1

CHAPTER 11 -The Aggregate Expenditures Model

The aggregate expenditures or the « Keynesian cross » model was developed by J.M KEYNES in 1936 (Great Depression
context). This model explains that the amount of goods and services produced, and the level of employment depend
directly on the level of aggregate expenditures (total spending = dépenses agrégées).

Firms decide how much real output to produce in response to unexpected changes in inventory levels.
If total spending is unexpectedly low in the economy, inventories will unexpectedly rise, causing firms to cut back on
production. If total spending is unexpectedly high, inventories will unexpectedly fall, causing firms to increase
production.

1. Assumptions and simplifications

Two main assumptions:

• The aggregate expenditures model is an extreme version of a sticky price model: the price level is fixed.
• Production decisions are made in response to unexpected changes in inventory levels.

2. Consumption and investment schedules

In the private closed economy, the aggregate expenditures = consumption (C) + gross investment (Ig).
Ig show the amount of investment forthcoming at each level of GDP.
Ig is different from the investment demand curve ID, which shows how much investment firms plan to make at each
interest rate.

3. Equilibrium GDP: C + Ig = GDP

Equilibrium output: The output whose production creates total spending just sufficient to purchase that output. In
other words, the equilibrium GDP occurs when GDP = C + Ig
(the total quantity of goods produced = the total quantity of G purchased).
Otherwise, there is a disequilibrium.

4. Other features of equilibrium GDP

Two more characteristics of equilibrium GDP:

• Saving and planned investment are equal (S=Ig).
• There are no unplanned changes in inventories.

Saving equals planned investment:

Why? If the leakage of saving at certain level of GDP exceeds the injection of investment, then C + Ig will be less than
GDP and that level of GDP cannot be sustained > above-equilibrium GDP.
Conversely, if the injection of investment exceeds the leaking of saving, then C + Ig will be greater than GDP and drive
GDP upward.

To resume: At equilibrium GDP, saving equals planned investment (S=Ig) and unplanned changes in inventories are
zero.

5. Changes in equilibrium GDP and the multiplier

Multiplier = change in real GDP / initial change in spending.

The size of the multiplier depends on the size of the Marginal propensity to save (MPS) :
Multiplier = 1/MPS

Marginal propensity to save (MPS) = Propension marginale à épargner

6. Adding international trade

2
Net exports = Exports - imports

Private closed economy, the aggregate expenditures are: C + Ig

Open economy, the aggregate expenditures are: C + Ig + (X-M)
X = exports
I = imports

7. Adding the public sector

Government purchases in the model of the mixed economy shift the aggregate expenditures schedule upward and
raise GDP.

In the complete aggregate expenditures model, equilibrium occurs where C + I + (X-M) + G = GDP
G = expenditures

8. Equilibrium versus Full-Employment GDP

A recessionary expenditure gap is the amount of which the aggregate expenditures at the full-employment GDP fall
short of those needed to achieve full-employment GDP.

An inflationary expenditure gap is the amount of which the aggregate expenditures at the full-employment GDP
exceed short of those just sufficient to achieve full-employment GDP.

Keynes’s solution to recession during Great Depression: increase expenditures or lowering taxes.

HOW TO - CHAPTER 11

How to find an equilibrium level?

Method 1 : Find the level of output and employment where Investment equals Savings.
Method 2 : Find the level of output and employment where aggregate expenditures (C + Ig) equal real output.

Example (cf Courses) : Assuming the level of investment is $16 billion and independent of the level of total output,
complete the following table and determine the equilibrium levels of output and employment in this private closed
economy. What are the sizes of the MPC and MPS?

How to find saving billions? : Real Domestic Output - Consumption

Answers: Saving: $ -4; 0; 4; 8; 12; 16; 20; 24; 28; equilibrium output = 340; equilibrium employment = 65; MPC = 0.8;
MPS = 0.2

How to compute the MPC? MPC = Δ Consumption/Δ Real Domestic Output = $16/$20 = 0.8
3
How to compute Δ? Do the difference between two values. Ex: Δ Consumption = 276 – 260= 16 ; 308 – 292 = 16…

How to compute the MPS? MPS = 1 – MPC

How to find the expenditure multiplier? Expenditure multiplier = 1/MPS = 1/(1-MPC)

How to compute the change in GDP?

