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CHAP 30: MONEY GROWTH AND INFLATION

● Questions for review
1. Explain how an increase in the price level affects the real value of money.
- An increase in price level will decrease the real value of money because:
+ Value of money, 1/P, is the quantity of goods and services that can be bought with $1,
or also the price of money and the purchasing power of money.
+ Price level, P, is the number of dollars needed to buy a basket of goods and services.
+ When the price level rises, people have to pay more for the goods and services they
buy. Consequently, each dollar in your wallet now buys a smaller quantity of goods
and services.

2. According to the quantity theory of money, what is the effect of an increase in the
quantity of money?
- The quantity of money available determines the price level
- The growth rate in the quantity of money available determines the inflation rates
→ The primary cause of inflation is the growth in the quantity of money.

3. Explain the difference between nominal variables and real variables and give two
examples of each. According to the principle of monetary neutrality, which variables are
affected by changes in the quantity of money?
- Nominal variables are the variables measured in monetary units.
E.g: nominal GDP, nominal wage,...
- Real variables are variables measured in physical units.
E.g: real GDP, nominal wage,...
- According to the principle of monetary neutrality, the changes in the quantity of money
affect nominal variables but not real ones.
4. In what sense is inflation like a tax? How does thinking about inflation as a tax help
explain hyperinflation?
- Inflation is like a tax because everyone who holds money loses purchasing power. When
price rises, buyers of goods and services pay more for what they buy. If inflation is a tax,
there is an incentive to spend money as fast as possible before the value of money continues
to lose.
- In hyperinflation, the government increases the money supply rapidly, which leads to a high
rate of inflation. Thus the government uses the inflation tax, instead of taxes, to finance its
spending.

5. According to the Fisher effect, how does an increase in the inflation rate affect the real
interest rate and the nominal interest rate?
- According to the Fisher effect, an increase in the inflation rate raises the nominal interest
rate while leaving the real interest rate unchanged in the long-run.

6. What are the costs of inflation? Which of these costs do you think are most important
for the U.S. economy?
- Cost of inflation:
+ Shoeleather costs: Are the resources wasted when inflation forces people to live with
minimal reserves of money. Inflation reduces the purchasing power of money rapidly.
So people have an incentive to keep their wealth in non-money forms, such as stocks,
bonds, real estate, gold, etc. Living with minimal cash reserves requires more frequent
trips to a financial institution to convert interest-bearing non-money assets into cash.
These extra trips to a financial institution are inconvenient and take time away from
productive activities.
+ Menu costs: The costs of changing prices. During inflationary times, it is necessary to
frequently update price lists and other posted prices. This is a resource-consuming
process that takes away from other productive activities.
+ Relative-price variability and the misallocation of resources: When inflation
distorts relative prices, consumer decisions are distorted and markets are less able to
allocate resources to their best use.
+ Inflation-induced tax distortions: Inflation exaggerates the size of capital gains and
increases the tax burden on this type of income. This reduces the incentive to save for
the future, and has a negative long-run effect on the economy.
 + Confusion and Inconvenience: When the Fed increases the money supply and creates
inflation, it reduces the purchasing power of a dollar. Inflation causes the purchasing
power of a dollar to be different at different times. Therefore, during rapid inflation, it
is more difficult to compare revenues, costs, and profits over time in inflation-adjusted
(or, real) units. → It is more likely that people will make mistaken decisions.
+ A Special Cost of Unexpected Inflation: Arbitrary Redistribution of Wealth:
When there’s unexpected inflation, lenders lose and borrowers gain. When there’s
unexpected deflation, lenders gain and borrowers lose. These redistributions occur
because many loans in the economy are specified in terms of the unit of account:
money. Unexpected inflation/deflation redistributes wealth among the population in a
way that has nothing to do with either merit or need.
- The most important cost for the U.S economy is Arbitrary Redistribution of Wealth.
Inflation can erode confidence in financial institutions and disrupt wealth equity, leading to
socioeconomic tensions.

7. If inflation is less than expected, who benefits debtors or creditors? Explain.

- If inflation is less than expected, the purchasing power of the money repaid is higher than
anticipated because prices did not rise as much as expected. This makes it more costly for
debtors and more advantageous for creditors.
- If inflation is lower than expected, the real interest rate is higher than anticipated. Creditors
effectively earn a higher return on their loans in real terms, while debtors bear a heavier
burden.
→ Creditors benefit because they receive payments with higher purchasing power than
anticipated.
→ Debtors are harmed because the real value of their debt payments is greater than expected,
increasing their repayment burden.

● Problems and applications

1. Suppose that this year’s money supply is $500 billion, nominal GDP is $10 trillion,
and real GDP is $5 trillion.
a. What is the price level? What is the velocity of money?
M = $500 billion = $0.5 trillion
Nominal GDP = P x Y = $10 trillion
Real GDP = Y = $5 trillion
The price level is: P x 5 = 10 → P = $2 trillion
The velocity of money is: V = (P x Y)/M = 10/0.5 = 20
b. Suppose that velocity is constant and the economy’s output of goods and services
rises by 5 percent each year. What will happen to nominal GDP and the price
level next year if the Fed keeps the money supply constant?
M = $0.5 trillion
Real GDP (new) = Y (new) = 5 + 5 x 5% = $5.25 trillion
Nominal GDP = P x Y = M x V = 0.5 x 20 = $10 trillion → Nominal GDP unchanged
The price level, P = (M x V)/Y = (0.5 x 20)/5.25 = $1.9 trillion → The price level decreases
by 5%
c. What money supply should the Fed set next year if it wants to keep the price level
stable?
P = $2 trillion
Money supply, M = (P x Y)/V = (2 x 5.25)/20 = 0.525 trillion → The money supply increases
by 5%
d. What money supply should the Fed set next year if it wants inflation of 10
percent?
P (new) = 2 x 10% = $2.2 trillion
Money supply, M = (P x Y)/V = (2.2 x 5.25)/20 = $0.5775 trillion → The money supply
increases by 15.5%

2. Suppose that changes in bank regulations expand the availability of credit cards so
that people can hold less cash.
a. How does this event affect the demand for money?
- When credit card availability increases, it allows people to make purchases without needing
to carry as much cash. Consumers can rely more on credit to make transactions which means
the demand for actual cash (and by extension, money) decreases as people do not need to hold
as much money for everyday transactions.
b. If the Fed does not respond to this event, what will happen to the price level?
- If the money demand decreases and the Fed does not change the supply of money, the
reduced demand for money can lead to an excess supply of money. This could potentially
cause the price level to increase (inflation), as the value of money falls due to the excess
supply.
c. If the Fed wants to keep the price level stable, what should it do?
- If the Fed wants to keep the price level stable in response to a decrease in the demand for
money, it should reduce the money supply. The Fed can accomplish this by selling
government bonds or through other contractionary monetary policies. This would counteract
the reduced demand for money, helping to keep the price level stable.

3. It is sometimes suggested that the Fed should try to achieve zero inflation. If we
assume that velocity is constant, does this zero-inflation goal require that the rate of
money growth equal zero? If yes, explain why. If not, explain what the rate of money
growth should equal.
- If the Fed tries to achieve zero inflation, the rate of money growth does not need to equal
zero. To maintain zero inflation, the rate of money growth should equal the rate of growth in
real GDP (Y).
- According to The quantity theory of money, M x V = P x Y. If velocity is constant and the
inflation is zero, which means that the price level is 0, any change in money supply, M, will
lead to a change in real GDP (Y). This ensures that the increase in money supply matches the
economy's real output growth, keeping the price level (PP) stable.

4. Suppose that a country’s inflation rate increases sharply.

What happens to the inflation tax on the holders of money?
- Inflation tax refers to the loss of the purchasing power of money when there is an increase in
the inflation rate. As inflation rises, the real value of currency depreciates, effectively acting
as a 'tax' on those who hold money. To analyze the inflation tax on the holders of money, one
must recognize that with higher inflation, each unit of currency can buy fewer goods and
services. Therefore, the 'tax' increases because the real value or purchasing power of the
money held decreases.
Why is wealth held in savings accounts not subject to a change in the inflation tax?
- Savings accounts are not directly subjected to the inflation tax if their interest rates
compensate for inflation. However, if inflation exceeds the interest rate, the real value of
savings decreases, indirectly affecting account holders.
Can you think of any way in which holders of savings accounts are hurt by the increase
in inflation?
- Holders of savings accounts may still be hurt by an increase in inflation if the interest rates
on their accounts do not keep up with the inflation rate. Although the nominal value of the
savings remains the same or even increases with interest, the real value (the purchasing
power) of the money in the savings account decreases if the interest rate is lower than the
inflation rate
5. Let’s consider the effects of inflation in an economy composed of only two people:
Bob, a bean farmer, and Rita, a rice farmer. Bob and Rita both always consume equal
amounts of rice and beans. In 2019, the price of beans was $1 and the price of rice was
$3.
a. Suppose that in 2020 the price of beans was $2 and the price of rice was $6. What was
inflation? Did the price changes leave Bob better off, worse off, or unaffected? What
about Rita?
For beans, the ìnlation rate is: 100%
For rice, the inflation rate is: 100%
→ Both Bob and Rita are unaffected.
b. Now suppose that in 2020 the price of beans was $2 and the price of rice was $4. What
was inflation? Did the price changes leave Bob better off, worse off, or unaffected? What
about Rita?
For beans, the inflation rate is: 100%
For rice, the inflation rate is: 33.33%
→ Bob, being a bean farmer, is better off because the price of his product (beans) has
increased more relative to rice. Conversely, Rita would be worse off because the price of her
product (rice) hasn't increased as much relative to beans.
c. Finally, suppose that in 2020 the price of beans was $2 and the price of rice was $1.50.
What was inflation? Did the price changes leave Bob better off, worse off, or unaffected?
What about Rita?
For beans, the inflation rate is: 100%
For rice, the inflation rate is: -50%
→ Bob is worse off due to the 100% increase in bean prices. Rita is better off due to the 50%
decrease in rice prices.
d. What matters more to Bob and Rita—the overall inflation rate or the relative price of
rice and beans?
- For both Bob and Rita, the relative price changes of rice and beans matter much more than
the overall inflation rate, as these directly affect their ability to purchase the goods they rely
on for consumption.

