185 spring 2004

IRP and PPP

Interest Rate Parity and Purchasing Power Parity are not necessarily inconsistent with one another.

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Progress Report 6

You can earn up to 12 points by reviewing up to two term papers.

Aggregate Supply and Aggregate Demand

We concluded our discussion of the Keynesian IS/LM Model with the aggregate supply and aggregate demand curves. In the 1960's, this line of thinking seemed to resonate with the empirical Phillips Curve that was also quite popular.

]]> We first constructed the aggregate demand curve by considering three price levels. Changing the price level changes the real money supply. This diagram also shows the effects of increasing government spending, which shifts the AD curve.

Here we have the two AD curves. The Early Keynesians would have agreed with a horizontal aggregate supply curve. During the Great Depression, we experienced deflation, there was considerable slack capacity, and additional output could have been produced without a price increase. The more recent AS curve is thought to be upward sloping to some extent.

The Classical Economists thought that the AS curve was vertical because output was determined by the supply and demand for a factor of production, labor. While their "equation of exchange" produces an AD curve much like the Keynesian AD curve, the effect of shifting that AD curve is limited to a change in P.

OEQ

The Amount of Money

The transaction demand for money faces a serious real-world challenge if you check out the actual amount of money. In the latest figures, M1 is $1,188,400,000,000 and reserves are $40,971,000,000. Of the latter amount, $40,949,000,000 is nonborrowed, giving you a sense of how little borrowing from the Fed actually occurs.

The stunning fact is that currency in circulation is $714,287,000,000. If you divide this amount by 260,000,000 people, it works out to $2,747 per person.

The Keynesian IS/LM Model

The IS/LM Model links the long-term interest rate, the short-term interest rate, and the level of output, which equals income. This model improves on the Simple Keynesian Model by making explicit the role of the long-term interest rate in determining the level of investment.

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Shown is a business cycle caused by a shock to investment. Please note that, due to time considerations, we did not finish the analysis by showing the changes in the right-hand diagram caused by the changes in the interest rate and income.

The Simple Keynesian Model

The (over) simplified Keynesian Model illustrates the important point that small changes in investment can cause large changes in output.

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The Classical Model of Production and Employment

Flush with their successes explaining things with supply and demand, the classical economists attempted to explain business cycles with a model based on the supply and demand for labor. The central concept in this model is a production function that determines the quantity of output in terms of capital and labor. The amount of capital is taken as fixed in the short run.

]]> At this point, we can determine the level of output.

Any unemployment that is observed should disappear quickly as the real wage rate adjusts.

Two additional diagrams account for the nominal price level and the nominal interest rate.

The left-hand diagrams above show a business cycle caused by a bad year for the production function.

The Transactions Demand for Money

The classic parable about the transactions demand for money involves a tradeoff between interest on bank deposits and the shoe leather cost of repeated visits to the bank.

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The Demand for Money

Again, you really need to go read the textbook because the words that go with these pictures are important.

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The Supply of Money

You really need to go read your textbook to get this material, but here are a few pictures that summarize the discussion.

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The topic continued on 4/6/04:

If you want to figure out the total over all banks using fancy math, try this:

Otherwise, you just note that the sum of all reserves must be $100 because that is how much new high-powered money was added and it all ends up as reserves in this story.

Exchange Rates

In our study of exchange rates, we are going to consider two kinds of linkages. Purchasing Power Parity operates through the goods market, and Interest Rate Parity links two countries' bond markets.

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These two theories are not necessarily inconsistent with each other.

A multinational firm faces complex considerations when exchange rates change.

March Web Site Traffic (as of 3/25)

Traffic at parke.econ-courses.com displays an interesting pattern. You can probably pick out the week of Spring Break. The interesting feature is that traffic before Midterm 1 (in both 70 and 185) on March 4th is smaller than traffic since. There is also a pronounced day-of-the-week pattern.

On March 22nd, 111 visitors requested 125 megabytes. (There are 100 students in Econ 70 and 26 students in Econ 185 so 15 students did not visit the course web sites that day.) On March 17th, 73 visitors requested 161 megabytes, which is the peak megabytes so far.

Interest Rate Parity

We begin our discussion of exchange rates by introducing the notion of interest rate parity (IRP). The idea is to establish a link between bond markets in two countries.

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If the interest rate is 5% in both countries and the exchange rate stays constant, there are no arbitrage profits.

If the interest rate in Europe changes to 3%, an arbitrage profit opportunity opens up. If the current exchange rate makes the euro worth only 1.2164 dollars, then the arbitrage profit opportunity goes away.

Here is how you secure those arbitrage profits either now or next year.

We have an equation the expresses the math involved. Here is now you calculate the exchange rate that shuts off the arbitrage profits.

Puts and Call

A call (put) is the right to buy (sell) a specified quantity as a specified strike price at a specified date.

]]> We studied a diagram that illustrates how a call option works.

Our second diagram illustrates a put option.

(We spent a good bit of the hour looking at online graphs.)