1. Calculate the expenditure multiplier

2. Take the expenditure multiplier and multiply this value by the change in investment
3. To find the new level of real GDP we add the change to the original level of real GDP (when investment
decreases the change is negative).

Example : Suppose that a certain country has an MPC of 0.9 and a real GDP of $400 billion. If its investment spending
decreases by $4 billion, what will be its new level of real GDP?

1. Expenditure multiplier: 1/(1-0,9) = 10

2. 10 x (-4) = -40$ à minus 4 because of the decrease
3. New level of real GDP = $400 +(-$40) = $400 – $40 = $360

How to compute a consumption after tax?

1. Calculate by how much consumption will decrease because of the tax.

2. Consumption after tax = Actual consumption – (amount of the tax * MPC)

For more exercises à Courses

CHAPTER 12 - Aggregate demand and aggregate supply

1. Define the aggregate demand (AD) —and explain how its downward slope is the result of the real-balances
effect, the interest-rate effect, and the foreign purchases effect

Aggregate demand curve shows the level of real output that the economy demands at each price level.

The aggregate demand curve slopes downward because of the real-balances effect, the interest-rate effect, and the
foreign purchases effect.

• The real-balances effects indicates that inflation reduces the real value or purchasing power of fixed-value
financial assets held by households.

4
 • The interest-rate effect means that with a specific supply of money, a higher price level increases the
demand for money, thereby raising the interest rate and reducing investment purchases.
• The foreign purchases effect suggests that an increase on one country’s price level relative to other
countries’ price levels reduces the net export component of that nation’s aggregate demand.

2. Factors that shift AD

The determinants of AD consist of spending by domestic consumers, businesses, government, foreign buyers à
changes in these groups’ spending shifts the AD curve.

3. Define aggregate supply (AS) and explain how it differs in the immediate short run, the short run, and the
long run

The aggregate supply curve shows the levels of real output that businesses will product at various possible price levels.

• The immediate-short-run AS curve assumes that both input prices and output are fixed. With output prices
fixed, the AS is a horizontal line at the current price level.

• The short-run AS curve assumes nominal wages and other input prices remain fixed while output prices vary.

• The long-run AS curve assumes that nominal wages and other input prices fully match any change in the price
level. The curve is vertical at the full-employment output level.

5
Productivity = Real GDP / Input Quantity
Per unit production cost = (price of input unit × input quantity)

4. Factors that shift AS

The determinants of AS are input prices, productivity, and the legal-institutional environment à changes in any of
these factors will change per-unit production costs at each output level and shift the AS curve.

5. Explain how AD and AS determine an economy’s equilibrium price level and real GDP

The intersection of the AD and AS curves determines an economy’s equilibrium price level and real GDP. At the
intersection, the quantity of real GDP demanded = the quantity of real GDP supplied.

6. Use the AD-AS model to explain demand-pull inflation, cost-push inflation, and recessions.

• Increases in AD beyond the full-employment level of real GDP cause demand-pull inflation.
• Decreases in AD cause recession and cyclical unemployment, partly because the price level and wages tend to
be inflexible in a downward direction.
• Decreases in AS cause cost-push inflation.
• Full employment, high economic growth, and price stability are compatible with one another if productivity-
driven increases in aggregate supply are sufficient to balance growing aggregate demand.

HOW TO CHAPTER 12

Example :
Suppose that the table presented below shows an economy’s relationship between real output and the inputs
needed to produce that output:

How to calculate a firm’s productivity?

Productivity is defined by how much output each unit of the input produces.
Productivity = Real GDP / Input Quantity

Answer : Productivity = $400/150 = 2.6667

How to compute a per unit cost ?

Suppose the price of each unit is $2.

The per unit cost is defined by how much each unit of output costs to produce. The total cost of production equals
$300 (you can use any combination above) when real GDP is $400.