6. Assuming a tax rate of 40 percent, compute the before-tax real interest rate and the
after-tax real interest rate for each of the following cases.
a. The nominal interest rate is 10 percent, and the inflation rate is 5 percent.
Before-tax real interest rate = nominal interest rate - inflation rate = 10 - 5 = 5%
After-tax real interest rate = Before-tax real interest rate - (Tax rate x Nominal interest rate)
= 5% - (40% x 10%) = 1%
b. The nominal interest rate is 6 percent, and the inflation rate is 2 percent.
Before-tax real interest rate = nominal interest rate - inflation rate = 6 - 2 = 4%
After-tax real interest rate = Before-tax real interest rate - (Tax rate x Nominal interest rate)
= 4% - (40% x 6%) = 0.016 = 1.6%
c. The nominal interest rate is 4 percent, and the inflation rate is 1 percent.
Before-tax real interest rate = nominal interest rate - inflation rate = 4 - 1 = 3%
After-tax real interest rate = Before-tax real interest rate - (Tax rate x Nominal interest rate)
= 3% -(40% x 4%) = 0.014 = 1.4%

7. Recall that money serves three functions in the economy. What are those functions?
How does inflation affect the ability of money to serve each of these functions?
- 3 functions of money:
+ Medium of exchange: Items that buyers give to sellers when they want to purchase
goods and services.
→ As the general price level rises, people need more money to transact which can result in
the money becoming less efficient as a medium of exchange.
+ Unit of account: Yardstick people use to post prices and record debts
→ During inflation, the value of money changes frequently, which undermines its role as a
unit of account as prices become less stable and predictable, making it harder for consumers
and businesses to make informed financial decisions.
+ Store of value: Item that people can use to transfer purchasing power from the present
to the future.
→ As inflation rises, the purchasing power of money decreases, making it a poorer store of
value. This loss of value over time discourages saving and can disrupt future planning.

8. Suppose that people expect inflation to be 3 percent but that, in fact, prices rise by 5
percent. Describe how this unexpectedly high inflation would help or hurt the following:
a. The government
- When inflation is higher than anticipated, it essentially acts as a 'hidden tax' on creditors by
reducing the real value of debt. Governments typically borrow money through the issuance of
bonds, which have fixed interest rates. Higher inflation means that the government can repay
its debt with money that has less purchasing power than when the debt was incurred.
- This decrease in the real value of debt benefits the government in the short term, as it lowers
the actual cost of borrowing.
b. A homeowner with a fixed-rate mortgage
- A homeowner with a fixed-rate mortgage benefits from unexpectedly high inflation because
their mortgage payments are fixed in nominal terms. As inflation increases, the real or
inflation-adjusted cost of their payments decreases, essentially making their house cheaper
over time compared to the original valuation in real terms.
c. A union worker in the second year of a labor contract
- A union worker who is in the second year of a labor contract is adversely affected by
unexpectedly high inflation if their contract does not include an inflation adjustment clause.
Their wages are fixed in nominal terms, and with higher inflation, their real income
(purchasing power) decreases.
d. A college that has invested some of its endowment in government bonds
- Unexpected inflation can erode investment returns. Government bonds often offer fixed
interest rates, and when these rates are set, inflation expectations are factored into the yield. If
actual inflation surpasses the expected rate, the real value of the bond's coupon payments
essentially decreases its yield.

9. Explain whether the following statements are true, false, or uncertain.

a. “Inflation hurts borrowers and helps lenders, because borrowers must pay a
higher rate of interest.”
- False. Inflation generally helps borrowers and hurts lenders, particularly if the inflation is
unexpected. Borrowers repay loans with money that has less purchasing power, reducing the
real burden of their debt. Conversely, lenders receive payments in devalued currency,
reducing the real value of the interest and principal they receive.
b. “If prices change in a way that leaves the overall price level unchanged, then no
one is made better or worse off.”
- False. Even if the overall price level remains unchanged, changes in relative prices can
redistribute wealth or affect economic outcomes.
c. “Inflation does not reduce the purchasing power of most workers.”
- Uncertain. If wages keep up with inflation, workers’ purchasing power remains unaffected,
so inflation does not harm them. However, if wages fail to rise at the same pace as inflation,
workers experience a decline in real income, reducing their purchasing power.
CHAP 31: OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS
● Questions for review
1. Define net exports and net capital outflow. Explain how and why they are related.
- Net exports of a country are the value of its export minus the value of its import.
- Net capital outflow refers to the purchase of foreign assets by domestic residents minus the
purchase of domestic assets by foreigners.
- Net exports are equal to net capital outflow by an accounting identity, because exports from
one country to another are matched by payments of some asset from the second country to the
first.
2. Explain the relationship among saving, investment, and net capital outflow.
- Savings, investment and capital outflow are all related in an open economy. The total
amount saved is equal to the amount of domestic investment plus capital outflow. To invest
people need to save, by saving they are building a supply of funds available to investment,
this increases the net capital outflow
3. If a Japanese car costs 1,500,000 yen, a similar American car costs $30,000, and a
dollar can buy
100 yen, what are the nominal and real exchange rates?
Nominal exchange rate = 100 yen per dollar
Real exchange rate
= (100 yen per dollar x $30,000 per American car)/1,500,000 yen per Japanese car
= 2 Japanese car per American car
4. Describe the economic logic behind the theory of purchasing-power parity.
- Purchasing Power Parity (PPP) is an economic theory that suggests that the cost of a
particular set of goods should be the same in all countries when considered in a common
currency. It is based on the law of one price, which states that in the absence of frictional
factors (like transportation costs and taxes), competitive markets will equalize the price of an
identical good in two countries when expressed in the same currency. Ultimately, PPP is a
useful concept to economists as it allows for a more reasonable comparison of economic
productivity and standards of living across countries.
5. If the Fed started printing large quantities of U.S. dollars, what would happen to the
number of Japanese yen a dollar could buy? Why?
- If the Fed started printing large quantities of U.S. dollars, the U.S. price level would
increase, and a dollar would buy fewer Japanese yen.
- If a dollar can buy 100 yen, the nominal exchange rate is 100 yen per dollar. The real
exchange rate equals the nominal exchange rate times the domestic price divided by the
foreign price, which equals 100 yen per dollar times $10,000 per American car divided by
500,000 yen per Japanese car, which equals two Japanese cars per American car.
 ● Problems and applications
1. How would the following transactions affect U.S. exports, imports, and net exports?
a. An American art professor spends the summer touring museums in Europe.
- When an American art professor spends money in Europe, it is an import because it is an
expenditure by a U.S citizen on a foreign service. This increases U.S. imports. When exports
remain unchanged but imports increase, net exports will decrease.
b. Students in Paris flock to see the latest movie from Hollywood.
- When students in Paris flock to see the latest movie from Hollywood, it is an export because
it is foreign expenditure on U.S service. While export increases, net export also rises.
c. Your uncle buys a new Volvo.
- When your uncle buys a new Volvo, a Swedish manufactured vehicle, it is considered as an
import because it involves a U.S. resident purchasing a foreign product. This increases U.S.
imports and decreases net exports as U.S. exports remain unchanged.
d. The student bookstore at Oxford University in England sells a copy of this
textbook.
- When student bookstore at Oxford University in England sells a copy of this textbook, it is
classified as export because the textbook, a U.S.-produced goods are sold abroad. While the
export increases and the import stable, the net export rises.
e. A Canadian citizen shops at a store in northern Vermont to avoid Canadian sales
taxes.
- When a Canadian citizen shops at a store in northern Vermont to avoid Canadian sales taxes,
it is considered as exports because the U.S produced goods or services are sold to a foreign
citizen. This increases U.S exports. While U.S exports increase and imports are stable, the
U.S net exports rise.
2. Would each of the following transactions be included in U.S. net exports or in U.S. net
capital outflow? Indicate whether it would represent an increase or a decrease in that
variable.
a. An American buys a Sony TV.
- When an American buys a Sony TV, which is a Japanese product, it represents an import.
This will increase U.S imports which lead to the decrease in U.S net exports and have no
effect on net capital outflow.
b. An American buys a share of Sony stock.
- When an American buys a share of Sony stock, which means U.S citizen invests in foreign
assets. This will increase U.S net capital outflow and have no effect on net exports.
c. The Sony pension fund buys a bond from the U.S. Treasury.
- When the Sony pension fund, a foreign entity, buys a bond from the U.S. Treasury, it's a
foreign investment in the United States. This would reduce net capital outflow and not affect
U.S. net exports.
d. A worker at a Sony plant in Japan buys some Georgia peaches from an American
farmer.
- A worker at Sony in Japan purchasing Georgia peaches constitutes an export for the U.S.
This increases U.S. net exports and doesn't have a direct effect on U.S. net capital outflow.
3. Describe the difference between foreign direct investment and foreign portfolio
investment. Who is more likely to engage in foreign direct investment—a corporation or
an individual investor? Who is more likely to engage in foreign portfolio investment?
- FDI occurs when a firm or individual invests in and controls a business or physical assets in
another country. FPI occurs when a firm or individual purchases financial assets in a foreign
country without direct control over the asset or business operations.
- Foreign Direct Investment is more likely to be done by corporations. Because corporations
typically have the resources, expertise, and strategic goals to establish and manage physical
operations abroad.
- Foreign Portfolio Investment is more likely to be done by individual investors. Because
individual investors are usually interested in financial returns rather than managing foreign
businesses and are more comfortable with passive investments like stocks and bonds.
4. Explain how the following transactions would affect U.S. net capital outflow. For each
transaction, state whether it represents direct investment or portfolio investment.
a. An American cellular phone company establishes an office in the Czech Republic.
- When an American cellular phone company establishes an office in the Czech Republic, it's
considered a direct investment because it involves a physical business operation. Since the
investment is outbound from the U.S. to another country, it increases U.S. net capital outflow.
b. Harrods of London sells stock to the General Motors pension fund.
- When Harrods of London sells stock to the General Motors pension fund, it is an example of
a portfolio investment because the transaction is in financial assets rather than physical
business operations. This purchase of foreign stock by a U.S. entity increases the U.S. net
capital outflow.
c. Honda expands its factory in Marysville, Ohio.
- When Honda expands its factory in Marysville, Ohio, this expansion involves a physical
operation controlled by the foreign firm so that this is direct investment. Because foreign
firms invest in physical assets in the U.S, this will lead to the decrease of U.S net capital
outflow.
 d. A Fidelity mutual fund sells its Volkswagen stock to a French investor.
- When a Fidelity mutual fund sells its Volkswagen stock to a French investor, this can be
considered as portfolio Investment since the transaction involves financial assets without
managerial control. Additionally, it will not have effect on U.S net capital outflow because a
U.S. investor sells a foreign financial asset, but it’s purchased by another foreign investor.
5. Would each of the following groups be happy or unhappy if the U.S. dollar
appreciated? Explain.
a. Dutch pension funds holding U.S. government bonds
- If the U.S. dollar appreciated, the value of the U.S. government bonds held by Dutch
pension funds would increase in terms of their home currency (euros). This is because the
payouts from these bonds, which are in dollars, would convert to more euros, potentially
increasing the value of their investment.
b. U.S. manufacturing industries
- U.S. manufacturing industries would likely be unhappy with an appreciation of the U.S.
dollar, as their exports would become more expensive for foreign buyers. This could lead to a
decrease in demand for their products abroad, potentially harming their sales and profits.
c. Australian tourists planning a trip to the United States
- Australian tourists planning a trip to the United States would be unhappy with a stronger
U.S. dollar because it means they would get fewer dollars in exchange for their Australian
currency. This makes the cost of travel and spending in the U.S. more expensive for them.
d. an American firm trying to purchase property overseas
- An American firm trying to purchase property overseas would be happy with an
appreciation of the U.S. dollar. A stronger dollar implies they would have to spend less in
dollar terms to get the equivalent in the foreign currency needed to purchase the property, thus
reducing their investment cost.
6. What is happening to the U.S. real exchange rate in each of the following situations?
Explain.
a. The U.S. nominal exchange rate is unchanged, but prices rise faster in the United
States than abroad.
- Since the U.S. nominal exchange rate is constant, the change in real exchange rate will
depend on the relative change in price levels. Given that prices are rising faster in the U.S. (P
is increasing) than abroad (P∗ is constant or increasing at a slower rate), real exchange rate
will increase. This means U.S. goods are becoming relatively more expensive compared to
foreign goods.
 b. The U.S. nominal exchange rate is unchanged, but prices rise faster abroad than
in the United States.
- Since the U.S. nominal exchange rate is constant, the change in real exchange rate will
depend on the relative change in price levels. Given that prices are rising faster abroad (P∗ is
increasing) than in the U.S. (P is constant or increasing at a slower rate), real exchange rate
will decrease. This means U.S. goods are becoming relatively cheaper compared to foreign
goods.
c. c. The U.S. nominal exchange rate declines, and prices are unchanged in the
United States and abroad.
- Given that the nominal exchange rate declines (E decreases) and price levels in both the U.S.
(P) and abroad (P∗) remain constant, real exchange rate will decrease. This means U.S. goods
are becoming relatively cheaper compared to foreign goods.
d. d. The U.S. nominal exchange rate declines, and prices rise faster abroad than in
the United States.
- The nominal exchange rate declines (E decreases), which puts downward pressure on the
real exchange rate. Simultaneously, if prices abroad (P∗) are rising faster than in the U.S. (P),
this reinforces the effect. As a result, real exchange rate will decrease. This means U.S. goods
are becoming even cheaper compared to foreign goods.
7. A can of soda costs $1.25 in the United States and 25 pesos in Mexico. What is the
peso–dollar exchange rate (measured in pesos per dollar) if purchasing- power parity
holds? If a monetary expansion causes all prices in Mexico to double, so that a soda now
costs 50 pesos, what happens to the peso–dollar exchange rate?
E = 25/1.25 = 20 pesos per dollar
E (new) = 50/1.25 = 40 pesos per dollar
- If all prices in Mexico double, the new price of the soda would be 50 pesos. Under PPP, the
exchange rate would also double, since the price increase was only in Mexico.
8. A case study in the chapter analyzed purchasing power parity using the prices of Big
Macs in several countries. Here are data for a few more countries:
 a. For each country, compute the predicted exchange rate in terms of local currency
per U.S dollar. (Recall that the U.S price of a Big Mac was $5.58)
The predicted exchange rate:
- In Chile: 2,640/5.58 = 473.12 pesos per U.S dollar
- In Hungary: 850/5.58 = 152.33 forints per U.S dollar
- In Czech Republic: 85/5..58 = 15.23 korunas per U.S dollar
- In Brazil: 16.9/5.58 = 3.03 real per U.S dollar
- In Canada: 6.77/5.58 = 1.21 Canadian dollar per U.S dollar
b. According to purchasing-power parity, what is the predicted exchange rate
between the Chilean peso and the Canadian dollar? What is the actual exchange
rate?
- The predicted exchange rate between the Chilean peso and the Canadian dollar
= 473.12/1.21 = 391.01 pesos per Canadian dollar
- The actual exchange rate = 679/1.33 = 510.53 pesos per Canadian dollar
c. How well does the theory of purchasing-power parity explain exchange rates?
- The purchasing power parity is saying that $1 dollar should have the same purchasing
power across all countries which means that the predicted exchange rate should be equal to
the actual exchange rate but we can see that they are actually very different. it's but the
Canadian dollar is the closest one so that that the reason why this Theory might not hold is
because we have the cost of transportation and the cost of it is not easily to move the items
across countries and not everyone in the same in different countries have the same preference
so there are many other determinants that might um change the price of the Big Mac so that is
why PPP does not always hold.
9. Purchasing-power parity holds between the nations of Ectenia and Wiknam, where
the only commodity is Spam.
a. In2020,a can of Spam costs 4 dollars in Ectenia and 24 pesos in Wiknam. What is
the exchange rate between Ectenian dollars and Wiknamian pesos?
- The exchange rate between Ectenian dollars and Wiknamian pesos = 24/4 = 6 pesos per
dollar
b. Over the next 20 years, inflation is expected to be 3.5 percent per year in Ectenia
and 7 percent per year in Wiknam. If this inflation comes to pass, what will the
price of Spam and the exchange rate be in 2040? (Hint: Recall the rule of 70 from
Chapter 27)
- In Ectenia: 70/3.5 = 20. Therefore, the level of inflation will last for 20 years so then the
price level is going to double, 4 x 2 = $8.
In Wiknam: 70/7 = 10. the price in 2040 = 24 x 2^2 = 96$
- The exchange rate = 96/8 = 12 pesos per dollar
c. Which of these two nations will likely have a higher nominal interest rate? Why?
nominal interest rate = real interest rate + inflation rate
→ Wiknam has a higher interest rate so it has a higher nominal interest rate.

