Summary

Taxes are an integral part of your life as an American. Each April you spend countless hours pouring over records and receipts, or paying an accountant to do this, in preparation for income taxes. Similarly, in most states whenever you purchase something, like clothing or a car, you are required to pay sales tax. These are just two of the most common taxes faced by the American people. Others include luxury tax, inheritance tax, and corporate income tax. What is all of this tax money used for? Why does the amount of tax change from place to place and from year to year? These are all questions for this SparkNote. Tax revenues are used to support government spending. Health care, defense, social security, and politicians' salaries are all government expenses. From an economic standpoint, it is reasonable to think of the American government as one large company. The total amount of government spending is dictated by the governmental budget, just as the spending of a company is dictated by the budget. Through taxes and government spending, the American government has a direct hand in the workings of the economy. By changing either taxes or government spending, the government affects the amount of money available to the public. Changes in taxation and in government spending are called fiscal policy. The government actively uses fiscal policy to steer the American economy. In this SparkNote, you will learn both how and why the government utilizes fiscal policy. But fiscal policy is not the only means that the government possesses to steer the economy. Through monetary policy, the Fed is able to affect output. The key factor that the Fed uses to affect the economy is the interest rate. Because the growth of the economy is dependent upon the interest rate, by manipulating this variable the Fed can effect an increase or decreases in output to help maintain stable growth and low inflation. The workings of monetary policy will also be revealed in this SparkNote. Together, monetary policy and fiscal policy work together as reigns to steer the mighty horse of the economy in the right direction.

Terms
Contractionary Fiscal Policy - Policy enacted by the government that reduces output. Examples include raising taxes and decreasing government spending. Contractionary Monetary Policy - Policy enacted by the Fed that reduces the money supply and thus reduces output. Examples include selling government bonds, raising the reserve requirement, and raising the federal funds interest rate. Currency - Physical money used in an economy. Demand Deposits - Money in a bank that can be withdrawn at any time, that is, on demand. Deposits - Assets placed in a bank for storage and profit. Disposable Income - Income that can be spent after taxes. Expansionary Fiscal Policy - Policy enacted by the government that increases output. Examples include lowering taxes and increasing government spending. Expansionary Monetary Policy - Policy enacted by the Fed that increases the money supply and thus increases output. Examples include purchasing government bonds, lowering the reserve requirement, and lowering the federal funds interest rate. Fed - Short for the Federal Reserve, the government agency that controls monetary policy. Federal Funds Interest Rate - The rate that banks pay to borrow money from branches of the Fed. Fiscal Policy - Policy that uses taxation and government spending to steer the economy. Fractional Reserve Banking System - A system of banking, like in the US, where only a portion of deposits are help in reserves. The rest is returned to the public as loans, thereby increasing the money supply and stimulating economic growth.

Government Bonds - Bonds issued by the government and sold by the Fed during open market operations as a means of monetary policy. Government Spending - Money that the government spends on goods and services like employees, social security, and defense. Government Spending Multipliers - Numbers that increase the change in output affected by a change in government spending due to consumer's marginal propensity to consume. Interest Rate - The rate paid to lenders by borrowers in return for the use of a sum of money. Marginal Propensity to Consume - A number that describes the amount of an additional dollar of income that a consumer will spend rather than save. Monetary Policy - Policy enacted by the Fed to affect output. The three basic types include performing open market operations, changing the reserve requirement, and manipulating the federal funds interest rate. Money - A means of exchange, store of value, and unit of account within an economy. Money Multiplier - The number that describes the total change in the money supply resulting from a single deposit in a bank under a fractional reserve banking system. Money Supply - The total amount of money in an economy including both demand deposits and currency. Multipliers - Numbers that dictate the overall effect of a policy change on the output of an economy. National Income - Output. (See the definition of output.) Open Market Operations - The purchase and sale of government bonds by the Fed as a form of monetary policy. Output - The total amount of goods and services produced within an economy in a given period of time. Price Level - The overall level of prices within an economy. Real Output - The total amount of goods and services produced within an economy in a given period of time valued in constant currency. Reserve Requirement - The percentage of deposits that banks are required to keep in reserves and not give out as loans. This can be manipulated by the Fed under monetary policy. Tax Multipliers - Numbers that describe the overall change in output created by a change in taxes due to fiscal policy change. Taxes - Money collected by the government to maintain its services. Theory of Money Demand - This basically states that as the demand for money increases, so does the interest rate. Formulae

Output = national income = Y = C(Y - T) + I In this formula, C is consumption, Y is income, T is taxes, I is + G + NX investment, G is government spending, and NX is net exports. Total change in output as a result of a change in tax policy Total change in output as a result of a change in government spending Total change in output as a result of a change in tax policy = [(change in taxes) * -MPC] / (1 - MPC) Total change in output as a result of a change in government spending = (change in government purchases) / (1 - MPC)

Fiscal Policy
Taxes and Government Spending Fiscal policy describes two governmental actions by the government. The first is taxation. By levying taxes the government receives revenue from the populace. Taxes come in many varieties and serve different specific

purposes, but the key concept is that taxation is a transfer of assets from the people to the government. The second action is government spending. This may take the form of wages to government employees, social security benefits, smooth roads, or fancy weapons. When the government spends, it transfers assets from itself to the public (although in the case of weaponry, it is not always so obvious that the population holds the assets). Since taxation and government spending represent reversed asset flows, we can think of them as opposite policies. In the first macroeconomic SparkNote on measuring the economy we learned that output, or national income, can be described by the equation Y = C + I + G + NX where Y is output, or national income, C is consumption spending, I is investment spending, G is government spending, and NX is net exports. This equation can be expanded to represent taxes by the equation Y = C(Y - T) + I + G + NX. In this case, C(Y - T) captures the idea that consumption spending is based on both income and taxes. Disposable income is the amount of money that can be spent on consumption after taxes are removed from total income. The new form of the output, or national income, equation reflects both elements of fiscal policy and is most useful for analysis of the effects of fiscal policy changes. Types of Fiscal Policy The government has control over both taxes and government spending. When the government uses fiscal policy to increase the amount of money available to the populace, this is called expansionary fiscal policy. Examples of this include lowering taxes and raising government spending. When the government uses fiscal policy to decrease the amount of money available to the populace, this is called contractionary fiscal policy. Examples of this include increasing taxes and lowering government spending. There is another way to interpret the terms expansionary and contractionary when discussing fiscal policy. If we look at the effects of fiscal policy on the economy as a whole rather than on the individual, we see that expansionary fiscal policy increases the output, or national income, while contractionary fiscal policy decreases the output, or national income. Thus, there are two basic classes of effects of fiscal policy, those that deal with the individual and those that deal with the economy at large. Let us first work through how expansionary fiscal policy functions. Recall that lowering taxes and raising government spending are both forms of expansionary fiscal policy. When the government lowers taxes, consumers have more disposable income. In terms of the economy as a whole, this is represented in the output equation Y = C(Y - T) + I + G + NX, where a decrease in T, given a stable Y, leads to an increase in C, and ultimately to an increase in Y. Raising government spending has similar effects. When the government spends more on goods and services, the population, which provides those goods and services, receives more money. In terms of the economy as a whole, this is again represented by Y = C(Y - T) + I + G + NX, where an increase in G leads to an increase in Y. Thus, expansionary fiscal policy makes the populace wealthier and increases output, or national income. Let us now work through how contractionary fiscal policy functions. Recall that raising taxes and lowering government spending are both forms of contractionary fiscal policy. When the government raises taxes, consumers are forced to put a larger portion of their income toward taxes, and thus disposable income falls. In terms of the economy as a whole, this is represented by Y = C(Y - T) + I + G + NX where an increase in T results in a decrease in Y, holding all other variables fixed. When the government reduces government spending, the recipients of government spending, the populace, have less disposable income. In terms of the economy as whole, this is represented by Y = C(Y - T) + I + G + NX where a decrease in G results in a decrease in Y. Contractionary fiscal policy makes the populace less wealthy and decreases output, or national income. Fiscal Policy Multipliers While expansionary and contractionary fiscal policy both directly affect the national income, the ultimate change in output is not always equal to the policy change. That is, there are factors that increase or decrease the efficacy of fiscal policy. These factors are called multipliers. In particular, there are two types of multipliers. There are tax

multipliers and government spending multipliers. Each of these will be discussed in detail in the proceeding paragraphs. Tax multipliers are based on the population's willingness to consume. The marginal propensity to consume, or MPC, is a measure of that willingness. It is defined as the amount of an additional dollar of income that a consumer will spend on goods and services. The MPC can have a value between 0 and 1. A small MPC represents a large amount of savings and a small amount of consumption. A large MPC represents a small amount of savings and a large amount of consumption. When a tax decrease occurs, consumers will spend part of the money and save part of it. Therefore, the actual change in national income as a result of a change in tax policy is equal to [(+ or -) change in taxes * - MPC] / (1 - MPC). The resulting number is called the tax multiplier. There is also a multiplier for government spending. This multiplier is derived in a different way. When the government increases purchases, it directly increases output, or national income. But, there is a greater effect than just the actual amount of increase in government purchases. When the government spends more, the populace receives more. That is, because the population is the target of increased government spending, personal incomes, and thus consumption, increases. Once again, the size of this increase is based on the MPC. The total change in output as a result of a change in government purchases is equal to (change in government purchases) / (1 - MPC). This number is called the government spending multiplier. Let us work through a couple of examples. The first one will deal with tax policy. What is the total change in output from a tax cut of $20 million if the MPC is 0.8? To solve this, simply plug these numbers into the tax multiplier, that is [(change in taxes) * -MPC] / (1 - MPC). This becomes [($-20 million) * -0.8] / (1 - 0.8) = $80 million. This means that a $20 million tax cut will yield an $80 million increase in output. What is the process this equation models? Simply put, when consumers have more disposable income, they spend some and save some. The money that they spend goes back into the economy and is saved and spent by somebody else. This process continues, and eventually the final change in output created by a tax cut is significantly larger than the initial tax cut itself. The second example we will work through deals with government spending policy. What is the total change in output from an increase in government spending equal to $20 million if the MPC is 0.8? To solve this, simply plug these numbers into the government spending multiplier: (change in government purchases) / (1 - MPC). This becomes ($20 million) / (1 - 0.8) = $100 million. A $20 million increase in government spending will cause a $100 million increase in output. When government spending increases, the populace, as the recipient of this spending, has more disposable income. When consumers have more disposable income, they spend some and save some. The money that they spend goes back into the economy and is saved and spent by somebody else. This process continues. Eventually the final change in output created by a tax cut, as in the previous example, is significantly larger than the initial tax cut itself. Interest Rates and Fiscal Policy Fiscal policy has a clear effect upon output. But there is a secondary, less readily apparent fiscal policy effect on the interest rate. Basically, expansionary fiscal policy pushes interest rates up, while contractionary fiscal policy pulls interest rates down. The rationale behind this relationship is fairly straightforward. When output increases, the price level tends to increase as well. This relationship between the real output and the price level is implicit. According to the theory of money demand, as the price level rises, people demand more money to purchase goods and services. Given that there is no change in the money supply, this increased demand for money leads to an increase in the interest rate. The opposite is the case with contractionary fiscal policy. When output decreases, the price level tends to fall as well. Again, this relationship between the real output and the price level is implicit. According to the theory of money demand, as the price level falls, people demand less money to purchase goods and services. Given that there is no

change in the money supply, this decreased demand for money leads to a decrease in the interest rate. This is how fiscal policy affects the interest rate. The next SparkNote presents a more complex and realistic explanation of the effects of fiscal policy on output in the short and long runs.