Per unit cost = (price of input unit × input quantity) / real GDP

Answer : Per unit cost = ($2 × 150)/$400 = $300/$400 = $0.75

6
 CHAPTER 13 - Fiscal Policy, Deficits, and Debt

1. Fiscal policy and the AD-AS model

Fiscal Policy: refers to the deliberate manipulation of taxes and government spending by Congress to alter real
domestic output and employment, control inflation, and stimulate economic growth.

Expansionary fiscal policy is used to combat a recession. The problem during a recession is that aggregate demand is
too low, so increasing government spending and/or a reduction in taxes will increase aggregate demand. Expansionary
fiscal policy will create a deficit.

This figure shows the expansionary fiscal policy. Expansionary fiscal policy uses increases in government spending or
tax cuts to push the economy out of recession.

Contractionary Fiscal Policy: When demand-pull inflation occurs, contractionary policy is the remedy. The problem
with inflation is that aggregate demand is too high so the government will decrease government spending and/or
increase taxes to cause aggregate demand to fall. When the government uses contractionary fiscal policy, it will create
a surplus.

This figure shows the effects of contractionary fiscal policy. Contractionary fiscal policy uses decreases in government
spending, increases in taxes, or both, to reduce demand-pull inflation.

2. Built-in stability

Built-in stability arises because net taxes change with GDP (recall that taxes reduce incomes and therefore, spending).
It is desirable for spending to rise when the economy is slumping and vice versa when the economy is becoming
inflationary. Automatic stability reduces instability but does not eliminate economic instability.
- Tax revenues vary directly with GDP; income, sales, excise, and payroll taxes all increase when the economy is
expanding and all decrease when the economy is contracting.
- Transfer payments like unemployment compensation and welfare payments vary indirectly with the economic
business cycles. Unemployment compensation and welfare payments decrease during economic expansion.
Unemployment compensation and welfare payments increase during economic contractions.
- The size of automatic stability depends on the responsiveness of changes in taxes to changes in GDP: The more
progressive the tax system, the greater the economy’s built-in stability.

7
 - A progressive tax system means the average tax rate rises with GDP.
- A proportional tax system means the average tax rate remains constant as GDP rises.
- A regressive tax system means the average tax rate falls as GDP rises.
- However, tax revenues will rise with GDP under both the progressive and the proportional tax systems, and
they may rise, fall, or stay the same under a regressive tax system.

3. Current Thinking on fiscal policy

- Some economists oppose the use of fiscal policy, believing that monetary policy is more effective, or that the
economy is sufficiently self-correcting.
- Most economists support the use of fiscal policy to help “push the economy” in a desired direction, and the
use of monetary policy more for “fine tuning.”
- Economists agree that the potential impacts (positive and negative) of fiscal policy on long-term productivity
growth should be evaluated and considered in the decision-making process, along with the short-run cyclical
effects.

4. The US public debt

Debt: The national or public debt is the total accumulation of the Federal government’s total deficits and surpluses
that have occurred through time. Deficits (and by extension the debt) are the result of war financing, recessions, and
lack of political will to reduce or avoid them.

Interest charges are the main burden imposed by the debt because government always has to at least pay the interest
on their debt in order to remain in good credit standing.

Can the federal government go bankrupt? There are reasons why it cannot.
- The government can raise taxes to pay back the debt, and it can borrow more (i.e. sell new bonds) to refinance
bonds when they mature.
- The government has the power to tax, which businesses and individuals do not have when they are in debt.

CHAPTER 14 - Money, Banking, and Financial Institutions

Money is a set of assets (things of value) that people use in trading goods and services with other people.

Functions of money:
- medium of exchange – used in trading goods and services
- store of value – a way to hold purchasing power over time (imperfect with inflation)
- unit of account – measure prices and debt in monetary terms.

The demand for money

Two assets:
8
 - Money : used for transactions, no interest, 2 types of money : currency checkable / deposits.
- Bonds : pay a positive interest rate, i (the rate of interest), but cannot be used for transaction Holding these
two assets depends on : your level of transaction and the interest rate on bonds. You can hold bonds indirectly
through money market funds, or money market mutual funds.