d. A friend of yours suggests a get-rich-quick scheme: Borrow from the nation with
the lower nominal interest rate, invest in the nation with the higher nominal
interest rate, and profit from the interest-rate differential. Do you see any
potential problems with this idea? Explain.
- The scheme suggests profiting from the interest-rate differential by borrowing in the lower-
interest-rate country (Ectenia) and investing in the higher-interest-rate country (Wiknam).
- Exchange Rate Risk: PPP predicts that currencies of high-inflation countries (like Wiknam)
will depreciate over time. Any profits from the interest-rate differential could be offset by
losses due to depreciation of Wiknam's currency when converting back to Ectenian dollars.
- Borrowing and investing across borders often involves transaction fees, taxes, and legal
restrictions, reducing profitability.

CHAP 32: A MACROECONOMICS THEORY OF THE OPEN ECONOMY

● Questions for review
1. Describe supply and demand in the market for loanable funds and in the market for
foreign-currency exchange. How are these markets linked?
- In the market for loanable funds, supply comes from national saving and demand comes
from domestic investment and net capital outflow.
- In the market for foreign currency exchange, supply comes from net capital outflow and
demand comes from net exports.

- The market for loanable funds is linked to the market for foreign-currency exchange by net
foreign investment (NFI). In the market for loanable funds, NFI is a portion of demand along
with private investment. In the market for foreign-currency exchange, NFI is the source of
supply.

2. Why are budget deficits and trade deficits sometimes called the twin deficits?
- Government budget deficits and trade deficits are sometimes called the twin deficits because
a government budget deficit often leads to a trade deficit. The government budget deficit leads
to reduced national saving, causing the interest rate to increase, and reducing net capital
outflow.

3. Suppose that a textile workers’ union encourages people to buy only American-made
clothes. What would this policy do to the trade balance and the real exchange rate?
What is the impact on the textile industry? What is the impact on the auto industry?
- If a union of textile workers encourages people to buy only American-made clothes, imports
would be reduced, so net exports would increase for any given real exchange rate.This would
cause the demand curve in the market for foreign exchange to shift to the right, as shown in
Figure 2. The result is a rise in the real exchange rate, but no effect on the trade balance. The
textile industry would import less, but other industries, such as the auto industry, would
import more because of the higher real exchange rate.
4. What is capital flight? When a country experiences capital flight, what is the effect on
its interest rate and exchange rate?
- Capital flight is large and sudden reduction in the demand for assets located in a country
- Capital flight has its largest impact on the country from which the capital is fleeing, but it
also affects other countries. If investors become concerned about the safety of their
investments, capital can quickly leave an economy. Interest rates increase and the domestic
currency depreciates.
* Problems and applications:

1. Japan generally runs a significant trade surplus. Do you think this surplus is most
related to high foreign demand for Japanese goods, low Japanese demand for foreign
goods, a high Japanese saving rate relative to Japanese investment, or structural
barriers against imports into Japan? Explain your answer.
Japan's significant trade surplus can be attributed to several interrelated factors, but the
most prominent reasons include:
- High Foreign Demand for Japanese Goods: Japan is known for its high-quality
products, particularly in technology, automobiles, and consumer electronics. The
global reputation of brands like Toyota, Sony, and Panasonic drives strong demand for
Japanese exports. This high foreign demand is a key contributor to the trade surplus.
- Low Japanese Demand for Foreign Goods: Historically, Japanese consumers have
shown a preference for domestic products, which can limit the demand for imports.
Cultural factors, brand loyalty, and a focus on quality often lead consumers to choose
Japanese-made goods over foreign alternatives.
- High Japanese Saving Rate Relative to Investment: Japan has a high saving rate,
which can exceed domestic investment opportunities. This results in excess savings
being channeled into foreign investments rather than into purchasing foreign goods,
thus contributing to a trade surplus.
- Structural Barriers Against Imports: Japan has been criticized for maintaining
structural barriers that can hinder imports, such as regulatory hurdles and tariffs. These
barriers can limit the competitiveness of foreign goods in the Japanese market, further
supporting a trade surplus.
2. Suppose that Congress is considering an investment tax credit, which subsidizes
domestic investment.
a. How does this policy affect national saving, domestic investment, net capital
outflow, the interest rate, the exchange rate, and the trade balance?
 b. Representatives of several large exporters oppose the policy. Why might that
be the case?
a. Effects of an Investment Tax Credit
- National Saving: An investment tax credit incentivizes domestic investment, which
can initially reduce national savings if the government finances the credit through
borrowing. However, if credit stimulates economic growth, it could increase future
national savings.
- Domestic Investment: The policy directly increases domestic investment as firms take
advantage of the tax credit to expand their capital expenditures.
- Net Capital Outflow (NCO): With increased domestic investment, net capital outflow
may decrease. As domestic investment rises, less capital may flow abroad since firms
are investing more domestically.
- Interest Rate: Higher domestic investment increases the demand for funds, which can
lead to an increase in interest rates. Higher interest rates can crowd out some private
investment.
- Exchange Rate: An increase in interest rates may attract foreign capital, leading to an
appreciation of the domestic currency. A stronger currency makes exports more
expensive and imports cheaper.
- Trade Balance: With a stronger currency, exports may decline while imports increase,
potentially worsening the trade balance. The increase in domestic investment and
consumption may also lead to higher imports.
b. Opposition from Large Exporters
- Stronger Currency: Large exporters may oppose the investment tax credit because it can
lead to a stronger domestic currency, making their products more expensive abroad. This
can hurt their competitiveness in international markets.
- Increased Import Competition: As the domestic currency appreciates, imported goods
become cheaper, which may lead to increased competition for domestic goods,
potentially harming exporters.
- Long-Term Economic Concerns: Exporters may worry that while the tax credit boosts
investment in the short term, it could lead to higher interest rates and a less favorable
business environment in the long term, potentially affecting their growth and profitability.
- Focus on Global Demand: Exporters might prefer policies that enhance global
competitiveness rather than those that primarily stimulate domestic investment, which
might not align with their interests in expanding international markets.
3. The chapter notes that the rise in the U.S. trade deficit during the 1980s was largely
due to the rise in the U.S. budget deficit. On the other hand, the popular press sometimes
claims that the increased trade deficit resulted from a decline in the quality of U.S.
products relative to foreign products.

a. Assume that U.S. products did decline in relative quality during the 1980s. How did
this decline affect net exports at any given exchange rate?

b. Draw a three-panel diagram to show the effect of this shift in net exports on the U.S.
real exchange rate and trade balance.

c. Is the claim in the popular press consistent with the model in this chapter? Does a
decline in the quality of U.S. products have any effect on our standard of living? (Hint:
When we sell our goods to foreigners, what do we receive in return?)

a. If the relative quality of US products declined during the 1980s, it means that foreign
products become more attractive to both US consumers in other countries. So, US consumers
would demand more foreign products (exports). It leads to a reduction in the net export
(export - import) at any given exchange rate.
A fall in the net exports leads to a leftward shift in the demand curve for dollars from D to D1
in panel ( C); which in turn leads to a decline in the real exchange rate from e to e1. Because
there is no change in the market for loanable funds in panel (a), there is no change in the real
interest rate. Since, there is no change in the real interest rate, there is no change in net capital
outflow as shown in panel (b). Since net capital outflows equals net exports, a shift in net
export does not change the trade balance.

