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12b
Business Cycles
Introduction to Economics
ETH Zürich, Prof. Dr. Jan-Egbert Sturm
Winter Term 2006/07
Exam
• Tuesday, Feb.13, 2007, 15:15 – 16:45, HG E 7
• Closed book test
• Dictionary and non-programmable calculator allowed
• Answers can be in either English or German
• Example Exam on the homepage:
• http://www.vwl.ethz.ch
• Re-exam (for those who failed):
• Date: Monday, Mar.19, 2007, 15:15 – 16:45 (tentative)
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Seminar: the economics of Globalization
• Aim of the seminar:
• discuss economic principles and political-economy approaches to the causes
and consequences of globalization
• explore the main debates about globalization
• evaluate arguments on the achievements and failures of globalization
• Important dates:
• March 20 (Introduction)
• June 4/5 (Seminar)
• Credit points: 2
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General Information
24.10.
Introduction; Transformation Curve, Opportunity Cost
Mankiw ch.1,2
31.10.
Markets: Demand and Supply
Ch. 4
7.11.
Elasticities
Ch. 5
14.11.
Costs, Production Function
Ch. 13
21.11.
Markets with perfect competiton
Ch. 7, 14
28.11.
Taxation
Ch. 8
5.12.
International Trade
Ch. 9
12.12.
Imperfect competition: Monopoly, and Oligoploy
Ch. 15, 16
19.12.
Public Goods, Externalities
Ch. 10,11
9.1.
National Accounting, Gross Domestic Product, Growth
Ch. 23, 25
16.1.
Money and Inflation
Ch. 24, 29, 30
23.1.
Business Cycles
Ch. 33, 34
30.1.
Open Economy Macro
Ch. 31
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Figure 8 A Contraction in Aggregate Demand
2. . . . causes output to fall in the short run . . .
Price
Level
Long-run
aggregate
supply
Short-run aggregate
supply, AS
AS2
3. . . . but over
time, the short-run
aggregate-supply
curve shifts . . .
A
P
B
P2
P3
1. A decrease in
aggregate demand . . .
C
Aggregate
demand, AD
AD2
0
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Y2
Y
4. . . . and output returns
to its natural rate.
Quantity of
Output
TWO CAUSES OF ECONOMIC FLUCTUATIONS
• Shifts in Aggregate Demand
• In the short run, shifts in aggregate demand cause fluctuations in the
economy’s output of goods and services.
• In the long run, shifts in aggregate demand affect the overall price
level but do not affect output.
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TWO CAUSES OF ECONOMIC FLUCTUATIONS
• An Adverse Shift in Aggregate Supply
• A decrease in one of the determinants of aggregate supply shifts the
curve to the left:
• Output falls below the natural rate of employment.
• Unemployment rises.
• The price level rises.
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Figure 10 An Adverse Shift in Aggregate Supply
1. An adverse shift in the shortrun aggregate-supply curve . . .
Price
Level
Long-run
aggregate
supply
AS2
Short-run
aggregate
supply, AS
B
P2
A
P
3. . . . and
the price
level to rise.
Aggregate demand
0
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Y2
2. . . . causes output to fall . . .
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Y
Quantity of
Output
The Effects of a Shift in Aggregate Supply
• Stagflation
• Adverse shifts in aggregate supply cause stagflation—a period of
recession and inflation.
• Output falls and prices rise.
• Policymakers who can influence aggregate demand cannot offset both of
these adverse effects simultaneously.
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The Effects of a Shift in Aggregate Supply
• Policy Responses to Recession
• Policymakers may respond to a recession in one of the following
ways:
• Do nothing and wait for prices and wages to adjust.
• Take action to increase aggregate demand by using monetary and fiscal
policy.
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Figure 11 Accommodating an Adverse Shift in Aggregate Supply
1. When short-run aggregate
supply falls . . .
Price
Level
Long-run
aggregate
supply
P3
C
P2
A
3. . . . which P
causes the
price level
to rise
further . . .
0
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4. . . . but keeps output
at its natural rate.
Natural rate
of output
Short-run
aggregate
supply, AS
AS2
2. . . . policymakers can
accommodate the shift
by expanding aggregate
demand . . .
AD2
Aggregate demand, AD
Quantity of
Output
13
Open-Economy
Macroeconomics
Introduction to Economics
ETH Zürich, Prof. Dr. Jan-Egbert Sturm
Winter Term 2006/07
Open-Economy Macroeconomics: Basic Concepts
• An Open Economy
• An open economy interacts with other countries in two ways.