Demand for money : (Md)

Nominal income : $Y (measure of level of transactions)
Decreasing function of the interest rate i: L(i)

Md = $Y*L(i)

An increase in the interest rate decrease the demand for money, as people put more of their wealth into bonds.

Md curve : represent the relation btw demand for money and interest rate for a given level of income $Y

For a given level of nominal income, a lower interest rate increases the demand for money.
At a given interest rate, an increase in nominal income shifts the demand for money to the right.

Banking: The industry consisting of financial intermediaries that maintain deposits (that is, the industry of banks).
Banking is one of several financial industries, with insurance and stock trading two other notable examples. Firms that
comprise the banking industry are traditional banks, savings and loan associations, credit unions, and mutual savings
banks. Banking in modern economies is generally fractional-reserve banking, with banks acting as financial
intermediaries and safekeepers of deposits.

Financial institutions: Many financial institutions play the role of a financial intermediary. That is, they help connect
borrowers and lenders of funds. We can think of the activities of a financial intermediary in terms of its balance sheet.

Banks are for example financial intermediaries that accept deposits and make loans. Banks offer several advantages
in connecting borrows and lenders. By pooling the funds of thousands of different depositors they are able to make

9
large loans beyond the means of any individual investor. In addition, because they deal in such a large volume of loans,
their costs to making a loan are smaller than for a single investor.

Banks make a variety of different kinds of loans. They lend money to businesses for capital improvement projects,
called commercial and industrial loans. They lend money to consumers for projects such as auto and college loans,
called consumer loans, and also to purchase a house, called a real estate loan, or a mortgage.

Banks make profits by the spread between the interest rate on the loan that they make and on the deposits that they
take.

CHAPTER 15 – Money creation

1. Explain the fractional reserve system used by US banks

The US has a fractional reserve banking system in which only a portion of checkable deposits are backed by reserves
of currency in vaults or deposits at the central bank.

2. Explain the basics of a bank’s balance sheet and distinguish a bank’s actual reserves and its required reserves

Balance sheet : statement of the bank’s assets and the legal claims to these assets. Every balance sheet must balance
ó assets amount = claims amount
The claims are divided into two groups : liabilities and net worth
ð Assets = liabilities + net worth
ð Reserve ratio = commercial bank’s required reserve / commercial bank’s checkable-deposit liabilities
o Defined as the specified percentage of checkable-deposit liabilities that a commercial bank must keep
as reserves.
ð Excess reserves = actual reserves – required reserves
o The amount by which a bank’s actual reserves exceed its required reserves

3. Describe how a bank creates money

• Banks create money when they make loans; money vanishes when bank loan are repaid
• New money is created when banks buy governments bonds from the public; money disappears when banks
sell government bonds to the public.
• A commercial bank can only extend loans up to the amount of its excess reserves.
• Banks balance profitability and safety in determining their mix of earning assets and highly liquid assets.
• Although the Fed pays interest on excess reserves, banks may be able to obtain higher interest rates by
temporarily lending the reserves to other banks in the federal funds market; the interest rate on such loans is
the federal funds rate.

4. Describe the multiple expansion of loans and money by the entire banking system

10
 The commercial banking system as a whole can lend by a multiple of its excess reserves because the system as a
whole cannot lose reserves. Individual banks, however, can lose reserves to other banks in the system.

5. Define and calculate the monetary multiplier

The multiplier by which the banking system can led on the basis of each dollar of excess reserves is the reciprocal
of the reserve ratio. This multiple credit expansion process is reversible.

CHAPTER 16 – Interest Rates and Monetary Policy

1. Explain how the equilibrium interest rate is determined

The total demand for money = transactions demand + asset demand

• The amount of money demanded for transactions varies directly with nominal GDP.
• The amount of money demanded as an asset varies inversely with the interest rate.
• The market for money combines the total demand for money with money supply to determine equilibrium
interest rates.
• Interest rates and bond prices are inversely related.