The claim that some people made in the popular press is not consistent with the model in this
chapter. The change in the real exchange rate that resulted from the decline in the quality of
U.S products may decrease our standard of living

4. An economist discussing trade policy in The New Republic wrote, “One of the
benefits of the United States removing its trade restrictions [is] the gain to U.S.
industries that produce goods for export. Export industries would find it easier to
sell their goods abroad—even if other countries didn’t follow our example and
reduce their trade barriers.” Explain in words why U.S. export industries would
benefit from a reduction in restrictions on imports to the United States.

The removal of trade restrictions on imports can benefit U.S. export industries in several
ways:

- Increased Competitiveness: When the U.S. reduces its import restrictions, domestic
industries may become more competitive. This can lead to improved efficiencies and
innovations, making U.S. products more attractive in international markets.
- Cost Reductions: Lower import restrictions can lead to reduced costs for raw materials
and components that U.S. manufacturers rely on. Access to cheaper inputs allows
these industries to lower their production costs, which can enhance their ability to
compete globally.
- Market Expansion: A more open trade policy can foster goodwill with trading
partners. If the U.S. demonstrates a commitment to free trade, other countries may be
more inclined to open their markets to U.S. exports, creating new opportunities for
American businesses.
- Diversification of Supply Chains: By allowing imports from various countries, U.S.
export industries can diversify their supply chains. This reduces dependency on a
single source and can enhance resilience against disruptions, making U.S. products
more reliable and appealing overseas.
 - Access to Technology and Innovation: Reducing trade restrictions can facilitate the
import of advanced technologies and innovations. U.S. companies can adopt these
improvements, enhancing their productivity and the quality of their exports

5. Suppose the French suddenly develop a strong taste for California wines. Answer the
following questions in words and with a diagram.

a. What happens to the demand for dollars in the market for foreign-currency
exchange?

b. What happens to the value of the dollar in the market for foreign-currency exchange?

c. What happens to U.S. net exports?

a. When the French develop a strong taste for California wines, the demand for dollars in the
market for foreign currency exchange will increase. This is because the French will need to
exchange their euros for dollars to purchase the California wines. The increase in demand for
dollars will shift the demand curve for dollars to the right.

b. As a result of the increased demand for dollars, the value of the dollar in the market for
foreign currency exchange will appreciate. This means that the exchange rate between the
dollar and the euro will increase, making the dollar more expensive compared to the euro. The
appreciation of the dollar is represented by a movement along the supply curve for dollars.

c. The increase in the value of the dollar will make U.S. exports more expensive for the
French. As a result, U.S. net exports will decrease. This is because the higher exchange rate
makes U.S. goods relatively more expensive compared to French goods. The decrease in U.S.
net exports is represented by a leftward shift of the U.S. net exports curve.

6. A senator renounces his past support for protectionism: “The U.S. trade deficit must
be reduced, but import quotas only annoy our trading partners. If we subsidize U.S.
exports instead, we can reduce the deficit by increasing our competitiveness.” Using a
three-panel diagram, show the effect of an export subsidy on net exports and the real
exchange rate. Do you agree with the senator?
I don't agree with the senator

7. Suppose the United States decides to subsidize the export of U.S. agricultural
products, but it does not increase taxes or decrease any other government spending to
offset this expenditure. Using a three panel diagram, show what happens to national
Real interest
saving, domestic investment, net capital outflow, the interest rate, the exchange rate, and
the trade balance. Also explain in words how this U.S. policy affects the amount of
S
imports, exports, and net exports.
Real
Interes
t
rate

Explanation of Economic Effects

- National Saving: The subsidy increases government spending without offsetting it

through taxes or reduced spending, leading to a decrease in national saving.
- Domestic Investment: With higher interest rates resulting from reduced national
saving, domestic investment may decline as borrowing costs rise.
- Net Capital Outflow: With reduced domestic investment and increased exports, net
capital outflow may initially rise as more capital is needed to support increased export
activities. However, higher interest rates could also attract foreign investment,
potentially reducing net capital outflow.
- Interest Rate: The equilibrium interest rate increases due to reduced national saving
and increased demand for loanable funds.
- Exchange Rate: The increased demand for U.S. dollars (due to more exports) leads to
an appreciation of the real exchange rate, which makes U.S. goods more expensive for
foreign buyers and imports cheaper for U.S. consumers.
- Trade Balance: Initially, the trade balance improved due to increased exports.
However, the appreciation of the dollar could lead to an increase in imports,
potentially offsetting some gains in net exports.
8. Suppose that real interest rates increase across Europe. Explain how this development
affects U.S. net capital outflow. Then explain how it affects U.S. net exports by using a
formula from the chapter and by drawing a diagram. What happens to the U.S. real
interest rate and real exchange rate?

If real interest rates increase across Europe, the return on investment in Europe will rise
relative to the United States. As the result, US capital will flow to Europe, leading to an
increase in Us net capital flow. This can be explained by the relationship between real interest
rates and net capital outflow as defined by the following formula:

Net capital outflow= Domestic saving - Domestic investment

When real interest rates increase across Europe, foreign investors seeking a lower return will
increase their investment in European countries. This will lead to an increase in domestic
saving as more funds are being invested abroad. As a result, the net capital outflow from the
United States will increase

This increase in US net capital outflow will cause a reduction in the demand for US exports.
This can be explained by the relationship between net exports and net capital outflow as
defined by the following formula:

Net exports= Net capital outflow

Therefore, an increase in net capital outflow from the United States will lead to a decrease in
net exports

As for the US real interest rate and real exchange rate, an increase in US net capital outflow
will cause the US real interest rate to rise and the US real exchange rate to depreciate. This
can be explained by the relationship between real interest rate, real exchange rates, and net
capital outflow as defined by the following formula:

Real interest rate = Nominal interest rate - Inflation rate

Real exchange rate= Nominal exchange rate * Domestic price level/ Foreign Price level

Net capital outflow= Real interest rate - real exchange rate

9. Suppose that Americans decide to increase their saving.

a. If the elasticity of U.S. net capital outflow with respect to the real interest rate is very
high, will this increase in private saving have a large or small effect on U.S. domestic
investment?

b. If the elasticity of U.S. exports with respect to the real exchange rate is very low, will
this increase in private saving have a large or small effect on the U.S. real exchange
rate?
With very high capital outflow elasticity, the effect on U.S. domestic investment would be
small. With very low export elasticity, the effect on the U.S. real exchange rate would also be
small.

CHAP 33: AGGREGATE DEMAND AND AGGREGATE SUPPLY

Questions for review

1. Name two macroeconomic variables that decline when the economy goes into a
recession. Name one macroeconomic variable that rises during a recession
Two macroeconomic variables that decline when the economy goes into a recession
are real GDP and investment spending. A macroeconomic variable that rises during a
recession is the unemployment rate.
2. Draw a diagram showing aggregate demand, shortrun aggregate supply, and
long-run aggregate supply. Be careful to label the axes correctly
3. List and explain the three reasons the aggregate demand curve slopes downward.
- Wealth Effect
The wealth effect is a classic principle that helps explain why the aggregate demand
curve slopes downward. Put simply, as the overall price level decreases, the real value
or purchasing power of existing money holdings increases. Imagine you have money
saved in your bank account; if prices for goods and services drop, the money you have
can now buy more. For the everyday consumer, this makes you feel wealthier, even if
your income hasn't changed.
The consequence is relatively straightforward: people tend to spend more when they
feel wealthier, and the increase in consumption drives demand for goods and services
upward. This resulting boost in spending contributes to the downward slope of the
aggregate demand curve. It's important to distinguish that the wealth effect considers
not just the cash people hold but their overall wealth, including savings and assets like
stocks and real estate, provided that their prices remain fixed as general price levels
fall.
- Interest Rate Effect
Another key reason behind the downward slope of the aggregate demand curve is the
interest rate effect. This effect is about borrowing costs: when overall prices decrease,
there's less pressure on the demand for money. Less demand for money can lead to
lower interest rates since banks are keen on lending out their funds. The logic here is
to encourage businesses and consumers to borrow more when it's cheaper to do so.
 With lower interest rates, companies are more inclined to take loans for investment,
and consumers are more tempted to finance large purchases, such as houses and cars.
The increase in borrowing leads to more spending and investment, thus expanding the
economy. So, as you'd expect, the aggregate demand moves upward as the general
price level moves down, illustrating once again the negative relationship between
price level and aggregate demand, reinforcing the slope of the curve.
- Exchange Rate Effect
In today's interconnected world economy, the exchange rate effect plays a vital role in
shaping the aggregate demand curve. How does it work? When a country's price level
falls, relative to other countries, its currency might be perceived as stronger. A stronger
currency means that foreign buyers will find this country’s goods and services
cheaper, which should increase the country’s exports.
On the flip side, the residents of the country that has witnessed a price decrease might
find foreign products more expensive and thus, reduce their imports. This combination
of increased exports and decreased imports causes net exports to rise, which is a
component of aggregate demand. Consequently, the aggregate demand curve will
slope downward, affirming the negative relationship between the country's price level
and its aggregate demand.

4. Explain why the long-run aggregate-supply curve is vertical.

The long-run aggregate supply curve is vertical because in the long run, the quantity of goods
and services that firms are willing to produce remains constant at the economy's potential
level of output, regardless of the overall price level. This is because, in the long run, all prices
are fully flexible, and the economy reaches an equilibrium state of full employment where
unemployment equals the natural rate of unemployment.