• It buys and sells goods and services in world product markets.
• It buys and sells capital assets in world financial markets.
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The Flow of Goods: Exports, Imports, Net Exports
• Exports are goods and services that are produced domestically
and sold abroad.
• Imports are goods and services that are produced abroad and
sold domestically.
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The Flow of Goods: Exports, Imports, Net Exports
• Net exports (NX) are the value of a nation’s exports minus the
value of its imports.
• Net exports are also called the trade balance.
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The Flow of Goods: Exports, Imports, Net Exports
• A trade deficit is a situation in which net exports (NX) are
negative.
• Imports > Exports
• A trade surplus is a situation in which net exports (NX) are
positive.
• Exports > Imports
• Balanced trade refers to when net exports are zero—exports
and imports are exactly equal.
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The Flow of Goods: Exports, Imports, Net Exports
• Factors That Affect Net Exports
• The tastes of consumers for domestic and foreign goods.
• The prices of goods at home and abroad.
• The exchange rates at which people can use domestic currency to
buy foreign currencies.
• The incomes of consumers at home and abroad.
• The costs of transporting goods from country to country.
• The policies of the government toward international trade.
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Figure 1 The Internationalization of the U.S. Economy
Percent
of GDP
15
Imports
10
Exports
5
0
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1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000
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The Flow of Financial Resources: Net Capital Outflow
• Net capital outflow refers to the purchase of foreign assets by
domestic residents minus the purchase of domestic assets by
foreigners.
• A Swiss resident buys stock in the Pfizer corporation and an
American buys stock in the Novartis corporation.
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The Flow of Financial Resources: Net Capital Outflow
• When a Swiss resident buys stock in Pfizer, the purchase raises
Swiss net capital outflow.
• When a Japanese residents buys a bond issued by the Swiss
government, the purchase reduces the Swiss net capital
outflow.
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The Flow of Financial Resources: Net Capital Outflow
• Variables that Influence Net Capital Outflow
•
•
•
•
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The real interest rates being paid on foreign assets.
The real interest rates being paid on domestic assets.
The perceived economic and political risks of holding assets abroad.
The government policies that affect foreign ownership of domestic
assets.
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The Equality of Net Exports and Net Capital Outflow
• Net exports (NX) and net capital outflow (NCO) are closely
linked.
• For an economy as a whole, NX and NCO must balance each
other so that:
NCO = NX
• This holds true because every transaction that affects one side must
also affect the other side by the same amount.
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Saving, Investment, and Their Relationship to the International
Flows
• Net exports is a component of GDP:
Y = C + I + G + NX
• National saving is the income of the nation that is left after
paying for current consumption and government purchases:
Y - C - G = I + NX
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Saving, Investment, and Their Relationship to the International
Flows
• National saving (S) equals Y - C - G so:
S = I + NX
or
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Saving
=
S
=
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Domestic + Net Capital
Investment
Outflow
I
+
NCO
Figure 2 National Saving, Domestic Investment, and Net Foreign
Investment
(a) US National Saving and Domestic Investment (as a percentage of GDP)
Percent
of GDP
20
Domestic investment
18
16
14
National saving
12
10
1960
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1965
1970
1975
1980
1985
1990
1995
2000
Figure 2 National Saving, Domestic Investment, and Net Foreign
Investment
(b) Net Capital Outflow (as a percentage of GDP)
Percent
of GDP
4
3
2
Net capital
outflow
1
0
–1
–2
–3
–4
1960
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1965
1970
1975
1980
1985
1990
1995
2000
THE PRICES FOR INTERNATIONAL TRANSACTIONS: REAL AND
NOMINAL EXCHANGE RATES
• International transactions are influenced by international
prices.
• The two most important international prices are the nominal
exchange rate and the real exchange rate.
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Nominal Exchange Rates
• The nominal exchange rate is the rate at which a person can
trade the currency of one country for the currency of another.
• The nominal exchange rate is expressed in two ways:
• In units of foreign currency per one unit of home currency.
• And in units of home currency per one unit of the foreign currency.
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Nominal Exchange Rates
• Assume the exchange rate between the Japanese yen and U.S.
dollar is 80 yen to one dollar.
• One U.S. dollar trades for 80 yen.
• One yen trades for 1/80 (= 0.0125) of a dollar.
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Nominal Exchange Rates
• Appreciation refers to an increase in the value of a currency as
measured by the amount of foreign currency it can buy.