2. List and explain the items in the Fed’s balance sheet

The consolidated balance sheet of Federal Reserve System lists the collective assets and liabilities of the 12 Federal
Reserve banks.
• The assets consist largely of Treasury notes, Treasury bills, and Treasury bonds.
• The major liabilities are reserves of commercial banks, Treasury deposits, and Federal Reserve notes
outstanding.

The balance sheet is useful in understanding monetary policy because open-market operations increase or
decrease the Fed’s assets and liabilities.

3. Explain the goals and tools of monetary policy

The goal of monetary policy is to help the economy achieve price stability, full employment, and economic growth.

The four main instruments of monetary policy are:

• Open-market operations
• The reserve ratio
• The discount rate
• Interest on reserves

In recent years, the Fed has relied mostly on open-market operations and changes in the IOER (interest on excess
reserves) rate to manage the money supply.

4. Define the Fed’s dual mandate and explain the logic behind the Taylor rule

The Fed has a legal mandate to simultaneously pursue two goals, or targets:
• the full-employment rate of unemployment which is currently estimated to be around 4 to 5 percent of the
labor force
• the target rate of inflation which the Fed has set at 2 percent per year.

The Taylor rule suggest that, to achieve the dual mandate, the Fed’s target for the nominal interest rate should be set
at the real risk-free interest rate of 2 percent + the current rate of inflation + ½ times the inflation gap – 1.0 times
the unemployment gap.
11
The Fed is, however, under no obligation to follow up the Taylor rule as it pursues the dual mandate.

5. Explain how monetary policy affects real GDP and the price level

Monetary policy affects the economy through a complex cause-effect chain:

• Policy decisions affect commercial bank reserves
• Changes in reserves affect the money supply
• Changes in money supply alter the interest rate
• Changes in the interest rate affect investment
• Changes in investment affect aggregate demand
• Changes in aggregate demand affect real GPD and the price level

The Fed engages in a expansionary monetary policy when it increases the money supply to reduce interest rates and
increase investment spending and the real GPD.

The Fed engages in a restrictive monetary policy when it reduces the money supply to increase interest rates and
reduce investment spending and inflation.

6. Explain the advantages and shortcomings of monetary policy

The advantages of monetary policy include its flexibility (the absence of an administrative lag) and political
acceptability.

In recent years, the Fed has used monetary policy to help stabilize the banking sector in the wake of the mortgage
debt crisis and to promote recovery from the Great Recession of 2007-2009. The Fed implemented the zero-interest
rate policy and quantitative easing. Today, nearly all economists view monetary policy as a significant stabilization
tool.

Monetary policy has two major limitations and potential problems:

• The recognition and operational lags complicate the timing of monetary policy
• In a severe recession, the reluctance of banks to lend excess reserves and of firms and households to borrow
may contribute to a liquidity trap that limits the effectiveness of an expansionary monetary policy.

7. Describe how the various components of macroeconomic theory and stabilization policy fit together

12
Input prices, productivity, and the legal-institutional environment determine an economy’s aggregate supply of final
goods and services.

The aggregate demand for final goods and services is determined by the factors that influence consumption spending,
investment expenditures, net export spending, and government expenditures.

CHAPTER 17 – FINANCIAL ECONOMICS

1. Distinguish between economic investment and financial investment

Financial investment refers to either buying or building an asset with the expectation of financial gain.

2. Explain the time value of money and calculate the present value of money

The compound-interest formula :

𝑋𝑡 = (1 + 𝑖)! 𝑋𝑜

The compound-interest formula states that if Xo dollars are invested today at interest rate I and allowed to grow for t
years, the original investment will become : Xt=(1+i)^t Xo in t years.

The present value formula :

𝑋𝑡
= 𝑋𝑜
(1 + 𝑖 )!

This formula rearranges the compound-interest formula. It tells investors the current number of dollars that they have
to invest today to receive Xt dollars in t years.

3. Distinguish among the most common financial investments: stocks, bonds, and mutual funds

- Stocks give shareholders the right to share in any future profits that corporations may generate.
- Bonds provide bondholders with the right to receive a fixed stream of future payments that serve to repay a
loan.
- Mutual funds own and manage portfolios of bonds and stocks

4. Explain how percentage rates of return provide a common framework for comparing assets

Investors estimate a risky investment’s proper current value using average expected rates of return. Average expected
rates of return are inversely related to an asset’s current price.