5. List and explain the three theories for why the short-run aggregate-supply curve
slopes upward.
The three theories for why the short-run aggregate-supply (SRAS) curve slopes
upward are the profit effect, the cost effect, and the output effect.
- The profit effect: When the price level for outputs increases while the price level of
inputs remains fixed, firms have an incentive to produce more to earn higher profits.
- The cost effect: As the price level rises, the cost of production also increases, which
leads to a higher price level for the output needed to cover the higher costs of inputs.
This upward pressure on prices increases the quantity of goods and services supplied.
- The output effect: When the price level rises, firms find it more profitable to increase
their output, resulting in an increase in real GDP.
6. What might shift the aggregate-demand curve to the left? Use the model of
aggregate demand and aggregate supply to trace the short-run and long-run
effects of such a shift on output and the price level.
When overall consumer spending declines, the aggregate demand curve typically
moves to the left.
- Elaborate on shifts in Aggregate Supply and Demand in the AS-AD Model.
+ Every expansionary policy tends to move the aggregate demand curve to the right,
and every contractionary policy tends to move it to the left. However, because long-
term aggregate supply is set by the elements of production in the long run, short-term
aggregate supply shifts to the left, meaning that any change in aggregate demand
merely affects the level of prices.
+ A short-run aggregate supply curve shift is far less common than an aggregate
demand curve shift. The aggregate supply curve only changes in the short run in
response to the aggregate demand curve. However, the short-run aggregate supply
curve moves in response to a supply shock without being prompted by the aggregate
demand curve. Fortunately, the correction procedure is the same whether the aggregate
supply curve shifts in the short run or the aggregate demand curve shifts. That is, a
short-run equilibrium exists where the short-run aggregate supply curve intersects the
aggregate demand curve when the short-run aggregate supply curve shifts. When the
aggregate demand curve intersects both the short-run and long-run aggregate supply
curves, it has moved along the short-run aggregate supply curve. When the economy
finds this new long-run equilibrium, the output is unaffected but the price level
changes.

7. What might shift the aggregate-supply curve to the left? Use the model of
aggregate demand and aggregate supply to trace the short-run and long-run
effects of such a shift on output and the price level.
The aggregate-supply curve might shift to the left because of a decline in the economy's
capital stock, labor supply, or productivity, or an increase in the natural rate of unemployment,
all of which shift both the long-run and short-run aggregate-supply curves to the left.

Problems and applications:

1. Suppose the economy is in a long-run equilibrium.

a. Draw a diagram to illustrate the state of the economy. Be sure to show aggregate
demand, short-run aggregate supply, and long-run aggregate supply.

b. Now suppose that a stock market crash causes aggregate demand to fall. Use your
diagram to show what happens to output and the price level in the short run. What
happens to the unemployment rate?

c. Use the sticky-wage theory of aggregate supply to explain what happens to output and
the price level in the long run (assuming no change in policy). What role does the
expected price level play in this adjustment? Be sure to illustrate your analysis in a
graph.

a.
b.
c.

The expected price level plays a critical role in how wages adjust and how quickly the
economy returns to equilibrium.

2. Explain whether each of the following events increases, decreases, or has no effect on
long-run aggregate supply.
a. The United States experiences a wave of immigration.

b. Congress raises the minimum wage to $15 per hour.

c. Intel invents a new and more powerful computer chip.

d. A severe hurricane damages factories along the East Coast.

a/ The United States experiences a wave of immigration

Labor, capital and natural resources

Labor increases, it moves the AS to the right

b/ Congress raises the minimum wage to $15 per hour

No effect

c/ Intel invents a new and more powerful computer chip

Increase in technological knowledge. It shift to the right

d/ A severe hurricane damages factories along the East Coast

It affects natural resources. LRAS shift to the right

3. Suppose an economy is in long-run equilibrium.

a. Use the model of aggregate demand and aggregate supply to illustrate the initial
equilibrium (call it point A). Be sure to include both short-run aggregate supply and
long-run aggregate supply.

b. The central bank raises the money supply by 5 percent. Use your diagram to show
what happens to output and the price level as the economy moves from the initial
equilibrium to the new short-run equilibrium (call it point B).

c. Now show the new long-run equilibrium (call it point C). What causes the economy to
move from point B to point C?

d. According to the sticky-wage theory of aggregate supply, how do nominal wages at

point A compare with nominal wages at point B? How do nominal wages at point A
compare with nominal wages at point C?

e. According to the sticky-wage theory of aggregate supply, how do real wages at point A
compare with real wages at point B? How do real wages at point A compare with real
wages at point C?
f. Judging by the impact of the money supply on nominal and real wages, is this analysis
consistent with the proposition that money has real effects in the short run but is neutral
in the long run?

a.

b.
According to economists, an increase in the money supply would affect the aggregate demand
curve (AD1). An increase in the money supply lowers the interest rate in the short run. This
event makes lending and borrowing cheaper. Thereby, this shifts the AD curve to the right,
making a new short run equilibrium at point B. At this point - B, the new short run
equilibrium sits at both a higher price level and output.
c/

The long run equilibrium of the economy is found at point C where the aggregate demand
curve intersects with the long run aggregate supply curve. When the economy reaches this
long run equilibrium, wages, prices, and perceptions will have adjusted so that the short run
aggregate supply (SRAS1-SRAS2) curve crosses this point as well. Additionally, the output
level also returns to its long run or “natural” level (Y2-Y3). This phenomenon can be
explained by the shift arising from change in expected level (P2-P3), the quantity of goods
and services supplied is diminished (Y2-Y3), shifting the curve to the left - at point C

d/ According to the sticky wage theory of aggregate supply, the nominal wages at

A compared to B, are fixed. This is because the nominal wages workers receive cannot change
readily. This slow adjustment may be ascribed to the slow change in the social norm and
notions of fairness, which influence wages. The wages at point A compared to C are lower
because of the higher expected price level shift. When workers expect a higher price level,
they are more inclined to negotiate high nominal wages. As a result, the higher product costs-
for any price level-lower the quantity of goods and services supplied

e/ The real wages at A compared to B, are higher. Due to slow change in wages for the reasons
mentioned above-in the previous question, the real wages fall when the price level increases at
point B. This is predicated on the fetch that real wages measure purchasing power, and that
power diminishes when price levels rise. At point C compared to A, the nominal wages are
then adjusted for the higher price level, making them higher than at A. After the adjustment,
the real wages inevitably rise, as the nominal wages change in conjunction with the higher
price level

f/ This is not consistent with the proposition. According to the sticky wage theory, the short
run wages do not change, contrary to the proposed short run changes. The factors that instill
changes in wages social and contractual do not line up with the classical theory. Simply put,
wages do not adapt quickly to changes in monetary policy. This aberration is also seen in the
long run trend, where money has real effects in the long run change in real wages. As output
returns to its long run or “natural level”, nominal wage increases, and real wages adjust to the
higher price level. This such effect increases production costs-at every price level, which is
turn leads to potential layoffs and diminished output

4/ In 1939, with the U.S. economy not yet fully recovered from the Great Depression,
President Franklin Roosevelt proclaimed that Thanksgiving would fall a week earlier
than usual so that the shopping period before Christmas would be longer. (The policy
was dubbed “Franksgiving.”) Explain what President Roosevelt might have been trying
to achieve, using the model of aggregate demand and aggregate supply
5. Explain why the following statements are false.

a. “The aggregate-demand curve slopes downward because it is the horizontal sum of

the demand curves for individual goods.”

b. “The long-run aggregate-supply curve is vertical because economic forces do not

affect long-run aggregate supply.”

c. “If firms adjusted their prices every day, then the short-run aggregate-supply curve
would be horizontal.”

d. “Whenever the economy enters a recession, its long-run aggregate-supply curve shifts
to the left.”

a/ The price level and consumption: Wealth Effect. Nominal value is fixed, one dollar is
always a dollar

The price level and investmentL The interest rate effect

The price and net exports: The exchange rate effect

b/ Prices do not affect long run supply. Just capital stock, natural resources or labor
c/ This is not the only reason why AS is upward slope

The sticky wage theory

The Misperceptions theory

d/ Recessions is when we face lower production and lower prices

AD can return to original place

AS can vary to reach the original output

6/ For each of the three theories for the upward slope of the short-run aggregate-supply
curve, carefully explain the following:

a. how the economy recovers from a recession and returns to its long-run equilibrium
without any policy intervention

b. what determines the speed of that recovery

a/
b/ The size of demand decrease

Contraction of supply in short run

Adjustment of salaries

7/ The economy begins in long-run equilibrium. Then one day, the president appoints a
new Fed chair. This new chair is well known for her view that inflation is not a major
problem for an economy.

a. How would this news affect the price level that people expect to prevail?

b. How would this change in the expected price level affect the nominal wage that
workers and firms agree to in their new labor contracts?

c. How would this change in the nominal wage affect the profitability of producing goods
and services at any given price level?

d. How would this change in profitability affect the short-run aggregate-supply curve?

e. If aggregate demand is held constant, how would this shift in the aggregate-supply
curve affect the price level and the quantity of output produced?

f. Do you think appointing this Fed chair was a good decision?

a/
b/
c/ Higher nominal wages increase production costs for firms. If the price level does not adjust
immediately to reflect these increased labor costs, profitability will decline since firms are
paying more for labor without a corresponding increase in the prices of their goods and
services

d. Effect on the Short-Run Aggregate-Supply Curve

As profitability increases due to lower nominal wages:

The short-run aggregate supply (SRAS) curve will shift to the right. Firms are willing and
able to produce more at every price level because their costs have decreased, leading to an
increase in the overall quantity of goods and services supplied.

e. Impact on Price Level and Quantity of Output

If aggregate demand remains constant and the SRAS shifts to the right:

Price Level: The price level would decrease because more goods and services are available in
the economy at the same demand level.
Quantity of Output: The total quantity of output produced would increase, as firms are
producing more due to lower costs and higher profitability.

f. Assessment of the Decision

Whether appointing this Fed chair was a good decision depends on the broader economic
context:

- Pros: If the economy is currently facing stagnation or recession, a more

accommodative stance could stimulate growth and employment without immediate
inflationary concerns.
- Cons: If inflation expectations become unanchored due to the Fed's perceived leniency
on inflation, it could lead to higher inflation in the long run, destabilizing the
economy.

Explain whether each of the following events shifts the short-run aggregate-supply
curve, the aggregate demand curve, both, or neither. For each event that does shift a
curve, draw a diagram to illustrate the effect on the economy.

a. Households decide to save a larger share of their income.

b. Florida orange groves suffer a prolonged period of below-freezing temperatures.

c. Increased job opportunities overseas cause many people to leave the country.

a/ This event would shift the aggregate-demand curve to the left. When households decide to
save more, they are effectively reducing their consumption. Lower consumption means less
demand for goods and services, which leads to a decrease in aggregate demand.
b/ This event would shift the short-run aggregate-supply curve to the left. The freezing
temperatures would damage the orange crops, reducing the overall supply of oranges. This
decrease in supply would lead to a decrease in the short-run aggregate supply
c/ This event would shift both the short-run aggregate-supply curve and the aggregate-demand
curve to the left. The departure of workers would reduce the labor force, leading to a decrease
in the short-run aggregate supply. At the same time, the decrease in population would also
lead to a decrease in aggregate demand, as there would be fewer consumers in the economy.
9/ For each of the following events, explain the short run and long-run effects on output
and the price level, assuming policymakers take no action.

a. The stock market declines sharply, reducing consumers’ wealth.

b. The federal government increases spending on national defense.

c. A technological improvement raises productivity.

d. A recession overseas causes foreigners to buy fewer U.S. goods.

a. Short-run: output and price level decrease. Long-run: return to potential output, possibly
with lower price levels.

b. Short-run: output and price level increase. Long-run: potential shift back to potential
output, higher price level, increased debt.
c. Short-run: output increases, price level decreases. Long-run: higher potential output, lower
price level.
d. Short-run: output decreases, price level may decrease. Long-run: return to potential output,
adjusted price level.

