185 summer 2004

The Phillips Curve Data Revisited

OEQ

One could even consider constructing a portfolio that yields arbitrage profits. The options prices should adjust to eliminate arbitrage profits.

We could also derive the IS curve using equations.

This would be the way to go if we wanted estimate the parameters and make specific numerical predictions. We could also increase the complexity of our analysis.

Stock Pricing Theory

To look ahead toward the final exam, we reviewed the algebra of our stock pricing theory.

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Deriving the Keynesian Aggregate Demand Curve

Adding an aggregate supply function lets a build a theory of business cycles caused by shifts in the AD curve.

The Phillips curve data (see handout) support a Keynesian view up to about 1969. Events in the 70's and early 80's do not look particularly like cycles caused by AD shifts.

That data actually looks more like the result of supply shocks.

The Classical Model

The Keynesian IS/LM Model

Deriving the IS and LM curves:

A collapse in investment caused by lack of "animal spirits" following the stock market crash could have cause the Great Depression.

Bank failures and a falling money supply are also a possible cause.

While a leftward shift in the LM curve leads to an increase in interest rates, this only follows if prices are fixed. In the Great Depression, deflation caused nominal interest rates to head toward zero.

Exchange Rates

In our brief discussion of exchange rates we will consider how exchange rates link the goods markets and bond markets in two countries.

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Purchasing Power Parity links the two goods markets.

Interest Rate Parity links the two bond markets.

The idea is that exchange rates and interest must somehow adjust to eliminate arbitrage profits.

Suppose we started in balance with no arbitrage profit opportunities.

Increasing the Canadian interest rate to 10% could have the effect of raising the value of the Canadian dollar to shut off the possibility of arbitrage profits.

Midterm Answers

The agent with no access could increase (or decrease) his utility by staying in school two more years.

The Demand for Money

The demand for money is one of the most controversial topics in economics. We will consider a simple transactions demand, but keep in mind that, since money does not appear in agents' utility functions, the theories of the demand for money are unconventional.

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The Supply of Money

The institutional details determining the supply of money (demand deposits plus currency) are fairly straightforward.

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Monetary Economics

Monetary economics is the most challenging area within the discipline. Our usual opening runs into problems right from the start.

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It not thought to be reasonable to simply put money in people's utility functions because money only yields utillity in the sense that it can be exchanged for goods. In fact, an n good n prices system really requires only n-1 prices. If one of the goods is taken to be the unit of account (money), then only the other n-1 goods have prices.

OEQ

Here is how we locate the best possible budget constraint:

Would a student stay in school forever if the interest rate on student loans were zero?