Monetary Policy
Money Supply and Monetary Policy In the SparkNote on money and interest rates we learned about the money supply. This is the starting point for understanding monetary policy. Initially we defined the money supply as the total amount of currency held by the public. While this definition is correct, it is incomplete. In the Sparknote on Banking we learned that through a fractional reserve banking system, the money supply increases. Thus, the money supply is better defined as the total amount of currency plus deposits held by the public. This accounts for all mony available as currency or demand deposits. Simply stated, monetary policy is carried out by the Fed to change the money supply. When the Fed increases the money supply, the policy is called expansionary. When the Fed decreases the money supply, the policy is called contractionary. These policies, like fiscal policy, can be used to control the economy. Under expansionary monetary policy the economy expands and output increases. Under contractionary monetary policy the economy shrinks and output decreases. Let's investigate how the Fed affects the money supply. There are three basic ways that the Fed can affect the money supply. The first is through open market operations. The second is by changing the reserve requirement. The third is through changing the federal funds interest rate. Each of these actions in some way affects the total amount of currency or deposits available to the public. Open market operations are the sale and purchase of government bonds issued and regulated by the Fed. When the Fed sells government bonds, the public exchanges currency for bonds, resulting in a shrinking of the money supply. When the Fed purchases government bonds, the Fed exchanges currency for bonds, thus resulting in an increase in the money supply. Open market operations are the most common tool that the Fed uses to affect the money supply. In fact, almost every weekday government bonds are bought and sold in New York City. The second way that the Fed can influence the money supply is through changing the reserve requirements. We learned in the SparkNote on the purpose of banks that the money multiplier shows how much an initial deposit increases the money supply after loans are made and redeposited. Recall that the money multiplier is one over the reserve requirement. Thus, if the reserve requirement is decreased, banks are required to hold fewer reserves and can then make more loans. Th is in turn repeats the cycle of loan to deposit, resulting in a greater increase in the money supply. For a given initial deposit, a smaller reserve requirement will result in a larger money multiplier, and thus in a larger change in the money supply. The third way that the Fed can influence the money supply is through changing the federal funds interest rate. As we know, banks make deposits, withdrawals, and loans from banks' banks that are usually branches of the Fed. When a bank makes many loans, its reserves are near their absolute required minimum. If a customer makes a withdrawal, banks must either recall a loan or take out a loan to pay the withdrawal while still maintaining the necessary reserves. If the Fed increases the federal funds interest rate, banks will be less likely to borrow money from the Fed and will thus be more weary of making loans to ensure that they have the necessary reserve requirements. Thus, if the federal funds interest rate is higher, banks make fewer loans, the money multiplier is not fully utilized to its end, and the change in the money supply for a given initial deposit is smaller.

Expansionary vs. Contractionary Monetary Policy The Fed has two basic types of monetary policy. Expansionary monetary policy increases the money supply while contractionary monetary policy decreases the money supply. Expansionary monetary policy includes purchasing government bonds, decreasing the reserve requirement, and decreasing the federal funds interest rate. Contractionary monetary policy includes selling government bonds, increasing the reserve requirement, and increasing the federal funds interest rate. Recall that the point of monetary policy is to allow the Fed to control the economy, and in particular output and inflation, through the interest rate. Monetary policy and fiscal policy are like the reigns held by the Fed as it steers the big, wild horse known as the economy. Monetary Policy and the Interest Rate The interest rate changes when the fed changes monetary policy. In general, when the Fed uses expansionary monetary policy, thus expanding the money supply, the interest rate falls. The reason for this change can be conceptualized in two ways. First, given a constant demand for money, when money is widely available in the economy due to expansionary monetary policy, the interest rate falls as people are eager to make loans and hesitant to take loans. If there is much money in the economy and constant demand for money, then the price of holding money--the interest rate--must be low. Second, when the Fed injects money into the economy by purchasing bonds from the public, decreasing the reserve requirement, or decreasing the federal funds interest rate, the demand and price for loans falls. Since the interest rate is the equilibrating factor in the market for loanable funds, a fall in the demand for loans results in a fall in the interest rate. This works in conjunction with a direct decrease in the interest rate effected by the Fed. We can apply the reverse of the above logic to the effects of contractionary monetary policy on interest rates. Given a constant demand for money, when money is relatively scarce due to contractionary monetary policy, the interest rate rises as people are hesitant to make loans and eager to take loans. Alternatively, when the Fed takes money from the economy by selling bonds to the public, increasing the reserve requirement, or increasing the federal funds interest rate, the demand for loans rises as money becomes harder, or more expensive, to obtain. Since the interest rate is the equilibrating factor in the market for loanable funds, a rise in the demand for loans results in a rise in the interest rate. Similarly, in order to induce the public to give up their cash in exchange for bonds, the government must offer an interest rate that is more attractive than the competing rates, corrected for risk. When the government does this, the overall interest rate in the economy also increases. Again, some Fed contractionary monetary policy--like increasing the reserve requirement and increasing the federal funds interest rate--directly affects the interest rate.

Which of the following pairs best fit with fiscal policy? (A) Taxes and government spending (B) Open market operations and reserve requirement (C) Taxes and open market operations (D) Open market operations and government spending Who uses fiscal policy? (A) Fed (B) Government

(C) Public (D) Firms What is the primary purpose of taxation? (A) To annoy the public (B) To save money (C) To support the government (D) To help the Fed Which of the following is not a form of taxation? (A) Luxury (B) Sales (C) Income (D) Death Which of the following does not involve government spending? (A) Jim purchases a new car. (B) Sally receives social security. (C) Scott is in the navy. (D) Joey works for a defense contractor. Which of the following is the key to taxation? (A) The government does not affect the public's money. (B) The government takes money from the public (C) The government gives money to the public. (D) None of the above. Which of the following is the key to government spending? (A) The government does not affect the public's money. (B) The government takes money from the public. (C) The government gives money to the public. (D) None of the above What is the equation for output or national income? (A) Y = C(Y - I) + T + G + NX

(B) Y = C(Y - G) + I + T + NX (C) Y = C(Y - NX) + I + G + T (D) Y = C(Y - T) + I + G + NX What does the term C(Y - T) represent in the equation for output or national income? (A) Disposable income (B) Spendable income (C) Disposable savings (D) Spendable savings What does expansionary fiscal policy do to output? (A) Does not affect it (B) Increases it (C) Decreases it (D) It depends What does contractionary fiscal policy do to output? (A) Does not affect it (B) Increases it (C) Decreases it (D) It depends What is the effect of expansionary fiscal policy on the money supply? (A) It depends (B) Does not affect it (C) Decreases it (D) Increases it What is the effect of fiscal policy on the money supply? (A) It depends (B) Does not affect it (C) Decreases it (D) Increases it What is the effect of stable fiscal policies on the money supply?

(A) It depends (B) Does not affect it (C) Decreases it (D) Increases it What is the effect of contractionary fiscal policy on the money supply? (A) It depends (B) Does not affect it (C) Decreases it (D) Increases it The number that expresses the total effect a fiscal policy has on output is called a (A) factor. (B) rate. (C) sum. (D) multiplier. What do you call the number that tells how much a change in tax policy affects total output? (A) Tax multiplier (B) Fiscal policy multiplier (C) Tax factor (D) Fiscal policy factor What do you call the number that tells how much a change in government spending policy affects total output? (A) Government spending factor (B) Government spending multiplier (C) Fiscal policy factor (D) Fiscal policy multiplier What is the basis of both the tax multiplier and the government spending multiplier? (A) Interest rate (B) Total consumption (C) Marginal propensity to consume (D) Marginal output

What equation shows the total change in output resulting from a change in tax policy? (A) [(change in taxes) * MPC] / (1 - MPC) (B) [(change in taxes) * -MPC] / (MPC) (C) [(change in taxes) * MPC] (D) [(change in taxes) * -MPC] / (1 - MPC) What equation shows the total change in output resulting from a change in government spending policy? (A) (change in government purchases) / (1 - MPC) (B) (change in government purchases) / (MPC) (C) (change in government purchases) / (1 + MPC) (D) (change in government purchases) * (MPC) What is the total change in output if taxes are reduced by $10 million and the MPC is equal to 0.5? (A) $5 million increase (B) $10 million increase (C) $5 million decrease (D) $10 million decrease What is the total change in output if taxes are reduced by $10 million and the MPC is equal to 0.8? (A) $10 million decrease (B) $40 million decrease (C) $40 million increase (D) $10 million increase What is the total change in output if taxes are increased by $50 million and the MPC is 0.2? (A) $12.5 million increase (B) $25 million increase (C) $25 million decrease (D) $12.5 million decrease What is the total change in output if taxes are increased by $100 million and the MPC is 0.9? (A) $900 million decrease (B) $100 million decrease (C) $900 million increase

(D) $100 million increase What is the total change in output if government spending is increased by $20 million and the MPC is 0.3? (A) $8.57 million increase (B) $28.57 million increase (C) $8.57 million decrease (D) $28.57 million decrease What is the total change in output if government spending is increased by $50 million and the MPC is 0.8? (A) $250 million decrease (B) $200 million decrease (C) $250 million increase (D) $200 million increase What is the total change in output if government spending is decreased by $10 million and the MPC is 0.1? (A) $1.11 million increase (B) $11.11 million increase (C) $1.11 million decrease (D) $11.11 million decrease What is the total change in output if government spending is decreased by $70 million and the MPC is 0.9? (A) $700 million decrease (B) $630 million decrease (C) $700 million increase (D) $630 million increase Which of the following does fiscal policy directly affect? (A) Unemployment rate (B) Interest rate (C) Birth rate (D) Reserve requirement rate Which of the following is not affected by fiscal policy? (A) Savings rate (B) Interest rate

(C) Population growth rate (D) Federal funds interest rate What is the effect of expansionary fiscal policy on the interest rate? (A) Decreases it (B) It depends (C) Does not effect it (D) Increases it What is the effect of contractionary fiscal policy on the interest rate? (A) Decreases it (B) It depends (C) Does not effect it (D) Increases it Which of the following is the best definition of the money supply? (A) Currency (B) Currency and demand deposits (C) Demand deposits (D) Money Who carries out monetary policy? (A) Banks (B) President (C) The Fed (D) Government What is it called when the Fed takes actions that result in an increase in the money supply? (A) Contractionary fiscal policy (B) Expansionary fiscal policy (C) Contractionary monetary policy (D) Expansionary monetary policy What is it called when the Fed takes actions that result in a decrease in the money supply? (A) Contractionary monetary policy

(B) Expansionary monetary policy (C) Contractionary fiscal policy (D) Expansionary fiscal policy What is the effect of expansionary monetary policy on output? (A) No effect (B) It depends (C) It decreases (D) It increases What is the effect of contractionary monetary policy on output? (A) No effect (B) It depends (C) It decreases (D) It increases Which of the following is not a way that the Fed can affect the money supply? (A) Open market operations (B) Taxes (C) Federal funds interest rate (D) Reserve requirement What is the effect of the Fed selling government bonds on the open market? (A) Decreases government spending (B) Increases government spending (C) Decreases the money supply (D) Increase the money supply What is the effect of the Fed purchasing government bonds on the open market? (A) Decrease government spending (B) Increase government spending (C) Decrease the money supply (D) Increase the money supply How does expansionary monetary policy effect the interest rate?