• Depreciation refers to a decrease in the value of a currency as
measured by the amount of foreign currency it can buy.
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Nominal Exchange Rates
• If a Swiss Frank buys more foreign currency, there is an
appreciation of the Swiss Frank.
• If it buys less there is a depreciation of the Swiss Frank.
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Real Exchange Rates
• The real exchange rate is the rate at which a person can trade
the goods and services of one country for the goods and
services of another.
• The real exchange rate compares the prices of domestic goods
and foreign goods in the domestic economy.
• If a case of German beer is twice as expensive as American beer, the
real exchange rate is 1/2 case of German beer per case of American
beer.
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Real Exchange Rates
• The real exchange rate depends on the nominal exchange rate
and the prices of goods in the two countries measured in local
currencies.
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Real Exchange Rates
• The real exchange rate is a key determinant of how much a
country exports and imports.
Nominal exchange rate  Domestic price
Real exchange rate =
Foreign price
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Real Exchange Rates
• A depreciation (fall) in the Swiss real exchange rate means that
Swiss goods have become cheaper relative to foreign goods.
• This encourages consumers both at home and abroad to buy
more Swiss goods and fewer goods from other countries.
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Real Exchange Rates
• As a result, Swiss exports rise, and Swiss imports fall, and both
of these changes raise Swiss net exports.
• Conversely, an appreciation in the Swiss real exchange rate
means that Swiss goods have become more expensive
compared to foreign goods, so Swiss net exports fall.
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A FIRST THEORY OF
EXCHANGE-RATE DETERMINATION: PURCHASING-POWER
PARITY
• The purchasing-power parity theory is the simplest and most
widely accepted theory explaining the variation of currency
exchange rates.
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The Basic Logic of Purchasing-Power Parity
• According to the purchasing-power parity theory, a unit of any
given currency should be able to buy the same quantity of
goods in all countries.
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Basic Logic of Purchasing-Power Parity
• The theory of purchasing-power parity is based on a principle
called the law of one price.
• According to the law of one price, a good must sell for the same price
in all locations.
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Basic Logic of Purchasing-Power Parity
• If the law of one price were not true, unexploited profit
opportunities would exist.
• The process of taking advantage of differences in prices in
different markets is called arbitrage.
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Basic Logic of Purchasing-Power Parity
• If arbitrage occurs, eventually prices that differed in two
markets would necessarily converge.
• According to the theory of purchasing-power parity, a currency
must have the same purchasing power in all countries and
exchange rates move to ensure that.
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Implications of Purchasing-Power Parity
• If the purchasing power of the dollar is always the same at
home and abroad, then the exchange rate cannot change.
• The nominal exchange rate between the currencies of two
countries must reflect the different price levels in those
countries.
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Implications of Purchasing-Power Parity
• When the central bank prints large quantities of money, the
money loses value both in terms of the goods and services it
can buy and in terms of the amount of other currencies it can
buy.
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Exchange rates of the euro and PPPs
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Figure 3 Money, Prices, and the Nominal Exchange Rate During the
German Hyperinflation
Indexes
(Jan. 1921 5 100)
1,000,000,000,000,000
Money supply
10,000,000,000
Price level
100,000
1
Exchange rate
.00001
.0000000001
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1921
1922
1923
1924
1925
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Limitations of Purchasing-Power Parity
• Many goods are not easily traded or shipped from one country
to another.
• Tradable goods are not always perfect substitutes when they
are produced in different countries.
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Summary
• Net exports are the value of domestic goods and services sold
abroad minus the value of foreign goods and services sold
domestically.
• Net capital outflow is the acquisition of foreign assets by
domestic residents minus the acquisition of domestic assets by
foreigners.
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Summary
• An economy’s net capital outflow always equals its net exports.
• An economy’s saving can be used to either finance investment
at home or to buy assets abroad.
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Summary
• The nominal exchange rate is the relative price of the currency
of two countries.
• The real exchange rate is the relative price of the goods and
services of two countries.
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Summary
• When the nominal exchange rate changes so that each dollar
buys more foreign currency, the dollar is said to appreciate or
strengthen.
• When the nominal exchange rate changes so that each dollar
buys less foreign currency, the dollar is said to depreciate or
weaken.
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Summary
• According to the theory of purchasing-power parity, a unit of
currency should buy the same quantity of goods in all
countries.
• The nominal exchange rate between the currencies of two
countries should reflect the countries’ price levels in those
countries.
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