10. Suppose firms become optimistic about future business conditions and invest heavily
in new capital equipment.

a. Draw an aggregate-demand/aggregate-supply diagram to show the short-run effect of

this optimism on the economy. Label the new levels of prices and real output. Explain in
words why the aggregate quantity of output supplied changes.

b. Now use the diagram from part (a) to show the new long-run equilibrium of the
economy. (For now, assume there is no change in the long-run aggregate-supply curve.)
Explain in words why the aggregate quantity of output demanded changes between the
short run and the long run.

c. How might the investment boom affect the long-run aggregate-supply curve? Explain

a. If firms become optimistic about future business conditions and invest a lot, the result is
shown in the figure below. The economy begins at point a with aggregate demand curve AD1
and short run aggregate supply curve AS1. The equilibrium has price level P1 and output level
Y1. Increased optimism leads to greater investment, so the aggregate demand curve shifts to
AD2. Now the economy is at point B, with price level P2 and output level Y2. The aggregate
quantity of output supplied rise because the price level has risen and people have
misperceptions about the price level, wage are sticky , all of which cause output supplied to
increase

b. Over time, as the misperceptions of the price level disappear, wages adjust, or prices adjust,
the short run aggregate supply curve shifts up to AS2 and the economy gets to equilibrium at
point C, with price level P3 and output level Y1. The quantity of output demanded declines as
the price level rises

c. The investment boom might increase the long run aggregate supply curve because higher
investment today means a larger capital stock in the future, thus higher productivity, and
output

CHAP 34: THE INFLUENCE OF MONETARY AND FISCAL POLICY ON

AGGREGATE DEMAND

Questions for review

1.What is the theory of liquidity preference? How does it help explain the downward
slope of the aggregate demand curve?

- The theory is, in essence, an application of supply and demand. According to Keynes, the
interest rate adjusts to balance the supply of and demand for money.
- The theory of liquidity preference help explain the downward slope of the aggregate-demand
curve:

+ A higher price level raises money demand

+ Higher money demand leads to a higher interest rate

+ A higher interest rate reduces the quantity of goods and services demanded

=> The result of this analysis is a negative relationship between the price level and the
quantity of goods and services demanded

2. Use the theory of liquidity preference to explain how a decrease in the money supply
affects the aggregate demand curve.

A decrease in money supply will cause aggregate demand to shift to the left because
investment will decrease.

3. The government spends $3 billion to buy police cars. Explain why aggregate demand
might increase by more or less than $3 billion.

Aggregate demand will increase exactly by $3 billion because government spending and
aggregate demand have a directly proportional relationship.

4. Suppose that survey measures of consumer confidence indicate a wave of pessimism

is sweeping the country. If policymakers do nothing, what will happen to aggregate
demand? What should the Fed do if it wants to stabilize aggregate demand? If the
Fed does nothing, what might Congress do to stabilize aggregate demand? Explain
your reasoning.

If policymakers do nothing, consumption and investment will decrease which will shift
aggregate demand to the left. If the Fed wants to stabilize aggregate demand, it will increase
the money supply. If the Fed does nothing, Congress might raise taxes or increase government
spending.

Give an example of a government policy that acts as an automatic stabilizer. Explain why the
policy has this effect.

Unemployment insurance is an automatic stabilizer because it mitigates the economy's

sensitivity to shocks because it protects those who lose their jobs during a recession.

Problems and applications:

1. Explain how each of the following developments would affect the supply of money, the
demand for money, and the interest rate. Use diagrams to illustrate your answers.

a. The Fed’s bond traders buy bonds in open-market operations. b. An increase in

credit-card availability reduces the amount of cash people want to hold.

c. The Fed reduces reserve requirements.

d. Households decide to hold more money to use for holiday shopping.

e. A wave of optimism boosts business investment and expands aggregate demand.

a. When the Fed’s bond traders buy bonds in open-market operations, the

money -supply curve shifts to the right from MS 1 to MS 2. The result

is a decline in the interest rate

b/ When an increase in credit card availability reduces the cash people

hold, the money-demand curve shifts to the left from MD 1 to MD 2.

The result is a decline in the interest rate. Graphically, this can be seen

as below
c/ When the Federal Reserve reduces reserve requirements, the money

supply increases, so the money-supply curve shifts to the right from MS 1

to MS 2. The result is a decline in the interest rate. The figure is same as

in (a)
d/ When households decide to hold more money to use for holiday

shopping, the money-demand curve shifts to the right from MD 1 to

MD 2. The result is a rise in the interest rate

e/

-When a wave of optimism boosts business investment and expands

aggregate demand, money demand increases from MD 1 to MD 2 in

Figure 3. The increase in money demand increases the interest rate.

Graphically, this can be seen as below

2. The Fed expands the money supply by 5 percent.

a. Use the theory of liquidity preference to illustrate in a graph the impact of this policy
on the interest rate.
b. Use the model of aggregate demand and aggregate supply to illustrate the impact of this
change in the interest rate on output and the price level in the short run.

c. When the economy makes the transition from its short-run equilibrium to its new
long-run equilibrium, what happens to the price level?
d. How does this change in the price level affect the demand for money and the
equilibrium interest rate?
e. Is this analysis consistent with the proposition that money has real effects in the short
run but is neutral in the long run?

3. Suppose a computer virus disables the nation’s automatic teller machines, making
withdrawals from bank accounts less convenient. As a result, people want to keep more
cash on hand, increasing the demand for money.
a. Assume the Fed does not change the money supply. According to the theory of
liquidity preference, what happens to the interest rate? What happens to aggregate
demand?

b. If instead the Fed wants to stabilize aggregate demand, how should it change the
money supply?

c. If it wants to accomplish this change in the money supply using open-market

operations, what should it do?

a. Impact on Interest Rate and Aggregate Demand

According to the theory of liquidity preference, if people want to hold more money (increase
in money demand) and the money supply remains unchanged, the interest rate will increase.
This is because the increased demand for money creates a shortage, driving up the price of
money, which is the interest rate.

The increase in interest rates will decrease aggregate demand. Higher interest rates make
borrowing more expensive, which discourages investment and consumption, leading to a
decrease in aggregate demand.

b. Stabilizing Aggregate Demand

If the Federal Reserve (Fed) wants to stabilize aggregate demand, it should increase the
money supply. By increasing the money supply, the Fed can offset the increase in money
demand, keeping the interest rate stable. This would prevent the decrease in aggregate
demand that would otherwise occur due to higher interest rates.

c. Open-Market Operations

To increase the money supply using open-market operations, the Fed should buy government
bonds. When the Fed buys bonds, it pays for them by creating money, which increases the
money supply. This is the primary tool the Fed uses to control the money supply.

4. Consider two policies—a tax cut that lasts for only one year and a tax cut that is
expected to be permanent. Which policy will stimulate greater spending by consumers?
Which policy will have the greater impact on aggregate demand? Explain.

The impact of a tax cut on consumer spending and aggregate demand depends on whether the
tax cut is temporary or permanent.
 - Temporary Tax Cut: A temporary tax cut, lasting only one year, will likely stimulate
less spending by consumers. This is because consumers may view the tax cut as a one-
time windfall and choose to save or pay off debt rather than increase their
consumption. This is known as the Permanent Income Hypothesis, which suggests that
consumers base their spending decisions on their long-term income expectations rather
than short-term fluctuations.
- Permanent Tax Cut: On the other hand, a permanent tax cut is expected to stimulate
greater spending by consumers. If consumers believe the tax cut is permanent, they are
likely to view it as an increase in their long-term income. This can lead to an increase
in consumption, as consumers adjust their spending habits to reflect their higher
disposable income.
- Impact on Aggregate Demand: In terms of aggregate demand, a permanent tax cut will
likely have a greater impact. Aggregate demand is the total demand for goods and
services within an economy. If consumers increase their spending due to a permanent
tax cut, this will increase consumption, one of the main components of aggregate
demand.

In contrast, a temporary tax cut may have a smaller impact on aggregate demand. If
consumers choose to save or pay off debt with their tax cut, this will not increase consumption
and therefore will not significantly increase aggregate demand.

5. The economy is in a recession with high unemployment and low output.

a. Draw a graph of aggregate demand and aggregate supply to illustrate the current
situation. Be sure to include the aggregate-demand curve, the short run aggregate-
supply curve, and the long-run aggregate-supply curve.

b. Identify an open-market operation that would restore the economy to its natural rate.

c. Draw a graph of the money market to illustrate the effect of this open-market
operation. Show the resulting change in the interest rate.

d. Draw a graph similar to the one in part a to show the effect of the open-market
operation on output and the price level. Explain in words why the policy has the effect
that you have shown in the graph.
a/

b/ Aim to increase Aggregate Demand => Buy government bonds

c/
d/

The open-market operation increases the money supply, lowering interest rates. Lower interest
rates encourage borrowing and spending by consumers and businesses, boosting aggregate
demand. As AD increases, firms respond by increasing production, leading to higher output
and employment. This process continues until the economy reaches the natural rate of output,
represented by the LRAS curve. The resulting increase in demand could also lead to a rise in
the price level, depending on how much the economy was below its potential output initially.

6. In the early 1980s, new legislation allowed banks to pay interest on checking deposits,
which they could not do previously.

a. If we define money to include checking deposits, what effect did this legislation have
on money demand? Explain.

b. If the Fed had maintained a constant money supply in the face of this change, what
would have happened to the interest rate? What would have happened to aggregate
demand and aggregate output?
c. If the Fed had maintained a constant market interest rate (the interest rate on
nonmonetary assets) in the face of this change, what change in the money supply would
have been necessary? What would have happened to aggregate demand and aggregate
output?

a. Increase. Check deposits will increase the quantity considered as money

b/

c/
7. Suppose economists observe that an increase in government spending of $10 billion
raises the total demand for goods and services by $30 billion.

a. If these economists ignore the possibility of crowding out, what would they estimate
the marginal propensity to consume (MPC) to be?

b. Now suppose the economists allow for crowding out. Would their new estimate of the
MPC be larger or smaller than their initial one?

a/ Multiplier = 1/ (1-MPC)

3 = 1/ (1-MPC)

=> MPC = ⅔

Multiplier = 1/ (1-⅔)

=> Multiplier = 3

b. This should be lower

8. An economy is producing output $400 billion less than the natural level of output, and
fiscal policymakers want to close this recessionary gap. The central bank agrees to
adjust the money supply to hold the interest rate constant, so there is no crowding out.
The marginal propensity to consume is 4 5, and the price level is completely fixed in the
short run. In what direction and by how much must government spending change to
close the recessionary gap? Explain your thinking.