(A) Decreases it (B) Increases it (C) Does not effect it (D) It depends How does contractionary monetary policy effect the interest rate? (A) Increases it (B) Decreases it (C) Does not effect it (D) It depends Which of the following is not a form of expansionary monetary policy? (A) Reducing the reserve requirement (B) Reducing the federal funds interest rate (C) Reducing taxes (D) Purchasing government bonds on the open market Which of the following is not a form of contractionary monetary policy? (A) Increasing the reserve requirement (B) Increasing the federal funds interest rate (C) Selling government bonds on the open market (D) Increasing taxes Which of the following is an example of expansionary fiscal policy? (A) Decreasing taxes (B) Increasing taxes (C) Decreasing government spending (D) Decreasing the reserve requirement Which of the following is an example of contractionary fiscal policy? (A) Selling government bonds on the open market (B) Decreasing government spending (C) Decreasing taxes (D) Increasing the reserve requirement

Terms
Bartering - The trading of one good for another. This requires the double Coincidence of wants, a condition met when two individuals each have different goods that they other wants. Commodity Money - Money that has an intrinsic value, that is, value beyond any value given to it because it is money. An example of this would be a gold coin that has value because it is a precious metal. Compound Interest - Interest that is paid on a sum of money where the interest paid is added to the principal for the future calculation of interest. Click here to see the Formula. Consumption - The purchase and use of goods and services by consumers. Currency - The form of money used in a country. Defaulting on the Loan - When a borrower fails to repay a loan leaving the lender without the money loaned. Demand for Money - The amount of currency that consumers use for the purchase of goods and services. This varies depending mainly upon the price level. Equilibrium - The state in a market when supply equals demand. Fiat Money - Money that has no intrinsic value, that is, its only value comes from the fact that a governing body backs and regulates the currency. Fischer Effect - The point for point relationship between changes in the money supply and changes in the inflation rate. Inflation - The increase of the price level over time. Interest - Money paid by a borrower to a lender for the use of a sum of money. Interest Rates - The percent of the amount borrowed paid each year to the lender by the borrower in return for the use of the money. Liquidity - The ease with which something of value can be exchanged for the currency of an economy. Medium of Exchange - An item used commonly to trade for goods and services. Money Supply - The quantity of money in an economy. In the US this is controlled through policy by the Fed. Nominal GDP - The total value of all goods and services produced in a country valued at current prices. Nominal Interest - The percent of the amount borrowed paid each year to the lender by the borrower in return for the use of the money not taking inflation into account. Nominal Value - The value of something in current dollars without taking into account the effects of inflation. Output - The amount of goods and services produced within an economy. Price Level - The overall level of prices of goods and services in an economy. This is used in the calculation of inflation rates. Purchasing Power - The real value of a dollar. This describes the quantity of goods and services that can be purchased for a dollar, taking into account the effects of inflation. Quantity Theory of Money - The theory that says that the value of money is based on the amount of money in circulation, that is, the money supply. Real Interest - The percent of the amount borrowed paid each year to the lender by the borrower in return for the use of the money adjusted for inflation. Real Value - The value of something in taking into account the effects of inflation. Store of Value - A good that holds a value in such a way that its price is fairly insensitive inflation. Unit of Account - Something that is used universally in the description of money matters such as prices. The unit of account most commonly used in the US is the dollar. Value of Money - The purchasing power of the dollar. The amount of goods and services that can be purchased for a fixed amount of money. Velocity - The speed with which a dollar bill changes hands. The higher the velocity of money, the quicker that a given piece of currency will be traded for goods and services.

Wage - The amount of money paid to workers by employers valued in current dollars. M * V = P * Y where M is the money supply, V is the velocity, P is the price level, and Y is the quantity of output. P * Y, the price level multiplied by the quantity of output, gives the nominal GDP. This equation can be rearranged as V = (nominal GDP) / M. It can also be converted into a percentage change formula as (percent change in the money supply) + (percent change in velocity) = (percent change in Velocity of Money the price level) + (percent change in output). First, calculate the value of the loan, by adding one to the interest rate, raising it to the number of years for the loan, and multiplying it by Compound Interest the loan amount. Then, to calculate the amount of interest, simply subtract the original loan amount from the total due. The real interest rate is equal to the nominal interest rate minus the Real Interest Rate inflation rate.

Money
Functions of Money Try to imagine an economy without money. Without money, it would be almost impossible to carry out the usual day to day business of life. For instance, if you wanted to buy a hamburger without cash, you would have to give the restaurant something else in return. Perhaps you could wash the dishes, or sweep the floor. Either way, the ability to pay for goods and services with money greatly simplifies consumer life and eliminates the necessity of bartering goods and services for other goods and services. What exactly does money do? Sure, you can buy things with it and save it, but how does it function within the economy? There are four basic functions of money:

The fourth is as liquidity. By understanding each of these functions, it is possible to see how important money is to the economy. The most obvious function of money is as a medium of exchange. When you hand the waiter a five-dollar bill in exchange for your hamburger, you are using money as a medium of exchange. You might have a hard time paying for your hamburger with five dollars worth of apples, but if you did, the apples would serve as a medium of exchange as well. To simplify, a medium of exchange is something that buyers give to sellers in exchange for goods and services. Perhaps money's most compelling advantage is that it is a commonly recognized and universally accepted medium of exchange. This allows anyone with money to walk into any restaurant with the confidence that the waiter or clerk will take your cash in exchange for goods or services. This would likely not be the case with a basket full of apples. The second function of money, as a unit of account, is rather obvious, but you may never have considered it before. When you walk into a restaurant, the menu tells you that a hamburger costs $5 and a steak costs $15. You know

The first is as a medium of exchange. The second is as a unit of account. The third is as a store of value.

what this means and are able to compare these prices. If, on the other hand, apples and oranges were used as units of account, comparison between the costs of goods and services would be much more difficult. Imagine trying to determine what costs more, a hamburger costing 25 apples or a steak costing 30 oranges. As a unit of account, money serves as the common base of comparison that people use to present prices and record debts. Without a common unit of account, these tasks would be much more difficult. The third function of money, as a store of value, is one that we all know well. When you work, you are paid a wage. The portion of that wage that you do not spend gets saved. By saving money, you are able to spend some now and some later. In this way, money serves as a store of value, allowing you to trade current consumption for future consumption. Imagine if you were paid in bananas. Any bananas that you did not eat or trade immediately would rot, rendering you unable to enjoy the fruits of your labor at a later time. The fourth and final function of money, as a means of liquidity, is important for an economy to move beyond a simple system of bartering. Imagine that you have 30 apples, and you really want a steak. You walk to the local restaurant and ask the waiter if you can trade 30 apples for a steak. He informs you that they have plenty of apples, but could use some oranges. Frustrated and hungry, you walk out of the restaurant. In this example, apples lacked liquidity since they could not easily be traded for what you wanted. Liquidity describes the ease with which an item can be traded for something that you want, or into the common currency within an economy. Money is the most liquid asset because it is universally recognized and accepted as the common currency. In this way, money gives consumers the freedom to trade goods and services easily without having to barter. Types of Money Money comes in a number of different forms. In the preceding section, we saw apples and oranges used as money. When something with intrinsic value, like precious metals, is used as money, it is called commodity money. It is interesting to think about the enormous variety of goods that can serve as commodity money. Basically, anything that can fulfill the four functions of money, to so some degree, can be used as commodity money. Barter economies depend on commodity money. When something lacking intrinsic value is used as money, it is called fiat money. This system only works if a government backs the fiat money and regulates its production. In most countries, the cash or currency is a form of fiat money. The advent of fiat money is a great convenience in many ways-- imagine trying to carry a week's pay in apples and oranges.

Quantity theory of money

Value of money What gives money value? We know that intrinsically, a dollar bill is just worthless paper and ink. However, the purchasing power of a dollar bill is much greater than that of another piece of paper of similar size. From where does this power originate? Like most things in economics, there is a market for money. The supply of money in the money market comes from the Fed. The Fed has the power to adjust the money supply by increasing or decreasing the number of bills in circulation. Nobody else can make this policy decision. The demand for money in the money market comes from consumers. The determinants of money demand are infinite. In general, consumers need money to purchase goods and services. If there is an ATM nearby or if credit cards are plentiful, consumers may demand less money at a given time than they would if cash were difficult to obtain. The most important variable in determining money demand is the average

price level within the economy. If the average price level is high and goods and services tend to cost a significant amount of money, consumers will demand more money. If, on the other hand, the average price level is low and goods and services tend to cost little money, consumers will demand less money.

Figure %: Sample money market The value of money is ultimately determined by the intersection of the money supply, as controlled by the Fed, and money demand, as created by consumers. Figure 1 depicts the money market in a sample economy. The money supply curve is vertical because the Fed sets the amount of money available without consideration for the value of money. The money demand curve slopes downward because as the value of money decreases, consumers are forced to carry more money to make purchases because goods and services cost more money. Similarly, when the value of money is high, consumers demand little money because goods and services can be purchased for low prices. The intersection of the money supply curve and the money demand curve shows both the equilibrium value of money as well as the equilibrium price level.

