP/P*: P and P* are sticky. • In the long run,  is independent of E: P adjusts. • If P is fully flexible, the long run comes about immediately and the nominal exchange rate does not affect the real economy. • Put differently, the choice of an exchange rate regime has mostly short-run effects because prices are sticky.

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