Rate of return on investment = (Current value – Original value) / Original value

5. Define arbitrage

Arbitrage is the term that financial economists use for the buying and selling process that leads profit-seeking investors
to equalize the average expected rates of return generated by identical or nearly identical assets.

6. Define risk and distinguish between diversifiable and non-diversifiable risk

An asset is risky if its future payments are uncertain. Risks that can be canceled out by diversification are called
diversifiable risks. Risks that cannot be canceled out by diversification are called non-diversifiable risks.

7. Explain the factors that determine investment decisions

13
The average expected rate of return is the probability-weighted average of an investment’s possible future returns.

The average expected rate of return formula is computed by multiplying each of its possible future rates of return by
its probability of happening.

Example : An investment has a 50 percent chance of generating a 10 percent return and a 50 percent chance of
generating a 16 percent return. What is the investment’s average expected rate of return?

Answer : 50 × 10 percent rate of return + 0.50 × 16 percent rate of return = 5 percent rate of return + 8 percent rate
of return = 13 percent rate of return. So the average expected rate of return will be 13 percent.

Beta measures the non-diversifiable risk of an investment relative to the amount of non-diversifiable risk facing the
market portfolio, which has a beta equal to 1.0.
Beta is used to compare various assets. For instance, an asset with beta = 2.0 has four times more exposure to non-
diversifiable risk than an asset with beta = 0.5.

8. Explain why arbitrage will tend to move all investments onto the security Market line

The Security Market Line (SML) is a straight upsloping line showing how the average expected rates of return on assets
and portfolios in the economy vary with their respective levels of non-diversifiable risk as measured by beta.

The slope of the SML reflects the investors’ dislike for non-diversifiable risk.

CHAPTER 18 – EXTENDING THE ANALYSIS OF AGGREGATE SUPPLY

1. Explain the relationship between short-run aggregate supply and long-run aggregate supply

The short-run AS curve slopes upward because nominal wages and other input prices are fixed while output prices
change.

The long-run AS curve is vertical because input prices eventually rises in response to changes in output prices.

The long-run equilibrium GDP and price level occur at the intersection of the AD curve, the long-run AS curve, the
short-run AS curve. In long-run equilibrium, the economy achieves its natural rate of unemployment and its full-
potential real output.

2. Apply the extended (short-run/long-run) AD-AS model to inflation, recessions, and economic growth

In the short run, demand-pull inflation raises both the price level and real output. In the long run, nominal wages rise,
the sort-run aggregate supply curve shifts to the left, and only the price level increases.

Cost-push inflation creates a policy dilemma for the government: if it engages in an expansionary policy to increase
output, additional inflation will occur; if It does nothing, the recession will linger until input prices have fallen by
enough to return the economy to producing at potential output.

In the short run, a decline in AD reduces real output. In the long run, if input and output prices are downwardly flexible,
input prices will fall, the short-run AS curve will shift to the right, and real output will return to its full-employment
level.

The economy has ongoing inflation because the Fed uses monetary policy to shift the AD curve to the right faster than
the supply factors of economic growth shift the long-run AS curve to the right.

3. The inflation-unemployment relationship

14
The Phillips curve (1960’s) suggests there is an inverse relationship between inflation and unemployment. The
theory claims that with economic growth comes inflation, which in turn should lead to more jobs and less
unemployment. However, the original concept has been disproven empirically due to the occurrence of stagflation in
the 1970’s (high levels of both inflation and unemployment).

4. Explain why there is no long-run trade-off between inflation and unemployment

There is no long-run trade-off between inflation and unemployment because workers adapt their expectations to
new inflation realities, and when they do, the unemployment returns to the natural rate.

5. Explain the relationship among tax rates, tax revenues and AS

The Laffer curve relates tax rates to levels of tax revenue and suggests that under some circumstances, cuts in tax
rates will expand the tax base and increase tax revenues.