Figure %: Sample shift in the money market The value of money, as revealed by the money market, is variable. A change in money demand or a change in the money supply will yield a change in the value of money and in the price level. Notice that the change in the value of money and the change in the price level are of the same magnitude but in opposite directions. An increase in the

money supply is depicted in Figure 2. Notice that the new intersection of the money supply curve and the money demand curve is at a lower value of money but a higher price level. This happens because more money is in circulation, so each bill becomes worth less. It takes more bills to purchase goods and services, and thus the price level increases accordingly. The quantity theory of money is based directly on the changes brought about by an increase in the money supply. The quantity theory of money states that the value of money is based on the amount of money in the economy. Thus, according to the quantity theory of money, when the Fed increases the money supply, the value of money falls and the price level increases. In the SparkNote on inflation we learned that inflation is defined as an increase in the price level. Based on this definition, the quantity theory of money also states that growth in the money supply is the primary cause of inflation. Velocity While the relationship between money supply, money demand, the price level, and the value of money presented above is accurate, it is a bit simplistic. In the real world economy, these factors are not connected as neatly as the quantity theory of money and the basic money market diagram present. Rather, a number of variables mediate the effects of changes in the money supply and money demand on the value of money and the price level. The most important variable that mediates the effects of changes in the money supply is the velocity of money. Imagine that you purchase a hamburger. The waiter then takes the money that you spent and uses it to pay for his dry cleaning. The dry cleaner then takes that money and pays to have his car washed. This process continues until the bill is eventually taken out of circulation. In many cases, bills are not removed from circulation until many decades of service. In the end, a single bill will have facilitated many times its face value in purchases. Velocity of money is defined simply as the rate at which money changes hands. If velocity is high, money is changing hands quickly, and a relatively small money supply can fund a relatively large amount of purchases. On the other hand, if velocity is low, then money is changing hands slowly, and it takes a much larger money supply to fund the same number of purchases. As you might expect, the velocity of money is not constant. Instead, velocity changes as consumers' preferences change. It also changes as the value of money and the price level change. If the value of money is low, then the price level is high, and a larger number of bills must be used to fund purchases. Given a constant money supply, the velocity of money must increase to fund all of these purchases. Similarly, when the money supply shifts due to Fed policy, velocity can change. This change makes the value of money and the price level remain constant. The relationship between velocity, the money supply, the price level, and output is represented by the equation M * V = P * Y where M is the money supply, V is the velocity, P is the price level, and Y is the quantity of output. P * Y, the price level multiplied by the quantity of output, gives the nominal GDP. This equation can thus be rearranged as V = (nominal GDP) / M. Conceptually, this equation means that for a given level of nominal GDP, a smaller money supply will result in money needing to change hands more quickly to facilitate the total purchases, which causes increased velocity. The equation for the velocity of money, while useful in its original form, can be converted to a percentage change formula for easier calculations. In this case, the equation becomes (percent change in the money supply) + (percent change in velocity) = (percent change in the price level) + (percent change in output). The percentage change formula aids calculations that involve this equation by ensuring that all variables are in common units. The velocity equation can be used to find the effects that changes in velocity, price level, or money supply have on each other. When making these calculations, remember that in the short run, output (Y), is fixed, as time is required for the quantity of output to change.

Let's try an example. What is the effect of a 3% increase in the money supply on the price level, given that output and velocity remain relatively constant? The equation used to solve this problem is (percent change in the money supply) + (percent change in velocity) = (percent change in the price level) + (percent change in output). Substituting in the values from the problem we get 3% + 0% = x% + 0%. In this case, a 3% increase in the money supple results in a 3% increase in the price level. Remember that a 3% increase in the price level means that inflation was 3%. In the long run, the equation for velocity becomes even more useful. In fact, the equation shows that increases in the money supply by the Fed tend to cause increases in the price level and therefore inflation, even though the effects of the Fed's policy is slightly dampened by changes in velocity. This results a number of factors. First, in the long run, velocity, V, is relatively constant because people's spending habits are not quick to change. Similarly, the quantity of output, Y, is not affected by the actions of the Fed since it is based on the amount of production, not the value of the stuff produced. This means that the percent change in the money supply equals the percent change in the price level since the percent change in velocity and percent change in output are both equal to zero. Thus, we see how an increase in the money supply by the Fed causes inflation. Let's try another example. What is the effect of a 5% increase in the money supply on inflation? Again, we being by using the equation (percent change in the money supply) + (percent change in velocity) = (percent change in the price level) + (percent change in output). Remember that in the long run, output not affected by the Fed's actions and velocity remains relatively constant. Thus, the equation becomes 5% + 0% = x% + 0%. In this case, a 5% increase in the money supply results in a 5% increase in inflation. The velocity of money equation represents the heart of the quantity theory of money. By understanding how velocity mitigates the actions of the Fed in the long run and in the short run, we can gain a thorough understanding of the value of money and inflation.

Interest Rates
Mechanics of Interest When you deposit money into a bank, the bank uses your money to give loans to other customers. In return for the use of your money, the bank pays you interest. Similarly, when you purchase something with a credit card, you pay the credit card company interest for using the money that paid for your purchase. In general, interest is money that a borrower pays a lender for the right to use the money. The interest rate is the percent of the total due that is paid by the borrower to the lender. The calculation of compound interest is rather simple. To calculate the value of a loan, add one to the interest rate, raise it to the number of years for the loan, and multiply it by the loan amount. For example if you borrow $10,000 at 8% per year, in one year you would owe $10,000 * (1.08 ^ 1) = $800 in interest. To calculate the amount of interest, simply subtract the original loan amount from the total due. In this example, the interest due would be $10,800 $10,000 = $800. Reasons for Paying Interest Why do people pay interest? Lenders demand that borrowers pay interest for several important reasons. First, when people lend money, they can no longer use this money to fund their own purchases. The payment of interest makes up for this inconvenience. Second, a borrower may default on the loan. In this case, the borrower fails to pay back the loan and the lender loses the money, less whatever can be recovered from the borrower. Interest helps to make the risk of default worth taking. In general, the more risk there is of default on the loan, the higher the interest rate demanded by the lender. Finally, and most importantly, lenders demand interest since while the borrower has the

money, inflation tends to reduce the real value, or purchasing power, of the loan. In this case, interest allows the balance due to grow as inflation erodes the real value of the balance due. Real vs. Nominal Interest Rates We learned above that the third and most important reason why lenders demand interest is that inflation tends to decay the real value of loans over time. For example, let's say a loan is made for $10,000, inflation is 5%, and the loan is paid back after one year. When the loan is made, it can purchase $10,000 worth of goods, such as a compact car. After a year of inflation at 5%, the same compact car costs $10,500. At the same time, one year later, the $10,000 loan is repaid in full. Unfortunately, due to inflation, the real value, or purchasing power, of the money when the loan is repaid is $500 less than when it was made. By charging an interest rate at least equal to the rate of inflation, this problem is corrected. For example, say a loan is made for $10,000 at 5% interest, inflation is 5%, and the loan is paid back after one year. When the loan is made, it can purchase $10,000 worth of goods, such as a compact car (again). After a year of inflation at 5%, the same compact car costs $10,500. At the same time, one year later, the loan is repaid in full plus interest, totaling $10,500. In this case, the effects of inflation and the interest rate counteract each other so that the real value of the money stays the same even though the nominal value of the money increases by $500. Two different interest rates are used in the discussion of loans. The nominal interest rate is the interest rate reported when a loan is made. This rate does not take into account the effects of inflation. The real interest rate is not usually reported when a loan is made. This rate takes into account the effects of inflation on the purchasing power of money repaid from a loan. There is a relationship between the nominal interest rate, the real interest rate, and the rate of inflation. The real interest rate is equal to the nominal interest rate minus the inflation rate; the real interest rate, or the purchasing power of the loan, is equal to the interest earned less the effect of inflation. In the problem above, the nominal interest rate was 5%, the inflation rate was 5%, and thus, using the equation, the real interest rate was 0%. In this case, the lender received no protection from default or payment for the inconvenience of having the money unavailable. In general, lenders always charge a nominal interest rate greater than the expected inflation rate. Fischer Effect The nominal interest rate is what is paid on the balance due on a loan. If the equation presented above is rearranged, we see that the nominal interest rate is equal to the real interest rate plus the inflation rate. In the previous section on the quantity theory of money, we learned that when the Fed increases the money supply, the major effect is an increase in the inflation rate. From the equation just presented, we learn a second effect of an increase in the money supply. Because the nominal interest rate is equal to the real interest rate plus the inflation rate, an increase in the inflation rate due to an increase in the money supply by the Fed results in an increase in the nominal interest rate. This increase is affected by lenders to ensure that they receive the real interest rate they wanted on the loan, regardless of the effects of inflation. The point for point adjustment of the nominal interest rate to the real interest rate is called the Fischer effect.

Review Test
Which of the following is the best example of bartering? (A) Trading a dozen apples for a piece of steak

(B) Purchasing a piece of steak with cash (C) Charging a dozen apples on a credit card (D) Growing a dozen apples Which of the following is not one of the basic functions of money? (A) A means of calculating real value (B) A store of value (C) A unit of account (D) A medium of exchange Which of the following is the best example of how money is used as a medium of exchange? (A) Exchange rates (B) Interest rates (C) Real prices (D) Nominal prices Which of the following is the best example of how money is used as a store of value? (A) The real value of currency remains constant over time (B) The nominal value of currency remains constant over time (C) The real value of currency changes predictably over time (D) The nominal value of currency changes predictably over time Which of the following best describes how money is used as a unit of account? (A) Prices at the grocery store are in dollars (B) Prices at the grocery store are in apples (C) There are no prices at the grocery store (D) Prices fluctuate over time Which of the following is the best example of how money is liquid? (A) In the US, anything can be purchased with dollars (B) In the US, it is difficult to use dollars to purchase goods and services (C) Interest rates vary with time (D) Coinage can be melted to make new coins What are the two types of money?

(A) Commodity money and fiat money (B) Real money and nominal money (C) Dirty money and clean money (D) Unrealized money and realized money Which of the following is the best example of commodity money? (A) Paper money (B) Coinage (C) Bonds (D) Gold bullion Which of the following is the best example of fiat money? (A) Gold bullion (B) Paper money (C) Diamonds (D) Apples According to the quantity theory of money, what is it that gives money value? (A) The quantity (B) The velocity (C) The interest rate (D) The exchange rate What do you call the real value of money? (A) Purchasing power (B) Nominal value (C) Interest (D) Price level Who controls the money supply? (A) The Fed (B) Consumers (C) Producers (D) White house

Who controls the money demand? (A) The Fed (B) The president (C) Nobody (D) Everybody If the money supply were decreased, what would happen to the price level? (A) Decrease (B) Increase (C) No change (D) Need more information What determines the value of money? (A) The intersection of money supply and money demand (B) The interest rate (C) The Fed (D) Consumers What is the cause of inflation, according to the quantity theory of money? (A) Increases in the money supply (B) Decreases in the money supply (C) Increases in the interest rate (D) Decreases in the interest rate What is the name for the rate that money changes hands in an economy? (A) Velocity (B) Interest (C) Price level (D) Output What is the equation that describes the quantity theory of money? (A) M * V = P (B) M = V + P (C) M * V = P + Y

(D) M * V = P * Y In the equation for the quantity theory of money, what term describes nominal output? (A) Y (B) P * Y (C) P (D) M x V Using the equation for the quantity theory of money, what is the price level if V = 10, M = 100, and Y = 50? (A) 20 (B) 110 (C) 90 (D) 160 Using the equation for the quantity theory of money, what is the price level if V = 5, M = 50, and Y = 125? (A) 2 (B) 100 (C) 45 (D) 250 Using the equation for the quantity theory of money, what is the percent change in the price level if V changes by 3%, M changes by 2%, and Y changes by 4%? (A) 1% (B) 5% (C) 6% (D) 8% Using the equation for the quantity theory of money, what is the percent change in the price level if V changes by 1%, M changes by 3%, and Y changes by 4%? (A) 4% (B) 2% (C) 1% (D) 0% What is the most important variable in the mediation of changes in the money supply?