Y = 400

MPC = ⅘

Multiplier = 1/ (1-⅘)

Multiplier = 1/ ⅕

Multipliers = 5

—-----------------

Delta G -> Delta Y = 400

Delta Y = Delta G * Multiplier

Delta G = Delta Y / Multiplier

Delta G = 400/5 => Delta G = 80

—------------------

To close the recessionary gap, fiscal policymakers need to increase government spending.
Since the economy is producing output 400 billion less than the natural level of output, the
government needs to increase spending by at least $400 billion to close the gap.

The marginal propensity to consume (MPC) is given as 4/5, meaning that for every additional
dollar of income, individuals will spend 80 cents. By increasing government spending,
income will increase, leading to an increase in consumption. The increase in consumption will
further stimulate aggregate demand and help close the recessionary gap.

Since the price level is completely fixed in the short run, changes in government spending
will not affect the overall price level. Therefore, the government can increase spending
without worrying about inflationary pressures.

9. Suppose government spending increases. Would the effect on aggregate demand

be larger if the Fed held the money supply constant in response or if the Fed
committed to maintaining a fixed interest rate? Explain.
- If government spending increases, the effect on aggregate demand would be larger if the
Federal Reserve (Fed) committed to maintaining a fixed interest rate rather than holding the
money supply constant. This is because fixed interest rates tend to stimulate consumption and
investment demand more vigorously. When the Fed fixes the interest rate, it typically must
adjust the money supply to maintain that rate, which can lead to more pronounced changes in
economic activity.

- In contrast, if the Fed holds the money supply constant, interest rates might rise as a result of
the increased demand for funds, which could dampen the stimulative effect of government
spending on aggregate demand.

- Additionally, if the Fed increases the supply of money at an increasing rate, the likely
impacts would include an increase in GDP and a decrease in unemployment in the short run.
However, over time, this could also lead to higher inflation rates.

10. Is expansionary fiscal policy more likely to lead to a short-run increase in investment

a. when the investment accelerator is large or when it is small? Explain.

b. when the interest sensitivity of investment is large or when it is small? Explain

a. Expansionary fiscal policy is more likely to lead to a short-run increase in investment when
the investment accelerator is large because it means that a given increase in output results in a
larger increase in investment.
b. Expansionary fiscal policy is more likely to lead to a short-run increase in investment when
the interest sensitivity of investment is small because changes in interest rates have a less
significant effect on investment decisions.

11. Consider an economy described by the following equations:

Y=C+I+G

C = 100 + 0,75( Y-T)

I= 500 - 50R

G= 125

T= 100

where Y is GDP, C is consumption, I is investment, G is government purchases, T is

taxes, and r is the interest rate. If the economy were at full employment (that is, at its
natural level of output), GDP would be 2,000.

a. Explain the meaning of each of these equations.

b. What is the marginal propensity to consume in this economy?

c. Suppose the central bank adjusts the money supply to maintain the interest rate at 4
percent, so r = 4. Solve for GDP. How does it compare to the full-employment level?

d. Assuming no change in monetary policy, what change in government purchases would

restore full employment? e. Assuming no change in fiscal policy, what change in the
interest rate would restore full employment?

a/ The meaning of each equation is as follows:

- Y = C + I + G: This equation represents the national income identity, where Y is the

GDP (output), C is consumption, I is investment, and G is government purchases. It
states that the total output in the economy (GDP) is equal to the sum of consumption,
investment, and government purchases.
- C = 100 + 0.75(Y - T): This equation represents the consumption function, where C is
consumption, Y is the GDP, and T is taxes. It states that consumption is determined by
a fixed autonomous component (100) plus a fraction (0.75) of the disposable income
(Y - T).
 - I = 500 - 50r: This equation represents the investment function, where I is investment
and r is the interest rate. It states that investment is determined by a fixed autonomous
component (500) minus a fraction (50) of the interest rate.
- G = 125: This equation represents government purchases, where G is the level of
government - purchases. It states that government purchases are fixed at 125.
- T = 100: This equation represents taxes, where T is the level of taxes. It states that
taxes are fixed at 100.

b/ C = 100 + 0.75(Y-T)

MPC = 0.75

c/ Y= 100 + 0.75(Y-T) + 300 + 125

Y= 525 + 0.75(Y-T)

Y= 525 + 0.75(Y-100)

0.25Y= 600

=> Y=2400 > 2000

d/

400/4 = Delta G
Decrease in 100 will get Y = 2000

Proof

G = 25

—---------------

Y=C+Y+G

Y = 100 + 0.75(Y-T) + 300 + 25

Y - 0.75(Y-100) = 425

0.25Y = 500

Y = 2000

e/ - The equations given represent an economy. The equation Y=C+I+G represents the GDP. It
states that the total output of an economy is the sum of consumption, investment, and
government spending. C=100+0.75(Y-T) represents household consumption, which means
that households consume a base level of 100 plus 0.75 times their disposable income (income
after tax). I=500-50r indicates investment, implying firms invest more when interest rates (r)
are low. G = 125 is the level of government purchases. T = 100 represents the level of taxes.

- The marginal propensity to consume (MPC) in this economy is 0.75 (derived from the
consumption equation). This figure indicates that for every additional dollar of income,
households will consume 75 cents.

- In the given scenario where the interest rate is 4%, the investment equation becomes I=500-
50*4=300. Substituting I=300, G=125, T=100 and C = 100 + 0.75(Y - 100) into the GDP
equation, solving for Y gives Y = 1900. This is lower than the full-employment level of 2,000,
indicating an output gap.

- Assuming no change in monetary policy, the increase in government purchases that would
restore full employment is found by calculating the spending gap which is (2000-1900) then
dividing it by the multiplier (1/(1-MPC)). Here, the output gap of 100 divided by the
multiplier of 4 gives 25, so government spending would need to be increased by 25 to restore
full employment.

- Assuming no change in fiscal policy, the change required in the interest rate can be worked
out using the investment equation. Re-arranging the investment equation to solve for r when Y
equals full employment, we find that the interest rate needs to decrease by 0.5%
 PART 1

So the Trump administration’s proposed policies comprise a mix of deregulatory and

protectionist measures, both of which could have different economic effects. These policies
are:

A. Deregulation Initiatives Analysis:

1. Impact on GDP:

This means lessening delays for businesses to begin or to expand their operations. It helps
with efficiency and lower production costs and increases investment and GDP as a
consequence. Relaxed planning further promotes the development of AI, leading to further
output on many fronts including logistics, healthcare, and manufacturing.

Price Level

AD’

AD
AS

AS’

Real GDP

Diagram: AD-AS Model for GDP Growth

With the deregulation shift Aggregate Demand (AD) rightward from increased investment
and consumer spending. At the same time, the Aggregate Supply curve (AS) will shift right
due to the decrease in production costs allowing for long term growth.

2. Impact on Price Levels:

Efficient business operations and AI driven productivity reduce price due to increased supply
of goods and services. As AD increases, however, the inflationary side effect from shifting
AS to the right is mitigated.

Price Level

AD’

AD
AS

AS’

Real GDP

Diagram: AD-AS Interaction for Price Levels

The initial rightward shift in AD could raise price levels. However, as AS also shifts
rightward, the price level remains stable or even decreases, reflecting reduced production
costs.

3. Impact on Interest Rates:

Deregulation stimulates borrowings for new business projects as well as ones for upgrading
AI infrastructure, increasing MD. That results in higher short term interest rates. Nevertheless,
lower government spending may oppose this effect by reducing the aggregate borrowing
demand.
 Interest Rate

M MS’ MD MD’
S
Money Supply/
Demand

Diagram: Money Supply (MS) and Money Demand (MD)

Higher MD shifts the MD curve rightward, raising interest rates. Lower federal expenditures
shift the MS curve rightward, partially neutralizing this effect.

4. Impact on Exchange Rates:

The domestic interest rates are higher when the foreign investors are attracted, thereby
increasing demand for U.S. currency. Deregulation increases GDP, increases economic
confidence, attracts FDI and promotes long term currency appreciation via AI innovation.
 Quantity of Currency

D’

Exchange Rate

Diagram: Exchange Rate Dynamics

Increased interest rates and economic growth shift the demand curve for the domestic
currency rightward, leading to appreciation. Lower production costs further improve export
competitiveness, increasing foreign currency inflows.

5. Long-Term Effects on LRAS:

Deregulation initiatives open infrastructure, remove bottlenecks and increase productivity,

thereby shifting the Long Run Aggregate Supply (LRAS) curve rightward. It shows
sustainable growth (structural inflation) of GDP and lower.
 Price Level
LRAS LRAS
’

Real GDP

Diagram: LRAS Expansion

LRAS shifts rightward due to long-term productivity gains from deregulation and AI
innovation, increasing the economy’s potential output.

=> Deregulation initiatives foster short-term economic growth by increasing investment

and production efficiency while mitigating price pressures. Over the long term, these
policies enhance productivity, expand LRAS, and lead to sustainable GDP growth.
However, the effectiveness depends on policy implementation and coordination with
fiscal and monetary measures.

PART 2

Secondly, the Trump administration also proposed a tax cut policy. This policy set a goal to
reduce corporate and personal tax rates to accelerate investment (I) and consumption (C),
which provide a short-term boost to economic growth. Here is the evidence taken from the
article:

“Stock and corporate-bond mand promotese broadly delighted with the prospect of
deregulation and tax cuts in a second Trump term.”

“The tax cuts will produce a sugar rush that boosts corporate profits.”
The impact on GDP: When corporate taxes are reduced, businesses have retained a larger
portion of their profits. This increase in after-tax income encourages firms to invest more in
expansion, research and development (R&D), and other capital projects. As businesses grow,
they often hire more workers, purchase more raw materials, and produce more goods and
services. Furthermore, higher investment typically leads to higher productivity in the
economy, which can lead to long-term growth. At the same time, the reduction in personal tax
rate raises disposable income and and promotes consumption as well. Both activities
contribute directly to economic output, increasing GDP.

The impact on price level: When demand for goods and services grows swiftly due to the
increase in investment and consumption, many businesses have struggled to meet this
intensive demand for the short term, especially when the economic market is now operating
near full capacity. This situation forces companies to raise prices in response to higher
demand. The upward price can be effortlessly recognized in some sectors where the supply
can’t adjust immediately, such as housing and energy.

P
P

LRAS
LRAS1 LRAS2

SRAS
SRAS

P2

P1

AD2
AD1
AD1
Y
Y1 Y2 Y
 R

MS

R2

R1

MD2

MD1
M

The impact on interest rate: The lower taxes increase disposable income for consumers and
after-tax profits for businesses. This means that consumers have more spending, and the
businesses might borrow to expand operations to meet increased demand, leading to a rise in
aggregate demand (AD). These activities boost the demand for loans in the financial market.
The increase in money demand causes a rightward shift in the demand curve within the
money market. If the money supply remains unchanged, this imbalance pushes the
equilibrium interest rate higher, making borrowing more expensive.

In addition, tax cuts may reduce the government's revenue if the government chooses to
maintain its spending levels (G). To address budget deficits, the government will need to
increase borrowing. This added demand for funds competes directly with businesses and
consumers in the same financial markets. If this condition persists, that might reduce the pool
of credit available to businesses and individuals. This competition drives up interest rates
further.