Bonus :
Rate of inflation :

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐶𝑃𝐼 − 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐶𝑃𝐼

𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒 =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐶𝑃𝐼
CPI : consumer price index

CHAPTER 20 – INTERNATIONAL TRADE

1. Several key facts about international trade

- The USA leads the world in the combined volume of exports and imports. Exports : chemicals, agricultural
products, consumer durables… ; imports : petroleum, automobiles, metals…
- Other major trading nations are Germany, Japan; the western European nations and the Asian economies.

2. Define comparative advantage and explain how specialization and trade add to a nation’s output

Mutually advantageous specialization and trade are possible between any two nations if they have different domestic
opportunity-cost ratios for any two products. By specializing on the basis of comparative advantage, nations can obtain
larger real incomes with fixed amounts of resources.

3. Explain why differences between world prices and domestic prices lead to exports and imports

- A nation will export a particular product if the world price exceeds the domestic price; it will import the
product if the world price is less than the domestic price.
- In a two-country world model, equilibrium world prices and equilibrium quantities of exports and imports
occur where one nation’s export supply curve intersects the other nation’s import demand curve.

4. Analyze the economic effects of tariffs and quotas

Trade barriers take the form of protective tariffs, quotas, nontariff barriers, and voluntary export restrictions. But
those tariffs and quotas increase the prices and reduce the quantities demanded of the affected goods.

5. Critique the most frequently presented arguments for protectionism

Arguments for protection:

- Infant industry (cf Friedrich List)
- Military self-sufficiency
15
 - Dumping
- Employment

6. Objectives of the WTO, EU, NAFTA and trade adjustment assistance

- The General Agreement on Tariffs and trade (GATT) of 1947 reduced tariffs and quotas and established a
process for numerous subsequent rounds of multinational trade negotiations.

- The World Trade Organization (WTO)- GATT’s current successor – rules on trade disputes.

- The European Union and the North American Free Trade Agreement (NAFTA) established multinational free-
trade zones.

- The offshoring of jobs has prompted programs like trade adjustment assistance to help displaced workers
transition to new jobs.

CHAPTER 21 - The balance of payments, exchange rates, and trade deficits

1. Explain the two types of international financial transactions

International financial transactions involve trade either in currently produced goods and services or assets.
- Imports cause outflows of money
- Exports of goods, services and assets create inflows of money

2. Define and explain the two components of the balance of payments: the current account and the capital
and financial account

The balance of payments records all international trade and financial transactions taking place between a given nation
and the rest of the world.

- The current account balance: (a nation’s exports of goods and services – imports of goods and services) + net
investment income + net transfers
- The capital and financial account balance: the net amount of the nation’s debt forgiveness + the nation’s sale
of real and financial assets – purchases of real and financial assets from foreigners
The current account balance and the capital and financial account balance always sum to zero.

3. Explain how exchange rates are determined

Flexible or floating rates between international currencies are determined by the demand for and supply of those
currencies. Under flexible rates, a currency will depreciate or appreciate as a result of changes in tastes, real interest,
speculation… à uncertainty.

4. Distinguish between flexible and fixed exchange rates

To circumvent the disadvantages if flexible exchange rates, at times nations have fixed or “pegged” their exchange
rates.

Under a system of fixed exchange rates, nations set their exchange rates and then maintain them by buying or selling
official reserves of currencies, establish trade barriers, employing exchange controls, or incurring inflation or recession.

5. Explain the current system of managed floating exchange rates

16
The managed floating system of exchange rates (1971- present) relies on foreign exchange markets to establish
equilibrium exchange rates. Under a managed float, market forces generally set rates, although governments
intervene with varying frequency to alter their exchange rates.

6. Identify the causes and consequences of recent U.S trade deficits

Between 1197 and 2007, the United Stades had large and rising trade deficits. Why ?
- More rapid income growth. In the US than in Jpaan and some European nations, resulting in expanding U.S
imports relative to exports
- The emergence of a large trade deficit with China
- Large surplus in the capital and financial account : Americans reduced their saving and bought more imports.

17