(A) Price level (B) Velocity (C) Output (D) Money supply When money changes hands slowly, what is the value of the velocity of money? (A) Low (B) High (C) Changing (D) Need more information When there are few dollar bills in circulation, what is the size of the money supply? (A) Small (B) Large (C) Changing (D) Need more information When it takes a large amount of currency to purchase goods and services, what is the price level? (A) High (B) Low (C) Changing (D) Need more information When there is a large quantity of goods and services being produced, what is the size of output? (A) Small (B) Medium (C) Changing (D) Large How does the equation for the velocity of money differ in the short run from in the long run? (A) In terms of output (B) In terms of velocity (C) In terms of the price level (D) In terms of the money supply

If the price level increases by 3%, what is the inflation rate over that period? (A) 3% (B) 0% (C) Need for information (D) Cannot tell What do you call the payment borrowers give to lenders in return for the use of money? (A) Interest (B) Gift (C) Price level (D) Inflation If inflation is present, is it a good idea for a lender to lend at a rate of interest below the expected inflation rate? (A) No (B) Maybe (C) Yes (D) Need more information If there is no inflation present, is it a good idea for a lender to lend at a rate of interest near zero? (A) Yes (B) No (C) If the amount of money is small (D) If the risk of default is low Which of the following is the best example of defaulting? (A) When a borrower pays back a loan (B) When a borrower fails to pay back a loan (C) When a lender forgives a loan (D) When a lender is repaid in full How does a high risk of default affect the interest rate on a loan? (A) Increases the interest rate (B) Decreases the interest rate (C) Has no effect on the interest rate

(D) Need more information What do you call interest paid on interest? (A) Compound interest (B) Real interest (C) Nominal interest (D) Wage How much interest is paid on a loan of $20,000 for 1 year at 8%? (A) $1600 (B) $800 (C) $400 (D) $200 What is the minimum interest rate that a lender should charge if there is no risk of default and inflation is expected to be 3%? (A) 1% (B) 2% (C) 3% (D) 4% What do you call an interest rate that takes into account the effect of inflation? (A) Nominal (B) Real (C) Compound (D) Unfair Which interest rate is usually reported when a loan is made? (A) Nominal (B) Real (C) Low (D) High How are the real interest rate, the nominal interest rate, and the rate of inflation related? (A) The real interest rate is equal to the nominal interest rate minus the inflation rate

(B) The inflation rate is equal to the real interest rate plus the nominal interest rate (C) The real interest rate less the inflation rate is equal to the nominal interest rate (D) The nominal interest rate times the inflation rate is equal to the rate of inflation What do you call the point for point relationship between the nominal interest rate and the real interest rate? (A) The Fischer effect (B) The quantity theory of money (C) The Phillips curve (D) Okun's law What is the real interest rate if the nominal interest rate is 6% and inflation is 3%? (A) 9% (B) 18% (C) 2% (D) 3% What is the nominal interest rate if the real interest rate is 5% and inflation is 1%? (A) 4% (B) 6% (C) 0% (D) Need more information Can the inflation rate decrease? (A) Yes (B) No (C) Maybe (D) Need more information Which of the following is not a real for interest? (A) Kindness (B) Default (C) Convenience (D) Risk What is the relationship between the velocity of money and the use of credit cards?

(A) The more credit cards are used, the lower the velocity of money (B) The more credit cards are used, the higher the velocity of money (C) Credit cards do not effect velocity (D) Velocity is always constant How does inflation affect money stored in a mattress? (A) It increases its value (B) It makes it worth nothing (C) It does not affect it (D) It decreases its value When the Fed changes the size of the money supply, how are credit cards affected? (A) They become more useful (B) They are not directly affected (C) They become less useful (D) They become worthless When is the quantity theory of money most useful? (A) In the long run (B) In the short run (C) When the variable change often (D) When the money supply is constant

Summary
Take a minute and look around. You might be surprised to discover how many of the everyday items in your life are made overseas. Your shirt might be made in China. Perhaps your stereo was assembled in Japan. The watch you're wearing could be from Switzerland. And yes, the shoes that you are sporting might have been assembled in the United States. The importing and exporting of goods is big business in today's global economy. When goods are produced in one country and sold in another, international trade occurs. It is so common to find items produced worldwide that people rarely even think about it. Not too long ago, countries consumed goods predominately produced within their borders. As transportation has become increasingly less expensive and telecommunications have improved, international trade has flourished. In general, international trade allows countries to focus on the industries in which they can be most productive and efficient. In this way, trade often raises the standard of living of both producers and consumers. International trade also has a dark side.

This SparkNote will address many of the questions about international trade that are probably looming in your mind. Why should countries trade? How does trade work? What is the effect of international trade? How do exchange rates affect trade? Can the government interfere in free trade? What is the trade deficit? The benefits and pitfalls of trade affect the economy at its core. Everything from output to standard of living to interest rates remains under the partial control of international trade. By understanding international trade, we will uncover one of the most important real life applications of macroeconomics.

Terms
Absolute Advantage - When a producer can create a given amount of output with the smallest amount of inputs. Budget Deficit - When the government spends more money than it receives. Capital - Money, machinery, and education put toward a business to increase its productivity. Comparative Advantage - When a producer has a lower opportunity cost of production for an item than another producer's. Consumption - Goods and services purchased by consumers. Cost of living - The relative amount of money needed to maintain a given lifestyle. Exchange Rates - Numbers that tell how much foreign product can be purchased with similar domestic product. Exports - Goods sent to another country for sale. Free Trade - Trade with which the government does not interfere. Goods - Products that consumers, manufacturers, and governments exchange. Imports - Goods produced in a foreign country and consumed in a domestic country. Income - Money that enters a country or household. Investment - Money spent to improve a company's growth and productivity. Net Exports - The difference between exports and imports. Net Foreign Investment - The total amount of investment in a country that results from trade deficits. Net foreign investment always equals net exports. Nominal Exchange Rates - The amount of foreign currency that exchangeable for domestic currency. Nominal Output - The amount of output valued in currency dollars. Opportunity Cost - What is given up in pursuing one option over another. Output - Goods and services produced. Protectionist Policies - Governmental policies that serve to help developing domestic industries. Quota - When a government limits the amount of a given good that can be imported. Imposing quotas is a protectionist policy. Real Exchange Rates - Numbers that describe the relative real value of foreign and domestic goods. Subsidy - Grants paid by the government to producers to help them develop. Subsidizing is a protectionist policy. Tariff - Fees charged by the government on imported goods to help raise the price and decrease the quantity sold. Use of tariffs is a protectionist policy. Trade - When goods from one producer are exchanged for goods from another producer. In this case, goods can be very broadly interpreted. Trade Balance - Exports minus imports. Trade Deficit - A trade deficit occurs when a country imports more than it exports. Trade Surplus - A trade surplus occurs when a country exports more than it imports. Formulae

Output = income Y = C + I + G + NX

Y = C + I + G + NX

Net Exports

Net Exports = exports - imports Real exchange rate = ((nominal exchange rate)(domestic price)) /(foreign price) Nominal exchange rate = (price of foreign currency) / (price of domestic currency)

Real Exchange Rate

Nominal Exchange Rate

Trade Basics
Why Trade? Why should countries trade? Simply put, if a country can produce a good for less than another country, then the opportunity for advantageous trade exists. Of course, the opportunity for advantageous trade also exists when a country can produce a good that another country is unable to produce. In each of these cases, both the consuming country and the producing country will be better off with trade than without it. Let's use an example to explain. Say Jim lives on an island with a coconut tree. Sally lives on another island with a banana tree. Jim tires of eating coconuts and desires something new to eat. Surprisingly enough, Sally is tired of bananas and would love some nice sweet coconut. In this example, trade would benefit both parties. This example presents only one of the two cases in which trade is adventurous. In the other case, a country can produce goods at an absolutely or relatively lower price than another country. These conditions are called the absolute advantage and the comparative advantage respectively. Advantages in Trade A country may have two advantages over another country (or countries) regarding trade. Absolute advantage occurs when a producer can use the smallest amount of inputs to produce a given amount of output compared to other producers. Absolute advantage may apply to many countries. Comparative advantage happens when a producer has a lower opportunity cost of production than another producer. Comparative advantage may also apply to many countries, but in this SparkNote it will be restricted to cases of two countries and two goods. Each of these two cases will be discussed in detail in the following paragraphs. Farmer John has a pistachio farm. It takes him five hours worth of work to harvest one pound of nuts. Farmer Rick also has a pistachio farm. It takes him four hours worth of work to harvest one pound of nuts. Farmer Erica owns a third pistachio farm. She can harvest one pound of nuts in three hours. In this example, Farmer Erica is said to have the absolute advantage in pistachio production since she is able to produce the largest amount of output in the smallest amount of time. In terms of trade, it is always most beneficial for the producer with the absolute advantage in the production of a good to specialize in the production of that good. For instance, in the above example, it was far more productive for Farmer Erica to spend time harvesting pistachios than it was for Farmer Rick or Farmer John to do the same. Farmer Erica therefore has a lower cost of production than either of the other two producers. Applying this idea to international trade leads us to the conclusion that goods should be produced for which the cost of production is lowest. In a more complex model though, producers can produce many different goods. Often times, if a producer chooses to produce one good, he or she must give up the opportunity to produce another good. This is called the opportunity

cost of producing a good. The opportunity cost describes what is sacrificed or relinquished when one choice is taken over another. Let's use another example. Revisiting the farms belonging to Farmer Erica and Farmer Rick, we discover that they are both able to produce pistachios and soybeans. Farmer Erica can harvest 1 pound of pistachios in 2 hours and she can harvest 5 pounds of soybeans in 2 hours. Farmer Rick, on the other hand, can harvest 1 pound of pistachios in 10 hours and 50 pounds of soybeans in 2 hours. Looking at this information in terms of the total amount of time each farmer takes to harvest a pound of each product is the next step to understanding comparative advantage. Farmer Erica can harvest 1 pound of pistachios in an hour while it takes Farmer Rick 10 hours to harvest 1 pound of pistachios. On the other hand, Farmer Rick can harvest 1 pound of soybeans in about 2.5 minutes, but it takes Farmer Erica about 24 minutes to harvest a pound of soybeans. Since each of these farmers only has a fixed number of hours to spend harvesting, each hour spent harvesting pistachios cannot be spent harvesting soybeans, and similarly, each hour spent harvesting soybeans cannot be spent harvesting pistachios. For every hour Farmer Erica spends picking soybeans, she gives up 0.5 pounds of pistachios; and for every hour that Farmer Erica spends picking pistachios, she gives up 0.1 pounds of soybeans. Farmer Rick gives up 25 pounds of soybeans for every hour that he spends harvesting pistachios, and for every hour that Farmer Rick spends harvesting soybeans, he gives up 0.1 pounds of pistachios. We can reexamine this example in terms of opportunity costs. Farmer Erica has an opportunity cost of 0.1 pounds of soybeans for every 0.5 pounds of pistachios harvested, or similarly, 5 pounds of pistachios for every 1 pound of soybeans harvested. Farmer Rick has an opportunity cost of 0.1 pounds of pistachios for every 25 pounds of soybeans harvested, or 250 pounds of soybeans for every pound of pistachios harvested.