The impact on exchange rate:

In the short term, there are various reasons that lead to appreciation of of the US dollar,
including increased foreign investment, higher interest rates, and speculative demand. In
terms of foreign investment, tax cuts will result in a more favorable business environment;
this might promote foreign investment into US equity and bond markets. This surge in capital
inflows elevates the demand for the dollar, driving its appreciation.
Moreover, a rapid increase in economic activity can lead to overheating, where demand
surpasses supply. This often creates inflationary pressures, with prices rising across goods and
services. In this case, the FED might conduct contractionary monetary policy by raising
interest rates. Higher interest rates attract global investors, as U.S. assets (like bonds) offer
better returns compared to those in other countries. To invest in these assets, foreign investors
need to exchange their local currency for U.S. dollars, increasing the demand for the dollar.

Finally, with the tax cut policy, investors may predict stronger economic growth in the US
and higher corporate profits. This creates an expectation that the dollar will appreciate,
encouraging speculative buying of the currency to profit from its future increase in value.

In the long term, while the dollar appreciates initially, long-term risks emerge from the
growing fiscal deficit caused by reduced tax revenues. Concerns about the sustainability of
U.S. fiscal policies could weaken investor confidence, potentially reversing the dollar’s
appreciation over time. Additionally, a stronger dollar may worsen the trade balance by
making U.S. exports less competitive, contributing to depreciation pressures in the future.

EE S2=NCO2 S1=NCO1

E2
E2

E1

D=NX

Dollar Dollar

The third policy of the Trump administration is mass deportations. This policy aims to deport
millions of illegal immigrants, many of whom are integral to labor-intensive industries such
as construction and agriculture. This could lead to a labor shortage, increased production
costs, and higher consumer prices. Here is the evidence taken from the article:

"Unfortunately, Mr. Trump also wants to deport millions of irregular migrants..."

"Roughly half of the workers on America’s farms have no legal status."

The impact on GDP:

In the short term, many sectors like hospitality, agriculture, and construction are heavily
dependent on undocumented workers because of the availability of sources, the relatively low
cost, and their flexibility (they can do some higher-risk jobs that not many people choose).
That is why the deportment of those workers could cause immediate labor shortages, driving
businesses to scale back operations. This situation could reduce the total output of affected
sectors, directly lowering Gross Domestic Product in the short term.

In the long term, if those industries cannot immediately make up for the lost labor force, the
economy’s LRAS could shift leftward.
The impact on price level: In order to handle the labor shortage, businesses may need to
offer higher wages or invest in expensive automation technology to attract and retain domestic
workers. While this strategy might partially address labor shortages, it would raise production
costs, cutting profitability down and potentially leading to higher consumer price levels
(Because higher production costs are passed on to consumers).

P
LRAS2 LRAS1
SRAS2

SRAS1

P2
P1

AD1
AD2

Y
Y2 Y1
 R

MS

R1

R2

MD1

MD2

The impact on interest rates: Labor shortages in key industries like agriculture and
construction can lessen overall economic output. A smaller workforce means many businesses
produce less, which limits GDP growth and hinders opportunities for new investment.

With weakening economic activities and capacity constraints, almost all businesses may scale
back expansion plans. This may reduce borrowing demand to fund investments, witnessing a
drop in Money Demand (MD).

In financial markets, a decline in MD also means reducing “the price” of borrowing, causing
the interest rates to fall. In the long term, lenders may face reduced competition among
borrowers; this situation might encourage them to lower rates to attract more businesses.

The impact on the exchange rate: There are a variety of reasons that could contribute to the
depreciation of domestic currency. Firstly, the labor shortage in some critical sectors may
result in lower productivity and lower output, diminishing overall economic growth. This
could put downward pressure on US domestic currency as investors’ confidence in economic
growth declines. Secondly, higher interest rates may weaken the purchasing power of US
currency. Lastly, rising labor costs reduce the expected profits of foreign businesses when
investing in the US. Investors may turn to countries with lower labor costs or higher levels of
productivity relative to costs. This leads to a decrease in foreign investment capital flows into
the US. As foreign investment declines, international businesses will need fewer dollars to
conduct transactions in the US (like building factories, paying wages, or importing
technology). Since then, demand has decreased, reducing the value of the USD in the foreign
exchange market.

E
S2 S1

E1

E2

D1
D2
Dollar

The Trump administration's final policy is trade tariffs. The government plans to impose
tariffs of up to 60% on Chinese imports as a strategic measure to tackle trade imbalances and
pressure China economically. It also aims to apply tariffs of 10-20% on imports from other
countries, with the possibility of exemptions for close allies depending on negotiation
outcomes. Here is the evidence taken from the article:

"Impose tariffs of up to 60% on China and 10-20% on the rest of the world."

"Some governments will be in the line of fire, especially if the threat to extend tariffs beyond
the universal rate becomes a Trumpian negotiating tool."

The impact on price level: Tariffs may raise the price of imported goods, which cause to
higher production costs for businesses, especially those heavily dependent on imported source
of materials. These companies could pass those costs to customers, letting the cost of
domestic goods and services rise. As a results, the price level in the economy tends to increase
due to inflationary pressures from higher costs of imported and domestic goods.

The impact on interest rates: This factor may depend on how the FED and economy react
to, which results in fluctuations in interest rates. In case of impose high tariffs on imports,
especially from China, will increase import costs. Domestic commodity prices may also
increase due to dependence on imported goods in some industries. As a result, inflation is
likely to increase. To control inflation, the Fed can increase interest rates to reduce consumer
demand and stabilize prices. Besides that, imposing high tariffs could lead to a trade war,
subjecting US exports to retaliation and reducing demand for US products in international
markets. This could slow economic growth or even push the economy into recession. If the
economy weakens, the Fed can reduce interest rates to encourage investment and
consumption, thereby stimulating growth.

The impact on GDP:

In this case, imposing higher tariffs could lead to a reduction in imports, thereby contributing
to narrowing the trade deficit and boosting domestic production in certain industries.
However, increases in production costs coupled with the possibility of retaliatory tax
measures from trading partners could negatively affect consumer spending and business
investment, thereby potentially the risk of slowing GDP growth.

The impact on exchange rates: Tariffs can have many negative impacts on the economy.
First, they can lead to retaliatory measures from trading partners, reducing exports, damaging
trade relations, and devaluing the domestic currency due to foreign capital outflows. At the
same time, tariffs increase the price of imported goods, contributing to inflation. If inflation
rises, tightening monetary policy may be applied, temporarily supporting the local currency,
but long-term reductions in purchasing power may weaken the currency. Furthermore,
protectionist tariffs could reduce foreign investor confidence due to concerns about trade
stability and supply chain disruptions. This reduces foreign investment, leading to the
depreciation of the domestic currency. Finally, high tariffs increase production costs,
reducing the economy's attractiveness to international investors. When investor confidence
declines, foreign capital flows withdraw from the market, contributing to the devaluation of
the domestic currency. In short, tariffs not only affect trade and production but also have a
profound impact on inflation, foreign investment, economic growth, and exchange rates.
These factors intertwine to create great pressure on the country's macroeconomic stability.
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 PART 3

II. Artical analysis:

3. Economic relationships between the U.S. and Vietnam:

The economic relationship between Vietnam and the United States has experienced
remarkable growth, evolving from former adversaries to significant economic partners.

Key Highlights:
* Booming bilateral trade: The US stands as one of Vietnam's largest trading partners. Two-
way trade has continuously expanded, reaching nearly 140 billion USD in 2023. Vietnam's
key exports to the US include textiles, footwear, agricultural products, and wood products,
while it imports machinery, equipment, and raw materials.

* Increased US investment in Vietnam: The US is a crucial foreign investor in Vietnam, with

investments spanning diverse sectors like manufacturing, energy, and real estate. Vietnam is
actively improving its investment climate to attract further US capital.

* Development cooperation across various fields: The US supports Vietnam in areas such as
education, healthcare, and environmental protection. Both nations collaborate within
international and regional organizations.

Challenges:
* Trade imbalance favoring Vietnam: This occasionally leads to the US imposing trade
remedies on Vietnamese goods.
* Investment barriers persist: Certain procedural and policy hurdles hinder US investment in
Vietnam.

Future prospects:
* The Vietnam-US economic relationship is projected to maintain its positive trajectory.

* Both nations are committed to enhancing cooperation across multiple sectors, aiming for a
comprehensive economic partnership.
Further insights into this relationship can be gained by examining:
* Trade agreements: Vietnam and the US participate in numerous bilateral and multilateral
trade agreements, providing a favorable framework for economic cooperation.

* The role of the Vietnamese community in the US: This community actively contributes to
promoting economic and cultural ties between the two countries.

* Influence of geopolitical factors: Regional and international developments also impact the
Vietnam-US economic relationship.

In conclusion, the Vietnam-US economic relationship is flourishing and mutually beneficial.

Continued cooperation and addressing challenges are essential to elevate this relationship to
new heights, bringing tangible benefits to the people and businesses of both nations.

4. How Trump administration policies might affect Vietnam’s economy.

The article points out that Trumponomics policies will have a profound impact not only on the
US economy but also on the entire global economy, including Vietnam. Below are some
specific impacts of these policies on Vietnam:

• Tariff policy and trade war: One of the important policies that Trump is pursuing is high
tariffs on imported goods from China and other countries. This could be an opportunity for
Vietnam, as many US companies could shift production from China to countries like Vietnam
to avoid tariffs. This would boost Vietnam’s exports, especially in sectors like textiles,
footwear, and electronics.

• Impact of immigration and labor policies: A large portion of US agricultural and

manufacturing workers are undocumented, and Trump’s policy of boycotting immigrant
workers could increase the labor shortage in the US, thereby putting pressure on US
production costs. If Vietnam can attract replacement workers in export industries, this could
increase productivity and reduce costs for Vietnamese exporters.

• Dollar growth and exchange rate: If the US continues to adopt protectionist policies and
the dollar grows, this could put countries with dollar-denominated debt in trouble, including
Vietnam. A strong dollar will increase dollar debt and may reduce the competitiveness of
exports from countries like Vietnam, especially in high-cost manufacturing sectors.

• Pressure on Mexico and China: Trump’s tariff and trade war policies against China and
Mexico could indirectly affect Vietnam, especially if global supply chains are disrupted.
Vietnamese exporters could be affected if supply chains from these countries are disrupted or
costs increase.

• Changes in foreign investment: The Trump administration may encourage investment in

technology sectors like AI, which could create opportunities for Vietnam if it can attract FDI
in this sector. However, if Trump’s policies lead to trade conflicts and global financial
markets become less stable, attracting investment will be difficult.

In conclusion, while Trump’s policies may create opportunities for Vietnam in some areas,
especially in trade and exports, the risks from the trade war and the dollar’s growth could hurt
Vietnam’s economy if not managed well. Vietnam’s ability to capitalize on the opportunities
will depend on its ability to diversify its trading partners and improve its internal
competitiveness in key sectors.