Figure %: Opportunity costs of production Figure 1 depicts the situation described above. Notice that for Farmer Erica, the opportunity cost of harvesting pistachios is lower than the opportunity cost of harvesting soybeans. Similarly, for Farmer Rick, the opportunity cost of harvesting soybeans is lower than the opportunity cost of harvesting pistachios. In both of these cases, this means that both farmers are better off spending their time harvesting the product that they can produce most efficiently. The producer with the lower opportunity cost of production is said to have the comparative advantage. Notice that in a case with two producers and two products, each producer must have a comparative advantage in one, and not both, products. Figure 1 makes finding the comparative advantage easy. Simply represent the opportunity cost of one product in terms of the other product for both producers, and then compare these numbers. Whichever producer has the lower opportunity cost has the comparative advantage and should produce that product. Absolute advantage and comparative advantage are theoretically straightforward. When a producer has an absolute advantage, he can produce a given output by using fewer inputs than any competing producer. When a producer has a competitive advantage, he can produce one product with a smaller amount of inputs than the competition. He therefore must produce another product with a greater amount of inputs than the competitor, hence the designation of

comparative advantage. When either an absolute advantage or a comparative advantage exists, benefits from trade are guaranteed.

The Means of Trade

Flows of Capital and Goods In the first macroeconomics SparkNote on measuring the economy, we learned the identity Y = C + I + G + NX to describe the output of an economy. In this equation, Y is the nominal output, C is money spent on consumption, I is money spent on investment, G is money spent by the government, and NX is net exports or exports less imports. The sum of these costs is the total amount of both income and output in a country. To understand how capital and goods flow in and out of countries, we should keep the Y = C + I + G + NX identity in mind. NX is of particular interest. NX is defined as the total amount of exports less the total amount of imports. NX is positive if a country exports more than it imports, negative if a country imports more than it exports, and zero if exports and imports are equal. Let's work through each of these examples in turn. First we'll examine the simplest case, in which exports and imports are equal. In this example, there are two countries, Country A and Country B. If Country A exports 1 million dollars worth of coconuts to Country B and imports 1 million dollars worth of bananas from Country B, then the NX for both countries is equal to zero since exports equal imports. In this case, goods are traded for goods and at the end of the term, the trade balance is equal. When countries import less than they export or import more than they export, the situation becomes significantly more complicated. Now let's examine the case when a country imports more than it exports. If Country A exports 0.5 million dollars worth of coconuts to Country B and imports 1 million dollars worth of bananas from Country B, then Country A has a negative trade balance, called a trade deficit. In this case, Country A owes Country B money for the imported bananas beyond the 0.5 million dollars worth of exported coconuts. If this is a short-term debt, nothing of consequence would occur since Country A has the ability to export more coconuts quickly to make up for the difference. If the debt is long term, however, Country A must somehow repay Country B for the imported bananas. The easiest way to think of this exchange is to imagine Country A giving Country B interest in the future coconuts produced by Country A. To repay the debt that Country A owes to Country B, Country B becomes invested in Country A. Any amount of exports that exceeds the total amount of imports results in foreign investment. The opposite occurs when exports exceed imports as the exporting country becomes a foreign investor in the importing country. This leads us to another important international trade identity: NX = NFI where NX is net exports or exports less imports and NFI is net foreign investment. Simply put, the difference between what a country exports and imports is equal to the amount of foreign investment. The trade balance can remain fairly even if a country imports more than it exports--it must make up the difference through foreign investment. If net exports remain equal to net foreign investment, a few tendencies arise:

countries with few imports and many exports will tend to have significant foreign investment countries with few exports and many imports will also tend to have significant foreign investment countries with exports equal to imports will tend to have little investment in foreign countries and little foreign investment

Understanding the identity NX = NFI and the means by which capital and goods flow between countries helps to clarify the workings of international trade.

Exchange Rates
Nominal Exchange Rates versus Real Exchange Rates As we begin discussing exchange rates, we must make the same distinction that we made when discussing GDP. Namely, how do nominal exchange rates and real exchange rates differ? The nominal exchange rate is the rate at which currency can be exchanged. If the nominal exchange rate between the dollar and the lira is 1600, then one dollar will purchase 1600 lira. Exchange rates are always represented in terms of the amount of foreign currency that can be purchased for one unit of domestic currency. Thus, we determine the nominal exchange rate by identifying the amount of foreign currency that can be purchased for one unit of domestic currency. The real exchange rate is a bit more complicated than the nominal exchange rate. While the nominal exchange rate tells how much foreign currency can be exchanged for a unit of domestic currency, the real exchange rate tells how much the goods and services in the domestic country can be exchanged for the goods and services in a foreign country. The real exchange rate is represented by the following equation: real exchange rate = (nominal exchange rate X domestic price) / (foreign price). Let's say that we want to determine the real exchange rate for wine between the US and Italy. We know that the nominal exchange rate between these countries is 1600 lira per dollar. We also know that the price of wine in Italy is 3000 lira and the price of wine in the US is $6. Remember that we are attempting to compare equivalent types of wine in this example. In this case, we begin with the equation for the real exchange rate of real exchange rate = (nominal exchange rate X domestic price) / (foreign price). Substituting in the numbers from above gives real exchange rate = (1600 X $6) / 3000 lira = 3.2 bottles of Italian wine per bottle of American wine. By using both the nominal exchange rate and the real exchange rate, we can deduce important information about the relative cost of living in two countries. While a high nominal exchange rate may create the false impression that a unit of domestic currency will be able to purchase many foreign goods, in reality, only a high real exchange rate justifies this assumption. Net Exports and the Real Exchange Rate An important relationship exists between net exports and the real exchange rate within a country. When the real exchange rate is high, the relative price of goods at home is higher than the relative price of goods abroad. In this case, import is likely because foreign goods are cheaper, in real terms, than domestic goods. Thus, when the real exchange rate is high, net exports decrease as imports rise. Alternatively, when the real exchange rate is low, net exports increase as exports rise. This relationship helps to show the effects of changes in the real exchange rate.

Trade and the Country

Barriers to Trade It may seem odd, but governments often step in to restrict trade. Why might a government want to restrict trade? If domestic industries cannot compete against foreign industries, the government will restrict trade to help the domestic

industries develop. Governments may also restrict trade to foster business at home rather than encouraging business to move out of the country. These protectionist policies encourage prices to stay high and help domestic industries to develop. Trade Interferences Governments three primary means to restrict trade: quota systems; tariffs; and subsidies. A quota system imposes restrictions on the specific number of goods imported into a country. Quota systems allow governments to control the quantity of imports to help protect domestic industries. Tariffs are fees paid on imported goods. Tariffs increase the price that consumers pay for the good, thus reducing the quantity of the good demanded and making the price more in line with the price charged by domestic producers. Tariff profits may go to the government or to developing industries. Subsidies are grants given to domestic industries to help them develop and compete with foreign producers. Through subsidies, domestic producers can charge less for their goods without losing money due to outside grants. Through judicious use of quotas, tariffs, and subsidies, governments are able to improve the domestic economy. This may increase the price that domestic consumers pay for goods, though this small annoyance is usually outweighed by significantly bolstered overall economic levels and long-term economic growth. Trade Deficit In the section on net exports we learned that net exports equal exports minus imports. The difference between exports and imports is referred to as the trade deficit or the trade surplus. When exports exceed imports, a trade surplus exists. When imports exceed exports, a trade deficit exists. There often talk about the effects of the trade deficit on the economy. What is the actual effect of the trade deficit though? Remember that when there is a trade deficit, net foreign investment fills the gap between exports and imports, as NX = NFI. Thus, if a large trade deficit exists, foreign investment must be high. This is slightly problematic as domestic companies often enjoy domestic ownership--a large trade deficit threatens this condition. A trade deficit is often matched with a large governmental budget deficit. Though the specific effects of a trade deficit are nebulous, in general a large trade deficit is thought to stunt long-term economic growth slightly. How can the trade deficit be resolved? First, exports can be increased to make annual net exports positive. When employed, this method will cause a trade deficit decrease over time. Second, funds can be used to pay off foreign investors, reducing balance due from trade and causing a lower trade deficit.

Test
Why should countries trade? (A) To help them thrive (B) To increase output (C) To decrease output (D) To keep them busy Which of the following is a situation in which trade is advantageous?

(A) Two countries produce the same goods for the same costs (B) Two countries produce different goods for different costs (C) Two countries are isolated (D) Two countries have the same markets When one producer can create a given amount of output with fewer inputs, what exists? (A) Comparative advantage (B) Comparative disadvantage (C) Absolute advantage (D) Absolute disadvantage When one producer has a lower opportunity cost of production than another producer for a given item, what exists? (A) Absolute disadvantage (B) Absolute advantage (C) Comparative disadvantage (D) Comparative advantage Farmer John has a pistachio farm. It takes him 5 hours worth of work to harvest 1 pound of nuts. Farmer Rick also has a pistachio farm. It takes him 10 hours worth of work to harvest 1 pound of nuts. Finally, Farmer Erica owns a third pistachio farm. She can harvest 1 pound of nuts in 2 hours. Who has the absolute advantage in this example? (A) Farmer Erica (B) Farmer Rick (C) Farmer John (D) Unclear There are three producers. Producer A spends $10 to make a widget. Producer B spends $50 to make a widget. Producer C spends $4. Who has the absolute advantage? (A) Producer B (B) Producer C (C) Producer A (D) Unclear Mechanic A can change a tire in 1 hour and change a sparkplug in 2 hours. Mechanic B can change a tire in 0.5 hours and change a sparkplug in 0.25 hours. Who has the comparative advantage in changing sparkplugs? (A) Need more information

(B) Both mechanics (C) Mechanic B (D) Mechanic A Rancher Tom can raise 10 goats and 20 pigs in a year. Rancher Joe can raise 20 goats and 100 pigs in a year. Who has the comparative advantage for raising pigs? (A) Need more information (B) Both ranchers (C) Rancher Tom (D) Rancher Joe What term applies when one option is chosen from among several possibilities? (A) Opportunity cost (B) Absolute advantage (C) Comparative advantage (D) Lost possibilities If there are two producers and two products, which of the following cannot happen? (A) A producer has an absolute advantage on one product (B) A producer has the comparative advantage on both products (C) A producer has the comparative advantage on one product (D) A producer has an absolute advantage on both products When a comparative advantage exists, what should the producer with the comparative advantage do? (A) Produce the item for which he does not have the comparative advantage (B) Produce both items (C) Produce the item for which he does have the comparative advantage (D) Produce neither item When an absolute advantage exists, what should the producer with the absolute advantage do? (A) Produce the item for which he does not have the absolute advantage (B) Produce both items (C) Produce the item for which he does have the absolute advantage (D) Produce neither item

Is it possible for a producer to have both an absolute advantage and a comparative advantage? (A) Yes (B) No (C) Only if the market is small (D) Only if there are two producers What equation describes output? (A) Y = C + I + G + X (B) Y = C + I + G + NX (C) Y = C + I + G + I (D) Y = C + I + G What else does the equation Y = C + I + G + NX describe? (A) Interest rate (B) Exchange rate (C) Income (D) Growth rate In the equation Y = C + I + G + NX, what does Y stand for? (A) Real output (B) Real wages (C) Nominal wages (D) Nominal output What is the equation that describes net exports? (A) Net exports = exports - imports (B) Net exports = output - exports (C) Net exports = exports - output (D) Net exports = imports - exports When a country exports and imports the same amount of goods, what is its net exports? (A) Need more information (B) Zero (C) Exports plus imports

(D) Output plus exports When a country exports more than it imports, what is the value of net exports? (A) Negative (B) Zero (C) Positive (D) Need more information When a country imports more than it exports, what is the value of the net exports? (A) Need more information (B) Zero (C) Positive (D) Negative When net exports are negative, what accounts for the difference? (A) Net foreign investment (B) Imports (C) Exports (D) Net exports What is the equation that relates net exports to net foreign investment? (A) NX = NFI + C (B) NX = NFI (C) NX = NFI - C (D) NX = 1 - NFI If a country always imports more than it exports, what will its net foreign investment look like? (A) Low (B) Medium (C) High (D) Need more information If a country always exports more than it imports, what will the net foreign investment look like? (A) Need more information (B) High

(C) Medium (D) Low Which of the following pairs go together? (A) Negative NX and high NFI (B) Negative NX and low NFI (C) Positive NX and high NFI (D) None of the above Which of the following pairs go together? (A) High imports and high net exports (B) Need more information (C) Low imports and high net exports (D) Low imports and low net exports What do you call the number that represents the nominal value of currency in two countries? (A) Interest rate (B) Output (C) Exchange rate (D) Price What do you call the number that compares the real cost of goods between two countries? (A) Nominal exchange rate (B) Real interest rate (C) Nominal interest rate (D) Real exchange rate Which is easier to calculate, the nominal exchange rate or the real exchange rate? (A) Nominal exchange rate (B) Real exchange rate (C) Need more information (D) None of the above Which of the following is not necessary to calculate the real exchange rate? (A) Domestic price

(B) Domestic interest rate (C) Foreign price (D) Nominal exchange rate What is the equation for the real exchange rate? (A) real exchange rate = (domestic price) / (foreign price) (B) real exchange rate = (nominal exchange rate X domestic price) (C) real exchange rate = (nominal exchange rate X domestic price) / (foreign price) (D) real exchange rate = (nominal exchange rate X foreign price) How are the nominal exchange rate and the real exchange rate related? (A) Inversely (B) Indirectly (C) Directly (D) Proportionally What is the real exchange rate if the domestic price is $5, the foreign price is 3 pounds, and the exchange rate is 1.5? (A) 2.5 (B) 3 (C) 8 (D) 4.5 What is the real exchange rate if the domestic price is $2, the foreign price is 2 pounds, and the exchange rate is 1.5? (A) 1 (B) 1.5 (C) 0 (D) 2 What is the real exchange rate if the domestic price is $10, the foreign price is 30 pounds, and the exchange rate is 2? (A) 0.5 (B) 0.55 (C) 0.67 (D) 0.70

What can be determined from the real exchange rate? (A) Standard of living (B) Interest rate (C) Output (D) Cost of living Which of the following situations is best if you wish to travel to a foreign country? (A) High nominal exchange rate and high real exchange rate (B) High nominal exchange rate and low real exchange rate (C) Low nominal exchange rate and high real exchange rate (D) Low nominal exchange rate and low real exchange rate What is the effect on net exports of an increase in the real exchange rate? (A) They rise (B) They fall (C) No effect (D) Need more information When the real exchange rate falls, what is likely to increase? (A) Cost of living (B) Imports (C) Exports (D) Standard of living What is the general term for when a government interferes in free trade? (A) Policy (B) Intercession (C) Hindrance to trade (D) Barrier to trade Which of the following is not a reason that the government might impose a barrier to trade? (A) To hurt the economy (B) To help young domestic industries (C) To raise money

(D) To make domestic producers competitive What do you call barriers to trade that help domestic producers? (A) Barriers to trade (B) Protectionist policies (C) Jingoist policies (D) Fiscal policies What is it called when the government places limits on the number of a given good that can be imported? (A) Subsidies (B) Taxes (C) Quotas (D) Tariffs What is it called when the government places taxes on imported goods? (A) Subsidies (B) Taxes (C) Quotas (D) Tariffs What is it called when the government gives domestic industries grants to keep them running competitively? (A) Subsidies (B) Taxes (C) Quotas (D) Tariffs What develops when exports exceed imports? (A) Trade deficit (B) Trade surplus (C) Barrier to trade (D) Tariff What develops when imports exceed exports? (A) Tariff (B) Quota

(C) Trade deficit (D) Trade surplus Which of the following is not an effect of a trade deficit? (A) High net foreign investment (B) Decreased domestic ownership (C) Increased balances due (D) Increased output Which of the following is not a way to cure the trade deficit? (A) Increase imports (B) Decrease imports (C) Increase exports (D) Pay balances due Which of the following is thought to be related to a high trade deficit? (A) A low budget deficit (B) A high budget deficit (C) An even balance of trade (D) Protectionist policies

Aggregate Demand
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Terms and Formulae

Terms Aggregate Demand - The total demand for goods and services in an economy. Aggregate Supply - The total supply of goods and services in an economy. Crowding In - When government spending induces private investment. Crowding Out - When government spending reduces private investment. Demand Curve - A schedule that relates price to quantity demanded. Disposable Income - Income that may be spent after taxes are subtracted. Exogenous - A change resulting from conditions outside of an economic model.

GDP - Gross domestic product is the total value of all goods and services produced within an economy. Income - Money taken in by a system, an individual, a firm, or an economy. Inflation - The year-to-year increase in the price level. Marginal Propensity to Consume - A number that describes the amount of an additional dollar of income that a consumer will spend rather than save. Money Supply - The total amount of currency and demand deposits that exists in an economy. National Income - The total amount of money earned in an economy in a year. C.f. GDP. Net Exports - The difference between exports and imports. Nominal Interest Rate - The cost of borrowing money, unadjusted for inflation. Nominal Value - The value of something in current currency, unadjusted for inflation. Output - The amount of goods and services produced in an economy. This can be in quantity or in currency. Price Level - The overall level of prices within an economy. Real Exchange Rate - The rate that goods and services of one country can be traded for goods and services of another country. Real Interest Rate - The cost of borrowing money, adjusted for inflation. Real Value - The value of something in constant currency, adjusted for inflation. Formulae

Formula for Output or income LM curve equation

Y = C(Y - T) + I(r) + G + NX(e) = basic equation for aggregate demand = IS curve equation

The Aggregate Demand Curve

Downward sloping aggregate demand curve

Figure %: Graph of the aggregate demand curve.

The most noticeable feature of the aggregate demand curve is that it is downward sloping, as seen in . There are a number of reasons for this relationship. Recall that a downward sloping aggregate demand curve means that as the price level drops, the quantity of output demanded increases. Similarly, as the price level drops, the national income increases. There are three basic reasons for the downward sloping aggregate demand curve. These are Pigou's wealth effect, Keynes's interest-rate effect, and Mundell-Fleming's exchange-rate effect. These three reasons for the downward sloping aggregate demand curve are distinct, yet they work together. The first reason for the downward slope of the aggregate demand curve is Pigou's wealth effect. Recall that the nominal value of money is fixed, but the real value is dependent upon the price level. This is because for a given amount of money, a lower price level provides more purchasing power per unit of currency. When the price level falls, consumers are wealthier, a condition which induces more consumer spending. Thus, a drop in the price level induces consumers to spend more, thereby increasing the aggregate demand. The second reason for the downward slope of the aggregate demand curve is Keynes's interest-rate effect. Recall that the quantity of money demanded is dependent upon the price level. That is, a high price level means that it takes a relatively large amount of currency to make purchases. Thus, consumers demand large quantities of currency when the price level is high. When the price level is low, consumers demand a relatively small amount of currency because it takes a relatively small amount of currency to make purchases. Thus, consumers keep larger amounts of currency in the bank. As the amount of currency in banks increases, the supply of loans increases. As the supply of loans increases, the cost of loans--that is, the interest rate--decreases. Thus, a low price level induces consumers to save, which in turn drives down the interest rate. A low interest rate increases the demand for investment as the cost of investment falls with the interest rate. Thus, a drop in the price level decreases the interest rate, which increases the demand for investment and thereby increases aggregate demand. The third reason for the downward slope of the aggregate demand curve is Mundell-Fleming's exchange-rate effect. Recall that as the price level falls the interest rate also tends to fall. When the domestic interest rate is low relative to interest rates available in foreign countries, domestic investors tend to invest in foreign countries where return on investments is higher. As domestic currency flows to foreign countries, the real exchange rate decreases because the international supply of dollars increases. A decrease in the real exchange rate has the effect of increasing net exports because domestic goods and services are relatively cheaper. Finally, an increase in net exports increases aggregate demand, as net exports is a component of aggregate demand. Thus, as the price level drops, interest rates fall, domestic investment in foreign countries increases, the real exchange rate depreciates, net exports increases, and aggregate demand increases. IS-LM model of aggregate demand There is another major model that is useful for explaining the nature of the aggregate demand curve. This model is called the IS-LM model after the two curves that are involved in the model. The IS curve describes equilibrium in the market for goods and services where Y = C(Y - T) + I(r) + G and the LM curve describes equilibrium in the money market where M/P = L(r,Y). The IS-LM model exists in a plane with r, the interest rate, on the vertical axis and Y, being both income and output, on the horizontal axis. The IS-LM model has the same horizontal axis as the aggregate demand curve, but a different vertical axis.

Figure %: Graph of the IS-LM curves. The IS curve describes equilibrium in the market for goods and services in terms of r and Y. The IS curve is downward sloping because as the interest rate falls, investment increases, thus increasing output. The LM curve describes equilibrium in the market for money. The LM curve is upward sloping because higher income results in higher demand for money, thus resulting in higher interest rates. The intersection of the IS curve with the LM curve shows the equilibrium interest rate and price level. The IS curve and the LM curve shift in response to economic activities. The IS curve shifts outward as a result of increased government purchases, exogenous increases in investment, decreases in taxes, and exogenous increases in consumption. The IS curve shifts inward as a result of decreases in government purchases, exogenous decreases in investment, increases in taxes, and exogenous decreases in consumption. The LM curve shifts outward as a result of increases in the money supply and decreases in the price level. The LM curve shifts inward as a result of decreases in the money supply and increases in the price level. The aggregate demand curve can be derived using the IS-LM model. Recall that the aggregate demand curve relates price level to income and output. The simplest way to derive the downward sloping aggregate demand curve from the IS-LM model is to look at the effects of an increase in the price level on output or income. When the price level increases, the LM curve shifts inward. An inward shift in the LM curve results in an intersection of the IS-LM model at a lower level of output and income and a higher interest rate. When a line connecting the old price level and the old output and income to the new price level and the new output and income in the price level and output and income space, the downward sloping aggregate demand curve appears. In general, from the IS-LM model, it is clear that aggregate demand slopes downward because as the price level increases, output and income decrease. The IS-LM curve is a useful way to incorporate the money market into the logic driving the aggregate demand curve. By understanding the basics of the IS-LM model and the three reasons that the aggregate demand curve is downward sloping as presented under the previous heading, the nature of the aggregate demand curve is clear. The

next step to work through is how shifts of and shifts along the aggregate demand curve function. In this capacity, the IS-LM model will become very useful.

Shifts in the Aggregate Demand Curve

Shifts to the left There are many actions that will cause the aggregate demand curve to shift. When the aggregate demand curve shifts to the left, the total quantity of goods and services demanded at any given price level falls. This can be thought of as the economy contracting. To understand what causes the economy to contract, let's start with the basic equation for the demand curve. Recall that the price level is not directly in the equation for aggregate demand. Rather, it is implicit in each of the terms in the equation. We know that aggregate demand is comprised of C(Y - T) + I(r) + G + NX(e) = Y. Thus, a decrease in any one of these terms will lead to a shift in the aggregate demand curve to the left. The first term that will lead to a shift in the aggregate demand curve is C(Y - T). This term states that consumption is a function of disposable income. If disposable income decreases, consumption will also decrease. There are many ways that consumption can decrease. An increase in taxes would have this effect. Similarly, a decrease in income-holding taxes stable--would also have this effect. Finally, a decrease in the marginal propensity to consume or an increase in the savings rate would also decrease consumption. The second term that will lead to a shift in the aggregate demand curve is I(r). This term states that investment is a function of the interest rate. If the interest rate increases, investment falls as the cost of investment rises. There are a number of ways that investment can fall. If the interest rate rises, say due to contractionary monetary or fiscal policy, investment will fall. Similarly, in the short run, expansionary fiscal policy will also cause investment to fall as crowding out occurs. Another interesting cause of a fall in investment is an exogenous decrease in investment spending. This occurs when firms simply decide to invest less without regard for the interest rate. The term variable that will lead to a shift in the aggregate demand curve is G. This term captures the whole of government spending. The only way that government spending is changed is though fiscal policy. Recall that the budgetary debate is an ongoing political battlefield. Thus, government spending tends to change regularly. When government spending decreases, regardless of tax policy, aggregate demand decrease, thus shifting to the left. The fourth term that will lead to a shift in the aggregate demand curve is NX(e). This term means that net exports, defined as exports less imports, is a function of the real exchange rate. As the real exchange rate rises, the dollar becomes stronger, causing imports to rise and exports to fall. Thus, policies that raise the real exchange rate though the interest rate will cause net exports to fall and the aggregate demand curve to shift left. Again, an exogenous decrease in the demand for exported goods or an exogenous increase in the demand for imported goods will also cause the aggregate demand curve to shift left as net exports fall. An example of this type of exogenous shift would be a change in tastes or preferences. Shifts to the right The aggregate demand curve also can shift right as the economy expands. When the aggregate demand curve shifts right, the quantity of output demanded for a given price level rises. Therefore, a shift of the aggregate demand curve to the right represents an economic expansion. A shift of the aggregate demand curve to the right is simply effected by the opposite conditions that cause it to shift to the left. Limits of aggregate demand

The aggregate demand curve alone is useful. It tells how the price level and output or income are related. It shows the general effects of changes in many economic variables and the relationship between price level and output or income. But there are limits to its usefulness. It cannot show where the economy currently sits. Similarly, it cannot predict the effects of an economic policy upon the economy. In the next section, we will look at aggregate supply. This counterpart to aggregate demand completes the AS-AD model of the macroeconomy. That is, the aggregate supply and aggregate demand model of the economy is based on the total demand for goods and services and the total supply of goods and services. Once you are comfortable with the reasons for the downward sloping aggregate demand curve and with the ways and directions that the aggregate demand curve shifts, you are prepared to move on to the aggregate supply curve.

Aggregate Demand
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What does aggregate demand express? (A) The quantity of goods and services demanded in an economy (B) The quantity of goods and services produced in an economy (C) The quantity of goods produced in an economy (D) The quantity of services demanded in an economy What is the aggregate demand curve most similar to? (A) A demand schedule (B) The demand curve for a firm (C) A demand system (D) The supply curve for a firm Which of the following sources of purchases is not included in aggregate demand? (A) Businesses (B) Consumers (C) Foreigners (D) Government What is the horizontal axis of the aggregate demand curve?

(A) Interest rate (B) Price level (C) Inputs (D) Output or income What is the vertical axis of the aggregate demand curve? (A) Price level (B) Income (C) Output (D) Interest rate When the price level is high, what is aggregate demand? (A) High (B) Low (C) Unchanged (D) Need more information When the price level is low, what is aggregate demand? (A) High (B) Low (C) Unchanged (D) Need more information What is the general slope of the aggregate demand curve? (A) Horizontal (B) Vertical (C) Upwards (D) Downwards What is the general equation for aggregate demand? (A) Y = C(Y - T) + I(r) + G + NX(e) (B) Y = C(Y - T) + I(r) + G (C) Y = C(Y - T) + I(r) + NX(e) (D) Y = C(Y - T) + G + NX(e)

The term C(Y - T) means that consumption is dependant upon what? (A) Income (B) Disposable income (C) Taxes (D) Output The term I(r) means that investment is dependent upon what? (A) Real income (B) Disposable income (C) Real interest rate (D) Real exchange rate The term NX(e) means that net exports are dependent upon what? (A) Nominal interest rate (B) Real interest rate (C) Nominal exchange rate (D) Real exchange rate What does the real exchange rate represent? (A) The rate at which the goods from one country can be traded for the goods of another country (B) The rate at which the goods from one country can be purchased from another country (C) The rate at which the goods from one country can be traded for goods of that country (D) The rate at which the goods from one country can be purchased in another country What economic number can be derived from output? (A) Standard of living (B) National income (C) GDP per capita (D) Nominal GDP What area of aggregate demand would movie tickets fall under? (A) Net exports (B) Investment (C) Consumption

(D) Government spending What are of aggregate demand would social security fall under? (A) Net exports (B) Investment (C) Consumption (D) Government spending What are of aggregate demand would raw materials shipped to Asia fall under? (A) Net exports (B) Investment (C) Consumption (D) Government spending What are of aggregate demand would new housing fall under? (A) Net exports (B) Investment (C) Consumption (D) Government spending Which of the following would not be considered consumption under aggregate demand? (A) Books (B) Movie tickets (C) New houses (D) Food Which of the following would not be considered investment under aggregate demand? (A) Education (B) Machinery (C) Factories (D) Used housing Which of the following types of economic activity are not represented in aggregate demand? (A) Aid from foreigners (B) Aid to foreigners

(C) Government transfers (D) Consumption spending Which model of aggregate demand is based upon exchange rates? (A) Laffer model (B) Mundell-Fleming model (C) Keynes model (D) Pigou model Which of the aggregate demand models is based on investment spending? (A) Laffer model (B) Mundell-Fleming model (C) Keynes model (D) Pigou model Which of the aggregate demand models is based on consumption spending? (A) Laffer model (B) Mundell-Fleming model (C) Keynes model (D) Pigou model Which of the following is not a model of aggregate demand? (A) Laffer model (B) Mundell-Fleming model (C) Keynes model (D) Pigou model What is the effect of a decrease in the price level on wealth? (A) It decreases wealth (B) It increases wealth (C) It has not effect on wealth (D) It has an indeterminate effect on wealth When consumers feel or become wealthier, what is the effect on consumption spending? (A) It increases consumption spending

(B) It decreases consumption spending (C) It has no effect on consumption spending (D) It has an indeterminate effect on consumption spending What is the effect of a high price level on interest rates? (A) Interest rates tend to be low (B) Interest rates tend to be high (C) There is no relationship between the price level and interest rates (D) Need more information Which of the following is not related to the interest rate? (A) The price of output (B) The price of consumption (C) The price of loans (D) The price of investment What happens when the domestic interest rate is lower than foreign interest rates? (A) Foreign investment shift domestically (B) Domestic investment shifts abroad (C) Domestic investment is unchanged (D) Foreign investment is unchanged When the real exchange rate decreases, what happens to net exports? (A) Net exports are unaffected (B) Net exports fall (C) Net exports rise (D) Net exports fall sometimes and rise other times What is the horizontal axis of the IS-LM model? (A) Interest rate (B) Growth rate (C) Exchange rate (D) Income and output What is the vertical axis of the IS-LM model?

(A) Interest rate (B) Exchange rate (C) Income and output (D) Growth rate Which market does the IS curve reflect? (A) The money market (B) The market for goods and services (C) The market for exports (D) The market for imports Which market does the LM curve reflect? (A) The market for goods and services (B) The money market (C) The market for imports (D) The markets for exports Which direction does the IS curve slope? (A) Horizontal (B) Vertical (C) Upward (D) Downward Which direction does the LM curve slope? (A) Upward (B) Downward (C) Horizontal (D) Vertical Why is the LM curve upward sloping? (A) Because higher income leads to lower money demand which leads to lower interest rates (B) Because higher income leads to higher money demand which leads to higher interest rates (C) Because lower income leads to higher money demand which leads to higher interest rates (D) Because lower income leads to lower money demand which leads to higher interest rates

Why is the IS curve downward sloping? (A) Because as the interest rate rises, investment increases, thus increasing output (B) Because as the interest rate rises, investment decreases, thus increasing output (C) Because as the interest rate falls, investment increases, thus increasing output (D) Because as the interest rate falls, investment decreases, thus increasing output What is an example of an exogenous change in the IS-LM model? (A) Changes in output (B) Changes in the money supply (C) Changes in the interest rate (D) Changes in tastes When the price level increases, which direction does the LM curve shift? (A) Inward (B) Outward (C) Upward (D) None of the above What happens when the aggregate demand curve shifts left? (A) Output increases at all price levels (B) Output decreases at all price levels (C) Input increases at all price levels (D) Input decreases at all price levels What happens when the aggregate demand curve shifts right? (A) Input increases at all price levels (B) Input decreases at all price levels (C) Output increases at all price levels (D) Output decreases at all price levels When disposable income falls, what happens to the aggregate demand curve? (A) It shifts left (B) It shifts right (C) It is inverted

(D) It does not change When happens to the aggregate demand curve when the savings rate increases? (A) It shifts left (B) It shifts right (C) It is inverted (D) It does not shift What happens to the aggregate demand curve when government spending increases? (A) It shifts left (B) It shifts right (C) It does not shift (D) It is inverted What happens to the aggregate demand curve when the real exchange rate rises? (A) It is inverted (B) It does not shift (C) It shifts left (D) It shifts right What happens to the aggregate demand curve when the marginal propensity to consume increases? (A) It is inverted (B) It does not shift (C) It shifts left (D) It shifts right What other curve is required to complete the AS-AD model? (A) Aggregate supply (B) Aggregate demand (C) IS (D) LM What information can be obtained from the AS-AD model of the economy? (A) Equilibrium in the foreign market for goods and services (B) Equilibrium in the domestic market for goods and services

(C) Changes in the domestic market for goods only (D) Changes in the foreign market for goods only